Notes

 Internal or domestic trade are meant transactions taking place

within the geographical boundaries of a nation or region. It is also
known as intra-regional or home trade

 International trade, on the other hand, is trade among different

countries or trade across political frontiers.

 International trade, thus, refers to the exchange of goods and

services between one country or region and another

 trade between one nation and another is called “international”

trade, and trade within the territory (political boundary) of a nation
“internal” trade.

Reasons why International Trade takes Place

1.Human wants and countries’ resources do not totally coincide. Hence,
there tends to be interdependence on a large scale.

2. Factor endowments in different countries differ.

3. Technological advancement of different countries differs. Thus, some

countries are better placed in one kind of production and some others
superior in some other kind of production.

4. Labour and entrepreneurial skills differ in different countries.

5. Factors of production are highly immobile between countries

Salient Features of International Trade

(1) Immobility of Factors:
The degree of immobility of factors like labour and capital is generally
greater between countries than within a country. Immigration laws,
citizenship, qualifications, etc. often restrict the international mobility of
labour.

the economic significance of such mobility of factors tends to equality

within but not between countries. For instance, wages may be equal in
Mumbai and Pune but not in Bombay and London.

In one country and the price obtained in a different country for it. For
instance, the price of tea in India must, in the long run, be equal to its
cost of production in India. But in the U.K., the price of Indian tea may
be permanently higher than its cost of production in India. In this way,
international trade differs from home trade.

(2) Heterogeneous Markets:
In the international economy, world markets lack homogeneity on
account of differences in climate, language, preferences, habit, customs,
weights and measures, etc. The behaviour of international buyers in each
case would, therefore, be different.

(3) Different National Groups:

International trade takes place between differently cohered groups. The
socio-economic environment differs greatly among different nations.

(4) Different Political Units:

International trade is a phenomenon which occurs amongst different
political units.
(5) Different National Policies and Government Intervention:
Economic and political policies differ from one country to another.
Policies pertaining to trade, commerce, export and import, taxation,
etc., also differ widely among countries though they are more or less
uniform within the country. Tariff policy, import quota system, subsidies
and other controls adopted by governments interfere with the course of
normal trade between one country and another.

(6) Different Currencies:
Another notable feature of international trade is that it involves the use
of different types of currencies. So, each country has its own policy in
regard to exchange rates and foreign exchange.
Differences between Internal Trade and International Trade

1. Specific Terms:
Exports and Imports. Internal trade is the exchange of domestic output
within the political boundaries of a nation, while international trade is
the trade between two or more nations. Thus, unlike internal trade, the
terms “export” and “import” are used in foreign trade. To export means
to sell goods to a foreign country. To import goods means to buy goods
from a foreign country.

2. Heterogeneous Group:
An obvious difference between home trade and foreign trade is that trade
within a country is trade among the same group of people, whereas trade
between countries takes place between differently cohered groups. The
socio-economic environment differs greatly between nations, while it is
more or less uniform within a country. Frederick List, therefore, put that:
“Domestic trade is among us, international trade is between us and
them.”

3. Political Differences:
International trade occurs between different political units, while
domestic trade occurs within the same political unit. The government in
each country is keen about the welfare of its own nationals against that
of the people of other countries. Hence, in international trade policy,
each government tries to see its own interest at the cost of the other
country.

4. Different Rules:
National rules, laws and policies relating to trade, commerce, industry,
taxation, etc. are more or less uniform within a country, but differ widely
between countries.

Tariff policy, import quota system, subsidies and other controls adopted
by a government interfere with the course of normal trade between it
and other countries. Thus, state interference causes different problems
in international trade while the value of theory, in its pure form, which is
laissez faire, cannot be applied in toto to the international trade theory.

5. Different Currencies:
Perhaps the principal difference between domestic and international
trade is that the latter involves the use of different types of currencies
and each country follows different foreign exchange policies. That is why
there is the problem of exchange rates and foreign exchange. Thus, one
has to study not only the factors which determine the value of each
country’s monetary unit, but also the divergent practices and types of
exchange resorted to.

6. Heterogeneous World Markets:

In a way, home trade has a homogeneous market. In foreign trade,
however, the world markets lack homogeneity on account of differences
in climate, language, preferences, habits, customs, weights and measures
etc.

The behaviour of international buyers in each case would, therefore, be

different. For instance, Indians have right-hand drive cars, while
Americans have left-hand driven cars. Hence, the markets for
automobiles are effectively separated. Thus, one peculiarity of
international trade is that it involves heterogeneous national markets.

7. Factor Immobility:
Another major difference between internal and international trade is the
degree of immobility of factors of production like labour and capital
which is generally greater between countries than within the country.
Immigration laws, citizenship qualifications, etc., often restrict
international mobility of labour. International capital flows are prohibited
or severely limited by different governments.

Advantages of International Trade

(1) Optimum Allocation:
International specialisation and geographical division of labour leads to
the optimum allocation of world’s resources, making it possible to make
the most efficient use of them.

(2) Gains of Specialisation:
Each trading country gains when the total output increases as a result of
division of labour and specialisation. These gains are in the form of more
aggregate production, larger number of varieties and greater diversity of
qualities of goods that become available for consumption in each country
as a result of international trade.

(3) Enhanced Wealth:
Increase in the exchangeable value of possessions, means of enjoyment
and wealth of each trading country.

(4) Larger Output:
Enlargement of world’s aggregate output.

(5) Welfare Contour:
Increase in the world’s prosperity and economic welfare of each trading
nation.

(6) Cultural Values:
Cultural exchange and ties among different countries develop when they
enter into mutual trading.

(7) Better International Politics:

International trade relations help in harmonising international political
relations.

(8) Dealing with Scarcity:

A country can easily solve its problem of scarcity of raw materials or food
through imports.

(9) Advantageous Competition:
Competition from foreign goods in the domestic market tends to induce
home producers to become more efficient to improve and maintain the
quality of their products.

(10) Larger size of Market:

Because of foreign trade, when a country’s size of market expands,
domestic producers can operate on a larger scale of production which
results in further economies of scale and thus can promote development.
Synchronised application of investment to many industries simultaneously
become possible. This helps industrialisation of the country along with
balanced growth.
Disadvantages of International Trade

1. Exhaustion of Resources:
When a country has larger and continuous exports, her essential raw
materials and minerals may get exhausted, unless new resources are
tapped or developed (e.g., the near-exhausting oil resources of the oil-
producing countries).

2. Blow to Infant Industry:

Foreign competition may adversely affect new and developing infant
industries at home.

3. Dumping:
Dumping tactics resorted to by advanced countries may harm the
development of poor countries.

4. Diversification of Savings:
A high propensity to import may cause reduction in the domestic savings
of a country. This may adversely affect her rate of capital formation and
the process of growth.

5. Declining Domestic Employment:

Under foreign trade, when a country tends to specialize in a few
products, job opportunities available to people are curtailed.

6. Over Interdependence:
Foreign trade discourages self-sufficiency and self-reliance in an
economy. When countries tend to be interdependent, their economic
independence is jeopardised. For instance, for these reasons, there is no
free trade in the world. Each country puts some restrictions on its foreign
trade under its commercial and political policies.
Absolute Advantage Theory

Absolute advantage theory was proposed by Scottish social scientist Adam

smith in 1776. This theory says that countries should focus on producing
such products that they can produce efficiently at a lower cost as
compared to other countries. Manufacturing a product in which a
particular country specializes is quite advantageous for them. Countries
should produce and export such products which can produce efficiently
and import those goods that they produce relatively less efficiently. This
kind of trade will be beneficial for both countries.

Comparative Advantage Theory

David Ricardo in 1817 has given the comparative advantage theory.

According to this theory, If a country cannot produce goods more
efficiently than other countries then it should only produce such goods in
which it is most efficient. Countries should specialize and export such
products in which it has a less absolute disadvantage as compared to
other products. 

Heckscher-Ohlin Theory

Heckscher-Ohlin theory of international trade was given by Eli Heckscher

and Bertil Ohlin. It is also called as factors proportions theory and states
that the country will produce and export those products whose
production require those factory which are in great supply in-country and
have low manufacturing cost. Whereas it will import all such goods whose
production requires nation’s scarce and expensive factors and have high
demand. According to this theory, trade patterns are recognized by
factor endowment rather than productivity. The cost of any factor or
resource is simply the function of demand and supply.

Mercantilism Theory

It is one of the oldest international trade theory which was developed in

1630. Mercantilism theory states that nation’s wealth is determined by its
gold and silver holdings. Every nation in order to increase its economic
strength should increase it’s gold and silver accumulation. It says that
nations should favor export which leads to inflow of gold whereas they
should disfavor import which lead to the outflow of gold. Mercantilism
theory focuses on creating a trade surplus that is more exports than
imports which will contribute to the accumulation of the nation’s wealth.

Product Life Cycle Theory

Product life cycle theory was developed in 1970 by Raymond Vernon, a

Harvard Business School professor. It says that initially new products will
be produced and exported from the home country of its innovation. Later
on, when demand for the product grows country will undertake foreign
direct investment in other countries and open several manufacturing
plants to meet the request. Both locations of production and sales of
product changes along with its life cycle or as product get matured.

National Competitive Advantage Theory

It was developed in 1990 by Harvard business school professor, Michael

porter. This theory state that national competitiveness in a particular
industry will depend upon the environment that such industry is getting in
the home country. The main source of innovation and up-gradation for
such industry is basically the environment in which they operate which
helps countries in getting a national competitive advantage. Porter
determined four factors as determinants of national competitive
advantage of the nation. Local market resources and capabilities, Local
market demand, Local suppliers and complementary industries and
characteristics of local firms. 

What is terms of trade ? 

The notion of terms of trade refers to the terms or rates at which the
products of one country are exchanged for the products of other country.
In other words, it’s defined as the ratio of export prices to import prices.
It is known to all that every country has its own currency & all the
currencies are different with each other. The currency of one country has
not legal tender in other countries. So every country has to export goods
in order to import the domestically demanded goods.
 For example, if Pakistan’s wants to import Indian wheat, then he has to
export cotton to India. If Pakistan’s demand for Indian wheat is more
intense than India’s demand for Pakistani cotton, then the terms of trade
will be more favorable to India than Pakistan. Similarly, if India’s demand
for Pakistani cotton is more elastic, then the terms of trade will favor
India than Pakistan.

What are the factors affecting terms of trade? 

1. Demand Elasticity
2. Elasticity of Supply
3. Nature of Goods
4. Economic Growth
5. Rate of Exchange
6. Trade Restrictions
7. Change in Factor Endowment
8. Change in Technology
9. Population Factor
10. Size of the Country

1.DEMAND ELASTICITY

The elasticity of demand severely affects a country’s terms of trade. If a

country’s demand for imports is more intense or less elastic, then the
terms of trade will dis-favor that country. Similarly, if a
country’s  elasticity of  for  imports is less intense or more elastic, then
the former gains some bargaining power &it leads to the improvement in
the terms of trade of that country.

2. ELASTICITY OF SUPPLY

Like the elasticity of demand, supply elasticity also affects the terms of
trade. When a country’s supply elasticity increases than its demand, it
will positively affect the international terms of trade. When a country
cannot reduce its supply, it de-possesses the power of bargaining & the
said country’s terms of trade start deteriorating.

3. NATURE OF GOODS
When a country exports primary products &imports industrialized
products, its terms of trade gets worsened. It is because the home
country cannot complete or bargain with the industrialized countries. The
prices of the primary products  not increases as much as the prices of
industrialized product’s prices. Similarly, if a country exports
industrialized products, its chances of improving terms of trade will
increase.

4. ECONOMIC GROWTH

In the process of economic growth, country’s imports increases drastically

due to increase in the purchasing power of the people of that country.
Due to this, consumption on importable goods increases & at the same
time, exports couldn’t be matched with the high imports. This leads to
the deterioration of terms of trade of that country.

In the other hand, as economic growth gathers momentum, the cost of

production of that country decreases significantly. It leads to the fall in
the price level of exportable goods, but at the same time, import prices
remains constant. This leads to export more quantities of goods to get
the same previous quantity of imports. So economic growth negativity
impacts the terms of trade.

Conversely,  if the growth arises in the importable goods industries, then

the imports of home country starts decreasing as home country now
started producing the same good domestically. In this scenario, home
country’s terms of trade improves.

5. RATE OF EXCHANGE

The international exchange rates also affects the terms of trade. When a
country’s currency appreciates, it leads to exports costlier & imports
cheaper. So appreciation of currency leads to the improvement in terms
of trade. Like wise, when a country’s currency depreciates due to
devaluation or depreciation, its imports gets costlier & exports becomes
cheaper. In this case, we have to give more export goods to get the same
previous quantity of imports. So devaluation leads to the deterioration of
terms of trade.
We can understand this concept by a mere example. Suppose the initial
exchange rate is fixed between India & USA as 1 dollar=100 rupees.
Suppose there is 1 commodity called leather bags & each bag costs
around 50 rupees. So India gets 1 dollar by selling 2 bag in USA. Now If
the Indian currency devaluates & the new exchange rate fixed as 1
dollar= 150 rupees, then to get the same Value, i.e., 1 dollar, we have to
sell 3 bags to the USA. It leads to our exports cheaper & consequently it
badly impacts the terms of trade

Similarly, if the Indian currency appreciates & new exchange rates fixed
as 1 dollar=50 rupees, then to get same 1 dollar, now we have to provide
only 1 leather bag to the USA. Here, our export prices increases &
imports gets cheaper & we can reap the benefit from international trade
& consequently our terms of trade will improve.

6. TRADE RESTRICTIONS

Due to various trade restrictions like tariffs, quotas, etc., the terms of
trade improves for the restriction imposing country. When a country
imposes restrictions, it means the country wants to reduce the imports.
When imports reduces, it automatically leads to the promotion of export
& generation of foreign exchange. So restrictions improve the terms of
trade.

7. CHANGE IN FACTOR ENDOWMENT

Normally, a labour abundant country produces labour intensive products

& exports it and imports capital intensive product from the capital
abundant country.

So, if the factor endowment changes, means due to some reasons, the
labour abundant country now produces capital intensive goods through
the movement of capital from one nation to others or due to the
economic growth, the labour abundant country can now bargain with
capital abundant country & reap the trade profit from international
trade. It will definitely improve the terms of trade of that country in
which the factor endowment changes.

8. CHANGE IN TECHNOLOGY
Technological improvements continues in the modern world. But its
impact on terms of trade may not always beneficial. If the technical
progress arises in the home country’s importable goods industry, then it
improves the terms of trade. On the other hand, if technical progress
arises in the home country’s exportable goods industry, then it
deteriorates the terms of trade.

Suppose, technical progress takes place in the importable goods industry.

By this, the cost of production may reduced or the factor’s productivity
may increased. In both the cases, the prices of importable goods
decreases in the home country. This leads to the lesser quantity of
imports from foreign country to satisfy the domestic demand & the terms
of trade gets improved.

Similarly, suppose the technical progress takes place in the home

country’s exportable industry. Due to this, the cost of production may be
reduced or the output per input may be increased. In both the scenarios,
the price of goods in the export industry falls. The fall in the price level
brings exports cheaper than the imports. So technical progress in export
industry leads to the deterioration of terms of trade of the home country.

9. POPULATION FACTOR

The over populated countries always creates problem in the betterment

of terms of trade. A huge population leads to huge consumption demand
which cannot be satisfied by the domestic supply of goods and services.
Even to provide basic amenities to the people, a country is forced to
import. Huge imports leads to the deterioration of terms of trade.

10. SIZE OF THE COUNTRY

The size of the country also affects the terms of trade. Always small
country gets benefit from the international trade more than the bigger
sized countries. As the size of the country is big, it leads to the
specialization & division of labour which leads to higher productivity and
lower cost. The prices of the goods produced by the big countries are
very low. So it exports goods at a cheaper rate.

Likewise, a small country always faces the problem of scarce resources,

better & skilled manpower, better technology etc. Due to the lack of all
these facilities, its product’s prices increases. So a small country always
exports goods at a higher rate. When international trade takes place in
between a large country & a small country, the larger country exports
goods at a cheaper rate & imports at a higher rate which deteriorates her
terms of trade. Similarly, the small country exports goods at a higher rate
& imports goods at a cheaper rate from the larger country. Due to this,
small country always gets benefitted & improves its terms of trade.

TOT Example

Developing countries experienced increases in their terms of trade during

the commodity price boom in the early 2000s. They could buy more
consumer goods from other countries when selling a certain quantity
of commodities, such as oil and copper.

In the past two decades, however, a rise in globalization has reduced the

price of manufactured goods. Industrialized countries' advantage over
developing countries is becoming less significant.

How Do You Calculate a Country's Terms of Trade?

Terms of trade for a country can be calculated by dividing its price index
of exports by its price index of imports. This ratio is then multiplied by
100:

TOT = Pexports/Pimports x 100

What Does a Rising Terms of Trade Indicate?

An increasing TOT ratio indicates that a country is exporting relatively

more goods than it is importing. Over time, this can lead to a trade
surplus. The opposite would be true if TOT were decreasing.

How Can Terms of Trade Be Improved?

A rise in the domestic currency's exchange rate should improve terms of

trade, as this makes imports relatively less expensive while boosting the
prices of exports. Increasing the competitiveness of firms will also tend
to boost TOT as they can compete better internationally. Inflation can
also have a short-term benefit to TOT.
Types of Terms of Trade
1 – Net Barter

It is calculated as the percentage ratio of the export unit value indexes

to the import unit value indexes, measured relative to the base year
2000.

Also, referred to as commodity terms of trade, it was coined to better

understand the overall view of the changes in a country’s trading.

#2 – Gross Barter

It is a ratio of total physical quantities of imports to the total physical

quantities of a given country’s exports. It is measured by
 TG = (QM/QX) × 100 where TG is Gross Barter TOT,

 QM is Aggregate Quantity of Imports and

 QX is the Aggregate Quantity of Exports.

A higher  TG can indicate that the country can import more units from
abroad for the given units of exports. In our example from earlier, we
easily see that Country A has a higher TG, relative to Country B as it can
import more units.

#3 – Income TOT

It is the purchasing power, in terms of (described as) the price of

imports, calculated as Pm, of the value (price times quantity) of a
country’s exports: ITT = PxQx/Pm.

ITT can increase through an increase in export prices, a rise in the

number of exports, and a decrease in imports’ prices. Overall, it is used
as one of the measurements of the capacity to import.

#4 – Single Factorial TOT

It is found by multiplying the net barter with the productivity index in the
domestic export sector. This is essentially the net barter terms of trade
corrected for changes in the productivity of export goods.

#5 – Double Factorial TOT

This expresses the change in the productivity of both the domestic export
industry and the export industries of the foreign countries selected.

It is found by TD = TC (ZX/ZM)

where

 TD is the Double Factorial TOT,

 TC is the Commodity TOT,
 ZX is the productivity index in the domestic export sector,
 ZM is the productivity index in the foreign countries’ export sector, or it is
an import productivity index.
 #6 – Real Cost TOT

It is the theory that states that an increase in export production drives

resources away from other sectors of the economy to the export sector.

For example, if farm workers are being used to produce wheat to export
to other countries, resources like the labor, extraction, processing,
shipping personnel etc. are being pulled from the production to suffice
wheat production. Those workers could also theoretically be used for
community farming or processing other grains needed for domestic
consumption.

The amount of resources allocated elsewhere or “utility” cost (also

described as “sacrifices”) per unit of resources employed in the
production of export goods is considered to be the real cost terms of
trade. Therefore, it accounts for the opportunity cost of exporting a
good into the overall picture of exports production.
It is calculated by Tr = Ts. Rx

Where,

 TR = Real Cost TOT

 RX = index of the amount of disutility suffered per unit of the resources
utlilized in the production of exports goods.

Also explained as when the single factorial terms of trade are multiplied
by an index of the relative average utility per unit of imported
commodities.

#7 – Utility TOT

This measures the changes in the disutility of producing a unit of

exports. It also measures the changes in the satisfactions arising imports
and the indigenous products wasted to produce those exports. It is
essentially the changes in the real cost tot in terms of the utilities
wasted.

It is found by multiplying the real cost terms of trade with an index of the
relative average utility of imports and domestic commodities wasted.
Exchange Rate
The rate at which the currency is exchanged for another currency is known
as an exchange currency. In other words, the value of other country’s
currency when compared with our own is the exchange rate. This is mostly
useful while traveling. Because you require ‘local currency’ for purchasing
and other activities. Learn Types of Exchange Rate here.

An exchange rate is a right way through which an authority manages their

own currency with respect to other currencies. Thus, it is like the price
that you pay for an asset. Here, the only difference is the price that you
use to buy that currency.

Also, exchange currency is very closely related to monetary policies.

Furthermore, these two are closely related to each other on many factors.

The basic type of exchange rate is called a floating exchange rate. In this,
the movements in the currency are dictated by the market. Also, there is
pegged currency, where the central bank keeps the rate from
differentiating too much.

There is a third one which is known as the fixed exchange rate. This type of
currency is tied up with other currencies and is mostly used for euro or US
dollar and another bunch of currencies.

Types of Exchange Rate

Fixed Exchange Rate

The rates that are directly convertible towards other currencies are called
fixed rate. Also, in case of a different currency, there is a currency board
arrangement where it is backed by the domestic currency against one to
one foreign reserves.

The countries falling under this have abandoned their own currency in favor
of other country’s currency. Also, they have very small bands which are
less than 1%.
Floating Exchange Rate

The most common regime today that is adopted in most countries are
floating exchange rates. Mostly used yen, dollar, Euro, and British pound
are the different types of currencies that fall under this category.

Also, in this case, central banks of the respective countries intervene

frequently in order to avoid deprecation or appreciation. These regimes are
many times managed float or dirty float.

Pegged float – These types of currencies are pegged against some value or
bands. They are adjusted either periodically or fixed. Pegged floats are
also considered as crawling bands.

Crawling band is the rate at which it is allowable to fluctuate around a

central value in a band. Also, this is adjusted periodically. So, it is done in
a controlled way or at a preannounced rate. Both of these follow certain
economic indicators.

Crawling pegs are the rate that is in itself fixed. It is adjusted as mentioned
above. When the rates are pegged at horizontal bands than the band is
allowed to fluctuate bigger than 1% although in a fixed rate. This
fluctuation happens around the central rate.

Dollarization

Dollarization is a term used when the citizens of a country use foreign

currency in relation to their own currency. This term is not only correlated
to US dollars. It is used generally when one uses foreign currency as a
national currency. One of the best examples of this is Zimbabwe.