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INTERNATIONAL ECONOMICS I
CHAPTER ONE: INTRODUCTION

1.1. Meaning, Nature, and Scope of International Economics
1We live in a world that is highly interconnected by a bewildering array of complex economic
transactions, social and environmental problems, and international political collaborations and
conflicts. Examples from global economics are found in the news everyday. A decision by
American policymakers to subsidize the production of ethanol, a form of gasoline containing an
additive produced from corn, is seen by many as a key reason that grain prices are high around the
world. The spectacular emergence of China as a major exporter of manufactured goods has affected
wages in both rich and poor countries. As large corporations, such as Microsoft, Intel, Toyota,
General Electric, and Siemens have expanded their investments in affiliates in many nations around
the world, they have built global production networks that share technological knowledge across
locations to produce increasingly complex goods that could be sold anywhere. Today, a major
cultural product, such as a Hollywood movie or a jazz band’s latest compact disk, is likely to employ
creative personnel from around the world, with various components of the product recorded, mixed
or edited in different locations.
The importance of international connections in trade, investment, and skilled services can be
illustrated by considering the apparently simple act of making and bringing to market an item of
apparel, say a fashionable woolen men’s suit. The initial task is to design the suit, a highly creative
activity that generally takes place in the headquarters of a major fashion label, such as Armani or
Hugo Boss. Beyond that, the firm must locate reliable suppliers of raw wool, which could be
farmers in New Zealand, Argentina, Scotland, or elsewhere. The wool needs to be spun into yarn
and then woven into finished fabrics, tasks that are likely to be done in low-wage economies with
abundant labor, such as Vietnam or Bangladesh, both major centers of fabric manufacture. The
fabrics then are shipped to locations where they are combined with such other materials as buttons
and zippers into high-quality sewn garments. These locations are most likely to be in somewhat
higher-productivity economies, such as China, Malaysia or Mexico and the firms involved typically
work as independent sub-contractors to many retailers rather than affiliates of one. The garments are
then shipped to brand-name apparel companies, who sell them to high-end department stores and
specialty retailers, and to generic trading companies that may ultimately sell them in discount or
outlet stores.
To international economists, globalization occurs when the markets of different countries

become more integrated and interconnected through economic transactions that cross
national borders. These transactions can be in real merchandise, various forms of services,
financial instruments, investments in local production facilities by multinational firms (a
process called foreign direct investment, or FDI), temporary and permanent labor migration,
and technological information. They can involve individuals, trade between unrelated firms,
transactions within international enterprises, and governments. Economists generally focus
on the sources of globalization, the channels through which transactions occur, and the
effects such integration seems to have on national economies.
Countries have chosen to become more integrated through successively reducing their restrictions on
international trade in goods and services and barriers to foreign investment. Beginning in the late
1940s, a small number of richer countries began jointly to bring down their taxes on imports, called
tariffs, through negotiation and renegotiations of a treaty called the General Agreement on Tariffs
and Trade (GATT). This process continued through nearly five decades until 1994 when the current
World Trade Organization (WTO) was founded. Currently the WTO membership comprises nearly
1 Markusen & Maskus, (2011. p 1…)

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HARAMAYA UNIVERSITY JANUARY 2022
every country in the world and each member must commit to limits on its tariffs while engaging in
periodic negotiations to reduce trade restrictions. The GATT and WTO also were instrumental in
liberalizing various quantitative barriers to trade, such as import quotas and favoritism in
government procurement programs. A second important factor is the remarkable reduction in certain
transportation costs in international commerce since the 1950s. There are many costs involved in
getting products from a factory in one country to customers in another. There are the within-
exporter surface transportation costs by railroad or truck to ocean port facilities or airports. These
costs have fallen considerably in countries that invested in roads and other transport infrastructure.
Similarly, the efficiency of the transit ports, whether by sea or air, matters considerably for shipping
costs. The increasing use of large containers for shipping massive quantities packed tightly has
increased this efficiency and encouraged more trade by ocean vessel. Similarly, the powerful jet
engines on today’s large cargo jets make it capable to ship considerable quantities of goods through
the air, especially those products where rapid delivery is crucial. The third one is the important
technological improvements also arrive from sources far beyond telecommunications and software.
Companies continually invest in research and development (R&D) to improve the quality of their
products and make them more distinctive. Just as consumers like to choose from a greater range of
products made within their home economies, they enjoy more variety from international product
differentiation and quality improvements.
Falling trade barriers and increasing access to new forms of technology have expanded the
possibilities for international transactions of all kinds. International trade in goods and
services, portfolio capital flows, foreign direct investment, contracts for technology and
labor migration are the fundamental means by which citizens and firms of different nations
interact with each other economically. They are, therefore, the basic conduits through which
integration of markets ties countries more closely together.
This major expansion in the exposure of economies to international transactions is highly

controversial precisely because it has substantial impacts on both the well-being of countries and the
welfare of individuals within nations. It also fundamentally alters the ways in which societies use
resources and make decisions. Economists profess almost universal support for free trade, or the
complete opening of markets to foreign competition through trade and investment. This attitude
comes from the basic logic of competition: free and open trade pushes countries to specialize their
resources in those industries goods where they are relatively most productive. In turn, this
specialization generates greater national output and income through trade than would be possible
for countries that remain isolated. Indeed, this simple but powerful concept of specialization is the
foundation on which international economists build their essential claim: globalization tends to raise
aggregate incomes and overall living standards in all countries. Countries become more productive
because they concentrate their production in areas of true advantage.
The positive view of international trade surely cannot be the entire story, however, since there are
frequent news items about people losing their jobs to import competition or outsourcing and entire
towns being devastated by the closure of manufacturing plants that were primary employers. Many
analysts at certain non-governmental organizations (NGOs) argue that because farmers in poor
countries cannot compete with subsidized agriculture in Europe and the United States, greater trade
exposure forces them to leave their land and raises rural poverty. Others note that the increased
economic activity caused by expanding flows of trade and investment places excessive stress on the
use of natural resources, generates more pollution and contributes to climate change. Globalization,
therefore, is an extraordinarily powerful and complex phenomenon with multiple sources, carriers,
and impacts.
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International economics deals with the economic and financial interdependence among
nations. It analyzes the flow of goods, services, payments, and monies between a nation
and the rest of the world, the policies directed at regulating these flows, and their effect on
the nation’s welfare. This economic and financial interdependence is affected by, and in
turn influences, the political, social, cultural, and military relations among nations.
Specifically, international economics deals with international trade theory, international

trade policy, the balance of payments and foreign exchange markets, and open-economy
macroeconomics. International trade theory analyzes the basis and the gains from trade.
International trade policy examines the reasons for and the effects of trade restrictions. The
balance of payments measures a nation’s total receipts from and the total payments to the
rest of the world, while foreign exchange markets are the institutional framework for the
exchange of one national currency for others. Finally, open-economy macroeconomics deals
with the mechanisms of adjustment in balance-of-payments disequilibria (deficits and
surpluses). More importantly, it analyzes the relationship between the internal and the
external sectors of the economy of a nation, and how they are interrelated or
interdependent with the rest of the world economy under different international monetary
systems.
The economics of the international economy can be divided into two broad subfields: the
study of international trade and the study of international money. International trade analysis
focuses primarily on the real transactions in the international economy, that is, transactions
involving a physical movement of goods or a tangible commitment of economic resources.
International monetary analysis focuses on the monetary side of the international economy,
that is, on financial transactions such as foreign purchases of U.S. dollars. An example of an
international trade issue is the conflict between the United States and Europe over Europe’s
subsidized exports of agricultural products; an example of an international monetary issue is
the dispute over whether the foreign exchange value of the dollar should be allowed to float
freely or be stabilized by government action.
In the real world, there is no simple dividing line between trade and monetary issues. Most
international trade involves monetary transactions, while many monetary events have
important consequences for trade. Nonetheless, the distinction between international trade
and international money is useful. International Economics I cover international trade issues
using theories of microeconomics to develop trade theory and apply trade theory to the
analysis of government policies toward trade. The International Economics II is devoted to
international monetary issues using macroeconomics theories to develop international
monetary theory and applies this analysis to international monetary policy.
International economic relations differ from interregional economic relations (i.e., the
economic relations among different parts of the same nation), thus requiring somewhat
different tools of analysis and justifying international economics as a distinct branch of
economics. That is, nations usually impose some restrictions on the flow of goods, services,
and factors across their borders, but not internally. In addition, international flows are to
some extent hampered by differences in language, customs, and laws. Furthermore,
international flows of goods, services, and resources give rise to payments and receipts in
foreign currencies, which change in value over time.
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International economics has enjoyed a long, continuous, and rich development over the
past two centuries, with contributions from some of the world’s most distinguished
economists, from Adam Smith to David Ricardo, John Stuart Mill, Alfred Marshall, John
Maynard Keynes, and Paul Samuelson.
1.2. The Components of International Economics
The international economic system has undergone a deep structural transformation over
recent decades, with globalization allowing for a greater exchange of products, services,
people and technology. Many governments and industries have felt the strain of competition,
leading to increased protectionist policies and, more recently, the rise of populist political
groups seeking to channel the frustration of people excluded from globalization. To better
understand this argument, it is crucial to examine the international economic system and its
main components to see how globalization impacts and affects them.
Microeconomics vs. Macroeconomics

Microeconomics and macroeconomics constitute the very basis of economic practice, and
understanding them can help make sense of how the modern international economic system
works and how globalization can have an impact on various economic actors and systems.
Depending on the degree of openness of an economy, macroeconomic indicators, such as
GDP, can be significantly influenced by changes in global markets.
International Trade
International trade is the economic exchange of goods and services between countries and is
governed by the law of comparative advantage, which states that some markets hold specific
advantages that allow them to generate products and services at a lower opportunity cost
than others. International trade and globalization have varying effects on other economic
indicators. When a national economy is strong, industries and businesses feel confident in
expanding and spending, which directly impacts the average citizen. However, because local
demographics can affect microeconomic indicators, a local economy can still succeed even
while national and international economies are facing difficulty.
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International Finance
International finance focuses on how macroeconomic indicators, such as GDP and inflation,
affect the international economy and global exchange rates. It studies various components of
finance, such as a balance of payments (all financial and trade transactions between a
nation’s residents and the rest of the world), the foreign exchange market, financial markets,
and international monetary policy. The wholesale foreign exchange market studies how
central banks, major corporations, and investment firms exchange currency, while the retail
market studies how individuals worldwide engage in the buying and selling of currency.
Countries can adopt a fixed exchange currency system in which governments intervene to
peg their exchange rates; a floating currency system in which demand and supply and the
free market determine the exchange rates; or a managed float system in which governments
allow their currencies to float and only intervene when and if they need to stabilize the
currency. International monetary policy is affected by different actors, such as governments,
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international organizations such as the World Bank, and businesses that are involved in the
exchange of financial assets.
Multinational Corporations
Multinational corporations (MNCs) can be defined as businesses with investments and
operations in nations other than their countries of origin. Many view MNCs as synonymous
with globalization and MNCs play a key role in the free movement of capital, labor, goods,
and services across borders. Major MNCs hold significant influence over policymaking, and
can even boast revenues larger than the GDPs of some countries. Multinational corporations
usually expand to locations where the business climate is friendliest and the potential for
returns is highest—typically, in countries with low taxes.
Increasing Globalization of Currency and Economic Systems

Before the Bretton Woods negotiations of 1944, many countries were still operating under
the gold standard, in which countries agreed to peg and freely convert their currencies to the
price of gold. After the agreements, the U.S. dollar became the dominant world currency,
and dozens of countries agreed to fix their exchange rates to it, while the dollar itself was
pegged to gold; the United States also happened to hold half of the world’s gold reserves at
the time. This system worked until the 1960s when European economies began to recover.
Countries started leaving the Bretton Woods system and asking the United States to
exchange their dollars for gold. Fearing depletion of the country’s gold reserves, the United
States unilaterally dissolved the system, de-pegging the dollar from gold and allowing the
operation of a floating exchange rate.
Globalization has profoundly impacted the world economy. While some governments and
nations may feel the strain from increased global competition, others have benefited from
globalization, receiving an overall increased return on trade and production efforts. Many
components of the international economic system—such as international trade, international
finance, and multinational corporations—continue to expand thanks to globalization, but
they are also facing volatility and change.
The subject matter of international economics consist issues raised by the special problems
of economic interaction between sovereign states. Seven themes recur throughout the study
of international economics: (1) the gains from trade, (2) the pattern of trade, (3)
protectionism, (4) the balance of payments, (5) exchange rate determination, (6)
international policy coordination, and (7) the international capital market.
The Gains from Trade
Probably the most important single insight in all of international economics is that there are
gains from trade—that is, when countries sell goods and services to each other, this
exchange is almost always to their mutual benefit. The range of circumstances under which
international trade is beneficial is much wider than most people imagine. For example, it is a
common misconception that trade is harmful if large disparities exist between countries in
productivity or wages. On one side, businesspeople in less technologically advanced
countries, such as India, often worry that opening their economies to international trade will
lead to disaster because their industries won’t be able to compete. On the other side, people
in technologically advanced nations where workers earn high wages often fear that trading
with less advanced, lower-wage countries will drag their standard of living down—one
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presidential candidate memorably warned of a “giant sucking sound” if the United States
were to conclude a free trade agreement with Mexico.
The Pattern of Trade

Generate accurate empirical predictions for the volume and pattern of trade. Some aspects of
the pattern of trade are easy to understand. Climate and resources clearly explain why Brazil
exports coffee and Saudi Arabia exports oil. Much of the pattern of trade is more subtle,
however. Why does Japan export automobiles, while the United States exports aircraft? In
the early 19th century, English economist David offered an explanation of trade in terms of
international differences in labor productivity, an explanation that remains a powerful
insight. In the 20th century, however, alternative explanations also were proposed. One of
the most influential explanations links trade patterns to an interaction between the relative
supplies of national resources such as capital, labor, and land on one side and the relative
use of these factors in the production of different goods on the other.
How Much Trade?

The debate over how much trade to allow took a new direction in the 1990s. Over the years,
international economists have developed a simple yet powerful analytical framework for
determining the effects of government policies that affect international trade. This
framework helps predict the effects of trade policies, while also allowing for cost- benefit
analysis and defining criteria for determining when government intervention is good for the
economy.
Balance of Payments
Is it good to run a trade surplus and bad to run a trade deficit? This comparison highlights
the fact that a country’s balance of payments must be placed in the context of an economic
analysis to understand what it means. It emerges in a variety of specific contexts: in
discussing foreign direct investment by multinational corporations in relating international
transactions to national income accounting and in discussing virtually every aspect of
international monetary policy. Like the problem of protectionism, the balance of payments
has become a central issue for the United States because the nation has run huge trade
deficits every year since 1982.
Exchange Rate Determination

A key difference between international economics and other areas of economics is that
countries usually have their own currencies—the euro, which is shared by a number of
European countries, being the exception that proves the rule. And as the example of the real
illustrates, the relative values of currencies can change over time, sometimes drastically. For
historical reasons, the study of exchange rate determination is a relatively new part of
international economics. For much of modern economic history, exchange rates were fixed
by government action rather than determined in the marketplace. Before World War I, the
values of the world’s major currencies were fixed in terms of gold; for a generation after
World War II, the values of most currencies were fixed in terms of the U.S. dollar. The
analysis of international monetary systems that fix exchange rates remains an important
subject.
International Policy Coordination
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The international economy comprises sovereign nations, each free to choose its own
economic policies. Unfortunately, in an integrated world economy, one country’s economic
policies usually affect other countries as well. Differences in goals among countries often
lead to conflicts of interest. Even when countries have similar goals, they may suffer losses
if they fail to coordinate their policies. A fundamental problem in international economics is
determining how to produce an acceptable degree of harmony among the international trade
and monetary policies of different countries in the absence of a world government that tells
countries what to do.
The International Capital Market

In any sophisticated economy, there is an extensive capital market: a set of arrangements by
which individuals and firms exchange money now for promises to pay in the future. The
growing importance of international trade since the 1960s has been accompanied by a
growth in the international capital market, which links the capital markets of individual
countries.
1.3. The Importance of International Economics
International trade theory and domestic microeconomics both rest on the same assumption
that economic agents maximize their own self-interest. Nevertheless, there are important
differences between domestic and foreign transactions. Similarly, international finance is
closely tied to domestic macroeconomics, but political borders do matter, and international
finance is far more than a modest extension of domestic macroeconomics. The differences
between international and domestic economic activities that make international economics a
separate body of theory are as follows:
1. Within a national economy labor and capital generally are free to move among regions;
this means that national markets for labor and for capital exist. Although wage rates may
differ modestly among regions, such differences are reduced by an arbitrage process in
which workers move from low- to high-wage locations. There are even smaller
differences in the return to financial capital across regions because investors have lower
costs (the price of a postage stamp) of moving funds from one location to another. As a
result in domestic microeconomic analysis generally rests on the assumption that firms
competing in a market pay comparable wages and borrow funds at comparable interest
rates.
International trade is quite different in this regard. Immigration laws greatly limit the
arbitraging of wage rates among nations, so that wage rates differ sharply across the
world. Labor in manufacturing can be hired in Sri Lanka for 40 rupees per hour.
Industrial wages in the United Kingdom, including fringe benefits, are typically over £11
per hour, implying a ratio of the UK to the Sri Lankan wage rate of about 30:1. Although
capital flows among nations more easily than do labor, exchange controls, additional
risks, costs of information, and other factors are sufficient to maintain significant
differences among interest rates in different countries. Therefore, international trade
theory centers on competition in markets where firms face very different costs.
2. There are normally no government-imposed barriers to the shipment of goods within a

country. Accordingly, firms in one region compete against firms in another region of the
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country without government protection in the form of tariffs or quotas. Domestic

microeconomics deals with such free trade within a country. In contrast, tariffs, quotas,
and other government-imposed barriers to trade are almost universal in international
trade. A large part of international trade theory deals with why such barriers are
imposed, how they operate, and what effects they have on flows of trade and other
aspects of economic performance.
3. Domestic macroeconomics normally deals with monetary and fiscal policy choices that
address cyclical economic fluctuations that affect the country as a whole. With one
currency used throughout the country, establishing a different monetary policy or
interest rate for different regions is not possible. While there are differences across
regions in the way central government spending is allocated and in the location of
interest-sensitive industries, essentially fiscal and monetary policies that exist in one part
of the country also prevail in other parts. International finance, or open economy
macroeconomics, is about a very different situation. Different countries have different
business cycles; the significance of strikes, droughts, or shifts in business confidence, for
example, regularly differs across countries. Because some countries may be in a
recession while others enjoy periods of economic expansion, they generally choose
different monetary and fiscal policies to address these circumstances. These differences
in macroeconomic conditions and policies among countries have major consequences for
trade flows and other international transactions.
4. A country normally has a single currency, the supply of which is managed by the central
bank operating through a commercial banking system. Because a New York dollar is the
same as a California dollar, for example, there are no internal exchange markets or
exchange rates in the United States. International finance involves a very different set of
circumstances. There are almost as many currencies as there are countries, and the
maintenance of a currency is typically viewed as a basic part of national sovereignty.
The choice of eleven European nations to give up some of this sovereignty in forming
the European Monetary Union and launching the euro in 1999 represents a remarkable
political achievement. International finance is concerned with exchange rates and
exchange markets, and the influence of government intervention in those markets.
1.4. International Economics and Economics Theories
International economic theories emerged within particular social, economic and political
frameworks and were developed as solutions to the problems of contemporary economics. In
order to understand the increasingly complex and interdependent state of today’s
international economy, we need to realize the importance of those theories that came before.
Theories of International Economics aims to redress the balance by taking a pluralistic

approach, presenting with authority both orthodox and heterodox international economic
theories. Each international economic theories shows the necessarily interdependent nature
of theories by including an historical component that shows how each school of thought
developed, why it developed and what it has to say about the contemporary world. We
should examine a wide range of theories with an emphasis on the benefits of a pluralistic
approach, addressing schools of thought including Classical, Neoclassical, Mercantilism and
others, alongside – and in relation to – each other. This approach allows the scholarly value
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of each approach to be understood and appreciated, and in doing so enables a greater

understanding of the world economy.
While international trade has been present throughout much of history, its economic, social,
and political importance has been on rise in recent centuries. In ancient times international
trade was important for few states like Egyptians, Greeks, and Romans ….etc. They were
highly beneficial from it and they were influential on world trades. By the time importance
of international trade to the economic health and over all standard of living of a country was
not clear as to the present time. As of this, some of the earliest economic data related to
international trade and early economic thinking often centered on the implications of
international trade for the well-being of a politically defined area.
1.5. Purposes of Economic Theories and/or Models
“Why do we need a theory?” and how it plays a big role in IE studies. Many people might
tend to avoid theories, but in fact through it we can identify the broader implications of
various facts obtained. Theories help us to see a variety of meaningful patterns in a very
complex IE studies. In addition, theories provide a simple and clear description in seeing a
problem that occurs in the world of IE. Many theorists agree that theory helps student to
focus on seeing and dealing with various IE problems that occur in the world from a great
deal of points of view or perspectives. Furthermore, we need to use theory to find solutions
or recommendations from many problems that occur in the world—it can be called creative
theorizing. This concept explains that the theory can be constructed in such a way as to see a
variety of recommendations. For example, liberalism can provide the right solution
regarding the Britain's Corn Law problem. We might think that it is a classic issue, but with
this case we can provide the best solution in solving problems that occur. Britain's Corn Law
is detrimental to the British societies, especially those who work as farmers. This law allows
the government (parliament) to interfere in market activities. When we viewed from the
perspective of liberalism, the state should not need to take part in market movements.
International Political Economy lies in individual freedom and is free from all obstacles that
occur in the market. Basically, liberalism believes that politics and economics must be
separated in order to achieve the welfare of society. In the end the law created by the
government caused unrest in various trading classes, for example wheat and corn farmers
had to pay more to get land to grow crops from the land owner. In addition, the profits from
maize imports ultimately only benefit the parliament and landowners but are detrimental to
farmers. The main thoughts of the theory of liberalism can provide a recommendation that
state interference should not be so beneficial to the market. For this reason, there needs to be
a gap between the state and the market in order to advance the economic welfare of the
people. The use of theory can open our minds more broadly because every problem that
occurs has a different point of view when viewed from each theory.
1.6. Testing a Hypothesis/Theory/ Model
When thinking about ideas in a scientific context the ideas in question get described
according to the level of corroboration and scrutiny they have received. In scientific
disciplines, the words, “hypothesis”, “theory” and “model” hold different connotations in
relation to the stage of acceptance or knowledge about a group of phenomena or ideas.
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The first step in the scientific process is to propose a solution or answer to the problem or
question. In science, this suggested solution or answer is called the hypothesis, and this is
one of the most important steps a scientist performs. A scientific hypothesis is an informed,
testable, and predictive solution to a scientific problem that explains a natural phenomenon,
process, or event. Scientific method requires that one can test a hypothesis. In early usage,
scholars often used the word hypothesis to refer to a clever idea or to a convenient
mathematical approach which simplified cumbersome calculations.
In common usage, a hypothesis refers to a provisional idea whose merit requires evaluation.
For proper evaluation, the one who frames a hypothesis needs to define the specifics in
operational terms. A hypothesis indicates that more work needs to be done by the researcher
in order to either confirm or disprove it. In due course, a confirmed hypothesis may become
part of a theory or may become a theory itself.
A proposition may take the form of asserting a causal relationship. An example of a

proposition often involves an assertion of causation: If a particular independent variable is
changed there is also a change in a certain dependent variable. This is referred to as an “If
and Then” statement whether or not it asserts a direct cause-and-effect relationship. A
hypothesis about possible correlation does not stipulate the cause and effect per se, only
stating that ‘A is related to B’. Causal relationships can be more difficult to verify than
correlations, because variables are often also involved which may give rise to the
appearance of a direct cause-and-effect relationship, but which upon further investigation
turn out to be more directly caused by some other factor not mentioned in the proposition.
An observation of a change in one variable, when correlated with a change in another
variable, can actually mistake the effect for the cause, and vice-versa (i.e., potentially gets
the hypothesized cause and effect backwards).
Hypothesis refers to a logical but unproven explanation for a given set of facts used as a
starting point for further experimentation and observation. A hypothesis must be testable, or
it is a worthless hypothesis. A hypothesis is tested by comparing results of experiments with
the hypothesis’ predictions.
A theory is a hypothesis that has been tested numerous times and found to explain previous
observations and make accurate predictions about future observations. The division between
hypothesis and theory is a bit fuzzy, but is broadly when there is no more ‘reasonable doubt’
of the hypothesis’ truth. Broadly speaking ‘enough’ different people have tested the theory
experimentally in ‘enough’ different ways that we can be reasonably sure that the theory is
correct.
A theory is a logically self-consistent framework for describing the behavior of a related set
of phenomena. It originates from, and/or is supported by, experimental evidence obtained
through application of the scientific method. In this sense, a theory is a systematic and
formalized expression of all previous observations that is predictive, logical and testable.
The important difference between theories and models is that the first is explanatory as well
as descriptive, while the second is only descriptive (although still predictive in a more
limited sense).
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1.7. The Role of Assumptions
Economists make assumptions to simplify the complex world and make it easier to
understand. To study the effects of international trade, for example, we may assume that the
world consists of only two countries and that each country produces only two goods. Of
course, the real world consists of dozens of countries, each of which produces thousands of
different types of goods. But by assuming two countries and two goods, we can focus our
thinking on the essence of the problem. Once we understand international trade in an
imaginary world with two countries and two goods, we are in a better position to understand
international trade in the complex world in which we live.
The art in scientific thinking whether in physics, biology or economics is deciding which
assumptions to make. Suppose, for instance that we were dropping a beach ball rather than a
marble from the top of the building. Our physicist would realize that the assumption of no
friction is far less accurate in this case. Friction exerts a greater force on a beach ball than a
marble because a beach ball is much larger. The assumption that gravity works in a vacuum
is reasonable for studying a falling marble but not for studying a falling beach ball.
Similarly, economists use different assumptions to answer different questions. Suppose that
we want to study what happens to the economy when the government changes the number of
dollars in circulation. An important piece of this analysis, it turns out, is how prices respond.
Many prices in the economy change infrequently; the newsstand prices of magazines, for
instance, change only every few years. Knowing this fact may lead us to make different time
horizons. For studying the short run effects of the policy, we may assume that prices do not
change much. We may even make the extreme and artificial assumption that all prices are
completely fixed. For studying the long run effects of the policy, however, we may assume
that all prices are completely flexible. Just as a physicist uses different assumptions when
studying falling marbles and falling beach balls economists use different assumptions when
studying the short run and long run effects of a change in the quantity of money.
1.8. International Trade

International trade is exchange of capital, goods, and services across international borders or
territories. In most countries, it represents a significant share of gross domestic product
(GDP). It examines how international transactions influence social welfare, income
distribution, employment, growth, price stability etc... Industrialization, advanced
transportation, globalization, multinational corporations, and outsourcing are all having a
major impact on the international trade system. Without international trade, nations would
be limited on the goods and services produced within their own borders.
The Basis of International Trade
The basic question in international trade theory is to explain why nations trade with each
other. Countries trade with each other basically for the same reasons that individual people
trade with each other. In today’s world of unlimited wants, no nation by itself can produce
all the goods and services which its citizens require for their consumption. The following
points explain why nations trade with each other.
Differences in factor endowments
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Nature has distributed the factors of production unequally over the surface of the earth.
Countries differ in terms of natural resource endowments, climatic conditions, mineral
resources and mines, labor, capital, technological capabilities, entrepreneurial and
management skills, and other variables that determine the capacities of countries to produce
goods and services. All these differences in production possibilities lead to situations where
some countries can produce some goods and services more efficiently than others; and no
country can produce all the goods and services in the most efficient manner ( at the lowest
possible cost of production). For example, Japan can produce automobiles or electronic
goods more efficiently than any other country in the world; Malaysia can produce rubber
and palm oil more efficiently than other countries can do. Their capacity to produce these
goods is in excess of their capacity to consume them. Japan and Malaysia can, therefore,
export these goods to other countries at relatively lower prices. Brazil, Ethiopia or Thailand
can import these goods at a lower price from Japan and Malaysia and in return they can
export coffee (Ethiopia) and rice (Thailand). Because Brazil and Ethiopia can produce
coffee at much lower production costs and Thailand can produce rice at much lower cost
than Japan and Malaysia.
Division of labor (specialization)
Just as there is division of labor among individuals, there could be division of labor among
countries of the world. No individual is able to produce all the goods and services that
he/she requires to consume and this applies to countries as well. Just as individuals
specialize in certain functions, countries specialize in the production of certain goods and
services in which they have production superiorities over the other countries. Thus, a
country specializes in the production and export of those goods and services over which they
have absolute or comparative advantage; and it imports other goods and services in the
production of which it has an absolute or a comparative disadvantage over the other
countries of the world.
Gains form exchange of goods and services
The basis of international trade is the gains or profits to be made from the exchange of goods
and services. If there are no gains to be made, there would be no such trade between
countries.
Price differentials
The immediate cause of international trade is the existence of differences in the prices of
goods and services between nations. Foreigners buy our goods because they find them
cheaper than anywhere else in the world; and we buy foreign goods because we find them
cheaper. Price differences can arise due to either differences in supply conditions or
differences in demand conditions or due to differences in both.
a) differences in supply conditions (or production possibilities)
Such differences can arise due to several factors that determine the cost of producing goods
and services. These factors include natural endowments of economic resources, the degree
of efficiency with which these factors are employed, the level of technology used in
production, labor skills, factor abundance, etc.
b) differences in demand conditions
Differences in demand conditions, which are largely a function of income levels and taste
patterns, contribute to international price differentials. Countries A and B may be
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producing the same commodity at the same cost of production, but that does not guarantee
the same price in both countries for that commodity. If country A has a higher level of
income matched by a stronger taste for that commodity, the commodity will sell for a
higher price in country A than in country B. In country B there may be lower level of
demand for that product due to lower level of income and/or taste. Hence, both income and
tastes, in their capacity to affect demand, would affect international trade, by causing
international price differentials.
International Trade versus Domestic (interregional) Trade
Interregional (domestic) trade is based on differences in prices between different sections

of the same country. All factors which affect prices and other aspect of international trade
also affect interregional trade. Endowment of the factors of production varies substantially
between different regions of single nation productivity, or efficiency, behaves in the same
way, being high in some regions and low in others. Certain products for which there is a
demand are simply not available in some sections of a nation and then interregional trade is
the only solution to satisfy this demand.
Intra-Regional Trade refers to trade which focuses on economic exchange primarily
between countries of the same region or economic zone. In recent years countries among
economic-trade regimes such as ASEAN in South-East-Asia for example have increased
their level of trade and commodity exchange between themselves which reduces the
inflation and tariff barriers associated with foreign markets resulting in growing prosperity.
In point of fact, there is no sustainable difference between interregional and international
flows of goods and services and the factors affecting them. The difference stems from the
social, political, cultural and economic boundaries that men have drawn around various
geographical areas called nations. Existence of difference in tastes and demand may possibly
play a large role internationally than interregional in determining the pattern of trade. In
spite of the fact that many of the causative forces bearing on trade operate in a similar
manner both internationally and interregional, there are numerous differences between the
operations of trade among separate nation states, on the one hand, and among different
regions of a single nation, on the other hand.
The difference between domestic and foreign trade can be explained as follows:
i. Factor mobility
The distinction made by classical economists between domestic and international trade was
grounded on the notion of geographic mobility of factors of production. The assumption
made was that within the nation, there is free mobility of factors of production. If internal
mobility were perfect, then all factors of production notably labor and capital- would move
into areas where they can receive highest rate of return for their services. Under idealized
perfect mobility there could not exist inter-regional differences in factor prices. The factors
would move away from the regions where their prices are relatively lower to regions where
their prices are relatively higher, until the factor price differences between the regions are
completely wiped off. In such a case, the price of any factor of production of a given type
and quality must be the same throughout the entire country.
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In international trade, however, the factor mobility is neither free nor perfect. First of all,
there are restrictive immigration laws which prevent free mobility of labor from one country
to another. In respect of capital also, there are restrictions on the inflow and outflow of
capital and investment across national frontiers. In addition to these legal barriers, there are
other social, cultural and political barriers that restrict the mobility of factors from one
country to another. Differences in language, climate, social customs and practices, political
and educational systems, etc. do create additional barriers to factor mobility between
nations. Within the nation, such differences may not exist, or may not appear too formidable
to be overcome by economic incentives. At any rate factor mobility is relatively greater
within country than between countries.
ii. Product mobility

Within the nation, the movement of goods and services from one region to another is free.
The only internal barriers to free movement of goods and services are the distance and cost
of transportation – what may be termed as natural barriers. But in the case of international
trade, such a movement is not free, because in addition to the natural barriers, are formidable
man-made barriers. For instance, there are import and export duties and quotas, exchange
controls, non-tariff (hidden) barriers which put countless obstacles to the free movement of
goods and services between countries (we will discuss much about barriers to trade in
chapter four). Growing protectionism and spirits of nationalism have been making trade
between countries more and more difficult. Agricultural protectionism in the western
industrialized countries and the policies of industrialization through import-substitution in
the developing countries are some of the examples of how international trade in
commodities is being deliberately reduced in today’s world.
iii. Economic environment

Within the nation, the economic environment is more or less the same in all the regions of
the country. For example, the legal framework or the laws governing consumption,
production and exchange of goods and services are the same throughout the country. The
government polices with regard to interest rates, taxes, wages or prices are the same within
the country. Production techniques, factor proportions, factor prices, infrastructure facilities
and production functions or possibilities are nearly the same in the country. Similarly,
market structures-the degree of competition or monopoly in production-and consumer taste
patterns and preferences are more or less the same throughout the country. All of them
would add up to create a certain economic environment or investment climate within the
nation. But between nations, they could all differ very significantly. This would make the
character of international trade significantly different from that of domestic trade.
iv. Monetary units

The difference between domestic and foreign trade is more obvious in international
monetary or currency differences. Within the nation, monetary laws and the financial system
and arrangements are the same for all regions in the country. Most significantly, there is a
single currency used as a medium of exchange or a measure of value which would make
exchange very smooth as far as domestic trade is concerned.
This is not so between countries. We have dollars, euros, yens, pounds, marks franks, birr
etc., and not all of them are freely accepted in discharge of international monetary
obligations. An Ethiopian importer must first obtain US dollars before he can think of
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buying goods from the United States of America. But with the domestic currency you can
“purchase” and “sale” goods from one region to another in any quantity you wish. There are
no currency complications or convertibility problems involved in carrying out domestic
trade. In respect of foreign trade, however, there are currency complications, problems of
non-convertibility of currencies, exchange controls and restrictions and many other
obstacles. International monetary differences, therefore, introduce complications and
complexities in international transactions; and these are absent in domestic trade and
exchange.
CHAPTER TWO:
2 INTERNATIONAL TRADE THEORIES
“Do what you do best. Trade for the rest” mean specialize and then trade. Oracle of 21st C
It has long been perceived that nations benefit in some way by trading with the other
nations. Although the underling basis for this belief has changed considerably over time, it is
surprising how often we encounter ideas about the gains from trade and the role of trade
policy that stem from some of the earliest views on the role of international trade in the
pursuit of domestic economic goals.
2.1 The Mercantilist Trade Theories
Mercantilism refers to the collection of economic thought of different persons that came into
existence during the period from 1500 to 1750. It was simple collection of similar attitudes
towards domestic economic activity and international trade that tended to dominate
economic thinking and policy during the period. The views laid great impact on
government’s policies. Mercantilism is often referred to as the political economy of state
building.
According to them national wealth reflected in a country’s holdings of precious metals. One
of the most important pillars of their thought was the static view of world resources.
Economic activities were viewed as a zero-sum- game, in which one country’s gain is at the
expense of the other. Acquisition of precious metals was the means for increasing wealth
and well-being. In a hostile world, the enhancement of state power was critical to the growth
process. Mercantilists perceived the economic system as consisting of three components: a
manufacturing sector, a rural sector and the foreign colonies. The former one is the group
most critical to the successful functioning of the economic system, and labors as the most
critical among the basic factors of production. Commodities were valued relatively in terms
of their relative labor content (labor theory of value).
Mercantilism's emphasis on the importance of gold and silver holdings as a sign of a
nation's wealth and power led to policies designed to obtain precious metals through trade
by ensuring "favorable" trade balances, meaning an excess of exports over imports,
especially if a nation did not possess mines or have access to them. In a favorable trade
balance, payments for the goods or services had to be made with gold or silver. Colonial
possessions were to serve as markets for exports and as suppliers of raw materials to the
mother country, a policy that created conflict between the European colonial powers and
their colonies. Mercantilism favored a large population to supply laborers, purchasers of
goods, and soldiers. Thrift and saving were emphasized as virtues because they made
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possible the creation of capital. Mercantilism provided a favorable climate for the early
development of capitalism.
This would lead to the depletion of the stock of precious metals within the nation. Thus,
exports were viewed favorably so long as they brought in gold but imports were looked at
with apprehension as depriving the country of its true source of riches, i.e., precious metals.
Taxing imports was often justified as a way of creating jobs and income for the national
population. Imports were supposed to be bad because they had to be paid for, which might
cause the nation to lose spices (gold or silver) to foreigners if it imported a greater value of
goods and services than it sold to foreigners. Imports were also to be feared because those
same foreign goods might not be available in time of war.
Bullionism is an early or primitive form of mercantilism. It was derived, in the 16thc, from
the observation that the English state possessed large amounts of gold and silver, in spite of
the fact that there was no mining of precious metals on English soil, because of its large
trade surplus. They said that there must not be importing of commodities which may lead to
reduction of precious metals from the domestic economy.
Mercantilism was finally challenged by advocates of "laissez-faire" who argued that
international and domestic trade were both important, and that it was not the case that one
country must grow wealthy at the expense of another. As this and other economic ideas
arose throughout the 19thc, the mercantilist view was superseded. Nonetheless, many of the
ideas and policies have not been forgotten, emerging again as circumstances changed .
2.2 Physiocracy: A Link between Mercantilism and Classical School
The Physiocrats were a group of economists who believed that the wealth of nations was derived
solely from agriculture. Their theories originated in France and were most popular during the second
half of the 18th century. Physiocracy was perhaps the first well developed theory of economics. They
called themselves economists but are generally referred to as Physiocrats in order to distinguish them
from the many schools of economic thought that followed them. Physiocrat is derived from the
Greek for “Government of Nature”.
The Physiocrats saw the true wealth of a nation as determined by the surplus of agricultural
production over and above that needed to support agriculture (by feeding farm laborers and so forth).
Other forms of economic activity, such as manufacturing, were viewed as taking this surplus
agricultural production and transforming it into new products, by using the surplus agricultural
production to feed the workers who produced the extra goods. While these manufacturers and other
non-agricultural workers may be useful, they were seen as 'sterile' in that their income derives
ultimately not from their own work, but from the surplus production of the agricultural sector. The
Physiocrats strongly opposed mercantilism, which emphasized trade of goods between countries, as
they pictured the peasant society as the economic foundation of a nation's wealth.
As commodities of equal value were exchanged, trade and commerce were considered as
unproductive. According to them trade did not produce any real wealth. Hence all
commodity transition was sheer waste of time and energy. They wanted to counteract the
evils of commerce by advocating complete freedom in the field of commerce.
For the Physiocrats — and this is a central tenet of their theory of production — neither
industry nor commerce generates wealth. How can this be explained? According to Joseph J.
Spengler, this conception is a distant legacy of the Middle Ages when work and land were
the only sources of wealth. The merits of that argument are hard to evaluate at such a
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general level. A more plausible explanation is that the Physiocrats developed their theory in
the light of the actual situation of the French economy, about which they were well informed
thanks to the Agricultural Societies and a well-developed network of correspondents, as
Jean-Claude Perrot has shown. Some features of that situation are worth recalling.
Agriculture employs the great majority of the population and contributes four-fifths of the
country’s wealth, not counting the significant share of so-called industrial production of
consumer goods and equipment (textiles, small metallurgy for example) that is in fact
carried on in cottage industry conditions as an activity complementary to agricultural work.
The landowning class as understood by the Physiocrats (the king, the receivers of tithe, and
the landed proprietors, all of them non-manual and non-peasant), represents 6% to 8% of the
kingdom’s population, owns 50% of the landed capital, and receives the totality of rents
from tenanted and sharecropped holdings, and of taxes .The mass of the peasant population,
organized in small family farms, practices a subsistence agriculture that produces the
essential minimum, with virtually all income being absorbed by food requirements. Finally,
exports as a source of revenue concern principally foodstuffs or processed commodities such
as wine. In these conditions, the Physiocrats find it hard to conceive that industrial
production, which was still of marginal economic importance, could generate wealth in
France.
A second explanation, not incompatible with the first, refers back to the quotation from
Norman Ware. The Physiocrats elaborated their doctrine in almost natural opposition to the
mercantilists. But as the Physiocrats observe the industrial and commercial wealth of
England and Holland, they have to recognize that two other models of economic
development are possible: international trade and industrialization. Quesnay, who argues for
an efficient and highly productive agriculture, therefore has to prove that the two other
sectors do not constitute satisfactory alternatives for ensuring the prosperity of the kingdom.
At several points, he mentions the example of trading nations. Commerce has indeed been a
source of prosperity for Holland, Hamburg, Genoa, but it is important to ensure that the
nation exports essential goods first and foremost (Quesnay is in fact thinking of grain). The
political argument recurs again and again: that the nation can do this proves that its
independence is guaranteed. Similarly, when despotism ruins agriculture, only trade is
possible, because wealth can be concealed or transported. Such is the fate of the Barbary
Coast and of Turkey. In any case, commerce is an inadequate basis for the prosperity of a
great nation.
2.3 The Classical Trade Theories

Adam Smith (1723 – 1790) provided the basic building block for the construction of the
classical theory of international trade. He enunciated the theory in terms of what is called
Absolute Advantage model. Another well-known classiest, David Ricardo (1722 – 1823),
articulated it and expanded it further into what is called Comparative Advantages model.
The models of Smith and Ricardo together constitute what is sometimes referred to as the
supply version of the classical theory of trade, because Smith and Ricardo paid almost
exclusive attention to considerations of supply or production costs in the determination of
terms of trade and the gains from trade. The modern version of the classical theory of trade,
however, treats supply and demand with equal weight. John Stuart Mill (1806 -1873),
another renowned classical economist, was the first to indicate that demand considerations
must be incorporated into Comparative advantage model. But Mill was not very clear or
articulate. The vagueness in Mill’s principle of Reciprocal Demand was removed in the
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19th century, first by F.Y. Edgeworth and later by Alfred Marshall. Both Marshal and
Edgeworth are credited with originating and developing the theory of offer curves, which is
a geometric technique of demonstrating the theory of reciprocal demand. All these
contributions of Smith, Ricardo, Mill, Edgeworth and Marshall, put together, would
constitute the modern version of the classical theory of comparative advantage, which is
the oldest and the most famous model of international trade.
2.3.1 Trade Based On Absolute Advantage

Absolute advantage refers to the ability of a party (an individual, or firm, or country) to
produce more of a good or service than competitors, using the same amount of resources.
Adam Smith first described the principle of absolute advantage in the context of
international trade, using labor as the only input. He challenged the mercantilists views on
what constituted the wealth of Nations, and what contributed to "nation building" or
increasing the wealth and welfare of nations. Smith was the first economist to show that
goods, rather than gold (or treasure), were the true measure of the wealth of a nation. He
argued that the wealth of a nation would expand most rapidly if the government would
abandon mercantilist controls over foreign trade. Smith also exploded the mercantilist myth
that in international trade one country gains at the cost of other countries. He showed how
all countries would gain from international trade through the international division of labor.
Adam Smith, in his Wealth of nations (1776), argued that a country could certainly gain by
trading with other nations. Just as a tailor does not make his own shoes but exchanges a suit
for shoes, and hence both the tailor and the shoe maker gain by trading, in the same manner,
Smith argued that a country as a whole would gain by having trade relations with other
countries. According to Smith, if one country has an absolute advantage over another in one
line of production, and the other country has an absolute advantage over the first country in
another line of production, then both countries would gain by trading. Let's discuss the
Smiths model by taking a simplistic world of two countries A and B both producing Rubber
and Textile.
Assumptions
1. There are constant returns to scale in the production of both goods in the two
countries (i.e. constant marginal opportunity cost conditions).
2. Both countries can produce both the goods if they wish.
3. The countries are endowed with X amounts of factors of production such that:
a) With X factors of production country A can produce either 100 units of rubber or
50 units of textile, or any other mix of rubber and textile, that satisfies the
opportunity cost ratio of 2:1
b) With X factors of production country B can produce either 50 units of rubber or
100 units of textile, or some other combinations of rubber and textile subject to
the opportunity cost ratio of 1:2
From the above production possibilities (or supply conditions) it is quite clear that country A
has an absolute advantage in the production of rubber, and country B has an absolute
advantage in the production of textile. This means there is symmetrical factor distribution
between the two countries so that there is scope for specialization in production and also a
scope for establishing mutually beneficial trade between the two countries.
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A. Autarky (closed economy) situation: Consider the following table

Table 1: Production and consumption levels under autarky situation
Commodities in units Units of output Opportunity cost ratio
Country Rubber Textile (GDP ) (R:T)
A 50 25 75 2:1
B 25 50 75 1:2
World 75 75 150
The above table implies that country A produces and consumes 50 units of rubber and 25
units of textile with the given production technology and input supply. The total production,
GDP, is 75 units and this is the maximum consumption level if we assume that saving is
zero. Country B produces 25 units of rubber and 50 unitsof textile with its given technology
and input supplies. The total production of country B is 75 units and total consumption will
also be 75 units if savings are assumed to be zero. For our simple world of two countries,
therefore, world production and consumption will be 150 units.
B. The case of open economy

Opening trade provides the two countries an opportunity to specialize in production. It will
lead to production and consumption gains. These effects can be seen in the following table.
Country A will specialize in the production and export of rubber and B will specialize in the
production and export of textile. Trade will enable the countries to realize production and
consumption gains.
Table 2: Production levels after international trade.

Country Commoditiesin unit Total output orGDP
Rubber Textile
A 100 0 100
B 0 100 100
World 100 100 200
After trade both countries become richer by 25 units than their situation without trade and
this is due to production gain from international trade. The world GNP has also increased
from 150 to 200 units. Country A has specialized in the production of rubber and country B
has specialized in the production of textile.
What about consumption gains? After trade, have the consumer in the two countries been
happier as a result of their countries becoming richer and more specialized in terms of
production? This depends on how the gains from production are distributed between the
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two countries. In other worlds consumption gains to the two countries depend up on the
terms of trade (TOT) i.e. how many units of rubber exchanged for one unit of textile
between country A and B.
Case 1 Trade at TOT = 1:1

At this TOT country A agree with country B to exchange 1 unit of rubber for 1 unit of
textile. Then depending up the taste pattern in the two countries and up on how much or how
little they want to trade each other's goods, the consumption gains can be determined.
• If the two countries want to consume all that they have produced, it means that
their consumers have no taste for the product of the other country then, there will
be no trade between countries.
• But if each country wants to consume some mix of both goods; then the countries
will trade each other’s goods. Country A could export, say; 40 units of rubber for
40 units of textile import from country B (at terms of trade 1:1). The result of this
trade can be depicted in table 3 below.
Country A, after trade, has produced 100 units of rubber (see table 2) consumers in country
A want to consume 60 of rubber, which means that this country can export 40 units of
rubber to country B in exchange for 40 units textile imports.
As a result, their consumption will increase by a total of 25 units than the case without trade
(see table 1). Similarly, country B's consumption level will also increase by 25 units than
the situation without trade.
Table 3: Consumption shares after international trade at TOT=1:1
Country Commoditiesin unit Total Consumption Consumption
Rubber Textile Gains
import
A 60 40 100 25
import
B 40 60 100 25
World 100 100 200 50
Note: Import of country A is export of country B
Conversely, if the term of trade is equal to the cost ration of county B, all the gains from
trade will be attributed to country A. Any other terms of trade between the cost ratios of the
two countries may lead to unequal gains to country A and B. The country whose domestic
cost ratio is larger by small amount than the TOT will gain the smaller share and vice versa
i.e. if TOT closer to the domestic opportunity cost ratio of country A, country A will gain
the smaller and B will gain larger.
Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1

All the consumption gains from international trade go to country B because the TOT is equal
to the domestic opportunity cost ratio of country A. Thus such a TOT is favorable to country
B but does not bring any change in welfare level of A.
Table 4: Consumption shares after trade at TOT =2:1
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Country Commodities in unit Total Consumption Consumption
import
A 50 25 75 0
import
B 50 75 125 50
World 100 100 200 50
Case 3: Trade at TOT =Domestic opportunity cost ratio of country B = 1:2

All the consumption gains from international trade go to country A because the TOT is
equal to the domestic opportunity cost ratio of country B. Thus such a TOT is favorable to
country A. It does not bring any change in the consumption level of country B.

import
A 75 50 125 50
Import
B 25 50 75 0
World 100 100 200 50
The welfare of country B before and after trade remains constant.

Case 4: Trade at TOT = 2:3
Most of the consumption gains from international trade go to country A because the TOT is
closer to the domestic opportunity cost ratio of country B than country A. Thus such a TOT
is more favorable to country A than country B.
import
A 60 60 120 45
import
B 40 40 80 5
World 100 100 200 50
Case 5: Trade at TOT = 3:2

Most of the consumption gains from international trade go to country B because the TOT is
closer to the domestic opportunity cost ratio of country A than country B. Thus such a TOT
is more favorable to country B than country A.
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import
A 40 40 80 5
import
B 60 60 120 45
World 100 100 200 50
It is important to note that production gains alone are not sufficient to determine the
profitability of international trade from the standpoint of an individual member country. The
consumption gains (welfare gains) are also equally important. How the consumption gains are
determined is crucial in determining whether the economic well-being (standard of living
measured by consumption gains) of a member country has gone up as a result of international
trade. International TOT, therefore, plays a very important part in determine the welfare gains
from trade. International trade would be beneficial and profitable for a country if it results in
consumption gains. Production gains alone do not bring profitable trade from the stand point
of the country concerned, but it may from world point of view.
2.3.2 Trade Based On Comparative Advantage

David Ricardo (1772-1823), in his theory of comparative cost suggested that countries will
specialize and trade in goods and services in which they have a comparative advantage. It is
easy to see that if countries have an absolute advantage it will has the potential to trade.
However, what happens if one country has an absolute advantage over its trading partners in
the production of two of goods. Specialization and trade can still result in welfare gains from
trade.
Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn
Laws. He concluded it was to England's advantage to trade with Portugal in return for grain,
even though it might be possible to produce that grain more cheaply in England than Portugal.
However, the concept is usually attributed to David Ricardo who explained it in his book On
the Principles of Political Economy and Taxation in an example involving England and
Portugal.
The case of winter roses offers an excellent example of the reasons why international trade
can be beneficial. Consider first how hard it is to supply American sweethearts with fresh
roses in February (On Valentine's Day). The flowers must be grown in heated greenhouses, at
great expense in terms of energy, capital investment, and other scarce resources. Those
resources could have been used to produce other goods. Inevitably, there is a trade-off. In
order to produce winter roses, the U.S. economy must produce less of other things, such as
computers.
Suppose, for example, that the United States currently grows 10 million roses for sale on
Valentine's Day, and that the resources used to grow those roses could have produced 100,000
computers instead. Then the opportunity cost of those 10 million roses is 100,000 computers.
(Conversely, if the computers were produced instead, the opportunity cost of those 100,000
computers would be 10 million roses.)
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Those 10 million Valentine's Day roses could instead have been grown in South America. It
seems extremely likely that the opportunity cost of those roses in terms of computers would be
less than it would be in the United States. For one thing, it is a lot easier to grow February
roses in the Southern Hemisphere, where it is summer in February rather than winter.
Furthermore, South American workers are less efficient than their U.S. counterparts at making
sophisticated goods such as computers, which means that a given amount of resources used in
computer production yields fewer computers in South America than in theUnited States. So
the trade-off in South America might be something like 10 million winter roses for only
30,000 computers.
This difference in opportunity costs offers the possibility of a mutually beneficial

rearrangement of world production. Let the United States stop growing winter roses and
devote the resources this frees up to producing computers; meanwhile, let South America
grow those roses instead, shifting the necessary resources out of its computer industry.
Assumption of Ricardo’s Model

1) A simple model of the world with two countries each producing two goods, rubber and
textile.
2) Both countries can produce both goods if they wish ( i.e., dependence on each other is
not mandatory)
3) Constant returns to scale in production of both goods in the two countries (constant
marginal opportunity cost condition)
4) One country’s comparative advantage is grater in one line of production and the other
country’s comparative disadvantage is smaller in the other line of production.
In simple example countries are endowed with X amount of factors of production such:
a) With X factors of production A can produce, say, 120 units of rubber or 120 units of
textile or any mix of rubber and textile conditioned by the opportunity cost ratio of
1:1. The cost of producing a unit of either commodity is the same in this country.
b) With X factors of production B can produce either 40 units of rubber or 80 units of
textile or any mix of rubber and textile conditioned by the opportunity cost ratio of 1:2.
Producing rubber costs two times producing textile.
From the above production possibilities (or supply condition) it is quite clear that county A
has an absolute advantage over country B in both lines of production and country B has an
absolute disadvantage over country A in both lines of production. In terms of relative or
comparative advantage, country A has a greater comparative advantage in the production of
rubber as compared with the production of textile. B's comparative disadvantage is smaller
in the production of textile compared with the first line of production (rubber). Using a
given quantity of factor inputs country A can produce 3 units of rubber whereas country B
produces only 1 unit of rubber using the same unit of factor input. In case of textile
production country A can produce 1.5 times what country B can produce using the same
quantity of factor input.
In brief, one country's comparative advantage is greater in one line of production, and the
other country's comparative disadvantage is smaller in the other line of production.
International trade would bring production and consumption gains, when the two countries
enter into trade with each other.
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Let's see with the help of numerical models, how international trade will benefit countries in
a situation where countries differ in both absolute and comparative advantages. In other
words, how countries will benefit from international trade in a situation where one country
has a larger comparative advantage in the production of one good and the other country has
a smaller comparative disadvantage in the production of the other good.
Table 8: Production possibilities in county A and B

Commodities in units Opportunity cost ratio
Country Rubber Textile (R:T)
A 120 120 1:1
B 40 80 1:2
World 160 200
Absolute advantage
• Country A has absolute advantage in the production of both products over country B.
• Country B has absolute disadvantage in the production of both goods over country A.
Relative (comparative) advantage

• Country A's comparative advantage over country B is greater in the production of
Ruber (3:1) as compared to Textile (1.5:1)
• Country B's comparative disadvantage, in relation to country A, is lower in the
production of Textile (1:1:5) as against Rubber (1:3)
In addition country B can produce rubber at a far higher cost of production than textile. For
country B the cost of producing 1 unit of rubber equals the cost of producing 2 units of
textile. Hence country A would specialize in product of rubber and country B in production
of textile. The theory of comparative advantage suggests that a country should specialize in
the production and export of those goods in which either its comparative advantage is
greater or its comparative disadvantage is smaller. It should import those goods, in the
production of which its comparative advantage is smaller or its comparative disadvantage
is greater there by a country would be able to maximize its production (GNP) and
consumption (economic welfare) gains from trade.
Case 1 Autarky Situation

Table 9 indicates that country a produces and consumes 80 units of rubber and 40 units of
textile with the given production technology and input supply. The total production, GDP, is
120 units and this is the maximum consumption level if we assume that saving is zero.
Table 9: Production and consumption under autarky

Country Commodities in unit Total output or GDP
Rubber Textile
24
A 80 40 120
B 20 40 60
World 100 80 180
Country B produces 20 units of rubber and 40 units of textile with its given technology and
input supplies. The total production of country B is 60 units and total consumption will also
be 60 units if savings are assumed to be zero. For our simple world of two countries,
therefore, world production and consumption will be 180 units.
Table 10: Production levels after internal trade

Countr Commodities in unit Total GDP and GNP gains
y Rubber Textile Consumption
A 120 0 120 0
B 0 80 80 20
World 120 80 200 20
After trade country B becomes richer by 20 units than the autarky situation and the world
GNP increases from 180 units to 200 units. This is due to the fact that trade enables country
A to specialize in the production of Rubber, for which it has a greater comparative
advantage, and country B has specialized in the production of textile for which it has a
smaller comparative disadvantage.
As in the case of Smith’s model, the distribution of production gains from international trade
among trading countries for consumption depends on the terms of trade. The following
tables illustrate the distribution of consumption gains at different terms of trade.
The gains are equally distributed to country A and B at TOT = 3:4. This TOT is exactly half
way between internal cost ratios of country A (1:1) and country B (1:2). From table 10 and
11 we observe that, although the production gains are obtained entirely by country B, the
consumption gains are distributed equally between country A and B. This is due to the
equitable terms of trade.
Table 11: Consumption levels after IT at TOT = 3:4
import
A 90 40 130 10
import
B 30 40 70 10
World 120 80 200 20
At TOT equal to 1:1 as shown below, all the gains in consumption are appropriated by
country B due to the reason that TOT is equal to the internal opportunity cost ratio of
country A. In this situation, country A will not gain anything from international trade,
25
because the cost of importing the good is the same as the cost of producing that good
domestically.
Table 12: Consumption levels after IT at TOT =1:1=OCR of A

import
A 80 40 120 0
import
B 40 40 80 20
World 120 80 200 20
All the gains in consumption are appropriated by country A due to the reason that TOT is equal
to the internal opportunity cost ratio of country B.
Table 13: Consumption levels after IT at TOT = 1:2 = OCR of B

import
A 90 60 140 20
import
B 30 20 50 0
World 120 80 200 20
2.3.3 Comparative advantage and opportunity cost theory

The opportunity cost theory states that, the opportunity cost of commodity is the amount of a
second commodity that must be given up to release just enough resources to produce one
additional unit of the first commodity. In this theory no assumption is made about labor theory
of value (i.e., labor is the only factor of production, labor homogenous, and the cost or price of a
commodity depends on exclusively from its labor content) consequently, the nation with the
lower opportunity cost in production of a commodity has a comparative advantage in that
commodity (and a comparative disadvantage in the second commodity).
For example, if in the absence of trade, Malaysia must give up 2 units of Rubber to release just
enough resources to produce one additional unit of textile domestically, then the opportunity
cost of textile is 2 units of rubber (i.e. 1t = 2r in Malaysia). In case of India 1t = 1/2r, then the
opportunity cost of textile (in terms of the amount of rubber that must be given up) is lower in
India than Malaysia, and India would have a comparative (cost) advantage over Malaysia in
textile. In two- nation, two-commodity world, Malaysia would then have a comparative
advantage in rubber. Note that, this result is exactly what we concluded earlier with the
comparative advantage trade theory based on the labor theory of value, but now our explanation
is based on the opportunity cost.
2.3.4 The basis for and gains from trade under constant costs
In the absence of trade, a nation can only consume the commodity that it produces. As a result,
the nation’s production possibility frontier represents its consumption frontier. Which
combination of commodities the nation actually chooses to produce and consume depends on
26
the people's tastes, or demand considerations as well as the term of trade between the two
commodities in the two nations.
Politicians, business leaders, and even economists frequently make statements that do not
stand up to careful economic analysis. For some reason this seems to be especially true in
international economics. Open the business section of any Sunday newspaper or weekly
news magazine and you will probably find at least one article that makes foolish statements
about international trade. However, our simple model of comparative advantage can be used
to see why they are incorrect2.
2.3.5 International Equilibrium in Trade: Extension of Classical Theory

The following figure shows how the equilibrium-relative commodity price with trade is determined
by partial equilibrium analysis. The Curves DX and SX in panels A and C refer to the demand and
supply curves for commodity X of nation 1 and Nation 2, respectively. the vertical axes in all three
panels of figure 4.1 measure the relative price of commodity X (i.e., PX/PY, or the amount of
commodity Y that a nation must give up to produce one additional unit of X). The horizontal axes
measure the quantities of commodity X.
Panel A of shows that in the absence of trade, Nation 1 produces and consumes at point A at the
relative price of X of P1 while nation 2 produces and consumes at point A’ at P3 with the opening of
trade, the relative price of X will be between P1 and P3 if both nations are large. At prices above P1,
nation 1 will supply (produce) more than it will demand (consume) of commodity X and will export
the difference of excess supply (see panel A). on the other hand, at prices below P3, nation 2 will
demand a greater quantity of commodity X than it produces or supplies domestically and will import
the difference of excess demand (see panel C).
Panel A Panel B Panel C

International Trade sx
Nation 1's Market P3 Nation 2's market
for Commodity x in commodity x for commodity x
A''
A'
P3 Exports sx S'
B B'' B'
E E'
P2 E'
A''
P1 A D imports
Dx
Dx
X XX 0
0 0
Figure 2.1 Equilibrium-Relative Commodity Price with Trade-Partial Equilibrium Analysis
Specifically, panel A shows that at P1, the quantity supplied of commodity X (QSX) equals
the quantity demanded of commodity X (QDx) in nation 1, and so nation 1 exports nothing
of commodity X this gives point A* on curve S (nation 1’s supply curve of exports) in panel
B. panel A also shows that at P2, the excess of BE of QSx over QDx represents the quantity
of commodity X that Nation 1 would export at P2. This is equal to B*E* in panel B and
defines point E* on nation 1’s S curve of exports of commodity X
2 Reading assignment: read the three misconceptions about comparative advantage

27
On the other hand, panel C shows that at P3, QDx = QSx (point A’) so nation 2 does not
demand and imports of commodity X. this defines point A” on nation 2s demand curve for
import of commodity X (D) in panel B. panel C also shows that at P2, the excess B’F’ of
QDx over QSx represents the quantity of commodity X that nation 2 would import at P2.
This is equal to B*E* in panel B and defines point E* on nation 2’s curve of imports of
commodity X.
At P2, the quantity of imports of commodity X demanded by nation 2 (B’E’ in panel C)

equals the quantity of exports of commodity X supplied by nation 1 (BE in panel A) this At
P, the quantity of imports of commodity X demanded by Nation 2 (B’E’ in panel C’) equals
the quantity of exports of commodity X supplied by nation 1 (BE in panel A). This is shown
by the intersection of the D and S curves for trade in commodity X in panel B. thus, P2 is
the equilibrium-relative price of commodity X with trade. From panel B we can also see that
at PX/PY>P2 the quantity of exports of commodity X supplied exceeds the quantity of
imports demanded, and so the relative price of X (P X/PY) will fall to P2. Dear student on the
other hand, at PX/PY<P2, the quantity of imports of commodity X demanded exceeds the
quantity of exports supplied and PX/PY will rise to P2.
How the relative commodity price of Y (i.e. PY/PX) could be measured? Try to show this
graphically. The same could be shown with commodity Y. Commodity Y is exported by
nation 2 and imported by nation 1. At any relative price of Y higher than equilibrium, the
quantity of exports of Y supplied by nation 2. Would exceed the quantity of imports of Y
demanded by nation 1 and the relative price of Y would fall to the equilibrium level. On the
other hand, at any PY/PX below equilibrium, the quantity of imports of Y demand would
exceed the quantity of exports of Y supplied, and PY/PX would rise to the equilibrium level.
2.3.6 The Reciprocal Demand and Offer Curve Analysis

The Principle of Reciprocal Demand was developed by J.S. Mill in 1848 when he wrote his
book: Principles of Political Economy. Later offer curve technique was developed by
Edgeworth and Marshall. The offer curve tries to show how the terms of trade are
determined by the interaction of demand and supply. Their merit lies in the fact that they
resolve the problem of determining the exact terms of trade that emerge in trade equilibrium.
Assumptions
• Simple model of the world with two countries A and B,
• Country A specializes in the production of textile and B in rubber.
The TOT, then according to the law of reciprocal demand, are determined by A’s demand
for B’s product and B’s demand for A’s product. In other words, the TOT are determined by
the intensity of domestic demand for foreign goods (offer curve of the country A) and of the
foreign demand for domestic good (offer curve of the other country B). The equilibrium
TOT is determined at the point where the offer curves of the two countries intersect.
Table 14 indicates that textile is country A’s exportable product, and rubber is its importable
product. Country A has completely specialized in the production of textile, because it has an
absolute or comparative advantage in this line of production. If consumers in country A
28
want to consume rubber, it can be fulfilled only by importing it from country B, which has
achieved complete specialization in rubber production.
Table 14: Schedule of Trade Propensity for country A

Textile (Exportable) Rubber (Importable) Potential TOT ratios
25 5 5:1
40 10 4:1
60 20 3:1
80 40 2:1
100 100 1:1
90 120 0.75:1
Initially when country A does not have any rubber to consume at all, it is willing to export
25 units of textile in exchange for 5 units of rubber implying trade takes place at 5:1 terms
of trade.
This is the highest TOT in the above table and as trade continues between A and B, the TOT
declines. The reason is, initially the marginal utility of rubber for country A is so high that it
is willing to offer 5 units of textile (export) in exchange for 1 unit of rubber (import). But as
trade continues and country A consumes more and more of the imported product (rubber),
the marginal utility from additional consumption of rubber goes down. This is explained by
the decrease in the TOT ratios in column 3 of table 10 from 5:1 to 1:1.
This follows from the law of diminishing marginal utility where the consumer is willing to
pay higher price per unit of utility initially, but only lower and lower price for subsequent
unit that he/she buys. In the same way the price that a country is willing to pay per unit of
imports decrease as the imports increase in quantity. The TOT in column 3 of table 14 are
potential terms of trade, which only indicate country A’s propensity to trade more and more
at different possible terms of trade. That is, as TOT decreases what country A want to export
and import will also increase as indicated in columns 1 and 2 of table 14. We can plot the
information in table 10 and draw the offer curve of country A as shown below.
The continuous line which is drawn from the point of origin connecting all the five points,
1,2,3,4, and 5 is the offer curve of country A. It is designated as OA. It has a positive slope
and it is non-linear. Its positive slope derives from country A's desire to trade more and
more, though at different terms of trade. Up to point 5 its slope continues to be positive. At
point 5, country A is willing to offer 100 units of textiles in exchange for 100 units of
rubber imports. Beyond point 5, however, the offer curve has a negative slope. This
indicates that at point 5 where country A exports 100 units, its desire or the capacity to
export more textiles is exhausted.
29
Textil
5
6
100
90
80
3 4
OA
60
40 2
1
20
20
40
60 80 100 120 Rubber
Figure 2.2: Derivation of an offer curve
At point 6 in the diagram, country A is willing to accept or import 120 units of rubber at a
price of only 90 units of textile exports. This will not be acceptable to country B; because,
for country B it is better to sell 100 units of rubber and receive100 units of textiles at point
5 than trading at point 6. This means country A would be willing to trade with country B
even beyond point 5, but this will not be acceptable by country B. Therefore, trade
virtually cannot take place beyond point 5. Thus, we can have the following properties of
offer curve of a country.
i. The relevant portion of the offer curve is positively sloped
Only the positively sloping portion of the offer curve is relevant for trade equilibrium. The
negative portion of the other offer curve is an irrelevant range.
ii. The offer curve is not a straight line, it is a non-linear curve.

This property follows from the law of diminishing marginal utility for the purchased goods.
For a given unit of imported commodity, country A is willing to offer less and less price as it
goes on importing more and more quantity. The rays which are drawn from the point of
origin across points 1, 2, 3, 4, 5 and 6 represent potentially acceptable terms of trade from
the standpoint of country A. They all have different slopes suggesting that the price of
rubber, payable in terms of the number of units of textiles per unit of rubber imported, goes
on decreasing as country A imports larger and larger quantities of imports.
iii. The offer curve is a composite curve (both demand and supply)
Each point on the offer curve represents the demand of the country for imports and supply of
the country (exports).
The offer curve of a country has an affinity with the potential terms of trade. The question
then is where the actual terms of trade are? This cannot be known until the other
country's offer curve is known. It is unnecessary to repeat the whole explanation, because
the same principles apply to country B's offer curve as those of country A's offer curve.
The only point to emphasize for contrast would be that country A's importable product
would be country B's exportable. Once we know the offer curve of country A and country B,
30
we can see where the actual terms of trade are. Figure 2.2 demonstrates where the terms of
trade are actually settled between the two countries.
OA and OB are the two offer curves of country A and country B. Both intersect at point 1,
country A is willing to offer (export) Oa quantity of textiles in exchange for Ob quantity of
rubber imports. This perfectly matches with country B's trading propensity as well, because
at point 1, country B is willing to offer (export) Ob quantity of rubber in exchange for Oa
quantity of textile imports. In other words, A's demand for B's product exactly coincides
with B's demand for A's product at point 1.
Textile OB e
1
a
OA
C2
2
C3
C1
a1
C4
O
b1 b Rubber
Figure 2.3: Determination of TOT
The straight line starting from the point of origin and going through point 1 is the
equilibrium terms of trade line, Oe. The slope of this line represents the international terms
of trade (i.e., the price of rubber in terms of textile).
The two countries can trade as much or as little as they wish along the terms of trade line
Oe, but beyond point 1 on the Oe line they will have no incentive to trade further. The
equilibrium size of trade is represented by the triangle Oal or Ob1 i.e., when Oa exports of
country A (or bl imports of country B) are matched by al imports of country a (or Ob
exports of country B). Beyond point 1 there will be no incentive for trade between the two
countries. By the same token, an incentive to trade will not stop until the two countries reach
point 1 on the Oe line. Let us see why this is so. Take for instance a point such as point 2 on
the terms of trade line Oe. At point 2 there is:
• Excess offer of C3C1 amount of rubber by country B to country A, and
• Excess offer of C2C4 amount of textiles by country A to country B.
Both the countries accept this excess offers and their trade volumes increase. This process of
trade expansion will go on until the excess offers by the two countries are eliminated. Such a
point is reached when both countries arrive at point 1, where country A's offer is exactly
equal to what country B is asking for, and country B's offer is also exactly equal to what
country A is willing to accept. We say that at point 1 the reciprocal demands of the two
countries are in exact balance and trade equilibrium point is reached. This has taken place at
a point where the two offer curves intersect. The size of international trade corresponding to
this equilibrium position is Oa of textile exports plus b1 of rubber imports for country A that
equals a1 textile imports plus Ob rubber exports of country B at Oe terms of trade.
Changes in Terms of Trade
The offer curve of a country is both a demand curve and a supply curve. It is a demand
curve to the extent that it represents domestic demand for foreign goods. It is also a
31
supply curve insofar as it represents quantities of exportable goods offered in exchange
for imported good. An offer curve of a country, therefore, is a composite curve,
representing demand for importable goods and supply of exportable goods. This applies
to offer curves of both (or all) the countries. When the offer curves of two countries
intersect at a point such as 1 in figure 2.3 we have equilibrium terms of trade in the
static sense. But the conditions underlying demand and supply in the home and the
foreign country do not remain static forever. Many dynamic changes are possible. For
example, the domestic demand for foreign goods may change due to changes in tastes,
incomes, foreign prices of the goods etc. Similarly, the supplies of exportable goods
may change on account of changes in domestic cost conditions or demand conditions.
In the same way there could be changes affecting foreign country's offer curve as well.
Textile b
OB1
OB2 OA2
3
e
OA1
1
O
Rubber
Figure 2.4: Changes in Terms of Trade
This figure demonstrates the effects of such dynamic changes on the equilibrium terms
of trade and size of international trade. OA and OB are the offer curves of countries A
and B respectively. Point 1 determines equilibrium size of international trade in the
static sense; Oe line represents static terms of trade. A leftward shift in country B's offer
curve from OB1 to OB2 would shift the terms of trade line from Oe to Ob.
This would shift the trade equilibrium position from point 1 to point 2 as shown in figure
2.3. Such a shift causes terms of trade to improve for country B and worsen for country A.
Country A is now able to import a smaller quantity of rubber in exchange for a given
quantity of textile exports. This is suggested by the fact that the new terms of trade line, Ob,
is steeper than the original terms of trade line Oe. As the terms of trade line becomes
steeper, and keeps moving closer to the vertical axis (measure country A's export product)
the terms of trade would go on worsening for country A & improving for country B.
A shift from point 1 to point 2 causing terms of trade deterioration for country A has, in this
case come about due to adverse changes in country B for country A's export product. This
may have been the as a result of several factors like:
32
• A drop in the taste in country B for the product of country A.
• Country B might have diverted its trade direction away from country A to some other
country in the world. This will reduce country B's demand for country A’s product.
• Country B might have launched a program of import substitution as a result of which
it has started' producing country A's product domestically within country B itself.
It is also possible for terms of trade to worsen for country A even though there are no
adverse changes in country B towards the product of country A. For instance, starting
from point 1 we could end up at point 3 in figure 2.3. This will also shift the terms of
trade line from Oe to Ob. Note, however, that this time the worsening of terms of trade
is a result of a leftward shift in country A's offer curve from OA 1 to OA2. Such a shift is
due to changes that have taken place within country A itself. These internal changes
could be:
• Increase in export production in country A leading to fall in the price of export
product.
• A technological revolution in the export production has considerably cut costs
of producing textiles in country A. This would mean that country A has become
a more efficient producer and exporter of its product to country B.
In this way it is possible to visualize number of changes in supply condition in country

A that will have the effect of shifting its offer curve from OA 1 to OA2. Compare now
the effects on terms of trade on country A as a result of going from point 1 to point 2
and going from point 1 to point 3. In either case, of course, there has been the same
degree of deterioration in terms of trade affecting country A adversely. But there are
differences too. These differences are:
• Movement from point 1 to point 2 has resulted in contraction of the volume of

world trade; but in respect of the movement from point 1 to point 3 there has been
an expansion in trade volume.
• Movement from point 1 to point 2 is the result of an adverse demand shift in the
foreign country (country B) causing terms of trade decline for country A. Country
A may suffer trading losses on account of such terms of trade deterioration. In the
case of a movement from point 1 to point 3, however, there is decline in terms of
trade for country A; but this term of trade decline may not amount to a trading loss
as such. Because, this movement has resulted from favorable supply shifts in the
home country (country A) itself, such as for example technological progress or
efficiency in export production leading to reduced input costs. Country B, in this
case benefits from such technological progress in country A, because country A
can now sell its product at a lower price to country B. Country A can increase
country B's welfare without suffering any loss of welfare itself. In this way the
benefits of progress in one country (country d A in this case) can be transmitted to
other countries (country B) in the form of reduced export prices.
The classical economists had these advantages of trade in their mind; they thought that
international trade would act as a "transmission belt" in which the benefits of growth,
productivity and efficiency in one country will be passed on to other countries through
the mechanism of trade.
33
The reality of the world today may appear to be quite puzzling. Advanced industrial
countries have experienced remarkable progress in technology and productivity in
the last several years, but this does not seem to have resulted in reduced prices of
their products to the developing countries. Examples are not lacking. According to a
United Nations' report, 25 tons of rubber exports could earn enough foreign
exchange for a less developed country to buy 6 tractors from an advanced industrial
country in 1960; but in 1975, the same 25 tons of rubber can buy only 2 tractors.
Technological breakthrough in rubber production has reflected in rubber price

reduction by rubber exporting countries (i.e. the LDCs), but the industrial countries
have not reduced their tractor prices in spite of a much more spectacular
technological progress in all fields of industrial production. This is quite contrary to
what the classical economists had hoped about benevolent trade between countries.
Where have the productivity gains, resulting from technological progress in the
industrial countries, gone then? They have gone in the form of higher wages, profits
and standards of living in those countries themselves. The benefits of technological
progress in the LDCs have gone to the industrial countries in the form of reduced
prices of primary goods, which the LDCs export to the industrial countries. This
would only suggest that trade is benefiting the rich countries and not the poor
countries. Productivity gains are going from the poor to the rich countries, while
rich countries themselves are retaining their productivity gains by improving their
wage and profit levels. LDCs are quite bitter about such kind of trade relationship
existing in the world today.
Let us now take another situation where the offer curve of country B, rich country, is a
straight line and the offer curve of country A, poor country, not as shown in the
following figure 2.5.
Textile
OB
3
OA3
2
OA2
1 OA1
Rubber
Figure 2.5: Trade between
To whatever direction the offer curve of country A shifts, the terms of trade remains
constant and equal to the offer curve of country B. From this it should be realized that a
small country could exercise no influence in changing the course of international terms of
trade. A small country, like country A in this case, is essentially price taker than a price-
maker.
Determinants of the Terms of Trade

The terms of trade ultimately decided on by the two trading parties will depend on a variety of
different and distinct factors. Next we describe many of these factors.
34
1. Preferences:-The strength of each farmer’s desire for the other product will influence
how much he is willing to give up obtaining the other product. Economists assume that
most products exhibit diminishing marginal utility. This means that the tenth orange
consumed by Farmer Smith adds less utility than the first orange he consumes. In effect,
we expect people to get tired of eating too many oranges. Since for most people the tenth
orange consumed will be worth less than the first apple consumed, Farmer Smith would
be willing to trade at least one orange for one apple. As long as the same assumption
holds for Farmer Jones, the tenth apple for him will be worth less than the first orange,
and he will be willing to trade at least one for one. How many more oranges might trade
for how many more apples will depend on how much utility each farmer gets from
successive units of both products: in other words, it depends on the farmers’ preferences.
2. Uncertainty:- In this situation, each farmer is unlikely to have well-defined preferences.
Farmer Smith may never have tasted an apple, and Farmer Jones may never have tasted
an orange. One simple way to resolve this uncertainty is for the farmers to offer free
samples of their products before an exchange is agreed on. Without a sample, the
farmers would have to base their exchanges on their expectations of how they will enjoy
the other product. Free samples, on the other hand, can be risky. Suppose a sample of
oranges is provided and Farmer Jones learns that he hates the taste of oranges. He might
decide not to trade at all. To overcome uncertainty in individual preferences, many
consumer products are offered in sample sizes to help some consumers recognize that
they do have a preference for the product. This is why many supermarkets offer free
samples in their aisles and why drink companies sometimes give away free bottles of
their products.
3. Scarcity:-The relative quantities of the two goods available for trade will affect the
terms of trade. If Farmer Smith came to the market with one hundred oranges to Farmer
Jones’s ten apples, then the terms of trade would likely be different than if the farmers
came to the market with an equal number. Similarly, if the farmers came to the market
with ten oranges and ten apples, respectively, but recognized that they had an entire
plantation of apples and an entire grove of oranges waiting back at home, then the
farmers would be more likely to give up a larger amount of their product in exchange.
4. Size:-The sizes of the apples and oranges are likely to influence the terms of trade. One
would certainly expect that Farmer Smith would get more apples for each orange if the
oranges were the size of grapefruits and the apples the size of golf balls than if the
reverse were true.
5. Quality:-The quality of the fruits will influence the terms of trade. Suppose the apples
are sweet and the oranges are sour. Suppose the apples are filled with worm holes.
Suppose the oranges are green rather than orange. Or consider the vitamin, mineral, and
calorie contents of each of the fruits. Quality could also be assessed by the variety of
uses for each product. For example, apples can be eaten raw, turned into applesauce,
squeezed into juice, made into pies, or covered with caramel.
6. Effort:-Although a pure exchange model assumes that no production takes place,
imagine momentarily that some effort is required to harvest the fruit. What if apples
grew at the top of tall trees that required a precarious climb? What if predatory wolves
lived in the orange grove? Surely these farmers would want to take these factors into
account when deciding the terms for exchange. Of course, this factor is related to
scarcity. The more difficult it is to produce something, the scarcer that item will be.
7. Persuasion:-The art of persuasion can play an important role in determining the terms of
trade. Each farmer has an incentive to embellish the quality and goodness of his product
35
and perhaps diminish the perception of quality of the other product. Farmer Smith might
emphasize the high quantities of vitamin C found in oranges while noting that apples are
relatively vitamin deficient. He might argue that oranges are consumed by beautiful
movie stars who drive fast cars, while apples are the food of peasants. He might also
underemphasize his own desire for apples. The more persuasive Farmer Smith is, the
more likely he is to get a better deal in exchange. Note that the farmer’s statements need
not be truthful as long as the other farmer is uncertain about the quality of the other
product. In this case, differences in the persuasive abilities of the two farmers can affect
the final terms of trade.
8. Expectations of Utility:-Decisions about how much to trade are based on the utility one
expects to obtain upon consuming the good. The utility one ultimately receives may be
less. Indeed, in some cases the value of what one receives may be less than the value of
what one gives up. However, this outcome will arise only if expectations are not
realized.
9. Expectations of a Future Relationship:-If the farmers expect that the current
transaction will not be repeated in the future, then there is a potential for the farmers to
misrepresent their products to each other. Persuasion may take the form of outright lies if
the farmers do not expect to meet again. Consider the traveling medicine man portrayed
in U.S. Western movies. He passes through town with a variety of elixirs and promises
that each will surely cure your ailment and possibly do much more. Of course, chances
are good that the elixirs are little more than colored water with some alcohol and are
unlikely to cure anything. But this type of con game is more likely when only one
transaction is expected. However, if the transaction is hoped to be the first of many to
come, then untruthful embellishments will be less likely.
10. Government Policies:-If a taxman stands ready to collect a tax based on the amounts
traded between the two farmers, this is likely to affect the terms of trade. Also, if laws
impose penalties for misrepresentation of a product, then this will also affect the
farmers’ behavior in determining the terms of trade.
11. Morality:-Imagine that Farmer Smith was raised to always tell the truth, while Farmer
Jones missed those lessons during his upbringing. In this case, Farmer Jones might be
more likely to misrepresent his apples in order to extract a more favorable terms of trade.
12. Coercion:-Finally, the terms of trade can also be affected by coercion. If Farmer Jones
threatens Farmer Smith with bodily injury, he might be able to force an exchange that
Farmer Smith would never agree to voluntarily. At the extreme, he could demand all of
Farmer Smith’s oranges and not give up any apples in exchange. Of course, once
coercion enters a transaction, it may no longer be valid to call it trade-it would be more
accurate to call it theft.
2.4. The Neoclassical Trade Theory
2.4.1 Factor Endowments and the Heckscher-Ohlin Theorem
Recent contributions to the pure theory of international trade have relied heavily on the
factor proportions analysis developed by the two Swedish economists, Eli Heckscher (1919)
and Bertil Ohlin (1933). According to their theory, the immediate cause of international
trade is, the differences in the relative prices of commodities between the countries, and
these differences in the commodity prices arise on account of the differences in the factor
supplies (endowments) in the two countries. The H-O theory examines the basis for
comparative advantage and the effect that trade has on factor earnings in the nations.
2.4.2 Assumption of the theory
36
The Heckscher–Ohlin theory is based on the following assumptions3:
1. There are two nations (Nation 1 and Nation 2), two commodities (commodity X and
commodity Y), and two factors of production (labor and capital).
2. Both nations use the same technology in production.
3. Commodity X is labor intensive, and commodity Y is capital intensive in both nations.
4. Both commodities are produced under constant returns to scale in both nations.
5. There is incomplete specialization in production in both nations.
6. Tastes are equal in both nations.
7. There is perfect competition in both commodities and factor markets in both nations.
8. There is perfect factor mobility within each nation but no international factor mobility.
9. There are no transportation costs, tariffs, or other obstructions to the free flow of
international trade.
10. All resources are fully employed in both nations.\
11. International trade between the two nations is balanced.
2.4.3 Factor Intensity, Factor Abundance, and the Shape of the Production Frontier
Since the Heckscher–Ohlin theory is in terms of factor intensity and factor abundance, it is
crucial that the meaning of these terms be very clear and precise. Hence, the meaning of
factor intensity is explained factor abundance and its relationship to factor prices. We focus
on the relationship between factor abundance and the shape of the production frontier of
each nation.
Factor Intensity
In a world of two commodities (X and Y) and two factors (labor and capital), we say that
commodity Y is capital intensive if the capital–labor ratio (K/L) used in the production of Y
is greater than K/L used in the production of X. For example, if two units of capital (2K) and
two units of labor (2L) are required to produce one unit of commodity Y, the capital–labor
ratio is one. That is 2/2, in the production of Y. If at the same time 1K and 4L are required to
produce one unit of X, K/L =1/4 for commodity X. Since K/L = 1 for Y and K/L =1/4 for X,
we say that Y is K intensive and X is L intensive. Note that it is not the absolute amount of
capital and labor used in the production of commodities X and Y that is important in
measuring the capital and labor intensity of the two commodities, but the amount of capital
per unit of labor (i.e., K/L). For example, suppose that 3K and 12L (instead of 1K and 4L)
are required to produce 1X, while to produce 1Y requires 2K and 2L (as indicated earlier).
Even though to produce 1X requires 3K, while to produce 1Y requires only 2K, commodity
Y would still be the K-intensive commodity because K/L is higher for Y than for X. That is,
K/L =2/2 for Y, but K/L = 3/12 =1/4 for X.
If we plotted capital (K) along the vertical axis of a graph and labor (L) along the horizontal
axis, and production took place along a straight-line ray from the origin, the slope of the line
would measure the capital–labor ratio (K/L) in the production of the commodity. This is
shown in Figure 5.1. Figure 5.1 show that Nation 1 can produce 1Y with 2K and 2L. With
4K and 4L, Nation 1 can produce 2Y because of constant returns to scale (assumption 4).
Thus, K/L =2/2=4/4 = 1 for Y. This is given by the slope of 1 for the ray from the origin for
commodity Y in Nation 1 (see the figure). On the other hand, 1K and 4L are required to
produce 1X, and
3 See Salvatore, page 110 for the meaning of assumption

37
2K and 8L to produce 2X, in Nation 1. Thus, K/L =1/4 for X in Nation 1. This is given by
the slope of for the ray from the origin for commodity X in Nation 1. Since K/L, or the slope
of the ray from the origin, is higher for commodity Y than for commodity X, we say that
commodity Y is K intensive and commodity X is L intensive in Nation 1.
In Nation 2, K/L (or the slope of the ray) is 4 for Y and 1 for X (see Figure 5.1). Therefore,
Y is the K-intensive commodity, and X is the L-intensive commodity in Nation 2 also. This
is illustrated by the fact that the ray from the origin for commodity Y is steeper (i.e., has a
greater slope) than the ray for commodity X in both nations. Even though commodity Y is K
intensive in relation to commodity X in both nations, Nation 2 uses a higher K/L in
producing both Y and X than Nation 1. For Y, K/L = 4 in Nation 2 but K/L = 1 in
Nation1.For X, K/L = 1 in Nation 2 but K/L =1/4 in Nation 1. The obvious question is: Why
does Nation 2 use more K intensive production techniques in both commodities than Nation
1? The answer is that capital must be relatively cheaper in Nation 2 than in Nation 1, so that
producers in Nation 2 use relatively more capital in the production of both commodities to
minimize their costs of production. But why is capital relatively cheaper in Nation 2? To
answer this question, we must define factor abundance and examine its relationship to factor
prices. Before doing this, however, we must settle one other related point of crucial
importance. This refers to what happens if, for whatever reason, the relative price of capital
falls. Producers would substitute capital for labor in the production of both commodities to
minimize their costs of production. As a result, both commodities would become more K
intensive. However, only if K/L in the production of commodity Y exceeds K/L in the
production of commodity X at all possible relative factor prices can we say unequivocally
that commodity Y is the K-intensive commodity.
Nation 2 uses a higher K/L in the production of both commodities because the relative price
of capital is lower in Nation 2 than in Nation 1. If the relative price of capital declines,
producers will substitute K for L in the production of both commodities to minimize their
costs of production. Thus, K/L will rise for both commodities, but Y continues to be the K-
intensive commodity.
38
Factor Abundance
There are two ways to define factor abundance. One way is in terms of physical units (i.e., in
terms of the overall amount of capital and labor available to each nation). Another way to
define factor abundance is in terms of relative factor prices (i.e., in terms of the rental price
of capital and the price of labor time in each nation).
According to the definition in terms of physical units, Nation 2 is capital abundant if the
ratio of the total amount of capital to the total amount of labor (TK/TL) available in Nation 2
is greater than that in Nation1 (i.e., if TK/TL for Nation 2 exceeds TK/TL for Nation 1). Note
that it is not the absolute amount of capital and labor available in each nation that is
important but the ratio of the total amount of capital to the total amount of labor. Thus,
Nation 2 can have less capital than Nation 1 and still be the capital-abundant nation if TK/TL
in Nation 2 exceeds TK/TL in Nation 1.
According to the definition in terms of factor prices, Nation 2 is capital abundant if the ratio
of the rental price of capital to the price of labor time (PK/PL) is lower in Nation 2 than in
Nation 1 (i.e., if PK/PL in Nation 2 is smaller than PK/PL in Nation 1). Since the rental
price of capital is usually taken to be the interest rate (r) while the price of labor time is the
wage rate (w), PK/LP = r/w. Once again, it is not the absolute level of r that determines
whether or not a nation is the K-abundant nation, but r/w. For example, r may be higher in
Nation 2 than in Nation 1, but Nation 2 will still be the K abundant nation if r/w is lower
there than in Nation 1.
The relationship between the two definitions of factor abundance is clear. The definition of
factor abundance in terms of physical units considers only the supply of factors. The
definition in terms of relative factor prices considers both demand and supply (since we
know from principles of economics that the price of a commodity or factor is determined by
both demand and supply considerations under perfect competition). Also from principles of
economics, we know that the demand for a factor of production is a derived demand—
derived from the demand for the final commodity that requires the factor in its production.
Since we have assumed that tastes, or demand preferences, are the same in both nations, the
two definitions of factor abundance give the same conclusions in our case. That is, with
TK/TL larger in Nation 2 than in Nation 1 in the face of equal demand conditions (and
technology), PK/PL will be smaller in Nation 2. Thus, Nation 2 is the K-abundant nation in
terms of both definitions.
This is not always the case. For example, it is conceivable that the demand for commodity Y
(the K-intensive commodity), and therefore the demand for capital, could be so much higher
in Nation 2 than in Nation 1 that the relative price of capital would be higher in Nation 2
than in Nation 1 (despite the relatively greater supply of capital in Nation 2). In that case,
Nation 2 would be considered K abundant according to the definition in physical terms and L
abundant according to the definition in terms of relative factor prices. In such situations, it is
the definition in terms of relative factor prices that should be used. That is, a nation is K
abundant if the relative price of capital is lower in it than in the other nation. In our case,
there is no such contradiction between the two definitions. Nation 2 is K abundant and
Nation 1 is L abundant in terms of both definitions. We will assume this to be the case
throughout the rest of the chapter, unless otherwise explicitly indicated.
In such situations, it is the definition in terms of relative factor prices that should be used.
That is, a nation is K abundant if the relative price of capital is lower in it than in the other
nation. In our case, there is no such contradiction between the two definitions. Nation 2 is K
abundant and Nation 1 is L abundant in terms of both definitions.
Factor Abundance and the Shape of the Production Frontier
39
Since Nation 2 is the K-abundant nation and commodity Y is the K-intensive commodity,
Nation 2 can produce relatively more of commodity Y than Nation 1. On the other hand,
since Nation 1 is the L-abundant nation and commodity X is the L-intensive commodity,
Nation 1 can produce relatively more of commodity X than Nation 2. This gives a
production frontier for Nation 1 that is relatively flatter and wider than the production
frontier of Nation 2 (if we measure X along the horizontal axis). In Figure 5.2, we have
plotted the production frontiers of Nation 1 and Nation 2 on the same set of axes. Since
Nation 1 is the L-abundant nation and commodity X is the L-intensive commodity, Nation
1’s production frontier is skewed toward the horizontal axis, which measures commodity X.
On the other hand, since Nation 2 is the K-abundant nation and commodity Y is the K-
intensive commodity, Nation 2’s production frontier is skewed toward the vertical axis
measuring commodity Y.
Having clarified the meaning of factor intensity and factor abundance, we are now ready to
present the Heckscher–Ohlin theory.
Factor Endowments and the Heckscher–Ohlin Theory

The Heckscher–Ohlin (H–O) theory can be presented in a nutshell in the form of two
theorems: the so-called H–O theorem (which deals with and predicts the pattern of trade)
and the factor–price equalization theorem (which deals with the effect of international trade
on factor prices).
The Heckscher–Ohlin Theorem
A nation will export the commodity whose production requires the intensive use of the
nation’s relatively abundant and cheap factor and import the commodity whose production
requires the intensive use of the nation’s relatively scarce and expensive factor. In short, the
relatively labor-rich nation exports the relatively labor-intensive commodity and imports the
relatively capital-intensive commodity. In terms of our previous discussion, this means that
Nation 1 exports commodity X because commodity X is the L-intensive commodity and L is
the relatively abundant and cheap factor in Nation 1. Conversely, Nation 2 exports
commodity Y because commodity Y is the K-intensive commodity and K is the relatively
abundant and cheap factor in Nation 2 (i.e., r/w is lower in Nation 2 than in Nation 1). Of all
the possible reasons for differences in relative commodity prices and comparative advantage
among nations, the H–O theorem isolates the difference in relative factor abundance, or
factor endowments, among nations as the basic cause or determinant of comparative
40
advantage and international trade. For this reason, the H–O model is often referred to as the
factor-proportions or factor-endowment theory. That is, each nation specializes in the
production and export of the commodity intensive in its relatively abundant and cheap factor
and imports the commodity intensive in its relatively scarce and expensive factor.
Thus, the H–O theorem explains comparative advantage rather than assuming it (as was the
case for classical economists). In other words, the H–O theorem postulates that the
difference in relative factor abundance and prices is the cause of the pre trade difference in
relative commodity prices between two nations. This difference in relative factor and
relative commodity prices is then translated into a difference in absolute factor and
commodity prices between the two nations (as outlined in Section 2.4d). It is this difference
in absolute commodity prices in the two nations that is the immediate cause of trade.
General Equilibrium Framework of the Heckscher–Ohlin Theory

The general equilibrium nature of the H–O theory can be visualized and summarized with
the use of Figure 5.3. Starting at the lower right-hand corner of the diagram, we see that
tastes and the distribution in the ownership of factors of production (i.e., the distribution of
income) together determine the demand for commodities. The demand for commodities
determines the derived demand for the factors required to produce them. The demand for
factors of production, together with the supply of the factors, determines the price of factors
of production under perfect competition. The price of factors of production, together with
technology, determines the price of final commodities. The difference in relative commodity
prices between nations determines comparative advantage and the pattern of trade (i.e.,
which nation exports which commodity).
Figure 5.3 shows clearly how all economic forces jointly determine the price of final
commodities. This is what is meant when we say that the H–O model is a general
equilibrium model.
However, out of all these forces working together, the H–O theorem isolates the difference
in the physical availability or supply of factors of production among nations (in the face of
equal tastes and technology) to explain the difference in relative commodity prices and trade
among nations. Specifically, Ohlin assumed equal tastes (and income distribution) among
nations. This gave rise to similar demands for final commodities and factors of production in
different nations. Thus, it is the difference in the supply of the various factors of production
41
in different nations that is the cause of different relative factor prices in different nations.
Finally, the same technology but different factor prices lead to different relative commodity
prices and trade among nations. Thus, the difference in the relative supply of factors leading
to the difference in relative factor prices and commodity prices is shown by the double lines
in Figure 5.3. Note that the H–O model does not require that tastes, distribution of income,
and technology be exactly the same in the two nations for these results to follow. It requires
only that they be broadly similar. The assumptions of equal tastes, distribution of income,
and technology do simplify the exposition and graphical illustration of the theory.
Illustration of the Heckscher–Ohlin Theory

The H–O theory is illustrated in Figure 5.4. The left panel of the figure shows the production
frontiers of Nation 1 and Nation 2, as in Figure 5.2. As indicated in Section 5.3c, Nation 1’s
production frontier is skewed along the X-axis because commodity X is the L-intensive
commodity, Nation 1 is the L-abundant nation, and both nations use the same technology.
Furthermore, since the two nations have equal tastes, they face the same indifference map.
Indifference curve I (which is common for both nations) is tangent to Nation 1’s production
frontier at point A and to Nation 2’s production frontier at A. Indifference curve I is the
highest indifference curve that Nation 1 and Nation 2 can reach in isolation, and points A
and A represent their equilibrium points of production and consumption in the absence of
trade. Note that although we assume that the two nations have identical tastes (indifference
map), the two nations need not be on the same indifference curve in isolation and end upon
the same indifference map with trade.
The tangency of indifference curve I at points A and A defines the no-trade, or autarky,
equilibrium-relative commodity prices of PA in Nation 1 and P in Nation 2 (see the figure).
Since PA< PAA, Nation 1 has a comparative advantage in commodity X, and Nation 2 has a
comparative advantage in commodity Y. The right panel shows that with trade, Nation 1
specializes in the production of commodity X, and Nation 2 specializes in the production of
commodity Y (see the direction of the arrows on the production frontiers of the two nations).
Specialization in production proceeds until Nation 1 has reached point B and Nation 2 has
reached point B, where the transformation curves of the two nations are tangent to the
common relative price line P Nation 1 will then export commodity X in exchange for
commodity Y and consume at point E on indifference curve II (see trade triangle B’C’E’).
42
On the contrary, Nation 2 will export Y for X and consume at point E, which coincides with
point E (see trade triangle B). Note that Nation 1’s exports of commodity X equal Nation 2’s
imports of commodity X (i.e., BC = C’E’). Similarly, Nation 2’s exports of commodity Y
equal Nation 1’s imports of commodity Y (i.e., B’C’= CE). At PX/P, Nation 1 wants to
export more of commodity X than Nation 2 wants to import at this high relative price of X,
and PX/PY falls toward PB. On the contrary, at PX/PYY < P> PBB, Nation 1 wants to export
less of commodity X than Nation 2 wants to import at this low relative price of X, and P
rises toward PB. This tendency of PX/P could also be explained in terms of commodity Y.
Also to be noted is that point E involves more of Y but less of X than point A. Nevertheless,
Nation 1 gains from trade because point E is on higher indifference curve II.
Similarly, even though point E’ involves more X but less Y than point A, Nation 2 is also
better off because point E’ is on higher indifference curve II . This pattern of specialization
in production and trade and consumption will remain the same until there is a change in the
underlying demand or supply conditions in commodity and factor markets in either or both
nations.
Note also that the H–O theory does not require identical tastes (i.e., equal indifference
curves) in the two nations. It only requires that if tastes differ, they do not differ sufficiently
to neutralize the tendency of different factor endowments and production possibility curves
from leading to different relative commodity prices and comparative advantage in the two
nations.
2.4.4 Critical evaluation of the H-O theorem

Although the factor proportions theorem developed by Heckscher and Ohlin provides a
thorough and plausible explanation of international trade as compared with the classical
comparative advantage model, yet it is not free from criticism. The H-O theorem has been
criticized mainly along the following three lines of arguments.
• Factor intensity reversal argument
• Leontief’s Paradox.
• Demand reversal argument. .
i. Leontief paradox
The first comprehensive and detailed examination of the H-O theorem was the one
undertaken by Leontief. You will recall that the theory of factor proportions predicted that
the capital abundant country exported capital-intensive goods and imported labor-
intensive goods, and the labor surplus country did the opposite. It is commonly agreed
that the United States is a capital rich and labor scarce country. Therefore, one would
expect exports to consist of capital-intensive goods and imports to consist of labor-
intensive goods. Leontief made an extensive study of the US structure of trade and the
results were startling. Contrary to what the H-O theory had predicted, Leontiefs study
showed that the US exports consisted of labor-intensive goods and the imports, (or more
precisely import competing products) consisted of capital-intensive goods. In Leontiefs
own words, "America's participation in division of labor in international trade is based on
its specialization in labor intensive rather than capital-intensive lines of production. In
other words, the country resorts to foreign trade in order to economize its capital and
dispose of its surplus labor, rather than vice versa”. Leontief’s findings are summarized
in the following table:
43
Exports Imports Replacements
Capital (US $ in 1947 prices) 2550780 3091339
Labor (man years) 180313 170004
Capital Labor ratio (US $ per man hour) 13911 18185
From the, above table, it is obvious that the US exports had a lower capital-labor ratio than
the import replacements. Note carefully that these are import replacements produced in the
United States as opposed to the actually imported goods in that country.
ii. Demand reversal argument

As we have discussed in figure 2.11 above, if production and consumption biases operate in
the same direction in each country, a capital surplus country will go for specializing in the
production of capital intensive good but it will export a labor intensive good and a labor
surplus country will go for exporting capital intensive good. This structure of trade is
contrary to the H-O prediction. Therefore, if demand reversal takes place in both countries,
the H-O prediction about the structure of trade will be invalid.
2.4.5 Empirical Validity of the H-O Theory

This section presents and evaluates the results of empirical tests of the Heckscher-Ohlin
model. A model must be successfully tested empirically before it is accepted as a theory. If a
model is contradicted by empirical evidence, it must be rejected and an alternative model
drawn up.
Empirical Results-The Leonie Paradox

The first empirical test of the Heckscher-Ohlin model was conducted by Wassily Leontief in
1951 using U.S data for the year 1947. Since the United States was the most K-abundant
nation in the world, Leontief expected to find that it exported K-intensive commodities and
imported L-intensive commodities. For this test, Leontief utilized the input-output table of
the U.S. economy to calculate the amount of labor and capital in a “representative bundle”
of $1 million with of U.S. exports and import substitutes for the year 1947. (The input-
output table is a table showing the origin and destination of each product in the economy.
Leontief himself had contributed importantly to the development of this new technique of
analysis and received the Nobel Prize in 1973 for his contributions.)
To be noted is that Leontief estimated K/L for U.S. import substitutes rather than for
imports. Import substitutes are commodities, such as automobiles, that the United States
produces at home but also imports from abroad (because of incomplete specialization in
production). Leontief was forced to use U.S. data on import substitutes because foreign
production data on actual U.S. imports were not available. However, Leontief correctly
reasoned that even though U.S. import substitutes would be more K intensive than actual
imports (because K was relatively cheaper in the Unite States than abroad), they should still
be less K intensive than U.S, exports if the H-O model held true. Of course, the use of U.S,
data on import substitutes, instead of foreign data on actual U.S, imports, also eliminated
from the calculations commodities, such as coffee and bananas, not produced at all in the
United States.
The results of Leontief’s test were startling. U.S. import substitutes were about 30 percent
more K intensive than U.S. exports. That is, the United States seemed to export L-intensive
44
commodities and import K-intensive commodities. This was the opposite of what the H-O
model predicted, and it became known as the Leontief paradox. In the same study, Leontief
tried to rationalize his results rather than reject the H-O model. He argued that what we had
here was an optical illusion; since in 1974 U.S. labor was about three times as productive as
foreign labor; the United States was really an L-abundant nation if we multiplied the U.S.
labor force by three and compared this figure to the availability of capital in the nation.
Therefore, it was only appropriate that U.S. exports should be L intensive in relation to U.S.
import substitutes. This explanation is not acceptable, and Leontief himself subsequently
withdrew it. The reason is that while U.S. labor was definitely more productive than foreign
labor (though the multiple of three used by Leontief was largely arbitrary), so was U.S.
capital. Therefore, both U.S. labor and U.S. capital should be multiplied by about the same
multiple, leaving the relative abundance of capital inch the United States more or less
unaffected.
Similarly, invalid is another explanation that postulated that U.S. tastes were biased so
strongly in favor of K-intensive commodities as to result in higher relative prices for these
commodities in the United States Therefore the United States would export relatively L-
intensive commodities the reason this explanation is not acceptable is that tastes are known
to be similar across nations. A study by Hotcake in 1957 on household consumption patterns
in many courtiers found that the income elasticity of demand for food, clothing, and other
classes of goods was remarkably similar across nations; As a result, this explanation of the
Leontief paradox based on a difference in tastes is also unacceptable.
One possible explanation of the paradox is that the year 1947, which Leontief used for the
test, was too close to World War II to be representative. Leontief himself answered this
criticism by repeating his study in 1956 using the 1947 input-output table of the U.S
economy but 1951 trade data, (The Year 1951 is usually taken to mare the completion of
postwar reconstruction.) These analyses showed that U.S. exports were only 6 percent are L
intensive than U.S. import substitutes. Leontief had reduced the paradox but had not
eliminated it.
A more general source of bias is that Leontief used a two-factor model (Land K), thus
abstracting from other factors such as natural resources (soil, climate, mineral deposits,
forests, etc,) However, a commodity might be intensive in natural resources so that
classifying it as either K of L intensive (with a two-factor model)would clearly be
inappropriate Furthermore, many production processes using natural resources-such as coal
mining, steel production, and farming-also require large amounts of physical capital. The
U.S. dependence on imports of many natural resources, therefore, might help explain the
large capital intensity of U.S. import-competing industries.
U.S. tariff policy was another source pf bias in the Leontief study, a tariff is nothing else
than a tax on import substitutes. As such, it reduces imports and stimulates the domestic
production of import substitutes. In a 1956 study, kravis found that the most heavily
protected industries in the United States were the L-intensive industries. This biased the
pattern of trade and reduced the labor intensity of U.S. import substitutes, thus contributing
to the existence of the Leontief paradox.
Perhaps the most important source of bias was the fact that Leontief include in his measure
of capital only physical capital (such as machinery, other equipment, building and so on)
45
and completely ignored human capital. Human capital refers to the education, job training,
and health embodied in workers, which increase their productivity. The implication is that
since U.S labor embodied more human capital than foreign labor, adding the human capital
component to physical capital would make U.S export more K intensive relative to U.S
import substitutes.
Somewhat related to human capital is the influence of research and development (R&D) on
U.S exports. The “knowledge” capital resulting from R & D leads to an increase in the value
of output derived from a given stock of material and human resources. Even casual
observation shows that most U.S exports are R & D and skill intensive. Thus, human and
knowledge capital are important considerations determining the pattern of U.S trade. These
were not considered by Leontef in his study. The most important of the numerous empirical
studies following a human capital approach were under taken by Kravis, Keesing, Kenen,
and Baldwin.
In view of these conflicting results, we conclude that the H-O model is useful in explaining
international trade in raw materials, agricultural products, and L-intensive manufactures,
which is large component of the trade between developing and developed countries, and as
well as in examine the effect of international trade, especially its effect on the distribution of
income. In the next section we will relax the assumptions of the H-O model and examine
new trade theories based on economies of scale and imperfect competition, which seems to
p0rovide a better manufacturing category (intra- industry trade), which is the largest
components of international trade among industrial countries.
Factor –Intensive Reversal

Factor-intensive reversal reefers to the situation where a given commodity is L-intensive
commodity in L- abundant nation and the K-intensive commodity in the K-abundant nation.
For example, factor-intensive reversal is present if commodity X-is L intensive commodity
in nation 1(the lower wage nation), and, at the same time, it is K-intensive commodity in
nation 2(the high wage nation).
To determine when and why factor-intensive reversal occurs, we use concept of the
elasticity of of substitution of factors in production. The elasticity of substitution measures
the degree or ease with each one factor can be substituted for another in production as the
relative price of the factor declines. For instance, suppose that the elasticity of substitution
of L for K is much greater in the production of X than Y. this means that it is much easier to
substitute L for K (vice versa) in the production of commodity X than in the production of
commodity Y.
For Factor-intensive reversal is more likely to occur is the greater is the difference in the
elasticity of substitution of L for K in the production of both commodities. With a large
elasticity of substitution of L for K in the production commodity X, nation 1 will produce
commodity X, with L-intensive techniques because its wage is low. On the other hand,
nation 2 will produce commodity X, with K-intensive techniques because its wage is high. If
at same time the elasticity of substitution of L for K is very low in the production of
commodity Y, the two nations will be forced to use similar techniques in producing
commodity Y even though their relative factor price may differ greatly. As a result,
46
commodities X will be L-intensive commodity in nation 1 and the K-intensive commodity in
nation 2, and we have a case of Factor-intensive reversal.
When Factor-intensive reversal is present, neither the H-O theorem nor the factor-pricing
equalization theorem holds. The H-O theorem fails because it would predict that nation 1
(the L- abundant nation) would export commodity X (L-intensive commodity) and that
nation 2(the K- abundant nation) would also export commodity X (K-intensive commodity).
Since the two nations cannot possibly export the same homogeneous commodity to each
other, the H-O model no longer predicts the patter of trade.
With Factor-intensive reversal, factor-pricing equalization theorem also fails to hold. the
reason for this is that as nation 1 specializes in the production commodity X, and demand
more labor, the relative and the absolute wage rate will rise in nation 1(the low wage
nation). On the other hand, since nation 2 cannot export commodity X to nation 1, it will
have to specialize in the production of and export commodity Y. since commodity Y is L-
intensive commodity in nation 2, the demand for labor and thus wage will also rise in nation
2. What happened to the difference in relative and absolute wage between nation 1 & 2
depends on how fast wage rise in each nation. The difference in relative and absolute wage
between the two nations could decline, increase, or remain unchanged as a result of
international trade, so that factor-pricing equalization theorem no longer holds.
2.4.6 The factor-price equalization theorem

The factor-price equalization theorem states that the effect of trade is to equalize factor
prices between countries, thus serving as substitute for international factor mobility. This
theorem has enjoyed far less limelight than the H-O theorem. Nevertheless, it has attracted
considerable attention from well-known economists. Heckscher (1919) stated that free trade
equalizes factor rewards completely. Ohlin (1933), on the other hand argued that full factor-
price equalization cannot occur in practice. Ohlin asserted that free trade brings about only a
tendency towards factor-price equalization, and only partial factor-price equalization is
possible. The later models by Stolper and Samuelson (1941) and Uzawa (1959) also support
partial equalization thesis. The later works of Samuelson (1948, 1949, and 1953) and of
Lerner (1953) make out a case for complete factor-price equalization.
Before trade (i.e. in a situation of autarky) we have the following situations:
o In country A, a labor surplus country, labor is abundant and cheap and capital is
scarce and expensive. Therefore, the K/ L (or capital labor ratio) is rather low. And
once the trade is opened up, labor becomes relatively scarce and the price of labor
will go up. Similarly, capital becomes relatively abundant and hence the cost of
capital will go down. This follows directly from the H-O theorem that the labor
surplus country will specialize in the production and exports of labor-intensive goods.
In other words, the abundant factor becomes scarce and the scarce factor becomes
abundant, relatively so that (after trade) the K/ L will go up in country A.
o In the capital surplus country-country B-the pre-trade situation is such that capital is
abundant and cheap, and labor is scarce and therefore expensive. The K / L will be
high before trade. But after trade, this country will specialize in the production of
capital-intensive goods, so that the demand for capital will rise relative to that of
labor. This will result in capital becoming scarce and the cost of capital going up, and
labor becoming abundant and the cost of labor going down. The K / L will drop as a
result.
47
In brief, we start with a low capital-labor ratio in country A and a high capital-labor
ratio in country B. This is before trade. But after trade capital ratio will rise in country A
and fall in country B until the capital ratios are equalized in the two countries. This is
the process by which the factor prices (capital-labor ratios) in the two countries are
equalized as a result of trade. Note that this factor-price equalization is brought about
without the movement of factors of production between the two countries. What brings
about this factor price equalization, then, is the international trade mechanism. It is in
this sense that we can argue that international trade in goods and services, is a substitute
for international labor and capital movements (or factor mobility).
Effect of Trade on the Distribution of Income
From our discussion in Section 5.5a, we know that trade increases the price of the nation’s
abundant and cheap factor and reduces the price of its scarce and expensive factor. In terms of our
example, w rises and r falls in Nation 1, while w falls and r rises in Nation2. Since labor and
capital are assumed to remain fully employed before and after trade, the real income of labor and
the real income of owners of capital move in the same direction as the movement in factor prices.
Thus, trade causes the real income of labor to rise and the real income of owners of capital to fall
in Nation 1 (the nation with cheap labor and expensive capital). On the other hand, international
trade causes the real income of labor to fall and the real income of owners of capital to rise in
Nation 2 (the nation with expensive labor and cheap capital.
2.5. The New Trade Theories
In this section we relax the assumptions of the Heckscher-Ohlin theory discussed previously and
examine the effect of making more realistic assumptions on the model. We will see that relaxing
many of the assumptions does not affect the validity of the basic Heckscher-Ohlin theory. Relaxing
others, however, will require new trade theories to explain the significant portion of international
trade that the Hickscher-Ohlin theory leaves unexplained. Thus relaxing the assumptions on which
the H-O theory rests represents an excellent way to introduce new trade theories and to examine
their relationship to the basic Heckscher-Ohlin model. In general relaxing, most of the assumptions
of the Heckscher-Ohlin theory only modifies but does not invalidate the theory. Relaxing the
assumptions of constant return to scale and perfect competition, however, requires new trade
theories to explain the significant portion of international trade that the H-O theory leaves
unexplained. International trade also calls for new trade theories. We now turn to these new trade
theories.
2.5.1. Tastes as a basis for trade

If peoples change their taste in favor of or against a product/service, there will be a change in the
demand for the product. For instance, scientists‘ discovery of higher content disease preventive
substances of a given product may increase your demand for that product. This condition
contributes to international price differentials and change in international trade partners. If country
A has a stronger taste for a given commodity, the commodity will sell for a higher price in country
A than in country B.Hence, tastes, in its capacity to affect demand, would affect international trade,
by causing international price differentials and change in trade partners.
48
2.5.2. Product differentiation as a basis for trade
A large portion of the output of modern economies today involves differentiated rather than
homogeneous products. Thus, a Toyota is not identical to a, Volkswagen, or a Volvo. As a result, a
great deal of international trade can and does involve the exchange of differentiated products of the
some industry or broad product group. A great deal of international trade is intra-industry trade in
differentiated products as opposed to inter-industry trade in completely different products.
2.5.3. Inter vs Intra-Industry Trade

Inter-industry trade arises when countries trade different goods with one another. Up to now we
have seen such types of trade between countries. However, a large portion of international trade
consists of a country export and imports similar goods, intra-industry trade. Intra-industry trade
arises in order to take advantage of important economies of scale in production. That is,
international competition forces each firm of plant in industrial countries to produce only one or at
most a few, varieties and styles of the same product rather than many different varieties and styles.
This is crucial in keeping unit costs low. With few varieties and styles, more specialized and faster
machinery can be developed for a continuous operation and a longer production run. The nation
then imports other varieties and styles from other nations. Intra-industry trade benefits consumers
because of the wider range of choices (i.e., the greater variety of differentiated products) available
at the lower prices made possible by economies of scale in production.
Several interesting considerations must be pointed out with respect to the intra-industry trade
models developed by Helpman, Krugman, Lancaster, and other since 1979.
1. Although trade in the H-O model is based on comparative advantage or difference in factor
endowment (Labor, capital, natural resources, and technology) among nations, intra- industry
trade is based on product differentiation and economics of scale. Thus, while trade based on
comparative advantage is likely to larger when the difference in factor endowments among
nation is greater, intra-industry trade is likely to be large among economies of similar size and
factor proportions ( i.e., among industrial nations)
2. With differentiated products produced under economies of scale, pre trade relative
commodity prices may no longer accurately predict the pattern of trade. Specifically, a large
country may produce a commodity at lower cost than a smaller country in the absence of trade
because of larger national economies of scale. With trade, however, all countries can take
advantage of economies of scale to the same extent, and the smaller country could conceivably
undersell the larger nation in the same commodity.
3. In contrast to the H-O model, which predicts that trade, will lower the return of the nation's
scarce factor, with intra-industry trade based on economies of scale it is possible for all factors
to gain. This may explain why the formation of the European Union and the great postwar trade
liberalization in manufactured goods met little resistance by interest groups. This is to be
contrasted to the strong objections raised by labor in industrial countries against liberalizing
trade with some of the most advanced of the developing counties because this trade, being of the
inter. rather than of the intra-industry trade type, could lead to the collapse of entire industries
(such as the textile industry) and involve lower real wages and massive reallocations of labor to
other industries in industrial nations.
49
4. Intra-industry trade is related the sharp increase in international trade in parts and components
of a product. international corporations often produce or import various parts of a product in
different nations in order to minimize their costs of production (international economies of
scale). The utilization of each nation's comparative advantage to minimize total production costs
can be regarded as an extension of the basic H-O model to modern production conditions. This
pattern also provides greatly needed employment opportunities in some developing nations. We
will return to this topic in our second semester study, which deal with international resource
movement and Multinational Corporation.
5. The tentative conclusion that can be reached, therefore, is that comparative advantage seems
determine the pattern of inter-industry trade, while economies of scale in differentiated products
give rise to intra-industry trade. Both types of international trade occur in today's world. The
more dissimilar are factor endowments (as between developing counties); the more important
are comparative advantage and inter-industry trade. On the other hand, intra-industry trade is
likely to be dominant the more similar are factor endowments (as among developed countries).
As Lancaster (1980) pointed out, however, even in the case of intra-industry trade," comparative
advantage is somewhere in the background" One could say that inter-industry trade, reflects
natural comparative advantage while intra-industry trade reflects acquired comparative
advantage
2.5.4. Imperfect competition as a basis for trade

In imperfect competition, firms are aware that they can influence the prices of their products and
that they can sell more only by reducing their price. Imperfect competition is characteristic both of
industries in which there are only a few major producers and of industries in which each producer's
product is seen by consumers as strongly differentiated from those of rival firms. Under these
circumstances each firm views itself as a. price setter, choosing the price of its product, rather than
a price taker. When firms are not price takers, it is necessary to develop additional tools to describe
how prices and outputs are determined. The simplest imperfectly competitive market structure to
examine is that of a pure monopoly, a market in which a firm faces no competition; the tools we
develop can then be used to examine more complex market structures.
2.5.5. Tastes as a basis for trade
If peoples change their taste in favor of or against a product/service due to some factor, there will be
a change in the demand for the product, ceteris paribus. For instance, scientists‘ discovery of higher
content disease preventive substances of a given product may increase your demand for that
product, ceteris paribus. This condition contributes to international price differentials. Countries A
and B may be producing the same commodity at the same cost of production, but that does not
guarantee the same price in both countries for that commodity. If country A has a stronger taste for
that commodity, the commodity will sell for a higher price in country A than in country B. In
country B there may be lower level of demand for that product due to lower level of taste. Hence,
tastes, in its capacity to affect demand, would affect international trade, by causing international
price differentials.
2.5.6. Trade based on Economies of Scale

One of the assumptions of the H-O model was that both commodities were produced under
conditions of constant returns to scale in the two nations. With increasing returns to scale, mutually
50
beneficial trade can take place even when the two nations are identical in every respect. This is a
type of trade that the H-O model does not explain.
Increasing returns to scale refers to the production situation where output grows proportionately
more than the increase in inputs or factors of production. That is, if all inputs are doubled, output is
more than doubled. If all in puts are tripled, output is more than tripled. Increasing returns to scale
may occur because at a larger scale of operation a greater division of labor and specialization
becomes possible. That is, each worker can specialize in performing a simple repetitive task with a
resulting increase in productivity. Furthermore, a larger scale of operation may permit the
introduction of more specialized and productive machinery that would be feasible at a smaller scale
of operation.
The following figure shows how mutually beneficial trade can be based on increasing returns to
scale. If the two nations are assumed to be identical in every respect, we can use a single production
frontier and a single indifference map to refer to both nations, increasing returns to scale result in
production frontier that are convex from the origin, or inward-bending. With identical production
frontier and indifference maps, the no-trade equilibrium relative commodity prices in the two
nations are also identical. In the figure, this is PX/PY = PA in both nations and is given by the slope
of the common tangent to the production frontier and indifference curve 1 at point A.
With trade, Nation 1 could specialize completely in the production of commodity X and produce at
point B. Nation 2 would then specialize completely in the production of commodity Y and produce
at point B’. By then exchanging 60X for 60Y with each other, each nation would end up consuming
at point E on indifference curve II, thus gaining 20X and 20Y. These gains from trade arise from
economies of scale in the production of only one commodity in each nation. In the absence of trade,
the two nations would not specialize in the production of only one commodity because each nation
wants to consume both commodities.
Y
B'
120
100
80
E
60
ll
40 A I
20
PA
B
0 20 40 60 80 100 120
X
Figure. 2.17 trade based on economies of scale
51
Note that the no-trade equilibrium point A is unstable in the sense that if, for whatever reason,
Nation 1 moves to the right of point A along its production frontier, the relative price of X (the
slope of the production frontier) will fall and will continue to fall until nation 1 becomes completely
specialized in the production of commodity X, similarly, if nation 2 moves to the left of point A
along its production frontier, PX/PY will rise (so that its inverse, PX/PY falls) Until Nation 2 becomes
completely specialized in the production of commodity Y.
Several additional aspects of the above analysis and the Figure 2.17must clarify; First of all, it is a
matter of complete indifference which of the two nations specializes in the production of
commodity X or commodity Y. In the real world this may result from historical accident. Second, it
should be clear, at least intuitively, that the two nations need not be identical in every respect for
mutually beneficial trade to result from increasing returns to scale. Third, if economies of scale
persist over a sufficiently long range of outputs, one or a few firms in the nation will capture the
entire market for a given product, leading to monopoly (a single producer of a commodity for which
there is no close substitute) or oligopoly (a few producers of a homogeneous or differentiated
product). Fourth, during the past decade or so, there has been a sharp increase in international trade
in parts of and components, as well as in setting up of production facilitates abroad, and these have
been the source of new and significant international economies of scale.
Economies of scale or increasing returns to scale must also be clearly distinguished from external
economies. The former refer to the reduction in the average costs of production as the firm’s output
expands. Thus, economies of scale or increasing returns to scale are internal to the firm. External
economies, on the other hand, refer to the reduction in each firm’s average costs of production as
the entire industry output expands (i.e. for reasons external to the firm)
2.5.7. Trade based on dynamic technological differences (Posner’s technology gap model)
Apart from differences in the relative availability of labor, capital, and natural resources (stressed
by the Heckscher-Ohlin theory) and the existence of economies of scale and product differentiation,
dynamic changes in technology among nations can be a separate determination of international
trade. These are examined by the technological gap and product cycle models. Since time is
involved in a fundamental way in both of these models, they can be regarded as dynamic extensions
of the static H-O model.
According to the technological gap model sketched by posner in 1961, a great deal of the trade
among industrialized counties is based on the introduction of new products and new production
processes. These give the innovating firm and nation a temporary monopoly in the world market.
Such a temporary monopoly is often based on patents and copyrights, which are granted to
stimulate the flow of inventions
As the most technologically advanced nation, the United States exports a large number of new high-
technology products. However, as foreign producers acquire the new technology, they eventually
are able to conquer markets abroad, and even the U.S. market for the product, because of their lower
labor costs. In the meantime, U.S. producers may have introduced still newer products and
production processes and may be able to export these products based on the new technological gap
established. A shortcoming of this model however, is that it does not explain the size of
technological gaps and does not explore the reason that technological gaps arise or exactly how they
are eliminated over time.
52
2.5.8. Vernon’s product cycle model
It is the generalization and extension of the technological gap model.It was full developed by
Vernon in 1996. According to this model, when a new product is introduced, it usually requires
highly skilled labor to produce, as the product matures and. As the product matures and acquires
mass acceptance it becomes standardized; it can then be produced by mass production techniques
and less skilled labor. Therefore, comparative advantage in the product shifts from the advanced
nation that originally introduced it to less advanced nations where labor is relatively cheaper. This
may be accompanied by foreign direct investments from the innovating nation to nations with
cheaper labor.
Vernon also pointed out that high-income and labor-saving products are most likely to be
introduced in rich nations because (1) the opportunities for doing so are greatest there, (2) the
development of these new products requires proximity to markets so as to benefit from consumer
feedback in modifying the product, and (3) there is a need to provide service. while the
technological gap model emphasizes the time lag in the imitation process, the product cycle model
stresses the standardization process, According to these models, the most highly industrialized
economies are expected to export non-standardized products embodying new and more advanced
technologies and import products embodying new and more advanced technologies and import
products embodying old or les advanced technologies.
A classic example of the product cycle model is provided by the experience of U.S. and Japanese
radio manufactures since World War II. Immediately after the war, U.S. firms dominated the
international market for radios, based on vacuum tubes developed in the United States. However,
within a few years, Japan was able to capture a large share of the market by copying U.S.
technology and utilizing cheaper labor. The United States recaptured technological leadership with
the development of transistors. But, once again, in a few short years, Japan imitated the technology
and was able to undersell the United States. Subsequently, the United States reacquired its ability to
compete successfully with Japan by introducing printed circuits, It remains to be seen whether this
latest technology will finally result in radios being labor or capital intensive and whether the United
states will finally result in radios being labor or capital intensive and whether the United States will
be able to stay in the market-or whether both the United States and Japan will eventually be
displaced by still cheaper producers in such nations as Korea and Singapore.
In 1967 study, Gruber, Mehta, and Vernon found a strong correlation between expenditures on
research and development (R&D) and export performance. The authors took expenditures on
research and development as a proxy for the temporary comparative advantage that firms and
nations acquire in new products and new production processes. As such these results tend to support
both the technological gap model and the closely related product cycle model.
Note that trade in these models is originally based on new technology developed by the relatively
abundant factors in industrialized nations (such as highly skilled labor and expenditures on research
and development). Subsequently, through imitation and product standardization, less developed
nations gain a comparative advantage based on their relatively cheaper labor. As such, trade can be
said to be based on changes in relative factor abundance (technology) among nations over time.
Therefore, the technological gap and product cycle models can be regarded as extensions of the
basic H-O model into a technologically dynamic world, rather than as alternative trade models, In
short, the product cycle model tries to explain dynamic comparative advantage for new products
and new production processes, as opposed to the basic H-O models.
53
CHAPTER THRE
3. INTERNATIONAL TRADE POLICY
3.1 Free Trade: Cases For and Against
Free trade is a system in which goods, capital, and labor flow freely between nations, without
barriers which could hinder the trade process. It will lower prices for goods and services by
promoting competition. Domestic producers will no longer be able to rely on government subsidies
and other forms of assistance, including quotas which essentially forcecitizens to buy from domestic
producers, while foreign companies can make inroads on new markets when barriers to trade are
lifted. In addition to reducing prices, free trade is also supposed to encourage innovation, since
competition between companies sparks a need to come up with innovative products and solutions to
capture market share. Free trade can also foster international cooperation, by encouraging nations to
freely exchange goods and citizens. Agreements between trading partners can also promote
educational advantages, such as sending engineers to train with people in the top of the engineering
field in one nation, or sending agriculture experts to rural areas to teach people about new farming
techniques and food safety practices.
Free trade is a system of trade policy that allows traders to act and or transact without interference
from government. According to the law of comparative advantage the policy permits trading
partners to have a mutual gain from trade of goods and services. Under a free trade policy, prices
are a reflection of true supply and demand, and are the sole determinant of resource allocation. Free
trade differs from other forms of trade policies where the allocation of goods and services among
trading countries are determined by artificial prices that may or may not reflect the true nature of
supply and demand. These artificial prices are the result of protectionist trade policies, whereby
governments intervene in the market through price adjustments and supply restrictions. Such
government interventions can increase as well as decrease the cost of goods and services for both
consumers and producers.
Many nations have free trade agreements, and several international organizations promote free trade
between their members. There are a number of arguments both for and against this practice, from a
range of economists, politicians, industries, and social scientists. A number of barriers to trade are
struck down in a free trade agreement. Taxes, tariffs, and import quotas are all eliminated, as are
subsidies, taxbreaks, and other forms of support to domestic producers. Restrictions on the flow of
currency are also lifted, as are regulations which could be considered a barrier to free trade. Put
simply, free trade enables foreign companies to trade just as efficiently, easily, and effectively as
domestic producers.
Opponents of free trade often argue that it hurts domestic producers by opening up competition to
companies which operate in nations with less stringent labor laws. Free trade agreements are a key
element of customs unions and free trade areas. The value of free trade was first observed and
documented by Adam Smith in his magnum opus, The Wealth of Nations, in 1776. Later, David
Ricardo made a case for free trade by presenting specialized an economic proof featuring a single
factor of production with constant productivity of labor in two goods, but with relative productivity
between the goods different across two countries.
54
1. Economies of scale (Static gain)
Protected markets not onlyfragment production internationally, but by reducing competition and
raising profits, theyalso lead too many firms to enter the protected industry. With a proliferation of
firms innarrow domestic markets, the scale of production of each firm becomes inefficient. A
goodexample of how protection leads to inefficient scale is the case of the Argentine automobile
industry, which emerged because of import restrictions. An efficient scale assembly plant should
make from 80,000 to 200,000 automobiles per year, yet in 1964 the Argentine industry, which
produced only 166,000 cars, had no less than 13 firms! Some economists argue that the need to
deter excessive entry and the resulting inefficient scale of production is a reason for free trade that
goes beyond the standard cost-benefit calculations.
Static gains arise from optimum use of the country’s factor endowments or human and physical
resources, so that the national output is maximized resulting in increase in social welfare.
2. Innovation
Another argument for free trade is that by providing entrepreneurs with an incentive to seek new
ways to export or compete with imports, free trade offers more opportunities for learning and
innovation than are provided by a system of "managed" trade, where the government largely
dictates the pattern of imports and exports. 'These additional gains from free trade are sometimes
referred to as "dynamic" gains, because increased competition and innovation may need more time
to take effect than the elimination of production and consumption distortions.It refers to those
benefits, which promote economic growth and economic development of the participating countries.
International trade increases national income and facilitates saving and opens out new channels of
investment. Increase in saving and investment is found to promote economic growth.
International trade promotes economic development in the following ways.

1) Developing countries can import capital goods in exchange for their exports that are mostly
agricultural exports. The capital goods then will increase the productive capacity of these
countries and promote the process of industrial development.
2) A country can also import technical know-how, technical skills, managerial talent and
entrepreneurship through foreign trade and collaboration.
3) International trade has brought about a tremendous movement of capital from developed
countries to developing countries. Thus, foreign trade facilitates the payment of interest or
repatriation of capital. The existence of large volume of foreign trade serves as a guarantee
for the payment of interest and the principal for lenders.
3. Political Arguments
Itreflects the fact that a political commitment to free trade may be a good idea in practice even
though there may be better policies in principle. Economists often argue that trade policies in
practice are dominated by special-interest politics rather than consideration of national costs and
benefits. Economists can sometimes show that in theory a selective set of tariffs and export
subsidies could increase national welfare, but in reality any government agency attempting to
pursue a sophisticated program of intervention in trade would probably be captured by interest
groups and converted into a device for redistributing income to politically influential sectors. If this
argument is correct, it may be better to advocate free trade without exceptions, even though on
purely economic grounds free trade may not always be the best conceivable policy.
55
4. Vested interests are created
Once certain industries are given protection, they claim it as a matter of right. It then becomes very
difficult to take away protection. The infants begin kicking if you touch them in any manner. Such
infants refuse to admit that they have grown into adults.
5. Protection produces lethargy and acts like an opiate

When foreign competition has been removed, it sends the home manufacturers to sleep, as it were.
They do not try to make any improvement, and technical progress comes to a standstill.
6. Then there is the danger of corruption

The industrialists bribe legislators so that protection is not taken away. This evil was rampant in the
U.S.A. at one time.
7. Protection creates monopolies

Tariff is said to be the mother of trusts. When foreign competition has been removed, the home
manufacturers are tempted to combine to reap monopoly profits.
8. Consumers and unprotected industries suffer
This is so because imposition of import duties invariably leads to the rising of prices.
9. The distribution of wealth becomes more unequal

Protection favors the rich capitalists who grow still richer. The gulf between the 'haves' and
'have-nots' is thus widened still further.
10. Source of conflict

Protection leads to conflict, friction and retaliation in international dealings. It thus breeds the
germs of future wars.
11. Inefficiency in world resource allocation

The most important argument against protection on economic grounds is that it militates against
optimum utilization of resources. It hampers international division of labor so that labor, capital and
other factors of production do not find their most remunerative employment. Their distribution is
not governed by natural economic forces-, but they are artificially forced into certain channels. The
result is that they do not make their maximum possible contribution in the production of commo-
dities. The world output is lower than it could be, so that the standard of living is necessarily
lowered. A natural movement towards world prosperity is hindered. Nonetheless, there are
intellectually respectable arguments for deviating from free trade, and thes4 e arguments deserve a
fair hearing.
3.2 Cases Against Free Trade

1. Diversification of Industry Argument
This argument was advanced, among other writers, by Friedrich List in Germany. According to
List, a nation should have a variety of sources of production and employment. Depending on one
industry or on a few industries is dangerous both politically and, economically. Politically it means
too much dependence on foreign trade which may be cut off during a war. Economically, a country
depending on a few industries is exposed to the danger of serious economic dislocation in case
some adverse circumstances affect such an industry. But it must be understood that this argument
56
cuts at the root of the principle of comparative cost according to which each country must specialize
in the production of certain articles. According to this argument a country must produce even those
articles in which it may not have comparative advantage.
2. Employment Argument
It is argued that industrial development through protection increases employment in a country.
Conversely, if protection is not given to old established industries; foreign competition may ruin
them and create unemployment in the country.
3. Conservation of National Resources Argument

Carey and Patten had argued that free trade resulted in the export of agricultural commodities from
America and thus led to the exhaustion of the soil. Jevons in England applied the same argument
again", the export of coal which exhausted coal fields. The same argument has also been applied the
Union of South Africa regarding gold mining and in India regarding the export of manganese. The
argument has some force. If a country exports its exhaustible materials in a raw-state, it loses
manufacturer's profits. It may also be seriously handicapped when such materials have been
altogether exhausted.
4. Defense Argument
Adam Smith remarked "Defense is better than opulence". It is said that essential to make a country
militarily strong though it may not be economically prosperous. Hitler preached to the German
nation, "Gun! Better than butter." According to this argument a country must actively encourage
the development of those industries which are essential from the point of view of defense, even
though it may result uneconomic distribution of the national resource. The advocates of free trade
point out that this is politics and not economics. On purely economic grounds, they say, free trade
is the best.
5. Revenue Argument
Protection is also advocated for revenue purposes. When protective import duties are imposed,
they certainly bring in revenue to the government. But it may be pointed out that there is a certain
degree of incompatibility between the revenue and protection. If full protection is given, the
government will not get any revenue, because full protection will mean that domestic goods have
driven foreign goods altogether. When foreign goods not come in, there will be no revenue from
import duty. On the other hand, if government wants revenue then foreign goods must come in and
compete with domestic goods. Then domestic industries do not get any protection. This
incompatibility, however, arises between maximum protection and maximum revenue. But if the
duties are moderate, they will yield revenue besides affording protection. It is, however, much
better to advocate protection for the sake of protecting industries rather than for raising revenues.
6. Key Industry Argument

If the industrial structure of a country is to be stable and sound, the country must develop 'key' or
basic industries; otherwise foundation of industries will have been laid on sand. The country may
not have any comparative advantage in such industries. But since they are of crucial importance and
have to be developed, protection must be granted to them.
7. Balance of Payments Argument

It may become necessary to check imports by means of tariff in order to rectify adverse balance
payments. The I.M.F. regulations permit member countries to impose temporary restriction trade to
cure a balance of payments deficit. Import restrictions on non -essential imports become necessary
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in the interest of accelerated economic growth.
8. Patriotism Argument.
Protection is advocated on patriotic grounds also. It is the duty of every citizen to use home-made
goods as far as possible. W-f: must, therefore, develop our industries, through protection, if
necessary, so that home-made goods in the right quantity and of good quality are made available for
use.
9. Self-sufficiency Argument
Another argument in favor of protection is that we should become self-sufficient and not depend
on other countries for our necessaries. Such dependence proves very dangerous during war when
foreign trade is cut off.
10. Avoid unfair competition

Protection also becomes necessary against unfair competition from abroad arising from dumping,
depreciated exchanges, bounties, etc.
11. For Economic Stability

Protection is also advocated to shut out the baneful influences trade cycles from abroad. It is
expected to make the domestic economy immune from the destabilizing effects of external
disturbing factors. In the Macmillan Committee (1931), the late Lord Keynes put forward the
opinion that protection and not free trade was needed to restore the much-needed economic stability
for an economy which is out of gear.
12. National Welfare Arguments against Free Trade

Most tariffs, import quotas, and other trade policy measures are undertaken primarily to protect the
income of particular interest groups. Politicians often claim, however, that the policies are being
undertaken in the interest of the nation as a whole, and sometimes they are even telling the truth.
Although economists often argue that deviations from free trade reduce national welfare, there are,
in fact, some theoretical grounds for believing that activist trade policies can sometimes increase the
welfare of the nation as a whole.
13. The Terms of Trade Argument for a Tariff

One argument for deviating from free trade comes directly out of cost-benefit analysis: For a large
country that is able to affect the prices of foreign exporters, a tariff lowers the price of imports and
thus generates a terms of trade benefit. This benefit must be set against the costs of the tariff, which
arise because the tariff distorts production and consumption incentives. It is possible, however, that
in some cases the terms of trade benefits of a tariff outweigh its costs, so there is a terms of trade
argument for a tariff.
For a sufficiently small tariff the terms of trade benefits must outweigh the costs, Thus at small
tariff rates a large country's welfare is higher than with free trade. As the tariff rate is increased,
however, the costs eventually begin to grow more rapidly than the benefits and the national welfare
to the tariff rate turns down. The tariff ratethat maximizes national welfare is the optimum tariff.
The optimumtariff rate is always positive but less than the prohibitive ratethat would eliminateall
imports.
14. The Domestic Market Failure Argument against Free Trade
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Leaving aside the issue of the terms of trade, the basic theoretical case for free trade rested on cost-
benefit analysis using the concepts of consumer and producer surplus. Many economists have made
a case against free trade based on the counterargument that these concepts, producer surplus in
particular, do not properly measure costs and benefits.
Why might producer surplus not properly measure the benefits of producing a good? We consider a
variety of reasons including the possibility that the labor used in a sector would otherwise be
unemployed or underemployed, the existence of defects in the capital or labor markets that prevent
resources from being transferred as rapidly as they should be to sectors that yield high returns, and
the possibility of technological spillovers from industries that are new or particularly innovative.
These can all be classified under the general heading of domestic market failures. That is, each of
these examples is one in which some market in the country is not doing its job right—the labor
market is not clearing, the capital market is not allocating resources efficiently, and so on.
Suppose, for example, that the production of some good yields experience that will improve the
technology of the economy as a whole but that the firms in the sector cannot appropriate this benefit
and therefore do not take it into account in deciding how much toproduce. Then there is a marginal
social benefit to additional production that is not captured by the producer surplus measure. This
marginal social benefit can serve as a justification for tariffs or other trade policies.
The domestic market failure argument against free trade is a particular case of a more general
concept known in economics as the theory of the second best. This theory states that a hands-off
policy is desirable in any one market only if all other markets are working properly. If they are not,
a government intervention that appears to distort incentives in one market may actually increase
welfare by offsetting the consequences of market failures elsewhere. For example, if the labor
market is malfunctioning and fails to deliver full employment, a policy of subsidizing labor-
intensive industries, which would be undesirable in a full-employment economy, might turn out to
be a good idea. It would be better to fix the labor market, for example, by making wages more
flexible, but if for some reason this cannot be done, intervening in other markets may be a "second-
best" way of alleviating the problem.
When economists apply the theory of the second best to trade policy, they argue that imperfections
in the internal functioning of an economy may justify interfering in its external economic relations.
This argument accepts that international trade is not the source of the problem but suggests
nonetheless that trade policy can provide at least a partial solution.
3.3 Tariffs and Non - Tariff Barriers
The two broader categories of barrier to free trade between countries are natural barriers and man-
made barriers. Natural barriers to trade: arise on account of the cost and the distance involved in
moving goods and services from one country to another. In short, it is the transport cost. Man-
made barriers is further classified into tariff and non-tariff (hidden) barriers.
Traditionally trade was regulated through bilateral treaties between two nations. For centuries under
the belief in mercantilism most nations had high tariffs and many restrictions on international trade.
The society of a nation and different organizations want to have a restriction on the import of the
nation. These restrictions and regulations deal with the nation’s trade or commerce is generally
known as trade policies. The restrictive techniques may be either tariff or non-tariff type.
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3.3.1 Tariff Trade Barriers

Tariff is a tax or duty levied on traded goods as it crosses the border on the nation. The tariff may be
either import or export tariff. The import tariff is a duty on importable commodities that increase the
value of the foreign goods in the domestic economic system. It is mainly used by many nations of
the world.
Having tariff protection has two main aims that benefited the domestic nation.
1. It is one source of revenue for the government. Since tariff is a tax on importable
commodities and this tax is full collected by the government.
2. It also enhances the overall economic system of the nation. Tariffs are means of protecting
the interference of the foreign giant industries in the domestic economic system which will
lead to competition with the domestic infant industries.
Types of Tariffs
1. Specific tariffs: are tariffs which are assessed on the basis of the physical weight of the
product which is imported or exported. The units are in terms of Birr/Kg, Birr/ tone. They
can be levied on goods like wheat, sugar, coffee, cattle, etc. Specific tariffs cannot be levied
on valuable goods like diamond, modern art paintings, TV etc.
2. Ad valorem tariffs: are tariffs levied based on the value of the product. It is a percentage
tax. E.g. 10% of the value of diamond, TV etc. The main problem of having this type of
tariff is that of the inability of the responsible agent to know the actual price of the
imported goods.
➢ Ad valorem tariff is revenue elastic but specific tariff is not.
3. Compound tariff: combines a specific duty with an ad valorem duty.
4. Discriminatory tariff calls for different rates of duties depending on the country of origin
or destination of the product
5. Non-discriminatory tariffs: uniform tariffs rates imposed on goods and services regardless
of their source of origin or destination.
➢ Tariffs are said to be single column when they are non- discriminatory
and double-column when they are discriminatory.
6. Revenue tariffs: these are tariffs that are imposed primarily to produce revenue for the
government
7. Protective tariffs: are tariffs that are imposed primarily to protect the domestic industries
from foreign competitions
8. Retaliatory tariffs: when country A imposes (increases) duties against the products from
country B, it is possible that country B will retaliate and levy duties on goods imported from
country A. Thus, country B’s tariffs are then described as retaliatory tariffs.
9. Countervailing tariffs: Tariffs are said to be countervailing when a country imposes
(increases) import duties with a view to offset export subsiding in the country of origin.
3.3.2 Non-Tariff Trade Barriers
Non-tariff barriers to trade are trade barriers that restrict imports but are not in the usual form of a
tariff. It is a restrictive method where barriers to trade are set up and take a form other than a tariff.
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Non-tariff barriers include quotas, voluntary export restraint, domestic content provision,
government procurement provision, levies, embargoes, sanctions and other restrictions, which are
frequently used by both developed and developing economies. Some of non-tariff barriers are not
directly related to foreign economic regulations, but nevertheless they have a significant impact on
foreign-economic activity and foreign trade between countries. The non-tariff barriers can include
wide variety of restrictions to trade. Here are some examples.
1. Import quota
It is a direct limitation of the physical quantity of exports and imports permitted in the country. We
will only discuss import quotas as they are more common than the export quotas. An import quota
is a physical restriction on the quantity of goods that may be imported during a specific time period;
the quota generally limits imports to a level below that which would occur under free-trade
conditions. The effects of quotas are similar to those of tariffs, but there are also substantive
differences between the two which are worth examining.
Types of Quotas
1) Unilateral quotas
It is quota imposedby home government alone, without prior negotiation or consultation of other
nations, example import quota. They are levied and administered exclusively by the importing
nation. Because of their unilateral nature, import quotas may be resented by other nations and
may lead to retaliatory quotas. It can be global or selective quota.
a. Global quota: This technique permits a specified number of goods to be imported each
year, but does not specify where the product is shipped from or who is permitted to import.
When the specified amount has been imported (the quota is filled), additional imports of the
product are prevented for the remainder of the year.In practice, the global quota becomes
unwieldy because of the rush of both domestic importers and foreign exporters to get their
goods shipped into the country before the quota is filled. Those who import early in the year
get their goods; those who import Tlate in the year may not. Moreover, goods shipped from
distant locations tend to be discriminated against because of the longer transportation time.
Smaller merchants, without good trade connections, may also be disadvantaged relative to
large merchants. Global quotas are thus plagued by accusations of favoritism against
merchants fortunate enough to be the first to capture a large portion of the business. For
these reasons, global quotas are relatively uncommon, especially among industrial nations.
b. Selective (allocated) quota: To avoid the problems of a global quota system, import quotas
are usually allocated to specific countries; this type of quota is known as a selective quota.
For example, the Ethiopia might impose a global quota of 10 million tons of canned food per
year, of which 3 million must come from the Kenya, 4 million from Germany, and 3 million
from Saudi Arabia. Customs officials in the importing nation monitor the quantity of a
particular good that enters the country from each source; once the quota for that source has
been filled, no more goods are permitted to be imported.
2) Bilateral quotas
It is mutual agreement between countries through negotiations. They do not provoke retaliation.
3) Mixing or indirect quotas
In this case the domestic producers are asked to use a fixed proportion of imported and domestic
materials used in producing their products. The quota is fixed not in absolute forms but in
percentage forms.
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Similarity and difference Tariffs and quotas
a. Similarities
i. both have the same objectives like protecting domestic industries, correcting BOP, and
expand domestic employment and economic activities
ii. A tariff of a certain height cuts imports to a certain quantity. It has, therefore a quota
equivalent effect. At the same time a quota would limit imports to a certain quantity and
therefore, raises the import price. A quota has, thus, a tariff equivalent effect.
iii. Since both quota and tariffs raise the import price and reduce the import quantity they
produce similar effects on consumption, production, trade balance, TOT, national
income redistribution, factor movements, economic growth and economic welfare.
b. differences
i. Tariffs bring revenue to the government whereas quotas do not. Under tariff same of
consumers’ loss goes to government in the form of revenue. But under quota it is
ambiguous. It could go to government if it charges a fee for selling import licenses and if
not, some of consumers loss will be distribute to importers and the imports welfare will
increase further more.
ii. Tariff revenues can be used for investment on social services, but the quota profits going
to importers may not contribute to net social welfare.
iii. Distribution of import licenses (associated with quota) may give rise to corruption and
bribery on the part of government. Import tariffs do not create such problems or even if
they do the degree is small.
iv. The TOT effects of tariffs are determined or predictable, but those resulting from quotas
are unpredictable.
2. Subsidies
National governments sometimes grant subsidies to domestic producers to help improve their
trade position. Such devices are an indirect form of protection provided to home businesses,
whether they may be import-competing producers or exporters. By providing domestic firms a
cost advantage, a subsidy allows them to market their products at prices lower than their actual
cost or profit considerations warrant. Governments wanting to see certain domestic industries
expand may provide subsidies to encourage their development.
Government subsidies assume a variety of forms. In the simplest method, a government makes
an outright cash disbursement to a domestic exporter after the sale has been completed. The
payment may be according to the discrepancy between the exporter's actual costs and the price
received or on the basis of a fixed amount for each unit of a product sold. The overall result is to
permit the producer a cost advantage that would not otherwise exist. Such direct export subsidies
when applied to manufactured goods have been prohibited by the General Agreement on Tariffs
and Trade.
Governments sometimes use indirect subsidies to achieve the same general result. For example,
governments may give their exporters special privileges, including tax concessions, insurance
arrangements, and loans at below market interest rates. Governments may also sell surplus
materials (such as ships) to domestic exporters at favorable prices. Governments may purchase a
firm's product at a relatively high price and then dump it in foreign markets at lower prices. This
has traditionally been the technique used by the U.S. government in conjunction with its farm-
support programs. As with direct cash disbursements to domestic producers, indirect subsidies
are intended to encourage the expansion of a nation's exports by permitting them to be sold
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abroad at lower prices.

For purposes of our discussion, two types of subsidy can be distinguished: a domestic subsidy,
which is sometimes granted to producers of import-competing goods, and an export subsidy,
which is made to producers of goods that are to be sold overseas. In both cases, the recipient
producer views the subsidy as tantamount to a negative tax: the government adds an amount to
the price the purchaser pays rather than subtracting from it. The net price actually received by the
producer equals the price paid by the purchaser plus the subsidy. The subsidized producer is thus
able to supply a greater quantity at each consumer's price.
3. Licenses
The license system requires that a state issues permits for foreign trade transactions of import
and export commodities included in the lists of licensed merchandises. Product licensing can
take many forms and procedures. The main types of licenses are general license that permits
unrestricted importation or exportation of goods included in the lists for a certain period of time;
and one-time license for a certain product importer (exporter) to import (or export). One-time
license indicates a quantity of goods, its cost, its country of origin (or destination), and in some
cases also customs point through which import (or export) of goods should be carried out. The
use of licensing systems as an instrument for foreign trade regulation is based on a number of
international level standard agreements.
4. Voluntary export restraint
The specifics of these types of restrictions is the establishment of unconventional techniques
when the trade barriers of importing country, are introduced at the border of the exporting and
not importing country. Voluntary export restraints are imposed on the exporter under the threat
of sanctions to limit the export of certain goods in the importing country. Similarly, the
establishment of minimum import prices should be strictly observed by the exporting firms in
contracts with the importers of the country that has set such prices. In the case of reduction of
export prices below the minimum level, the importing country imposes anti-dumping duty which
could lead to withdrawal from the market.
5. Domestic Content Provision

It is an instrument that tries to reserve some of the value added and some of the sales of product
components for domestic suppliers. It said that a given commodity sold in the domestic economy
must contain a certain percentage of inputs from the importer country. This implies that there
must be a value addition on the products imported by the exporter nation. The international trade
must provide benefit to both nations. In the present time member nation of NAFTA do not
permit duty-free entry of automobiles from non-member countries unless 62.5% of the value of
the vehicle originates from one of the member.
6. Government procurement provision

The rule restricts the purchasing of foreign products by the home government agencies. The
government of the importer nation protects usage of foreign goods by his agencies and
parastatals.
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7. The Infant - Industry Argument for Protection
The infant industry argument rests on the following grounds:

✓ Every country has its own potentialities for developing some industries in the form of
labour skill, raw materials and entrepreneurial talent. No country is completely devoid of
productive elements which may yet be latent.
✓ Every nation has the right to develop its potentialities or discover its latent productive
powers. No nation would like its efforts for economic development to be smothered
before it has had a full chance for trial and error.
✓ It takes time for the productive elements to be developed. Labour can be trained; raw
materials can be improved; and entrepreneurs can become competent by experience. But
they should have enough time to develop and discover themselves.
✓ Infant industries cannot be expected to withstand completion from old and well-
entrenched industries. It will be unfair to expose new industries.
✓ If infant industries are not duly protected against competition from strong and well-
established' industries, they are bound to die. This will mean waste of valuable national
assets invested in the industry and a serious setback to entrepreneurial venture in future.
Problems with the Infant Industry Argument

The infant industry argument seems highly plausible, and in fact it has been persuasive to many
governments. Yet economists have pointed out many pitfalls in the argument, suggesting that it
must be used cautiously.
✓ First, it is not always good to try to move today into the industries that will have a
comparative advantage in the future. Suppose that a country that is currently labor
abundant is in the process of accumulating capital: When it accumulates enough capital,
it will have comparative advantage in capital-intensive industries. That does not mean it
should try to develop these industries immediately. In the 1980s, for example, South
Korea became an exporter of automobiles; it would probably not have been a good idea
for South Korea to have tried to develop its auto industry in the 1960s, when capital and
skilled labor were still very scarce.
✓ Second, protecting manufacturing does no good unless the protection itself helps make
industry competitive. Pakistan and India have protected their manufacturing sectors for
decades and have recently begun to develop significant exports of manufactured goods.
The goods they export, however, are light manufactures like textiles, not the heavy
manufactures that they protected; a good case can be made that they would have
developed their manufactured exports even if they had never protected manufacturing.
Some economists have warned of the case of the "pseudo infant industry," where industry
is initially protected, then becomes competitive for reasons that have nothing to do with
the protection. In this case infant industry protection ends up looking like a success but
may actually have been a net cost to the economy.
More generally, the fact that it is costly and time-consuming to build up an industry is not an
argument for government intervention unless there is some domestic market failure. If an
industry is supposed to be able to earn high enough returns for capital, labor, and other factors of
production to be worth developing, then why don't private investors develop the industry without
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government help? Sometimes it is argued that private investors take into account only the current
returns in an industry and fail to take account of the future prospects, but this is not consistent
with market behavior. In advanced countries at least, investors often back projects whose returns
are uncertain and lie far in the future. (Consider, for example, the U.S. biotechnology industry,
which attracted hundreds of millions of dollars of capital years before it made even a single
commercial sale.)
Market Failure Justifications for Infant Industry Protection

To justify the infant industry argument, it is necessary to go beyond the plausible but
questionable view that industries always need to be sheltered when they are new. The argument
for protecting an industry in its early growth must be related to some particular set of market
failures that prevent private markets from developing the industry as rapidly as they should.
Sophisticated proponents of the infant industry argument have identified two market failures as
reasons why infant industry protection may be a good idea: imperfect capital markets and the
problem of appropriability.
The imperfect capital markets justification for infant industry protection states if a developing
country does not have a set of financial institutions (such as efficient stock markets and banks)
that would allow savings from traditional sectors (such as agriculture) to be used to finance
investment in new sectors (such as manufacturing), then growth of new industries will be
restricted by the ability of firms in these industries to earn current profits. Thus low initial profits
will be an obstacle to investment even if the long-term returns on this investment are high. The
first-best policy is to create a better capital market, but protection of new industries, which would
raise profits and thus allow more rapid growth, can be justified as a second-best policy option.
The approprability argument for infant industry protection can take many forms, but all have in
common the idea that firms in a new industry generate social benefits for which they are not
compensated. For example, the firms that first enter an industry may have to incur "start-up"
costs of adapting technology to local circumstances or of opening new markets. If other firms are
able to follow their lead without incurring these start-up costs, the pioneers will be prevented
from reaping any returns from these outlays. Thus, pioneering firms may, in addition to
producing physical output, create intangible benefits (such as knowledge or new markets) in
which they are unable to establish property rights. In some cases the social benefits from creation
of a new industry will exceed its costs, yet because of the problem of approprability no private
entrepreneurs will be willing to enter. The first-best answer is to compensate firms for their
intangible contributions. When this is not possible, however, there is a second-best case for
encouraging entry into a new industry by using tariffs or other trade policies.
Both the imperfect capital markets argument and the approprability case for infant industry
protection are clearly special cases of the market failures justification for interfering with free
trade. The difference is that in this case the arguments apply specifically to new industries rather
than to any industry. The general problems with the market failure approach remain, however. In
practice it is difficult to evaluate which industries really warrant special treatment, and there are
risks that a policy intended to promote development will end up being captured by special
interests. There are many stories of infant industries that have never grown up and remain
dependent on protection.
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3.4. Trade Policy and Economic Welfare

In this case we will try to see the effect of having trade barriers on the economy of a small nation
in the partial analysis way. There will be calculation of the welfare and market effects of trade
policies. Having any of the trade policies will result into change in the welfare of the consumers
and producers and at the same time there is may be change in the government. Besides to the
change in the welfare there will be a change in the price, demand and supply with in the
domestic economic system.
Consumer surplus is used to measure the welfare of a group of consumers who purchase a
particular product at a particular price. Consumer surplus is defined as the difference between
what consumers are willing to pay for a unit of the good and the amount consumers actually do
pay for the product. The market demand curve shows the quantity of the good that would be
demanded by all consumers at each and every price that might prevail. The demand curve tells us
the maximum price that consumers would be willing to pay for any quantity supplied to the
market. The total consumer surplus in the market is given by the sum of the areas of the
rectangles. Thus total consumer surplus can reasonably be measured as the area between the
demand curve and the horizontal line drawn at the equilibrium market price.
Changes in Consumer Surplus
Suppose the supply of a good rises, represented by a rightward shift in the supply curve from S to
S′. At the original price, P1, consumer surplus is given by the blue area in the diagram (the
triangular area between the P1 price line and the demand curve). The increase in supply lowers
the market price to P2. The new level of consumer surplus is now given by the sum of the two
shaded areas (the triangular area between the P2 price line and the demand curve). The change in
consumer surplus, is given by the area denoted by a and b. Note that the change in consumer
surplus is determined as the area between the price that prevails before, the price that prevails
after, and the demand curve. In this case, consumer surplus rises because the price falls. Two
groups of consumers are affected. Consumers who would have purchased the product even at the
higher price, P1, now receive more surpluses (P1−P2) for each unit they purchase. These extra
benefits are represented by the rectangular area a in the diagram. Also, there are additional
consumers who were unwilling to purchase the product at price P1 but are now willing to
purchase at the price P2. Their consumer surplus is given by the triangular area b in the diagram.
NB: The exact reveres of the above occasion will happen when there is imposition of tariff on
importable goods.
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Changes in Producer Surplus

Producer surplus is used to measure the welfare of a group of firms that sell a particular product
at a particular price. Producer surplus is defined as the difference between what producers
actually receive when selling a product and the amount they would be willing to accept for a unit
of the good. Firms’ willingness to accept payments can be read from a market supply curve for a
product.
The market supply curve shows the quantity of the good that firms would supply at each and
every price that might prevail. The supply curve tells us the minimum price that producers would
be willing to accept for any quantity demanded by the market. The price that ultimately prevails
in a free market is the price that equalizes market supply with market demand. The light shaded
area of the above graph shows the additional producer surplus after the tariff which increases the
price the goods in the domestic market. The new level of producer surplus is now given by the
sum of the two areas in the above figure (the triangular area between the price P and the supply
curve). The change in producer surplus, PS, is given by the light shaded area in the above figure
(the area between the two prices and the supply curve). Note that the change in producer surplus
is determined as the area between the price that prevails before, the price that prevails after, and
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the supply curve. In this case, producer surplus rises because the price increases and output rises.
The increase in output also requires an increase in variable factors of production such as labor.
Change in the government revenue

The government tries to increase his revenue through levying tariff on importable goods. The
shaded area of the graph given below showed the revenue of the government collected from
levying tariff on importable goods.
The graph given below showed the distribution of the benefit of levying tariff on import. There
will be redistribution of welfare from the consumers to the producers and the government. A
partial equilibrium analysis distinguishes between the welfare of consumers who purchase a
product and the producers who produce it. Consumer welfare is measured using consumer
surplus, while producer welfare is measured using producer surplus. Revenue collected by the
government is assumed to be redistributed to others. Government revenue is either spent on
public goods or is redistributed to someone in the economy, thus raising someone’s welfare.
We can continue this procedure until the market demand at the price P is reached. The total
producer surplus in the market is given by the sum of the areas of the rectangles. Producer
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surplus can be interpreted as the amount of revenue allocated to fixed costs and profit in the
industry. Consider a market in a small importing country that faces an international or world
price of PFT in free trade (see the following figure). The free trade equilibrium is PFT is the free
trade equilibrium price. At that price, domestic demand is given by DFT, domestic supply by SFT,
and imports by the difference DFT − SFT .
When a specific tariff is implemented by a small country, it will raise the domestic price by the
full value of the tariff. Suppose the price in the importing country rises to PIMT because of the
tariff. In this case, the tariff rate would be t=PIMT−PFT .
Welfare effects of an import tariff seem the following.
Importing Country
Consumer Surplus − (A + B + C + D)
Producer Surplus + A
Govt. Revenue +C
National Welfare − B – D
Tariff effects on the importing country’s consumers. Consumers of the product in the importing
country are worse off as a result of the tariff. The increase in the domestic price of both imported
goods and the domestic substitutes reduces consumer surplus in the market by area of A, B, C
and D.
Tariff effects on the importing country’s producers. Producers in the importing country are better
off as a result of the tariff. The increase in the price of their product increases producer surplus in
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the industry by area of A. The price increases also induce an increase in the output of existing
firms (and perhaps the addition of new firms), an increase in employment, and an increase in
profit, payments, or both to fixed costs.
Tariff effects on the importing country’s government. The government receives tariff revenue as
a result of the tariff, which is equal to area of C. Who will benefit from the revenue depends on
how the government spends it. These funds help support diverse government spending programs;
therefore, someone within the country will be the likely recipient of these benefits.
Tariff effects on the importing country. The aggregate welfare effect for the country is found by
summing the gains and losses to consumers, producers, and the government. The net effect
consists of two components: a negative production efficiency loss (B) and a negative
consumption efficiency loss (D). The two losses together are typically referred to as “deadweight
losses.”
Because there are only negative elements in the national welfare change, the net national welfare
effect of a tariff must be negative. This means that a tariff implemented by a small importing
country must reduce national welfare. In summary, the following are true:
1. Whenever a small country implements a tariff, national welfare falls.
2. The higher the tariff is set, the larger will be the loss in national welfare.
3. The tariff causes a redistribution of income. Producers and the recipients of government
spending gain, while consumers lose.
4. Because the country is assumed to be small, the tariff has no effect on the price in the rest
of the world; therefore, there are no welfare changes for producers or consumers there.
Even though imports are reduced, the related reduction in exports by the rest of the world
is assumed to be too small to have a noticeable impact.
Import Quota: Small Country Price Effects
The small country assumption means that the country’s imports are a very small share of the
world market-so small that even a complete elimination of imports would have an imperceptible
effect on world demand for the product and thus would not affect the world price. Thus when a
quota is implemented by a small country, there is no effect on the world price.
To depict the price effects of a quota, we use an export supply/import demand diagram shown in
below. The export supply curve is drawn as a horizontal line since the exporting country is
willing to supply as much as the importer demands at the world price. The small importing
country takes the world price as exogenous since it can have no effect on it.
Depicting a Quota Equilibrium: Small Country Case
70
When the quota is placed on imports, it restricts supply to the domestic market since fewer imports are
allowed in. The reduced supply raises the domestic price. The world price is unaffected by the quota and
remains at the free trade level. In the final equilibrium, two conditions must hold-the same two conditions
as in the case of a large country, namely,
MDMex(PMexQ)=Q− and XSUS(PFT)=Q−
This implies that, in the case of a small country,
Consider a market in a small importing country that faces an international or world price of PFT
in free trade. The free trade equilibrium is depicted in below, where PFT is the free trade
equilibrium price. At that price, domestic demand is given by DFT, domestic supply by SFT, and
imports by the difference, DFT − SFT (the blue line in the following figure).
Suppose an import quota is set below the free trade level of imports. A reduction in imports will
lower the supply on the domestic market and raise the domestic price. In the new equilibrium,
the domestic price will rise to the level at which import demand equals the value of the quota.
Since the country is small, there will be no effect on the world price, which will remain at PFT. If
the quota is set equal to Q−=DQ−SQ , then the price will have to rise to PQ.
71
Welfare Effects of a Quota: Small Country Case
The above figure can be revised in the following way
Importing Country
Consumer Surplus − (A + B + C + D)
Producer Surplus + A
Quota Rents +C
National Welfare − B – D
Welfare effects on the importing country’s consumers. Consumers of the product in the importing
country are worse off as a result of the quota. The increase in the domestic price of both
imported goods and the domestic substitutes reduces consumer surplus in the market by the area
of A, B, C and D.
Welfare effects on the importing country’s producers. Producers in the importing country are
better off as a result of the quota. The increase in the price of their product increases producer
surplus in the industry by the area of A. The price increase also induces an increase in the output
of existing firms (and perhaps the addition of new firms), an increase in employment, and an
increase in profit, payments, or both to fixed costs.
72
Welfare effects on the quota rents. Who receives the quota rents depends on how the government
administers the quota.
1. If the government auctions the quota rights for their full price, then the government
receives the quota rents. In this case, the quota is equivalent to a specific tariff set equal
to the difference in prices (t = PQ − PFT),
2. If the government gives away the quota rights, then the quota rents accrue to whoever
receives these rights. Typically, they would be given to someone in the importing
economy, which means that the benefits would remain in the domestic economy.
3. If the government gives the quota rights away to foreigners, then people in the foreign
country receive the quota rents. In this case, the rents would not be a part of the importing
country effects.
Welfare effects on the importing country. The aggregate welfare effect for the country is found
by summing the gains and losses to consumers, producers, and the domestic recipients of the
quota rents. The net effect consists of two components: a negative production efficiency loss (B)
and a negative consumption efficiency loss (D). The two losses together are referred to as
“deadweight losses.”
Because there are only negative elements in the national welfare change, the net national welfare
effect of a quota must be negative. This means that a quota implemented by a small importing
country must reduce national welfare.
Generally speaking, the following are true:
1. Whenever a small country implements a quota, national welfare falls.

2. The more restrictive the quota, the larger will be the loss in national welfare.
3. The quota causes a redistribution of income. Producers and the recipients of the quota
rents gain, while consumers lose.
4. Because the country is assumed to be small, the quota has no effect on the price in the
rest of the world; therefore there are no welfare changes for producers or consumers
there. Even though imports are reduced, the related reduction in exports by the rest of the
world is assumed to be too small to have a noticeable impact.
CHAPTER FOUR
4 TRADE, GROWTH AND DEVELOPMENT
The issues of international trade and economic growth have gained substantial importance with
the introduction of trade liberalization policies in the developing nations across the world.
International trade and its impact on economic growth crucially depend on globalization. As far
as the impact of international trade on economic growth is concerned, the economists and policy
makers of the developed and developing economies are divided into two separate groups.
One group of economists is of the view that international trade has brought about unfavorable
changes in the economic and financial scenarios of the developing countries. According to them,
the gains from trade have gone mostly to the developed nations of the world. Liberalization of
trade policies, reduction of tariffs and globalization have adversely affected the industrial setups
73
of the less developed and developing economies. As a result of liberalization, majority of the
infant industries in developing nations have closed their operations. Many other industries that
used to operate under government protection found it very difficult to compete with their global
counterparts.
On the other hand the classicists believed that international trade has a positive effect on the
economic growth. International Trade has positively influenced the economic growth of a
country in the following ways:
• International trade injects global competitiveness and hence the domestic business units tend
to become very efficient being exposed international competition. Due to the integration with
the world economy the entrepreneurs can have easy access to the technological innovations.
They can utilize the latest technologies to enhance their productivity.
• The developing countries have higher trade protectionism measures as compared to the
developed countries. The countries that have adopted such measures are seen to reap the
benefits of an open trade regime.
4.1 Defining Trade Strategy
4.2 Inward - and Outward - Looking strategies

A traditional way to approach the complex issues of appropriate trade strategies for development
is to set these specific policies in the context of a broader strategy of looking outward or looking
inward. In the words of Paul Streeten, outward-looking development strategy (it is a strategy
that encourage exports, often through the free movement of capital, workers, enterprises, and
students; a welcome to multinational corporations; and open communications.) “encourage not
only free trade but also the free movement of capital, workers, enterprises and students . . . , the
multinational enterprise, and an open system of communications.” By contrast, inward-looking
development strategies (it is a strategy that stress economic self-reliance on the part of
developing countries including domestic development of technology, the imposition of barriers
to imports, and the discouragement of private foreign investment.) stress the need for nations to
evolve their own styles of development and to control their own destiny. This means policies to
encourage indigenous “learning by doing” in manufacturing and the development of
technologies appropriate to a country’s resource endowments.
According to proponents of inward-looking trade policies, greater self-reliance can be

accomplished, in Streeten’s words, only if “you restrict trade, the movement of people, and
communications and if you keep out the multinational enterprise, with its wrong products and
wrong want-stimulation and hence its wrong technology.” A lively debate regarding these two
philosophical approaches has been carried on in the development literature since the 1950s. The
debate pits the free traders, who advocate outward-looking export promotion strategies of
industrialization, against the protectionists, who are proponents of inward looking import
substitution strategies. The latter predominated into the 1970s; the former gained the upper hand
in the late 1970s and especially among Western and World Bank economists in the 1980s and
early 1990s.
74
Basically, the distinction between these two traditional trade-related development strategies is
that advocates of import substitution (IS) believe that a developing economy should initially
substitute domestic production of previously imported simple consumer goods (first-stage IS)
and then substitute through domestic production for a wider range of more sophisticated
manufactured items (second-stage IS)—all behind the protection of high tariffs and quotas on
these imports. In the long run, IS advocates cite the benefits of greater domestic industrial
diversification (“balanced growth”) and the ultimate ability to export some previously protected
manufactured goods as economies of scale, low labor costs, and the positive externalities of
learning by doing cause domestic prices to become more competitive with world prices.
By contrast, advocates of export promotion (EP) of both primary and manufactured goods cite
the efficiency and growth benefits of free trade and competition, the importance of substituting
large world markets for narrow domestic markets, the distorting price and cost effects of
protection, and the tremendous successes of such export-oriented economies as South Korea,
Taiwan, Singapore, Hong Kong, China, and others in Asia. They stress that firms in these
economies have learned a great deal from the firms in the United States, Japan, and other
developed-country economies that have been their long-term customers. Sometimes a distinction
is made between “strong export promotion,” in which policies are explicitly geared to expansion
of exports (in general, such as through a weak currency), rather than production for the domestic
market, and “weak export promotion,” which emphasizes free trade and a level playing field and
is viewed by advocates as likely to promote exports by comparison with previous import
substitution policies (which tend to discourage exports in relative terms). Beyond this, many
Asian countries also adopted a more nuanced approach that draws on some elements of both to
develop targeted sectors, examined later in the chapter.
In practice, the distinction between IS and EP strategies is much less pronounced than many
advocates would imply. Most developing economies have employed both strategies with
different degrees of emphasis at one time or another. For example, in the 1950s and 1960s, the
inward-looking industrialization strategies of the larger Latin American and Asian countries such
as Chile, Peru, Argentina, India, Pakistan, and the Philippines were heavily IS oriented.
By the end of the 1960s, some of the key sub-Saharan African countries like Nigeria, Ethiopia,
Ghana, and Zambia had begun to pursue IS strategies, and some smaller Latin American and
Asian countries also joined in. However, since the mid-1970s, the EP strategy has been
increasingly adopted by a growing number of countries. The early EP adherents, South Korea,
Taiwan, Singapore, and Hong Kong; were thus joined by the likes of Brazil, Chile, Thailand, and
Turkey, which switched from an earlier IS strategy. It must be stressed, however, that most
successful East Asian export promoters have pursued protectionist IS strategies sequentially and
simultaneously in certain industries, so it is inaccurate to call them free traders, even though they
are outward-oriented.
The issue of outward-looking export promotion versus inward-looking import substitution

strategies can be categorization in to four groups as follow4:
1. Primary outward-looking policies (encouraging agricultural &raw-material exports)
2. Secondary outward-looking policies (promotion of manufactured exports)
3. Primary inward-looking policies (mainly agricultural self-sufficiency)
4 “For detail understanding four strategies read Michael P. Todaro, 11th edition from page 595 to 607”
75
4. Secondary inward-looking policies (manufactured commodity self-sufficiency through

import substitution)
4.3 Trade Strategy and Industrialization
Most observers agree that the import-substituting strategy of industrialization has been largely
unsuccessful. Specifically, there have been five undesirable outcomes.
➢ First, secure behind protective tariff walls and immune from competitive pressures, many
IS industries (both publicly and privately owned) remain inefficient and costly to operate.
➢ Second, the main beneficiaries of the import substitution process have been the foreign
firms that were able to locate behind tariff walls and take advantage of liberal tax and
investment incentives. After deducting interest, profits, and royalty and management fees,
much of which are remitted abroad, the little that may be left over usually accrues to the
wealthy local industrialists with whom foreign manufacturers cooperate and who provide
their political and economic cover.
➢ Third, most import substitution has been made possible by the heavy and often
government-subsidized importation of capital goods and intermediate products by foreign
and domestic companies. In the case of foreign companies, much of this is purchased
from parent and sister companies abroad. There are two immediate results;
✓ On the one hand, capital-intensive industries are set up, usually catering to the
consumption habits of the rich while having a minimal employment effect.
✓ On the other hand, far from improving the developing nation’s balance of
payments situation and alleviating the debt problem, indiscriminate import
substitution often worsens the situation by increasing a need for imported capital-
good inputs and intermediate products while, as just noted, a good part of the
profits is remitted abroad in the form of private transfer payments.
➢ A fourth detrimental effect of many import substitution strategies has been their impact
on traditional primary-product exports. To encourage local manufacturing through the
importation of cheap capital and intermediate goods, official exchange rates (the rates at
which the central bank of a nation is prepared to purchase specific foreign currencies)
have often been artificially overvalued. This has had the effect of raising the price of
exports and lowering the price of imports in terms of the local currency. The net effect of
overvaluing exchange rates in the context of import substitution policies is to encourage
capital-intensive production methods still further (because the price of imported capital
goods is artificially lowered) and to penalize the traditional primary-product export sector
by artificially raising the price of exports in terms of foreign currencies. This
overvaluation, then, causes local farmers to be less competitive in world markets. In
terms of its income distribution effects, the outcome of such government policies may be
to penalize the small farmer and the self-employed while improving the profits of the
owners of capital, both foreign and domestic. Industrial protection thus has the effect of
taxing agricultural goods in the home market as well as discouraging agricultural exports.
Import substitution policies have in practice often worsened the local distribution of
income by favoring the urban sector and higher-income groups while discriminating
against the rural sector and lower-income groups.
➢ Fifth and finally, import substitution, which may have been conceived with the idea of
stimulating infant-industry growth and self-sustained industrialization by creating
“forward” and “backward” linkages with the rest of the economy, has often inhibited that
industrialization. Many infants never grow up; content to hide behind protective tariffs
76
and governments loath to force them to be more competitive by lowering tariffs. In fact,
governments themselves often operate protected industries as state-owned enterprises.
Moreover, by increasing the costs of inputs to potentially forward-linked industries (those
that purchase the output of the protected firm as inputs or intermediate products in their
own productive process, such as a printer’s purchase of paper from a locally protected
paper mill) and by purchasing their own inputs from overseas sources of supply rather
than through backward linkages to domestic suppliers, inefficient import-substituting
firms may in fact block the hoped-for process of self-reliant integrated industrialization.
4.4 Trade Strategy and Economic performance
International trade has often played a central role in the historical experience of the developing
world. In recent years, much of the attention to trade and development issues has been focused
on understanding the spectacular export success of East Asia. Taiwan, South Korea, and other
East Asian economies pioneered this strategy, which has been successfully followed by their
much larger neighbor, China. The experiences of these countries are an important plot in the
unfolding trade and development drama.
At the same time, throughout Africa, the Middle East, and Latin America, primary product
exports have traditionally accounted for a sizable proportion of individual gross domestic
products. In some of the smaller countries, a substantial percentage of the economy’s monetary
income is derived from the overseas sale of agricultural and other primary products or
commodities such as coffee, cotton, cacao, sugar, palm oil, bauxite, and copper. They derived
from all extractive occupations— farming, lumbering, fishing, mining, and quarrying, foodstuffs,
and raw materials. In the special circumstances of the oil-producing nations in the Persian Gulf
and elsewhere, the sale of unrefined and refined petroleum products to countries throughout the
world accounts for over 70% of their national incomes. But unlike the oil producing states and
successfully industrializing countries like South Korea, Taiwan, and now China, many
developing countries must still depend on non-mineral primary-product exports for a relatively
large fraction of their foreign- exchange earnings. This is a particularly serious problem in sub-
Saharan Africa. Because the markets and prices for these exports are often unstable, primary-
product export dependence carries with it a degree of risk and uncertainty that few nations’
desire. This is an important issue because despite strength since 2002 and some rebounding after
the 2008 crisis, the long-term trend for prices of primary goods is downward, as well as very
volatile.
Some African countries, including Mali, Niger, Burkina Faso, and Burundi, continue to receive
8% or less of their merchandise export earnings from manufactures (none of them received more
than 3% of their export earnings from fossil fuels in 2005). Nigeria received 98% of its export
earnings from fossil fuels in 2005. Indeed, some developing countries continue to receive at least
two-fifths of their export earnings from one or two agricultural or nonfuel mineral products. And
as noted by David Harvey and his coauthors, “For 40 countries, the production of three or fewer
commodities explains all export earnings.” And UNCTAD reported in 2006 that “out of 141
developing countries, 95 are more than 50% dependent on commodity exports. In most sub-
Saharan African countries, the figure is 80%.”In addition to their export dependence, many
developing countries rely, generally to an even greater extent, on the importation of raw
materials, machinery, capital goods, intermediate producer goods, and consumer products to fuel
their industrial expansion and satisfy the rising consumption aspirations of their people. For a
77
majority of developing nations, import demands exceeded their capacity to generate sufficient
revenues from the sale of exports for much of the post–World War II period. This led to chronic
deficits on their balance of payments position vis-à-vis the rest of the world. Whereas such
deficits on the current account (an excess of import payments over export receipts for goods
and services) were compensated for on their balance of payments table by a surplus on the
capital account (a receipt of foreign private and public lending and investment in excess of
repayment of principal and interest on former loans and investments), the debt burden of
repaying earlier international loans and investments often becomes acute. In a number of
developing countries, severe deficits on current and capital accounts have led to a depletion of
international monetary reserves, currency instability, and a slowdown in economic growth.
In the 1980s and 1990s, this combination of rising trade deficits, growing foreign debts,
accelerated capital flight, and diminished international reserves led to the widespread adoption of
fiscal and monetary austerity measures, especially in Africa and Latin America (often with the
involvement of the International Monetary Fund), which may have further exacerbated the
slowdown in economic growth and the worsening of poverty and unemployment in much of the
developing world.
Here the point is merely that a chronic excess of foreign expenditures over receipts (which may
have nothing to do with a developing country’s inability to handle its financial affairs but rather
may be related to its vulnerability to global economic disturbances) can significantly retard
development efforts. It can also greatly limit a poor nation’s ability to determine and pursue its
most desirable economic strategies.
Many indebted countries went into surplus as they paid down some of their debt. In the new
century, a pattern of trade surpluses has strengthened for many though by no means all
developing countries. Developing countries have sought to avoid repeats of the crisis conditions
of Latin America in the 1980s, sub-Saharan Africa in the 1980s and 1990s, and East Asia in
1997–98. The sudden collapse of export earnings during the 2008 financial crisis provided a
glimpse of the dangers, although the global economy quickly moved back toward its apparently
unsustainable imbalances. This pattern carries its own risks; for example, it means that
developing countries are effectively exporting capital, and it leaves economies vulnerable to a
sharp correction when the large and chronic U.S. balance of payments deficits are inevitably
reversed.
But international trade and finance must be understood in a much broader perspective than
simply the inter-country flow of commodities and financial resources. By opening their
economies and societies to global trade and commerce and by looking outward to the rest of the
world, developing countries invite not only the international transfer of goods, services, and
financial resources but also the developmental or anti-developmental influences of the transfer of
production technologies; consumption patterns; institutional and organizational arrangements;
educational, health, and social systems; and the more general values, ideals, and lifestyles of the
developed nations of the world. The impact of such technological, economic, social, and cultural
transfers on the character of the development process can be either consistent or inconsistent
with broader development objectives. Much will depend on the nature of the political, social, and
institutional structure of the recipient country and its development priorities. Whether it is best
78
for developing countries to look primarily outward (as single economies or as blocs) and
promote more exports, either passively or actively; to emphasize looking inward and substitute
domestic production for imports, as the protectionists and cultural nationalists propose; or to be
simultaneously and strategically outward- and inward-looking in their international economic
policies cannot be stated a priori. Individual nations must appraise their present and prospective
situations in the world community realistically in the light of their specific development
objectives. Only thus can they determine how to design the most beneficial trade strategy.
Although participation in the world economy is all but inevitable, there is ample room for policy
choice about what kind of participation to promote and what policy strategies to pursue.
Five Basic Questions about Trade and Development

Our objective in the next few sections is to focus on traditional and more contemporary theories
of international trade in the context of five basic themes or questions of particular importance to
developing nations.
1. How does international trade affect the rate, structure, and character of economic growth?
This is the traditional “trade as an engine of growth” controversy, set in terms of
contemporary development aspirations.
2. How does trade alter the distribution of income and wealth within a country and among
different countries? Is trade a force for international and domestic equality or inequality? In
other words, how are the gains and losses distributed, and who benefits?
3. Under what conditions can trade help a nation to achieve its development objectives?
4. Can a developing country by its own actions determine how much it trades or which products
and services it sells?
5. In the light of past experience and prospective judgment, should a developing country adopt
an outward-looking policy (freer trade, expanded flows of capital and human resources, etc.)
or an inward-looking one (protectionism in the interest of self-reliance), or some combination
of both, for example, in the form of regional economic cooperation and strategic export
policies? What are the arguments for and against these alternative trade strategies for
development?
Clearly, the answers or suggested answers to these five questions will not be uniform throughout
the diverse economies of the developing world. The whole economic basis for international trade
rests on the fact that countries do differ in their resource endowments, their preferences and
technologies, their scale economies, their economic and social institutions, and their capacities
for growth and development. Developing countries are no exception to this rule. Some are
rapidly ascending through the income rankings as they expand their industrial capacities. Some
are very populous yet deficient in both natural resources and human skills, at least in large
regions of the country. Others are sparsely populated yet endowed with abundant mineral and
raw material resources. Yet others are small and economically weak, still having at present
neither adequate human capital nor the material resources on which to base a sustained and
largely self-sufficient strategy of economic and social development.
We begin with a statistical summary of recent trade performance of developing countries and
patterns. There follows a simplified presentation of the basic neoclassical theory of international
trade and its effect on efficiency, equity, stability, and growth (four basic economic concepts
related to the central questions outlined here). We then provide a critique of the relevance of pure
79
free-trade theories for developing countries in the light of both historical experience and the
contemporary realities of the world economy.
Like free markets, free trade has many desirable theoretical features, not the least of which is the
promotion of static economic efficiency and optimal resource allocation. But also like free
markets and perfect competition, free trade exists more in theory than in practice and today’s
developing nations have to function in the imperfect and often highly unequal real world of
international commerce.
Trade Theory and Development: The Traditional Arguments
We are now in a position to summarize the theoretical answers to our five basic questions about
trade and development derived from the neoclassical free trade model.
1. Trade is an important stimulator of economic growth. It enlarges a country’s
consumption capacities, increases world output, and provides access to scarce resources
and worldwide markets for products without which poor countries would be unable to
grow.
2. Trade tends to promote greater international and domestic equality by equalizing factor
prices, raising real incomes of trading countries, and making efficient use of each
nation’s and the world’s resource endowments(e.g., raising relative wages in labor-
abundant countries and lowering them in labor-scarce countries).
3. Trade helps countries achieve development by promoting and rewarding the sectors of
the economy where individual countries possess a comparative advantage, whether in
terms of labor efficiency or factor endowments. It also lets them take advantage of
economies of scale.
4. In a world of free trade, international prices and costs of production determine how much
a country should trade in order to maximize its national welfare. Countries should follow
the principle of comparative advantage and not try to interfere with the free workings of
the market through government policies that either promote exports or restrict imports.
5. Finally, to promote growth and development, an outward-looking international policy is
required. In all cases, self-reliance based on partial or complete isolation is asserted to be
economically inferior to participation in a world of unlimited free trade.
80

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INTERNATIONAL ECONOMICS I

CHAPTER ONE: INTRODUCTION

To international economists, globalization occurs when the markets of different countries

1 Markusen & Maskus, (2011. p 1…)

This major expansion in the exposure of economies to international transactions is highly

Specifically, international economics deals with international trade theory, international

1.2. The Components of International Economics

Microeconomics vs. Macroeconomics

Increasing Globalization of Currency and Economic Systems

The Pattern of Trade

How Much Trade?

Exchange Rate Determination

International Policy Coordination

The International Capital Market

1.3. The Importance of International Economics

2. There are normally no government-imposed barriers to the shipment of goods within a

country without government protection in the form of tariffs or quotas. Domestic

1.4. International Economics and Economics Theories

Theories of International Economics aims to redress the balance by taking a pluralistic

of each approach to be understood and appreciated, and in doing so enables a greater

1.5. Purposes of Economic Theories and/or Models

1.6. Testing a Hypothesis/Theory/ Model

A proposition may take the form of asserting a causal relationship. An example of a

1.8. International Trade

The Basis of International Trade

International Trade versus Domestic (interregional) Trade

Interregional (domestic) trade is based on differences in prices between different sections

ii. Product mobility

iii. Economic environment

iv. Monetary units

2.1 The Mercantilist Trade Theories

2.3 The Classical Trade Theories

2.3.1 Trade Based On Absolute Advantage

A. Autarky (closed economy) situation: Consider the following table

B. The case of open economy

Table 2: Production levels after international trade.

Case 1 Trade at TOT = 1:1

Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1

Case 3: Trade at TOT =Domestic opportunity cost ratio of country B = 1:2

Table 5: Consumption shares after trade at TOT =1:2

The welfare of country B before and after trade remains constant.

Case 5: Trade at TOT = 3:2

2.3.2 Trade Based On Comparative Advantage

This difference in opportunity costs offers the possibility of a mutually beneficial

Assumption of Ricardo’s Model

Table 8: Production possibilities in county A and B

Relative (comparative) advantage

Case 1 Autarky Situation

Table 9: Production and consumption under autarky

Table 10: Production levels after internal trade

Table 12: Consumption levels after IT at TOT =1:1=OCR of A

Table 13: Consumption levels after IT at TOT = 1:2 = OCR of B

2.3.3 Comparative advantage and opportunity cost theory

2.3.5 International Equilibrium in Trade: Extension of Classical Theory

Panel A Panel B Panel C

2 Reading assignment: read the three misconceptions about comparative advantage

At P2, the quantity of imports of commodity X demanded by nation 2 (B’E’ in panel C)

2.3.6 The Reciprocal Demand and Offer Curve Analysis

Table 14: Schedule of Trade Propensity for country A

Figure 2.2: Derivation of an offer curve

ii. The offer curve is not a straight line, it is a non-linear curve.

In this way it is possible to visualize number of changes in supply condition in country