Haramaya University

College of Agriculture and Environmental Sciences

School of Agricultural Economics and Agribusiness

Handout on the Course International Trade (AgEc411)

Prepared for Students Admitted to BSc Program in Agricultural

Economics (Year IV)

By: Bekele Wegi

November 2022
Haramaya University, Haramaya, Ethiopia
 This course provides students with the concepts of international trade;
Course Description theories of international trade; international trade policies; economic
integration and regional trade organizations; and Trade, and Economic
Growth and Development.

After successful completion of this course, students will be able to:

• Explore the subject matter of international trade;
• Explain the reasons, basis and gains of international trade;
• Review the historical development of international trade;
Course Objectives • Differentiate between classical and modern theories of international
trade;
• Discuss the reasons for trade restriction between countries;
• Explain economic integration and their effect on international trade;
• Illustrate the effect of international trade on economic growth and
development.

Course Lecturer: Bekele Wegi

Program: Agricultural Economics
Course Code: AgEc 411
Degree Program: BSc in Agricultural Economics
Credit Hours: 3
IT ECTs 5
Target Group: Year IV
Semester: I
Status of the Course: Compulsory

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Course Contents and Schedule
Week Lecture Conceptual focus
(hrs)
1 3 Chapter 1: The concepts of international trade
1.1. Definition of international trade
1.2. Features of inter-regional and international trade
1.3. Commonly used terminologies in international trade
1.4. The reason for international trade and its significance
2-5 15 Chapter 2: Theories of international trade
2.1. Classical theories of international trade
2.1.1. The mercantilists trade theory
2.1.2. Theories of absolute and comparative advantage
2.1.3. Comparative advantage and opportunity costs
2.1.4. Offer curve and terms of trade
2.2 Modern trade theories of international trade
2.2.1 Heckscher-Ohlin theory of trade
2.2.2 Extensions of the Heckscher Ohlin theory
5-7 10 Chapter 3: International trade policies
3.1 The concept of free trade
3.2 Trade protection
3.2.1 Concept and meaning of protection
3.2.2 Method of protection
3.2.2.1 Import tariff
3.2.2.2 Export subsidy and import quota
8-11 10 Chapter 4: Economic integration and regional trade organizations
4.1 Types of economic integration
4.2 Effects of regional trade arrangements
4.3 The major trade agreements
4.4 Regional trade organizations (gatt, wto…)
12-16 11 Chapter 5: Trade and economic growth and development
5.1 International trade and economic growth
5.2 International trade and economic development
5.3 Trade development strategies
5.3.1 Import substitution
5.3.2 Export promotion
Chapter 6: Impacts of Covid-19 and War on International Trade
(optional)
6.1 Effects of Covid-19 on international trade
6.2. Comparative assessments of the effects of Russian-
Ukraine war and Ethiopian conflicts on international trade

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 All students are expected to abide by the code of conduct of
the University Academic legislation throughout this course.

Course Policy Academic dishonesty, including cheating, fabrication, and

plagiarism will not be tolerated and will be reported to
concerned bodies for action.

Attendance will be observed. A student who has missed more

than 20% attendance shall be given a grade of IA (Incomplete
Attendance) and be required to provide acceptable reasons
for failure to attend classes.

Evaluation:

Continuous assessment (quiz, testes, assignments and/or seminar and attendance (50%)

Final examination (50%)

References:

1. Appleyard, D.R., Alfred J. Field, Steven L. Cobb. 2008. International Economics, 6th
edition. McGraw-Hill Boston.
2. Tweeten, L. 1989. Agricultural policy analysis, West views Press, London.
3. Robert J. Carbaugh. 2004. International Economics, 9th edition.
4. Krugnan, Paul and Maurue Obstfeld. 1997. International Economics: Theory and Policy,
Addison-Wesley press.
5. Hajela, T.N, 1998. Money, Banking, and International Trade 7th edition. Konark, Delhi.
6. Jhingan, M.L.,2007. International Economics. 5th edition. Vrinda, India
7. Salvatore Dominidik. 2001. International Economics, 7th edition John Willy & Sons, New
York.

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 CHAPTER ONE
CONCEPTS OF INTERNATIONAL TRADE

Dear students! This chapter introduces you to the concepts of International trade, its
definition, features of International and inter-regional trade, commonly used terminologies
in International trade, reasons for International trade and its significance.

1.1. Definition of International Trade

International trade is the branch of economics concerned with the exchange of goods and
services with foreign countries. In today's world, no nation exists in economic isolation. All
aspects of a nation's economy-its industries, service sectors, levels of income and
employment, living standard are linked to the economies of its trading partners. This
linkage takes the form of international movements of goods and services, labor, business
enterprise, investment funds, and technology. Indeed, national economic policies cannot be
formulated without evaluating their probable impacts on the economies of other countries.

What does this term mean? Globalization is the process of greater interdependence among
countries and their citizens. It consists of increased integration of product and resource
markets across nations via trade, immigration, and foreign investment-that is, via
international flows of goods and services, of people, and of investment such as equipment,
factories, stocks, and bonds. It also includes noneconomic elements such as culture and the
environment.

1.2. Features of Inter-regional and International Trade

Inter-regional trade refers to trade between regions within a country. Thus inter-regional
trade is domestic or internal trade. International trade, on the other hand, is trade between
two nations or countries.

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Difference between Inter-Regional and International Trade

Factor Immobility: factors of production are freely mobile within each region as between
places and occupations and immobile between countries entering into international trade.

Differences in Natural Resources: Different countries are endowed with different types
of natural resources. Hence they tend to specialize in production of those commodities in
which they are richly endowed and trade them with others where such resources are
scarce.

Geographical and Climatic Differences: Every country can’t produce all the commodities
due to geographical and climatic conditions, except at possibly prohibitive costs.

Different Markets: International markets are separated by difference in languages, usages,

habits, tastes, fashions etc. Even the systems of weights and measures and pattern and
styles in machinery and equipment differ from country to country.

Mobility of Goods: The mobility of goods within a country is restricted by only

geographical distances and transportation costs. But there are many tariff and non tariff
barrier on movement of goods between countries.

Difference currencies: The principal differences between inter-regional and international

trade lies in use of different currencies in foreign trade, but the same currency in domestic
trade.

Problem of Balance of Payments: The problem of balance of payments is perpetual in

international trade while regions within a country have no such problem. This is because
there is greater mobility of capital within regions than between countries.

Different Transport Costs: Trade between countries’ involves high transport costs as
against inter-regionally within a country because of geographical distances between
different countries.

Different Economic Environment: Countries differ in their economic environment which

affects their trade relations. The legal framework, institutional set-up, monetary, fiscal and

2
commercial policies, factor endowments, production techniques, nature of products, etc.
differ between countries.

Different National Policies: Another difference between inter-regional and international

trade arises from the fact that policies relating to commerce, trade, taxation, etc. are the
same within a country but differ from one country to another.

Similarities

Both Inter-regional and International trade relations involve the overcoming of space or
distance. Indeed, both arise from the problems created by distance. These distinguishes
them from the rest of economics, which abstracts from space and treats the economy as a
single point in space, in which production exchange and consumption takes place.

1.3. Commonly used terminologies in international trade

Imports: the purchase of goods or services from another country

Exports: the sale of goods or services to other countries
Merchandise goods: includes manufacturing, mining, and agricultural products
Service exports: includes business services like eBay, travel, insurance, and transportation
Migration: is the flow of people across borders as they move from one country to another
Foreign Direct Investment: is the flow of capital across borders when a firm owns a
company in another country
Balance of Payments: is a summary statement of all the international transactions of the
residents of a nation with the rest of the world during a particular period of time, usually a
year.
Comparative advantage: is ability to produce a good or service at a lower opportunity
cost than others can produce it
Terms of trade: the relative prices at which two products are traded in the market place
Trade balance: derived by computing the net exports (imports) in the merchandise
accounts; also called merchandise trade balance

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1.4. Reasons for International Trade and its Significance

Why do countries trade?

Generally they can get products from abroad cheaper or of higher-quality than those
obtained domestically. Germany, the largest exporter of goods, shows its technology for
producing high quality manufactured goods. China produces goods more cheaply than most
industrialized countries

Some of the reasons for trade

1. Proximity
The closer countries are the lower the costs of transportation. For example, the largest
trading partner of most European countries is another European country. Close proximity
often leads to countries joining into a free trade area.

2. Resources
A country can have resources that give it an edge in the production of certain goods. A
country with a lot of resources may be very good at producing goods and services.
Geography includes natural resources (including land and minerals), labor resources, and
capital. For example, Ethiopia also called the water tower of Africa very good at producing
hydroelectric power which is traded to other countries.

Resources are also called factors of production—the land, labor, and capital used to
produce goods and services. Some countries that have a large resource of cheap labor
produce unfinished products that are then processed in another country. Trade in
unfinished goods is an example of outsourcing—when production activities are spread
across several countries and trade semi-finished products between them

3. Absolute Advantage
When a country has the best technology for producing a good, it has an absolute advantage
in the production of that good. Germany has an absolute advantage in the production of

4
snowboards. Why is it that so many are imported from China then? Or why doesn’t the US
just make all its own snowboards?

4. Comparative Advantage
Absolute advantage is actually not a good explanation of trade pattern. Comparative
advantage is primary explanation for trade among countries. A country has a comparative
advantage in producing these goods that it produces best compared to how well it
produces other goods. Ethiopia may not have an absolute advantage compared to the Brazil
but is better at producing coffee Arabica than some other agricultural product.

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 CHAPTER TWO
THEORIES OF INTERNATIONAL TRADE

2.1. Classical Theories of International Trade

2.1.1. Mercantilism Theory of Trade

Mercantilism is a trade theory which holds that a government can improve the well-being
of the country by encouraging exports and stifling imports. The mercantilists were also
attacked for their static view of the world economy. To the mercantilists, the world's
wealth was fixed. This meant that one nation's gains from trade came at the expense of its
trading partners; not all nations could simultaneously enjoy the benefits of international
trade.

This view was challenged with the publication in 1776 of Adam Smith's Wealth of Nations.
According to Smith (1723-1790), the world's wealth is not a fixed quantity. International
trade permits nations to take advantage of specialization and the division of labor, which
increase the general level of productivity within a country and thus increase world output
(wealth). Smith's dynamic view of trade suggested that both trading partners could
simultaneously enjoy higher levels of production and consumption with trade.

2.1.2. Theories of Absolute and Comparative Advantage

2.1.2.1. Theories of Absolute Advantage

Adam Smith, a classical economist, was a leading advocate of free trade (open markets) on
the grounds that it promoted the international division of labor. With free trade, nations
could concentrate their production on goods they could make most cheaply, with all the
consequent benefits of the division of labor.

Accepting the idea that cost differences govern the international movement of goods, Smith
sought to explain why costs differ among nations. Smith maintained that productivities of
factor inputs represent the major determinant of production cost. Such productivities are
based on natural and acquired advantages. The former include factors relating to climate,
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soil, and mineral wealth, whereas the latter include special skills and techniques. Given a
natural or acquired advantage in the production of a good, Smith reasoned that a nation
would produce that good at lower cost, becoming more competitive than its trading
partner. Smith thus viewed the determination of competitiveness from the supply side of
the market.'

Smith's trading principle was the principle of absolute advantage: in a 2-nation, 2-product
world, international specialization and trade will be beneficial when one nation has an
absolute cost advantage (that is, uses less labor to produce a unit of output) in one good
and the other nation has an absolute cost advantage in the other good. For the world to
benefit from specialization, each nation must have a good that it is absolutely more efficient
in producing than its trading partner. A nation will import those goods in which it has an
absolute cost disadvantage; it will export those goods in which it has an absolute cost
advantage.

Assumptions of the theory of absolute advantage

a) Labor is the only factor of production and is homogenous,

b) Labor was completely free to move within a single country, yet it was entirely immobile
internationally. If labor were free to move between nations, then differences in wage rates
and hence commodity prices could be equalized via labor migration, and there would be no
need for international trade,

c) Both countries can produce both commodities,

d) No transportation costs were involved in trade

e) There existed no other barriers, such as tariffs and quotas, to trade between countries.

f) Constant returns to scale,

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Table 2.1 A Case of Absolute Advantage When Each Nation Is More Efficient in the
Production of One Good

Output per labor hour

Nations Wine Cloth

USA 5 bottles 20 yards

UK 15 bottles 10 yards

Referring to Table 2.1, suppose workers in the United States can produce 5 bottles of wine
or 20 yards of cloth in an hour's time, while workers in the United Kingdom can produce 15
bottles of wine or 10 yards of cloth in an hour's time. Clearly, the United States has an
absolute advantage in cloth production; its cloth workers' productivity (output per worker
hour) is higher than that of the United Kingdom, which leads to lower costs (less labor
required to produce a yard of cloth). In like manner, the United Kingdom has an absolute
advantage in wine production.

According to Smith, each nation benefits by specializing in the production of the good that
it produces at a lower cost than the other nation, while importing the good that it produces
at a higher cost. Because the world uses its resources more efficiently as the result of
specializing, there occurs an increase in world output, which is distributed to the two
nations through trade. All nations can benefit from trade.

Criticism on theory of absolute advantage

Smith has been criticized for his vagueness and lack of clarity. Accordingly, Smith assumes
mutually beneficial trade requires each nation to be the least-cost producer of at least one
good that it can export to its trading partner. But this basis of trade is not realistic because
there are many underdeveloped countries which do not possess absolute advantage in the
production of any commodity, and yet they have trade relations with other countries. Thus,
Smith's analysis is weak and unrealistic.

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2.1.2.2. Theories of Comparative Advantage

According to Smith, mutually beneficial trade requires each nation to be the least-cost
producer of at least one good that it can export to its trading partner. But what if a nation is
more efficient than its trading partner in the production of all goods? Dissatisfied with this
looseness in Smith's theory, David Ricardo (1772-1823) developed a principle to show that
mutually beneficial trade can occur even when one nation is absolutely more efficient in
the production of all goods.

Like Smith, Ricardo emphasized the supply side of the market. The immediate basis for
trade stemmed from cost differences between nations, which were under laid by their
natural and acquired advantages. Unlike Smith, who emphasized the importance of
absolute cost differences among nations, Ricardo emphasized comparative (relative) cost
differences. Ricardo's trade theory thus became known as the principle of comparative
advantage.

According to Ricardo's comparative-advantage principle, even if a nation has an absolute

cost disadvantage in the production of both goods, a basis for mutually beneficial trade may
still exist. The less efficient nation should specialize in and export the good in which it is
relatively less inefficient (where its absolute disadvantage is least). The more efficient
nation should specialize in and export that good in which it is relatively more efficient
(where its absolute advantage is greatest).

To demonstrate the principle of comparative advantage, Ricardo formulated a

simplified model based on the following assumptions:

1. The world consists of two nations, each using a single input to produce two commodities.

2. In each nation, labor is the only input (the labor theory of value). Each nation has a fixed
endowment of labor, and labor is fully employed and homogeneous.

3. Labor can move freely among industries within a nation but is incapable of moving
between nations.

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 4. The level of technology is fixed for both nations. Different nations may use different
technologies, but all firms within each nation utilize a common production method for each
commodity.

5. Costs do not vary with the level of production and are proportional to the amount of
labor used.

6. Perfect competition prevails in all markets. Because no single producer or consumer is

large enough to influence the market, all are price takers. Product quality does not vary
among nations, implying that all units of each product are identical. There is free entry to
and exit from an industry, and the price of each product equals the product's marginal cost
of production.

7. Free trade occurs between nations; that is, no government barriers to trade exist.

8. Transportation costs are zero. Consumers will thus be indifferent between domestically
produced and imported versions of a product if the domestic prices of the two products are
identical.

9. Firms make production decisions in an attempt to maximize profits, whereas consumers

maximize satisfaction through their consumption decisions.

10. There is no money illusion; that is, when consumers make their consumption choices
and firms make their production decisions, they take into account the behavior of all prices.

11. Trade is balanced (exports must pay for imports), thus ruling out flows of money
between nations.

Table 2.2 a Case of Comparative Advantage when the United States has an Absolute
Advantage in the Production of Both Goods

Natic Output per labor hour

Country
Wine Cloth

USA 40 bottles 40 yards

UK 20 bottles 10 yards

Table 2.2 illustrates Ricardo's comparative advantage principle when one nation has an
absolute advantage in the production of both goods. Assume that in one hour's time, U.S.
workers can produce 40 bottles of wine or 40 yards of cloth, while UK workers can produce

10
20 bottles of wine or 10 yards of cloth. According to Smith's principle of absolute
advantage, there is no basis for mutually beneficial specialization and trade, because
the United States is more efficient in the production of both goods. Ricardo's principle
of comparative advantage, however, recognizes that the United States is four times as
efficient in cloth production (40/10 = 4) but only twice as efficient in wine production
(40/20 = 2). The United States thus has a greater absolute advantage in cloth than in wine,
while the United Kingdom has a smaller absolute disadvantage in wine than in cloth. Each
nation specializes in and exports that good in which it has a comparative advantage-the
United States in cloth, the United Kingdom in wine.

The output gains from specialization will be distributed to the two nations through the
process of trade. Like Smith, Ricardo asserted that both nations can gain from trade.

It is possible for a nation not to have an absolute advantage in anything; but it is not
possible for one nation to have a comparative advantage in everything and the other nation
to have a comparative advantage in nothing. That's because comparative advantage
depends on relative costs. As we have seen, a nation having an absolute disadvantage in all
goods would find it advantageous to specialize in the production of the good in which its
absolute disadvantage is least.

Criticisms on the theory of comparative advantage

Ø The most severe criticism of the comparative advantage doctrine is that it is based
on the labor theory of value. Under the labor theory of value, the value or price of a
commodity depends exclusively on the amount of labor time going into the production of
the commodity. Since neither of these assumptions is true, the labor theory of value must
be rejected.
Ø Labor is also not used in the same fixed proportion in the production of all
commodities.
Ø Ricardo ignores transport costs in determining comparative advantage in trade.
This is highly unrealistic because transport costs play an important role in determining the
pattern of world trade.

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Ø The assumption that factors of production are perfectly mobile internally and
wholly immobile internationally is not realistic because even within a country factors do
not move freely from one industry to another or from one region to another.
Ø The Ricardian model is related to trade between two countries on the basis of two
commodities.
Ø Another serious weakness of the doctrine is that it assumes perfect and free world
trade. But, in reality, world trade is not free.
Ø The theory of comparative advantage is based on the assumption of full
employment. This assumption also makes the theory static and unrealistic.
Ø The theory neglects the role of technological innovations in international trade.
Ø The Ricardian theory is one-sided because it considers only the supply side of
international trade and neglects the demand side.
Ø Complete specialization will be impossible on the basis of comparative advantage in
producing commodities entering into international trade.
Ø The classical conclusion of complete specialization between two countries can hold
ground only by assuming trade between two countries of approximately equal economic
performance.
Ø The theory simply explains how two countries gain from international trade. But it
fails to show how the gains, from trade are distributed between countries.

2.1.3. Comparative Advantage and Opportunity Costs

We have seen that Ricardo based his law of comparative advantage on a number of
simplifying assumptions including the labor theory of value. However, the labor theory of
value is not valid and should not used for explaining the law of comparative advantage.

Under the labor theory of value, the value or price of a commodity depends exclusively on
the amount of labor going into the production of the commodity. This implies that either
labor is the only factor of production or labor is used in the same fixed proportion in the
production of all commodities and that labor is homogeneous (i.e., of only one type). Since
neither of these assumptions is true, we cannot base the explanation of comparative
advantage on the labor theory of value.
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According to the opportunity cost theory, the cost of a 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. No assumption is made here that labor is the only
factor of production or that labor is homogeneous. Nor is it assumed that the cost or price
of a commodity depends on or can be inferred exclusively from its labor content.
Consequently, the nation with the lower opportunity cost in the production of a commodity
has a comparative advantage in that commodity (and a comparative disadvantage in the
second commodity).

Recall Table 2.2, in the absence of trade the United States must give up one yards of cloth to
release just enough resources to produce one additional unit of wine domestically, then the
opportunity cost of wine is one unit of a cloth (i.e., 1W = 1C in the United States). However
the United Kingdom would give up ½ yards of cloth to produce one bottle of wine (1W =
1/2C), then the opportunity cost of wine (in terms of the amount of cloth that must be
given up) is lower in the United kingdom than in the United States, and the United Kingdom
would have a comparative (cost) advantage over the United Sates in wine. In a two-nation,
two-commodity world, the United States would then have a comparative advantage in
cloth.

According to the law of comparative advantage, the United Kingdom should specialize in
producing Wine and export some of it in exchange for UK cloth. This is exactly what we
concluded earlier with the law of comparative advantage based on the labor theory of
value, but now our explanation is based on the opportunity cost theory.

Incomplete specialization

There is one basic difference between trade model under increasing and the constant
opportunity costs case. Under constant costs, both nations specialize completely in
production of the commodity of their comparative advantage. However, under increasing
opportunity costs, there is incomplete specialization in production in both nations.

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The reason for this is that as country I specializes in the production of X, it incurs
increasing opportunity costs in producing X. Similarly, as country II produces more Y, it
incurs increasing opportunity costs in Y (which means declining opportunity costs of X).
Thus, as each nation specializes in production of the commodity of its comparative
advantage, relative commodity prices move toward each other until they are identical in
both nations. This occurs before either nation has completely specialized in production.

Opportunity costs can be illustrated with the production possibility frontier, or

transformation curve. The production possibility frontier is a curve that shows the
alternative combinations of the two commodities that a nation can produce by fully
utilizing all of its resources with the best technology available to it.

Table 2.3 gives the (hypothetical) production possibility schedules of wheat (in million
bushels/year) and cloth (in million yards/year) for the United States and the United
Kingdom.

Table 2.3. Production possibility schedules for wheat and cloth in the USA and UK
United States (USA) United Kingdom (UK)
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120

We see that the United States can produce 180W and 0C, 150W and 20C, or 120W and 40C,
down to 0W and 120C. For each 30W that the United States gives up, just enough resources
are released to produce an additional 20C. That is, 30W = 20C (in the sense that both
require the same amount of resources). Thus, the opportunity cost of one unit of wheat in
the United States is 1W = 2/3C and remains constant. On the other hand, the United
14
Kingdom can produce 60W and 0C, 50W and 20C, or 40W and 40C, down to 0W and 120C.
It can increase its output by 20C for each 10W it gives up. Thus, the opportunity cost of
wheat in the United Kingdom is 1W = 2C and remains constant.

Figure 2.1. The Production Possibility Frontiers of the USA and UK

The United States and United Kingdom production possibility schedules given in Table 2.3
are graphed as production possibility frontiers in Figure 2.1. Each point on a frontier
represents one combination of wheat and cloth that the nation can produce. For example,
at point A, the United States produces 90W and 60C. At point A, the United Kingdom
produces 40W and 40C.

Points inside, or below, the production possibility frontier are also possible but are
inefficient, in the sense that the nation has some idle resources and/or is not using the best
technology available to it. On the other hand, points above the production frontier cannot
be achieved with the resources and technology currently available to the nation.

The downward, or negative, slope of the production possibility frontiers in Figure 2.1
indicates that if the United States and the United Kingdom want to produce more wheat,
they must give up some of their cloth production. The fact that the production possibility
frontiers of both nations are straight lines reflects the fact that their opportunity costs are

15
constant. That is, for each additional 1W to be produced, the United States must give up
2/3C and the United Kingdom must give up 2C, no matter from which point on its production
possibility frontier the nation starts.

Constant opportunity costs arise when (1) resources or factors of production are either
perfect substitutes for each other or used in fixed proportion in the production of both
commodities and (2) all units of the same factor are homogeneous or of exactly the same
quality. Then, as each nation transfers resources from the production of cloth to the
production of wheat, it will not have to use resources that are less and less suited to wheat
production, no matter how much wheat it is already producing. The same is true for the
production of more cloth. Thus, we have constant costs in the sense that the same amount
of one commodity must be given up to produce each additional unit of the second
commodity.

Although opportunity costs are constant in each nation, they differ among nations,
providing the basis for trade. Constant costs are not realistic; however, they are discussed
only because they serve as a convenient introduction to the more realistic case of
increasing costs.

2.1.4. Offer Curve and Terms of Trade

Offer curves incorporate elements of both demand and supply, we shall see how,
international terms of trade are established by the interaction of supply and demand.
Alternatively, we can say that the offer curve of a nation shows the willingness of the nation
to import and export at various relative commodity prices.

The offer curve of a nation can be derived rather easily and somewhat informally from the
nation's production frontier, its indifference map, and the various hypothetical relative
commodity prices at which trade could take place.

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Derivation of Offer Curve

The terms of trade or offer curve of the countries, are determined by the intensity of
domestic demand for foreign goods and of the foreign demand for domestic goods.

Figure 2.2 (a) shows a production possibility curve and a set of community indifference
curves that characterize demand in country I. In the absence of trade, equilibrium will be
established at point A, where an indifference curve is tangential to the production
possibility curve. At this point, the marginal rate of substitution in production equals
the marginal rate of substitution in consumption. The highest level of satisfaction that
the country can enjoy under autarky is that symbolized by the indifference curve I. The
price ratio that will be ruling under autarky is given by the line P=¼, which is tangential to
the production-possibility curve and the indifference curve at A.

Suppose now that we open up the, possibility of international trade. Production and
demand conditions in country I are as shown in Figure 2.2(a). Which commodity country I
will export and import depends on the international terms of trade that are established. Let
country I has a comparative advantage in production of commodity X and that the new
terms of trade established under trade are as shown by the line P = ½ in Figure 2.2(a).
Country I will then produce at point F and consume at point H, and export FG (40X) of
commodity X in exchange for GH (20Y) imports of commodity Y.

By trade, country I can move to the indifference curve II, which represents a higher level of
satisfaction than do I. Had the terms of trade been even more favorable, for instance such
as represented by P=1, the country could have reached indifference curve III by trading BC
(60X) of X for CE (60Y) of Y.

We can now show how country I's volume of exports and imports change as the terms of
trade change. As it has been shown in Figure 2.2 (b), on the vertical axis, we have net
exports of Y and on the horizontal axis we have net imports of X. The triangle 0GH in Figure
(b) corresponds to the trade triangle HGF in Figure 2.2 (b). It shows that if the terms of
trade are 0H (these terms of trade are the same as those depicted by PF = ½ in Figure 2.2
(a)),"40X will be exchanged for 20Y. If the terms of trade instead should change to 0E

17
(which corresponds to PB = 1 in Figure 2.2 (a)), 60X would be exchanged for 60Y (the
triangle 0CE corresponds to the trade triangle BCE in Figure 2.2 (a).

Figure 2.2 Offer curve for country I

In this way we can trace out a pattern of points that show how the traded volumes change
when the terms of trade change. If we join together all these points for country I, we get a
curve such as 0K in Figure 2.2(b). 0K is an example of an offer curve. Thus an offer curve
shows how the volumes traded change when the terms of trade change.

The offer curve of the trade partner is derived in a completely analogous way, that is, from
its production frontier, its indifference map, and the various relative commodity prices at
which trade could take place.

Figure 2.3 Offer curve for country II

18
Figure 2.3 (a) indicates that, country II starts at the autarky equilibrium point A’. when
trade takes place at PH’ =Px/Py= 2 , country II moves to point F' in production, exchanges
40Y for 20X with country I, and reaches point H' on its indifference curve II'. Trade triangle
F'G'H' in the Figure 2.3 (a) corresponds to trade triangle O'G'H' in the Figure 2.3 (b), and we
get point H' on country II’s offer curve.

At PE’’ = Px/Py = 1 in Figure 2.3 (a), country II would move instead to point F' in
production, exchange 60Y for 60X with country I, and reach point E' on its indifference
curve III'. Trade triangle B'C'E' in Figure 2.3 (a) corresponds to trade triangle 0'C'E' in
Figure 2.3 (b) and we get point E' on country II’s offer curve.

Joining the origin with points H' and E' and other points similarly obtained, we generate
country II’s offer curve in the right panel. The offer curve of country II’s also shows how
much imports of commodity X country II demands to be willing to export various quantities
of commodity Y.

The Equilibrium Relative Commodity Price with Trade

The offer curves of the two trading countries intersect at point E. This is the only
equilibrium point and the equilibrium terms of trade are given by the ray 0E from the
origin. Only at this equilibrium price will trade be balanced between the two nations. At
any other relative commodity price, the desired quantities of imports and exports of the
two commodities would not be equal. This would put pressure on the relative commodity
price to move toward its equilibrium level.

The offer curves of country I and II in Figure 2.4 intersect at point E, defining equilibrium
relative price (PB =PB’,= 1). At PB, country I offers 60X for 60Y and country II offers exactly
60Y for 60X. Thus trade is in equilibrium at PB.

19
Figure 2.4 Equilibrium Relative Commodity Price with Trade

At any other price, trade would not be in equilibrium. For example, at PF = ½, the 40X that
country I would export would fall short of the imports of commodity X demanded by
country II. In this case, the excess import demand for commodity X by country II tends to
drive Px/Py up. As this occurs, country I will supply more of commodity X for export (i.e.,
country I will move up its offer curve), while country II will reduce its import demand for
commodity X (i.e., country II will move down its offer curve). This will continue until supply
and demand become equal at PB.

The shape of the offer curves are determined by both supply and demand conditions in the
respective countries. The limits within which they will fall are given by the autarky terms of
trade in the two countries. With improving terms of trade, a country is willing to offer more
and more of its exports for more imports. After a certain amount of trade, however, the
country could become more and more unwilling to accept an increase in the amount of
imports, even though they are offered at improving terms of trade.

When we derived the other curve, we argued as though the terms of trade were changing
for some exogenous reason and then derived the shape of the curve. This was a pedagogical
device and must not be misunderstood. The offer curve is a general-equilibrium concept. It
is determined jointly by production and consumption conditions. It is more appropriate to
say that these conditions determine the shape of the trading partners' offer curves, which
in turn determine the terms of trade,

20
Change In Terms Of Trade

The terms of trade of a nation are defined as the ratio of the price of its export commodity
to the price of its import commodity. Since in a two nation world, the exports of a nation
are the imports of its trade partner, the terms of trade of the 'latter are equal to the inverse,
or reciprocal, of the terms of trade of the former.

These terms of trade are often referred to as the commodity or net barter terms of trade. As
supply and demand considerations change over time as a result of factors affecting demand
and supply of tradable, offer curves will shift, changing the volume and the terms of trade.
An improvement in a nation's terms of trade is usually regarded as beneficial to the nation
in the sense that the prices that the nation receives for its exports rise relative to the prices
that it pays for imports.

For instance, if a nation's tastes change and desire for its import commodity increases, the
nation's offer curve will rotate closer to the axis measuring the commodity of its
comparative advantage. The reason for this is that the nation is now willing to give up more
of its export commodity in exchange for any given amount of the imported commodity
because of its increased desire for the imported commodity. This results in an expanded
volume of trade but in deterioration in the nation's terms of trade.

Figure 2.5. Shift in offer curve

As it has been shown in Figure 2.5, country I’s terms of trade deteriorate from Px/Py = 1 at
point E1 to Px/Py = 1/2 at point E2 and the volume of trade increases after country I's offer

21
curve shifts (rotates) from 1 to 1* as a result of its increased desire for its imported
commodity Y. The same would be true if an improvement in technology or an increase in
resources shifted country I's offer curve to 1* .

Similarly, an increase in country II's desire for imports of commodity X, an improvement in

its technology, or increased availability of resources over time will rotate country II's offer
curve upward (counter-clockwise). This will result in deterioration in country II’s terms of
trade and an expansion of trade. For example, if country II's offer curve rotates from 2 to 2*
while assuming no change in country I, then country II's terms of trade deteriorate from
Py/Px = 1 at point E1 to Py/Px = 1/2 (the inverse, or reciprocal, of Px/Py = 2) at point E3
and the volume of trade expands.

2.2. Modern Trade Theories of International Trade

2.2.1. Heckscher-Ohlin Theory of Trade

The modern theory of international trade or the Heckscher-Ohlin (H.O.) theory was
developed by two Swedish economists, Eli Heckscher, and his student Bertil Ohlin, in
1920s. The H.O theory states that the main determining factor for the pattern of
production, specialization and trade among countries is the relative availability of factor
endowments and factor prices.

Regions or countries have different factor endowments and therefore have factor prices.
Some countries have much capital, others have much labor. The theory says that countries
that are rich in capital will export capital intensive goods and countries that have much
labor will export labor-intensive goods.

Assumptions of the H-O theory of International Trade

The Heckscher-Ohlin theory is based on the following assumptions:

It is a two-by-two-by-two model: there are two countries (A and B), two commodities (X
and Y), and two factors of production (capital and labor).

22
Both nations use the same technology in production: both countries have access to and use
the same general production techniques.

Commodity X is labor intensive and commodity Y is capital intensive in both countries: The
labor-capital ratio is higher for commodity X than for commodity Y in both countries at the
same relative factor prices. This is equivalent to saying that the capital-labor ratio (K/L) is
lower for X than for Y. But it does not mean that the K/L ratio for X is the same in Country 1
and Country 2, only that K/L is lower for X than for Y in both countries.

Constant returns to scale in the production of both commodities in both countries:

Incomplete specialization in production in both countries: even with free trade both
countries continue to produce both commodities. This implies that neither of the two
countries is very small.

Equal tastes in both countries: demand preferences, as reflected 'in the shape and
location of indifference curves, are identical in both countries. Thus, when relative
commodity prices are equal in the two countries, both countries will consume X and Y in
the same proportion.

Perfect competition in both commodities and factor markets in both countries:

Perfect factor mobility within each country but no international factor mobility:

No transportation costs, tariffs, or other obstructions to the free flow of international trade:

Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

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.

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,
country 1 can produce 1Y with 2K and 2L. Thus, K/L = 2/2 = 1 for Y. On the other hand, 3K
and 12L are required to produce 1X, in Country 1. Thus K/L = 1/4 for X. Since K/L is higher

23
for commodity Y than for commodity X, we say that commodity Y is capital intensive and
commodity X is L intensive in Country 1. If Country 2, K/L is 4 for Y and 1 for X. Therefore,
Y is the capital intensive commodity and X is the labor intensive commodity.

Factor abundance: There are two ways to define factor abundance.

i. In terms of physical units (i.e., in terms of the overall amount of capital and labor
available to each country). For instance, Country 2 is capital abundant if the ratio of the
total amount of capital to the total amount of labor (TK/TL) available is greater than that in
Country 1. Note that it is not the absolute amount of capital and labor available in each
country that is important but the ratio. Thus, Country 2 can have less capital than Country 1
and still be the capital abundant country if TK/TL in Country 2 exceeds in Country 1.

ii. In terms of relative factor prices (i.e., in terms of rental price of capital and price of labor
time in each country). For instance, in terms of factor price, Country 2 is capital abundant if
the ratio of the rental price of capital to the price of labor time (PK/PL) is lower in Country
2 than in Country 1. Since the rental price of capital is the interest rate & while the price of
labor is the wage rate (w), PK/PL=r/w. Once again, it is not the absolute level of wage or
interest that determines whether or not a country is the capital abundant country but it is
r/w. For example, r may be higher in Country 2 than in Country 1, but Country 2 will still be
the capital abundant country if r/w is lower there than in Country 1.

Since we have assumed that tastes, or demand preferences, are the same in both countries,
the two definitions of factor abundance give the same conclusions in our case. That is, with
TK/TL larger in Country 2 than in Country 1 in the face of equal demand conditions (and
technology), PK/PL will be smaller in Country 2. Thus, Country 2 is the capital abundant
country in terms of both definitions.

24
Figure 2.6 Shape of the production possibility curves

If Country 2 is the capital abundant country and commodity Y is the capital intensive
commodity, Country 2 can produce relatively more of commodity Y than Country 1.
Therefore, its production frontier, figure 2.6, is skewed toward the vertical axis measuring
commodity Y. On the other hand, Country 1 is the labor abundant country and commodity X
is the labor intensive commodity, Country 1 can produce relatively more of commodity X
than Country 2. This gives a production frontier for Country 1 that is relatively flatter and
wider than the production frontier of Country 2 (if we measure X along the horizontal axis).

Patterns of Trade (POT)

Based on the assumptions of the H-O theory presented before, the Heckscher-Ohlin
theorem can be stated as: A country will export the commodity whose production
requires the intensive use of the country's relatively abundant and cheap factor and
import the commodity whose production requires the intensive use of the country's
relatively scarce and expensive factor. In short, the relatively labor-rich country exports
the relatively labor-intensive commodity and imports the relatively capital-intensive
commodity.

Of all, the possible reasons for differences in relative commodity prices and comparative
advantage among countries, the H-O theorem isolates the difference in relatively factor
abundance, or factor endowments, among countries as theory determinant of comparative
advantage and international trade. For this reason, the H-O model is often referred to as the
factor-proportions or factor-endowment theory.

25
Therefore, according to the H-O theorem, each country specializes in the production and
export of the commodity which intensively uses the country’s relatively abundant and
cheap factor (comparative advantage) and imports the commodity which intensively uses
the country’s relatively scarce and expensive factor (its comparative disadvantage).

Thus, 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
countries. This difference in relative factor and commodity prices is then translated into a
difference in absolute factor and commodity prices between the two countries. It is this
difference in absolute commodity prices between the two countries that is the immediate
cause of trade.

Illustration of Heckscher-Ohlin Theory

As indicated before, Country 1 is the L-abundant country and its production frontier is
skewed along the X axis because commodity X is the L-intensive commodity. Furthermore,
since the two countries have equal tastes, they face the same indifference map. Indifference
curve I (which is common for both countries) is tangent to Country 1's production frontier
at point A and to Country 2's production frontier at A'. Indifference curve I is the highest
indifference curve that Country 1 and Country 2 can reach in isolation, and points A and A'
represent their equilibrium points of production and consumption in the absence of trade.

The tangency of indifference curve I at points A and A’ defines the autarky, or no trade,
equilibrium relative commodity prices of PA in Country 1 and PA’ in Country 2. Since PA <
PA’, Country 1 has a comparative advantage in commodity X, and Country 2 has a
comparative advantage in commodity Y.

26
Figure 2.7. Hecksher-Ohlin Model

The right panel, Figure 2.7, shows that with trade Country 1 specializes in the production of
commodity X, and Country 2 specialize in the production of commodity Y (see the direction
of the arrows on the production frontiers of the two countries). Specialization in
production proceeds until Country 1 has reached point B and Country 2 has reached point
B' where the transformation curves of the two countries are tangent to the common
relative price line PB. Country 1 will then export commodity X in exchange for commodity Y
and consume at point E on indifference curve II (trade triangle BCE). On the other hand,
Country 2 will export Y for X and consume at point E', which coincides with point E (trade
triangle B'C'E').

Note that Country 1's exports of commodity X equal Country 2's imports of commodity X
(i.e., BC=C'E'). Similarly, Country 2's exports of commodity Y equal Country 1's imports of
commodity Y (i.e.; B'C'=CE). At, PX/PY > PB, Country 1 wants to export more of commodity
X than Country 2 wants to import at this high relative price of X, and PX/PY falls toward PB.
On the other hand, at PX/PY < PB, Country 1 wants to export less of commodity X than
Country 2 wants to import at this low relative price of X, and PX/PY rises toward PB. This
tendency of PX/PY 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,
Country 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', Country 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

27
underlying demand or supply conditions in commodity and factor markets in either or both
countries.

Factor-Price Equalization Theorem

The factor-price equalization theorem is a corollary of H-O theorem and holds only if the H-
O theorem holds. It was Samuelson who rigorously proved this factor-price equalization
theorem. For this reason, factor-price equalization theorem is sometimes referred to as the
Heckscher Ohlin Samuelson theorem (H-O-S theorem).

Based on the assumptions of the H-O theory presented before, the factor-price equalization
theorem can be stated as: International trade will bring about equalization in the relative
and absolute returns to homogeneous factors across countries. Similarly, international
trade will cause the return (interest) to homogeneous capital (i.e., capital of the same
productivity and risk) to be the same in all trading countries. That is both relative and
absolute factor prices will be equalized.

From what we discussed above, we know that in the absence of trade the relative price of
commodity X is lower in Country 1 than in Country 2 because the relative price of labor, or
the wage rate, is lower in Country 1. As Country 1 Specializes in the production of
commodity X (the labor intensive commodity) and reduces its production of commodity Y
(the capital intensive commodity), the relative demand for labor rises, causing wages (w)
to rise, while the relative demand for capital falls, causing the interest rate (r) to fall. The
exact opposite occurs in Country 2. That is, as Country 2 specializes in the production of Y
and reduces its production of X with trade, its demand for labor falls, causing w to fall,
while its demand for capital rises and causing r to rise.

We can go further and demonstrate that international trade not only tends to reduce the
international difference in the returns to homogeneous factors, but would in fact bring
about complete equalization in relative factor prices when all of the assumptions made
hold. This is so because as long as relative factor prices differ, relative commodity prices
differ and trade continues to expand. But the expansion of trade reduces the difference in
factor prices between countries. Thus, international trade keeps expanding until relative

28
commodity prices are completely equalized, which means that relative factor prices have
also become equal in the two countries.

Criticisms of H-O Theorem

Ohlin’s theory has been criticized on the following grounds:

ü Two-by-two-by-two Model. Ohlin has been criticized for presenting two by-two-by-two
model based on over simplified assumptions. But, as Ohlin himself points out, it can be
extended to many regions, many commodities and many factors.
ü Static Theory. Like the classical theory, the Ohlin model is static in nature. It only gives
some characteristics of an economy at a given point in time
ü Factors not Homogeneous. The theory assumes the existence of the homogeneous
factors in the two countries which can be measured for calculating factor endowment
ratios. But, in reality, no two factors are homogenous qualitatively between countries,
and even one factor is of various types.
ü Production Techniques not Homogeneous. Again, the Ohlin model assumes
homogeneous production techniques for each commodity in the two countries.
ü Tastes and Demand Patterns not Identical. The H.O theory is based on the assumption
of identical tastes and demand patterns of consumption in both countries.
ü No Constant Returns. The assumption that there are constant returns to scale is also
not realistic because a country having rich factor endowments often obtains the
advantages of economies of scale through mass production and exports. Thus there are
increasing returns to scale rather than constant.
ü Transport costs influence trade. This theory does not consider transport costs in trade
between two countries.
ü Unrealistic Assumptions of full employment and perfect competition. The H.O theory is
based on the unrealistic assumptions of full employment and perfect competition
because there is neither full employment nor perfect competition in any country of the
world. Rather, countries do not have free trade but impose trade restrictions on a large
scale.

29
Despite these criticisms, the Ohlin theory of international trade is definitely an
improvement over the classical theory as it attempts to explain the basis of international
trade in the general equilibrium setting.

• Testing the Heckscher-Ohlin Theorem: Leontief’s Paradox

Wassily Leontief performed the first test of the H-O theorem in 1953 using data for the US
from 1947. He measured the amounts of labor and capital used in all industries needed to
produce $1 million of US exports and to produce $1 million of imports into the US. These
data are in Table 2.4 which also shows the capital/labor ratio in dollars per person.

Table 2.4. Leontif’s test

Export Import

Capital ($ millions) $2.55 $3.1

Labor (person-year) 182 170

Capital/labor ($/person) $14,000 $18,200

Leontief used labor and capital used directly in the production of final good exports in each
industry. He also measured the labor and capital used indirectly in the industries that
produced the intermediate inputs used in making exports. The capital is high because we
are measuring the whole capital stock—not that part actually used to produce exports. The
capital/labor ratio was $14,000: each person employed was working with $14,000 worth
of capital.

It was impossible for Leontief to get information on the amount of labor and capital used to
produce imports. He used data on US technology to calculate estimated amounts of labor
and capital used in imports from abroad. Remember, the H-O model assumes technologies
are the same across countries. This gave a capital/labor ratio of $18,200 per worker. This
exceeds the ratio for exports.

Leontief assumed correctly that in 1947 the US was capital abundant relative to the rest of
the world. From the H-O model, Leontief expected that the US would export capital
intensive goods and import labor intensive goods. Leontief, however, found the opposite.

30
The capital/labor ratio for US imports was higher than for exports. This contradiction came
to be called Leontief’s paradox.
Why would this paradox exist?
w US and foreign technologies are not the same as assumed
w By focusing only on labor and capital, land abundance in the US was ignored
w No distinction between skilled and unskilled labor
w The data for 1947 could be unusual due to the recent end of WWII
w The US was not engaged in completely free trade as is assumed by the H-O model
Other possible explanations depend on having more than two factors of production
w The US is land abundant, and much of what it was exporting might have been
agricultural products which use land intensively
w It might also be true that many of the exports used skilled labor intensively
The “extended” H-O model works much better for the same year of data

2.2.2. Extension of the Heckscher-Ohlin Theory

We need to make the H-O model more realistic by allowing for more than two goods,
factors, and countries. This is the first modification to the model. In the second
modification, we will allow the technologies used to produce each good to differ across
countries.

Many Goods, Factors, and Countries

The predictions of the H-O model depend on knowing what factor a country has in
abundance, and which good uses that factor intensively. When there are more than two
goods, it is more complicated to evaluate factor intensity and factor abundance.
w How do we measure the factor intensity of exports and imports when there are
thousands of products traded between countries?
w How can we use this to test the H-O model?

31
 • Measuring Factor Abundance
How should we measure factor abundance when there are more than two factors and two
countries? To determine whether a country is abundant in a certain factor, we compare the
country’s share of that factor with its share of world GDP. If the share of a factor > share
of world GDP, the country is abundant in that factor. If the share of factor < share of
world GDP, the country is scarce in that factor.

• Capital Abundance
We can use the data in Figure 2.8. For example, 24% of the world’s physical capital is
located in the US, 8.7% is located in China, 13.3% in Japan, etc. The final bar in the graph
shows the % of each country in world GDP. The US had 21.6% of world GDP, China had
11.2%, Japan had 7.5%, etc. We can conclude that the US was abundant in physical capital
in 2000. This is true for Japan and Germany. The opposite holds for China and India—their
shares of world capital are less than their share of GDP. They are scarce in capital.

32
 • Labor and Land Abundance

We can use a similar comparison to determine whether each country is abundant or not
in R&D scientists, in types of labor distinguished by skill, in arable land, or any other
factor of production. For example, US is abundant in R&D scientists: 26.1% of the
world’s total as compared to 21.6% of the world’s GDP. The US is also abundant in
skilled labor but is scarce in less-skilled labor and illiterate labor. India is scarce in R&D
scientists: 2.5% of world’s total as compared to 5.5% of the world’s GDP

Remark:
The US is also scarce in arable land which is surprising since we think of the US as a major
exporter of agriculture. Another surprise is that China is abundant in R&D scientists. These
findings seem to contradict H-O model. It is likely that the productivity of R&D scientists
and arable land are not the same in both countries. In this case, shares of GDP are not the
whole story. We need to allow for differences in productivity.

• Differing Productivities Across Countries

• Remember that Leontief found that US was exporting labor-intensive products even
though it was capital-abundant at that time
One explanation is that labor is highly productive in the US and less productive in the rest
of the world. Then the effective labor force in the US is much larger than if we just count
people. Effective labor force is the labor force times its productivity. We can now look at
differing productivities in the H-O model.

• Measuring Factor Abundance Once Again

Effective Factor Endowment is the actual factor endowment times the factor productivity.
The amount of effective labor in the world is found by adding up the effective factor
endowments across all countries. To determine if a country is abundant in a certain factor,
we compare the country’s share of that effective factor with share of world GDP.
§ If share of an effective factor is greater than its share of world GDP then that
country is abundant in that effective factor.

33
 § If share of an effective factor is less than its share of world GDP, then that country is
scarce in that effective factor.

• Effective R&D Scientists

The effectiveness of R&D Scientist depends on what they have to work with. One way to
measure this is through a country’s R&D spending per scientist. If more spending, then
scientist will be more productive. Take the total number of scientists and multiply that by
the R&D spending per scientists. Figure 2.9 shows these shares. With these productivity
corrections, the US is more abundant in effective R&D scientists and China is lower.

• Effective Arable Land

We also need to do a correction for arable land. Effective arable land is the actual amount of
arable land times the productivity in agriculture. The US has a very high productivity in
agriculture where China has a lower productivity. We repeat the same calculations from
Figure 2.8 using Figure 2.9. The 4th bar graph shows each country’s share of effective arable
land, corrected for productivity differences. The numbers before and after the correction
are very close. The US is neither abundant nor scarce in effective arable land.

34
35
 CHAPTER THREE: INTERNATIONAL TRADE POLICIES

3.1. The Concept of Free Trade

Free trade means unrestricted trade or exchange of goods and services between countries.
A policy of free trade implies non-intervention of the government in international trade. It
is a situation in which there are no artificial barriers in the form of quotas and tariffs to the
movement of goods and services between countries and the government allows the trade
to take its own course. In other words, the governments of the countries do not have a
formal trade policy at all.

Adam Smith has defined free trade as the system of commercial policy which draws no
distinction between domestic and foreign commodities. Therefore, neither imposes
additional burdens on the latter, nor grants any special favors to the former. In such a
world, a country would import all those commodities that it could buy from abroad at a
delivered price lower than the cost of producing them at home." Thus the policy of free
trade implies complete freedom of international trade without any restrictions on the
movement of goods between countries.

In the international trade, Free Trade is an idealized market model often stated as a
political objective, where trade between countries flows unhindered by government-
imposed artificial costs. Intellectually, this arrangement is supported by followers of the
neoclassical and microeconomic schools of thought. The benefit of trade is a net gain to
both trading partners. However, it is opposed by anti-globalization and some labor
campaigners due to perceived tendencies for abuse by wealthier states.

The Gains from Trade once Again

We will now demonstrate the gains from trade using Home demand and supply curves,
together with the concepts of consumer surplus and producer surplus.

Consumer and Producer Surplus

To understand the concepts of consumer and producer surplus, look at figure 3.1 below.
¡ Figure 3.1 (a) shows the Home demand curve D where consumers face a price
of P1.

36
¡ Remember, CS is the difference between the price the consumer is willing to
pay and the actual price.
¡ Part (b) of figure 3.1 illustrates producer surplus.
¡ Remember that PS is the difference between MC and price, where the supply
curve represents a firm’s MC in a perfectly competitive market.

37
 The Gains from Trade
ž Free Trade for a Small Country
¡ Suppose Home can now engage in trade.
¡ The world price PW is determined by the supply and demand in the world
market (shown in figure below)
¡ Suppose Home is a small country.
¡ Price taker in the world market
¡ Faces a fixed price at PW
¡ Assume PW is below the Home no-trade price PA.
¡ At the lower price, Home will be an importer of the product at the world price.

38
 Home Import Demand Curve
¡ We can derive the import demand curve, shown in figure
¡ The relationship between the world price of a good and the quantity of imports
demanded by Home consumers.
¡ At the no-trade equilibrium (autarky), there are zero imports
¡ This is shown as point A′ in panel (b).
¡ At the world price of PW, the quantity demanded is greater than quantity
supplied, and we import M1.
¡ This is point B in panel (b).
¡ Joining A′ and B gives import demand curve M.

3.1.1 Arguments for Free Trade

We have seen what free trade is; now we are going to discuss about arguments for free
trade.

Arguments in favor of Free Trade

The following arguments have been advanced in favor of free trade.

39
Maximization of output: Free trade leads to the maximization of output in the
participating countries because of international specialization. A country produces only
those commodities in which it is best suited and exports those commodities in exchange for
goods from outside which it cannot produce cheaply. The world as a whole is certainly
materially better off under free trade than with no trade at all and so is the individual
nation. Free trade thus increases the real national income of the world economy.

Optimum Utilization of Resources: With international specialization and division of labor

free trade leads to the optimum allocation of resources. The productive resources of the
world are used properly and most efficiently. It helps in avoiding the wasteful use of
resources in producing those commodities for which country has comparative
disadvantage and which it can import cheaply from other countries. Hence, free trade leads
to optimum utilization of resources.

Optimization of consumption: Free trade enables a country to secure the optimization of

consumption. In the absence of international trade a country's domestic consumption is
limited to the production of those commodities which it is capable of producing. But,
through international trade the consumption possibilities of the country can expand
beyond its production possibilities. Free trade, therefore, enables the consumers to buy a
variety of commodities from other countries at the minimum possible prices.

Wide Markets: Free trade results in extension of markets for goods. Since the entire world
becomes a market for all commodities, the quality goods are produced at low prices
because of competition. This also results in minimization of cost and optimization of
world's material welfare.

Check on monopolies: Free trade checks the establishment of monopolies. Because of the
fear of foreign competition; the domestic producers do not dare to form monopolies and
exploit the consumers by raising the prices of their products.

Increase in factor incomes: Free trade also leads to an increase in the incomes of various
factors of production because they are employed more efficiently in proper uses.

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Economic development: free trade is the best policy from the point of view of economic
development. Free trade helps to a large extent in the economic development of a country.
It gives a number of benefits particularly for less developed countries by:

i) Stimulating specialization and division of labor;

ii) Extending the size of the market;

iii) Promoting healthy competition leading to improvement in productive efficiency;

iv) Augmenting skills, technical knowhow and managerial efficiency; and

v) Facilitating the availability of raw materials, machinery and foreign capital.

Therefore, international trade has made tremendous contribution to the development of

less developed countries in the nineteenth and twentieth century’s and can be expected to
make in the future if it is allowed to proceed freely.

Efficient Entrepreneurs: Fear from competition owing to free trade, stimulates the
domestic producers not only to maintain their efficiency but also to improve it by
improving their methods of production and reducing their production costs.

International cooperation: Free trade promotes cooperation and mutual understanding

among the nations. It helps in creating an atmosphere of peace and goodwill all over the
world.

3.1.2. Arguments against Free Trade

We have discussed arguments in favor of free trade. There are also arguments against free
trade. The following arguments have been advanced against free trade:

Unrealistic policy: The policy of free trade assumes non-intervention of the government.
Its success also depends upon perfect competition. But neither of these conditions are
fulfilled in the actual world.

Non-cooperation of countries: The success of free trade also depends entirely upon the
cooperation of all the trading countries. However, if any of the participating country
decides to gain more by imposing trade restrictions, the system of free trade will break.

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Economic dependence: Since under free trade countries specialize only in the production
of those commodities for which they are best suited they have necessarily to depend on
other countries for the supply of other commodities which they are not able to produce.
This increases the economic dependence of the countries on each other. Such dependence
may prove harmful during war time or emergency, particularly when a country is
depending on the other country for the supply of essential products or primary raw
materials.

Unbalanced development: Free trade leads to unbalanced development of a country’s

economy. Since under free trade a country produces only those commodities in which it
has a competitive advantage, other sectors are neglected and remain undeveloped.

Dumping: Free trade may also result in' cut throat competition and dumping. In order to
capture the foreign market a country may dump its goods and sell at very cheap rates and
even below its, cost of production in foreign markets.

Harmful products: Under free trade, there is no check on the production and trade of
injurious and harmful goods. A country may produce such goods and export them to other
countries since there is no check on the import of such goods in other countries.

International monopolies: Free trade, 'by encouraging the establishment of multinational

corporations, may lead to international monopolies which may harm the interest of the
importing country.

Reduction in welfare of certain groups: Under free trade the output of only those
commodities in the production of which the country has comparative advantage increases
at the cost of those goods in which the country has comparative disadvantage.
Consequently, the output of export industries expands and the output of import industries
contracts. This will lead to increase in the real income of the group engaged in the export
industries and decrease in the real income of those groups who are engaged in the import
industries.

Harmful to less developed countries: Free trade is not in the best interest of the less
developed countries because:

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 Ø they are not in a position to compete with the advanced countries;
Ø they do not get equal share of the gain from trade, the terms of trade are always
favorable for the developed countries;
Ø they always experience unfavorable balance of payments which cannot be solved by
adopting a policy of free trade;
Ø Owing to competition from foreign imports the less developed countries cannot
protect their infant industries; and Free trade endangers their economic and
political independence. The colonization of poor countries by the advanced
countries ‘is an example of this sort of situation.

3.2. Trade Protection

3.2.1. Concepts of Protection

Are you familiar with the term protection in international trade? If not, read this section
carefully. Protection implies granting a protective cover to the home industries against
foreign competition either by imposing duties on the foreign goods or by helping the
domestic industries by giving subsidies and making raw materials available at subsidized
prices. Broadly speaking, protection refers to the commercial policy safeguarding the
national interests through restrictions on the international trade.

Generally, protection of industries may involve:

i) Levying of import duties which may raise price of foreign goods relative to domestic
goods; or

ii) Fixing of quotas or posing of non-tariff restrictions, which make the entry of cheap
foreign goods difficult or impossible; or

iii) Granting of subsidies or reward to the domestic industries to enable them to compete
with cheap foreign goods.

Arguments in Support and against of Protection Policy

The idea of protection as a source of economic growth was put forward for the first time by
Alexander Hamilton in 1791 supported later by Henry George, Mathew Carey, etc. In
Germany it was advocated by Federich List in the nineteenth century. After the

43
abandonment of the policy of free trade particularly after great depression all the countries
of the world, in one way or the other; have followed the policy of protection.

Economists have advanced a number of arguments in support of protection. These

arguments are divided into two groups: Economic arguments; and Non-economic
arguments.

i. Economic Arguments: The main arguments under this group are as follows:

Infant industry argument: According to this argument industries which are in their
infancy are to be protected against foreign competition because they are not strong enough
to compete with the well-established foreign industries. The main idea behind this
argument is that free trade among unequal is not at all desirable.

The infant industry argument is based on the fact that the infant industry is not in a
position to realize internal and external economies. Protection helps the infant industry to
grow up to its optimum level and to reduce costs by growing a cadre of skilled labor force
or by spreading knowledge of production techniques.

In this case, granting protection to infant industry does not mean that there is no scope for
free trade. The supporters of this argument say that once the infant industry gains strength
to compete with the foreign industry it will have a competitive advantage and then it can
freely compete with the foreign industry. So, the advocates of providing protection to infant
industry hold that the infant industry must be protected only in the initial stages so long as
it is notable to realize its true competitive advantage under free trade.

This argument can be generalized so as to apply to developing countries. Since

industrialization requires a skilled labor force, adequate quantity and quality scarce
resources and the necessary infrastructure, the policy of protection can help a developing
country to achieve all these. Lastly, when List advocated for protection to infant industry,
he only meant the adoption of a policy of discriminating protection. This means that
protection should be given only to those selected industries which have the potential of
becoming viable units in future.

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Criticisms of infant Industry Argument: The infant industry argument has been
subjected to the following criticisms:

Ø It is difficult to identify the industry which is to be protected, i.e., which has the
potential to grow into an economically viable industry;
Ø After granting protection it becomes impossible to withdraw it because of vested
interest;
Ø Protection may also lead to political corruption because, whether justified or not, all
kinds of industries will start clamoring for protection;
Ø Protected industries generally become indifferent towards their growth as they
develop a tendency to depend more and more on government help;
Ø Protection reduces the efficiency of the firm which ultimately leads to increase the
price of goods of that industry and also to the deterioration in the quality of the
product.

In spite of these weaknesses protection has been adopted widely by the countries all over
the world. The only thing is that protection should not be adopted as a general policy and
as List has said countries should have a policy of discriminating protection.

Diversification of Industries Argument: Protection helps in the diversification of

industries in a country. From the political point of view international specialization is
dangerous because it makes the country too much dependent on foreign trade which is
risky and undesirable particularly during war time. From the economic point of view
dependence on a few industries may lead to serious economic consequences when such
industries pass through rough weather. Hence, it is necessary that for attaining national
self-sufficiency and balanced economic growth, the industries should be diversified with
the help of a policy of protection.

Criticisms of Diversification of Industries Argument: Diversification of Industries

Arguments has been criticized on the following grounds:

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 Ø No country can ever be fully self-sufficient. Even the highly advanced and
industrialized countries like USA, Japan, UK, etc. have not been able to attain self-
sufficiency because they do not possess all types of resources.
Ø This argument demolishes the principle of comparative advantage as the basis of
international trade.
Ø It may also result in spoiling the international economic relations. By allowing a
policy of diversification of industries a country will be completely isolated, which is
neither desirable nor possible in the present day situation of international relations.

Employment Argument: A policy of protection stimulates economic activity and raises the
level of employment in the country. This happens through two effects: The multiplier
effect; and the acceleration effect.

When imports are reduced through the adoption of protective measures and exports are
maintained at the same level, foreign trade multiplier comes into operation leading to an
increase in the level of income and employment by a multiple of reduced expenditure on
imports. Second, an increase in the level of employment and income requires more capital
and, therefore, investment in capital goods will rise and further stimulate investment,
income and employment through acceleration effect.

Limitations of Employment Argument: This argument suffers from the following

limitations:

Ø This argument assumes that there is unutilized capacity available in the economy.
Ø Protection can lead to an increase in the level of employment only if exports are
maintained at the previous level and there is no reduction in exports through
retaliation by other countries. But such a situation is highly improbable.
Ø A reduction in import will also lead to a reduction in export. So additional
employment generated in the protected industries will be nullified by reduction in
employment in export industries due to a decline in exports.
Ø If the demand for imports is highly inelastic, protection will be hardly of much help
in reducing imports and thus the desired increase in employment will not be
possible.

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 Ø Since less developed countries suffer from disguised unemployment, a policy of
protection will hardly be of much use to such countries.

Terms of Trade Argument: It is held that protection improves a country's terms of trade
and enables it to secure larger gains from international trade. Imposition of tariffs raises
the price of imports in the country that imposes tariffs. This makes the demand for imports
to fall which compels the producers in the exporting country to lower the price of their
products and reduce the foreign supply to match the reduced demand in the country
imposing tariffs.

To what extent the terms of trade will improve and to what extent the foreigners would be
made to pay the duty will depend upon the extent to which the price rises in the importing
country and the extent to which the price falls in the exporting country. If the demand for
imports in the home country is elastic and the supply of the foreign products is inelastic
then there will be a greater rise in prices in the importer country and a greater fall in prices
in the exporting country.

Limitations of Terms of Trade Argument: The following defects have been pointed out in
this argument:

Ø Imposition of tariffs can improve the terms of trade only when the foreign supply is
less elastic.
Ø Imposition of tariffs can bring gains to the tariff imposing country only at the cost of
other countries. If other countries also retaliate and impose tariffs on their imports,
this policy will not benefit.
Ø Imposition of tariffs will reduce the volume of trade and will curtain the world
output.
Ø If very high tariffs are imposed than permitted by the optimum level then it will be
detrimental to the national economic welfare. An optimum tariff is one which
maximizes the gains from the improved terms of trade, minus the loss from the
reduced volume of trade. Even the terms of trade continue to improve at tariff levels
beyond the optimum tariff; the resultant reduction in the volume of trade will
neutralize this improvement.

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 Ø Imposition of tariffs will increase the prices of imported goods and make the
consumers to suffer.

Bargaining Argument: The protagonists of protection argue that it increases the

bargaining power of the country in international trade. It means that if tariffs are imposed
by a country, it can force other countries to lower their tariff duties and thus enable that
country to obtain favorable terms for its exports from other countries.

Limitations of Bargaining Argument: This argument has the following defects:

Tariff as a method of bargaining may invite other countries to retaliate.

Ø If a country is dependent on other countries for the supply of basic commodities, a

rise in tariff may be inflationary.
Ø It is also possible that a country may use non-tariff concessions to obtain tariff
concessions from its trading partners.

Balance of Payments Arguments: It is held that protection helps the countries in

removing the disequilibrium in their balance of payments. In order to correct the
imbalance in the balance of payment a country by imposing tariffs can have an excess of
exports over imports and will thus earn more foreign exchange. This argument is more
relevant, for the less developed countries which have limited foreign exchange resources
and which really need more of such resources for their development programs.

Anti-Dumping Argument: Free trade leads the developed countries to resort to dumping.
Dumping means that the foreign country dumps the domestic market with its goods at a
very low price, even lower than what that country receives in its own market. Thus a policy
of dumping aims at flooding the foreign markets with cheap goods so as to capture those
markets. Consequently, dumping is detrimental to a country in which it occurs. It ruins the
competing firms in the importer country. So, to protect the home industry from dumping
high tariffs are imposed.

Revenue Argument: It is held that protection is a good device for increasing revenues of
the government. In the first place, imposition of tariff protects the home industries as well

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as brings revenue to the government. In the second place, foreigners will be made to pay
whole or part of the tariff duty. But how much the foreigner will share the tariff duty will
depend upon the elasticity of supply of the foreign producer and the elasticity of demand of
the domestic producer. If the demand is more elastic and the supply is more inelastic, the
foreigner will bear a larger part of the tariff duty.

Capital Formation Argument: Protection can also lead to the promotion of capital
formation by increasing the saving ratio in the country. Increase in tariff may increase the
domestic saving ratio by: providing better terms of trade, attracting foreign investment,
and by increasing saving through a cut in consumption.

Self-sufficiency Argument: This argument has been advanced in favor of protection as a

source of attainment of national self-sufficiency and for providing protection to the country
from outside disturbances. Protection can lead to national self-sufficiency by:

i) Making the country economically self-dependent;

ii) Saving the economy from the effects of fluctuating world prices;

iii) Promoting industrialization through diversification of industries;

iv) Minimizing economic disruptions; and

v) Avoiding the undesirable effects of world depressions.

Basic Industry Argument: Power is essential for the development of basic and key
industries. Protection can help in the development of such industries and thus promote
industrialization.

Retaliation Argument: Protection is also being advocated for adoption as a retaliatory

measure. If a country levies tariffs against another country, the latter would also levy the
same tariff against the former in retaliation.

Maintaining High Wage Argument: A policy of protection has been advocated to protect
the interest of the domestic workers. It is held that competition from a high wage country
with a low wage country will create problems to both the countries. The country paying

49
high wages will be at a disadvantage when it imports cheaper goods from countries where
the wages are low and exports costlier goods to them. But a policy of protection enables the
high wage countries to compete with the low wage countries.

ii. Non-Economic Arguments for Protection:

We have discussed economic arguments for protection. Now we will discuss non-economic
arguments for protection. These arguments are discussed as follows:

Defense Argument: Protection is necessary for the development of national defense

industries particularly for meeting war time situations. In fact national security and
maintenance of the sanctity of national frontiers are more important than economic
prosperity or economic development.

Nationalist Argument: Protection creates a spirit of nationalism and patriotism in the

people, and stimulates the development of domestic industries by restricting imports
through protective measures.

Preservation Argument: Protection is also supported for the preservation of particular

groups of people and particular occupations. For example, in under developed countries
agriculture forms the backbone of the society and, therefore, by levying tariff duties on the
import of cheap food grains, mainly for protecting the agriculturists, would be justified.

To Check Import of Harmful Goods: The imposition of protective tariffs on the import of
goods which are health hazards or socially undesirable will be helpful for the importing
country. It would save the health of the people, prevent the waste of wealth on the use of
such commodities and raise the overall economic welfare of the people.

Arguments against Protection

So far we have discussed both economic and non economic arguments in favor of
protection. Arguments have also been advanced against the policy of protection. Some of
these important arguments are discuss below:

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Loss of Revenue: The imposition of protective tariffs reduces imports and consequently
the revenue of the government from customs duties declines.

Uneconomic Use of Resources: Since protection may lead to the development of

economically less efficient industries, the resources would be transferred from more
productive use to less productive use.

Prevents Industrial Growth: Protection once granted cannot be easily withdrawn

because of vested interests. Protection in fact becomes a permanent feature and the
protected industry continues to remain an infant industry.

Producers become Lethargic: The absence of competition owing to the adoption of policy
of protection makes the home producers lethargic. They do not care to improve their
efficiency or reduce the cost of their production.

No Increase in the Level of Employment: Protection may also not lead to generate
employment, because, whatever jobs will be created in the protected domestic industries
will be balanced by a fall in the employment in export industries.

Loss to Consumers: Protection leads to restrict imports and increase domestic prices and
ultimately makes the consumers to suffer.

Unequal Distribution of Income: Protection makes the rich, richer and poor; poorer. The
rich enjoy larger benefits and the poor suffer because of increase in prices. Thus protection
aggravates inequalities in the distribution of wealth.

Creation of Monopolies: Imposition of tariff leads to the growth of monopolistic

tendencies. Since there is no foreign competition, domestic producers enjoy monopolistic
gains by earning high profits.

Tariff Wars: By imposing protective tariffs a country forces other trading partners also to
impose tariffs on their imports as a retaliatory measure. This ultimately results in tariff
war.

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General Arguments against Protectionism
Prices: -Protection may raise prices to consumers and producers of the imports they buy.
Choice: -Protection would lead to less choice for consumers
Competition: -Competition would diminish if foreign firms are kept out of a country, and
so domestic firms may become inefficient without the incentive to minimize costs.
Ø Innovation may also be reduced for the same reason.
Comparative Advantage: - Protectionism distorts comparative advantage leading to the
inefficient use of the world’s resources.
Ø Specialization is reduced and this would reduce the potential level of world’s output.
Economic Growth: -For all reasons listed previously, protection may hinder economic
growth.

If we take stock of the relative merits and demerits of free trade and protection, we arrive
at the inevitable conclusion that protection is no doubt indispensable for developing
countries. However, protection should not be adopted as a permanent policy. Moreover,
blank protection is neither desirable nor justified. Countries have to strike a judicious
balance between the two.

Protection could be beneficial if it is adopted on a discriminatory basis. That is why List

was not in favor of indiscriminate protection. Only those industries which have a potential
of growth should be provided protection and it should be withdrawn as soon as the
protected industries are in a position to compete with foreign industries.

3.2.2. Methods of protection

3.2.2.1. Import Tariffs and Quota

Tariff and quota are the most widely used devices all over the world for restricting foreign
trade with the objective of protecting home industries from foreign competition. The use of
tariffs restricts trade in an indirect manner while the use of quotas restricts trade directly.

Tariffs and quotas could be used simultaneously with others or singly for restricting trade.
However, their use usually be determined by the government on the basis of political and
economic situation prevailing within the country as well as in the countries of the trading

52
partners. The prime considerations, however, will be the level of government revenue and
the interest of home industries. We are going to discuss the important aspects of both these
methods in the following paragraphs.

Import Tariffs

Tariff refers to a tax or duty levied by the government of a country on goods and services
entering foreign trade. When a duty is imposed on a commodity at the time of its leaving
the national border, it is called 'export duty' and when it is levied on the goods entering
the national border, it is called 'import duty'. In addition, there is also a 'transit duty'
which is levied on goods which are in transit, that is, which are going from one foreign
country to another but passing through the country imposing the 'transit duty’. Tariffs can
be classified as follows:

Specific Duty: It is a fixed sum of money imposed as a duty on a commodity according to

its weight or measurement (physical dimensions) as Birr. X per unit or per meter or per
liter, etc.

Ad valorem Duty: It is imposed as a percentage of the value of the imported commodity.

The value is inclusive of insurance plus freight charges, that is, cost of the commodity plus
insurance and freight charges, represent the total value of a commodity on which, the duty
is charged.

Of the two duties mentioned above, ad valorem duty is equitable because its’ burden rises
or falls according to the richness or poverty of the consumers, since the more costly the
commodity the higher is the duty. Moreover, it is easy to discern the burden of an ad
valorem duty.

Compound Duty: A combination of both specific and ad valorem duties is a compound

duty levied on a commodity. In such a case the duty levied on a unit of an imported
commodity includes a specific duty per unit plus a certain percentage of the value of that
unit as ad valorem duty.

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Sliding Scale Duty: It is levied on the basis of the price of the imported commodity rising
and falling with an increase or decrease in the price. It can be specific or ad valorem but
mostly it is specific.

Import Tariffs for a Small Country

¡ Since Home is a small country, the tariff does not affect world prices.
¡ The Foreign export supply curve X* is horizontal at the world price PW.
ž Effect of the Tariff
¡ The new export supply curve shifts up to X*+t.
¡ Quantity demanded falls while quantity supplied rises
¡ However, as firms increase the quantity produced, the marginal costs of
production rise.
¡ The domestic price will equal the import price.

ž Effect of the Tariff on Consumer Surplus

¡ With the tariff, consumers now pay the higher price, PW+t, and their surplus is
the area under the demand curve and above the higher price, PW+t.
¡ The fall in consumer surplus due to the tariff is the area in-between the two
prices and to the left of Home demand, (a+b+c+d) in figure below.

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 ¡ This area is the amount that consumers lose due to the higher price caused by
the tariff.

ž Effect of the Tariff on Producer Surplus

¡ With the tariff, producer surplus is the area above the supply and below the
higher price, PW+t.
¡ Since the tariff increases Home price, firms can sell more goods, and producer
surplus increases
¡ This area, a, is the amount that Home firms gain due to the higher price caused
by the tariff.
¡ Increases in producer surplus can benefit Home workers but at the expense of
consumers.

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ž Effect of the Tariff on Government Revenue
¡ In addition to the tariff’s impact on consumers and producers, it also affects
government revenue.
¡ The amount of revenue collected is the tariff t times the quantity of imports (D2 –
S2).
¡ In thefigure revenue is shown by area c.
¡ The collection of revenue is a gain for the government in the importing country.

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 Overall Effect of the Tariff on Welfare
ž Note, we do not care whether the consumers facing higher prices are rich or poor,
and do not care whether the specific factors in the industry earn a lot or a little.
¡ The overall impact of the tariff in the small country can be summarized as
follows:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Rise in government revenue +c
Net effect on Home welfare -(b+d)
ž The areas b and d in the figure correspond to the triangle (b+d) and is the net
welfare loss.
¡ We refer to this area as a deadweight loss—it is not offset by a gain
elsewhere in the economy.

Why are Tariffs Used?

ž Why do so many countries use tariffs if they always lead to deadweight losses?
¡ One idea is that developing countries do not have any other source of
revenue.
¡ Import tariffs are “easy-to-collect” relative to income taxes.
¡ However, to the extent that developing countries recognize that tariffs have a
higher deadweight loss, we would expect that over time they will shift away
from such “easy-to-collect” taxes.

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 ¡ A second reason is politics.
¡ The might governments care more about producer surplus than consumer
surplus.
¡ The benefits to producers (and their workers) are typically more
concentrated on specific firms and states than the costs to consumers, which
are spread nationwide.
ž Under the small country assumption that we have used so far, the importing country
is always harmed due to the tariff.
¡ The small country is a world price taker.
ž If we consider a large enough importing country or a large country, however, then
we might expect that its tariff will change the world price.
¡ Its imports are large enough that it can affect world price with a change in its
imports.
ž Foreign Export Supply
¡ If the Home country is large, then the Foreign export supply curve X* is no
longer horizontal at the world price PW.
¡ We construct the foreign export supply curve in a fashion similar to the
import demand curve.
¡ In panel (a) of the following figure, we show the Foreign demand curve D*
and supply curve S*, giving price of PA* at A*.
¡ At this point, foreign exports are zero. Suppose the world price is PW above
PA*.
¡ At the higher price, there is a Foreign excess supply of X1* = S1* - D1*, which
will be exported at the price of PW at point B*.

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Meaning and Types of Quota

Quotas are a device under which limit is fixed in respect of either the value or the quantity
of a commodity that may be imported by a country during a specified period of time,
usually one year. The prime objective is the quick and effective regulation of imports and
exports.
A country may use different types of quotas, which includes:

Tariff Quotas: Under this system a country may allow the imports of a specified quantity
of a commodity either duty free or at a very low duty. Beyond this limit a high rate of duty
is charged.

Unilateral Quotas: Under this a country may unilaterally fix a quantity or value of a
commodity either through legislation or by decree that can be imported. It is global if a
specific commodity can be imported from any part of the world. If the quantities to be
imported are fixed or allowed country wise, on the basis of some criteria, then it is an
allocated quota system.
Bilateral Quotas: When the quotas are fixed by mutual agreement between the countries,
it is known as bilateral quota system. Such a system works more smoothly than the
unilateral quota system.

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Mixing Quotas: When the domestic producers are made to use the imported raw material
in a fixed proportion with domestic raw material in the production of a commodity and
quotas for the import of specified raw material are fixed on this basis the quotas are called
'mixing quotas'. Under such quotas licenses are issued to the producers and not to the
importers. Such a system provides protection to the home producers and also conserves
foreign exchange for the country.

3.2.2.2. Export Subsidy

Ø including special tax exemptions and the provision of capital at favored rates,
Ø to increase the volume of exports
Ø intended to encourage a nation's exports by reducing the price paid by foreigners
Ø The foreign price of a subsidized export is less than the product's domestic price.
Ø an export subsidy yields two direct effects for the home economy:
§ terms-of trade effect and
o An export-revenue effect.
Ø the home nation's terms of trade is worsened
Ø the home nation's export revenues will increase
Ø Although export subsidies may benefit industries and workers in a subsidized
industry by increasing sales and employment
Ø Consumers in the exporting nation suffer as the international terms of trade moves
against them
o a greater number of exports must be exchanged for a given dollar amount in
imports
o Furthermore, to the extent that taxes are required to finance the export
subsidy, domestic consumers find themselves poorer.

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 Unit Four: Economic Integration and Regional Trade
Organizations

4.1 Types of Regional Trading Arrangements

Economic integration is a process of eliminating restrictions on international trade,

payments and factor mobility. Economic integration thus results in the uniting of two or
more national economies in a regional trading arrangement. There are different degrees of
economic integration (regional trading arrangements). Below are the different types of
economic integration.

1. Free- trade area. This is an association of trading nations whose members agree to
remove all tariff and non- tariff barriers among themselves. Each member, however,
maintains its own set of trade restrictions against outsiders. An example of this stage of
integration is the North American Free Trade Agreement (NAFTA), consisting of Canada,
Mexico and the US.

2. Customs Union. A second stage in the process of economic integration is the formation
of customs union. Like a free trade association, a custom union is an agreement among two
or more trading partners to remove all tariff and non- tariff trade barriers among
themselves. In addition, however, each member nation imposes identical trade restrictions
against non-participants. That is, each nation follows a common external trade policy. The
effect of the common external trade policy is to permit free trade within the customs union,
while all trade restrictions imposed against outsiders ( non- members) are equalized.

3. Common Market. A further stage in the process of economic integration is a common

market. A common market is a group of trading nations that permits;

I. The free movements of goods and services among member nations

II. The initiation of common external trade restrictions against non members and

III. The free movement of factors of production across national borders within the
economic bloc (group).

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The common market thus represents a more complete stage of integration than a free-
trade area or customs union. The European Union (EU) achieved the status of a common
market in 1992.

4. Economic Union: This represents an even further step in economic integration than a
common market. In addition to permitting free movement of goods, services and factors of
production, and following a common external trade policy against non members, national,
social, taxation and fiscal policies are harmonized and administered by a supranational
institution in economic union. In other words, in addition to abolition of existing trade
barriers, economic union requires an agreement to transfer economic sovereignty to a
super natal authority.

5. Monetary Union: This represents the ultimate degree of economic union and it requires
the unification of national monetary policies and the acceptance of a common currency
administered by a supranational monetary authority. The U.S. serves as an example of a
monetary union. Fifty states are linked together in a complete monetary union with a
common currency, implying completely fixed exchange rates among 50 states.

4.2 Effects of Regional Trade Arrangements

1. The static welfare effects, resulting from trade

v Trade creation and
v Trade diversion.
2. The dynamic welfare effects that stem from
v Greater competition,
v Economies of scale, and
v The stimulus to investment spending that economic integration makes
possible
• Combined, these static and dynamic effects determine the overall welfare gains or
losses associated with the formation of a regional trading arrangement.
Static welfare effects
— Trade creation occurs when some domestic production of one customs-union
member is replaced by another member's lower-cost imports.

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 — The welfare of the member countries is increased by trade creation because it leads
to increased production specialization according to the principle of comparative
advantage.
— Trade-creation effect is a welfare gain resulting from increasing trade caused by the
formation of a regional trade bloc. Net welfare gains if trade creation is more than
trade diversion.
— Trade-diversion effect is a welfare loss resulting from the formation of a regional
trade bloc
v It occurs when imports from a low-cost supplier outside the trade bloc are
replaced by purchases from a higher-cost supplier within the trade bloc.
— Several factors influence the extent of trade creation and trade diversion:

a) The degree of competitiveness that member-nation economies have prior to

formation of the customs union,
b) The number and size of its members
c) The size of its external tariff against non-members.
The overall consequence of a customs union on the welfare of its members, as well as
on the world as a whole, depends on the relative strengths of these two opposing forces.

— If Pre union economies are quite competitive, the more likely to benefit from trade
creation. Because the formation of the union offers greater opportunity for
specialization in production.

• The larger the size and the greater the number of nations in the union,

v The greater the gains are likely to be,

v Because there is a greater possibility that the world's low-cost producers will
be union members.

Dynamic effects of customs union

However, not all welfare consequences of regional trading arrangements are static in
nature. There may also be dynamic gains that influence member- nation growth rates over
the long-run. These dynamic gains stem from the creation of larger markets by the
movement to freer trade under customs unions. The benefits associated with a customs

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union’s dynamic gains may more than offset any unfavorable static effects. The dynamic
gains include economies of scale, greater competition and a stimulus of investment.

Perhaps the most noticeable result of a customs union is market enlargement. Being able to
penetrate freely the domestic markets of other member nations, producers can take
advantage of economies of scale that would not have occurred in smaller markets limited
by trade restrictions. Larger markets may permit efficiencies attributable to greater
specialization of workers and machinery, the use of most efficient equipment, and the more
complete use of by- products.

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 Chapter Five: International Trade and Economic Growth and
Development
5.1. International Trade and Economic Growth

The trade theory discussed so far is completely static in nature. That is, given the nation’s
factor endowments, technology, and tastes, we proceeded to determine the nation’s
comparative advantage and the gains from trade. However, factor endowments change
over time; technology usually improves; and tastes may also change. As a result, the
nation’s comparative advantage also changes over time.

In this chapter, we extend our trade model to incorporate these changes. We show how a
change in factor endowments and/or an improvement in technology affect the nation’s
production frontier. These changes, together with possible changes in tastes, affect the
nation’s offer curve, the volume and the terms of trade, and the gains from trade.

Growth of Factors of Production

Through time, a nation’s population usually grows and with it the size of its labor force.
Similarly, by utilizing part of its resources to produce capital equipment, the nation
increases its stock of capital. Capital refers to all the human-made means of production,
such as machinery, factories, office buildings, transportation, and communications, as well
as to the education and training of the labor force, all of which greatly enhance the nation’s
ability to produce goods and services.

Although there are many different types of labor and capital, we will assume for simplicity
that all units of labor and capital are homogeneous (i.e., identical), as we have done in
previous chapters. This will leave us with two factors—labor (L) and capital (K)—so that
we can conveniently continue to use plane geometry for our analysis. In the real world, of
course, there are also natural resources, and these can be depleted (such as minerals) or
new ones found through discoveries or new applications.

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We will also continue to assume that the nation experiencing growth is producing two
commodities (commodity X, which is L intensive, and commodity Y, which is K intensive)
under constant returns to scale.

Labor Growth and Capital Accumulation over Time

An increase in the endowment of labor and capital over time causes the nation’s production
frontier to shift outward. The type and degree of the shift depend on the rate at which L
and K grow. If L and K grow at the same rate, the nation’s production frontier will shift out
evenly in all directions at the rate of factor growth. As a result, the slope of the old and new
production frontiers (before and after factor growth) will be the same at any point where
they are cut by a ray from the origin. This is the case of balanced growth.

If only the endowment of L grows, the output of both commodities grows because L is used
in the production of both commodities and L can be substituted for K to some extent in the
production of both commodities. However, the output of commodity X (the L-intensive
commodity) grows faster than the output of commodity Y (the K-intensive commodity).
The opposite is true if only the endowment of K grows. If L and K grow at different rates,
the outward shift in the nation’s production frontier can similarly be determined.

Figure 5.1: Growth of Labor and Capital over Time.

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The left panel shows the case of balanced growth with L and K doubling under constant
returns to scale. The two production frontiers have identical shapes and the same slope, or
PX / PY, along any ray from the origin. The right panel shows the case when only L or only
K doubles. When only L doubles, the output of commodity X (the L -intensive commodity)
grows proportionately more than the output of Y (but less than doubles). Similarly, when
only K doubles, the output of Y grows proportionately more than that of X but less than
doubles (see the dashed production frontier).

The left panel of Figure 5.1 shows the case of balanced growth under the assumption that
the amounts of L and K available to Nation 1 double. With constant returns to scale, the
maximum amount of each commodity that Nation 1 can produce also doubles, from 140X to
280X or from 70Y to 140Y. Note that the shape of the expanded production frontier is
identical to the shape of the production frontier before growth, so that the slope of the two
production frontiers, or PX/PY, is the same at such points as B and B, where they are cut by
a ray from the origin.

The right panel repeats Nation 1’s production frontier before growth (with intercepts of
140X and 70Y) and shows two additional production frontiers—one with only L doubling
(solid line) and the other with only K doubling (dashed line). When only L doubles, the
production frontier shifts more along the X-axis, measuring the L-intensive commodity. If
only K doubles, the production frontier shifts more along the Y-axis, measuring the K-
intensive commodity. Note that when only L doubles, the maximum output of commodity X
does not double (i.e., it only rises from 140X to 275X). For X to double, both L and K must
double. Similarly, when only K doubles, the maximum output of commodity Y less than
doubles (from 70Y to 130Y).

When both L and K grow at the same rate and we have constant returns to scale in the
production of both commodities, the productivity, and therefore the returns of L and K,
remains the same after growth as they were before growth took place. If the dependency
rate (i.e., the ratio of dependents to the total population) also remains unchanged, real per
capita income and the welfare of the nation tend to remain unchanged. If only L grows (or L
grows proportionately more than K), K/L will fall and so will the productivity of L, the

67
returns to L, and real per capita income. If, on the other hand, only the endowment of K
grows (or K grows proportionately more than L), K/L will rise and so will the productivity
of L, the returns to L, and real per capita income.

The Rybczynski Theorem

The Rybczynski theorem postulates that at constant commodity prices, an increase in the
endowment of one factor will increase by a greater proportion the output of the commodity
intensive in that factor and will reduce the output of the other commodity. For example, if
only L grows in Nation 1, then the output of commodity X (the L-intensive commodity)
expands more than proportionately, while the output of commodity Y (the K-intensive
commodity) declines at constant PX and PY.

Figure 5.2 shows the production frontier of Nation 1 before and after only L doubles (as in
the right panel of Figure 5.1). With trade but before growth, Nation 1 produces at point B
(i.e., 130X and 20Y) at PX/PY = PB = 1, as in previous chapters. After only L doubles and
with PX/PY remaining at PB = 1, Nation 1 would produce at point M on its new and
expanded production frontier. At point M, Nation 1 produces 270X but only 10Y. Thus, the
output of commodity X more than doubled, while the output of commodity Y declined (as
predicted by the Rybczynski theorem). Doubling L and transferring some L and K from the
production of commodity Y more than doubles the output of commodity X.

The proof is as follows. For commodity prices to remain constant with the growth of one
factor, factor prices (i.e., w and r) must also remain constant. But factor prices can remain
constant only if K/L and the productivity of L and K also remain constant in the production
of both commodities. The only way to fully employ all of the increase in L and still leave
K/L unchanged in the production of both commodities is for the output of commodity Y
(the K-intensive commodity) to fall in order to release enough K (and a little L) to absorb
all of the increase in L in the production of commodity X (the L-intensive commodity).
Thus, the output of commodity X rises while the output of commodity Y declines at
constant commodity prices.

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Figure 5.2 The Growth of Labor Only and the Rybczynski Theorem.

With trade but before growth, Nation1produces at point B (130Xand20Y) at PX/ PY = PB

=1, as in previous chapters. After only L doubles and with PX / PY remaining at PB = 1,
Nation 1 produces at point M (270X and 10Y) on its new and expanded production frontier.
Thus, the output of X (the L -intensive commodity) expanded, and the output of Y (the K -
intensive commodity) declined, as postulated by the Rybczynski theorem.

Technical Progress and the nation’s production possibility curve

Several empirical studies have indicated that most of the increase in real per capita income
in industrial nations is due to technical progress and much less to capital accumulation.
However, the analysis of technical progress is much more complex than the analysis of
factor growth because there are several definitions and types of technical progress, and
they can take place at different rates in the production of either or both commodities.

For our purposes, the most appropriate definitions of technical progress are those
advanced by John Hicks, the British economist who shared the 1972 Nobel Prize in
economics. In the following paragraphs, we define the different types of Hicksian technical
progress and then examine the effect that the different types of Hicksian technical progress
have on the nation’s production frontier. Throughout our discussion, we will assume that
constant returns to scale prevail before and after technical progress takes place and that
technical progress occurs in a once-and-for-all fashion.

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Neutral, Labor-Saving, and Capital-Saving Technical Progress

Technical progress is usually classified into neutral, labor saving, or capital saving. All
technical progress (regardless of its type) reduces the amount of both labor and capital
required to produce any given level of output. The different types of Hicksian technical
progress specify how this takes place.

Neutral technical progress increases the productivity of L and K in the same proportion,
so that K/L remains the same after the neutral technical progress as it was before at
unchanged relative factor prices (w/r). That is, with unchanged w/r, there is no
substitution of L for K (or vice versa) in production so that K/L remains unchanged. All that
happens is that a given output can now be produced with less L and less K.

Labor-saving technical progress increases the productivity of K proportionately more

than the productivity of L. As a result, K is substituted for L in production and K/L rises at
unchanged w/r. Since more K is used per unit of L, this type of technical progress is called
labor saving. Note that a given output can now be produced with fewer units of L and K but
with a higher K/L.

Capital-saving technical progress increases the productivity of L proportionately more

than the productivity of K. As a result, L is substituted for K in production and L/K rises
(K/L falls) at unchanged w/r. Since more L is used per unit of K, this type of technical
progress is called capital saving. Note that a given output can now be produced with fewer
units of L and K but with a higher L/K (a lower K/L).

As in the case of factor growth, all types of technical progress cause the nation’s production
possibility curve to shift outward. The type and the degree of the shift depends on the type
and rate of technical progress in either or both commodities. Non neutral technical
progress is extremely complex and can only be handled mathematically in most advanced
texts.

With the same rate of neutral technical progress in the production of both commodities, the
nation’s production possibility curve will shift out evenly in all directions at the same rate
at which technical progress takes place. This has the same effect on the nation’s production

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possibility curve as balanced factor growth. Thus, the slope of the nation’s new and old
production possibility curve will be the same at any point where they are cut by the ray
from the origin.

Analogous reasoning explains the shift in the production possibility curve when the
productivity of labor and capital doubles only in the production of commodity Y. finally it
must be pointed out that, in the absence of trade, all types of technical progress tends to
increase the nation’s welfare. The reason is that with the higher production possibility
curve and the same labor and population, each citizen could be made better off after
growth than before by an appropriate redistribution policy.

5.2. International Trade and Economic Development

5.2.1 The theory of economic development

Economic Development—refers to the achievement of a quality of life for the average

citizen of a country that is comparable to that enjoyed by the average citizen of a country
with a modern economy. Economic development is characterized by High levels of
consumption, Broad-based educational achievement, Adequate housing, Access to high-
quality health care, etc.

In relation to developed (or more developed) countries, developing nations are

characterized in general by low (and sometimes extremely low) average real per capita
income, a high proportion of the labor force in agriculture and other primary activities such
as mineral extraction, low life expectancies, high rates of illiteracy, high rates of population
growth, and low rates of growth in average real per capita income.

In fact international trade may maximize welfare of developing nations in the short term.
However, these nations believe that this pattern of specialization and trade leads them to a
subordinate position with developed nations and keeps them from reaping the dynamic
benefits of industries and from maximizing their welfare in the long-run. The dynamic
benefits resulting from industrial production includes a more trained labor force, more
innovations, higher and more stable prices for the nation’s exports, and higher income for
citizens. Therefore all or most of these dynamic benefits accrue to developed nations,

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leaving developed nations poor, undeveloped and dependent. This belief is reinforced by
the observation that all developed nations are primarily industrial while all developing
nations are primarily agricultural. Thus developing nations attack traditional trade theory
as completely static and irrelevant to the development process. As a result developing
nations demand changes in the pattern of trade and reform of the present international
economic system to take in to consideration their special development needs.

Traditional trade theory can readily be extended to incorporate changes in factor supplies,
technology and tastes by the technique of comparative statics. This may indicate that a
nation’s pattern of development is not determined once and for all, but must be
recomputed as underlying conditions change or is expected to change over time. Therefore
developing nations are not necessarily or always relegated by traditional trade theory to
export mostly primary commodities and import mostly manufactured products.

5.2.2 The contribution of trade to development

Beside the static gain from comparative advantage, by which it can contribute to the
economic development developing nations, there are important beneficial effects that
international trade can have on economic development.

Ø Trade can lead to full utilization of underemployed domestic resources.

Ø By expanding the size of the market, trade makes possible division of labor and
economies of scale. This is especially important and has actually taken place in the
production of light manufactures in such small economic units as Taiwan, Hong
Kong, and Singapore.
Ø International trade is a vehicle for the transmission of new ideas, new technologies
and new managerial and other skills.
Ø Trade also stimulates and facilitates the international flow of capital from developed
to developing nations.
Ø In several large developing nations, the importation of new manufactured products
has stimulated domestic demand until efficient domestic production of these goods
become possible.

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5.3. Trade development strategies

5.3.1. Import substitution strategies

Industrialization through import substitution: is a way of promoting domestic

industrialization, particularly in consumer goods through import restriction, so that
domestic market is preserved for domestic products, which can thus takeover markets
already established in the country. The main advantages of this policy are the following:

Ø The market for industrial products already exists, as evidenced by imports of the
commodity, so that risks are reduced in setting up an industry to replace imports.
Ø It is easier for developing nations to protect their domestic market against foreign
competition than to force developed nations to lower trade barriers against their
manufactured exports.
Ø Foreign firms are induced to establish tariff factories to overcome the tariff wall of
developing nations.

Against those advantages, there are the following disadvantages.

Ø Domestic industries grow accustomed to protection from foreign completion and

have no incentive to become more efficient
Ø Import substitution leads to inefficient industries because the smallness of the
domestic market, which does not allow to take advantage of economies of scale.
Ø After the simpler manufactured imports are replaced by domestic production,
import substitution becomes more difficult and costly as more capital incentive and
technologically advanced imports have to be replaced by domestic production.

5.3.2. Export promotion

This strategy involves policies designed to exploit natural comparative advantage by

increasing production of a few export goods most closely related to the country’s resource
base.

The main advantages of export promotion are the following:

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 Ø It overcomes the smallness of domestic market and allows a developing nation to
take advantage of economies of scale. This is particularly important for many
developing nations that are very poor and small.
Ø Production of manufactured goods for export requires and stimulates efficiency
throughout the economy. This is especially important when the output of an
industry is used as an input by another industry in the economy.
Ø The expansion of manufactured exports is not limited (as in the case of import
substitution) by the growth of the domestic market.

The two serious disadvantages of export promotion as a policy are:

Ø It may be very difficult for developing nation to set up exporting industries because
of the competition from the more established and efficient industries in developed
nations.
Ø Developed nations often provide a high level of protection for their simple labor-
intensive commodities in which developing nations already have or can soon
acquire a comparative advantage.

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