Industrial Economics and

Foreign Trade
Module 5 – Part 1 International
Trade
By
Dr. Johnson T T
Assistant Professor in Economics
CET
Mob. 9447450408
International Trade
International trade or foreign trade means trade between countries. In other words, it is the exchange of goods or services
between two or more countries. The branch of economics which deal with foreign trade is International Economics.
Advantages and disadvantages of foreign trade
1. Optimal use of natural resources:
2. Availability of all types of goods:
3. Specialisation:
4. Advantages of large-scale production:
5. Stability in prices:
6: Establishment of new industries:
7. Increase in efficiency:
8. Development of the means of transport and communication:
9. International co-operation and understanding:
10. Discouragement to Monopolies:
11. Better Employment Opportunities:
Disadvantages
1. A threat to domestic industries:
2. Economic dependence:

3. Misuse of natural resources :

4. Import of harmful goods:.
6. Evil Effects of Dumping:
7 Against national Defence:

Theories of International Trade

Absolute Advantage Theory
According to Adam Smith the basis of international trade is absolute cost advantage. Suppose there are two commodities
and two countries which produce these two commodities. The countries will specialise and produce that commodity upon
which they have an absolute advantage. They will export this commodity to the other country.
The absolute advantage theory can be explained with the help of an example.
USA UK
Number of Units of wheat per unit of labour 10 5
Number units of cloth per unit of Labour 3 8
Comparative Advantage Theory
Comparative cost advantage theory was developed by David Ricardo in 1857. According to Ricardo, even in the case of a
country for which there is no absolute advantage for both the commodities, it can gain from international trade. In this
situation, the country should specialise in the production and export of the commodity in which its absolute disadvantage is
smaller and import the commodity in which its absolute disadvantage is greater.

The Ricardian theory is based on the following assumptions.

1. There are only two countries and two commodities
2. There are no barriers in international trade
3. There is no transport cost
4. Labour is the only component of cost of production
Ricardo in his two commodity, two country model taken cloth and wine as commodities and England and Portugal as
two countries.
Country No. of units of labour No. of units of labour Exchange ratio
Per unit of cloth per unit of wine
England 100 120 1 wine = 1.2 cloth
Portugal 90 80 1 wine = 0.88 cloth

The Heckscher-Ohlin Theorem or Factor Endowment Theory

The factor endowment theory was originally developed by Eli Heckscher in 1919. Later in 1935 it was refined by his
student Bertil Ohlin. Hence the theory is popularly known as Heckscher-Ohlin Theorem. It is a two-country two-
commodity model.
The Heckscher-Ohlin theorem tried to explain the causes of comparative cost differences that exist internationally.
According to the theorem, the differences in comparative advantage among nations is mainly due to the differences in
relative factor abondance or factor endowments.
Heckscher-Ohlin theorem can be stated as follows. A country will produce and export that commodity whose production
requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose production
requires the intense use of relatively scarce and expensive factor.

In the Heckscher-Ohlin theorem factors of production are considered as abundant or scarce in relative terms and not in
absolute terms.

Country A Supply of labour = 50

Supply of capital = 40
Capital- labour ratio = 0.8

Country B Supply of labour = 16

Supply of capital = 20
Capital-labour ratio = 1.25

Factor Price Equalisation Theorem

Factor price equalisation theorem is a corollary of Heckscher-Ohlin theorem. It was proved by Paul Samuelson and hence
it is called Heckscher-Ohlin-Samuelson theorem.

The theorem state that free international trade will equalise factor prices between countries relatively and absolutely and
this serve as a substitute for international factor mobility.
Effects of International Trade
According to Heckscher-Ohlin theorem, international trade has the following effects.
1. Equalisation of factor prices:
2. Equalisation of Commodity prices:
 Industrial Economics and
Foreign Trade
Module 5 – Part 2 International
Trade
By
Dr. Johnson T T
Assistant Professor in Economics
CET
Mob. 9447450408
Balance of Payments
Balance of payments is a systematic record of all economic transactions of a nation with the rest of the world for a specific
period of time. Usually, time period is taken as one year.

It is obvious that during a period of time millions of transactions take place between one nation and with the rest of the world.
Therefore, all these transactions cannot appear individually in the balance of payment statement. As a summary statement,
balance of payments aggregates all these transactions under different heads.

Balance of Trade and Balance of Payments

Balance of trade includes only those transactions which are involved in the exporting and importing of visible items (goods). It
does not include invisible items such as various kinds of services (shipping, banking, insurance), payment of interest and
dividend etc. On the other hand, balance of payments includes both visible and invisible item.
Components of Balance of Payments
Usually, international transactions are classified under the following heads:

1. Current Account 2. Capital Account 3. Unilateral payments Account 4. Official Reserve Account
Current Account
Current account consists of two major items i) merchandise (visible) exports and imports ii) invisible exports and imports.
Capital Account
The capital account includes short term and long-term capital transactions. Capital inflows are coming as credit entries
and capital outflows as debit entries.

The following are the two major items coming under capital account.
1. Loans and borrowings – It includes all types of loans from both the private and public sectors located in foreign
countries.
2. Investments – These are funds invested in the corporate stocks by non-residents.

Unilateral Transfers Account

Unilateral Transfer means the one-way transfer of an item from one person to another.

The official reserve account

. It is the foreign currency and securities held by the government, usually by its central bank, and is used to balance the
payments from year to year.
Balance of Payments Disequilibrium – Deficit
Economic Factors
The following are the important economic factors which lead to balance of payment disequilibrium.
i) Development disequilibrium:
ii) Cyclical Disequilibrium:
iii) Secular Disequilibrium:

Political Factors
Social factors
Correction of Disequilibrium or Deficit
1. Automatic Correction:
2. 2. Deliberate Measures: The three deliberate measures are a) Monetary measures b) trade
measures and c) Miscellaneous measures
Monetary measures The important monetary measures are
i) Monetary contraction or expansion:
ii) Devaluation:
iii) Exchange control:
Trade Measures
i) Export promotion:
ii) Import control:

Miscellaneous Measures
Devaluation
Devaluation means a deliberate reduction of the value of the domestic currency in terms of foreign currencies. A country
which faces a serious problem of deficit in the balance of payments may resort to devaluation. This will stimulate their
export and discourage import.

Limitations of Devaluation
1. The success of devaluation depends on reactions of other countries. If they retaliate by devaluing their currencies,
devaluation will not be successful.
2. If prices in the domestic country increases at the same rate or at a higher rate of devaluation, it will not will not
increase export or decrease import.
3. The success of devaluation also depends on the elasticities of demand for export and import.
4. In spite of an increase in the demand for a country’s export due to devaluation, the extent of increase in exports
depends on the exportable surplus or the quantity available for export.
Devaluation and Elasticities of Demand for Exports and Imports
The success of devaluation depends on the elasticities of demand for exports and imports.
Devaluation and Exports
1. More elastic demand: When demand for exports is more elastic, a fall in price of exports in terms of foreign currency
increases the export earnings and there will be a favourable effect on balance of payments.
Less Elastic Demand
When price elasticity of demand is less than one, there will be a decrease in export earnings due to devaluation.
Unit elastic demand
When Demand for exports is unit elastic, devaluation will have no effect on the export earnings
Devaluation and Imports
Devaluation increases the price of the imports in terms of home currency

Zero elasticity
Less elastic demand

When the value of elasticity of demand is greater than zero but less than one, there will be a decline in imports due
to an increase in the price of imports. But it will not be substantial
More elastic demand
When demand for imports is more elastic, an increase in price causes a substantial decrease in the volume of
imports and hence it has larger impact on import bill as well as balance of payments.
Marshall-Lerner Condition
The Marshall-Lerner condition states that devaluation will improve the balance of payments of a country if the
sum of elasticities of demand for a country’ exports and its demand for imports is greater than one. In other words
ex + em > 1 where ex is the elasticity of export and em is the elasticity of import.
• If ex + em > 1, devaluation will improve current balance of payments position
• If ex + em < 1, Devaluation will deteriorate balance of payments
• If ex + em = 1, devaluation will have no effect on balance of payments

Devaluation – the J-curve effect

The J-curve shows the time path of trade flows after devaluation. It says that, devaluation will lead to an initial
deterioration of the trade balance and this will be followed by a subsequent improvement.
 Industrial Economics and
Foreign Trade
Module 5 – Part 3 Foreign Trade
By
Dr. Johnson T T
Assistant Professor in Economics
CET
Mob. 9447450408
Free Trade Versus Protection
Free trade is a trade policy that does not restrict imports or exports. In other words, it refers to the trade that is free from all
artificial barriers to trade like, tariffs, quota restrictions, exchange control etc. In the case of free trade the free market idea
is applied to international trade. Protection on the other hand is the policy of protecting domestic industries against foreign
competition by means of tariffs, subsidies, import quotas etc. It affects mainly the imports of a country.
Arguments for Free Trade
The following are the important arguments in favour of free trade
1. Better utilisation of resources:
2. Division of labour and specialisation:
3. Efficiency:
4. Dampen monopoly practices
5. Wide variety of goods:
6. Avoid corruption and red-tapism:
7. Economic growth:
Arguments Against Free Trade
1. Threat to domestic industries:
2. Harmful commodities:
3. The Unfair-Competition Argument:
4. Job outsourcing leads to unemployment:
5. Degradation of environment
6. Poor Working Conditions:

Arguments in Favour of Protection

1. Infant industry argument:
2. Strategic and Key industry argument: 3. National Defence:
4. Diversification 5. Improving balance of payments:
6. Anti-Dumping: 7. Employment argument: 8. Keeping money at Home
Arguments Against Protection
1. Protection is against the interest of the consumers as it increases the price of the imported products. Further,
consumers are denied the opportunity for enjoying variety goods.
2. It discourages competition and hence compromises efficiency.
3. It encourages the growth of domestic monopolies because of the weakening of foreign competition.
4. Protection discourages innovations and cost reduction.
5. It leads to uneconomic utilisation of world’s resources.
6. Protection may lead to trade wars and international conflicts among trading nations. When one country takes protective measures,
others may retaliate.

Trade Barriers
Trade barriers refer to the government policies and measures which restrict the free flow of goods between the
countries. Broadly, trade barriers are divided into two groups. They are tariff barriers and non-tariff barriers.
Tariff Barriers
Tariff barriers are duties or taxes imposed by the government of a country on its imports or exports.
On the basis of origin and destination of goods, tariffs can be classified in to the following three categories.
i) Export duties: ii) Import duties: iii) Transit duty:
Based on the purpose they serve, tariffs can be classified as
i) Revenue tariff: ii) Protective tariff: iii) Countervailing and Anti-Dumping tariffs:

Effects of Tariff
The following are the effects of tariff on the economy.
i) Protective effect:.
ii) Revenue effect:
iii) Income and employment:
iv) Balance of payments effect:
v) Consumption effect:
vi) Competitive effect:
vii) Redistribution effect:
Non-Tariff Barriers (NTBs)
1. Voluntary Export Restraints: A voluntary export restraint (VER) is a trade restriction on the quantity of a good that
an exporting country is allowed to export to another country.
2. Administered Protection: Administered protection encompasses a wide range of bureaucratic government actions.
The important measures under administered protection include
a) Safeguards: A safeguard is a temporary import restriction that a country is allowed to impose on a product if imports
of that product are increasing
b) b) Health and product standards: The developed countries fix certain health and product standards which hinder
the exports of developing countries because of added cost or technical requirements.
c) Customs Procedures: Customs procedures of many countries act as a trade barrier
d) Licensing: Many countries use licensing as a measure to restrict trade, especially imports.
e) Monetary controls: Monetary controls are also employed to regulate imports. For example, RBI in 1990s took several
measures which include a 25 percent interest rate surcharge on bank credit for imports.
f) Environmental protection laws: Many countries framed environment protection laws to restrict imports.
g) Foreign Exchange Regulations: In some countries, the State monopolise foreign exchange and hesitate to release
foreign exchange for imports.
Quantitative Restrictions or Quotas
A quota represents a ceiling or limit on the volume of exports or imports. The following are the important types of
import quotas.
1. The tariff or custom quota: Under this system, import of a commodity up to a specified quantity is allowed to
be imported duty-free or at a special low rate of duty. But imports in excess of this fixed limit are charged a higher
rate of duty. The tariff quota thus combines the features of a tariff with those of quota.
2. The Unilateral Quota: Under this system, a country places an absolute limit on the import of a commodity
during a given period. It is imposed without prior negotiation with foreign governments.
3. The Bilateral Quota: Under this system, quotas are set through negotiation between the importing country and
the exporting country.
4. The Mixing Quota: It is a type of regulation which requires producers to utilise a certain proportion of domestic
raw materials along with imported parts to produce finished goods domestically. It thus sets limits on the proportion
of foreign-made raw materials to be imported and used in domestic production.
5. Import Licensing: Under this, prospective importers are required to obtain a licence from the proper authorities
for importing any quantity within the specified quotas.
Effects of quotas
The following are the important economic effects of quotas
1. Price effect:
2. Consumption effect:
3. Balance of payments effect:
4. Protective effects:
5. Revenue effect:
6. Redistributive effect: