International Trade

International trade is the voluntary exchange of goods, services, assets or money between

residents of different countries.

It is trade between many countries of the world. It can be:

i. Bilateral (between two countries)

ii. Multilateral (amongst countries)

Justification for International Trade

1. Factor Endowment

Different countries trade in different goods and services and thus will enable a country to

receive/ get what they cannot produce.

2. Different prices

The key objective why countries are involved in international trade is differences in

prices of goods and services with reference to cost of production. In such a case, a

country can import the goods which it cannot produce at a cheaper cost domestically.

Absolute Advantage
International trade occurs as a result of absolute advantage where a country will
specialize in production of different goods and services and as a result of specialization,
the countries concerned will exchange the surplus.

4. Foreign Exchange Currency

Countries do involve themselves in international trade in order to obtain foreign currency
3. Absolute Advantage

International trade occurs as a result of absolute advantage where a country will

specialize in production of different goods and services and as a result of specialization,

countries concerned will exchange the surplus.

4. Foreign Exchange Currency

Countries do involve themselves in international trade in order to obtain foreign currency

International trade theories

THE CLASSICAL VIEW

Absolute Cost Advantage Theory (Adam Smith)

• Also known as free trade theory (assumes no restrictions on international trade by any
country.
• He held that free trade between countries brings about an optimum allocation of the
productive resources of the world, leading to enhancement of real income of the trading
countries.
• According to him, trade occurs between two countries if one of them has an absolute
advantage in producing one commodity and the other country having absolute
advantage in producing some other commodity. In other words, each country
specializes in the production of that commodity in which it enjoys an absolute cost
advantage and trade with other countries in between the countries would result in
optimum allocation of the resources in the world ad hence productivity will boost.

Comparative Cost Advantage Theory: David Ricardo (1817)

• David Ricardo agreed with the analysis of Adam Smith that international trade would
be mutually' beneficial if one country has absolute advantage over another in one line
of production and another country in other.
• But Ricardo further showed that the countries can very well gain by trading even if one
of the countries is having an absolute advantage in both the goods over another,
provided the extent of absolute advantage is different in the two commodities in
question or the comparative advantage is greater in respect of one goods than in that of
other i.e there are comparative differences in cost.
• In fact, the doctrine of comparative costs was developed by Ricardo out of his
(classical) labours theory of value.
• According to this theory, the value of any commodity is determined by the labours
costs. It asserts that goods are exchanged against one another according to the relative
amount of labours embodied in them
• According to the principle of comparative costs, under free trade conditions, a country
specializes in the production of a commodity in which its comparative advantage is
greater or its comparative disadvantage is lesser. Each country exports a commodity in
 the production of which it has a greater comparative: advantage or a lesser comparative
disadvantage

The Heckscher-Ohlin Theory

• The H.O. theory states that main determinant of the pattern of production,
specialisation and trade among regions is the relative availability of factor endowments
and factor prices. Regions or countries have different factor endowments and factor
prices. "Some countries have much capital, other have much labour.
• The theory says that countries that are rich in capital will export capital-intensive goods
while those rich in labour will export labour intensive goods
• To Ohlin the immediate cause of international trade always is that some commodities
can be bought more cheaply from other regions, whereas in the same region their
production is possible at high prices.
• Thus, the main cause of trade between regions is the difference in prices of
commodities based on relative factor endowments and factor prices.

FREE TRADE AND PROTECTIONISM

Free trade is trade that occurs between countries without any barriers or hindrances.

The firm exporting into the country should not face any additional barriers, taxes, regulations
or any other obstacles that prevent them selling their goods/services.

Free trade at an international level means that this freedom is true for trade between all
countries. In this way, countries gain the benefits from competition that exist where the national
markets are free from barriers and restrictions.

Types of protectionism

Protectionism (protecting against imports) has arisen in various forms. These include:

Tariffs

A tariff is a tax on imports, which can either be specific (so much per unit of sale) or ad valorem
(a percentage of the price of the product).
Tariffs reduce supply and raise the price of imports. This gives domestic equivalents a
comparative advantage. As such, tariffs are distorting the market forces and may prevent
consumers from gaining the benefit of all the advantages of international specialisation and
trade. The impact of a tariff is shown in the Figure below.

The tariff has the effect of shifting the world supply curve vertically upwards by the amount of
the tariff. The level of imports will fall from QaQd to QbQc. The government will also raise
revenue, shown by the blue shaded area. The level of domestic production will increase from
0Qa to 0Qb.

Quotas

Quotas have the effect of restricting the maximum amount of imports allowed into an economy.
They reduce the amount of imports entering an economy and increase the equilibrium price
within the market.

Exchange controls

The government could limit the amount of foreign currency available for paying for imports.

Export subsidies

Export subsidies allow exporters to supply the market with more product than the natural
equilibrium would have allowed. Foreign consumers will enjoy increased economic welfare as
the price of their purchases fall. Domestic employees might enjoy more wages and job security.
But taxpayers are footing the bill for this. Domestic firms might divert trade into exports and
ignore the home market. This could lead to increases in domestic prices.
The impact of a subsidy is shown in the Figure below. The supply curve is shifted vertically
downwards by the amount of the subsidy and this leads to a lower equilibrium price and a
higher quantity being traded.

Voluntary export restraints (VER's)

Some quotas are voluntarily agreed between countries. Where the quotas have been agreed,
they are known as Voluntary Export Restraints (VER's).

Other protectionist measures

Countries can also use a range of other protectionist measures to restrict imports. These might
include:

• Administrative obstacles - countries can set administrative hurdles. For example, they
may require significant levels of paperwork and then deal with these processes slowly
making it difficult for importers to compete on a level playing field with other firms.
• Health and safety standards - countries may set onerously high health and safety
standards for goods that are imported, once again making life difficult for importers.
• Environmental standards - countries can set high environmental standards that they
know only domestic firms are likely to be able to achieve, once again making life
difficult for importers.

Why protectionism

The main reasons include:

• To safeguard domestic employment - as protectionist polices reduce import
penetration. In terms of the identity AD = C + I + G + (X-M), the lower is M, the greater
will be aggregate demand and thus the higher the level of domestic output and
employment.
• To correct balance of payments disequilibrium - as demand for imports is dampened
and exports promoted. This makes the domestic output appear to be more competitive.
• To prevent labour exploitation in developing economies - this is really a moral
argument as it rests on making imports more accurately reflect their true cost of
production. However, it might also reduce imports from some of the poorest economies
in the world.
• To prevent dumping - which is where economies sell goods in overseas markets at a
price below the cost of production. Domestic consumers pay more than those buying
overseas. Such low prices are part of a policy to destroy rivals in export markets.
• To safeguard infant industries - as shifts in comparative advantages arise, so some
countries become able to enter new markets. Their fledgling industry needs some
protection from the power of already established competitors.
• To enable a developing country to diversify - If they want to diversify and develop
new export revenue streams, they may need to protect these new industries from full
exposure to international competition for a while.
• Source of government revenue -
• Strategic arguments - a particular product or industry might be of strategic importance
to a country, e.g. agriculture or coal, and protectionism may be justified on the grounds
that it is keeping alive an industry which plays a vital part in the economy, perhaps
because of social, political or military reasons.

Disadvantages of protectionism

They include:

• Downward multiplier effects - if a country successfully protects against imports, this

will reduce the level of imports. However, one country's imports are another country's
exports and this reduction in exports will lead to a multiplied effect. This may even
reduce demand for exports from the country that raised the protectionist measures in
the first place, but will certainly reduce world output.
 • Retaliation - any protectionist measure tends to be instantly met with some form of
retaliation. This will tend to mean that any success in protecting against imports leads
to a fall in exports when the retaliation starts to bite.
• Costs - tariffs (and other protectionist measures) tend to lead to a cost on society. In the
tariff diagram below, the tariff leads to a reduction in imports. Some of the benefits
from the reduced imports are passed to domestic firms in the form of higher prices and
the government in the form of revenue, but the triangles either side of the blue shaded
area represent a welfare cost to society. Consumers will be paying higher prices for
many of the goods and services they consume.

• Inefficiency of resource allocation - the imposition of tariffs or other protection may

not be the best solution. Firms may be able to shelter behind the tariff wall and remain
inefficient. They may not have an incentive to reduce costs and become fully globally
competitive if they believe that the tariffs will continue. This will be true also where
infant industries are protected. If the tariffs remain in the long-term, the infant industry
may never 'grow-up'. Firms operating with higher costs may be unable to achieve export
competitiveness. In short, resources will not be allocated to their most efficient uses.
• Bureaucracy - many protectionist measures are very bureaucratic to enforce. This is
likely to reduce choice for domestic consumers and perhaps lead to possible corruption
and other administrative costs. These will not be beneficial for the economy.

Terms of trade
• Refers to the rate at which the goods of one country exchange for goods of

another country.

• It is the price index of exports over price index of imports.

 • It is a measure of the purchasing power of exports of a country in terms of its imports,
and is expressed as the relation between export prices and import prices of its goods.

When the export prices of a country rise relatively to its import prices, its terms of trade are
said to have improved. The country gains from trade because it can have a larger quantity of
imports in exchange for a given quantity of exports.

Disequilibrium in BOP

• A disequilibrium in the balance of payment means its condition of Surplus Or deficit.

• A Surplus in the BOP occurs when Total Receipts exceeds Total Payments.

Causes of disequilibrium in BOP

• Cyclical fluctuations

• Short fall in the exports

• Economic Development

• Rapid increase in population SS

• Structural Changes

• Natural Calamites

• International Capital Movements

MEASURES TO CORRECT DISEQUILIBRIUM IN THE BOP

1. Monetary Measures:

a) Monetary Policy: concerned with money supply and credit in the economy. The Central
Bank may expand or contract the money supply in the economy through appropriate measures
which will affect the prices.

b) Fiscal Policy - Its government's policy on income and expenditure. Government incurs
development and non - development expenditure, It gets income through taxation and non - tax
sources. Depending upon the situation governments expenditure may be increased or
decreased.

c) Exchange Rate Depreciation - By reducing the value of the domestic currency, government
can correct the disequilibrium in the BOP in the economy. Exchange rate depreciation reduces
the value of home currency in relation to foreign currency. As a result, import becomes costlier
and export become cheaper. It also leads to inflationary trends in the country

d) Devaluation – Refers to lowering the exchange value of the official currency. When a
country devalues its currency, exports becomes cheaper and imports become expensive which
causes a reduction in the BOP deficit.

e) Deflation - Is the reduction in the quantity of money to reduce prices and incomes. In the
domestic market, when the currency is deflated, there is a decrease in the income of the people.
This puts curb on consumption and government can increase exports and earn more foreign
exchange.

f) Exchange Control - All exporters are directed by the monetary authority to surrender their
foreign exchange earnings, and the total available foreign exchange is rationed among the
licensed importers. The license-holder can import any good but amount if fixed by monetary
authority.

2. Non- Monetary measures

a) Export Promotion - To control export promotions the country may adopt measures to
stimulate exports like: export duties may be reduced to boost exports; cash assistance, subsidies
can be given to exporters to increase exports; goods meant for exports can be exempted from
all types of taxes. b) Import Substitutes Steps may be taken to encourage the production of
import substitutes. This will save foreign exchange in the short run by replacing the use of
imports by these import substitutes.

c) Import Control Import may be kept in check through the adoption of a wide variety of
measures like quotas and tariffs.

BALANCE OF TRADE

Is the difference between the value of commodity exports and imports. The balance of trade of
a country shows its trade transactions with the rest of the world during the course of a year.

Takes into account only visible exports and imports (those which are actually recorded at the
ports).

Balance of trade for one country could be of three types-

(i) Balanced Balance of Trade (exports = Imports)

 (ii) Surplus Balance of Trade (Exports > Imports) - Favourable
(iii) Deficit Balance of Trade (Exports < Imports) - Unfavourable

EFFECTS OF FAVOURABLE BALANCE OF TRADE

1. Improvement in the Situation of Balance of Payment

2. It Increases the Soundness of the Economic

3. It Enhances the Goodwill of the country

4. It helps in Accelerating the Pace of Economic Development

5. Favourable Rate of Exchange

6. Increase in Foreign Exchange Reserve

7. Fear of Inflation 8. Increase in Competition

Effects of Unfavorable balance of trade

1. It Increases Disequilibrium in Balance of payment

2. Economy Becomes Weak

3. Hurdle in Economic Development

4. Fall in Prestige and Goodwill of the country

5. Unfavourable Rate of Exchange

6. Decrease in Foreign Exchange Reserve

7. Bad Effects on Production, Employment Level of the Country

Measures for correcting unfavorable balance of trade

1. Export Promotion

2. Import Control and Substitution

3. Dumping

4. Devaluation: - It purposefully decreases the value of its currency in terms of other foreign
currencies. Export will be cheaper and import will become more expensive, thus by this way,
a country can rectify its adverse balance of trade.
5. Policy of Protection

6. Increase in Export Credit and Facilities

Exchange rates

An exchange rate is the price of one currency expressed in terms of another. An exchange rate
system is the way in which the exchange rate is determined. These come in three types. They
are:

1. Fixed - this is an exchange rate system where one currency is fixed in value against
another. It involves the government working to keep the parity via intervention on the
currency markets. These give certainty but can cost vast sums of foreign exchange from
national reserves.
2. Floating - this is an exchange rate which accepts that market forces will determine rates
based on how they view a country's trade performance and its economic and political
stability.
3. Managed or dirty float - which is where the rate is floating but between upper and
lower limits that the domestic government keeps it to. It brings more stability but at less
cost to the national reserves.

Factors which affect exchange rates

Exchange rates will be affected by a number of factors. Consider this in the case of the Kenyan
shilling.

i. Trade flows

A surplus of exports over imports for Kenya (a trade surplus) will cause an increase in demand
for Kshs. (overseas buyers need the Kshs to pay for the goods) and will therefore exert an
upward pressure on the exchange rate.

However, a deficit situation in which Kenyan imports exceed exports (a trade deficit) will cause
an increase in supply of Kshs (Kenyan importers will need to supply Kshs to obtain the foreign
currency required to pay for the imports). This will exert a downward pressure on the exchange
rate

ii. Capital flows / interest rate changes / speculation

if interest rates were to fall below those in other major world economies, or international
speculators were pessimistic about the future of the Kenyan economy, or suspected a large
future depreciation in the Kenyan sh, they might decide to sell their holdings of Kshs and
convert them into dollar. This would increase the demand for dollar, while increasing the
supply of Kshss and cause a depreciation of the currency.

A currency crisis is caused when large numbers of speculators decide to sell their holdings of
a currency at the same time, causing its price to crash.

iii. Inflation

A higher rate of inflation in Kenya than in other competitor countries would make Kenya
exports less competitive and may lead to less exports being sold, depending on the price
elasticity of demand for exports. If this resulted in a worsening of the current account, the
exchange rate would depreciate. With less demand for exports and imports becoming relatively
more price attractive, the demand for Kshs would fall while the supply would increase.

Inflation may also be a factor which currency speculators take into account when making
decisions about buying/selling currencies. If a very high, uncontrollable rate of inflation was
expected (a hyper-inflation), speculators might lose confidence in the currency and sell,
causing a depreciation.

iv. Use of foreign currency reserves

Exchange rates, whether fixed or floating, are usually influenced by the actions of
governments. Thus, if the Kenyan government wished to exert an upward pressure on the
shilling, (perhaps as part of a monetary policy to lower the rate of inflation), they
could buy Kshs on the foreign exchange market using their reserves of foreign currency. This
would increase the demand for Ksh., causing an appreciation, while increasing the supply of
other currencies, exerting a downward pressure on them.

International institutions

IMF (International monetary fund)

Key IMF activities

The IMF supports its membership by providing

• policy advice to governments and central banks based on analysis of economic trends and
cross-country experiences;

• research, statistics, forecasts, and analysis based on tracking of global, regional, and
individual economies and markets;

• loans to help countries overcome economic difficulties;

• concessional loans to help fight poverty in developing countries; and

• Technical assistance and training to help countries improve the management of their
economies.

Objectives of the IMF

1) To promote international monetary co-operation through a permanent institution which

provides machinery for consultation and collaboration on international monetary co-operation.

2) To facilitate the expansion of balanced growth of international trade, and to contribute for
the promotion of the productive resources of all members as the primary objectives of
economic policy. 3) To promote exchange stability, to maintain orderly exchange arrangements
among members, and to avoid competitive exchange depreciation.

4) To assist in the establishment of a multilateral system of payments in respect of current

transactions between members and in the elimination of foreign exchange restrictions which
hamper the growth of world trade?

5) To lend confidence to members by making the fund’s resources available to them under
adequate safeguards thus providing them with opportunity to correct maladjustments in their
BOP without resorting to measure destruction of national or international prosperity.

Function of IMF

1) It functions as a short-term credit institution.

2) It provides machinery for the orderly adjustment of exchange rates.

3) It is reservoir of the currencies of all the members countries, for which a borrower nation
can borrow the currency of other nation.

4) It grants loans for financing current transactions only and not capital transactions.
5) It tries to provide for an orderly adjustment of exchange rates, which will improve the long-
term BOP position of the member countries.

6) It also provides a machinery for international consultations.

International Bank for Reconstructions and Development (IBRD) / World Bank

The IBRD or World Bank was set up on December 27, 1945 when their article of agreement
was signed by 29 Governments in Washington D.C. On 30th June 1983, 144 countries were its
members. The Principal purposes as set forth in its articles of agreement are as follows-

(i) to assist in the reconstruction and development of its member countries by facilitating
the investment of capital for productive purposes, thereby promoting long range growth
of international trade and improvements in standard of living;
(ii) To promote private foreign investment by guarantees of, and participation in, loans and
other investments made by private investors; and
(iii) When private capital is not available on reasonable terms to make loans for productive
purposes out of its own resources or the funds borrowed by it. Activities. In order to
achieve this purpose, the charter authorizes the world Bank to engage in the following
financing activities-
(i) It may lend funds directly, either from its capital funds or from the funds it
borrows in private investment markets.
(ii) It may guarantee loans advanced by others or it may participate in such loans.
(iii) Loans may be advanced to member countries directly or to any of their
political subdivisions or to private business or agricultural enterprises in the
territories of members.