Module 5 (International Trade)

International trade

International trade refers to the exchange of capital, goods and services

across international borders.

Without trade, nations would have to rely only on products produced

domestically.

Trade plays a dominant role in the economic development of a country

by helping it widen its market.
Advantages of International Trade

• Optimal use of natural resources

• Availability of all types of goods
• Advantages of large-scale production
• Stability in prices
• Exchange of technical know-how and establishment of new industries
• Development of the means of transport and communication
• Ability to face natural calamities
• International cooperation and understanding
Disadvantages of International Trade

● Impediment in the Development of Home Industries

● Economic Dependence
● Political Dependence
● Import of Harmful Goods
● Free trade can lead to pollution and other environmental problems
● It is unwise to export all the natural resources of a country
Adam Smith’s Theory of Absolute Advantage

• The concept of absolute advantage was developed by Adam Smith in

The Wealth of Nations

Assumptions
1. There are no barriers to trade in goods.
2. Labour is the only relevant factor of production.
3. Production exhibits constant returns to scale.
4. There are no transportation costs.
5. Labour is mobile within a country but immobile between
countries.
Statement of Theory

• Countries should specialize in producing the goods and services

in which they have absolute advantage and engage in free trade
with other countries to sell their goods.
• A country’s resources would therefore be utilized in the best
possible way—in the production of goods and services in which
the country has a productivity advantage compared with other
countries—and national wealth would be maximized.
 Labour cost in hours required to produce one unit of
wheat or cloth
U.S. U.K.

Wheat 3 10
Cloth 6 4

● The above table gives the man-hours required to produce a unit of wheat and
cloth in the US and UK.
● It will be seen from the above table that to produce one unit of wheat in the U.S. 3
hours of labour and in the U.K. 10 hours are required.
● To produce one unit of cloth, in the U.S. 6 hours of labour and in the U.K. 4 hours
are required.
● Thus the U.S. can produce wheat more efficiently (that is, at a lower cost), while
the U.K. can produce cloth more efficiently
Criticism

● The theory assumed that each exporting country has an

absolute advantage in the production of a commodity.
Developing countries may not have any such advantage.
● There are a large number of factors influencing trade between
countries.
● The theory does not consider that countries are often forced to
export to neutralise their balance of payments deficit.
Comparative advantage Theory: David Ricardo

Assumptions

1. Labour is the only relevant factor of production.

2. Production exhibits constant returns to scale.
3. There are no transportation costs.
4. Labour is mobile within a country but immobile between countries.
5. There is no intervention by the government in the economic system.
6. Perfect competition exists both in the commodity and factor markets.
7. There is full employment of resources in both the countries.
Statement of Theory

• According to Ricardo even in the case of a country for which there is no

absolute advantage for both the commodities, it can still gain from the
international trade.
• In this situation, the country should specialize in the production and export
of the commodity in which its absolute disadvantage is smaller and import
the commodity in which the its absolute disadvantage is greater.
 Labour cost in hours required to produce one unit of wheat or
cloth
U.S. U.K.

Wheat 3 10
Cloth 4 6

● The above table indicates that England has an absolute advantage in

producing both the commodities through smaller inputs of labour thanUK. It
does not mean that England will specialise in both cloth and wheat and UK
will have nothing to export.
● England has comparative cost advantage in the production of wheat and UK
has comparatively lesser cost disadvantage in the production of
[Link], US will specialise in the production and export of wheat,
while UK will specialise in the production and export of cloth.
Criticism

● The theory assumes that there are no other costs except labour costs
● The theory assumes constant returns to scale. Diminishing returns are likely to
set in as scale increases.
● The theory ignores differences in transport cost.
● The assumption that labour is mobile only within the country is not valid.
● Actual international trade is influenced by various government restrictions
like tariffs and other trade restrictions.
● The assumption of full employment is not valid.
Heckscher - Ohlin theory of international trade (Factor endowment theory)

● The theory was originally developed by Eli Heckscher in 1919. Later in 1935
it was refined by Bertil Ohlin. Hence it is known as Heckscher – Ohlin
Theorem.
● Heckscher – Ohlin Theorem states that a country will produce and export that
commodity whose production requires the intensive use of nation’s relatively
abundant and cheap factor and import the commodity whose production
requires the intense use of relatively scarce and expensive factor.
● In other words, relatively labor abundant country will export the relatively
labor-intensive commodity and import the relatively capital – intensive
commodity.
Assumptions

1. There are only two factors of production.

2. It is a two country two commodity model.
3. There is perfect competition.
4. There is full employment.
5. There are no transport costs.

Merits
1. The H-O theory takes into account both the demand and supply factors for determining
international trade.
2. This model lays down a permanent basis for international trade.
3. The theory maintains that production involves two factors of production-labour and capital.
Criticism
1. It is a two commodity model.
2. The theory assumes perfect competition.
3. The theory assumes that there is full employment.
4. The theory ignores differences in transport cost.
Balance of Payments (BoP)

The balance of payments summarises the economic transactions of an economy with

the rest of the world. These transactions include exports and imports of goods,
services and financial assets, along with transfer payments (like foreign aid).

Importance of balance of payments

1. The BOP statement of a country is an indicator of its economic status in the world.
2. It helps the government formulate its trade policies.
Components of BOP

The BOP is divided into three main components or elements: the current account, the capital account, and the
financial account.
1. The Current Account

It is used to monitor the inflow and outflow of goods and services in a country. It is called current since it
refers to transactions currently occurring - those that do not give rise to future claims.

The current account consists of:

a. Merchandise trade. This is referred to as visible trade. This is the trade in manufactured goods and raw materials.
[Link]. This is referred to as invisible trade. It is the sale of services like travel and tourism, insurance,
engineering, patents and copyrights etc.
[Link] receipts. This includes income derived from ownership of assets abroad such as dividends from shares
and interest from bonds.
[Link] transfers. These include worker remittances from abroad, foreign aid, contribution to charitable
institutions and gifts from one country to another.
2. The Capital Account
The capital account refers to the net change in ownership of foreign assets. It is where all international
capital transfers are recorded.
The capital account is divided into:
a. Capital transfers.
b. Purchase and sale of real assets.

3. The Financial Account

In the financial account, international monetary flows related to investment in business, real estate,
bonds, and stocks are documented. Also included are government-owned assets such as foreign
reserves, gold, special drawing rights held with the International Monetary Fund, private assets held
abroad, and direct foreign investment.
Apart from the above three major components, bop also includes:
4. Official reserve account.
It refers to the foreign currency held by the central bank of a country and is used to balance the
payments from year to year.

5. Errors and Omissions

Sometimes the balance of payments does not balance. It is due to errors that have crept in during the
compilation of the bop statement. Hence an entry called errors and omissions is made to reflect this
imperfection.
Balance of Payments Deficit

• 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. Thus,

BOP= CREDIT>DEBIT

• A Deficit in the BOP occurs when Total Payments exceeds Total Receipts. Thus,

BOP= CREDIT<DEBIT
Reasons for disequilibrium in balance of payments
1. Economic Factors
a) The BOP will have deficits if the level of imports in a country is high.
b) Lack of adequate international capital inflow into a country.
c) External borrowings and loans from foreign countries.
2. Political Factors
a) Political instability in a country creates uncertainty among foreign investors
which leads to a reduced inflow of foreign capital into the country.
b) Disequilibrium in BOP also occurs in the event of fear of war with some other
country.
3. Structural Factors
a) The high degree of protection given to domestic industries leads to inefficiency and
poor quality products. Hence exports suffer.
4. Social Factors
a) Countries like India export mainly agriculture and agro based products. The price
of these he wave fluctuate heavily in thorold markets.
b) Indian agricultural exports were constantly affected by crop failures.
5. Technological Factors
a)The lack of thrust in research and development has created a situation where
countries like India have very few products that foreigners find attractive.
b)Excessive stress on technology intensive export-oriented industries by countries
like China has resulted in bop disequilibrium in countries like India.
Methods to correct disequilibrium in the BOP

1. Monetary Measures
a) Monetary Policy. Monetary policy is the policy concerned with the supply of money in the economy. A
reduction in the money supply will decrease the purchasing power of the people. Demand will decline and
prices will come down. This reduces imports and encourages exports.
b) Devaluation. It is the lowering of the exchange value of the currency of a country. When a country
devalues its currency, exports become cheaper and imports become expensive which causes a reduction in
the BOP deficit.
2. Trade policy measures
a) Export Promotion. The country tries to increase exports by adopting various measures like reducing
export duties, providing incentives to exporters, providing subsidies to exporters and exempting exports
from taxes.
b) Import Substitution. Steps may be taken to encourage the production of goods which are currently being
imported. This will save valuable foreign exchange.
3. Non- Monetary measures

a) Promoting international travel and tourism.

b) Inviting foreign companies to come and invest in the country.
c) Taking extra efforts to ensure that Indians working abroad deposit their savings in banks in India.
d) Postponing debt repayments.
e) Keeping inflation under control.
f) Check on smuggling
Devaluation
It is the lowering of the exchange value of the currency of a country. When a country devalues
its currency, exports become cheaper and imports become expensive which causes a reduction in the
BOP deficit.
Objectives of Devaluation
● To boostexports. Imports become more expensive and exports become more competitive
and lucrative.
● To encourage a greater quantity of export from the country whose currency is being devalued.
● To reduce trade deficits. The increase in exports along with a reduction in imports will cause a
positive impact on the balance of trade.
● To lower the cost of a country’s external debt.
Limitations of devaluation
1. Devaluation may cause inflation. Higher exports due to the devaluation in the currency will increase the
level of income of the consumers causing domestic demand to rise, which raises prices.
2. It can result in an increase in the production cost of commodities that depend on inputs that are imported.
3. Domestic companies that have taken international loans will face greater servicing costs.
4. It will foster uncertainty within the global markets.
5. Devaluation may also spark trade wars. It will create tension with other competing countries.
Free trade versus protection

Free trade
Free trade occurs when there are no artificial barriers put in place by governments to restrict the flow of goods and
services between trading nations. When trade barriers, such as tariffs and subsidies are put in place, they protect domestic
producers from international competition and redirect, rather than create trade flows.

Advantages of free trade

1. International trade enables countries to specialize in the production of those commodities in which they have a
comparative advantage.
2. It increases the size of a firm’s market, resulting in lower average costs and higher productivity.
3. International competition promotes innovative production, new technology and marketing.
4. Consumers benefit in the domestic economy as they can now obtain a greater variety of goods and services.
5. The increased competition ensures commodities are supplied at the lowest prices.
Protectionism

It is the policy of protecting domestic industries by imposing high customs duties on foreign products. Economic theory
does not rule out protectionism as a welfare maximizing policy option.

Advantages of protectionism

[Link] main argument for protectionism is the infant industry argument. Industries in developing countries can
effectively compete with those already developed if they receive some initial protection in the form of tariffs or
subsidies.
[Link] economic stability as economies do not become dependent on global markets. This means that businesses
are not vulnerable to downturns in the economies of their trading partners, e.g. Recession in the USA leads to
decreased demand for India’s exports, leading to falling export incomes, lower GDP, lower incomes, lower domestic
demand, and rising unemployment.
[Link] with surplus products may dump them on world markets at prices below the cost of production.
[Link] whose economies are largely agricultural face unfavourable terms of trade. Their export income is much
smaller than the import payments they make for high value imports resulting in large foreign debt levels.
[Link] round industrial development will occur in the country since it cannot depend on foreign industries.
Trade policy

Trade policy refers to the regulations and policies that state how a country carries out international trade with
other foreign countries. It is also referred to as commercial policy. It consists of tariffs on imported goods, quotas,
export constraints and restrictions on the domestic operations of foreign companies. Subsidies may also be provided
to domestic industries to enable them to compete with foreign industries.
A major component of trade policy are trade barriers consisting of tariffs and non-tariff barriers.
Tariff

A tariff is a tax imposed by one country on the goods and services imported from another country. Tariffs are used to restrict imports. They increase the price
of goods purchased from another country, making them less attractive to domestic consumers. They are used to (a) discourage domestic consumers from consuming
foreign goods and (b) encourage consumption and production of the domestically produced import-replacement substitutes.

Types of Tariffs
There are several types of tariffs and barriers that a government can employ:

1. Specific tariffs. It is a fixed amount of tariff imposed on one unit of an imported or exported good.
2. Ad valorem tariffs. It is levied on a good based on a percentage of that good's value.
3. Countervailing tariffs. These are levied on imported commodities which are heavily subsidised by foreign governments.
4. Anti-dumping tariffs. These are imposed on imported goods sold in the country at a price lower than its cost of production.

Advantages of Tariffs
1. Tariffs are a source of revenue for governments.
2. Infant industry argument. Industries in developing countries can effectively compete with those already developed if they receive some initial protection
in the form of tariffs.
3. By making foreign-produced goods more expensive, tariffs can make domestically produced alternatives seem more attractive.
4. Governments often use tariffs to benefit particular domestic industries.
5. Tariffs are used to protect companies and jobs.
Disadvantages of Tariffs

1. They create trade distortions.

2. It can hurt domestic consumers since a lack of competition tends to push up prices.
3. They can make domestic industries less efficient and less innovative by reducing competition.
4. Tariffs lead to a fall in the volume of international trade.
5. They can generate tensions by favouring certain industries over others.
6. An attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of
retaliation, commonly known as a trade war.
Non-tariff barriers (NTBs)

A non-tariff barrier is a way to restrict trade using trade barriers in a form other than a tariff. While tariffs constitute visible
barriers to trade.

The non-tariff barriers constitute the hidden or invisible barriers to trade. In more recent years, these non-tariff barriers have
come into greater prominence than the conventional tariff barriers.

These include direct restrictions or quotas, monetary restrictions, technical and administrative regulations. Their effect on
trade is the same as tariffs - trade restriction and trade distortion causing misallocation of world resources and reducing global
welfare.
Types of Non-Tariff Barriers
There are several types of NTB’s that a government can employ:

1. Quotas. Quantitative restrictions, or quotas, are imposed with a view to reduce the quantity of imports or exports to a limited size. The effects of quotas are
more severe than those which are created by tariffs since they physically limit the number of products that a country imports. Import quotas are more common than
export quotas. The world has witnessed severe import quotas of the mandatory type by the importing countries.

2. Voluntary export restraints. In this case the exporting countries are asked to put voluntary restraints on their exports.

3. Licenses. Countries may use licenses to limit imported goods to specific businesses. If a business is granted a trade license, it is permitted to import
goods that would otherwise be restricted for trade in the country.

4. Monetary restrictions. A country can impose foreign exchange controls to limit the volume of imports. The importer needs foreign exchange to import
foreign goods, and the government of the country can deny the use of foreign exchange for certain types of imports or for imports from certain counties. Exchange
controls are quite widespread particularly in the poor countries which experience severe shortage of foreign exchange.

5. Administrative regulations. They include custom restrictions on banning certain products either on the grounds that they constitute a health hazard or
they do not meet the safety and health regulations in the country. For instance, imports of food stuffs or fruits or toys are restricted on the ground that they constitute
a potential health hazard endangering the safety of people in the country.

6. Technical regulations. They include regulations with regard to labelling and packaging.
Advantage of NTBs
1. NTBs support domestic industrial development. It provides sufficient room for domestic industries to
grow, achieve economies of scale, and be competitive in the international market.
2. NTBs support strategic industrial development. The decline in imports will divert demand for domestic
products.
3. To increase production, domestic companies invest in capital goods and recruit more local workers. Thus
more jobs are created.
4. They create more income and growth in the domestic economy.
Disadvantages of NTBs
1. Governments cannot generate extra income. Under tariff, the government imposes a tax on imported
goods which will increase revenue.
2. They limit the functioning of the free market. Countries should specialize and trade in products in which
they have a comparative advantage. That way, free trade results in maximum benefits globally.
3. The cost of running a business increases. Companies have to fulfil several administrative requirements
such as product standardization.
4. Companies have to follow complicated customs procedures.
5. Exporters face unfair competition in partner countries. Non-tariff barriers are beneficial for domestic
companies but put foreign companies at a disadvantage.
 Module 5 (International Trade)

Advantages and disadvantages of international trade - Absolute and Comparative

advantage theory - Heckscher-Ohlin theory - Balance of payments – Components –
Balance of Payments deficit and devaluation – Trade policy – Free trade versus
protection – Tariff and non-tariff barriers.
International trade
International trade refers to the exchange of capital, goods and services
across international borders. Without trade, nations would have to rely only on
products produced domestically. Trade plays a dominant role in the economic
development of a country by helping it widen its market.

Advantages of International Trade

1. International trade enables countries to specialize in the production of

those commodities in which they have a comparative advantage.
2. It increases the size of a firm’s market, resulting in lower average costs
and higher productivity.
3. International competition promotes innovative production, new
technology and marketing.
4. Consumers benefit in the domestic economy as they can now obtain a
greater variety of goods and services.
5. The increased competition ensures commodities are supplied at the
lowest prices.
6. It results in foreign exchange gains. When India sells its products
abroad, it receives foreign currency. This money is then used to pay for
imports that are produced more cheaply overseas.
7. Free trade creates new jobs in the domestic economy. Employment will
increase in exporting industries.
8. The countries involved in free trade experience rising living standards,
increased real incomes and higher rates of economic growth. This is
created by more competitive industries, increased productivity, efficiency
and production levels
Disadvantages of International Trade

1. The main argument for protectionism is the infant industry

argument. Industries in developing countries can effectively compete with
those already developed if they receive some initial protection in the form
of tariffs or subsidies.
2. Increased economic stability as economies do not become dependent
on global markets. This means that businesses are not vulnerable to
downturns in the economies of their trading partners, e.g. Recession in the
USA leads to decreased demand for India’s exports, leading to falling
export incomes, lower GDP, lower incomes, lower domestic demand, and
rising unemployment.
3. Countries with surplus products may dump them on world markets
at prices below the cost of production.
4. Countries whose economies are largely agricultural face
unfavourable terms of trade. Their export income is much smaller than the
import payments they make for high value imports resulting in large
foreign debt levels.
5. All round industrial development will occur in the country since it
cannot depend on foreign industries.
6. Free trade can lead to pollution and other environmental problems as
companies fail to include these costs in the price of goods while trying to
compete with companies operating under weaker environmental legislation
in some countries.
7. If old traditional industries are not protected, foreign competition
may ruin them and create unemployment.
8. It is unwise to export all the natural resources of a country. For
example, India has exhausted its large supply of manganese and mica in
the name of earning foreign exchange.
Absolute advantage theory of international trade

Assumptions
1. There are no barriers to trade in goods.
2. Labour is the only relevant factor of production.
3. Production exhibits constant returns to scale.
4. There are no transportation costs.
5. Labour is mobile within a country but immobile between countries.

The Theory
The theory of absolute advantage was put forward by Adam Smith. The
theory states that the basis of international trade is an absolute advantage in the
production of a commodity. It was the trade theory that first indicated the
importance of specialization and division of labour.
Suppose there are two commodities and two countries which produce these
commodities. One country is efficient in the production of one commodity and has
an absolute advantage in the production of this commodity. The other country has
an absolute advantage in the production of the other commodity. The countries will
specialise in the commodity in which they have an absolute advantage. They will
export this commodity to another country. From this trade both the countries will
benefit.
The following table gives the man-hours required to produce a unit of
wheat and cloth in the US and UK.
Labour cost in hours required to produce one unit of wheat or cloth
U.S. U.K.

Wheat 3 10
Cloth 6 4

It will be seen from the above table that to produce one unit of wheat in the
U.S. 3 hours of labour and in the U.K. 10 hours are required. To produce one unit
of cloth, in the U.S. 6 hours of labour and in the U.K. 4 hours are required. Thus
the U.S. can produce wheat more efficiently (that is, at a lower cost), while the
U.K. can produce cloth more efficiently.
 The U.S. has an absolute advantage in the production of wheat while the
U.K. has an absolute advantage in the production of cloth. Adam Smith showed
that the two countries would benefit and world output will increase if the two
countries specialize in the production of goods in which they have absolute
advantage and trade with each other.
How such specialization and trade would lead to gain in output and would be
mutually beneficial for the two countries is shown in the following table.
Gain in Output when labour is transferred

U.S. U.K. World

Output
Gain in +2 -1 +1
wheat
Gain in -1 +2.5 +1.5
cloth

Supposed to specialize in the production of wheat, the U.S. withdraws 6

man-hours from the production of cloth and devote them to the production of
wheat, it will lose 1 unit of cloth and gain 2 units of wheat.
Similarly, to specialize in the production of cloth, if the U.K. withdraws 10
hours of labour from wheat and use them for the production of cloth, it will lose
one unit of wheat but gain 2.5 units of cloth.
The total world output of wheat would increase by 1 unit while that of cloth
would increase by 1.5 units. According to Adam Smith, international division of
labour and trade leads to the expansion in world output and wealth without any
increase in productive resources.
Criticism
1. The theory assumed that each exporting country has an absolute
advantage in the production of a commodity. Developing countries may
not have any such advantage.
2. There are a large number of factors influencing trade between
countries.
3. The theory does not consider that countries are often forced to export
to neutralise their balance of payments deficit.
Comparative advantage theory of international trade

The theory of comparative advantage was put forward by David Ricardo.

The theory states that the basis of international trade is comparative advantage in
the production of a commodity. He argued that even if the countries did not have
an absolute advantage in the production of any product, international trade would
be beneficial and would bring gains to all countries.
A country will specialise in that line of production in which it has a greater
comparative advantage in costs than other countries and will import those in which
it has a
comparative cost disadvantage. Each country will benefit if it specializes in
the production and export of those goods that it can produce at relatively lower
cost.
Assumptions
1. Labour is the only relevant factor of production.
2. Production exhibits constant returns to scale.
3. There are no transportation costs.
4. Labour is mobile within a country but immobile between countries.
5. There is no intervention by the government in the economic system.
6. Perfect competition exists both in the commodity and factor markets.
7. There is full employment of resources in both the countries.

This two-country, two-commodity model can be analysed through the Table 2.3
Country Labour cost per unit of Exchange ratio
commodity in hours
Cloth Wheat Domestic Domestic
exchange ratio of exchange ratio of
Cloth Wheat
England 12 10 1 unit of cloth = 1 unit of wheat =
12/10 or 1.20 units 10/12 or 0.83 units
of wheat of cloth
Portugal 16 12 1 unit of cloth = 1 unit of wheat =
16/12 or 1.33 units 12/16 or 0.75 unit
of wheat of cloth
 The above table indicates that England has an absolute advantage in
producing both the commodities through smaller inputs of labour than Portugal. It
does not mean that England will specialise in both cloth and wheat and Portugal
will have nothing to export. In England, the domestic exchange ratio between cloth
and wheat is 12:10, i.e., 1 unit of cloth = 12/10 or 1.20 units of wheat.
Alternatively, 1 unit of wheat = 10/12 or 0.83 units of cloth. In Portugal, the
domestic exchange ratio is 16:12, i.e., 1 unit of cloth = 16/12 or 1.33 units of
wheat. Alternatively, 1 unit of wheat = 16/12 or 0.75 unit of cloth.
From the above cost ratios, it follows that England has comparative cost
advantage in the production of cloth and Portugal has comparatively lesser cost
disadvantage in the production of wheat. . Accordingly, England will specialise in
the production and export of cloth, while Portugal will specialise in the production
and export of wheat.

Diagrammatic representation of the gains from trade

In the following figure, AA1 and BB1 are the production possibility curves
pertaining to England and Portugal. Using the same amount of productive
resources, England can produce larger quantities of both commodities than
Portugal and hence England has an absolute cost advantage over Portugal in
respect of both [Link] the curve BC1 is drawn parallel to AA1, the curve
BC1 can represent the production possibility curve of England. If England gives up
OB quantity of wheat and diverts resources to the production of cloth, it can
produce OC1 quantity of cloth, which is more than OB1. It means that England has
a comparative cost advantage in the production of cloth.

From the point of view of Portugal, it can produce the same quantity OB of wheat,
if it gives up the production of smaller quantity OB1 of cloth. It signifies that
Portugal has less comparative disadvantage in the production of wheat.
Accordingly, England will specialise in the production and export of cloth, while
Portugal will specialise in the production and export of wheat.

Criticism

1. The theory assumes that there are no other costs except labour costs.
2. The theory assumes constant returns to scale. Diminishing returns are
likely to set in as scale increases.
3. The theory ignores differences in transport cost.
4. The assumption that labour is mobile only within the country is not
valid.
5. The theory assumes the existence of perfect competition.
6. Actual international trade is influenced by various government
restrictions like tariffs and other trade restrictions.
7. The assumption of full employment is not valid.
Heckscher - Ohlin theory of international trade (Factor endowment theory)

The Heckscher-Ohlin theorem was developed by Eli Heckscher and Bertil

Ohlin. The theory states that the capital abundant country will export capital
intensive goods and import labour intensive goods and the labour abundant country
will export labour intensive goods and import capital intensive goods.
Ohlin pointed out that differences in factor endowments of nations and
difference in factor proportions of producing different commodities form the
ultimate basis of international trade.
Assumptions
1. There are only two factors of production.
2. It is a two country two commodity model.
3. There is perfect competition.
4. There is full employment.
5. There are no transport costs.
In the figure, the production possibility curve of country A is AB that of country B
is CD. Steel is the capital intensive good and cloth is the labour intensive good.

Suppose, the two countries produced the goods in the same proportion along
the ray OR. Country A would produce at Q1 and country B at Q2 on their respective
production possibility curves. The slope of country A’s production-possibility
curve at Q1, is steeper than the corresponding slope of country B at Q2. This
implies that steel is cheaper in country A and cloth is cheaper in country B, if the
two countries are producing at Q1 and Q2 respectively. Country A would,
therefore, tend to expand production of steel and country B would do so for cloth.
This means that country A, a capital abundant country, has a production bias in
favour of the capital-intensive good, steel, while the labour-abundant country,
country B, has a bias in favour of producing the labour intensive good, cloth.

Merits
1. The H-O theory takes into account both the demand and supply factors
for determining international trade.
2. This model lays down a permanent basis for international trade.
3. The theory maintains that production involves two factors of
production-labour and capital.
4. The theory is based upon the general theory of value.
5. This theory explains the reason for comparative cost differences
between nations in terms of factor endowments.
Criticism
1. It is a two commodity model.
2. The theory assumes perfect competition.
3. The theory assumes that there is full employment.
4. The theory ignores differences in transport cost.

Balance of payments

Balance of payments (BOP) sheet is an accounting record of all monetary

transactions between a country and the rest of the world. These transactions
include payments for the country's exports and imports of goods, services, financial
capital and financial transfers. The BOP summarizes the international transactions
for a specific period, usually a year. Sources of funds for a nation, such as exports
or the receipts of loans and investments, are recorded as positive or surplus items.
Uses of funds, such as for imports or investment in foreign countries are recorded
as negative or deficit items.
Importance of balance of payments
1. The BOP statement of a country is an indicator of its economic status
in the world.
2. It helps the government formulate its trade policies.
Components of BOP

The BOP is divided into three main components or elements: the current
account, the capital account, and the financial account.

1. The Current Account

It is used to monitor the inflow and outflow of goods and services in a
country. It is called current since it refers to transactions currently occurring - those
that do not give rise to future claims. The trade position of the country is reflected
by the current account. A current account is in balance when the country has
enough resources to fund all of its foreign purchases. India has a current account
deficit.
The current account consists of:
a. Merchandise trade. This is referred to as visible trade. This is the trade in
manufactured goods and raw materials.
b. Services. This is referred to as invisible trade. It is the sale of services like travel
and tourism, insurance, engineering, patents and copyrights etc.
c. Income receipts. This includes income derived from ownership of assets abroad
such as dividends from shares and interest from bonds.
d. Unilateral transfers. These include worker remittances from abroad, foreign
aid, contribution to charitable institutions and gifts from one country to another.

When combined, goods and services together make up a country's balance of trade
(BOT). The BOT forms the biggest bulk of a country's balance of payments as it
makes up total imports and exports. If a country has a balance of trade deficit, it
imports more than it exports, and if it has a balance of trade surplus, it exports
more than it imports.
2. The Capital Account
The capital account refers to the net change in ownership of foreign assets. It
is where all international capital transfers are recorded. This refers to the
acquisition or disposal of international assets. If a country purchases more foreign
assets than it sells then the capital account is said to be in deficit.
The capital account is divided into:
a. Capital transfers.
b. Purchase and sale of real assets.

3. The Financial Account

In the financial account, international monetary flows related to investment
in business, real estate, bonds, and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights
held with the International Monetary Fund, private assets held abroad, and direct
foreign investment.
Assets owned by foreigners are also recorded in the financial account.

Apart from the above three major components, bop also includes:
4. Official reserve account.
It refers to the foreign currency held by the central bank of a country and is
used to balance the payments from year to year.

5. Errors and Omissions

Sometimes the balance of payments does not balance. It is due to errors that
have crept in during the compilation of the bop statement. Hence an entry called
errors and omissions is made to reflect this imperfection.
Balance of Payments deficit
The international BOP of a country reflects its economic strengths and weaknesses.
Surpluses or deficits in the bop can lead to imbalances between countries. In
general there is concern over deficits in the current account. Countries with deficits
in their current accounts will build up increasing debt or see increasing foreign
ownership of their assets.

Reasons for disequilibrium in balance of payments

1. Economic Factors
a) The BOP will have deficits if the level of imports in a country is high.
b) Lack of adequate international capital inflow into a country.
c) External borrowings and loans from foreign countries.
d) Rising petroleum prices have put a strain on the forex reserves of
several countries.
e) The quality of products of developing countries are not up to the world
standards due to which they could not sustain foreign markets.

2. Political Factors
a) Political instability in a country creates uncertainty among foreign
investors which leads to a reduced inflow of foreign capital into the
country.
b) Disequilibrium in BOP also occurs in the event of fear of war with
some other country.
3. Structural Factors
a) The high degree of protection given to domestic industries leads to
inefficiency and poor quality products. Hence exports suffer.
b) In the case of India, the instability in the exchange value of the rupee
was another problem. This has created problems for both exporters and
importers. Even though the value of rupee was managed by the central
bank, it was not able to maintain stability since the currency was often
affected by factors beyond the control of the RBI.
 4. Social Factors
a) Countries like India export mainly agriculture and agro based products.
The price of these have fluctuated heavily in the world markets.
b) Indian agricultural exports were constantly affected by crop failures.
5. Technological Factors
a) The lack of thrust in research and development has created a situation
where countries like India have very few products that foreigners find
attractive.
b) Excessive stress on technology intensive export-oriented industries by
countries like China has resulted in bop disequilibrium in countries like
India.

Methods to correct disequilibrium in the BOP

1. Monetary Measures
a) Monetary Policy. Monetary policy is the policy concerned with the
supply of money in the economy. A reduction in the money supply will
decrease the purchasing power of the people. Demand will decline and
prices will come down. This reduces imports and encourages exports.
b) Devaluation. It is the lowering of the exchange value of the currency of
a country. When a country devalues its currency, exports become cheaper
and imports become expensive which causes a reduction in the BOP
deficit.
c) Exchange Control. In 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.

2. Trade policy measures

a) Export Promotion. The country tries to increase exports by adopting
various measures like reducing export duties, providing incentives to
exporters, providing subsidies to exporters and exempting exports from
taxes.
 b) Import Substitution. Steps may be taken to encourage the production of
goods which are currently being imported. This will save valuable
foreign exchange.
c) Import Control. Imports and foreign travel is strictly monitored since
they take away valuable foreign exchange. All foreign exchange earned
has to be surrendered to RBI which then rations it out.

3. Non- Monetary measures

a) Promoting international travel and tourism.

b) Inviting foreign companies to come and invest in the country.
c) Taking extra efforts to ensure that Indians working abroad deposit their
savings in banks in India.
d) Postponing debt repayments.
e) Keeping inflation under control.
f) Check on smuggling

Devaluation
It is the lowering of the exchange value of the currency of a country. When a
country devalues its currency, exports become cheaper and imports become
expensive which causes a reduction in the BOP deficit.
As a result of reduction in the exchange rate of a currency with respect to
foreign currencies, the prices of goods to be exported fall, whereas prices of
imports go up. This encourages exports and discourages imports. With exports so
stimulated and imports discouraged, the deficit in the balance of payments will
tend to be reduced.

Objectives of Devaluation
1. To ​ boost​ exports. Imports become more expensive and exports
become more competitive and lucrative.
2. To encourage a greater quantity of export from the country whose
currency is being devalued.
 3. To reduce trade deficits. The increase in exports along with a reduction
in imports will cause a positive impact on the balance of trade.
4. To lower the cost of a country’s external debt.

Condition for devaluation

Devaluation will be effective only if the demand for exports is elastic. The
value of price elasticity should be greater than 1. In the following figure, the
demand curve is elastic. Even a small percentage change in the price of exports
will result in a large percentage change in quantity. The loss in revenue due to a
decline in price is more than compensated by the gain in revenue due to the
increase in quantity purchased. Hence devaluation is recommended.

In the figure given below, the demand curve is inelastic. A large percentage change
in the price of exports will result in a small percentage change in quantity. The loss
in revenue due to a decline in price is more than the gain in revenue due to the
increase in quantity purchased.
Limitations of devaluation
1. Devaluation may cause inflation. Higher exports due to the devaluation
in the currency will increase the level of income of the consumers
causing domestic demand to rise, which raises prices.
2. It can result in an increase in the production cost of commodities that
depend on inputs that are imported.
3. Domestic companies that have taken international loans will face
greater servicing costs.
4. It will foster uncertainty within the global markets.
5. Devaluation may also spark trade wars. It will create tension with other
competing countries.

Free trade versus protection

Free trade
Free trade occurs when there are no artificial barriers put in place by
governments to restrict the flow of goods and services between trading nations.
When trade barriers, such as tariffs and subsidies are put in place, they protect
domestic producers from international competition and redirect, rather than create
trade flows.

Free trade is supported as the policy, which is most conducive to maximizing

the economic welfare of a given society. It is argued that free trade allows different
economies to make use of comparative advantages by the exchange of
commodities. After the signing of the General Agreement on Tariffs and Trade, per
capita growth was at an all-time high while tariffs were at a historically low level.
People within a national economy will all be better off if they specialize at what
they do best instead of trying to be self-sufficient.

Advantages of free trade

1. International trade enables countries to specialize in the production of
those commodities in which they have a comparative advantage.
2. It increases the size of a firm’s market, resulting in lower average costs
and higher productivity.
 3. International competition promotes innovative production, new
technology and marketing.
4. Consumers benefit in the domestic economy as they can now obtain a
greater variety of goods and services.
5. The increased competition ensures commodities are supplied at the
lowest prices.
6. It results in foreign exchange gains. When India sells its products
abroad, it receives foreign currency. This money is then used to pay for
imports that are produced more cheaply overseas.
7. Free trade creates new jobs in the domestic economy. Employment will
increase in exporting industries.
8. The countries involved in free trade experience rising living standards,
increased real incomes and higher rates of economic growth. This is
created by more competitive industries, increased productivity, efficiency
and production levels
9. Greater access to imports will benefit consumers and businesses by
widening the choice of products available and boosting the living
standards of the people.
10. Having a bigger market to sell to means that a business can sell more,
earn more profits and pay higher wages. Exporting businesses pay more
to workers and sell more per worker than non-exporters.
Protectionism

It is the policy of protecting domestic industries by imposing high customs

duties on foreign products. Economic theory does not rule out protectionism as a
welfare maximizing policy option. Whether or not a particular economy warrants
protection depends on whether it will maximize the economic welfare of its
populace. Historically, most economies developed while significant tariffs were in
place and high tariffs tended to coincide with relatively high rates of per capita
GDP growth.

Advantages of protectionism

1. The main argument for protectionism is the infant industry

argument. Industries in developing countries can effectively compete with
 those already developed if they receive some initial protection in the form
of tariffs or subsidies.
2. Increased economic stability as economies do not become dependent
on global markets. This means that businesses are not vulnerable to
downturns in the economies of their trading partners, e.g. Recession in the
USA leads to decreased demand for India’s exports, leading to falling
export incomes, lower GDP, lower incomes, lower domestic demand, and
rising unemployment.
3. Countries with surplus products may dump them on world markets
at prices below the cost of production.
4. Countries whose economies are largely agricultural face
unfavourable terms of trade. Their export income is much smaller than the
import payments they make for high value imports resulting in large
foreign debt levels.
5. All round industrial development will occur in the country since it
cannot depend on foreign industries.
6. Free trade can lead to pollution and other environmental problems as
companies fail to include these costs in the price of goods while trying to
compete with companies operating under weaker environmental legislation
in some countries.
7. If old traditional industries are not protected, foreign competition
may ruin them and create unemployment.
8. It is unwise to export all the natural resources of a country. For
example, India has exhausted its large supply of manganese and mica in
the name of earning foreign exchange.
9. Protective import duties are a way to generate tax revenue.

Trade policy
Trade policy refers to the regulations and policies that state how a country
carries out international trade with other foreign countries. It is also referred to as
commercial policy. It consists of tariffs on imported goods, quotas, export
constraints and restrictions on the domestic operations of foreign companies.
Subsidies may also be provided to domestic industries to enable them to compete
with foreign industries.
A major component of trade policy are trade barriers consisting of tariffs and
non-tariff barriers.

Tariff
A tariff is a tax imposed by one country on the goods and services imported
from another country. Tariffs are used to restrict imports. They increase the price of
goods purchased from another country, making them less attractive to domestic
consumers. They are used to (a) discourage domestic consumers from consuming
foreign goods and (b) encourage consumption and production of the domestically
produced import-replacement substitutes.

The effect of a tariff is explained with the help of an example from the
American market. The domestic demand curve of American consumers is drawn as
DD and the domestic supply curve of American firms as SS. In a situation where
there is no international trade, price would be high at $8 per unit and domestic
producers would be meeting all the demand.

The world price of cloth is equal to $4 per unit. If international free trade
occurs, the price in America would equal the world price level. The horizontal line
at $4 represents the supply curve for imports, it is horizontal or perfectly
price-elastic because American demand is assumed to be too small to affect the
world price of cloth. Once trade opens up, imports flow into America lowering the
price of clothing to the world price of $4 per unit. Domestic producers will supply
100 units while at that price consumers will want to buy 300 units. The difference,
shown by the line EF, is the amount of clothing imports.

Suppose America imposes a tariff of $2. The price per unit is now $6.
Domestic consumption is now lowered from 300 units in the free-trade equilibrium
to 250 units. Domestic production is raised by 50 units, and the quantity of imports
is lowered by 100 units. A tariff will tend to raise prices, lower the amount
imported and raise domestic production of the goods.
Types of Tariffs
There are several types of tariffs and barriers that a government can employ:

1. Specific tariffs. It is a fixed amount of tariff imposed on one unit of an

imported or exported good.
2. Ad valorem tariffs. It is levied on a good based on a percentage of that
good's value.
3. Countervailing tariffs. These are levied on imported commodities
which are heavily subsidised by foreign governments.
4. Anti-dumping tariffs. These are imposed on imported goods sold in the
country at a price lower than its cost of production.

Advantages of Tariffs
1. Tariffs are a source of revenue for governments.
2. Infant industry argument. Industries in developing countries can
effectively compete with those already developed if they receive some
initial protection in the form of tariffs.
3. By making foreign-produced goods more expensive, tariffs can make
domestically produced alternatives seem more attractive.
4. Governments often use tariffs to benefit particular domestic industries.
5. Tariffs are used to protect companies and jobs.
Disadvantages of Tariffs
1. They create trade distortions.
2. It can hurt domestic consumers since a lack of competition tends to
push up prices.
3. They can make domestic industries less efficient and less innovative by
reducing competition.
4. Tariffs lead to a fall in the volume of international trade.
5. They can generate tensions by favouring certain industries over others.
6. An attempt to pressure a rival country by using tariffs can devolve into
an unproductive cycle of retaliation, commonly known as a trade war.

Non-tariff barriers (NTBs)

A non-tariff barrier is a way to restrict trade using trade barriers in a form
other than a tariff. While tariffs constitute visible barriers to trade, the non-tariff
barriers constitute the hidden or invisible barriers to trade. In more recent years,
these non-tariff barriers have come into greater prominence than the conventional
tariff barriers. These include direct restrictions or quotas, monetary restrictions,
technical and administrative regulations. Their effect on trade is the same as tariffs
- trade restriction and trade distortion causing misallocation of world resources and
reducing global welfare.

Types of Non-Tariff Barriers

There are several types of NTB’s that a government can employ:

1. Quotas. Quantitative restrictions, or quotas, are imposed with a view

to reduce the quantity of imports or exports to a limited size. The effects of quotas
are more severe than those which are created by tariffs since they physically limit
the number of products that a country imports. Import quotas are more common
than export quotas. The world has witnessed severe import quotas of the
mandatory type by the importing countries.
2. Voluntary export restraints. In this case the exporting countries are
asked to put voluntary restraints on their exports.
3. Licenses. Countries may use licenses to limit imported goods to
specific businesses. If a business is granted a trade license, it is permitted to import
goods that would otherwise be restricted for trade in the country.
4. Monetary restrictions. A country can impose foreign exchange
controls to limit the volume of imports. The importer needs foreign exchange to
import foreign goods, and the government of the country can deny the use of
foreign exchange for certain types of imports or for imports from certain counties.
Exchange controls are quite widespread particularly in the poor countries which
experience severe shortage of foreign exchange.
5. Administrative regulations. They include custom restrictions on
banning certain products either on the grounds that they constitute a health hazard
or they do not meet the safety and health regulations in the country. For instance,
imports of food stuffs or fruits or toys are restricted on the ground that they
constitute a potential health hazard endangering the safety of people in the country.
6. Technical regulations. They include regulations with regard to
labelling and packaging.
Advantage of NTBs
1. NTBs support domestic industrial development. It provides sufficient
room for domestic industries to grow, achieve economies of scale, and be
competitive in the international market.
2. NTBs support strategic industrial development. The decline in imports
will divert demand for domestic products.
3. To increase production, domestic companies invest in capital goods
and recruit more local workers. Thus more jobs are created.
4. They create more income and growth in the domestic economy.
5. They are more effective in limiting import volumes. Under quotas, for
example, the main target is the quantity of imports. When the government
tries to reduce imports, quotas are more effective than tariffs because they
directly impact import volumes.
Disadvantages of NTBs
1. Governments cannot generate extra income. Under tariff, the
government imposes a tax on imported goods which will increase
revenue.
2. They limit the functioning of the free market. Countries should
specialize and trade in products in which they have a comparative
advantage. That way, free trade results in maximum benefits globally.
3. The cost of running a business increases. Companies have to fulfil
several administrative requirements such as product standardization.
4. Companies have to follow complicated customs procedures.
5. Exporters face unfair competition in partner countries. Non-tariff
barriers are beneficial for domestic companies but put foreign companies
at a disadvantage.
6. Exporters would be able to sell only fewer goods under the quota
policy. When exposed to quota restrictions, they have to find other
markets to sell their products. If not, they have to cut production,
lowering their income and profits.
7. When the government limits quotas, the market supply decreases. If
domestic companies cannot compensate by increasing production, then
scarcity will occur and prices will rise.
8. Competitiveness weakens in the long term. Competition is essential for
promoting efficiency, and productivity.