International Economics (Unit 1)
Characteristics of international trade
Territorial specialization: International trade among the countries is possible only because each country has certain resources that can be well utilized for the production of certain type of commodity that is not available in other countries or available in very less quantities.Hence, each country has some sort off comparative cost advantage that means each country can produce a good at a lower price than the other country and hence, can export that.
International competition: Producers from different nations are always in a race with one another to sell their products in as much quantity as possible. Thus, advertisements, sales promotion activities are very helpful in these types of selling techniques.
Separation of sellers from buyers -Each country is separated by a large geographical distance and hence, the buyers and the sellers are unable to meet each other physically. They contact each other through mass communication devices such as telephones, internet, video conferencing etc.
Long chain of middleman-Since the buyers and the sellers are unable to meet each other, they have to rely on long chain of middleman to complete their international transactions. It does increases the cost of the goods of the buyers and hence, the imported goods are much expensive.
Mutually acceptable currency: All the nations, except countries of Europe, have their own currencies and other modes of payment. Hence, it is not possible to have a common currency for exchange between nations. Thus, dollars, pounds are selected for this purpose and hence, they are called "hard currencies". These currencies are acceptable all over the world.
International rules and regulations: Each buyer and seller involved in the international trade have to complete the guidelines and norms set up the custom authorities of the others country. They have to follow the restrictions of that nation.
Government control: The government of every nation exercises effective control over the export and import trade of the nation. Hence, various types of formalities and documents have to be submitted to the government.
Basis of international or foreign trade -
Foreign trade is based on the theory of comparative cost advantage.It states that every nation exercises certain kinds of benefits from the production of a particular type of commodity whose resources are exclusively available in that nation or available in other nations in very less amounts. For example, Iraq and the similar nations have comparative advantage over th production of crude oil. Hence, it can export it to other nations and earn huge profits. Similarly, India specializes in the production of sugarcane and tobacco. No country is self-sufficient and it has to depend on other nations to obtain the required inputs be it machines, labor, raw materials or even finished products.
Thus, the need for foreign trade arises due to the following factors:
All nations of the world have to depend on the other nations as it cannot produce every things by itself in a lower cost.
A country may get the resources and manpower to produce all types of commodities but it may be able to get that commodity at a cheaper rate from the other nation who specializes in the production of that commodity.
Similarly, a country may produce some goods at a cheaper rate than the other nation and may try to export it to other nations at a higher rate if there is a surplus.
Difficulties in International trade
Different languages;Different languages are spoken in different nations. Hence, the buyers and the sellers may not be able to communicate with each other effectively. They may have to depend on the translators that are not always reliable.
Risk in transit: Foreign trade involves high risks than the home trade. Many of the risks can be covered by insurance but still, the danger persists.
Lack of information about foreign businessman: A seller is always worried about the credit-worthiness and the financial standing of the prospective buyer as there is no strong proof of the buyers ability to pay. Thus, there is the risk of bad debt for the seller.
Import and export restrictions: Every country charges a high rate of custom taxes and duties on the import of the goods. Also, businessman are required to fill various documents and formalities to complete the transactions. Foreign trade policies and procedures vary from nation to nation and also from time to time.
Study of foreign markets: Every foreign market have its own features. There is different price interactions, demand supply interactions, government policies, marketing methods, customs laws, weights etc. It is very difficult to collect all the information accurately about the foreign markets.
Problems in payments: Every country has its own currency and exchange rates with which the transactions can completed. These exchange rates keep on changing. Remittance of money in foreign trade involves much time and expense. There is also huge risks of bad debt.
Intense competition: There is a huge competition between the sellers of the different nations involved in exporting the same commodity. The one who succeeds in influencing the buyers from the advertisements and other incentives stands out as the winner of the market. Thus, heavy and useless expenses are incurred in these activities.
Advantages of foreign trade
Geographical specialization: Foreign trade permits every nation to produce those goods only that have all the advantages and facilities of being produced at a cheaper rate, thus ensuring full and optimum utilization of the resources such that the country earns maximum profits. It also helps in lowering the cost of production due to the various economies of scale.
Economic development: Foreign trade enables the nation to import manpower, technical assistance from developed nations and machines and other tools required for mass scale production to enable the economies of scale. A county can also earn valuable foreign exchange from the exports of the goods and the services and can utilize them for the economic ans social development.
Economies of scale: Foreign trade enables the nation to produce not only or the home consumption but also for the export. It enables the nation to reap the harvest of the large scale production in the form of economies of scale. It helps in lowering the cost of production.
Generation of employment: Foreign trade assist the development of the agriculture and industrial sectors. Expansion of these activities helps in the generation of new employment opportunities. Also, foreign trade requires long chain of middlemen, that generates employment also.
High standard of living: Due to the globalization, people have an access to the variety of products and services out of which the consumers select the best. Thus, exchange of goods and services between the nations increase the standard of living for the people.
Price equalization: Foreign trade helps in equalizing the prices of goods and services during boom and depression periods. When the prices of the goods tend to fall, the commodities are exported in large quantities so that the surplus can be removed from the nation and there is a balance between demand and supply. Similarly, when the prices of goods rises, the exports are reduced and the imports are increases to balance the demand and the supply.
Security from famine and drought conditions: When the supply of the good and necessities falls drastically, the country may ask for help to the other nation and the other nations may supply the necessary items such as the blankets, medicines, water, food, clothing etc. Foreign trade protects the nation from starvation.
International brotherhood: Through foreign trade, the cultures and the ideas of the nations are exchanges between each other. There is a mutual understanding between the nations that helps to promote the feeling of mutual understanding and brotherhood. It also develops healthy business conditions for both the nations and provide a sense of security to the people as neither of the nations will attack the other.
Disadvantages of foreign trade
Economic dependence: Too much dependent on the other nations in the form of increases imports may seriously affect the economic sovereignty of that nation and may result in the colonization of the nations that are economically and politically weaker.
Restricted growth of home industries: Foreign trade allows the full participation of the foreign industries that in most of the cases, are better in every respect. They sell high quality goods at a very low rate. As such, the domestic industries may face stiff competition from these industries and as a result, may be forced to shut down. This is what happened in India before independence when the domestic industries could not cope up with the textiles of Europe and many hand-made textile industries has to be closed down.
Misuse of natural resources: It may happen that the demands and the nature of demands vary too much from country to country. As such, the exporting industries may be interested to produce those goods only that are in high demand in other nations. As such, the may produce luxury items at the cost of basic necessities. As luxury goods do not have much market in a developing nation like India, it may affect the utilization of the natural resources.
also it politically and Economically dependent on other countries.
Classical Theory of International Trade
Classical economists were oriented primarily toward growth economics, and their main concern was explaining how the “wealth of nations” was increased.
In explaining increased output, specialization and division of labour were given special attention. Adam Smith’s description of how a large number of pins could be produced when labour was specialized by detail functions as opposed to handicraft methods was widely quoted and generalized.
The extent of specialization and division of labour was dependent upon the size of the market; a larger market would encourage a greater degree of specialization and division of labour.
Questions as to the contribution of foreign trade to “wealth of nations” arose. It appeared clear that foreign trade enlarged the market and allowed further gains from specialization and division of labour. However, it was still necessary to set down the arguments clearly to show what goods would be imported and exported and to show the gains from trade.
The classical theory of international trade was formulated primarily with a view to its providing guidance on questions of national policy. Although it included considerable descriptive analysis of economic process, the selection of phenomena to be scrutinized and problems to be examined was almost always made with reference to current issues of public interest.
In the realm of foreign trade, the classical economists were mainly concerned with two questions. First, in the production of what product a country should specialize or which goods a country will export and which it will import. Second, once different countries produce different goods; what will be the ratio of exchange between goods? To the first question, the classical theory gives the following answer.
Each country will specialize in the production of those goods for the production of which it is especially suited on account of its climate, of the qualities of its soil, of its other natural resources, of the innate and acquired capacities of its people, and of the real capital which it possesses as a heritage from its past generation, such as buildings, plants and equipment’s and means of transport. Each country will concentrate upon the production of such goods, producing more of them than it requires for its own needs and exchanging the surplus with other countries against goods which it is less suited to produce or which it cannot produce at all.
The classical theory of trade is based on the labour cost theory of value. This theory states that goods are exchanged against one another according to the relative amounts of labour embodied in them. Goods which have equal prices embody equal amounts of labour.
Adam Smith gives the following well-known illustration. If with the same expenditure of labour one can kill either one beaver or two deer, then one beaver will always exchange in the market against two deer. Thus exchange ratio or prices are determined solely by relative labour costs, through their influence upon supply and demand.
, The labour cost theory of value holds good under following assumptions:
(i) Labour is the only factor,
(ii) All labour is of the same quality or homogeneous,
(iii) Free mobility of labour,
(iv) Every occupation is open to all,
(v) There is free competition between workers,
(vi) The marginal productivity of labour everywhere is equal to its wages.
ADAM SMITH VIEW OF INTERNATIONAL TRADE
Absolute Advantage
Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than another entity that produces the same good or service. An entity with an absolute advantage can produce a product or service at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same good or service.
The concept of absolute advantage was developed by Adam Smith in his book Wealth of Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the funds that good or service generates to purchase goods and services from other countries.By Smith’s argument, specializing in the products that they each have an absolute advantage in and then trading products, can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.
Consider the two hypothetical countries, Atlantica and Krasnovia, with equivalent populations and resource endowments, which each produce two products, Guns and Bacon. Each year Atlantica can produce either 12 Guns or 6 slabs of Bacon, while Krasnovia can produce either 6 Guns or 12 slabs of Bacon. Each country needs a minimum of 4 Guns and 4 slabs of Bacon to survive. In a state of autarky, producing solely on their own for their own needs, Atlantica can spend ⅓ of the year making Guns and ⅔ making Bacon for a total of 4 Guns and 4 slabs of Bacon. Krasnovia can spend ⅓ of the year making Bacon and ⅔ making Guns to produce the same, 4 Guns and 4 slabs of Bacon. This leaves each country at the brink of survival, with barely enough Guns and Bacon to go around. However, not that Atlantica has an absolute advantage in producing Guns, and Krasnovia has an absolute advantage in producing Bacon.
Absolute advantage also explains why it makes sense for individuals, businesses and countries to trade. Since each has advantages in producing certain goods and services, both entities can benefit from trade.
If each country were to specialize in their absolute advantage, Atlantica could make 12 Guns and no Bacon, while Krasnovia makes no Guns and 12 slabs of Bacon. By specializing, the two countries divide the tasks of their labor between them. If they then trade 6 Guns for 6 slabs of Bacon, each country would then have 6 of each. Both countries would now be better off than before, because each would have 6 Guns and 6 Bacon, as opposed to 4 of each good which they could produce on their own.
This mutual gain from trade forms the basis of Adam Smith’s argument that specialization, the division of labor, and subsequent trade leads to an overall increase of wealth from which all can benefit. This, Smith believed, was the root cause of the enormous Wealth of Nations.
Advantage of International Trade: by David Ricardo
The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. It was formulated by David Ricardo in 1815.
The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading.
The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade.
Being dissatisfied with the application of classical labour theory of value in the case of foreign trade,
Ricardo developed a theory of comparative cost advantage to explain the basis of international trade as under
Ricardo stated a theorem that, other things being equal, a country tends to specialise in and export those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage.
The Ricardian Model:
To explain his theory of comparative cost advantage, Ricardo constructed a two-country, two-commodity, but one-factor model with the following assumptions:1. Labour is the only productive factor.
2. Costs of production are measured in terms of the labour units involved.
3. Labour is perfectly mobile within a country but immobile internationally.
4. Labour is homogeneous.
5. There is unrestricted or free trade.
6. There are constant returns to scale.
7. There is full employment equilibrium.
8. There is perfect competition.
Under these assumptions, let us assume that there are two countries A and В and two goods X and Y to be produced.
country A has an absolute advantage over В in the production of X while В has an absolute advantage in producing Y. As such, when trade takes place, A specialises in X and exports its surplus to В and В specialises in У and exports its surplus to A.Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for any country.
It further follows that when countries A and В enter into trade, both will gain. In the absence of trade, domestically in country A, IX = 0.5У. Now, if after trade, assuming the terms of trade to be IX — 1Y, country A gains 0.5 unit more. Similarly, in country В, IX = 0.6 У domestically, after trade, its gain is 0.4Y.
In short, “each country can consume more by trading than in isolation with a given amount of resources. Indeed, the relative gains of the two countries will be conditioned by the terms of trade and one is likely to gain proportionately more than the other but it is definite that both will gain.
In fact, the principle of comparative costs shows that it is possible for both the countries to gain from trade, even if one of them is more efficient than the other in all lines of production.
The theory implies that comparative costs are different in different countries because the abundance of factors which may be necessary for the production of each commodity does not bear the same relation to the demand for each commodity in different countries.
Thus, specialisation based on comparative cost advantage clearly represents a gain to the trading countries in so far as it enables more of each variety of goods to be produced cheaply by utilising the abundant factors fully in the country concerned and to obtain relatively cheaper goods through mutual international exchange.
Ricardo’s theory pleads the case for free trade. He stresses that free-trade is the pre-requisite of gains and improvement of world’s welfare. Free trade “by increasing the general mass of production diffuses general benefit and binds together by one common tie of interest and intercourse, the universal society of nations throughout the civilised world.”
To sum up, what goods will be exchanged in international trade is the main question solved by Ricardo’s theory of comparative costs.
Introduction to Theories of International Trade:
The exchange of goods across national borders is termed as international trade. Countries differ widely in terms of the products and services traded. Countries rarely follow the trade structure of other nations; rather they evolve their own product portfolios and trade patterns for exports and imports. Besides, nations have marked differences in their vulnerabilities to the upheavals in exogenous factors.
Trade is crucial for the very survival of countries that have limited resources, such as Singapore or Hong Kong (presently a province of China), or countries that have skewed resources, such as those located in the Caribbean and West Asian regions. However, for countries with diversified resources, such as India, the US, China, and the UK, engagement in trade necessitates a logical basis.
The trade patterns of a country are not a static phenomenon; rather these are dynamic in nature. Moreover, the product profile and trade partners of a country do change over a period of time. Till recently, the Belgian city of Antwerp, the undisputed leader in diamond polishing and trade, had witnessed a shift of diamond business to India and other Asian countries.
It is also imperative for international business managers to find answers to some basic issues, such as why do nations trade with each other?
Is trading a zero-sum game or a mutually beneficial activity?
Why do trade patterns among countries exhibit wide variations?
Trade theories also offer an insight, both descriptive and prescriptive, into the potential product portfolio and trade patterns. They also facilitate in understanding the basic reasons behind the evolution of a country as a supply base or market for specific products.
The principles of the regulatory frameworks of national governments and international organizations are also influenced to a varying extent by these basic economic theories.
# 2. Theory of Mercantilism of International Trade:
The theory of mercantilism attributes and measures the wealth of a nation by the size of its accumulated treasures. Accumulated wealth is traditionally measured in terms of gold, as earlier gold and silver were considered the currency of international trade. Nations should accumulate financial wealth in the form of gold by encouraging exports and discouraging imports.
The theory of mercantilism aims at creating trade surplus, which in turn contributes to the accumulation of a nation’s wealth. Between the sixteenth and nineteenth centuries, European colonial powers actively pursued international trade to increase their treasury of goods, which were in turn invested to build a powerful army and infrastructure.
The colonial powers primarily engaged in international trade for the benefit of their respective mother countries, which treated their colonies as exploitable resources. The first ship of the East India Company arrived at the port of Surat in 1608 to carry out trade with India and take advantage of its rich resources of spices, cotton, finest muslin cloth, etc.
Other European nations—such as Germany, France, Portugal, Spain, Italy—and the East Asian nation of Japan also actively set up colonies to exploit the natural and human resources.
Mercantilism was implemented by active government interventions, which focused on maintaining trade surplus and expansion of colonization. National governments imposed restrictions on imports through tariffs and quotas and promoted exports by subsidizing production.
The colonies served as cheap sources for primary commodities, such as raw cotton, grains, spices, herbs and medicinal plants, tea, coffee, and fruits, both for consumption and also as raw material for industries. Thus, the policy of mercantilism greatly assisted and benefited the colonial powers in accumulating wealth.
The limitations of the theory of mercantilism are as follows:
i. Under this theory, accumulation of wealth takes place at the cost of another trading partner. Therefore, international trade is treated as a win-lose game resulting virtually in no contribution to the global wealth. Thus, international trade becomes a zero-sum game.
ii. A favorable balance of trade is possible only in the short run and would automatically be eliminated in the long run, according to David Hume’s Price-Specie- Flow doctrine. An influx of gold by way of more exports than imports by a country raises the domestic prices, leading to increase in export prices.
In turn, the county would lose its competitive edge in terms of price. On the other hand, the loss of gold by the importing countries would lead to a decrease in their domestic price levels, which would boost their exports.
iii. Presently, gold represents only a minor proportion of national foreign exchange reserves. Governments use these reserves to intervene in foreign exchange markets and to influence exchange rates.
iv. The mercantilist theory overlooks other factors in a country’s wealth, such as its natural resources, manpower and its skill levels, capital, etc.
v. If all countries follow restrictive policies that promote exports and restrict imports and create several trade barriers in the process, it would ultimately result in a highly restrictive environment for international trade.
vi. Mercantilist policies were used by colonial powers as a means of exploitation, whereby they charged higher prices from their colonial markets for their finished industrial goods and bought raw materials at much lower costs from their colonies. Colonial powers restricted developmental activities in their colonies to a minimum infrastructure base that would support international trade for their own interests. Thus, the colonies remained poor.
A number of national governments still seem to cling to the mercantilist theory, and exports rather than imports are actively promoted. This also explains the raison d’etre behind the ‘import substitution strategy’ adopted by a large number of countries prior to economic liberalization.
Can government policies influence trade?
Theories of international trade provide the raison d’etre for most of these queries.
This strategy was guided by their keenness to contain imports and promote domestic production even at the cost of efficiency and higher production costs. It has resulted in the creation of a large number of export promotion organizations that look after the promotion of exports from the country. However, import promotion agencies are not common in most nations.
Presently, the terminology used under this trade theory is neo-mercantilism, which aims at creating favourable trade balance and has been employed by a number of countries to create trade surplus. Japan is a fine example of a country that tried to equate political power with economic power and economic power with trade surplus.
# 3. Theory of Absolute Advantage of International Trade:
Economist Adam Smith critically evaluated mercantilist trade policies in his seminal book An Inquiry into the Nature and Causes of the Wealth of Nations, first published in 1776. Smith posited that the wealth of a nation does not lie in building huge stockpiles of gold and silver in its treasury, but the real wealth of a nation is measured by the level of improvement in the quality of living of its citizens, as reflected by the per capita income.
Smith emphasized productivity and advocated free trade as a means of increasing global efficiency. As per his formulation, a country’s standards of living can be enhanced by international trade with other countries either by importing goods not produced by it or by producing large quantities of goods through specialization and exporting the surplus.
An absolute advantage refers to the ability of a country to produce a good more efficiently and cost-effectively than any other country.
Smith elucidated the concept of ‘absolute advantage’ leading to gains from specialization with the help of day-today illustrations as follows:
It is the maxim of every prudent master of a family, never to make at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor.
The farmer attempts to make neither one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way which they have some advantage over their neighbors.
What is prudence in the conduct of every private family can scarce be folly in that of great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry. Thus, instead of producing all products, each country should specialize in producing those goods that it can produce more efficiently.
Such efficiency is gained through:
i. Repetitive production of a product, which increases the skills of the labour force.
ii. Switching production from one produce to another to save labour time.
iii. Long product runs to provide incentives to develop more effective work methods over a period of time.
Therefore, a country should use increased production to export and acquire more goods by way of imports, which would in turn improve the living standards of its people. A country’s advantage may be either natural or acquired.
Natural:
Natural factors, such as a country’s geographical and agro-climatic conditions, mineral or other natural resources, or specialized manpower contribute to a country’s natural advantage in certain products. For instance, the agro-climatic condition in India is an important factor for sizeable export of agro-produce, such as spices, cotton, tea, and mangoes.
The availability of relatively cheap labour contributes to India’s edge in export of labour-intensive products. The production of wheat and maize in the US, petroleum in Saudi Arabia, citrus fruits in Israel, lumber in Canada, and aluminium ore in Jamaica are all illustrations of natural advantages.
Acquired Advantage:
Today, international trade is shifting from traditional agro-products to industrial products and services, especially in developing countries like India. The acquired advantage in either a product or its process technology plays an important role in creating such a shift.
The ability to differentiate or produce a different product is termed as an advantage in product technology, while the ability to produce a homogeneous product more efficiently is termed as an advantage in process technology.
Production of consumer electronics and automobiles in Japan, software in India, watches in Switzerland, and shipbuilding in South Korea may be attributed to acquired advantage. Some of the exports centers in India for precious and semiprecious stones in Jaipur, Surat, Navasari, and Mumbai have come up not because of their raw material resources but the skills they have developed in processing imported raw stones.
To illustrate the concept of absolute advantage, an example of two countries may be taken, such as the UK and India. Let us assume that both the countries have the same amount of resources, say 100 units, such as land, labour, capital, etc., which can be employed either to produce tea or rice.
However, the production efficiency is assumed to vary between the countries because to produce a tonne of tea, UK requires 10 units of resources whereas India requires only 5 units of resources. On the other hand, for producing one tonne of rice, UK requires only 4 units of resources whereas India needs 10 units of resources (Table 2.1).
Since India requires lower resources compared to UK for producing tea, it is relatively more efficient in tea production. On the other hand, since UK requires fewer resources compared to India for producing rice, it is relatively more efficient in producing rice.
Although each country is assumed to possess equal resources, the production possibilities for each country would vary, depending upon their production efficiency and utilization of available resources.
All of the possible combinations of the two products that can be produced with a country’s limited resources may be graphically depicted by a production possibilities curve (Fig. 2.1), assuming total resource availability of 100 units with each country.
The slope of the curve reflects the ‘trade-off of producing one product over the other, representing opportunity cost. The value of a factor of production forgone for its alternate use is termed as opportunity cost.
For instance, if the UK wishes to produce one tonne of tea, it has to forgo the production of 2.5 tonnes of rice. Whereas in order to produce one unit of rice, it has to relinquish the production of only 0.40 tonne of tea.
Suppose no foreign trade takes place between the two countries and each employs its resources equally (i.e., 50:50) for production of tea and rice. The UK would produce 5 tonnes of tea and 12.5 tonnes of rice at point B whereas India would produce 10 tonnes of tea and 5 tonnes of rice at point A as shovra in Fig. 2.1.
This would result in a total output of 15 tonnes of tea and 17.5 tonnes of rice (Table 2.2). If both India and the UK employ their resources on production of only tea and rice, respectively, in which each of them has absolute advantage, the total output, as depicted in Fig. 2.1, of tea would increase from 15 tonnes to 20 tonnes (point C) whereas rice would increase from 17.5 tonnes to 25 tonnes (point D).
Thus, both countries can mutually gain from trading, as the total output is enhanced
The theory of absolute advantage is based on Adam Smith’s doctrine of laissez faire that means ‘let make freely’. When specifically applied to international trade, it refers to ‘freedom of enterprise’ and ‘freedom of commerce’.
Therefore, the government should not intervene in the economic life of a nation or in its trade relations among nations, in the form of tariffs or other trade restrictions, which would be counterproductive.
A market would reach to an efficient end by itself without any government intervention. Unlike as suggested by the mercantilist theory, trading is not a zero-sum game under the theory of absolute advantage, wherein a nation can gain only if a trading partner loses. Instead, the countries involved in free trade would mutually benefit as a result of efficient allocation of their resources.
# 4. Theory of Comparative Advantage of International Trade:
In Principles of Political Economy and Taxation, David Ricardo (1817) promulgated the theory of comparative advantage, wherein a country benefits from international trade even if it is less efficient than other nations in the production of two commodities.
Comparative advantage may be defined as the inability of a nation to produce a good more efficiently than other nations, but its ability to produce that good more efficiently compared to the other good.
Thus, the country may be at an absolute disadvantage with respect to both the commodities but the absolute disadvantage is lower in one commodity than another.
Therefore, a country should specialize in the production and export of a commodity in which the absolute disadvantage is less than that of another commodity or in other words, the country has got a comparative advantage in terms of more production efficiency.
To illustrate the concept, let us assume a situation where the UK requires 10 units of resources for producing one tonne of tea and 5 units for one tonne of rice whereas India requires 5 units of resources for producing one tonne of tea and 4 units for one tonne of rice . In this case, India is more efficient in producing both tea and rice. Thus, India has absolute advantage in the production of both the products.
Although the UK does not have an absolute advantage in any of these commodities it has comparative advantage in the production of rice as it can produce rice more efficiently. Countries also gain from trade by employing their resources for the production of goods in which they are relatively more efficient.
Measuring Comparative Advantage:
The Balassa Index is often used as a useful tool to measure revealed comparative advantage (RCA) that measures the relative trade performance of individual countries in particular commodities.It is assumed to ‘reveal’ the comparative advantage of trading countries, based on the assumption that the commodity patterns of trade reflects the inter-country differences in relative costs as the well as the non-price factors. The factors that contribute to the changes in the RCA of a country include economic factors, structural changes, improved world demand, and trade specialization.
RCA is defined as a country’s share of world exports of a commodity divided by its share in total exports. The index for commodity j from country i is computed as
RCAij = (Xij/Xwj)/(Xi/Xw)
Where,
Xij = i th country’s export of commodity j
Xwj = world exports of commodity j
Xi = total export of country i
Xw = total world exports
If the value of the index of revealed comparative advantage (RCAij) is greater than unity (i.e., 1), the country has a RCA in that commodity. The RCA index considers the intrinsic advantage of a particular export commodity and is consistent with the changes in the economy’s relative factor endowment and productivity. However, it cannot distinguish between the improvements in factor endowments and the impact of the country’s trade policies.
China has an RCA in industries such as clothing, electronics, information technology (IT) and consumer electronics, leather products, textiles, and miscellaneous manufacturing that belongs to different technology categories (i.e., low, medium, and high) but not in resource-base manufacture.
On the other hand, India has an RCA in resource-based and low-technological industries, such as fresh food, leather products, minerals, textiles, basic manufacture, chemicals, and clothing.
It is also observed that the US, Japan, and the UK have an RCA in high- and medium- technology categories, such as IT, consumer electronics, electronics, manufacturing, etc., whereas China’s main competitors such as Mexico, Hong Kong, and Thailand have RCA in low-, medium-, and high-technology categories.
This implies that countries specializing in medium- to high-technology products may explore opportunities of expanding bilateral trade with India and those in resource-based industries may stand to benefit substantially by an increase in demand of such products in China.
For example, Latin American countries mainly produce and export various commodities. The major producer of Latin America is copper, oil, soy, and coffee, as the region produces about 47 per cent of the world soybean crop, 40 per cent of copper, and 9.3 per cent of oil.
The rising demand for commodities in China and other countries presents opportunities to these countries for expanding their production and increasing foreign exchange revenues. Similarly, the rapid growth in economic activities in India and China opens up opportunity for oil exporting countries. Thus, revealed comparative advantage may be employed as a useful tool to explain international trade patterns.
Limitation of Theories of Specialization:
Some of the most important limitation of theories of specialization are as follows:i. Theories of absolute and comparative advantage lay emphasis on specialization with an assumption that countries are driven only by the impulse of maximization of production and consumption. However, the attainment of economic efficiency in a specialized field may not be the only goal of countries. For instance, the Middle East countries have spent enormous resources and pursued a sustained strategy in developing their agriculture and horticulture sector, in which these countries have very high absolute and comparative disadvantage, so as to become self-reliant.
ii. Specialization in one commodity or product may not necessarily result in efficiency gains. The production and export of more than one product often have a synergistic effect on developing the overall efficiency levels.
iii. These theories assume that production takes place under full employment conditions and labour is the only resource used in the production process, which is not a valid assumption.
iv. The division of gains is often unequal among the trading partners, which may alienate the partner perceiving or getting lower gains, who may forgo absolute gains to prevent relative losses.
v. The original theories have been proposed on the basis of two countries-two commodities situation. However, the same logic applies even when the theories experimented with multiple-commodities and multiple-countries situations.
vi. The logistics cost is overlooked in these theories, which may defy the proposed advantage of international trading.
vi. The sizes of economy and production runs are not taken into consideration.
# 5. Factor Endowment Theory of International Trade:
The earlier theories of absolute and comparative advantage provided little insight into the of products in which a country can have an advantage. Heckscher (1919) and Bertil Ohhn (1933) developed a theory to explain the reasons for differences in relative commodity prices and competitive advantage between two nations.According to this theory, a nation will export the commodity whose production requires intensive use of the nation’s relatively abundant and cheap factors and import the commodity whose production requires intensive use of the nation’s scarce and expensive factors.
Thus, a country with an abundance of cheap labour would export labour-intensive products and import capital-intensive goods and vice versa. It suggests that the patterns of trade are determined by factor endowment rather than productivity.
The theory suggests three types of relationships, which are discussed here:
(i) Land-Labour Relationship:
A country would specialize in production of labour intensive goods if the labour is in abundance (i.e., relatively cheaper) as compared to the cost of land (i.e., relatively costly). This is mainly due to the ability of a labour-abundant country to produce something more cost-efficiently as compared to a country where labour is scarcely available and therefore expensive.
(ii) Labour-Capital Relationship:
In countries where the capital is abundantly available and labour is relatively scarce (therefore most costly), there would be a tendency to achieve competitiveness in the production of goods requiring large capital investments.
(iii) Technological Complexities:
As the same product can be produced by adopting various methods or technologies of production, its cost competitiveness would have great variations. In order to minimize the cost of production and achieve cost competitiveness, one has to examine the optimum way of production in view of technological capabilities and constraints of a country.
The Leontief Paradox:
According to the factor endowment theory, a country with a relatively cheaper cost of labour would export labour-intensive products, while a country where the labour is scarce and capital is relatively abundant would export capital-intensive goods.
Wassily Leontief carried out an empirical test of the Heckscher-Ohlin Model in 1951 to find out whether or not the US, which has abundant capital resources, exports capital-intensive goods and imports labour-intensive goods. He found that the US exported more labour-intensive commodities and imported more capital-intensive products, which was contrary to the results of Heckscher-Ohlin Model of factor endowment.
# 6. Country Similarity Theory of International Trade:
As per the Heckscher-Ohlin theory of factor endowment, trade should take place among countries that have greater differences in their factor endowments. Therefore, developed countries having manufactured goods and developing countries producing primary products should be natural trade partners.A Swedish economist, Staffan B. Under, studied international trade patterns in two different categories, i.e., primary products (natural resource products) and manufactures.
It was found that in natural resource-based industries, the relative costs of production and factor endowments determined the trade. However, in the case of manufactured goods, costs were determined by the similarity in product demands across countries rather than by the relative production costs or factor endowments.
It has been observed that the majority of trade occurs between nations that have similar characteristics. The major trading partners of most developed countries are other developed industrialized countries.
The country similarity theory is based on the following principles:
i. If two countries have similar demand patterns, then their consumers would demand the same goods with similar degrees of quality and sophistication. This phenomenon is also known as preference similarity. Such a similarity leads to enhanced trade between the two developed countries.
ii. The demand patterns in countries with a higher level of per capita income are similar to those of other countries with similar income levels, as their residents would demand more sophisticated, high quality, ‘luxury’ consumer goods, whereas those in countries with lower per capita income would demand low quality, cheaper consumer goods as a part of their ‘necessity’.
Since developed countries would have a comparative advantage in the manufacture of complex, technology-intensive luxury goods, they would find export markets in other high income countries.
iii. Since most products are developed on the demand patterns in the home market, other countries with similar demand patterns due to cultural or economic similarity would be their natural trade partners.
iv. Countries with the proximity of geographical locations would also have greater trade compared to the distant ones. This can also be explained by various types of similarities, such as cultural and economic, besides the cost of transportation. The country similarity theory goes beyond cost comparisons. Therefore, it is also used in international marketing.
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# 7. New Trade Theory of International Trade:
Countries do not necessarily trade only to benefit from their differences but they also trade so as to increase their returns, which in turn enable them to benefit from specialization. International trade enables a firm to increase its output due to its specialization by providing a much larger market those results in enhancing its efficiency.
The theory helps explain the trade patterns when markets are not perfectly competitive or when the economies of scale are achieved by the production of specific products. Decrease in the unit cost of a product resulting from large scale production is termed as economies of scale.
Since fixed costs are shared over an increased output, the economies of scale enable a firm to reduce it’s per unit average cost of production and enhance its price competitiveness.
(i) Internal Economies of Scale:
Companies benefit by the economies of scale when the cost per unit of output depends upon their size. The larger the size, the higher are the economies of scale. Firms that enhance their internal economies of scale can decrease their price and monopolize the industry, creating imperfect market competition. This in turn results in the lowering of market prices due to the imperfect market competition.
Internal economies of scale may lead a firm to specialize in a narrow product line to produce the volume necessary to achieve cost benefits from scale economies.
Industries requiring massive investment in R&D and creating manufacturing facilities, such as branded software by Microsoft, microprocessors by Intel or AMD, and aircrafts by Boeing or Airbus, need to have a global market base so as to achieve internal economies of scale and compete effectively.
(ii) External Economies of Scale:
If the cost per unit of output depends upon the size of the industry, not upon the size of an individual firm, it is referred to as external economies of scale. This enables the industry in a country to produce at a lower rate when the industry size is large compared to the same industry in another country with a relatively smaller industry size.
The dominance of a particular country in the world market in a specific products sector with higher external economies of scale is attributed to the large size of a country’s industry that has several small firms, which interact to create a large, competitive critical mass rather than a large-sized individual firm.
However, external economies of scale do not necessarily lead to imperfect markets but may enable the country’s industry to achieve global competitiveness. Although no single firm needs to be large, a number of small firms in a country may create a competitive industry that other countries may find difficult to compete with.
The automotive component industry o India and the semiconductor industry in Malaysia are illustrations of external economies of scale. The development of sector-specific industrial clusters, such as brassware in Moradabad, hosiery in Tirupur, carpets in Bhadoi, semi-precious stones in jaipur, and diamond polishing in Surat, may also be attributed to external economies
The new trade theory brings in the concept of economies of scale to explicate the Leontief paradox. Such economies of scale may not be necessarily linked to the differences in factor endowment between the trading partners. The higher economies of scale lead to increase in returns, enabling countries to specialize in the production of such goods and trade with countries with similar consumption patterns.
Besides intra-industry trade, the theory also explains intra-firm trade between the MNEs and their subsidiaries, with a motive to take advantage of the scale economies and increase their returns.
# 8. International Product Life-Cycle Theory of International Trade:
International markets tend to follow a cyclical pattern due to a variety of factors over a period of time, which explains the shifting of markets as well as the location of production. The level of innovation and technology, resources, size of market, and competitive structure influence trade patterns.
In addition, the gap in technology and preference and the ability of the customers in international markets also determine the stage of international product life cycle (IPLC).
In case the innovating country has a large market size, as in case of the US, India, China, etc., it can support mass production for domestic sales. This mass market also facilitates the producers based in these countries to achieve cost-efficiency, which enables them to become internationally competitive.
However, in case the market size of a country is too small to achieve economies of scale from the domestic market, the companies from these countries can alternatively achieve economies of scale by setting up their marketing and production facilities in other cost-effective countries.
Thus, it is the economies of scope that assists in achieving the economies of scale by expanding into international markets. The theory explains the variations and reasons for change in production and consumption patterns among various markets over a time period
IPLC has four distinct identifiable stages that influence demand structure, production, marketing strategy, and international competition as follows.
(i) Introduction:
Generally, it is in high-income or developed countries that the majority of new product inventions take place, as product inventions require substantial resources to be expended on R&D activities and need speedy recovery of the initial cost incurred by way of market-skimming pricing strategies.
Since, in the initial stages, the price of a new product is relatively higher, buying the product is only within the means and capabilities of customers in high-income countries. Therefore, a firm finds a market for new products in other developed or high income countries in the initial stages.
(ii) Growth:
The demand in the international markets exhibits an increasing trend and the innovating firm gets better opportunities for exports. Moreover, as the market begins to develop in other developed countries, the innovating firm faces increased international competition in the target market.
In order to defend its position in international markets, the firm establishes its production locations in other developed or high income countries.
(iii) Maturity:
As the technical know-how of the innovative process becomes widely known, the firm begins to establish its operations in middle- and low-income countries in order to take advantage of resources available at competitive prices.
(iv) Decline:
The major thrust of marketing strategy at this stage shifts to price and cost competitiveness, as the technical know-how and skills become widely available. Therefore, the emphasis of the firm is on most cost-effective locations rather than on producing themselves.
Besides other middle-income or developing countries, the production also intensifies in low-income or least-developed countries (LDCs). As a result, it has been observed that the innovating country begins to import such goods from other developing countries rather than manufacturing itself.
The UK, which was once the largest manufacturer and exporter of bicycles, now imports this product in large volumes. The bicycle is at the declining stage of its life cycle in industrialized countries whereas it is still at E
a growth or maturity stage in a number of developing countries.
The chemical and hazardous industries are also shifting from high-income countries to low-income countries as a part of their increasing concern about environmental issues, exhibiting a cyclical pattern in international markets.
Although the product life cycle explains the emerging pattern of international markets, it has got its own limitations in the present marketing era with the fast proliferation of market information, wherein products are launched more or less simultaneously in various markets.
# 9. Theory of Competitive Advantage of International Trade:\
As propounded by Michael Porter in The Competitive Advantage of Nations, the theory of competitive advantage concentrates on a firm’s home country environment as the main source of competencies and innovations. The model is often referred to as the diamond model, wherein four determinants as
Porter’s diamond consists of the following attributes:
(i) Factor (Input) Conditions:
Factor conditions refer to how well-endowed a nation is as far as resources are concerned. These resources may be created or inherited, which include human resources, capital resources, physical infrastructure, administrative infrastructure, information infrastructure, scientific and technological infrastructure, and natural resources.
The efficiency, quality, and specialization of underlying inputs that firms draw while competing in international markets are influenced by a country’s factor conditions.
The inherited factors in case of India, such as the abundance of arable land, water resources, large workforce, round-the-year sunlight, biodiversity, and a variety of agro-climatic conditions do not necessarily guarantee a firm’s international competitiveness.
Rather the factors created by meticulous planning and implementation, scientific and market knowledge, physical and capital resources and infrastructure, play a greater role in determining a firm’s competitiveness.
(ii) Demand Conditions:
The sophistication of demand conditions in the domestic market and the pressure from domestic buyers is a critical determinant for a firm to upgrade its product and services. The major characteristics of domestic demand include the nature of demand, the size and growth patterns of domestic demand, and the way a nation’s domestic preferences are transmitted to foreign markets.
As the Indian market has long been a sellers’ market, it exerted little pressure on Indian firms to strive for quality up gradation in the home market. However, as a result of India’s economic liberalization, there has been a considerable shift in the demand conditions.
(iii) Related and Supporting Industries:
The availability and quality of local suppliers and related industries and the state of development of clusters play an important role in determining the competitiveness of a firm. These determine the cost-efficiency, quality, and speedy delivery of inputs, which in turn influence a firm’s competitiveness.
This explains the development of industrial clusters, such as IT industries around Bangalore, textile industries around Tirupur, and metal handicrafts around Moradabad.
(iv) Firm Strategy, Structure, and Rivalry:
It refers to the extent of corporate investment, the type of strategy, and the intensity of local rivalry. Differences in management styles, organizational skills, and strategic perspectives create advantages and disadvantages for firms competing in different types of industries. Besides, the intensity of domestic rivalry also affects a firm’s competitiveness.
In India, the management system is paternalistic and hierarchical in nature. In the system of mixed economy with protectionist and monopolistic regulations, the intensity of competition was almost missing in major industrial sectors.
It was only after the economic liberalization that the Indian industries were exposed to market competition. The quality of goods and services has remarkably improved as a result of the increased intensity of market competition. Two additional external variables of Porter’s model for evaluating national competitive advantage include chance and government, discussed below.
(v) Chance:
The occurrences that are beyond the control of firms, industries, and usually governments have been termed as chance, which plays a critical role in determining competitiveness. It includes wars and their aftermath, major technological breakthroughs, innovations, exchange rates, shifts in factor or input costs (e.g., rise in petroleum prices), etc.
Some of the major chance factors in the context of India include disintegration of the erstwhile USSR and the collapse of the communist system in Eastern Europe, opening up of the Chinese market, the Gulf War, etc.
(vi) Government:
The government has an important role to play in influencing the determinants of a nation’s competitiveness. The government’s role in formulating policies related to trade, foreign exchange, infrastructure, labour, product standards, etc. influences the determinants in the Porter’s diamond.
Assessing country competitiveness:
In order to facilitate the quantifiable assessment of competitiveness, the World Economic Forum has developed the Global Competitiveness Index. It presents a quantified framework aimed to measure the set of institutions, policies, and factors that set the sustainable current and medium-term levels of economic prosperity.
The US was ranked as the most competitive economy in the world, followed by Switzerland, Denmark, Sweden, Singapore, Finland, and Germany whereas China and India were ranked at 30th and 50th positions, respectively.
India has made remarkable progress in improving its global competitiveness during the recent years. The rapid rise in the share of the working age population for the last 20 years would add to favourable demographics to India’s competitiveness.
However, to benefit from this India will have to find ways to bring its masses of young people into the workforce, by spending on education and improving the quality of its educational institutions so as to enhance the productivity of its young.
Moreover, the country still has to take effective measures to deal with its bureaucratic red-tape, illiteracy, and infrastructure bottlenecks, especially road, rail, seaports and airports, and electricity, among others, so as to boost its global competitiveness.
Essay # 10. Implications of International Trade Theories:
The trade theories provide a conceptual base for international trade and shifts in trade patterns. This article brings out the significance of developing a conceptual understanding of the trade theories as it deals with the fundamental issues, such as why international trade takes place, trade partners, shifts in trade patterns, and determinants of competitiveness.
The initial theory of mercantilism was based on accumulating wealth in terms of goods by increasing exports and restricting imports.
Trade was considered to be a zero-sum game under the mercantilism theory wherein one country gains at the cost of the other. However, a new form of mercantilism, known as neo-mercantilism, is followed by a number of countries so as to increase their trade surpluses. In 1776, Adam Smith advocated the concept of free trade as a means of increasing gains in world output from specialization.
The theory of absolute advantage suggests that a country should produce and export those goods that it can produce more efficiently. David Ricardo’s theory of comparative advantage was based on the international differences in labour productivity and advocates international trade even if a country does not have an absolute advantage in the production of any of its goods.
Although it is possible for a country not to have an absolute advantage in production of any good, it is not possible for it not to have a comparative advantage in any of the goods it produces. In the later case, the country should specialize in the production and export of those goods that can be produced more efficiently as compared to others.
The factor endowment theory highlights the interplay between proportions in which the factors of production such as land, labour, and capital are available to different countries and the proportions in which they are required for producing particular goods. Trade between countries with similar characteristics such as economic, geographic, cultural, etc. is explained by the country’ similarity theory.
The new trade theory explains the specialization by some countries in production and exports of particular products as international trade enables a firm to increase its output due to its specialization by providing much larger market that results into enhancing its efficacy.
The shifting patterns of production location are elucidated by the theory of IPLC that influences demand structure, production, the innovator company’s marketing strategy, and international competitiveness. The theory of competitive advantage comprehensively deals with the micro-economic business environment as the determinants of competitive advantage.
Earlier trade theories suggested the shift in comparative advantage in low-skilled production activities from advance economies to developing countries. The product life-cycle theory too heavily relied on such presumptions.
However, in recent years, the rapid shift of high-value activities such as R&D, technology-intensive manufacturing, and white-collar jobs to India and other Asian countries have evoked considerable apprehension among intellectuals in the US and other advanced economies about whether free trade is still beneficial for their countries or not.
Balance of Payment
Balance Of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporate and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases.
BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, BOP deficit indicates that a country’s imports are more than its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.
A country’s BOP is vital for the following reasons:
BOP of a country reveals its financial and economic status.
BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
BOP statement helps the Government to decide on fiscal and trade policies.
It provides important information to analyze and understand the economic dealings of a country with other countries.
By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.
Elements of balance of payment
Current AccountThe current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they make up to a country’s Balance Of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries are referred to as visible items and import/export of services (banking, information technology etc) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This can also be personal transfers like – money sent by relatives to their family located in another country.
Capital Account
All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving out/in to a different country. The deficit or surplus in the current account is managed through the finance from capital account and vice versa.
There are 3 major elements of capital account:
Loans & borrowings – It includes all types of loans from both the private and public sectors located in foreign countries.
Investments – These are funds invested in the corporate stocks by non-residents.
Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.
FINANCIAL; ACCOUNTS
The flow of funds from and to foreign countries through various investments in real estates, business ventures, foreign direct investments etc is monitored through the financial account. This account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. On analyzing these changes, it can be understood if the country is selling or acquiring more assets (like gold, stocks, equity etc).Illustration
if for the year 2018 the value of exported goods from India is Rs. 80 lakhs and the value of imported items to India is 100 lakhs, then India has a trade deficit of Rs. 20 lakhs for the year 2018.
BOP statement acts as an economic indicator to identify the trade deficit or surplus situation of a country. Analyzing and understanding the BOP of a country goes beyond just deducting the outflows of funds from inflows. As mentioned above, there are various components of BOP and fluctuations in these accounts which provide a clear indication about which sector of the economy needs to be developed.
Causes and Measures of Disequilibrium
Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account.
In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.
1. Causes of disequilibrium in BOP:
There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit.
Such causes for disequilibrium in BOP are listed below:
(i) Economic Factors:
(a) Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR), (b) Large scale development expenditure which causes large imports, (c) High domestic prices which lead to imports, (d) Cyclical fluctuations (like recession or depression) in general business activity, (e) New sources of supply and new substitutes.
(ii) Political Factors:
Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.
(iii) Social Factors:
(a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports; (b) High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.
2. Measures to correct disequilibrium in BOP:
Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold.Following remedial measures are recommended:
(i) Export promotion:
Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.
(ii) Import:
Restrictions and Import Substitution are other measures of correcting disequilibrium.
(iii) Reducing inflation:
Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country.
(iv) Exchange control:
Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the central bank and then ration out among licensed importers.
(v) Devaluation of domestic currency:
It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.
(vi) Depreciation:
Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)
Disequilibrium in a Country’s BOP (3 Approaches)
The analysis of mechanism by which devaluation rectifies the deficit disequilibrium in a country’s BOP can be approached in three different ways:(i) The elasticities approach,(Traditional )
(ii) The absorption approach and
(iii) The monetary approach.
These three approaches are complementary rather than competitive to each other.
(i) Elasticities Approach:
The immediate effect of devaluation is a change in relative prices. The traditional approach to the effects of devaluation on trade balance runs in terms of elasticites. The essence of this elasticities approach in contained in the so called Marshal-Lerner condition which states that the sum of the elasticities of demand for a country’s exports and its demand for imports has to be greater than unity if devaluation is to have a beneficial effect on a country’s trade balance. But if the sum of these elasticities is smaller than unity that a country can instead improve its balance of trade by revaluation.
But what the effect of this price increase will be depends on the elasticity of demand for imports. The value of the demand elasticity of imports depends largely on what type of goods the devaluing country imports. If the devaluing country mainly imports necessities and raw materials the demand elasticity of imports may be very low and a devaluation may not be an efficient measure of correcting a deficit disequilibrium.
After devaluation, the exporters of devaluing country receive more for every unit of foreign currency they earn and this being the case, they can now lower the price of their exports coupled in foreign currency. By lowering their prices they should be able to sell more. By how much the volume of exports increases depends on the foreigner’s demand elasticity for devaluing country’s exports. Moreover, it also depends to a large extent on the type of goods the country exports and the international market conditions.
The so called Marshall-Lerner condition is a necessary condition for the improvement of the balance of trade by devaluation, provided the supply elasticities (both exports and imports) are large. If the supply elasticities are relatively low the devaluation is an inefficient means of correcting the deficit.
If the elasticity of supply of exports is low, the price of exports lends to rise as the demand for them expands with devaluation and thus the foreign exchange earnings will not decline to the same extent as they would have done with a high or infinite supply elasticity. “This reduces the power of the Marshal-Lerner condition to one where it is a sufficient but not necessary condition for balance of payments improvement.
The sum of demand elasticities can be less than unity and still improve the trade balance if supply elasticities are low”. The Marshal-Lerner condition is a necessary condition only if elasticities of supply are infinite but the condition is weakened turning it from necessary to sufficient condition if the supply elasticities are low.
Another limitation on the Marshal-Lerner condition is that the Imbalance which is to be corrected is not too large that imports must not greatly exceed exports. If the initial deficit is very large, then much higher elasticities will be required to eliminate this deficit.
Thus, “the Marshal-Lerner condition has important theoretical implications. If it operates rigorously not only does it imply that price reductions, either directly or through exchange rate depreciation are ineffective in adjusting a BOP, but it points to the possibility that depreciation may even worsen the balance and that, in certain circumstance any movement away from exchange equilibrium will produce forces which serve to increase the disequilibrium rather than correct it”.
The elasticities approach takes into account the possibilities of substitution among commodities both in consumption and production induced by price changes brought about by devaluation. After devaluation the prices of foreign traded goods will rise in terms of devaluing country’s currency. This rise in price will divert purchases out of existing income to non-traded goods thereby reducing the domestic demand for imports and export goods releasing the later for sale abroad. A the same time increased profitability in the foreign trade sector arising from the fact that prices in domestic currency have risen more than domestic costs, will stimulate new production of exports and import competing goods and will draw resources into these industries.
The elasticities approach was a partial equilibrium approach in which the success of devaluation depended upon the reaction of demand for imports and exports to the change in their prices attendant upon devaluation.
(ii) absorption approach
The elasticities approach ignored the likelihood that devaluation might result in changes in income levels. The realization lead to the revision of the elasticities approach in an effort to enhance its realism and a new variant of the devaluation model the absorption approach gained its champions. Thus, an alternative approach to the effect of evaluation was first formulated by Sidney S. Alexander in a famous paper “Effects of a devaluation on a trade balance” published in 1952 which we have discussed above.
(iii) monetary approach
The monetary approach to devaluation focuses on the demand for money balances. Devaluation is equivalent to a decline in the money supply when measured in foreign currency. As the real value of money supply will be reduced by devaluation through price rise, the public will accordingly reduce its spending with a view to restoring the real value of its money and other financial asset holdings. This reduction in spending will produce the required improvement in the BOP.
An important implication of this approach is that the effects of devaluation on BOP will be undermined if the monetary authorities expand the money supply and credit following devaluation. All these three approaches elasticities approach, absorption approach and monetary approach are complementary rather than competitive to each other.
Foreign Trade Multiplier:
Foreign Trade Multiplier:Meaning:
The foreign trade multiplier, also known as the export multiplier, operates like the investment multiplier of Keynes. It may be defined as the amount by which the national income of a country will be raised by a unit increase in domestic investment on exports.
As exports increase, there is an increase in the income of all persons associated with export industries. These, in turn, create demand for goods. But this is dependent upon their marginal propensity to save (MPS) and the marginal propensity to import (MPM). The smaller these two marginal propensities are, the larger will be the value of the multiplier, and vice versa.
It’s working:
The foreign trade multiplier process can be explained like this. Suppose the exports of the country increase. To begin with, the exporters will sell their products to foreign countries and receive more income. In order to meet the foreign demand, they will engage more factors of production to produce more.
This will raise the income of the owners of factors of production. This process will continue and the national income increases by the value of the multiplier. The value of the multiplier depends on the value of MPS and MPM, there being an inverse relation between the two propensities and the export multiplier
The foreign trade multiplier can be derived algebraically as follows:
The national income identity in an open economy is
Y = C + I + X – M
Where Y is national income, C is national consumption, I is total investment, X is exports and M is imports.
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The above relationship can be solved as:
Y-C = 1 + X-M
or S = I+X-M (S=Y-C)
S + M = I + X
Thus at equilibrium levels of income the sum of savings and imports (S+M) must equal the sum of investment and export (1+X).
In an open economy the investment component (I) is divided into domestic investment (Id) and foreign investment (If)
I=S
Id + If = S… (1)
Foreign investment (If) is the difference between exports and imports of goods and services.
If =X-M…. (2)
Substituting (2) into (1), we have
ld+ X-M – S
or Id + X = S+M
Which is the equilibrium condition of national income in an open economy. The foreign trade multiplier coefficient (Kf) is equal to
Kf = ∆Y/∆X
And ∆X = ∆S + ∆M
It shows that an increase in exports by Rs. 1000 crores has raised national income through the foreign trade multiplier by Rs. 2000 crores, given the values of MPS and MPM.
It’s Assumptions:
The foreign trade multiplier is based on the following assumptions:
1. There is full employment in the domestic economy.
2. There is direct link between domestic and foreign country in exporting and importing goods.
3. The country is small with no foreign repercussion effect
4. It is on a fixed exchange rate system.
5. The multiplier is based on instantaneous process without time lags.
6. There is no accelerator.
7. There are no tariff barriers and exchange controls.
8. Domestic investment (Id) remains constant.
9. Government expenditure is constant.
10. The analysis is applicable to only two countries.
Diagrammatic Explanation:
Given these assumptions, the equilibrium level in the economy is shown in Figure 1, where S(Y) is the saving function and (S+M) Y is the saving plus import function. ld represents domestic investment and ld + X, domestic investment plus exports. (S+M) Y and Id+ X functions determine the equilibrium level of national income OY at point E, where savings equal domestic investment and exports equal imports.
Fig1 12.48
If there is a shift in the Id + X function due to an increase in exports, the national income will increase from OY to OY1 as shown in Figure 2. This increase in income is due to the multiplier effect, i.e. ∆Y = Kf ∆X. The exports will exceed imports by sd, the amount by which savings will exceed domestic investment. The new equilibrium level of income will be OY1. It is a case of positive foreign investment.
Fig2 12.49
If there is a fall in exports, the export function will shift downward to Id + X1 as shown in Figure 3. In this case imports would exceed exports and domestic investment would exceed savings by ds. The level of national income is reduced from OY to OY1. This is the reverse operation of the foreign trade multiplier.
Fig3 12.50
Foreign Repercussion or Backwash Effect:
The above analysis of the simple foreign trade multiplier has been studied in the case of one small country. But, in reality, countries are linked to each other indirectly also. A country’s exports or imports affect the national income of the other country which, in turn, affects the foreign trade and national income of the first country.
This is known as the Foreign Repercussion or Backwash or Feedback Effect. The smaller the country is in relation to other trading partner, the negligible is the foreign repercussion. But the foreign repercussion will be high in the case of a large country because a change in the national income of such a country will have significant foreign repercussions or backwash effects.
Assuming two large countries A and B where A’s imports are B’s exports and vice versa. An increase in A’s domestic investment will cause a multiplier increase in its income. This will increase its imports. This increase in A’s imports will be increase in B’s exports which will increase income in B through B’s foreign trade multiplier.
Now the increase in B’s income will bring an increase in its imports from country A which will induce a second round increase in A’s income, and so on.
When autonomous domestic investment (Id) increases in country A, its national income increase (+Y).
It induces country A to import more from country B. This increases the demand for country B’s exports (X+). Consequently, the national income in country B increases (Y+). Now this country imports more (M+) from country A.
As the demand for country A’s exports increases (+X), its national income (+Y) increases further and this country imports more (+M) from B country. This process will continue in smaller rounds. These are the foreign repercussions or the backwash effects for country A which will peter out and dampen the effects of increase in the original autonomous domestic investment (Id) in country A.In stage I, domestic investment in country A increases form Id to Id1 in Panel I. This leads to an upward shift in the Id+ X curve to Id1 + X. As a result, the new equilibrium point is at E1 which shows an increase in the national income from OY to OY1. As the national income increases, the demand for imports from country B also increases.
This shows how the foreign repercussions in one country affect its own national income and that of the other country which, in turn, again affects in own national income through the backwash effects with greater force.
the backwash effects with greater force.
Implications of Foreign Repercussion:
The following are the implications of foreign repercussion effects:1. The foreign repercussion effects suggest a mechanism for the transmission of income disturbances between trading countries. If a country is small, it will be affected by change in income of other countries that will alter the demand for its exports. But it will not be able to transmit its own income disturbances to the latter.
If a country is large, it may transmit its own income disturbances to other countries and, in turn, be affected by income disturbances in them. It implies that a boom or slump in one country has repercussion on the incomes of other countries. Thus swings in business cycles are likely to be internationally contagious, as happened in the 1930s and 2008.
2. The repercussion effects also suggest that since the backwash effects ultimately peter out, automatic income changes cannot eliminate completely the current account BOP deficit or surplus produced by an automatic disturbance.
3. The policy implications of the backwash effects suggest that export promotion policies raise national income in the trading partners at a lower rate than by an increase in domestic investment. The export promotion measures raise national income via the simple foreign trade multiplier, whereas increase in domestic investment policies raise national income many times in multiplier rounds via the repercussion effects.
Criticisms of Foreign Trade Multiplier:
The two models of the foreign trade multiplier presented above are based on certain assumptions which make the analysis unrealistic.1. Exports and Investment not Independent:
The analysis of simple foreign trade multiplier is based on the assumption that exports and investment (both domestic and foreign) are independent of changes in the level of national income. But, in reality, this is not so. A rise in exports does not always lead to increase in national income. On the contrary, certain imports, of say capital goods, have the effect of increasing national income.
2. Legless Analysis:
The foreign trade multiplier is assumed to be an instantaneous process whereby it provides the final results. Thus it involves no lags and is unrealistic.
3. Full Employment not Realistic:
The analysis is based on the assumption of a fully employed economy. But there is less than full employment in every economy. Thus the foreign trade multiplier does not find clear expression in an economy with less than full employment.
4. Not Applicable to More than two Countries:
The whole analysis is applicable to a two-country model. If there are more than two countries, it becomes complicated to analyse and interpret the foreign repercussions of this theory.
5. Neglects Trade Restrictions:
The foreign trade multiplier assumes that there are no tariff barriers and exchange controls. In reality, such trade restrictions exist which restrict the operations of the foreign trade multiplier.
6. Neglects Monetary-Fiscal Measures:
This analysis is based on the unrealistic assumption that the government expenditure is constant. But governments always interfere through monetary and fiscal policies which affect exports, imports and national income. Despite these shortcomings, the foreign trade multiplier is a powerful tool of economic analysis which helps in formulating policy measures.
Tariff and its Impact
It is a specific tax levied on an imported good at the border. Tariffs have historically been a tool for governments to collect revenues, but they are also a way to protect domestic industry and production. The theory is that with an increase in the price of imports, American consumers would choose to buy American goods instead. In today’s global economy, many products we buy in the United States have parts from other countries, or were assembled in other countries, or were manufactured entirely overseas.In today’s free market-leaning global economy, tariffs have something of a bad reputation. And rightfully so: many economists, for instance, blame the Smoot-Hawley Tariff for worsening the Great Depression in the 1930s. In an attempt to strengthen the U.S. economy during the Great Depression, Congress passed the Smoot-Hawley Tariff Act which increased tariffs on farm products and manufactured goods. In response, other nations, also suffering, raised tariffs on American goods bringing global trade to a standstill. Since then, most policymakers, on both sides of the aisle, have turned away from trade barriers like tariffs towards free-market policies that allow nations to specialize in certain industries and incentivize optimal efficiency.
Tariff Basics
Put simply, a tariff is a specific tax levied on an imported good at the border. Tariffs have historically been a tool for governments to collect revenues, but they are also a way to protect domestic industry and production. The theory is that with an increase in the price of imports, American consumers would choose to buy American goods instead. In today’s global economy, many products we buy in the United States have parts from other countries, or were assembled in other countries, or were manufactured entirely overseas.KEY TAKEAWAYS
Tariffs are duties on imports imposed by governments to raise revenue, protect domestic industries, or exert political leverage over another country.
Tariffs often result in unwanted side effects, such as higher consumer prices.
Tariffs have a long and contentious history, and the debate over whether they represent good or bad policy rages on to this day.
In today’s free market-leaning global economy, tariffs have something of a bad reputation. And rightfully so: many economists, for instance, blame the Smoot-Hawley Tariff for worsening the Great Depression in the 1930s. In an attempt to strengthen the U.S. economy during the Great Depression, Congress passed the Smoot-Hawley Tariff Act which increased tariffs on farm products and manufactured goods. In response, other nations, also suffering, raised tariffs on American goods bringing global trade to a standstill. Since then, most policymakers, on both sides of the aisle, have turned away from trade barriers like tariffs towards free-market policies that allow nations to specialize in certain industries and incentivize optimal efficiency.
The U.S. had not imposed high tariffs on trading partners since the early 1930s. Because of the tariffs during that era, economists have estimated that overall world trade declined about 66% between 1929 and 1934. In the post World War II period, President Donald Trump was one of a few presidential candidates to speak about trade inequities and tariffs when he vowed to take a tough line against international trading partners, especially China, to help American blue-collar workers displaced by what he described as unfair trade practices.
Tariffs are used to restrict imports by increasing the price of goods and services purchased from another country, making them less attractive to domestic consumers. There are two types of tariffs: A specific tariff is levied as a fixed fee based on the type of item, such as a $1,000 tariff on a car. An ad-valorem tariff is levied based on the item's value, such as 10% of the value of the vehicle.
Governments may impose tariffs to raise revenue or to protect domestic industries—especially nascent ones—from foreign competition. By making foreign-produced goods more expensive, tariffs can make domestically produced alternatives seem more attractive. Governments that use tariffs to benefit particular industries often do so to protect companies and jobs. Tariffs can also be used as an extension of foreign policy: Imposing tariffs on a trading partner's main exports is a way to exert economic leverage.
The cost of tariffs are paid by consumers in the country that imposes the tariffs, NOT by the exporting country.
Tariffs can have unintended side effects, however. They can make domestic industries less efficient and innovative by reducing competition. They can hurt domestic consumers, since a lack of competition tends to push up prices. They can generate tensions by favoring certain industries, or geographic regions, over others. For example, tariffs designed to help manufacturers in cities may hurt consumers in rural areas who do not benefit from the policy and are likely to pay more for manufactured goods.
Finally, an attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of retaliation, commonly known as a trade war.
How Do the Tariffs Affect the Economy?
In CBO’s projections, the tariffs affect U.S. economic activity in several ways. First, they make consumer goods and capital goods more expensive, thereby reducing the purchasing power of U.S. consumers and businesses. Second, they increase businesses’ uncertainty about future barriers to trade. Such uncertainty leads some U.S. businesses to delay or forgo new investments or make costly adjustments to their supply chains because changes in trade policies might affect the costs of their operations. Third, they prompt retaliatory tariffs by U.S. trading partners, which reduce U.S. exports by making them more expensive for foreign purchasers. All of those effects lower U.S. output. In the other direction, U.S. consumers and businesses are expected to replace certain imported goods with goods produced in the United States, which would offset some of that decline in output. In addition, tariff revenues, by reducing the deficit, increase the resources available for private investment.
On balance, in CBO’s projections, the trade barriers imposed since January 2018 reduce both real output and real household income. By 2020, they reduce the level of real U.S. GDP by roughly 0.3 percent and reduce average real household income by $580 (in 2019 dollars). Beyond 2020, CBO expects those effects to wane as businesses adjust their supply chains. By 2029, in CBO’s projections, the tariffs lower the level of real U.S. GDP by 0.1 percent and the level of real household income by 0.2 percent. Those estimated economic effects are small because the value of imports subject to the tariffs is less than 2 percent of the value of all goods and services purchased by U.S. consumers and businesses. Imposing higher tariffs on a wider array of items would have larger economic effects.
Partial Equilibrium and General Equilibrium
1.Partial equilibrium is a condition of equilibrium in the theory of economics which takes into consideration only a part of the market to attain the equilibrium. It studies the effect of one variable upon the other without considering the effect of other factors.
For example, law of demand is studied in relationship with price by keeping all other factors constant.
2.General equilibrium is the equilibrium that studies an economic phenomenon by taking all the aggregate units in the economy into consideration.
For example, product prices make demand for each commodity equal to its supply and factor prices make the demand for each factor equal to its supply so that all product markets and factor markets are simultaneously in equilibrium
equilibrium price and quantity of a commodity or a factor is determined through demand and supply, assuming prices of other commodities and factors would remain the same when changes occur in the price of the commodity under consideration.
That means the effect, if any, of the changes in price of a commodity on the demand for other commodities is ignored. This type of analysis where we do not take into account the interrelationship or inter-dependence between prices of commodities or between prices of commodities and factors of production is called partial equilibrium analysis. In this partial equilibrium analysis each product or factor market is considered as independent and self-contained for the proper explanation of the determination of price and quantity of a commodity
However, partial equilibrium analysis is not useful and relevant to apply when there is interrelationship between commodities or between factors. Thus when markets for various commodities and factors are interdependent, that is, when changes in the price of a commodity or a factor have important repercussions on the demand for other commodities or factors, partial equilibrium analysis would not yield correct results.
In such cases when there is significant inter-relationship between various markets or that the changes in one market would significantly affect others, we should employ general equilibrium analysis which considers simultaneous equilibrium of all markets taking into account all effects of changes in price in one market over others.
It may be mentioned that both types of equilibrium analysis are useful, each being valuable in its own way. Partial equilibrium analysis is useful when the changes in conditions in one market have little repercussions on other markets.
However, when the changes in conditions in one market have significant effects on other markets, general equilibrium analysis should be used. Thus, in partial equilibrium analysis when we consider the determination of market price of a commodity we assume that prices of other goods do not change.
For example, the rise in price of petrol following imposition of a tax on it would cause little effect on the prices of goods such as wrist watches, drapers, bowling balls, and in turn there would be negligible feedback effect of changes in prices of these goods on the demand and price of petrol.
If prices of petrol and of only these commodities are to be considered and since there are little repercussions of changes in prices of petrol on these other commodities, the use of partial equilibrium analysis of price determination of petrol would be quite reasonable.
However, when market for automobiles is considered, the rise in price of petrol would have an important effect on their demand and price. Therefore, the assumption of partial equilibrium analysis that prices of automobiles would remain constant, when the price of petrol changes would be seriously wrong.
This is because petrol and automobiles being complements to each other, their markets are inter-related and mutually inter-dependent and changes in their prices would significantly affect each other. In such cases when there exist inter-relationship and inter-dependence of the markets for goods (whether they are complements or substitutes), the general equilibrium analysis should be used. In general equilibrium analysis, all prices are considered variable and the analysis of simultaneous determination of equilibrium in all markets is made.
In fact when we look at the economic system as a whole, there is a great deal of inter-relation- ship and inter-dependence among various markets for commodities and factors and there are a large number of decision making agents—consumers, producers, workers, (who supply labour) and other resource owners.
All these agents are self-interested and would behave to maximise their goals; consumers would maximise their utility, and producers would maximise their profits. A comprehensive analysis of the economic system when prices and quantities of all commodities and factors are considered as variable and which would take into account all inter-relationships and interdependence could be made only through general equilibrium analysis. The general equilibrium would occur when markets for all commodities and factors and all decision-making agents, consumers, producers, resource owners are simultaneously in equilibrium.
To sum up, partial equilibrium analysis focuses on explaining the determination of price and quantity in a given product or factor market when one market is viewed as independent of other markets. On the other hand, general equilibrium analysis deals with explaining simultaneous equilibrium in all markets when prices and quantities of all products and factors are considered as variables. Thus, in general equilibrium analysis inter-relationship among markets of all products and factors are explicitly taken into account.
general equilibrium with regard to the, following three aspects:-
1. The distribution of goods and services for consumption among individuals in the society;
2. The allocation of productive factors to the production of various goods and services; and
3. The composition of production (or output mix) together with the distribution of consumption.
The political economy of nontariff barriers
Nontariff barriers to trade are most pervasive when deteriorating macroeconomic conditions give rise to demands for protection by pressure groups, when countries are sufficiently large to give policymakers incentives to impose protection, and when domestic institutions enhance the ability of public officials to act on these incentives. Statistical results based on a sample of advanced industrial countries during the 1980s support the argument that the incidence of nontariff barriers tends to be greatest when the preferences of pressure groups and policymakers converge. More attention should be devoted to the interaction between societal and statist factors in cross-national studies of trade policy.
Bretton Woods System and Its Collapse
Bretton Woods System:After the abandonment of gold standard and chaotic international monetary conditions during the inter-war period, the need was being felt to evolve a more efficient and effective world monetary system. In 1944, the representatives of 44 countries met at Bretton Woods, New Hampshire in the United States for creating the framework of the international monetary system. The conference at Bretton Woods outlined certain principles as the guidelines for operating the world monetary system.
(i) The international monetary system must facilitate unrestricted trade and investment.
(ii) The national currencies would be defined in terms of gold parities and there would be fixed exchange rates.
I
Finally, an attempt to pressure a rival country by using tariffs can devolve into an unproductive cycle of retaliation, commonly known as a trade war.
How Do the Tariffs Affect the Economy?
In CBO’s projections, the tariffs affect U.S. economic activity in several ways. First, they make consumer goods and capital goods more expensive, thereby reducing the purchasing power of U.S. consumers and businesses. Second, they increase businesses’ uncertainty about future barriers to trade. Such uncertainty leads some U.S. businesses to delay or forgo new investments or make costly adjustments to their supply chains because changes in trade policies might affect the costs of their operations. Third, they prompt retaliatory tariffs by U.S. trading partners, which reduce U.S. exports by making them more expensive for foreign purchasers. All of those effects lower U.S. output. In the other direction, U.S. consumers and businesses are expected to replace certain imported goods with goods produced in the United States, which would offset some of that decline in output. In addition, tariff revenues, by reducing the deficit, increase the resources available for private investment.
On balance, in CBO’s projections, the trade barriers imposed since January 2018 reduce both real output and real household income. By 2020, they reduce the level of real U.S. GDP by roughly 0.3 percent and reduce average real household income by $580 (in 2019 dollars). Beyond 2020, CBO expects those effects to wane as businesses adjust their supply chains. By 2029, in CBO’s projections, the tariffs lower the level of real U.S. GDP by 0.1 percent and the level of real household income by 0.2 percent. Those estimated economic effects are small because the value of imports subject to the tariffs is less than 2 percent of the value of all goods and services purchased by U.S. consumers and businesses. Imposing higher tariffs on a wider array of items would have larger economic effects.
1.Partial equilibrium is a condition of equilibrium in the theory of economics which takes into consideration only a part of the market to attain the equilibrium. It studies the effect of one variable upon the other without considering the effect of other factors.
For example, law of demand is studied in relationship with price by keeping all other factors constant.
2.General equilibrium is the equilibrium that studies an economic phenomenon by taking all the aggregate units in the economy into consideration.
For example, product prices make demand for each commodity equal to its supply and factor prices make the demand for each factor equal to its supply so that all product markets and factor markets are simultaneously in equilibrium
equilibrium price and quantity of a commodity or a factor is determined through demand and supply, assuming prices of other commodities and factors would remain the same when changes occur in the price of the commodity under consideration.
That means the effect, if any, of the changes in price of a commodity on the demand for other commodities is ignored. This type of analysis where we do not take into account the interrelationship or inter-dependence between prices of commodities or between prices of commodities and factors of production is called partial equilibrium analysis. In this partial equilibrium analysis each product or factor market is considered as independent and self-contained for the proper explanation of the determination of price and quantity of a commodity or a factor.
However, partial equilibrium analysis is not useful and relevant to apply when there is interrelationship between commodities or between factors. Thus when markets for various commodities and factors are interdependent, that is, when changes in the price of a commodity or a factor have important repercussions on the demand for other commodities or factors, partial equilibrium analysis would not yield correct results.
In such cases when there is significant inter-relationship between various markets or that the changes in one market would significantly affect others, we should employ general equilibrium analysis which considers simultaneous equilibrium of all markets taking into account all effects of changes in price in one market over others.
It may be mentioned that both types of equilibrium analysis are useful, each being valuable in its own way. Partial equilibrium analysis is useful when the changes in conditions in one market have little repercussions on other markets.
However, when the changes in conditions in one market have significant effects on other markets, general equilibrium analysis should be used. Thus, in partial equilibrium analysis when we consider the determination of market price of a commodity we assume that prices of other goods do not change.
For example, the rise in price of petrol following imposition of a tax on it would cause little effect on the prices of goods such as wrist watches, drapers, bowling balls, and in turn there would be negligible feedback effect of changes in prices of these goods on the demand and price of petrol.
If prices of petrol and of only these commodities are to be considered and since there are little repercussions of changes in prices of petrol on these other commodities, the use of partial equilibrium analysis of price determination of petrol would be quite reasonable.
However, when market for automobiles is considered, the rise in price of petrol would have an important effect on their demand and price. Therefore, the assumption of partial equilibrium analysis that prices of automobiles would remain constant, when the price of petrol changes would be seriously wrong.
This is because petrol and automobiles being complements to each other, their markets are inter-related and mutually inter-dependent and changes in their prices would significantly affect each other. In such cases when there exist inter-relationship and inter-dependence of the markets for goods (whether they are complements or substitutes), the general equilibrium analysis should be used. In general equilibrium analysis, all prices are considered variable and the analysis of simultaneous determination of equilibrium in all markets is made.
In fact when we look at the economic system as a whole, there is a great deal of inter-relation- ship and inter-dependence among various markets for commodities and factors and there are a large number of decision making agents—consumers, producers, workers, (who supply labour) and other resource owners.
All these agents are self-interested and would behave to maximise their goals; consumers would maximise their utility, and producers would maximise their profits. A comprehensive analysis of the economic system when prices and quantities of all commodities and factors are considered as variable and which would take into account all inter-relationships and interdependence could be made only through general equilibrium analysis. The general equilibrium would occur when markets for all commodities and factors and all decision-making agents, consumers, producers, resource owners are simultaneously in equilibrium.
To sum up, partial equilibrium analysis focuses on explaining the determination of price and quantity in a given product or factor market when one market is viewed as independent of other markets. On the other hand, general equilibrium analysis deals with explaining simultaneous equilibrium in all markets when prices and quantities of all products and factors are considered as variables. Thus, in general equilibrium analysis inter-relationship among markets of all products and factors are explicitly taken into account.
general equilibrium with regard to the, following three aspects:-
1. The distribution of goods and services for consumption among individuals in the society;
2. The allocation of productive factors to the production of various goods and services; and
3. The composition of production (or output mix) together with the distribution of consumption.
The political economy of nontariff barriers
Nontariff barriers to trade are most pervasive when deteriorating macroeconomic conditions give rise to demands for protection by pressure groups, when countries are sufficiently large to give policymakers incentives to impose protection, and when domestic institutions enhance the ability of public officials to act on these incentives. Statistical results based on a sample of advanced industrial countries during the 1980s support the argument that the incidence of nontariff barriers tends to be greatest when the preferences of pressure groups and policymakers converge. More attention should be devoted to the interaction between societal and statist factors in cross-national studies of trade policy.
Only in the event of a fundamental disequilibrium in the BOP would a country be expected to change its exchange rates.
(iii) The international liquidity would be made available to the countries for overcoming the temporary BOP deficits.
Thus Bretton Woods meet sought to combine certain features of the old gold standard with a greater degree of flexibility and some measure of control over international liquidity. The expectation and objective at the Bretton Woods was to create a new system that would avoid the undesirable aspects of the old system while retaining its best features.
The things that were to be avoided included rigidity of exchange rates and associated deflationary adjustment mechanism of the gold standard, the instability of the freely floating exchange rates, conflicts of national economic policies, competitive exchange depreciation and the repressive and distorting techniques of exchange controls.
The features, on the other hand, that were to be retained included stability of gold standard, easy adjustment mechanism, market freedom of floating rates, the discretionary control over market forces of the flexible rate system and the selective use of controls. In order to accomplish these objectives, new practices and institutions had to be devised.
The most far-reaching result of the Bretton Woods meet was the creation of International Monetary Fund (IMF). It was a compromise between the British plan put forward by Keynes and the American counter-plan put forward by Dexter and White. While the former was for the creation of an international clearing union, the latter was for a less ambitious stabilisation fund.
The IMF started functioning in March, 1947 with a membership of 30 countries. At present, its membership has gone upto 184. The IMF had two specific objectives of overseeing that the member countries followed a set of agreed rules of conduct in international trade and finance and of providing borrowing facilities for the member countries to tide over their BOP difficulties. Such borrowings were to be repaid within a period of three to four years.
Each member country was assigned a quota on the basis of its economic importance and the volume of its international trade. The member countries’ quota determined their respective voting power and the ability to borrow funds. The total subscription to the Fund was $ 8.8 billion originally. It had grown to $ 205 billion or SDR 145 billion by 1993. The US quota was the largest in 1989 at 21 percent, followed by 7 percent each for the U.K., 6 percent each for Germany and France and 5 percent for Japan.
The member country on joining was to pay 25 percent of its quota in gold and remainder in its own currency. The member country could borrow 25 percent of its quota in one year upto a total of 125 percent of its quota over a period of 5 years. The first 25 percent of its quota, called gold tranche, could be borrowed almost automatically without any restriction or condition.
For further borrowing in the subsequent years, called credit tranche, the higher interest rates are charged and the IMF imposes more supervision and conditions to ensure that the deficit nation was taking appropriate measures to eliminate the BOP deficit.
As regards repayments, these were to be made within a period of 3 to 5 years. It involved the nation’s repurchase of its own currency from the Fund with other convertible currencies approved by the Fund until the IMF once again held no more than 75 percent of the nation’s quota in the nation’s currency.
Under the Bretton Woods System, the gold exchange standard was introduced. The United States was to maintain the price of gold fixed at $ 35 per ounce and to be ready to exchange dollars for gold at that price without restrictions or limitations. Other nations were required to fix the price of their currencies directly in terms of dollars and indirectly in terms of gold. The exchange rate could fluctuate within plus or minus 1 percent around the agreed par value.
The member countries could intervene in the exchange markets to prevent the fluctuation beyond the permissible limit. With the allowed band of fluctuation, the rate of exchange was determined by the forces of demand and supply. However, if a country faced a fundamental disequilibrium in the BOP, the alteration in the exchange rate beyond the permissible limit (± 1 percent) could be affected by it after seeking the consent of the IMF. It is clear that Bretton Woods System ushered in an adjustable peg system of exchange rate that combined the stability of fixed exchange system with greater flexibility than was allowed under the gold standard.
The Bretton Woods System envisaged the removal of all restrictions on the full convertibility of the currencies of member countries into currencies of one another or into dollar. The member countries were expected not to impose additional trade restrictions. The existing trade restrictions were to be removed gradually through multilateral negotiations. The restrictions on the international liquid capital flows were, however, permitted to enable the member countries to protect their currencies against large destabilizing, international money flows.
Since the IMF could provide assistance to the member countries only for tackling the temporary BOP deficit, the amounts obtained from it were to be repaid within a short period of 3 to 5 years. This provision was considered necessary so that the IMF funds should not get tied up for long periods. Under the Bretton Woods System, the long term development assistance was to be provided by the International Bank for Reconstruction and Development (IBRD) also called as the World Bank.
Subsequently, International Development Association (IDA) was established in 1960 to provide concessional development assistance to the poorer countries. Another affiliate of the World Bank— International Finance Corporation was established in 1956 to stimulate private investments in the developing countries from the indigenous and foreign sources.
The Bretton Woods System worked reasonably well in the late 1950’s and early 1960’s. During this period, there were conditions of relatively free trade, a rapid expansion in trade and capital mobility. There was very little inflation or unemployment in the major industrial countries. On the whole, the System served the world community well until the mid 1960’s.
Breakdown of the Bretton Woods System:
No doubt the system worked fairly well until the mid-1960 but the system had some in-built weaknesses and contradictions, under the pressure of which, it eventually broke down on 15th August 1971.
The main factors that led to the collapse of this system were as follows:
(i) The Confidence Problem:
By the end of 1950’s many European countries were having BOP surpluses and the USA was running counterpart deficit. For the continued economic expansion, it was essential for the United States to maintain this deficit as it was the only way through which the growth of international reserves could be sustained in the absence of any other reserve asset including gold.
In the event, the USA continued to run bigger and bigger deficits while its gold assets remained constant. It was just a matter of time when the foreign holders of dollars, including central banks, doubted the ability of the United States to maintain the price of gold at $ 35 per ounce and rushed to convert dollars into gold before the dollar was devalued. This phenomenon was termed as the ‘confidence problem’.
Similar crises of confidence continued to occur during the 1960’s. Britain faced in 1967 a continuing BOP deficit and dwindling official reserves creating the expectations of devaluation of pound. The outflow of funds from England put pressure upon the pound sterling and led eventually to the devaluation of pound sterling in November 1967. A similar episode occurred in 1968-69. The persistent BOP surplus of West Germany led to widespread expectation of upward revaluation of the Mark.
Such an expectation resulted in an almost embarrassing accumulation of reserves due to large scale inflow of foreign funds to that country. France particularly suffered a huge outflow of funds and to protect Franc, the French government imposed stringent exchange controls. But ultimately storm could be weathered only after there was upward readjustment of Mark and downward adjustment of Franc.
(ii) Seigniorage Problem:
It was argued that the Bretton Woods System gave rise to the seigniorage of the United States over other countries, since dollar became the international reserve currency that conferred some undue privilege upon the Americans. The question of seigniorage arose because the United States was the issuing country of dollar. As and when it required dollar, it could issue more dollars.
On the other hand, another country that wanted to increase its holding of dollars could do so only by creating an export surplus i.e., it would have to forego real resources in exchange for the dollars. The central bank of the United States could obtain a much higher rate of return for dollars from the foreigners than what it could obtain in the home country. The existence of seigniorage was the cause of irritation among some of the countries including France. This factor, in the long run, undermined the Bretton Woods System.
(iii) Adjustment Problem:
From the long run point of view, a serious weakness in the Bretton Woods System was the absence of an efficient balance of payments adjustment mechanism. No country can afford to have a persistent BOP deficit. The principal types of adjustment mechanism include adjustment through changes in relative incomes, through relative price changes, through the movements in exchange rates and through the imposition of direct controls over foreign transactions. The Bretton Woods System almost prohibited the use of direct controls .K
As regards exchange rate variations, the system prescribed that exchange rate should be held stable with scope only for ±1 percent variation unless a fundamental disequilibrium warranted a greater degree of variation. So the crucial issue was to determine whether the disequilibrium was temporary or fundamental. The operational difficulty had been the timely recognition of the presence of fundamental disequilibrium. There was a general tendency among the member countries of IMF to resist changing the par value of the currency.
Devaluation was often opposed on the ground that it amounted to the acceptance of the failure of government policies and also on account of loss of national prestige. The upward revaluation was frequently opposed by the export industries of the surplus countries. The alternative adjustment mechanism through changes in prices and incomes was found to be in conflict with the domestic goals of full employment and price stability.
The adjustment through quantitative controls was opposed on account of possible distortion of resource allocation and reduction in economic efficiency. In such circumstances the countries adopted wait-and-see policy rather than taking a decisive and speedy action for BOP adjustments. The undue delay led to an aggravation of maladjustment and deepening of the BOP crisis.
(iv) Triffin Dilemma:
A serious inbuilt contradiction in the system was exposed by Triffin as early as 1960. It is often referred as ‘Triffin dilemma’ i.e., either the United States corrected its deficit and created a liquidity shortage or it continued to run the BOP deficit. The latter alternative could only cause the crisis of confidence. The existence of this dilemma clearly showed that the system was inherently unstable and was destined to collapse.
(v) Problem of Symmetry:
There was a general problem of symmetry between deficit and surplus countries or between the USA and the rest of the world. Although the Bretton Woods System intended that both deficit and surplus countries should share the burden of adjustment in payments imbalances, yet the brunt of adjustment fell practically entirely upon the deficit countries.
While the surplus countries could continue to run surpluses so long as they were willing to accumulate reserves, the deficit countries could not run down their reserves indefinitely. This asymmetry between the deficit and surplus countries exposed a serious weakness in this system and became partly responsible for its eclipse.
(vi) The Liquidity Problem:
One of the predominant causes of the breakdown of the Bretton Woods System was the problem of liquidity. Any system of fixed or stable exchange rate could work efficiently only if there were sufficient international reserves. During the 1950’s and 1960’s, the U.S. deficits in BOP continued to increase on account of overseas investments and escalation of Vietnam War. The European countries and Japan at the same time could create surpluses in their BOP.
The U.S. balance of payments deficit could be financed by either the export of gold or through the acquisition of dollars by the foreign surplus countries. In either of the two cases, the United States reserves deteriorated. The rest of the world continued to have large demand for dollars for making the BOP adjustments among themselves as dollar was the key currency. Even for maintaining the exchange rates stable in terms of dollars, countries started keeping a large fraction of their international reserves in the form of dollar balances and the short term dollar securities.
Apart from persistently increasing demand for dollars, this currency also emerged as the principal ‘intervention currency’—a currency which monetary authorities bought or sold in foreign exchange markets to keep exchange rates within ± 1 percent margin round the par values.
This problem of liquidity continued to become grave raising the worldwide expectation of the impending devaluation of dollar. But since other countries were tied to the dollar, that did not permit the United States to make readjustment of the exchange rate of dollar with other principal currencies.
(vii) Speculation and Short Term Capital Movements:
After the development of Euro-dollar market in the late 1950’s, there was rapid growth of highly mobile short term capital. The anticipated changes in par values on account of heavy pressure upon dollar resulted in large scale speculative capital. It led to the speculative capital movements from the United States to other surplus countries such as Germany, Japan and Switzerland. These large scale capital movements were bound to have destabilising effect upon exchange rate as well as the BOP adjustments.
(viii) Conditions of Inflation:
An important factor to cause the collapse of the Bretton Woods System was the domestic inflation in the United States particularly after the escalation of Vietnam War from 1965. Both Johnson and Nixon administrations were unwilling to finance the war efforts by increased taxes. Instead easy money policies were pursued.
These policies intensified inflation in the United States and the balance of current account got weakened. The surplus countries of Europe feared the transmission of inflation to their own countries, when their balance of payments surpluses had been bringing about an increase in their money supplies.
These countries, especially West Germany, attempted to counter inflation through the enforcement of strict monetary policies. The high interest rates further accentuated capital flow from the United States to the countries of Europe and Japan and precipitated in 1970-71 the fall of Bretton Woods System.
All these developments eventually resulted in the United States declaring on August 15, 1971 the inconvertibility of dollar into gold. At the same time, it imposed a temporary 10 percent surcharge on imports and the Bretton Woods System broke down.
The negotiations began almost immediately to bring about proper readjustments in the international monetary system. In December 1971, the representatives of the Group of Ten met at the Smithsonian Institute in Washington. This meeting could hammer out an agreement called as Smithsonian Agreement. It was agreed to increase the dollar price of gold from $ 35 per ounce to $ 38 per ounce. This implied the devaluation of dollar by about 9 percent.
The currencies of the two countries with the largest BOP surplus— Germany and Japan, were revalued. While the German mark was revalued by 17 percent and the Japanese yen was revalued by 14 percent. The band of fluctuation was increased from 1 percent to 2.25 percent on either side of the central rate. The United States withdrew 10 percent surcharge on imports. As the dollar remained inconvertible into gold, the world was essentially on the dollar standard. President Nixon of the United States assured that the dollar would not again be devalued.
It was expected that Smithsonian Agreement would remove the underlying cause of the disequilibrium that led to the crisis of August 1971. These expectations were realised only for a short period. The first break in the pattern of exchange rates established through Smithsonian Agreement occurred in May 1972, when the British pound came under heavy pressure. Britain decided to cease support of the exchange rate and to allow the rate to respond to market forces. Over the next six months, the value of pound dropped 10 percent below the level set in December 1971.
Japan, on the other hand, continued to have a large BOP surplus. The Japanese yen was subject to upward pressure. Throughout the latter half of 1972, the Japanese monetary authority had to buy large amounts of dollar in the foreign exchange market to keep the value of the yen within limits prescribed by the Smithsonian Agreement.
The United States had another huge BOP deficit ($ 10 billion) in 1972. The recognition started dawning that the Smithsonian Agreement was not working and that another devaluation of dollar was required. There was renewed speculation against the dollar and consequent large scale movement of short term capital from the United States to mainly Germany.
During the first seven trading days of February 1973, the German central bank purchased some $ 6 billion in order to prevent the mark from appreciating against the dollar. A second realignment of exchange rates had become unavoidable. On February 12, 1973, the United States was once again forced to devalue dollar by about 10 percent. There was the corresponding appreciation of the EC currencies in terms of dollar.
They decided to let their currencies float jointly. Japan and Italy too joined Britain in rescinding their previous policies of maintaining stable exchange rates and allowed their currencies to float and readjust according to market forces. When the exchange markets reopened on March 19, 1973, all of the World’s major currencies were floating. The Bretton Woods System which had actually died in August 1971 was finally buried. The system of stable and pegged exchange rates gave way to the system of managed floating exchange rates.
Monetary System after the Collapse of Bretton Woods System:
After the crisis of 1971, the Board of Governors of the IMF recognised the necessity of investigating the possible measures for the improvement in the international monetary system. In 1972, it constituted a committee of twenty members, often referred as The “Committee of Twenty” (C20). Three basic weaknesses of the Bretton Woods System, identified by the Committee included liquidity, confidence and adjustment. The outlines of recommendations made by the Committee, therefore, attempted to address to these issues.
Despite prolonged discussion between 1972 and 1974, there could not be any headway towards evolving measures for reforming the system. An agreement was finally reached at a meeting in Jamaica in 1976 concerning some amendments to the Articles of Agreement of the IMF.
These were to be enforced from 1978. There was only a limited purpose behind it to make the system of managed float work better.
The principal changes introduced in the International monetary system included:
Firstly, the most significant development since 1978 in the international monetary relations has been the replacement of Special Drawing Rights (SDR’s) in place of gold as a reserve asset system. The official price of gold has been abolished and the restrictions on its sale in the open market have been removed. In fact, the IMF has been itself selling off gold reserves and putting the proceeds in the special funds.
The dominant reserve assets at present are the national currencies, about 75 percent of which are in the U.S. dollar. However, other major currencies have also gained importance. Since SDR is no longer related to gold, it has been linked with a basket of 16 major currencies. The IMF has been engaged in expanding the range of activities for which the SDR’s could be used. In addition, the interest rates on the IMF lendings have been raised closer to the market rate of interest.
Secondly, in order to relieve the problem of shortage of international liquidity, the IMF created several new credit facilities.
These include:
(i) The Compensatory Financing Facility (CFF), which enabled the member countries to draw from the fund upto 100 percent of their quota when they experienced BOP difficulties, caused by temporary shortfalls in the export receipts;
(ii) The Buffer Stock Financing Facility (BSFF) which permitted member countries to draw upto 50 percent of their quota to finance international buffer stock arrangements;
(iii) The Extended Fund Facility (EFF) which allowed the member countries to draw upto 140 percent of their quota extended over a period of three years, when facing serious structural imbalances;
(iv) The Supplementary Financing Facility (SFF) which provided supplementary financing facility when the member countries required the funds over and above those that could be made available under regular and standby arrangements for longer periods; and
(v) The oil facility, under which IMF borrowed funds from some surplus nations to assist those countries that suffered BOP deficits in view of steep rise in petroleum prices in 1973-74. By 1976, the oil facility had been fully utilised and it is now no longer operational. In view of the huge international debt problem faced by several LDC’s, the IMF has also initiated some debt rescheduling and rescue operations.
Thirdly, in the present international monetary system, the member countries are allowed either to float or peg their currencies. In the latter case, the exchange rate of one currency may be pegged to the currency of a particular country, the SDR or a basket of currencies. The exchange rate cannot be fixed in terms of gold. The exchange rate fixation or adjustments are subject to IMF supervision or guidelines. There are no limits on the margins within which these rates are pegged and there are no rules about how these should be altered.
In contrast to the structured arrangements of the gold standard and Bretton Woods System, the present system is more chaotic and reminiscent of the 1930’s.
Some serious shortcomings in the present monetary system are as follows:
(i) There is the existence of a variety of exchange rate regimes with very little effective supervision.
(ii) The reserve asset system depends on the portfolio decisions of central bankers.
(iii) In the present system, there are no accepted rules for sharing the adjustment to payments imbalances.
(iv) The emergence of floating exchange rates has greatly accentuated uncertainty in international trade. Consequently many traders, bankers and economists like to see the return to a more orderly system.
