international trade and balance of payments for 2nd semester economics for BBA

International Trade
and Balance of
payments
Chapter 10

International Trade and
Balance of payments
“The benefit of international trade-a more
efficient employment of the productive forces
of the world.” (J.S. Mill)

Gains from international trade
 Whether trade liberalization promotes growth or hurts
it, there are debates on this. A number of anti-
globalization activists and domestic industry
protectionists argue that trade creates unemployment
by displacing workers employed in the domestic
industry, increases environmental pollution and
degradation, and contributes to higher income
inequality.
 But the supporters of trade liberalization argue that it
increases specialization, contributes to economies of
scale, brings new ideas and innovation, makes
domestic market competitive and ultimately
contributes to growth and poverty reduction.

 In their paper “Trade, Growth and Poverty”, Dollar
and Kraay mention that globalizers countries that
liberalized trade have grown at the higher rate than
the non-globalizers, countries that didn’t liberalize
trade. In the 1990s, the globalizing developing
economies grew at 5% per capita more than double
of such rate in the rich countries (2.2%) and more
than triple of the non globalizing developing
countries (1.4%).
 According to Dollar and Kraay, the experiences of
the post-1980 globalizers show that the process can
have great benefits, contributing to rising incomes
and falling poverty and enabling some of the poorest
countries in the world to catch up with richer
countries.

 The real losers from globalization are those
developing countries that have not been able
to seize the opportunities to participate in this
process. Thus, their idea seems that the
integration of the world economy over the
past twenty years has been dramatic and
open trade regimes has led to faster growth
and poverty reduction in poor countries

 Economies of scale: Trade provides an opportunity
to countries to specialize in certain products and
reduce the unit costs with a larger output resulting in
from increasing return to scales. But, protected
markets not only have fragmented production
internationally, they also create room for proliferation
of too many firms in narrowly domestic markets.
Because of this, the scale of production becomes
inefficient.
 Increased competition: Trade provides opportunities
to domestic producers to be competitive, explore new
ways of doing business and diversify trade in the
global market.

• Knowledge spillover and transfer of technology:
Not only domestic producers but also the economy as
a whole gain from the knowledge and technology
transfer resulting in from the economic integration in
the world market.
• Increased efficiency or Elimination of deadweight
loss: Trade provides opportunities to domestic
producers to be competitive, explore new ways of
doing business and diversify trade in the global
market.

• Good governance: Trade reduces the chance
of corruption, rent seeking and unnecessary
bureaucratic hurdles to entrepreneurs. It gives
an opportunity to government to timely review its
trade policy, modernize customs and other
revenue mechanisms, and offer better services
in the face of global competition.
 Widens the market: the foreign trade
integrates a country with other countries. Hence,
the market for goods is widened. A country need
not remain limited to own market.

 Promotion of employment opportunities:
The increase in foreign trade leads to the
development of export-oriented industries.
This promotes employment opportunities.
Consequently, the income and standard of
living of people increase.

Meaning of comparative
advantage
 The Comparative Cost Theory was first
systematically formulated by the English economist
David Ricardo in his "Principles of Political Economy
and Taxation," published in 1817. It was later
refined by J.S. Mill, Marshall, Taussig and others.
 The Ricardian theory is based on the following
assumptions:
1. Labour is the only element of cost of production.
2. Goods are exchanged against one another
according to the relative amounts of labour
embodied in them.

advantage
3. Labour is perfectly mobile within the country but
perfectly immobile between countries.
4. Labour is homogeneous.
5. Production is subject to the law of constant returns.
6. International trade is free from all barriers.
7. There is no transportation cost.
8. There is full employment.
9. There is perfect competition.
10. There are only two countries and two commodities.

advantage
 Based on its simple assumptions,
 The Ricardian model is the simplest model that
shows how differences between countries give rise
to trade and gains from trade. In this model labor is
the only factor of production and countries differ only
in the productivity of labor in different industries.
 In the Ricardian model, countries export goods that
their labor produces relatively efficiently and import
goods that their labor produces relatively
inefficiently. This means a country’s production
pattern is determined by comparative advantage.

advantage
 A country is said to have a comparative
advantage in producing a good if the
opportunity cost of producing that good in
terms of other goods is lower in that country
than it is in other countries.
 Trade between two countries can benefit both
if each country exports the goods in which it
has a comparative advantage.

advantage
Apples Bananas
Home aLa=3 hrs for
one apple
aLb=2 hrs for
one banana
Foreign a*La=5 hrs for
one apple
a*Lb= 1hr for
one banana

advantage
 Based on the information given in the above table,
 Opportunity cost of producing one apple for Home
=3/2=1.5 (i.e. 1 apple is equal to 1.5 banana)
 Opportunity cost of producing one apple for
Foreign=5/1=5 (i.e. 1 apple is equal to 5 banana for
foreign)
 Think which country has higher opportunity cost for
producing apple, and which country will produce and
export which product according to the comparative
advantage theory.

Analyzing the case of
comparative advantage
 Suppose the home country has 1200 units of
labor available. It can produce two goods:
apples and bananas. The unit labor
requirements for Home are 3 and 2 for apples
and bananas respectively.
a) Graph Home’s PPF
b) What is the opportunity cost of apples in
terms of bananas?

Home’s PPF
 When there is only one factor of production, PPF
will look like:

 Given that it takes 3/2 as much time to make
an apple as a banana, the opportunity cost
must be: 3/2

 Now, suppose the foreign country has 800
units of labor available. The unit labor
requirements for Foreign are 5 and 1 for
apples and bananas respectively.
a) Graph Foreign’s PPF
b) Show the Home and Foreign gains from
trade on the PPF

Main idea of Ricardian Model
 Ricardian model is based on the notion of
comparative advantage. This model recommends
that a country should specialize in a good in which
it has comparative advantage rather than absolute
advantage. Thus, this model does a good job in
predicting that countries will tend to export goods
in which they have relatively higher productivity.
This prediction of Ricardian model is confirmed by
a number of studies as mentioned by Krugman
and Obstfeld in “International Economics”.

Some drawbacks associated
with the prediction
 Despite the good prediction this model does, it makes
misleading predictions in the following ways:
 First, this model predicts an extreme degree of
specialization that we do not observe in the real
world. In the real world, countries do not confine in
producing a single product. Extreme degree of
specialization may not be practical because of the
existence of more than one factor of production,
because countries sometimes protect their industries
from competition, and it is costly to transport goods
and services.

with the prediction
 This model assumes that countries as a whole will
always gain from trade. But, in real life, there is a
strong effect of international trade on income
distribution. For example, with opening of trade
certain section of the people who are engaged in
some small and cottage industries may loose their
job because of the displacement of such industry.
And these labors may not be able to move freely
since their skill may not match with the requirement
of new industries. Even if they could move, their real
wage may be less since they are new for the new
industry. But the Ricardian model assumes that
trade makes real wages to go up or remain same
because of the free movement of labor without the
loss of skill.

with the prediction
 The model does not allow any role for differences in
resources among countries. But the international
trading system is largely driven, among others, by
resource differences. A country with more resource
endowment can have more influence in the global
trade. The influence of OPEC countries is an
example of this.
 The model ignores the role of economies of scale as
a cause of trade. Thus, the large trade flows
between apparently similar nations is unexplained by
Ricardian Model. When countries concentrate their
resources in certain products, they also gain from
the economies of scale.

Protectionism
Meaning:
 The term protection refers to a policy whereby
domestic industries are to be protected from foreign
competition. The aim is to impose restrictions on the
imports of low-priced products in order to encourage
domestic industries producing high priced products.
 Protection takes in form of imposing import duties
which raise the price of foreign goods by more than
the price of domestic goods. Or, they may be
protected by quotas or other non-tariff restrictions
which make imports of cheap foreign goods difficult.
Or, the domestic industries may be paid subsidies-
or bounties to enable them to compete with cheap
foreign goods.

Arguments for protectionism
 Terms of Trade Argument. The terms of trade
argument is given to correct disequilibrium in the
balance of payments of a country. It is argued that
the imposition of a tariff on imports improves the
rate at which the country's exports are exchanged
for imports. This means that a tariff improves its
terms of trade because the foreign exporter is forced
to pay some part of the import duty.
 Bargaining Argument. It is argued that the
imposition of tariffs is necessary to bargain in trade
negotiations with other countries. Since international
trade is based on reciprocal basis, tariff is used as a
weapon to persuade or dissuade other countries to
lower the tariff wall. Thus, the fear of tariffs may
induce countries to give reciprocal concessions to
each other.

 Anti Dumping Argument. Protection is
advocated against the practice of dumping.
Dumping means selling a product in a foreign
market at a lower price than in the home
market, after taking into account transport
and other costs of transfer. Dumping aims at
flooding foreign market with-low-priced
commodities. As a result, the import
competing firms are ruined. To protect such
firms, a high tariff is imposed. This will raise
the price of the product in the importing
country and remove the threat of dumping.

 Diversification Argument. Another
argument in support of protection is to
diversify the domestic industries. It means
that there should be a balanced growth of the
economy so that all the sectors of the
economy develop simultaneously. For this,
agriculture and manufacturing industries
should be protected from foreign competition.
This is assumed to be valid argument
particularly during the period of international
economic disturbances, such as crop failures,
depression, inflation, war, etc.

 Infant Industry Argument. The infant
industry argument is the oldest argument for
protection. It was formulated by Alexander
Hamilton in 1790 and was popularized by
Friedrich List in 1885. This argument tests on
the assumption that the country has a latent
comparative advantage in the industry or
group of industries to be protected. It is,
therefore, argued that if industries in their
infancy are not protected from established
foreign producers, they cannot develop to
enjoy the comparative advantage. For this,
they must attain the optimum size so as to
operate most efficiently and competitively.

 Socially Important or Key Industries Argument.
Protection should be given to socially important
-industries such as agriculture or strategically
important industries as iron and steel, heavy
electrical, machine making, heavy chemicals, etc.
 Employment Argument. A usual argument for
protection is that it is a cure for unemployment. The
imposition of a tariff reduces imports and
encourages employment directly in import
competing industries. This in turn, generates
employment in other industries dependent upon this
import-competing industry and may ever spread to
import substitution industries.

 Balance of Trade Argument. The balance of
trade argument is based on the notion that a
country should impose tariffs to have a
surplus of exports over imports.
 Pauper Labor Argument. It is argued that
goods produced by workers getting high
wages in one country cannot compete with
goods produced by low-wage workers in the
other country. Therefore, high wage domestic
goods should be protected from low-wage
imported goods by imposing tariffs.

 Defense Argument. A country should adopt
the policy of protecting its industries from the
standpoint of national defense. If a country is
dependent on other countries for its
requirement of agricultural and industrial
products, it will be very harmful for its national
interest in times of war. The argument runs
that it is no of use amassing wealth and
becoming richer, if the country is not in a
position to defend its freedom.

 Preservation Argument. Protection is advocated to
preserve the special ethos of the nation and certain
classes of the population or certain occupations. It is
argued that these would tend to disappear under
free trade and there preservation is desired on
political and social grounds. This argument is put
forth to safeguard the interests of the agriculturists.
The imposition of agricultural duties on the import of
farm products is beneficial for the farmers who
would be assured fair prices for their products. This
is the reason for what US and European Union
countries have protected their farmers with huge
amount of subsidy.

Balance of payments (BOP)
 A through understanding of balance of payments
accounting helps in evaluating the implications
of a country’s international transactions.
 The trends and the existing position of the
balance of international payments of a country
significantly affect the economic policies of its
government. As every country strives to maintain
a favorable balance of payments, the trends and
the existing position of the balance of payments
significantly influence, in particular, the nature
and types of regulation on export and import
business.

Balance of payments
 A country’s balance of payments accounts
keep track of both its payments to and its
receipts from foreigners. Any transaction
resulting in a payments to foreigners is
entered in the BOP accounts as a debit
and is given a negative (-) sign. Any
transaction resulting in a receipt from
foreigners is entered as a credit and is
given a positive (+) sign.

Balance of payments
 The IMF BOP Manual 5 defines balance of
payments as a “statistical statement that
systematically summarizes, for a specific
time period, the economic transactions of
an economy with the rest of the world.”
 The basic convention applied in
constructing the BOP is the double-entry
accounting system. Every transaction is
represented by two entries with equal
values but opposite signs, a debit (-) and a
credit (+).

Balance of payments
 By convention certain items are recorded as
debits and others as credit, as follows:
Export of goods and services Credit (+)
Import of goods and services Debit (-)
Increase in financial liabilities Credit (+)
Increase in financial assets Debit (-)
Decrease in liabilities Debit (-)
Decrease in assets Credit (+)

Balance of payments
 The BOP identity is shown in the following way:
A. Current account
B. Capital account
C. Financial account
D. Net errors and omissions
E. Reserves and related items
See the attached NRB sheet for detail

Balance of payments
 The BOP manual’s standard classification system has
three accounts: current account, capital account, and
financial account.
 Current account: The current account is comprised of
goods, services, income, and current transfers.
 Transactions classified under goods relate to the
movement of merchandise and generally involve a
change of ownership.
 Services refer mostly to the transportation and
insurance of merchandise shipments, transport fares
paid by travelers, tourist services (hotels, restaurants),
royalties and license fees, communications,
constructions, house rentals, government purchases (in
connection with embassies, for example), and other
items.

Balance of payments
 Income may be derived from labor, and financial
assets and liabilities. Thus, there are mainly two
items: compensation of employees, and
investment income.
 In compensation, earnings of Nepalese workers
working abroad for less than one year is a credit
item, and payments to foreign workers working
in Nepal for less than one year is debit item.
 Under investment income, credit entries reflect
dividend and interest received by domestic
owners of capital. For example, interest earned
by NRB and commercial banks on their holdings
of foreign government bills and securities.

Balance of payments
 Under investment income, debit entries reflect
dividend and interest received by foreign owners
of capital. For example, dividend received by the
foreign firms owning Bhotekoshi and Khimti, and
also dividend received by the parent companies
of Nepalese joint ventures.
 Interest paid on foreign debt also comes under
this item.

Balance of payments
 Another item under current account is current
transfers. These transfers are largely
dependent on decisions made by governments
of countries that are foreign aid donors. Thus,
current transfers mainly include: grants and
workers remittances. Current transfer grants
include food aid, emergency and relief
assistance and other grants which are not of
investment nature. Workers remittance is the
amount that people working abroad for more
than one year have sent or the amount paid to
foreign workers who are working in this country
for more than one year.

Balance of payments
 Capital account consists of: (a) capital transfers, (b)
acquisition or disposal of non-financial assets. Capital
transfer is the transfer of investment nature. Capital
expenditure related assistance by the foreigners or to the
foreigners. Migrants’ income or transfer for example
British Armies’ selling properties and transferring wealth
to the UK is also capital transfer. It may be in cash or
kind. Debt forgiveness is also included under this.
 Financial account has four functional categories: (a)
direct investment, which is further divided into equity
capital, and reinvested earnings, (b) portfolio investment,
which includes long term debt and equity securities,
money market instruments, and tradable financial
derivatives, including currency and interest rate swaps.

Balance of payments
 Financial account has four functional
categories: (c) Other investment such as trade
credits and general borrowing and IMF credit,
and (d) reserve assets, available to meet
immediate needs to make foreign payments.
 Net errors and omissions are unidentified and
missing amounts of different headings.
 Reserve assets include foreign exchange
(currency, deposits, and securities), monetary
gold, SDRs, and country’s reserve position in the
IMF.
 Overall BOP is the change in the net foreign
assets of the banking sector.

Balance of payments
Causes of disequilibrium:
 Development schemes: for industrialization, country may
need to import more, export may fall.
 Price cost structures: Increase in prices because of
higher wages, and higher cost of raw materials etc
reduce exports and makes the BOP unfavorable.
 Changes in foreign exchange rate: Appreciation of
domestic currency may induce import and cause BOP
balance deteriorate.
 Fall in export demand: Because of the cheap products
produced within country or imported from other countries
may cause a fall in export demand.
 Demonstration effect: countries of poor countries may
also change their consumption habit and follow those of
the developed countries leads to high import demand.

Balance of payments
Causes of disequilibrium:
 Cyclical fluctuations: During depression,
foreigners may demand less since their income
has fallen. This may cause disequilibrium on
BOP.
 Population growth: Rapid growth of population
cause high import and BOP disequilibrium.
 Natural factors: Natural calamities such as
droughts, floods, cause low production and high
import. This also causes BOP disequilibrium.

Balance of payments
Methods of correcting BOP disequilibrium:
 Deflation: Adopting contractionary monetary policy. This
causes lower price and low monetary income. The idea
is this causes export promotion through price reduction
and reduction in import through income decline at home.
 Currency devaluation: This is done to make import
dearer and export cheaper.
 Exchange control: All exporters are asked to surrender
foreign currency at central bank and central bank rations
the currency among license holders.
 Capital movement: Raising domestic interest rate can
cause capital inflow.
 Encouraging exports: Through duty reduction, subsidy,
negotiations with trading partners for favorable trade
conditions.
 Discouraging imports: Through import quotas, import
duties, import substitution policies.

Foreign direct investment
 Foreign finance: in addition to the foreign aid, it can
be in the form of private foreign direct and portfolio
investment.
 Private direct investment, commonly known as FDI
is made by large multinational corporations (e.g.
General Motors, USA; Ford Motor, USA; Toyota
Motor, Japan; Daimler Benz, Germany) with
headquarters in the developed nations.
 Foreign portfolio investment (e.g. stocks, bonds, and
notes) in LDC “emerging” credit and equity markets
by private institutions (banks, mutual funds,
corporations) and individuals.

Why do countries need foreign finance?
 To meet the saving investment gap (Recall the
Harrod-Domar model g=s/k). If a country needs to
grow at the rate of 10% at a “k” of 3, the required
saving investment would be 30%. And if the
domestic saving is only 14%, the country needs to
meet this gap of 16% through foreign finance.
 To meet the foreign exchange gap. Forex gap is the
difference between the required foreign reserve and
the net export earnings plus net public foreign aid.

Why do countries need foreign finance?
 The third gap it can meet between targeted
governmental tax revenues and locally raised taxes.
Raising tax from MNCs, developing countries’
government would be in better position to utilize
resources.
 Another can be in reducing the gap in technological
knowledge, managerial expertise and
entrepreneurial skills. Transfers of knowledge, skills,
and technology are both desirable and productive
for the recipient countries.

What are the counter arguments?
 May lower domestic savings and investments
by stifling competition through exclusive
production agreement with host
governments, failing to reinvest much of their
profits, generating domestic incomes for
groups with lower saving propensities, and
inhibiting the expansion of indigenous
industries that would supply materials and
intermediate goods.

 Despite the short term accumulation of forex
reserve, in the long run both current account
and capital account may deteriorate. Current
account will deteriorate because of the
imports of capital goods and intermediate
goods and capital account because of the
overseas repatriation of profits, interest,
royalties, management fees and other funds.

 Even though there are some contributions of
MNCs to tax revenue, it can be lower than
what it should be because of the liberal tax
concessions, excessive investment
allowances, tariff protection by the host
government.
 It may inhibit the growth of local
entrepreneurship since the local market is
dominated by MNCs.

Some more fundamental objections:
 MNCs only cater to the needs of local elites.
Production, job opportunities, and location all
are in favor of rich people. They don’t
produce goods like food for mass
consumption rather produce sophisticated
goods for rich people. They are located in
urban centers and increase the rural-urban
gap. .

 MNCs produce inappropriate products (demanded
by local elites, small fraction of population) and
convert local tastes and preferences into exotic
ones.
 Create more capital-intensive processes, thus
replacing labor and causing increased
unemployment problem.
 MNCs may damage host economies by suppressing
domestic entrepreneurship and using their superior
knowledge, worldwide contacts, advertising skills.

 At the political level, MNCs gradually gain control
over local assets and jobs and then build influence
on host country government/political forces and
decision-making. They can do this also by joining
hands with corrupt officials at high levels through
corruptive means and promoting rent seeking
cultures.

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international trade and balance of payments for 2nd semester economics for BBA