Subject COMMERCE Paper No and Title 11 and International

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PAPER No. : 11 INTERNATIONAL BUSINESS

MODULE No. : 9 ECONOMICS OF TRADE

Subject COMMERCE

Paper No and Title 11 and International Business

Module No and Title Module 9: Economics of Trade

Module Tag COM_P11_M9

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TABLE OF CONTENTS

1. Learning Outcomes

2. Gains from Trade

3. Terms of Trade

4. Foreign Trade Multiplier

5. Summary

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1. Learning Outcomes

After studying this module, you shall be able to:

I. Evaluate Gains from trade

II. Measure the Foreign trade multiplier

III. Evaluate Terms of trade

2. Gains from Trade

2.1 Introduction

After having understood comparative cost advantage and the need for specialization in

international trade. We now wish to examine the case of gains from trade. In the above section we

have seen how India although is more efficient in the production both radios and fans, still India

possesses a comparative advantage in the production of radios as opposed to fans. Similarly

although Bangladesh is less efficient in the production of both radios and fans, it possesses a

comparative advantage in the production of fans. So, this points towards the need for international

specialization in production. Therefore, India should specialize in the production of radios and

Bangladesh in production of fans. This also tells us why do countries trade. If international

specialization takes place then each country is concentrating on the production of one commodity,

but is desirous of other commodity. Similarly the trading partner (the other country, Bangladesh

in this case) specializes in the production of other commodity (fans) but is desirous of having first

commodity (radios). This determines the need for trade.

When India is better off in the production of both goods radios and fans why should India want to

trade? The answer is that India needs to specialize in the production of that commodity (radios) in

which it has comparative advantage. It would give up the production of a part of the other

commodity (fans). However since the other commodity (fans) is consumed domestically, India

would have to import that commodity (fans) with its trading partner (Bangladesh).A similar

situation would arise for the trading partner Bangladesh, who would specialize in the production

of the other commodity (fans). This results in two things:

1. Basis for trade. 2. International Specialization of production

Thus, we can say that the justification for trade comes from the possibility of gains from trade.

Let us take an example to illustrate gains from specialization and trade. As long as relative cost of

two goods- radio and fan differ between India and Bangladesh, gains from trade will be possible.

In this illustration India can produce one unit of radio and one unit of fan with labor cost

measured in hours which is 80 hours & 100 hours respectively for radio and fan which less than

the cost of production of Bangladesh for both the goods as Bangladesh uses 120 and 100 labor

hours for the production of one unit of each good. Therefore, India has absolute advantage over

the production of both the goods (radio & fan).

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Table I. Country

Labor Cost of Production(in

hours)

Radio Fan

India 80 90

Bangladesh 120 100

Total 200 190

To understand and analyze the concept of gains from trade we use the concept of opportunity

cost. Opportunity cost of production of one commodity X is the amount of another commodity Y

which has to be given up to produce an additional unit of good X. We have to find out the opportunity cost of production of radio and fan in India and Bangladesh.

It needs 80 labor hours to produce one unit of radio in India. However, in India a fan can be

produced with 90 labor hours. 90 labor hours produces: - 1 unit of fan 1 labor hour produces: - 1/90 unit of fan

80 hours of labor produces: - 80/90 unit of fan With 80 labor hours, one can produce 8/9 unit of fan.

Table II.

Opportunity Cost of Production(in units)

Country For 1 unit of Radio For 1 unit of Fan

India 8/9 (<1) 9/8 (>1)

Bangladesh 12/10 (>1) 10/12 (<1)

From the Table II, it is clear that the opportunity cost production of production radio is less in

India than the opportunity cost of production of radio in Bangladesh. Whereas the opportunity

cost of production of fan is lower in Bangladesh as compared to India. Thus, India has the

comparative advantage in the production of radio and Bangladesh has comparative advantage in

the production of fan.

In order to explain the gains arising from trade we will take up following three different

propositions:

Proposition I. If country A (India) gains and country B (Bangladesh) is not worse off.

Proposition II. If country B (Bangladesh) gains country A (India) is not worse off.

Proposition III. If country A (India) gains as well as country B (Bangladesh) also gains.

Note: If one country is better off and the other is not worse off then there are gains from

trade.

Proposition I: Here we fix will the terms of trade arbitrarily to show that country A (India) gains

and country B (Bangladesh) is not worse off. Suppose the terms of trade are fixed such that

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Bangladesh exports 12 units of fans and imports 10 units of radios. In this case the entire gain

will accrue to India. This is shown in the following Table III.

Table III.

In terms of labor hours spent and saved Gains from trade(in labor hours)

Country Exports(spent) Imports(saved)

India 10*80=800(radios) 12*90=1080(fans) 280

Bangladesh 12*100=1200(fans) 10*120=1200(radios) NIL

Proposition II: Here we will fix the terms of trade arbitrarily such that country B (Bangladesh)

gains country A (India) is not worse off. Suppose terms of trade are fixed such that India exports

9 units of radios and imports 8 units of fans. In this case the entire gain will accrue to Bangladesh.

This proposition is illustrated in the following Table IV.

Table IV.



India 9*80=720(radios) 8*90=720(fans) NIL

Bangladesh 8*100=800(fans) 9*120=1080(radios) 280

Proposition III. Here we will fix the terms of trade arbitrarily such that country A (India) gains

as well as country B (Bangladesh) also gains. Suppose both India and Bangladesh agree for 1 to

1(1 – 1) trade that is India exports 1 unit of radio and exports 1 unit of fans. Whereas Bangladesh

do the same exports I unit of fan and import 1 unit of radio. This is clearly illustrated in Table V.

Table V.



India 1*80=80(radios) 1*90=90(fans) 10

Bangladesh 1*100=100(fans) 1*120=120(radios) 20

3. Foreign Trade Multiplier

Multiplier constitutes an important edifice of Keynesian theory of employment and income

determination. There exist various types of multiplier in Macroeconomics. They include

investment multiplier, government expenditure multiplier, tax multiplier, transfer payment

multiplier etc. All these multipliers result in change in National Income arising out of change in

different entities like investment, government expenditure, tax and transfer payment. However,

these multipliers relate to a closed economy, which does not conduct any economic transactions

with rest of the world. Once this assumption is dropped, national income will change when export

changes. This leads to the concept of foreign trade multiplier.

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The equation for foreign trade multiplier:

Kf = 1/MPS+MPM

where MPS is Marginal Propensity to Save(S/Y), and MPC is Marginal Propensity to

Import(M/Y) Therefore, the smaller the MPS & MPC, the larger will be the value of foreign trade

multiplier and vice-versa.

Hence, foreign trade multiplier is: Kf = 1/S+M

It is thus evident from the above equation that smaller the leakages (i.e. the smaller the MPS and

MPM) the greater the foreign trade multiplier and vice-versa.

Foreign Trade Multiplier may be defined as the amount by which national income of a nation will

be raised by a unit increase in domestic exports. It is based on a fundamental assumption which is

the basis of operation of varied types of multiplier, as mentioned above. The assumption relates to

existence of unemployed resources in the economy. The reason is well understood. For additional

income generation, production must expand. Such an expansion is made possible by two factors,

one relating to demand, while the other relates to supply. First, there needs to be a source of

additional demand for output. It does not matter, what leads to such a rise in demand. It may be

rise in investment, rise in government expenditure, fall in tax and rise in transfer payment made

by government. While any one among them provides the additional demand for output, they lead

to a rise in output and income in so far as unemployed resources are available in the economy. It

just needs to be added that if the source of rise in demand does not relate a foreign country in the

form of export, we have a new concept of foreign trade multiplier, which like other multiplier

changes income, but unlike the rest relate to a phenomenon, which does not emanate from the

domestic economy. We need to be aware of all the assumptions of the concept of foreign trade

multiplier, before an explanation of the process leading to change in national income due to

change in export.

Assumptions of foreign trade multiplier

1. Existence of unemployment of resources in the economy needs to be assumed. If this

assumption is not fulfilled, it will not raise income consequent to a rise in export. Price

will rise instead of output and income.

2. One needs to assume an open economy, where there are economic transactions with rest of

the world.

3. We are assuming a small economy. The significance of the assumption must be

understood. In the discussion of investment multiplier, investment is assumed to be

autonomous, i.e., it is assumed to be independent of national income. In order to simplify

the analysis of foreign trade multiplier, one needs to make a similar assumption about

exports. However, this has a very significant implication. It needs to be remembered that

exports of the one country are imports of the trading partner, which depends on its national

income. Now there need not be appreciable increase in income of the other country,

which is exporting from the country in which production for such export is taking place.

For this to happen, the concerned country need to be small so that changes in the national

http://en.wikipedia.org/wiki/National_income

http://en.wikipedia.org/wiki/Export

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economy need not produce a large impact on the

national income of its trading partner. The assumption

of a small domestic economy will ensure this.

4. We are keeping investment, government expenditure, tax and transfer payment to be

constant, so that change in national income may be explicitly linked to change in export.

Illustration:

Suppose S (savings) = 0.3 and M (imports) = 0.2

Then Kf = 1/0.3+ 0.2 = 1/0.5 = 2

i.e. an increase in export income of Rs. 100 crore will lead to an increase in national income of

Rs. 200 crore when Kf = 2.

The process of foreign trade multiplier

Rounds Change in

Exports((∆X)

Change in

Consumption

∆C=C*∆Y,

where C=0.5

Change in

Imports

∆M=m*∆Y

where, M=0.2

Change in

Savings ∆S

where S=0.2

Change in

Income (∆Y)

1

2

3

4

5

......

…..

…..

…...

100

......

…..

…..

…..

…..

…..

…..

…..

500

250

125

62.5

31.25

…..

…...

…...

……

200

100

50

25

12.5

…..

…..

…..

…...

300

150

75

37.5

18.75

......

…..

…..

…...

1000

1500

1750

1875

1937.5

…..

…..

…..

…...

? 1000 1000 400 600 2000

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Diagrammatic Illustration

In the figure given below, national income has been shown on X- axis and savings, investments,

exports and imports have been shown on Y- axis. The horizontal line marked Kx represents

exports. The savings and imports functions are represented by the line with a positive slope

marked S+M.

Initially, the economy is in equilibrium at OY level of income where savings plus imports are in

balance with exports at point E. Now, let us assume that there is an autonomous increase in

exports so that the export function is shifted from Kx to KX1. This increase in exports causes an

injection of income of the exporting country to rise by more than the amount of new income from

exports because people spend most of their additional income on domestic goods and services.

Only part of the additional income will leak out by way of savings and imports. Suppose that the

autonomous increase in exports amount to Rs. 100 crore, and the income will be Rs. 200 crore

(because S+M=0.5) and value of Kf = 2.

It becomes clear from the Figure I, that new equilibrium is established at OY1 level of income

where savings + imports are in balance with new level exports. Figure I, clearly depicts the

multiplier effect of the autonomous increase in exports because. ∆Y is greater than ∆X. How

large the expansionary effect on national income will be from a given increase I exports, depends

on the slope of the savings + imports schedule. This slope, obviously depends on the marginal

propensities to save and import. The smaller the sum of these propensities, the smaller will be the

slope of the schedule and the larger the expansionary effect of an increase in exports on national

income and vice-versa.

Leakages and injections

Leakages or withdrawals in a economy consist of spending by households, which does not flow

back into the domestic firms. On the other hand, injections in an economy consist of spending by

households, which flows back to the economy. In a very simple economy without any

government intervention, consumption of domestic goods constitutes the injection, while saving

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constitutes leakages. If government is introduced, we have one

more factor each for injection and withdrawal. They are tax and

transfer payment respectively. Once the economy is open, consumption need not relate to

domestic goods alone and demand for goods need not emanate from where they are produced. In

such a case, export constitutes the injection and conversely imports constitute withdrawal. This

has a significant policy implication. Unless, production is carried out in the economy pulled by

stable domestic demand, the process of income generation may be very unstable, because export

demand need not be stable. However, production may be mostly geared for domestic market only

if the economy is large and capable of producing huge domestic demand. But this advantage does

not exist for a small economy. That was why they had to pursue the strategy of export led

growth.

4. Terms of Trade

Different sectors in an economy trade with each other. For example, while agriculture sells wheat

to industrial sector, industrial sector, in turn sells tractors to agriculture. Both sectors pay a price

for the goods they buy from each other. But the producers belonging to a sector are not per se

interested in the price they get for their products. Even when they get a high price for their

product, the product they want to buy may be even costlier. What actually they are interested is

what is the rate at which they can convert what they produce into what they want? For example,

what is the quantity of the good, they got in exchange for unit of the good they sold for each unit

of product. This brings us to the concept of terms of trade between the two sectors, which

measures the rate of exchange of one good or service for another when two sectors trade with

each other. Terms of trade so defined refer to terms of trade between two sectors of the same

economy. In the current context, we need to define the concept in an international context in

which two sectors do not belong to the same economy, but different economies. For example, we

may think of agricultural sector in Indonesia is exporting rice to Germany and importing

Machines from Germany. In the changed context, the basic concept remains the same and terms

of trade for Indonesia implies the quantity of machines it can import for per unit of rice exported

to Germany. Similarly, one can define the terms of trade for Germany. Clearly, terms of trade for

Indonesia and Germany are inversely related. If Indonesia can get a larger numbers of units of

machine for each unit of rice sold to Germany, terms of trade will favor Indonesia at the cost of

Germany and vice versa. In the literature, two measures exist for calculating terms of trade. We

start with the first measure.

Net Barter Terms of Trade

The ratio between the prices of exports and imports is called the net barter terms of trade. It is

also called "the commodity terms of trade."

Net Barter Terms of Trade= Px /Pm. Px and Pm refer to export price index and import price

respectively.

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If export prices are raising faster than import prices, the terms

of trade index will rise and it is said that the terms of trade

become favorable to the country. This means that fewer exports have to be given up in exchange

for a given volume of imports. On the other hand, if import prices rise faster than export prices,

the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given

amount of imported goods and services. The direction of change in the terms of trade is

determined by the exchange rate and rate of inflation.

Evaluation of the measure

The concept of net barter terms of trade is accepted as a useful device for measuring short-term

changes in trading positions. It also serves as an important index expressing the purchasing power

of exports in paying for imports. However, the problem with this measure of terms of trade is that

it ignores the quantum of trade and hence cannot reveal anything about the behavior of the

balance of payments.

Income terms of trade

The concept of net barter terms of trade has been improved by G.S. Dorrance who formulated the

concept of income terms of trade. Income terms of trade refer to the ratio between the values of

exports to the import prices. In other words, income terms of trade are the net terms of trade

multiplied by volume of exports. Symbolically, Income terms of trade = NBTT*Qx = Px Qx/Pm

Where Q= volume of exports and

NBTT= net barter terms of trade.

Evaluation

The income terms of trade determines the volume of imports that a country can obtain with the

export earnings and hence indicate nation's capacity to import. The concept of income terms of

trade has two major drawbacks:

(i) The income terms of trade cannot indicate the country' total capacity to import. It indicates

export-based capacity to import. The total capacity to import is a function of factors like

unilateral payments, capital inflow, receipts from invisibles, and.

(ii) A change in the income terms of trade does not necessarily reflect the real gains accruing

from trade. With falling export prices and constant import prices, the income terms of trade will

improve, if the physical volume of exports increases more than in proportion to the fall in export

prices.

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5. Summary

The justification for trade comes from the possibility of gains from trade. Gains from

trade refer net benefits to nations arising from allowing increased trade with each other.

Countries can reap the gains from trade by specializing in the production of that

commodity in which it has comparative advantage and importing that commodity in

which it has less comparative advantage leading to international specialization of

production.

There can be different magnitudes of gains from trade depending upon the terms of trade

fixed. It might be possible that one country is gainer and the other is not worse off and

vice-versa but in all the situations there will be gains from trade.

Foreign Trade Multiplier may be defined as the amount by which national income of a

nation will be raised by a unit increase in domestic exports. It is based on a fundamental

assumption which is the basis of operation of varied types of multiplier. The assumption

relates to existence of unemployed resources in the economy. Smaller the leakages (i.e.

the smaller the MPS and MPM) the greater the foreign trade multiplier and vice-versa.

Terms of trade from international trade perspective refer to terms of trade between two

sectors of two different economies. If country A gets larger number units of a good for

each unit of the other good sold to the other country B, the terms of trade will favor

country A and vice-versa.

There are different measures of terms trade. The most commonly used are Net Barter

Terms of Trade and Income Terms of Trade. The ratio between the prices of exports and

imports is called the net barter terms of trade. It is also called "the commodity terms of

trade." The concept of net barter terms of trade has been improved by G.S. Dorrance who

formulated the concept of income terms of trade. Income terms of trade refer to the ratio

between the values of exports to the import prices.

http://en.wikipedia.org/wiki/National_income

http://en.wikipedia.org/wiki/Export

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Subject COMMERCE Paper No and Title 11 and International