Chapter 3

International Trade
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International Trade
The exchange of goods between citizens of different countries is called international Trade. Technological improvements, improved transport system, development of banking and credit have been largely responsible for the immense growth in international trade. Goods are constantly transported from country to country. Freights are cheap. It does not take much time and money to send them from one end of the world to another.
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Basis of International Trade

Different Costs
Difference in costs of production in two countries make exchange of goods profitable. Exchange will not be beneficial if goods are produced at the same cost. A lower cost of production gives an advantage to one country over the other, and vice versa. Now this advantage can be of one of the following three types: (a) Absolute Differences in Costs (b) Equal Differences in Costs (c) Comparative Differences in Costs

Basis of International Trade

(a)Absolute Differences in Costs
Suppose a country has a monopoly in the production of a commodity. If other countries need this commodity, the country producing it will have an absolute advantage over them. Example: India has almost a monopoly of manufactured Jute(with the exception of Bangladesh) and all other countries that need jute goods must buy them from India. Such absolute advantages are usually the result of differences in climate or other natural gifts.
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Basis of International Trade

(b) Equal Differences in Costs The differences in costs will be called equal, when a unit of productive power produces. Import of specie into country A will raise prices there and export of goods to country B will make things cheaper in B. Thus, the difference between the price levels of the two countries tend to equalise. As a result, the trade between them will cease.
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Basis of International Trade

(c) Comparative Differences in Costs
It looks strange, but it is nevertheless true, that it may be more profitable for a country to import some goods from another country even though it can produce them cheaper itself. A country will do this when it finds that its labour and capital can be more profitably employed when used in producing some other goods in which it enjoys a greater comparative advantage in production. Suppose, Britain can produce both dairy products and steel cheaper than Holland, but she enjoys relatively greater advantage in producing steel. In that case, she gains more by concentrating on steel goods and exporting them to Holland and importing dairy products from Holland. Such a difference is called comparative difference and forms the basis of permanent international trade. In these circumstances, the trade between the two countries will not 6 only start but will also continue.

Modern theory of International Trade

This theory has been put forward by Bertil Ohlin, a Swedish economist, and it has replaced the traditional comparative cost theory. Just as individuals specialise in economic activity in which they have comparative advantages, similarly countries specialise in the production of certain commodities in which they have comparative advantage on the basis of factor endowments. Just as differences in individual capabilities is the cause of exchange between individuals, similarly differences in factor price is the cause of international trade.
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Modern theory of International Trade

Bertil Ohlin thus extends the analysis which is applicable to a single market to the determination of values internationally i.e., exchange between different countries. Thus, Ohlin observes international trade is but a special case of inter-local or inter-regional trade. Hence, according to Ohlin, there is no need to have separate theory of international trade. He says that the same fundamental principles holds good for all trade, whether it is internal trade or international trade.

Modern theory of International Trade

The classical theory of comparative cost is based on the assumption of comparative immobility of the factors of production between different countries. But Ohlin points out that this immobility is to be found even in different regions of the same country. According to Ohlin, the immediate cause of international trade is the difference in commodity prices which in turn is due to the differences in factor prices.

Modern theory of International Trade

Goods are purchased because it is cheaper to buy them from outside the country. The establishment of the rate of exchange between the two countries facilitates the comparison between the commodity prices prevailing in the two countries. Thus, in Ohlins Opinion there are no fundamental differences but only quantitative differences between inter-regional and international trade. Ohlins theory represents a departure from the classical theory and marks a great improvement on it.
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Advantages of International Trade

(i) The productive resources of the world are utilised to the best advantage. Every country concentrates on the production of goods for which it is best fitted. There is economy of effort and a consequent fall in prices. Thus, every country receives the highest return from its resources. (ii) A country is able to consume goods which it cannot produce at all, or only at an impossibly high cost. Thus consumers can enjoy a large variety of products. Commodities produced in the tropics find their way to the temperate zone, and vice versa. This provides greater economic welfare and a higher standard of living. (iii) Violent price fluctuations are toned down. As the area of markets is enlarged by trade, the effects of the disturbing factors are spread over this large area and prices become more stable. If, at any time, the price of a commodity goes up abnormally, it can be imported from abroad and its price brought down.
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Advantages of International Trade

(iv) Shortages in times of famine and scarcity can be met from imports. Surplus produce can be sent out to needy countries. The world thus tends to be united into one economic unit. (v) Countries economically backward but rich in unused resources are able to develop their industries. In the early stage, the industries of a backward country have to be protected but once they develop, free trade stimulates them still further. (vi) Trade develops racial sympathies and creates common interests. Man gains culturally and the cause of world peace is promoted. Exchange of goods is accompanied by exchange of ideas. This promotes international understanding. Since a war is bound to interrupt international trade and put the people to loss, every effort is made to avoid it. (vii) The existence of international trade promotes peace. No country, however big, can be self-sufficient. To achieve self-sufficiency, it will have to undertake expensive wars, conquer free areas and convert them into colonies. This is horrible. Free international trade supplies the essential needs of nations, and thus checks their greed and desire to conquer.
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Disadvantages of International Trade

(i) The worst effect of foreign trade on backward countries is the destruction of their handicrafts and cottage industries. In India such industries had reached a high stage of perfection. In recent times, Japan tried to crush our cotton industry by flooding Indian markets with cheap goods and protection had to be granted to save it. Industrially weak countries have to suffer like this. (ii) The empire-builder follows the trader. The foothold gained by traders is used to complete a countrys political slavery. For example, the British came to India for trade and stayed to rule. A powerful country can easily find some excuse for attacking a weak country. (iii) Dependence on foreign goods creates difficulties in time of war when the country is cut off by enemy action. India had to face great trouble in getting ordinary articles like needles, tools and medicines during the war.
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Disadvantages of International Trade

(iv) Extreme specialization which makes a country depend on one or two industries only is bad. This is like putting all eggs in one basket. If a substitute is discovered or the industry otherwise suffers, the economic life of the people would be endangered. (v) Countries which sell primary commodities and buy manufactured goods in return are losers. The standard of living of the people in such countries remains low. Foreign trade under such conditions leads more to discontent and unrest than to peace and goodwill. It is well known that the feelings of the Indian people for the British before they left India were very bitter. (vi) Foreign trade may completely exhaust a countrys natural resources like coal and oil which are irreplaceable. These goods are exported for the sake of profit. But the country suffers in the long run when their source is dried up completely.
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Disadvantages of International Trade

(vii) Imports of harmful drugs and luxuries, as opium in China, ruin the health of the nation. For the use of such harmful articles, the blame must be put on international trade which brings them into the country. (viii) Through foreign trade, the economic troubles of one country are transmitted to others. The economic disturbances in one country are transmitted to others and their economy is upset. For example, the collapse of American markets in 1929 resulted in a world-wide depression. (ix) Trade rivalry leads to war and friction. Germanys desire to secure markets for her goods was the most important cause of the last two World Wars. Commercial competition often strains relations. Here also, India and Pakistan find it difficult to come to an understanding due, to some extent, to a clash of trade interest.
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BALANCE OF TRADE
A comparison of the total imports and exports of a country is its balance of trade. The balance of trade is regarded as favourable or active or positive when the value of exported goods exceeds that of imported goods. It is unfavourable or adverse or negative when imports exceed the value of exports. In the Middle Ages, it was thought that a favourable balance was the only way to make a country rich, as it brought in gold and silver from outside. Now, however, this idea has been discarded, and it is believed that, in the long run, exports and imports, including services of all kinds, should balance.
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BALANCE OF TRADE
If, however, an unfavourable balance of trade persists for a long time and is very large in amount, gold shall have to be exported. In that case, steps would have to be taken to set it right. It should, however, be noted that the visible unfavourable balance of trade may be corrected by the export of invisible items which do not enter into the account books.
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BALANCE OF PAYMENTS
The balance of trade includes only the visible items in foreign trade. They are material goods exported and imported. Only these are entered in the port registers maintained by the customs authorities. But there are a large number of other items which fall outside and are called invisible. The balance of payments includes all visible and invisible items. Hence, the balance of payments is a comprehensive record of economic transactions of the residents of a country with the rest of the world during a given period of time.
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BALANCE OF PAYMENTS
Invisible Items:
Services India uses a good deal of foreign banking, shipping and insurance services. She does not have enough of her own ships, insurance companies and exchange banks. Hence foreign agencies, like Lloyds Bank provided these services. India has to pay for all such services. Tourists expenses When Indian students and tourists purchase goods and service Europe, it is like importing these goods and services. The only difference is instead of goods coming to the consumers, the consumers have gone to them. They have to be paid for in goods exported from India. In the case of Indian students receiving education abroad, India is importing education and has to pay for it.
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BALANCE OF PAYMENTS
Invisible Items:
Interest on borrowed capital The services of capital have to be paid for by the borrowing country. An investment made abroad is an export item and remains so till withdrawn. Ultimately all loans borrowed in foreign money markets have to be paid back and adjusted through exports. Besides the above, there are various minor items like gifts, donations and money remitted home by foreign settlers; these are also invisible items. All these invisible items produce exactly the same effect on a country's account with the rest of the world as the export and import of commodities. When they are added to the balance of trade, we have a complete list of all the items which have to be paid for or received by trading countries. Their sum total is called the balance of payments.
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BALANCE OF PAYMENTS
Hence, the balance of payments is a comprehensive record of economic transactions of the residents of a country with the rest of the world during a given period of time. This record is so prepared as to provide meaning and measure to the various components of a countrys external economic transactions. Thus, the aim is to present all receipts and payments on account of goods exported, service rendered and capital transferred by the residents of a country. The main purpose of keeping these account is to inform the government of the country of its international economic position and to help it in making decision on monetary and fiscal policies to be pursued as well as on the trade and payments issues.
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BALANCE OF PAYMENTS
Any item that typically gives rise to a purchase of foreign currency is recorded as a debit item in the balance of payments accounts and any item that gives rise to a sale of foreign currency is recorded as credit item. The record of international transactions in balance of payments always balances. The BOP is divided in 2 parts:
1. Current Account. 2. Capital Account.
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BALANCE OF PAYMENTS
1. Current Account: The balance of payments on current account includes items like imports and exports, expenses on travel, transportation, insurance, investment, etc. These relate to current transactions. It basically records all transactions in goods and services. 2. Capital Account: The capital account is made up of capital transactions, e.g. borrowing and lending of capital, repayment of capital, sale and purchase of securities and other assets to and from foreigners individuals, government and international organisations. When both current and capital accounts are taken, it is called Overall Balance of Payments. It is overall balance of 23 payments which must balance.

Theory of Protection
Doctrine of Free Trade A policy of no restrictions on the movement of goods between countries is known as the policy of Free Trade. Restrictions placed with a view to safeguarding home industries constitute the policy of protection. Free trade, however, does not require the removal of all duties on commodities. It only insists that they shall be imposed only for revenue and not at all for protection. As a practical policy, free trade is based on the theory of international trade. Protection aims at helping some industries against foreign competition. This is done either through duties on imported goods, or bounties to domestic producers. An import duty makes the foreign articles sell at higher price and so helps the home manufactures.
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ADVANTAGES OF PROTECTION
(I) To help Infant industries An infant has to be protected till it grows to manhood, Nurse the baby feed the infant and free the adult is a well-known maxim. Protective duties are crutches to teach new manufacturers to walk. The advantage thus gained often greater than the cost paid by consumers in the shape of higher prices. India extended protection to some important industries on the basis of this argument. (II) To keep money at home When we purchase swadeshi goods, we are keeping purchasing power in our own country. It is possible that we are paying more for the goods than we may have to pay for foreign goods of the same quality, if allowed to come in freely. But we do not mind paying more and feel a glow of pride, when making a little sacrifice. (Ill) To get an In flow of gold When you send goods to others and close your doors to other goods, you may have to be paid in gold. This will be possible, however, only when our goods have an inelastic demand and the others either 25 cannot or do not retaliate.

ADVANTAGES OF PROTECTION
(iv)To develop key Industries Key industries are keys to further industrial expansion. They provide machines and materials for other industries. Chemical and metallurgical industries are of this type. They serve as a base for the national economy. They are essential for the defence of the country in war and its prosperity in peace. (v) To attain self-sufficiency When the government wants to make the country independent of foreign supplies, protection is necessary. Complete self-sufficiency, however, is impossible and even a partial one is costly. Therefore, a self-sufficiency should be sought for only essential industries. (vi) To secure diversification of occupations The greater the number of openings for the people of a country, the better it is for their material progress. Too much reliance on any single industry is risky. Therefore, it may be necessary to encourage some industries with the artificial aid of protection.
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ADVANTAGES OF PROTECTION
(vii) To prevent dumping of foreign goods When a foreign country plans to crush our industry by selling goods at a price even below the cost of production, it is a case of dumping. Such a supply of cheap goods might be welcome if it were permanent; but it is usually temporary. It is done to kill competition and then to make up all losses by charging higher prices. Anti-dumping duties are, therefore, justified to save the home industry. (viii) To create employment Protection helps to develop industries, and it creates more employment. There is no doubt that the development of sugar and other Indian industries under protection provided a large volume of employment. (ix) To correct adverse balance of payments Sometimes, protection is given with a view to correcting an adverse balance of payments. Protection reduces imports, and the balance of payments situation can thus be improved, although temporarily. (x) For the countrys defence Certain industries which produce defence materials and equipment such as arms, ammunition, tanks must be protected. (xi) To safeguard the Interest of high-wage labour Sometimes it is argued that in the absence of protection, the highly-paid labour of the industrially advanced countries would he exposed to the competition of cheap foreign labour, and that the products of their high-wage labour can be under sold by those of pauper labour from abroad.
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DISADVANTAGES OF PROTECTION
(I) When foreign competition is removed, the home manufacturers become lethargic. Protection acts like an opiate. It sends the home producer to sleep. All improvements are neglected. There is no incentive to cut down the costs or to improve the quality. Technical progress thus comes to a standstill. (II) Another disadvantage is that there is a loss in public revenues. If high protective duties are imposed, imports will shrink and revenue from customs will fall. (III) Burden on consumers. The most important objection to protection comes from the consumers. The burden of protective duties does not fall on the foreign manufacturers. The burden is on the home consumer because he has to pay a higher price than before on account of the imposition of import duties. It is said that it does not look fair that a poor consumer should be penalised to enrich the already rich manufacturer. Thus, inequalities of wealth distribution are further aggravated.
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DISADVANTAGES OF PROTECTION
(iv) Tariff is said to be the mother of trusts. As soon as protection has removed foreign competition, the home manufacturers are induced to form combinations of their own in order to remove the internal competition also. In lndia, the sugar factory owners formed the Indian Sugar Syndicate to eliminate competition among themselves, and to charge a monopoly price from the consumers. (v) There is also the danger of corruption. It is very well known that in America the legislators used to be offered bribes by industrialists. The object was that no legislative measure may be adopted which might adversely affect them, and legislation which suits them may be passed. (vi) Misdirection of resources. Protection diverts labour and capital and other factors of production into set channels. They are prevented from seeking their most remunerative employment. This is bound to decrease the national dividend. Misallocation of the available resources into unsuitable channels cannot be economically justified.
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DISADVANTAGES OF PROTECTION
(vii) Vested interests are created which refuse to give up protection. The infants refuse to admit that they are grown up. They start kicking at the slightest indication of withdrawal of protection. (viii) There is a danger of retaliation from abroad. As a result, some home industries might suffer. (ix) Choice limited. Protection limits the choice of consumer goods. Through tariffs, quotas and exchange control, the availability of foreign goods is severely limited. The various protective policies drastically cut down the availability of foreign movies, books, magazines, pictures, clothing, food, etc. Goods imported from other countries also bring with them ideas and styles and other ways of living. Indeed, they enrich life.
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Reason for Protection for Underdeveloped Countries

In spite of all the objections and dangers enumerated above, there is yet a strong case for protection, especially in the case of under-developed countries: (i) Protection in these countries brings about a fuller utilisation of the unutilised or under-utilised natural resources. (ii) Protection would also restrict imports and create demand for the home products, thereby giving a fillip to investment, employment and income. (iii) Further, since in under-developed countries, there is an excessive dependence on agriculture, diversification is very much needed in these countries. Protection helps to bring about diversification in industries, and hence gives economic stability to them. (iv) Above all, the protection of infant industries is an absolute necessity in these countries. (v) The economies of most the under-developed countries are unbalanced, and there are strong reasons for a protectionist policy to 31 support industrialization in them.

TARIFFS AND SUBSIDIES

The import duties (tariffs) and export subsidies affect the prices and quantities of goods and government revenue. Tariffs: Tariff is an important tool of protection used mainly to cut imports as imposition of import duties increases the prices of imported goods. It diverts the demand from imported goods to indigenous goods providing promotional environment for indigenous industries. Tariff is also useful for reducing the wide deficit in balance of payments as it discourages import reducing the burden on BOP.

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Tariffs
The main effects of imposition of tariffs are: 1. Protective Effect Tariff reduces the imports of competing goods thus affording protection to the domestic producer. Domestic production is increased as a result of the imposition of tariff. This is known as Protective effect. 2. Consumption Effect When tariff is imposed, price of the commodity rises and domestic consumption is reduced. This is called the Consumption effect. 3. Revenue Effect The government derives revenue from the tariff which is measured by the quantity of the imports multiplied by the rate of tariff. This is the Revenue effect. 4. Redistribution Effect The imposition of the tariff increases the price of the commodity and thus reduces the consumers surplus. In this way, some income is transferred from the consumers to the producers. This affects distribution of income. It is called Redistribution effect.
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Tariffs
The main effects of imposition of tariffs are: 5. Terms of Trade Effect Take the case of two countries A and B with different factor endowments giving comparative advantage to each in the production of a certain commodity. Tariff will reduce the volume of trade and the terms of trade will improve for the country imposing the tariff. 6. Effect on National Income If a country is facing unemployment problem, imposition of tariff will increase employment and thus increase national income. This happens because with the imposition of tariff consumers demands are diverted to the domestically produced goods. To meet this increased demand new production units will be set up. As a result lot of employment will be created and national income increased. Optimum Tariff A tariff is said to be optimum when its rate maximises the welfare of the country i.e. when the rate is considered best from all points of view; it is neither high nor low. It is the ideal rate.
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Subsidies
Subsidies are provided to the exporting industries so that they can compete in the world market. Goods that are exported are usually lower priced and abundant in the country that exports it. Exports is thus encouraged to utilise the surplus and avoid the further fall in prices of such exportable commodities. This encouragement to such industries is given with the view to earn more foreign exchange as well as protect the interest of such export industries having excess capacities.
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Foreign Exchange Control

Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by nonresidents. Such control is used to restore equilibrium in the Balance of Payments. If a country finds that its balance of trade has been persistently unfavourable, then it must do something to set it right. The various ways of foreign exchange control include devaluation of currency, over valuation of currency.
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Objectives of Exchange Control

The object of controlling exchange is to fix it at a level different from what it would be if the economic forces were permitted free interplay. The objectives of exchange control may be : (a) To correct a serious imbalance in the economy of the country relatively to the outside world. (b) To conserve the countrys gold reserves which are being depleted (c) To correct a persistently adverse balance of payments (d) To prevent a flight of capital from the country (e) To conserve foreign exchange reserves for large payments abroad (f) To maintain stable exchange rate (g) To ensure growth with stability.
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Foreign Exchange Control

There are three possible course that a country adopting exchange control may like to pursue, considering the economic situation in which it may find itself. (1) It may like to undervalue or depreciate currency (2) It may decide on over-valuation (3) It may decide to avoid fluctuations and maintain a stable rate.
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Foreign Exchange Control

Under Valuation Undervaluation is advocated for curing depression. When a country decides on undervaluation or depreciation, i.e., fixing a rate lower than it would be in a free exchange market, exports are stimulated and imports are discouraged. It will give stimulus to export industries and domestic industries will also benefit because imports have been discouraged. Thus, undervaluation will increase economic activity in the country, add to the total output (GDP) and will create more employment.
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Foreign Exchange Control

Over Valuation The second object of exchange control may be overvaluation or fixing the value of its currency at a level higher than it would be if there was no intervention in foreign exchange. This course is indicated in the following situations: (i) When there is a serious imbalance in the countrys trade relationship. As a consequence, the supply of national currency may far exceed the demand for it. (ii) The country may be in great need of foreign goods either for prosecution of a war or for reconstruction after the war or for economic development. (iii) If a country is suffering from inflation, the exchange value of the national currency will go down when exchanges are left free to move. If foreign trade plays a very important part in the economy of the country, this downward trend must be arrested by overvaluing the domestic currency, otherwise imports will become very dear and the exporters will have windfall profits. (iv) A policy of overvaluation is also in the interest of a country which has to meet a large debt payments expressed in foreign currency.
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Methods of Exchange Control

Influencing Exchange Rate
Exchange control is exercised either by regulating international movements of goods through various devices or by the purchase and sale of foreign currency at specified rates in order to maintain a particular range of exchange fluctuations. Exchange control can be exercised by influencing demand for, and supply of, currencies in the exchange market. This can be done indirectly by devices like tariffs, quotas, bounties, changes in interest rates, etc. Imposition of import duties and of import quotas will reduce imports, cut down the demand for foreign currency, lower its value or raise the value of the domestic currency. Export duties, which are not so common, will have the opposite effect. Bounties affect the other way about. Export bounty will raise and import bounty (which exists nowhere) will lower the value of the home currency. A rise in the interest rates attract funds from abroad, increases demand for domestic currency and raises its value, and vice versa.
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Methods of Exchange Control

Controlling Exchange Rate There are two methods generally adopted for controlling exchange:
(a) Intervention In this case, the government enters the exchange market either to purchase or to sell foreign exchange in order to bring the rate up or down to the desired level. This method has been called intervention and leads to exchange pegging. (b) Restriction In this case, the government can prevent the existing demand for, or supply of, the currency, in which they are interested, from reaching the exchange market. This method as been called restriction. The second method has been more popular because intervention proved a weak weapon and was also expensive.
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Methods of Exchange Control

Exchange Control Proper
Exchange restriction is exchange control proper. For this three things are done: (a) All foreign dealings are centralised, usually in the central bank. (b) The national currency cannot be offered for exchange without previous permission. (c) It is made a criminal offence to enter into an unauthorised foreign exchange transaction. The usual procedure is to order all exporters to surrender claims in foreign currency to the central bank and ration the foreign exchange made so available among the licensed importers. Exchange control thus involves import control. 43

Devaluation
A very common method of correcting an adverse balance of payments is the devaluation of the home currency. The devalued currency falls in value against foreign currencies so that the foreigners have to pay less in terms of their own currencies for our goods. The importers in the country, on the other hand, have now to pay more in terms of the devalued currency for foreign goods. Hence, they (i.e., foreigners) are induced to import more from such a country. Thus imports decrease and exports increase, and the balance of payments is corrected.

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Devaluation Example
India, following the U.K. devalued her currency in terms of the dollar in September 1949. Her trade balance had been very unfavourable. There used to be a big gap between her exports and imports. After the devaluation, however, her balance of payments was set right. In June 1966, again, India had to devalue the rupee. This resulted in some improvement in the balance of payments position.
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Objectives of Devaluation
1. Correction of Balance of Payments: when the country is faced with chronic deficit in the balance of payments, it becomes essential for her to devalue her currency. The purpose is to eliminate the deficit in BOP completely or reduce it to the maximum possible extent. 2. Prevention of dumping: It means that preventing the sale of a product by one country in another country at a price lower than its cost of production. A country dumping goods wants to capture the market and thus in the beginning it sells at almost throw-away prices.
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Merits of Devaluation
1. Lowers external value: Devaluation of currency implies lowering of external value of currency against foreign exchange as a deliberate policy adopted by the government or the monetary authority under exchange control system. 2. More evasion of foreign exchange: Devaluation provides more and more evasion of foreign exchange to black marketing of foreign exchanges due to the smuggling of restricted imported goods, which makes foreign exchange control difficult.
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Merits of Devaluation
3. Monetary policy: The policy of devaluation would be effective if it is supported by monetary policy by increasing rate of interest so that more capital inflow in terms of foreign exchange may follow. It may help further to reduce the deficit in BOP. 4. Scope of exchange control: New economic policy covering foreign exchange obtained only in current account has reduced the scope of exchange control allowing market forces to focus in areas of current account transactions.
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Limitations of Devaluation
1. Elasticity of supply & demand: The policy of devaluation is likely to get successful only when the elasticity of supply & demand are more than one. This situation is rarely found especially in a country like India. 2. Devaluation is limited: The effectiveness of policy of devaluation is limited when the demand for imported goods is inelastic. It implies that even though prices of imported goods may go up, demand may not get reduced to extent of devaluation of rupee.
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