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COMMERCE
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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COMMERCE
PAPER No. : 11 INTERNATIONAL BUSINESS
MODULE No. : 9 ECONOMICS OF TRADE
TABLE OF CONTENTS
1. Learning Outcomes
2. Gains from Trade
3. Terms of Trade
4. Foreign Trade Multiplier
5. Summary
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PAPER No. : 11 INTERNATIONAL BUSINESS
MODULE No. : 9 ECONOMICS OF TRADE
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.
In terms of labor hours spent and saved Gains from trade(in labor hours)
Country Exports(spent) Imports(saved)
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.
In terms of labor hours spent and saved Gains from trade(in labor hours)
Country Exports(spent) Imports(saved)
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
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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.