Foreign Trade
-
Foreign trade is exchange exchange of capital, goods, and and services across across international international borders or territories. It is also called as International trade, External trade or Inter-Regional trade. According to Wasserman and and Haltman, “International trade consists of of transaction transaction between residents of different countries”.
Types of Foreign Trade Foreign Trade can be divided into following three groups.
1. Import Trade: Import trade refers to purchase purchase of goods by one country from another country country or inflow of goods and services from foreign country to home country. 2. Export Trade: Export Export trade refers refers to the sale of goods by one country to to another country or outflow of goods from home country to foreign country. 3. Entrepot Trade: Entrepot trade is also known as Re-export. It refers to purchase of goods from one country and then selling them to another country after some processing operations. Need & Import ance of Foreign Trade Following points explain the need and importance of foreign trade Need to a nation.
1. Division of labor labor and specialization: Countries that have abundant natural resources, export raw materials and import finished goods from countries which are advanced in skilled manpower. This gives benefits to all the countries and thereby leading to division of labor and specialization. 2. Optimum allocation and utilization of of resources: Resources are channelized for the production of only those goods which would gi ve highest returns through exporting. 3.
Equality of prices: Foreign trade helps to keep the demand and supply position position stable, which in turn stabilizes the prices. 4. Availability of multiple multiple choices: Foreign Foreign trade helps helps in making available new varieties to consumers all all over the world and providing a better choice to them. 5. Ensures quality and standard goods: Foreign trade is highly competitive. To maintain and increase the demand for goods, the exporting countries have to keep up the quality and standard of goods. 6. Raises standard of living of the people: Imports can facilitate standard of living of the people. By consuming new and better varieties of goods, people can improve their standard of living. 7.
Generate employment opportunities: opportunities: Foreign trade helps in generating employment opportunities by increasing the mobility of labor and resources. It generates direct employment in import sector and indirect employment in other sector of the econom y such as Industry, Service Sector (insurance, banking, transport, and communication), etc.
8. Facilitate economic development: With the import of capital goods goods and technology, technology, a country can generate growth in all sectors of the economy, i.e. agriculture, industry and service sector. On the other hand, exports can increase a county’s national income. 9. Maintains balance of payment position: Import results in outflow of foreign exchange and export results in the inflow of f oreign exchange. By importing and exporting a country can maintain its BOP position. 10. Promotes World Peace: Foreign trade brings countries closer due to economic relations arising out of trade agreements. It promotes world peace as such countries try to m aintain friendly relations among themselves.
Theories The ories of Foreign Tra Trade de 1.
Absolut e Advantage Theory: Adam Smith says that trade trade between two nations is based on absolute advantage. 1
Absolute advantage refers to a country’s ability to produce a certain good more efficiently at a lower cost per unit than other country, using the same amount of resources. When one nation is more efficient than another nation in the production of one commodity but is less efficient than the other nation in producing a second commodity, then both nation can gain by each specializing in the production of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage. Example: Suppose, In Bangladesh, one hour of labor produces six units of wheat but only one unit in India. On the other hand, one hour of labor produces four units of Cloth in India but only 2 units in Bangladesh. Bangladesh
India 1 4
Wheat (bushels/ man power) 6 It is clear from the above i llustration that Bangladesh Cloth (Yards/ man power) 2 is more efficient or has an absolute advantage over India in the production of wheat and India is more efficient or has an absolute advantage over Bangladesh in the production of cloth. Hence Bangladesh would specialize in the production of wheat and exchange part of it for cloth of India and vice versa. As a result both the products would be produced and consumed in more quantities and both the nations would be benefited. 2.
Comparati ve Advant age Theory:
Law of Comparative Advantage: According to the law of comparative advantage even if one nation is less efficient than the other nation in the production of both commodities, there is still a basis for mutually beneficial trade.
The first nation should specialize in the production of and export commodity in which its absolute disadvantage is smaller and import commodity in which its absolute disadvantage is greater. EXAMPLE: India In our illustration, India is half Wheat (bushels/ man power) 1 as productive in cloth but six Cloth (Yards/ man power) 2 time less productive in wheat with respect to the Bangladesh, India has a comparative advantage in cloth.
Bangladesh 6 4
Productivity Ratio 1:6 1:2
Bangladesh has an absolute advantage in both wheat and cloth with respect to the India, but since its absolute advantage is greater in wheat than that in cloth, the Bangladesh has a comparative advantage in wheat. The gain from Trade: Bangladesh will be benefitted if it exchange 6W for more than 4C from India. The India will be benefitted if it import 6W from the Bangladesh by giving up less than 12C. The range for mutually advantageous trade is 4C<6W<12C Exception to the law of comparative advantage: T here is one case where there is no comparative advantage. This occurs when one nation has same absolute disadvantage with respect to another in both commodities. If one hour produced 3W instead of 1W in the India, the India would be exactly half as productive as the Bangladesh in both wheat and cloth. Comparative Advantage with money: According to comparative advantage theory, there will be mutually benefited international trade when wage is comparatively less in the nation where there are absolute disadvantage in both the goods with respect to the other nation. The wage rate of a country who has absolute advantage, is higher than the country who has absolute disadvantage.
2
Wheat (bushels/ man power) Cloth (Yards/ man power)
India 1 2
Bangladesh 6 4
Productivity Ratio 1:6 1:2
Since India has an absolute disadvantage in both commodity, the wage in India will be lower than wage in the Bangladesh so as to make the price of cloth (the commodity in which India has a comparative advantage) lower in the India, and the price of wheat lower in Bangladesh when both commodities are expressed in terms of the currency of either nation. In this regard, India can export cloth to the Bangladesh as long as the India wage rate is between 1/6 and ½ of the Bangladesh wage rate. If wage ratio is equal to productivity ratio, then there is no i nternational trade. It should be between the productive ratios. Illustration: Information are given below: Wheat (bushels/ man power) Cloth (Yards/ man power) 2Tk. What will be happened?
India 1
Bangladesh 6
Productivity Ratio 1:6
2
4
1:2
Wage rate in Bangladesh is 6Tk per hour and in India 1Rs per hour and exchange rate is 1Rs =
Answer: India Wheat (bushels/ man power)
1
Bangladesh 6
Productivity Ratio 1:6
Cloth (Yards/ man power) 2 4 1:2 Wage per hour 1Rs= 2Tk 6Tk Wage Ratio I:B=1:3 Since India has an absolute disadvantage in both commodity, the wage in India is comparatively lower than wage in the Bangladesh, there will be mutually benefitted international trade. Also the wage ratio is between the productivity ratios. India is half as productive in cloth but six time less productive in wheat with respect to the Bangladesh, India has a comparative advantage in cloth. Bangladesh has an absolute advantage in both wheat and cloth with respect to the India, but since its absolute advantage is greater in wheat than that in cloth, the Bangladesh has a comparative advantage in wheat. So India will export cloth for wheat from Bangladesh, and Bangladesh wheat export wheat for cloth from India. Suppose Bangladesh will exchange 6W for 6C from India. In Bangladesh, the production cost of 6W= 6Tk and 6C= (6/4) x6 =9Tk. In India, production cost of 6W= (6x2) = 12tk and 6C= (2/2) x6= 6tk Bangladesh and India both will be benefitted from this international trade. Because Bangladesh can import 6C at 6tk from India when the production cost of 6C in Bangladesh is 9tk. And India can import 6W at 6Tk from Bangladesh when the production cost of 6W in India is 12tk. 3. -
Opportunity Cost theory: Given by Haberler in1936 According to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that must be given up to release j ust enough resources to produce one additional unit of the first commodity.
Example: In Bangladesh, 6W = 4C or, 1W=4/6C=2/3C and 1C=6/4C= 1.5C
Wheat (bushels/ man power) Cloth (Yards/ man power)
India 1 2
Bangladesh 6 4
3
In India, 1W= 2C and 1C= 0.5W This means that production of wheat in Bangladesh is less costly than India. And production of cloth in India is less costly then Bangladesh. The basis for and the gai ns from trade under constant costs : In absence of International trade both nation will produce that is required for the consumption. Total world production will lower. Due to the presence of international trade both nation will be specialized in product where it has lower opportunity cost in compare to the other country and then exchange with other product of another country. Both country will be mutually benefited and world production will increase. Illustration: Opportunity costs can be illustrated with the production possibility schedules or transformation curve. From the table it is found that in Bangladesh 30W= 20C. Thus the opportunity cost of one unit of wheat in Bangladesh is 1W=2/3C and remain constant. In India it is 1W= 2C and remain constant. Gains from Trade: In the absence of trade, the Bangladesh might choose to produce and consume combination A (90W, 60C) and the India might choose to produce and consume combination A’ (40W , 40C). If Bangladesh exchange 70W for 70C with the India, it ends up consuming at point E (110W and 70C), and the India ends up consuming at E’ (70W and 50C). Thus the Bangladesh gains 20W and 10C from trade (compare point E with point A in figure) and the India gains 30W and 10 (compare point A’ with point E’). That is, in the absence of trade the Bangladesh produced 90W and the India 40W, for a total of 130W. W ith specialization in production and trade, 180W are produced (all in the Bangladesh). Similarly, in the absence of trade, the Bangladesh produced 60C and the India 40C, for a total of 100C. With specialization on production and trade, 120C are produced (all in the India).
Three concept of H-O theory Factor Intensity Factor intensity is used to com pare relative factor usage between nations. It depends on what is the ratio between two factors of production (i.e. capital and labor) rather than their absolute amount. Example: Suppose, there are two commodities X and Y and two factors Capital (K) and Labor (L). • •
If production of Y requires 2K and 2L, then K/L = 1 If production of X requires 1K and 4L, then K/L = ¼ 4
We say that Y is Capital (K) intensive and X is Labor (L) intensive because Y’s (K/L) is greater than (K/L) of X If price of capital falls, producers would substitute capital for labor in production of X&Y to minimize production costs. As a result both commodities become capital intensive. Graphical Representation: Nation 1: Suppose. In Nation 1, Production of Y requires 2K and 2L which meansNation 1 can produce 1Y by using 2K-2L, and 2Y by using 4K-4L. Thus, K/L = 1. T his gives the slope of Y in Nation 1 On the other hand, Production of X requires 1K and 4L. Thus, K/L = ¼. This gives the slope of the ray of X in nation 1 So, Y is Capital (K) intensive and X is Labor (L) intensive in Nation 1 Nation 2: In nation 2, Production of Y requires 8K and 2L which meansNation 2 can produce 1Y by using 8K-2L, and 2Y by using 16K-8L. Thus, K/L = 4. This gives the slope of Y in Nation 2 On the other hand, Production of X requires 4K and 4L. Thus, K/L = 1. This gives the slope of the ray of X in nation 2. Therefore, Y is Capital (K) intensive and X is Labor (L) intensive in Nation 2 also. This is shown by the figure that the ray from the origin for good Y is steeper than that of X in both nation. Even though Y is capital intensive relative to X in both nations, Nation 2 uses a higher (K/L) than Nation 1. -
For Y, K/L = 4 in nation 2, but K/L= 1 in Nation 1 For X, K/L= 1 in nation 2, but K/L= ¼ in Nation 1
Nation 2 uses more capital-intensive production technique in both commodities than nation 1. Capital must be cheaper in Nation 2 than in Nation 1, so that producer in Nation 2 use relatively more capital on the production of both commodities to minimize their cost of production. Factor abundance: Two ways to define factor abundance.
1) In terms of physical unit, a nation is capital abundant if the ratio of total amount of capital to total amount of labor available in nation is greater than the other nation. This definition considers only the supply of factors. A nation can have less capital (K) than the other nation and still be the capital abundant nation if TK/TL in that nation exceeds TK/TL in the other nation. That means the ratio of TK/TL is important, not the absolute amount of K&L available in each nation.
5
2) In terms of relative factor prices, a nation is capital abundant if the ratio of the rental price of capital (Pk) to the rental price of labor (PL) is lower than the other nation. This definition considers both demand and supply of factors. The demand of the factor is derived from demand for the final commodity that requires the f actor in its production. Rental price of capital (K) is the interest rate and the price of labor (L) time is wage (w). The ratio r/w is important, not the absolute level of r that determines whether a nation is K abundant. Factor abundance and the shape of the production front ier: Suppose there is two nation, Nation 1 and Nation 2. Nation 1 is labor abundant and Nation 2 is capital abundant. Both countries produce two commodities X and Y where X is labor intensive and Y is capital intensive. Since Nation 2 is capital abundant, it can produce more Y than Nation 1. Similarly Nation 1 can produce more X. If Nation 1 produce 140unit of X & 70 unit of Y and Nation 2 produce 85 unit of X and 140unit of Y then the production frontiers for both nations are drawn as follows: The production frontier for nation 1 is relatively flatter and wider than that of Nation 2.
4.
Heckscher Ohlin's H-O Theory:
The Heckscher Ohlin theorem states that a nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nation's scarce and expensive factor. In other words, nations which is rich in labor will export labor intensive commodity and import capital intensive commodity Assumption: Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following assumptions: 1. 2. 3. 4. 5. 6. 7.
There are two countries involved. Each country has two factors of production (labor and capital). Each country produce two commodities or goods (labor intensive and capital intensive). There is perfect competition in both commodities and factor markets in both nations. Both commodities are produced under constant return to scale in both nation Factors are freely mobile within a country but immobile between countries. Both countries have pure competition market. That means trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers. 8. There are no transportation costs. 9. Taste are equal in both countries. 10. International trade in both countries are balanced. 11. There is full employment of resources in both countries and demand are identical in both countries.
What is the benefit of internation al trade accordi ng to H-O theory? Ohlin states that international trade results of the different relative price of different goods in different countries.
The relative price commodity difference is the result of relative costs and factor price differences in different countries. So the difference in relative factor abundance or factor endowments among nations is the basic cause of comparative advantage and international trade.
6
For this reason, this theory also described as the factor endowment theory or the factor proportions analysis. The Heckscher-Ohlin theorem is: countries which are rich in labor will export labor intensive goods and countries which have plenty of capital will export capital-intensive products. Illustration: Suppose there is two nation, Nation 1 and Nation 2. Two nations have equal tastes. Nation 1 is labor abundant and Nation 2 is capital abundant. Both countries produce two commodities X and Y where X is labor intensive and Y is capital intensive. In absence of international trade:
Since two nations have equal taste, they face the same indifference Curve I which is tangent to nation 1’s production frontier at point A and to nation 2’s production frontier at A’. Indifference Curve I is the highest IC that Nation 1 and Nation 2 can reach isolation. Points A and A’ represent their equilibrium points of production and consumption. The tangency of IC I at point A and A’ defines no trade equilibrium at relative commodity prices of Pa in Nation 1 and Pa’ in Nation 2. Since Pa
In presence of international trade: According to the H-O theory Nation 1 exports X because X is labor intensive and labor is relatively abundant and cheap factor in Nation 1. Similarly Nation 2 exports Y.
After trade Nation 1 specializes in X and Nation 2 in Y Specialization continues until nation 1 reaches at point B and Nation 2 at B’, where transformation curves are tangent to the common relative price line Pb. Nation 1 exports X in exchange for Y and consume at point E on IC II. Point E involves more Y but less X than point A Similarly Nation 2 exports Y for X and consume at point E’ (which coincides with point E). Point E’ involves more X and less Y than point A’. Nation 1 and Nation 2 gains from trade because E and E’ are on higher IC II Note thatNation 1’s exports of X equal Nation 2’s import of X (i.e. BC=C’E’) and Nation 2’s exports of Y equal Nation 1’s import of Y (i.e. B’C’=CE). The price of commodity X is Px and price of Y is Py. At Px/Py > Pb, Nation 1 wants to export more of X than Nation 2 wants to import at this high relative price, and Px/Py falls towards Pb and At Px/Py < Pb, Nation 1 wants to export less of X than Nation 2 wants to import at this low relative price, and Px/Py rises towards Pb •
• •
•
How supply of factor determine a countr y’s comp arative advantage (competiv eness) in International Trade?
Among nations the basic cause or determinant of comparative advantage is the difference in relative factor abundance or factor endowments, which has effect on the differences in relatively commodity prices. The general equilibrium framework of the (H-O) theory explain the way of determination of relative commodity price. 7
The general equilibrium framework of the (H-O) theory 1.
2.
3.
4.
5.
The tastes and the distribution in the ownership of factors of production together determine the demand for commodities. The demand for commodities determines the derived demand for the factors required to produce them. The demand for factors of production, together with the supply of factors, determines the price of factors of production under perfect competition. The price of factors of production, together with technology, determines the price of final commodities. The difference in relative commodity prices between nations determines comparative advantage and the pattern of trade.
Figure shows clearly how all economic forces jointly determine the price of final commodities. This is why we say that the H–O model is a general equilibrium model. As tastes are equal in both nation, demand for final commodities and factors of production in both nations are same. Thus it is the differences in the supply of the various factors of production in both nations that is the cause of different relative factor prices in different nations. Finally the same technology, but different factor prices lead to different relative commodity prices and trade among nations. So the difference in the relative sup ply of factors leading to the difference in relative factor prices and commodity prices is shown in figure by the double lines. Free Trade vs. Protectio n Free Trade:
-
International trade that takes place without barriers such as tariff, quotas and foreign exchange controls is called free trade. Thus, under free trade, goods and services flow between countries freely. In other words, free trade implies absence of governmental intervention on international exchange among different countries of the world.
Protection: By protection we mean restricted trade. Protection denotes a pol icy of encouraging home industries by the use of boundaries or by the imposition of high custom duties on foreign products.
Argument for protection: 1.
2.
3.
4.
Infant Industry Argument: An infant industry is a new industry. For an infant industry, operating costs during the transition period are high. It cannot compete with established foreign exporters. In the initial stages of its growth, such an industry needs full protection from the state without which it cannot survive. “Diversification of Industry” Argument: Free trade increases specialization. Excessive specialization leads to unbalanced economy and over-dependence o f a country on other countries. In order to bring about balanced growth of all industries and self -sufficiency, it is necessary to bring about a diversification of industries through protection. Employment Argument: Protection restricts certain imports so that some money is saved in the domestic economy which will be spent upon the purchase of the products of protected home industries. As the protected industries expand, employment therein increases and income of the economy increases. Defense Argument: Certain industries which produce defense materials and equipment such as arms, ammunition, tanks must be protected. 8
5.
Balance of payment Argument: A deficit in the balance of payments can be cured by curtailing imports. Protection reduces imports, and the balance of payments situation can thus be improved, although temporarily. 6. Revenue Argument: When protectionism takes the form of a tariff, this will raise revenue for the government, like any other tax. 7. Patriotism Argument: It is the duty of every citizen to prefer home-made goods to foreign goods. As such, home-made goods should be available in the right quantity and quality. This is not possible without home industries being developed with the aid of protection. 8. Key Industry Argument: Key industries are keys to further industrial expansion. They provide machines and materials for other industries. They have a strong case for protection if they need help. 9. Self-sufficiency Argument: If the government wants to make the country independent of foreign supplies, protection is necessary. 10. For economic stability and conservation of national resources, protection is needed. Argument against protection: 1. 2.
3. 4.
5.
6. 7.
8.
1. 2. 3. 4. 5. 6. 7.
8. 9.
Vested interests are created which refuse to give up protection: The ‘infants’ refuse to admit that they are grown up. They start to protest at the slightest indication of withdrawal of protection. Increase in corruption: The big and influential industrialists try to secure protection for their industries by offering bribes to corrupt political leaders an d government officials, even though they are quite strong to face foreign competition. Protection create monopolies: As foreign competition is eliminated under protectionism, certain vested interests create monopoly to earn high profits by exploiting the consumers and workers. Burden on consumer: Under protectionism consumer suffer for two reasons. They have to pay higher prices for country made goods owing to absence of foreign competition, and Protection limits the choice of consumer goods. Protection Acts Like an Opiate: When foreign competition is removed, the home manufacturers become lethargic. Protection acts like an opiate. It sends the home producer to sl eep. All improvements are neglected. There is no incentive to cut down the costs or to improve the quality. Technical progress thus comes to a s tandstill. Low Economic Utilization of Resources. Under protectionism the country even produces those goods in which it enjoys no cost advantage. The resources are not utilized fully. Inequality in the Distribution of National Income. Under protectionism, consumers have to pay higher prices for country made goods and i ndustrialists who already belong to rich section of the society, earn higher profits. It, therefore, creates inequality in the society. Strained Foreign Relations: protection leads to conflict, friction and problems in international dealings. When a government restricts its imports by imposing heav y import duties, the other countries retaliate in the same manner. This produces unnecessary strain on their political relationship. Why Under-developed and developing co unties (BD) need prot ection? For protecting infant industry: To protect the infant industry like textile industry or software industry protection is must, otherwise multinational company can capture the market. To protect poor industry: Poor industry cannot survive with the multinational company. So protection is must for protecting poor industry. To increase the national resources though customs and duties, protection is must To build up productive power. Protection preserve the available foreign exchange. To save foreign currency we need to avoid importing luxurious goods. Protection strengthens the economy of underdeveloped countries and increases the GNP. Protection will strengthen defense and promote self-sufficiency. When there is no import due to protection but there is demand, then there is need for diversification of production in order to fulfill the demand which ensure the self sufficiency of a country. In order to ensure full employment, protection is must. To protect the policy of developing countries, protection is needed. Because they have less bargaining power.
Kumkum Sultana (26th Batch, DM, CU) 9
