Economics Chapter 7 International trade Class 12 notes

Economics Chapter 7 International trade Class 12 notes for FA/ FSC

Exercise

Q.1 Differentiate between domestic trade and international trade and explain why it is necessary to study international trade separately.

Answer: 

INTERNATIONAL TRADE

Exchange of goods and services between countries is called international trade. The resources such as land, climate, minerals, capital and labour are not evenly distributed throughout the world. As a result, the ability of various countries in producing goods is not the same. Some countries can produce a commodity cheaper than the others. They give more attention to the production of such goods. They find it convenient not to produce every commodity in the country. Instead, they produce their cheaper goods in greater quantities and then exchange a part of extra production with other countries to get their desired commodities. The trade relations between nations are very important for the economic life of the people. So a scientific study of the nature and problems of international trade should be undertaken.

DOMESTIC VS INTERNATIONAL TRADE

The trade between different countries is called international trade. While trade between various regions of the same country is called domestic trade. The fundamental cause and principles in both kinds of trade are the same. International and comparative advantage is one result of the division of labour, specialization and advantage of one region/ or country over the others in the production of a commodity. However, the two types of trade are not exactly similar. There are several differences between domestic and foreign trade, which make it necessary that international trade be studied as a separate topic.

Why study international trade separately.

The reasons why we should study international trade separately could be assessed by its merits.

ALL Kinds of trade, whether internal or external, bring benefits for the people. But international trade has certain specific advantages.

1.      A country does not get those commodities which it cannot produce itself. For example, Pakistan does not grow tea which we can import, some countries do not produce petroleum yet they get it. In the absence of trade, our economy will not function properly for want of many essential goods.

2.      A country can get goods at cheaper rates which produce only at a very high cost. Japan can grow cotton but it the is cheaper for her to import it from Pakistan.

3.      Foreign trade enables countries to specialize in production of those commodities for which its resources are more suitable. Goods are produced at lower comparative costs as well as in larger quantities. Pakistan, because of its suitable soil has a special position in the production of cotton and rice. Instead of using our land for a small number of coconuts, from the same area we get huge quantities of cotton or wheat.

4.      During famines and other calamities, a country can get food grains and necessities of life. When Pakistan faces food shortage it imports wheat. Time and again we import sugar and pulses to compensate for fall in local production.

5.      International trade helps in industrial and agricultural development. A country can import materials, machinery, equipment, and fertilizers etc. which are used in the production of domestic goods as inputs. Developing countries can get new technology from advanced countries. Rapid economic growth in Saudi Arabia has been possible only due to foreign trade. Had Pakistan no foreign trade, our progress in applying modern technology to agriculture, industries, transport and education would have been slow. Instead of using trains and aeroplanes we might still be travelling by horses. Facilities such as T.V and computers have resulted from international trade.

6.      Fear of competition helps to improve the quality of local products. For example, if Pakistan allows import of cycles, the quality of locally produced cycles will definitely improve.

7.      International trade extends markets and encourages large scale production which results in lower per unit cost. ups and downs in local prices are also reduced.

8.      In case of over production of some commodity in the country, it can be sold abroad e.g. in some years. Pakistan over produces potatoes. Then, these are exported.

9.      International trade prevents local monopolies Because of fear of cheap imports the local producers cannot create monopoly and exploit the consumers.

10.            International trade relations facilitate borrowing and lending abroad.

11.  International trade brings people from various countries closer. They learn new ideas, techniques and better ways of living from each other. Various civilizations and cultures interact and new cultures come into existence. For instance, we have learned a lot about foods, clothes and town planning from countries and have improved our living patterns. Other nations have learnt from our culture and social values.

Conclusion

             On the whole, the advantages of foreign trade are more than disadvantages. Moreover, many disadvantages can be removed or reduced through control of free trade, so the interest of all countries lies in the expansion of trade.

Q.2 Write down advantages and disadvantages of international trade.

Answer:

Advantages

All kinds of trade, whether internal or external, bring benefits for the people. But international trade has certain specific advantages.

1. A country can get those commodities which it cannot produce itself. For example Pakistan does not grow tea which we can import. Some countries do not produce petroleum yet they get it. In the absence of trade our economy will not function properly for want of many essential goods.

2. A country can get goods at a cheaper rate which it can produce only at a very high cost. Japan can grow cotton but it is cheaper for them to import it from Pakistan.

3. Foreign trade enables countries to specialize in production of those commodities for which their resources are more suitable. Goods are produced at lower comparative costs as well as in larger quantities. Pakistan, because of its suitable soil, has a special position in production of cotton and rice. Instead of using our land for a small quantity of coconuts, from the same area we get huge quantities of cotton or wheat.

4. During famines and other calamities, a country can get food grains and necessities of life. When Pakistan faces food shortage it imports wheat. Time and again we import sugar and pulses to compensate for fall in local production.

5. International trade helps in industrial and agricultural development. A country can import materials, machinery, equipment, and fertilizers etc. which are used in production of domestic goods as inputs. Developing countries can get new technology from advanced countries. Rapid economic development in Saudi Arabia has been possible only due to foreign trade. Had Pakistan no foreign trade, our progress in applying modern technology to agriculture, industries, transport and education would have been slow. Instead of using trains and aeroplanes we might still be travelling by horses. Facilities such as T.V. and computers have resulted from international trade.

6. Fear of foreign competition helps to improve the quality of local products. For example, if Pakistan allows import of cycles, the quality of locally produced cycles will definitely improve.

7. International trade extends markets and encourages large scale production which results in lower per unit cost. Ups and downs in local prices are also reduced.

8. In case of over production of some commodity in the country, it can be sold abroad e.g. in some years Pakistan over products potatoes, then, these are exported.

9. International trade prevents local monopolies because of fear of cheap imports the local producers cannot create monopoly and exploit the consumers.

10. International trade relations facilitate borrowing and lending abroad.

11. International trade brings people from various countries closer. They learn new ideas, techniques and better ways of living from each other. Various civilizations and cultures interact and new cultures come into existence. For instance, we have learned a lot about foods, clothes and town planning from other countries and have improved our living patterns. Other nations have learnt from our culture and social values.

Disadvantages

Foreign trade is not free from disadvantages:

1. Due to excessive exports a country may exhaust its essential non-renewable resources and minerals. Middle East countries are fast exhausting their oil reserves. They will deprive the next generations of this valuable nature’s bounty. If they don’t develop industries or find other sources of income, someday, they will be in trouble.

2. Flag may follow trade, as it happened in the case of the sub-continent. At first, foreign trade goes on without any harm, but later it may become a threat to the independence of the country.

3. Foreign trade may bring harmful products in a country. For example, the import of opium to China during the 19th century seriously damaged the health of local people. Heroin from Afghanistan is ruining our people and other countries: import of wine in Pakistan also has undesirable consequences.

4. Some countries become too dependent on other countries for food or essential raw materials. During war, they face serious trouble. Moreover when there is some economic disturbance in one country its trading partner is also affected.

5. Specialization in a few commodities increases economic instability. Pakistan depends too much on exports of cotton products while it imports engineering goods. If in some years cotton production falls, our economy is badly affected.

6. In the presence of imports, less developed countries may find it too difficult to establish new industries. The new infant industries are unable to stand up and compete with the cheap products of old established industries abroad.

7. Foreign trade may lead to war. Countries compete and fight each other for markets and sources of raw materials. The main cause of the 1st World War was competition between England and Germany for markets and raw materials. American invaded Iraq to get control of oil.

Conclusion

             On the whole, the advantages of foreign trade are more than disadvantages. Moreover, many disadvantages can be removed or reduced through control of free trade, so the interest of all countries lies in the expansion of trade.

Q.3 Critically explain Comparative Cost Theory of international trade

Answer:

Adam Smith had put forward the theory of absolute advantage as the basis of international trade i.e. trade between two countries, A and B is possible only A has absolute advantage over B in production of one commodity and country B has advantage over A in the production of another commodity. The theory was later modified by David Ricardo. He explained that trade takes place on the basis of comparative advantages and the existence of absolute is not a necessary condition.

According to Ricardo’s theory of comparative advantage, trade between two countries A and B is possible even if a country A can produce every commodity cheaper than the commodity B. In such a case, country A will export that commodity in which its advantages are relatively greater and will import the other commodity. Country B has disadvantage compared to the first country in production of the commodities. Yet, it will specialize in only one commodity in which its disadvantage is relatively less. In simple words:

“It benefits a country to specialize in the production of that commodity in which it has the greatest comparative advantage or the least comparative disadvantage.”

To explain the theory, we take the example of two countries, Pakistan and japan. Suppose they produce two commodities cotton and radios. Pakistan can produce both the commodities cheaper than japan i.n. Pakistan has advantages of Pakistan is greatest in production of cotton and the disadvantage of japan is least in radios. Then Pakistan should produce (specialize in) cotton only and import radios from japan. Japan should produce radios only and get cotton from Pakistan. In this way both the countries will benefit.

Suppose the cost of producing cotton and radios in Pakistan and japan, in terms of labour hours, is as this:

Marginal cost of production (in labour hours)

            We see that Pakistan has more productive labour. It can produce both cotton and radios at a lower (labour) cost than japan. But its relative advantage is greater in cotton. Japan has disadvantage in both, but its disadvantage is less in radio. See the cost ration (labour costs)

This difference in relative costs is the basis for international trade.

Suppose, Japan offers us 3 radios against 1 unit of cotton. We will accept this offer, because we are getting an extra radio. If we produce within the country, we can make only 2 radios by giving up one unit of cotton. On the other hand, japan is also saving two radios. If it grows cotton itself, it will have to sacrifice 5 radios for one unit of cotton, whether through trade it gives us only 3 radios for the same quantity of cotton imported. Thus both countries benefit from trade.

Gain from trade

Trade between two countries can take place only when there is some gain for both. Let us see how both countries can gain. We assume that total resources available are 120 hours of labour.

Total production without trade

Pakistan : 1 unit of cotton + 2 radios (cost 20 hours)

Japan : 1 unit of cotton + 5 radios (cost 100 hours)

Pakistan + japan : 2 units of cotton + 7 radios (cost 120 hours)

Total production with trade

When Pakistan produces only cotton and japan radios, the combined production of the countries with the same quantity of labour (i.e. 120 hours) will be:

Pakistan : 2 unit of cotton + 0 radio

Japan : 0 unit of cotton + 10 radios

Pakistan + japan: 2 units of cotton + 10 radios

Comparing the two situations, we find that total production has increased.

Gain from trade after specialization = 3 radios.

Both countries must share the gain of additional production. If Pakistan has inelastic demand for radios of japan, Pakistan will get less share in the gain and vice versa. As assumed above. If Japan offers Pakistan 3 radios while Japan’s gain is two radios.

Terms of Trade

The terms of trade for cotton and radios must lie between the separate exchange ratios in two countries i.e.

Exchange ratio in Pakistan before trade 1 C = 2 radios

Exchange ratio in japan before trade 1 C = 5 radios

After trade, the common ratio will lie somewhere between these ratios. For example, we have assumed that the new ratio will be 1C = 3 radios.

Assumptions

1. Cost of production consists of labour cost only. Other costs can either be ignored or shown in labour terms.

2. Within a country, the factors of production, especially labour, are perfectly mobile but perfectly immobile between various countries.

3. Trade is free. There is no government intervention.

4. Cost ratios remain constant i.e., law of constant returns applies.

5. There is perfect competition in local and foreign markets.

6. Currencies are on Gold Standard so exchange ratios of currencies remain fixed.

Evaluation (criticism)

The theory is criticized on the following points.

1. The assumptions of the theory are incorrect. The assumptions about labour costs only, constant returns, mobility of factors, free trade etc. are not true.

2. The theory is static because it assumes that resources of a country, methods of production and tastes remain constant. But these things change with time. For example the economic condition and resource position in Pakistan are different than they were in the 1950s.

3. The theory ignores transport costs. Sometimes, in spite of different cost ratios the trade between two countries may not take place because transport costs are higher than the expected gain from exchange of goods.

4. The theory considers the supply side of trade, ignoring the demand side. Unless we introduce the demand conditions, the problem of exchange price cannot be decided.

5. Complete specialization is not essential. A country may import a commodity and at the same time, may itself be producing some quantity to meet demand.

6. The theory is based on the assumption of Gold Standard and Quantity Theory of Money. Which have been rejected. (Because of modern paper currencies, exchange rates frequently change and affect trade relations of countries).

Sometimes trade between two countries can arise due to military considerations and not economic reasons. Pakistan can get many goods cheaper from India than from other countries, yet we avoid importing them from India because it has been blackmailing Pakistan in the past. It is better not to depend on India even if we pay a higher price to other countries.

Q.4 What is the modern theory of international trade?

Answer:

Modern theory

Modern theory of international trade is based on the views of Bertin Ohlin and Heckscher. They rejected the classical comparative cost theory as incomplete and unrealistic. They point out that assumptions of labour cost only, perfect immobility of factors of production between different countries are not true. The theory is static because it takes a country’s ability and capacity to produce various commodities as unchanging. Classical theory fails to take into account dynamic and changing conditions about production and consumption of goods.

The Theory

Ohlin – Hecksher (H-O) theory gives explanation of the chain of events and conditions which give rise to international trade. The theory is explained with the basic assumption that trade is free. It points out that:

First of all, the immediate cause of trade is the difference in prices of commodities, which are traded, an importer of japan is interested to import cotton from Pakistan because the price of cloth in Pakistan is lower, and Pakistani importer wants to order T.V. sets from japan since their price is less in japan. If the government does not interfere, then Pakistani traders will import sugar from Cuba and cycles from India, for the reason that the commodities are cheaper there. Now, if trade takes place because prices of a commodity are different in different countries, then, according to Ohlin, there is no difference in international trade and domestic trade which also starts because of price difference at various places.

According to Ohlin and Hecksher, the most important cause of price differences lies in the difference in the relative scarcities of productive factors (i.e. supply of factors in relation to demand). It is this difference in relative scarcities which gives countries comparative advantage in production of some goods. They explain the fact in two parts.

(a). Difference in factor endowments.

(b) Difference in use of factor proportions.

•       Different Factor Endowments

Factor endowment of a region means the availability of labour, capital and land resources. Some countries have abundant cheap labour. Some have greater amounts of capital while still others have vast areas of fertile land or abundance of other natural resources. As a result, each country’s ability to produce goods is not the same. For example, Pakistan’s ability to produce agricultural goods is superior to Saudi Arabia and the latter is better endowed to supply petroleum products. Thus, prices of petroleum products are lower in Saudi Arabia while Pakistan can supply rice and cotton garments cheaply. This situation gives rise to trade between the two countries. So the relative scarcities of factors in different countries will determine direction and the pattern of flow of goods. In this respect too, domestic trade is similar to international trade.

•       Different Factor Proportions

The relative use of various factors in production is not the same for all goods. Every commodity requires factor inputs in different proportions. Carpets and sports goods require more labour while trucks and computers need more capital and technology. So it is convenient to produce carpets in that country where labour is cheaper and trucks in a country which has more capital. It is for this reason that capital intensive goods are cheaper in America and are exported to Pakistan. In turn, labour intensive goods have low prices in Pakistan and are sent to the U.S.A.

Two important aspects of \ Heckscher-Ohlin theory.

(i) Factors are immobile between countries but trade acts as a partial substitute for this immobility. For example, Nepal does not produce petroleum. Oil wells are situated in Saudi Arabia and Kuwait etc. Through trade Nepal gets oil and directly benefits from natural resources of Saudi Arabia.

(ii) Trade (especially free trade) will tend to equalize factor price in different countries. So when Pakistan exports labour-intensive goods, demand for labour and wages level at home tend to rise. In Germany, capital is abundant and the return on capital is low as compared to Pakistan. So when Germany produces capital intensive imports of labour intensive goods from Pakistan, it tends to raise wages in our country and depress wages in Germany. Thus trade decreases the difference of wages levels in the two countries.

Assumptions of Theory

1. There is perfect competition in various markets of trading countries.

2. Trade is free of any government intervention.

3. Factors prices show relative scarcities of factors.

4. There is partial immobility of factors between countries.

Criticism

H-Ohlin’s theory is criticized on many grounds.

1. It ignores the effect of demand for commodities on their prices. Only factor prices and factor endowment have been considered to influence prices of goods.

2. Difference in production techniques, consumer’s tastes etc. have not been given due weight.

3. The assumption that relative factor prices reflect relative endowment is unrealistic. Many other things such as the social system and industrial organization affect prices of factors.

4. Commodity price ratios may not correspond to cost ratios due to imperfections in the market.

5. It is argued that prices of products are not determined by factors costs, rather the opposite is true and the prices of factors depend upon the prices of final goods.

6.      Empirical research made by Leontief and others goes against the theory. The U.S.A. has an abundance of capital, so according to this theory, its exports must consist of capital intensive goods. Research shows that exports of the U.S.A. have more labour content.

Q.5 Define terms of trade. What factors determine the terms?

Answer:

TERMS OF TRADE (TOT)

In order to know the performance of a country in international trade and balance of payments, terms of trade play an important role. So all countries estimate their terms of trade regularly. Two concepts of terms of trade are in common use.

(a) Barter terms of trade.

(b) Income terms of trade.

Barter terms of Trade

Barter terms of trade refer to the ratio of export prices to import prices (Px/Pm). Since, very large number of goods and services are exported and imported, the price of not any single commodity, but the index of export prices is divided by the index of import prices.

The ratio is then expressed in percentage.

Barter TOT= Px/Pm x 100

Suppose the price index of exports of a country in a particular year is 180, while that of imports is 200. Then

Barter TOT = 180/200 x 100 = 90

Terms of trade are said to be unfavorable if the value of BOT is less than 100. It shows that export prices have risen less than import prices. (A given volume of exports will exchange for a less volume of imports).

Pakistan’s terms of trade for most of the years have remained unfavorable. The position in 2010 was as follows:

Price index of exports (Px) = 570

Price index of imports (Pm) = 970

TOT (Px/Pm) = 570/970 x 100 =58.76

Income Terms of Trade

Income terms of trade measure the import capacity of a country. Income terms of trade are measured as export receipts (Px,Qx) divided by import price index (Pm).

Income TOT = Px/Pm x Q

Where Qx is the quantity index of exports.

Suppose in a particular year the export price index Px is 180 quantity Qx is 100 and price index of imports Pm is 200, then income TOT = 180/200 x100 = 90

Factors on which TOT depend

The main factors which determine the terms of trade of a country are as follows:

1. Elasticity of demand and supply for exports and imports. If the demand for a country’s exports is elastic it will have to accept poor terms of trade and if demand is inelastic, it can get better terms.

2. Availability of substitutes. Easy availability of substitutes for the exports of a country has an unfavorable effect on its terms of trade.

3. Total size of demand. If the size of demand for imports in a country is larger the country can bargain better and get favorable terms from other countries e.g. as India and China do.

4. Exchange rate of currency. The decrease in the exchange rate of a country has a negative effect on its terms of trade.

5. Nature of exports and imports. If a country exports primary products, while its imports are mostly manufactured goods, then its terms of trade will be unfavorable e.g. Pakistan’s TOT

Q.6 Give arguments in favour of Protection and Free trade

Answer:

FREE TRADE

Free trade refers to the policy in which no restrictions are put by the government on the movement of goods between various countries. There are no tariffs, no quotas and no control over foreign exchange. Everybody’s free to export or import anything from any country of the world. However, if some custom duty is charged simply for the purpose of collecting revenue for the government, and not to provide protection to any home industry, it will still be called free trade. Many countries followed this policy in the 18th and 19th centuries. Most economists favor free trade policy because its benefits are more than harms. An international body, WTO is working to liberalize international trade.

Arguments in favor of free trade

The following arguments are put forward in support of free trade.

1. Maximization of output under free trade, a country specializes in those commodities for which its resources are best suited and imports the goods which are cheaper abroad. In this way, all countries can produce more and gain from trade.

2. Optimum Utilization of Resources As a result of free trade, the international specialization and division of labour increases. So allocation of resources becomes more efficient.

3. Increase in Consumption Free trade benefits the consumers. They are able to buy more varieties of commodities from abroad at minimum possible prices. The standard of living is raised.

4. Improvements in Skills and Methods of Production Due to competition the home producers try to improve the quality of products and methods of production and make innovations.

5. Wider Markets Due to free trade, extent of markets for goods increases. When goods are produced on a large scale, cost of production is reduced.

6. Prevents Monopolies Under free trade, the chances of creating monopolies decrease. The circumstances in various countries are not the same, so it is not easy to eliminate all competitors.

7. Promotes Economic Development Free trade encourages import of capital

8. Goods and raw materials. It also helps in getting foreign capital! And new technology. So it is helpful in accelerating the rate of development.

PROTECTION

Protection refers to a policy in which domestic industries are protected from foreign competition. For this purpose different measures are adopted which restrict imports. Generally applied types of restrictions are:

Tariffs: These are taxes on imported commodities i.e. custom duties. High custom duties raise prices of foreign goods relative to the prices of domestic products.

Quota means ‘to restrict the quantity of import of a good so that its price rises relative to the local good’.

Subsidies: Another way to protect local goods is to pay subsidies to local producers to enable them to compete with cheap foreign goods.

Exchange controls: By putting restrictions on the use of foreign currency, the Govts, can get control over which commodities are imported, and in what quantities.

Arguments for Protection

1. Protection of infant industries: This is the most important and widely accepted argument for protection. Sometimes a country achieves superiority in production of a good only because it had started production earlier than the others. Later, when a new country decides to produce the same commodity, its infant industry is unable to compete with the well-established foreign firms. Its cost of production may be high and quality’ poor. Protection can help such industry to continue. For example, in Pakistan, if the cycle industry is not protected; it will not be able to compete with imported cheaper cycles. The infant industry argument especially applies to those countries, which like Pakistan, started developing later and whose over all industrial base is weak
2. Increase in employment: In many countries, unemployment is a serious problem. To cure it. Custom duties on imported goods are raised. This step encourages local industries to expand and thus provide employment to more people.
3. Terms of trade improve if tariff on imports is imposed. Foreign producers are forced to pay some part of the import duty.
4. Diversification of local industries It is desirable that a country should have balanced growth of the economy so that all sectors develop side by side. For this purpose, some weak or less profitable industries need protection to be able to continue production and compete with imported goods.
5. To check dumping Dumping aims at flooding a foreign market with low- priced commodities. This can ruin the industries of that country. To protect the local import-competing firms, a high tariff is needed. Unfair competition can be eliminated through a tariff on imported goods.
6. Self-sufficiency in some essential goods is desirable even if their local cost is higher than imported ones.
7. Conservation of national resources If a country exports its exhaustible resources, (e.g. oil, gas) in very large quantities, it may soon deplete the whole reserves. To conserve such resources, tariffs are imposed on exports.
8. Improvement in the balance of payments is possible by imposing tariffs on imports.         
9. Defence argument A country must encourage the domestic production of those goods which are essential from the defense point of view
   Protection of key industries To develop the economy on sound lines and create a strong industrial base, a country must protect its basic or key industries.

Q.7 What is an open economy?

Answer:

Open economy has following aspects

A. Foreign Trade and Economic Activity

An open economy is one that engages in international exchange of goods, services, and investments. Exports are goods and services sold to buyers outside the country, while imports are those purchased from foreigners. The difference between exports and imports of goods and services is called net exports.

B. Interdependence in the Global Economy

In the longer run, operating in the global marketplace provides new constraints and opportunities for countries to improve their economic growth. Perhaps the most important element concerns saving and investment, which are highly mobile and respond to incentives and the investment climate in different countries.

C. International Economic Issues

Popular analysis looks at large trade deficits and sees “deindustrialization.” But this analysis overlooks the important distinction between productivity and competitiveness. Competitiveness refers to how well a nation’s goods can compete in the global marketplace and is determined primarily by relative prices. Productivity denotes the level of output per unit of input. Real incomes and living standards depend primarily upon productivity, whereas the trade and current-account positions depend upon competitiveness. There is no close linkage between competitiveness and productivity.