ECON 412: INTERNATIONAL ECONOMICS

TOPIC 1; INTRODUCTION

When Kenya purchased Toshiba personal computers(PC), Sony television set, a Nissan car, an
IMB type writer among other things all these combined together are foreign products. These are
only a few examples of numerous products that are available to Kenyan consumers.

It is important to note that all the products indicated above are made in and imported from other
countries.

According to economists the study of international trade and finance is among the oldest
specialists in economics. It was conceived in the 16th century as a child of Europe version for
Spanish gold and grew maturity in the turbulent years that witnessed the emergence of nations
states.

It attracted the leading economists of the 18th and 19th centuries such as Davide Hume, Adam
smith, David Ricardo and John Stuart mill.

Their work supplied a legacy that continues to guide us today.

It is observed for example that an early version of the quantity theory of money was developed
by David Hume to show how foreign trade affects the level of domestic prices. The first full
formulation of the laws of supply and demand was developed by John Stuart Mill to show how
prices are determined in International markets.

Economics state further that international problems have been studied by many recipients of the
Nobel price in economics including Wassily Leontief, Bertil Ohlim, Paul Samuelson and James
Meade received the Nobel price of an economics because of the focus.

It is observed further that international economics flourishes today because the analytical and
policy issues that brought it to being continue to require attention.

Effects of International trade

Economists commonly identified the following as the significant effects of international trade.

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1. Efficient use of resources by each national economy.
2. Trade raises real income in each country through specialization.
3. Improvements in technology developed in one country are shared with other countries.
4. Countries can grow faster by participating in international capital markets by borrowing
from those markets, countries can supplement domestic savings and raise rates of capital
formation.
5. Events in international market affect levels of domestic employment, growth rate and
inflation rate.
6. Commercial and financial arrangements among countries affect the functioning of
domestic policies.

The subject matter of international economics

International economics deals with economic inter-dependence among nations.

It analyses the flow of goods, services and payments between a nation and the rest of the
world.

It also analyses the policies directed at regulating this flow and their effect on the nations is
affected by an in turn influences the political, social, cultural and military relations among
nations.

Specifically, international economics deals with international trade theory, international

trade policy, foreign exchange markets and balance of payments and open economy
macroeconomics.

International trade theory analyses the basis for and the gains from trade. International trade
policy examines the reasons for and the effect of trade restrictions and the new
protectionism.

Foreign exchange markets are the framework for the exchange of one national currency for
another. The BOP measures a nation’s total receipts from and total payments to the rest of
the world.

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Open economy macroeconomics deals with the mechanisms of adjustment in balance of
payments disequilibrium or where disequilibrium means deficit and surpluses in balance
trade. It also deals with the effects of the macroeconomics interdependence among nations
under different international monetary systems and their effects on national welfare.

International trade theories and policies are the micro-economics aspects of international
economics. This is because, they deal with individual commodities.

On the other hand, the BOP and adjustment policies represent the macroeconomic aspects of
international economics. The reasons are that the BOP is concerned with receipts and
payments while adjustment policies affect the level of national income and general price
index.

The purpose of international theories and polices

According to economists the purpose of economic theory is to predict and explain. In other
words, economic theory has trapped the details surrounding an economic event in order to
isolate the few variables and relationships considered most important in predicting and
explaining the event.

The international economics usually assume a two-nation, two-commodity and a two-factor

world.

It further assumes no trade restrictions, perfect mobility of factors within nations but no
international mobility.

It also assumes perfect competition in all commodity and factor markets and no
transportation costs.

Current international economic problems

The following are considered by economists to be the current international economic

problems.

a) The rising trade protectionism in developed countries.

b) The excessive fluctuations and large equilibrium in exchange rates.

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 c) The high structural unemployment in Europe and other parts of the world.
d) The structuring problems facing Eastern Europe and former Soviet Union.
e) The deep poverty of some of the poorest developing countries.

The Basis for Trade

Differences in prices from country are the basic cause of trade.

They reflect differences in costs of production.

Trade serves to minimize the real resource cost of worldwide production.

In other words, trade serves to maximize the real value of production from the world
resources by permitting and encouraging producers in each country to specialize in those
economic activities that make the best uses of their countries physical and human resources.

TOPIC 2: THEORIES OF INTERNATIONAL TRADE

The law of comparative advantage

It is emphasized that under this topic we examine the development of trade theory from the 17 th
century up to the 1st part of the 20thcentury. Specifically we will attempt to answer the following
two basic questions.

What is the basis for trader and what are the gains from trade?

What is the pattern of trade?

Note that the law of comparative advantage is divided into two components:

Mercantilism and the theory of absolute advantage: The law of comparative advantage is
commonly regarded as one of the most important laws of economics. It applies to nations as well
as to individuals and it is useful for exposing many fallacies in seemingly logical reasons.

For simplicity, our discussion will mainly focus on only two nations and two commodities.

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 i. Mercantilism

According to economists, economics as an organized science can be set to have originated with
publication in 1776 of a book known as “The Wealth of Nations” 1776 by Adams Smith. We are
also reminded that writings on international trade presided this date is England, Spain, France,
Portugal and Netherlands.

Specifically, during the 17th and 18th centuries, a group of men consisting of Merchants, Bakers,
Government Officials and even Philosophers wrote essays and bank pamphlets on international
trade that advocated an economic philosophy known as Mercantilism.

The mercantilists maintained that the way which a nation could become rich and powerful was to
port more than it imported. The resulting export surplus would then be settled by an inflow of
billion or precious metals primarily gold and silver.

It was believed that the more gold and silver a nation possessed the richer and more powerful it
was as such a government had to do all in balance to stimulate the nations export and discourage
and restrict imports especially the import of luxury consumption goods.

Note that Mercantilists measured the wealth of nations by the stock of precious metals they
possessed. Today we measure the wealth of a nation by its stock of human, manmade and natural
resources available for producing goods and services. The grayer these stock of resources the
greater is the flow of goods and services to satisfy human wants and the higher the standard of
hiring in the nation.

In general mercantilists advocated strict government control of all economic activity and riched
economic nationalism. This is because they believed that a nation could gain in trade only at the
expense of other nations. In other words, trade has considered to be a zero sum game. The
importance of these views is linked to the ff arguments.

1. The ideas of Adams Smith, David Ricardo and other classical economists can be
understood if they are regarded as reactions to mercantilist views on trade and on the role
of government.

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 2. Today there seems to be a resurgence of neo-mercantilism. This is explained by the fact
that nations affected by high levels of unemployment seek to restrict imports in an effort
to stimulate domestic production and employment.

ii. Absolute Advantage

Adams smith (1723 to 1790) started his analysis of international trade with the simple
truth that for two nations to trade with each other voluntarily both nations must gain. If
one nation gain nothing it will refuse to trade.
According to Adams Smith therefore trade between nations is based on Absolute
Advantage. This means that when nation is more efficient than or has an absolute
advantage over another in the production of one commodity but is less efficient than or
has an absolute disadvantage with respect to the other nation in producing a second
commodity, then both nations can gain by specializing in the production of the
commodity of its absolute advantage.
It can then exchange part of its output with the other nations for the commodity of its
absolute disadvantage.
By this process, resources are utilized in the most efficient way and the output of both
the commodities will rise.
The increase of both commodities means the gains from specialization that are available
and which can be divided between the two nations through trade.

EXAMPLE
An example of absolute advantage is due to different climatic conditions Canada is
efficient in growing wheat but inefficient in growing bananas.
On the other hand, Japan is efficient in bananas but inefficient in growing wheat. It
follows that Canada has an absolute advantage over Japan in the cultivation of wheat but
an absolute disadvantage in the cultivation of bananas. The opposite is true on Japan.
Under the above circumstances both nations would benefit if each specialized in the
production of the commodity of its absolute advantage.

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It should then trade with other nations. Canada would specialize in the production of
wheat and exchange some of it or the surplus for bananas grown in Japan. As a result,
both more wheat and bananas would be grown and be consumed.
Both Canada and Japan would gain.
As indicated above, a nation does not behave differently from an individual. This is
because an individual does not attempt to produce all the commodities she or he needs
rather they produce all they need that commodity they can produce most efficiency.
They can then exchange part of the output for the commodity needed. In this way total
output and the welfare of all individuals are maximized.
We know that why the mercantilists belief that one nation could gain only at the expense
of another nation and therefore advocated strict government control of all economic
activity and trade. Adams Smith and the other classical economists who followed him
believed that all nations would gain from trade.
They strongly advocate the policy of Laissez faire i.e. [has little government
interference with the economic system as possible]
Smith and his followers believed that free trade would cause world resources to be
utilized most efficiently and would maximize world welfare.
There were a few expectations to the policy of Laissez faire and free trade welfare e.g.
there was a need for the protection of industries important for national defence.
Application of Absolute Advantage
We examine below the numerical example of A.A that to examine a framework for
presenting a more challenging theory of comparative advantage to follow .
Table 2.1 shows that one hour of labour time produces 6 kg of wheat in the United
States but only 1 kg in the United Kingdom. On the other hand 1 hour of labour time
produces 5metres of both in the United Kingdom but only if United States. Therefore,
the UK is more efficient than or has an absolute advantage over the US in the
production of cloth.
Table 2.1 Absolute Advantage
US UK
Wheat (kg/man-hour) 6kg 1
Cloth (metres/man-hour) 4kg 5

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According to table 2.1 we note that, with trade, the US would specialize in the
production of wheat and exchange part of it with British cloth. The opposite is true for
the UK.
Suppose that the US exchanges 6kg of wheat (6W) for 6m of British cloth (6C). The US
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gains 2C or saves 2 man-hour or 30 minutes of labour time. This is because the US

can only exchange 6W for 4C domestically.

In the same way the 6W that the UK receives from the US is equivalent to or would
require 6 man-hours of labour time to produce in the UK.
The same 6 man-hours can produce 30C in the UK [6 hours X 5metres of cloth per man
hours]. By being able to exchange 6C which requires a little over 1 hour to produce in
the UK for 6W with US, the UK gains 24 C or saves almost 5 man-hours.
It is emphasized that absolute advantage can explain only a very smart part of world rate
today. This reduces some of the trade between and developing countries. Most of the
world trade especially trade among developed countries could not be explained absolute
a developed dvantage.
It remained for David Ricardo that the law of comparative advantage truly explain the
basis and gains for trade.
Indeed Absolute Advantage will be seen to be only a special case of the more general
theory of comparative advantage.

The Ricardian Law of Comparative Advantage

In 1817, David Ricardo published his “principles of political economy and taxation” in
which he presented the law of comparative advantage.
This law is one of the most important and still had challenges loss of economics with
many practical application. It states as follows:
Even if one nation is less efficient than or has an absolute disadvantage with respect to
the other nation in the production of both commodities there is still a basis for mutually
beneficial trade.
The above expression/statement indicates that the first nation should specialize in the
production of and export the commodity in which its absolute advantage is moral. This
is the commodity of its comparative advantage.
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It should import the commonly in which its absolute disadvantage is greater because this
is the commodity of its comparative disadvantage.
The law can be clarified by examining table 2.2. The only difference between this table
and table 2.1 is that the UK now produces only 2metres of cloth per man-hour instead of
five. Thus, the UK now has an absolute disadvantage in the production of both wheat
and cloth with respect to the US.

Table 2.2 Comparative Advantage

US UK
Wheat (kg/man-hour) 6 1
Cloth (metres/man-hour) 4 2
Comparative advantage is where a country has an advantage in production of both
commodities but can produce although quantity of certain commodities even through the
production is high or low in different countries.
According to the above table it is clear that since UK labour is half less productive in
cloth, but six (6) times less productive in wheat with respect to the US, the UK has a
comparative advantage in cloth.
On the other hand, the US has an absolute advantage in both wheat and cloth WRY UK.
However, since its absolute advantage is greater in wheat (6:1) than in cloth (4:2) the
US has a comparative advantage in wheat. In short the US absolute advantage is greater
in wheat and so it has a comparative advantage in wheat.
The UK absolute disadvantage is smaller in cloth so its comparative advantage lies in
cloth.
At the same time the UK is specializing in the production of and exporting cloth.
Note that in a two nation, two commodity world, once it is determinate that one nation
has a comparative advantage is one commodity then the other nation must necessarily
have a comparative advantage in the other commodity.

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The Gains from trade under comparative advantage
In order to proof the law of comparative advantage, it is important to show for example,
that the US and UK can both gain by each specializing in the production of and
exporting the commodity of its comparative advantage.
To begin with, the US would be indifferent to trade if it receives only 4C from the UK
in exchange for6W. This will be because the US can produce exactly 4C domestically
by utilizing the resources released in giving up 6W. (Table 2.2)
The US would certainly not trade if it received less than 4C for 6W.
Similarly the UK would be indifferent to trade if it had given up 2C for each 1W it
received from the US. It certainly would not trade if you had to give up more than 2C
for 1W.

In order to show that both nations can gain we suppose that the US would exchange 6W
1
for 6C with UK. (1:1). The US would then gain 2C for saving 2 hour of labour time.

This is so because the US would only exchange 6W for 4C domestically.

To see that the UK would also gain, it should be noted that the 6W that the UK receives
from the US would require 6 man-hours to produce in the UK.
The UK would instead use this 6 man-hours to produce 12C and give up only 6C for
6W from the US. Thus, the UK would gain 6C or save 3 hours of labour time.
Both US and UK would gain by exchanging 6W for 6C but this is not the only rate of
exchange at which mutually beneficial trade can take place.
Since the US would exchange 6W for 4C domestically the US would gain if it would
exchange 6W for more than 4C from the UK. On the other hand, in the UK 6W equals
12C (6W=12C).
Anything less than 12C that the UK must give up to obtain 6W from the US represents a
gain from trade for the UK.
In summary, the US gains to the extent that it can exchange 6W for more than 4C from
the UK. The UK gains to the extent that it can give up less than 12C for 6W from the
US. As such the range for mutually advantageous trade is between 4C<6W<12C.

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EXCEPTION TO THE LAW OF COMPARATIVE ADVANTAGE
Economists state that there is one rare exception to the law of comparative advantage.
This occurs when the Absolute Disadvantage that one nation has with respect to another
nation is the same in both the commodities.
An example is that if one man hour produces 3W instead of 1W in the UK the UK
would exactly half as productive as the US in both wheat and cloth. The UK and the US
would then have a comparative advantage in neither of the commodity and no mutually
beneficial trade would take place. This is illustrated as follows;

Table 2.3 Exception to Comparative Advantage

US UK
Wheat (kg/man-hour) 6 3
Cloth (metres/man-hour) 4 2
The above situation arises because the US can only trade if can exchange 6W for 4C. As
shown above however the UK is not willing to give up more than 4C to obtain 6W from
the US because the UK can produce 6W or 4C with 2 man hours domestically. Under
these circumstances, no mutually beneficial trade can take place.
The exception indicated above requires modifying the law of comparative advantage
slightly to read as follows.
Even if one nation has an absolute disadvantage with respect to the other nation in the
production of both commodities there is still a basis for mutually beneficial trade unless
the absolute disadvantage that one nation has with respect to the other nation is in the
same population for the two commodities.
It is important to note that why the above exception is possible in theory its occurrence
is rare and may only be a matter of coincidence as such as the ability of the law of
comparative advantage is not much affected.

Comparative Advantage with Money

According to the law of comparative advantage [disregarding the exception] even if one
nation such the UK in this case has an absolute disadvantage in the production of both

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commodities with respect to the other nation [the US], there is still a basis for mutually
beneficial trade. The question however is:
How can the UK export anything to the US if it is less efficient than the US in the
production of both the commodities? The answer is that wages in the US.
This will make the price of cloth [the commodity in which the UK has a comparative
advantage] lower in the UK and the price of wheat lower in the US. This position
becomes more specific in terms of the currency of either nation.

Example:
Suppose that the wage rate in the US is 1&6 per hour since one man hour produces 6W
in the US PW=$1.
On the other hand, since 1 man hour produces 4C, PC equals 1$ and so cents the price
of cloth in US.
6
=1. 50
4
Suppose also that at the same time the wage rate in the UK is Ε 1 per hour. Since 1 man
hour produces 1W. In the UK the price of wheat would be PW= Ε 1 . Similarly, since 1
1
Ε 0 .5 ( )
man hour in UK produces 2C, the price of cloth in the UK is equivalent PC= 2
If the exchange rate between the pound and the dollar is E1=$2, then PW=E1=$2 and
PC=E0.5=$1
PW=E1=$2 in the UK
Table 2.4 shows the dollar price of wheat and cloth in the US and UK at the exchange
rate of E1=$2
Table 2.4: Dollar price of wheat and cloth in the United States and the United
Kingdom at E1=$2
US UK
Price of one kg of wheat $1.00 $2.00
Price of one kg of cloth $1.50 $1.00
Source Salvatore, 1995 P.34

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The above table reveals that the dollar price of wheat the commodity in which the US
has the comparative advantage is lower in the US than UK.
On the other hand the dollar price of which the commodity in which UK has
comparative advantage is lower in the UK.

Assumptions of the Ricardian law of comparative advantage

According to economists Ricardo based his law of comparative advantage of a no of
simplified assumptions located below.
1. There are only two nations and two commodities
2. Free trade
3. Perfect mobility of labour within each nation but immobility between the two
nations
4. Constant costs of production
5. No transportation costs
6. No technical changes
7. The labour theory of value
Economists point out that while assumptions 1-6 can easily be relaxed. Assumption (7)
is not valued and should not be used for explaining comparative advantage.

Comparative Advantage and the labour theory of value

According to labour theory of value, the value of price of a commodity depends
exclusively on the amount of labour going into the production of a commodity.
This implies the ff
1. That either labour is the only factor of production or that labour is used in the
production of all the commodities.
2. That labour is homogenous i.e. it is of only one type.
Since neither of the above assumptions is true we cannot base the explanation of
comparative advantage in the labour theory of value specifically labour is neither the
only factor of production nor is it used in the same fixed proportion in the production of
all the commodities.

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It is to be noted for example that much more capital equipment per worker is required to
produce same product such as steel than produce products such as textile.
In addition there is usually some possibility of substitution between labour, capital and
other factors in the production of most of commodities. Furthermore, labour is
obviously not homogenous but varies greatly in training productivity and wages
(experience).

THE OPPORTUNITY COST OF THEORY

While Ricardo laid the theoretical foundations for comparative advantage, it was left for
an economist known as Haberler in 1936 to explain or base the theory of comparative
advantage on the opportunity cost theory.
In this form the law of comparative advantage is sometimes referred to as the law of
comparative cost.
According to the opportunity cost theory, the cost of a commodity is the amount of of
the second commodity that must be given up to release just enough resources to produce
an additional unit of the first commodity.
In this case, no assumption is made that labour is the only factor of production or that
labour is homogenous.
It is also not assumed that the cost or price of a commodity depends on or can be
inferred exclusively from its labour content. As a result, the nation with the lower
opportunity cost in the production of a commodity has comparative advantage in first
commodity and a comparative disadvantage in the second commodity.

Example:
If in the absence of trade, the US must give up two thirds of a unit of cloth to release
enough resources to produce one additional unit of wheat domestically then the
2
opportunity cost of wheat is 3 of a unit cloth.
2
C
In other words 1W= 3 .

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If 1W=2C in the UK then the opportunity cost of wheat in terms of the amount of cloth
that must be given up is lower in US than UK. Consequently the US would have a
comparative or cost advantage over the UK in wheat.
In two nation two commodity would the UK would then have a comparative advantage
in cloth.

The production possibility frontier

Under constant costs
Opportunity costs can best be illustrated with production possibility frontier or
transformation curve.
The production possibility frontier is a curve that a nation can produce by fully utilizing
all of its resources with the best technology available to it.
Table 2.5 gives the hypothetical production possibility schedules of wheat in millions of
kg per year and cloth in millions of metres per year for the US and the UK.

Table 2.5 production possibility schedules for wheat and cloth in the United States
and the United Kingdom
United States United Kingdom
Wheat cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
Source: Salvatore. P.38
The above table shows that the US can produce 180W and OC, 150W and 20C, or 120C
and 40C down to 0W and 120C.
For each 30W that the US gives up, enough resources are released to produce an
additional 20C.

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 As such 30W=20C in the sense that both require the same amount of resources therefore
2
C
the opportunity cost of one unit of wheat in the US is 1W= 3 and remains constant.
On the other hand the UK can produce 60W and 0C, 50W and 20C, or 40W and 40C
down to OW and 120C. It can increase its output by 20C for each 10W. It gives up than
the opportunity cost of wheat in the UK is 1W=2C and remains constant.
The US and UK production possibility schedules in table 2.5 are grouped as production
possibility frontier in figure 2.1.
Note that each point on a frontier represents one combination of wheat and cloth that the
nation can produce.
Figure 2.1 The production possibility frontier of the United States and the United
Kingdom

140

120

Cloth 100

80 A

60

40

20

0 Wheat

30 60 90 120 150 180

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 140

120

`100

Cloth 80

60

40

20

0 Wheat

10 20 30 40 50 60 70

The downward or negative slope of the production possibility frontiers in figure 2.1 indicates
that if the US and the UK want to produce more wheat, they must give up some of their cloth
production.

The fact that the production possibility frontiers of both nations are straight lines, reflect the
situation that their opportunity cost are constant. This means that for each additional 1W to be
2
C
produced the US must give up 3 and the UK must give up 2C. It does not matter from which
on the frontier the nation starts.

It is emphasized that constant opportunity arises when the following conditions hold.

I. Resources or factors of production are either perfect substitutes for each other.
All are used in fixed proportions in the production of both commodities.
II. All units of the same factor are homogenous or exactly the same quality.

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It is important to note that while opportunity costs are constant in each nation, they differ among
nations used to provide the basis for trade.

It is worth noting also that constant costs are not realistic. They are discussed only because they
serve as convenient introduction to the more realistic case of increasing costs to be examined
later.

Opportunity costs and relative commodity prices

It has been shown in the preceding section that the opportunity cost of wheat is the amount of
cloth that the nation must give up to increase enough resources to produce one additional unit of
wheat. This situation is indicated by the slope of the production possibility frontier or
transformation curve and is sometimes referred to as marginal rate of transformation.

120
Figure 2.1 shows that the slope of the US transformation curve is 180 . The higher value of the
2
vertical verse horizontal which = 3 equals opportunity cost of wheat in the US and remains
constant.

The slope of the UK transformation curve is 120/60= and which equals to opportunity cost of
wheat in UK and remains constant.

If it is assumed that prices equals cost of production and that the nation produces both some
wheat and some cloth then the opportunity cost of wheat is equal to the price of what relative to
that of the cloth or PW/PC.

2 3
Therefore PW/PC = 3 in US and inversely PC/PW= 2 =1.5

PC 1
=
In the UK PW/PC =2 and PW 2

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 2
The lower PW/PC in US which is 3 as opposed to 2 is a reflection of the US comparative
1 3
advantage in wheat. Similarly, the lower PC/PW in UK= 2 as compared to 2 reflects its
comparative advantage in cloth. Under constant costs PW/PC is determined exclusively by
production or supply consideration in each nation. Demand consideration do not enter at all in
the determination of relative commodity prices.

If relative prices are low in both countries, production will be high hence trade.

The difference in relative commodity prices between the two nations are shown by the difference
by the slope of transformation of curves is a reflection of comparative advantage and provides
the basis for mutually beneficial trade.

THE STANDARD THEORIES OF INTERNATIONAL TRADE

The production frontier with increasing costs

Economists state that it is more realistic for a nation to face increasing rather than constant
opportunity costs.

Increasing opportunity cost means that the nation must give up more and more of one
commodity in order to release enough resources to produce each additional unit of another
commodity as opposed to constant which can give half a portion i.e. 30W to 20C of only.

Increasing cost results in a production frontier i.e. concave to the origin rather than a straight
line.

Figure 2.2 shows that the hypothetical production frontiers of commodities X and Y for nation 1
and 2. Note that both frontiers are concave from the origin reflecting the fact that each nation
incurs increasing opportunity costs in the production of both the commodities.

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Figure 2.2 production frontiers of Nation 1 and Nation 2 with increasing costs

0 10 30 50 70 90 110 130

Y A

Nation 1

20
 0 10 30 50 70 90 110

140

120 B’

60

40

A’

20

Using the graphs in figure 3.2, let us suppose that Nation 1 wants to produce more of commodity
X starting from point A on production possibility frontier.

Since at point A the nation is already utilizing all its resources with the best technology available
such a nation can only produce more of X by reducing the output of commodity Y.

Figure 2.2 also shows that for each additional bundle of 20X that nation 1 produces it must give
up more and more Y. The increasing opportunity cost in terms of Y that nation 1 faces are
reflected in longer and longer downward arrows in the figure and result in a production frontier
that is concave from the origin.

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Nation 2 also faces increasing opportunity costs in the production of Y. Instead of showing this
graphically increasing opportunity cost in the production of Y are demonstrated in the production
frontier of nation in figure 2.2.

By money upwards from point A’ along the production frontier of nation 2, we observe leftward
arrows of increasing length. This reflects the increasing amounts of X that Nation2 must give up
to produce each additional bundle of 20Y.

Therefore concave production frontiers for Nation1 and Nation 2 reflects increasing opportunity
costs in each Nation in the production of both the commodities.

The marginal Rate of Transformation

The MRT (Marginal Rate of Transformation) of X for Y refers to the amount of Y that a nation
must give up to produce each additional unit of X as such MRT is another flame of opportunity
cost of X. It is given by the absolute slope of the production frontier as the point of production.

We observe that if in figure 2.3 the slope of the production frontier i.e. MRT of nation 1 at point
1 1
A is a quarter ( 4 ). This means that Nation 1 must give up 4 of a unit of Y to release enough
resources to produce one additional unit of X at this point.

Similarly of the slope MRT=1 at this point B within the same nation this means that Nation1
must give up one unit of Y to produce an additional unit of X.

Thus a movement from point A down to point B along the production frontier of Nation 1
1
involves an increase in the slope from 4 at point A to 1 at point B and reflects the increasing
opportunity cost in producing more X. This is in constant to the case of the straight line
production frontier where the opportunity cost of X was constant regardless of the level of ouput.

Reasons for increasing opportunity costs and different production frontiers

Increasing opportunity costs arise because of the ff reasons.

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 I. Resources of factors of production are not homogenous i.e. (all units of the same factor
are not identical or of the same quantity)
II. Resources of factors of production are not used in the same fixed proportion or intensity
in the production of all the commodities. This means that as a nation produces more of a
commodity, a nation must utilize resources that become progressively less suited for the
production of that product. As a result that nation must give up more and more of the
second commodity to release enough resources to produce each additional unit of the
first commodity.
The difference in the production frontiers in Nation 1 and 2 is due to the fact that the two
nations have different factor endowments or resources at their disposal or use different
technologies in production.
NB; In the real world the production frontiers of different nations will usually differ.
This is because practically, no two nations have identical factor endowments even if they
could have access to the same technology
As the supply or availability of factors or technology changes overtime a nation’s
production frontier shifts the type and extent of this shift depends on the type and extent
of the changes that take place.

COMMUNITY INDIFFERENCE CURVES

In this section, we introduce tastes or demand preferences in a nation. These are given by
community or social indifference curves.
A community indifference curve shows the various combinations of two commodities
that yield equal satisfaction to the community or nation.
Greater curves refer to greater satisfaction and lower curves refer to lower satisfaction.
Community indifference curves are negatively sloped and convex to the origin. To be
useful they must not cross each other.
The figure below shows hypothetical indifference curves for nation 1 and 2. They differ
on the assumption that tastes and demand preferences are different in the two nations.

23
 III Y
E

120 H II 120

100 I 100

80 A 80 E’

60 60 A H’ III’

40 40 B’ II’

20 20 I’

0 10 30 50 70 90 0 20 40 60 80 100

NATION 1 X NATION 2 X

-Points N and A gives equal satisfaction to nation 1 since they are both on indifference curve I.

-Points T and H refer to higher level of satisfaction because they are on a higher indifference II.

Even though T involves more Y but less of X, satisfaction is greater at T because it is on high
indifference curve II.

-Point E refers to greater satisfaction because it is on indifference curve III.

For nation 2, A’< B’< H’ < E’

24
THE MARGINAL RATE OF SUBSTITUTION (MRS) Slope of indifference curve.

The Marginal Rate of Substitution (MRS) of X and Y refers to the amount of Y that a nation
could give up for an extra unit of X and still remains on the same indifference curve. This is
given by absolute or total slope of community indifference curve at the point consumption of Y
and X and declines as the nation moves down the curve.

An example is that the slope or MRS of indifference curve I is greater at point N than at point A.

Similarly, the slope or MRS of indifference I’ is greater at point A’ and at B’.

The decline in MRS of an indifference curve is a reflection of the fact that the more of X and less
of Y a nation consumes the more valuable the nation is in the unit of Y at the margin compared
to the unit of X. Therefore, the nation can give up less and less of Y for each additional of X it
wants.

NB; Declining MRS means that, community indifference curve are convex from the origin.
Thus, while increasing opportunity costs in production is reflected in concave production frontier
a decline in marginal rate of substitution is reflected in convex community curves.

EQUILIBRIUM IN ISOLATION

Here we consider how the interaction of the forces of demand and supply (community
indifference curves =Taste/demand preferences production frontier represents production and
supply.

A nation in isolation is one without or a nation that exist in the absence of trade.

Equilibrium in Isolation is a situation whereby in the absence of trade, a nation is in equilibrium

when it reaches the highest indifference curve possible given its production frontier. This occurs
at the point where community Indifference Curve is tangent to the nation’s production frontier.

The common slope of the two curves at the tangency point gives the internal equilibrium price in
the nation and reflects the Nations Comparative Advantage.

25
ILLUSTRATION OF EQUIBRIUM IN ISOLATION

The figure below combines the production possibility frontier and community indifference curve.

It shows that indifference curve I is the highest indifference curve that nation 1 can reach with its
production frontier. As such, nation 1 is in equilibrium or maximizes its welfare which it
produces and consumes at point A in the absence of trade.

Similarly, nation 2 is in equilibrium at point A’ where its production frontier is tangent to the
indifference curve I’.

80

A I

60

40 B

20

10 30 50 70 90 110 130 150

26
Y 140 B’

120 PX=4

100

80 A’

60

40 I’

20

0 20 40 60 80 100 120

TOPIC 3: TERMS OF TRADE AND GAINS FROM TRADE

Factor endowments and the Heckscher –Ohlin Theory

Economists explain that in 1919 Eli Heckscher, a Swedish Economist

published an article entitled the effect of foreign trade on the “Distribution
of Income.” In which the presented and outline of what was to become the
modern Theory of International Trade. The article has largely and noticed
for over ten years until Berhtil-Ohlin another Swedish Economist and
formwr student of Heckscher picked it up, build on it, clarify it and in 1933
published his famous book entitled “Inter regional and International Trade.”

In the book Ohlin expanded and greatly elaborated the factor endowment
theory.

According to modern Economists, the factor endowment approach is

primarily aimed at explaining the pattern of comparative advantage.

27
However, Economists acknowledge that this is difficult to do because there
are many difficult reasons for countries to trade. This includes e.g.

Reasons for trade: Examples

- Climate (conditions)
- Geographical proximity (scale)
- Location of waterways (for irrigation)
- Tastes
- Factor endowments

The factor endowments theory originated in the first half of 20 th century but
it has been defined and elaborated by many Economists. The refining
process of the theory continues.

- Factor endowments are the land, labor, capital and resources that a
country has access to which will give an economic advantage over the
other.
- Developed by Swedish Economist Bertil Ohlin (1899-1979).
- Heckscher Ohlin factor endowment theory emphasizes factor
endowments as basis for trade, while Ricardian theory stresses the role of
labour productivity.
- Factor endowment theory demonstrates how trade affects the distribution
of income within trading partners. E.g. Australian endowment factors –
has a huge endowment of valuable minerals e.g. Iron ore, coal, bauxite,
gold, lead e.t.c. These minerals are exported to countries around the
world especially Asian countries.
- Factor endowment affect a country’s opportunity act of specialization in
producing certain goods relative to others
- Countries with large or diverse factor endowments are more wealthy and
able to produce more goods than countries with small factor
endowments.
- The result of the differences and variation in a counties endowments
factor endowment theory states in economic reasoning that the different
breakdowns of capital to labor will determine a country’s comparative
advantage on what to manufacture or specialize as an economy.

28
 - An example of a factor endowment with respect to land would be the
presence of geographic scale or natural resources such as oil. Countries
with abundant oil tend to export oil, by redirecting internal resources
towards producing the factor they have in quantity.
- In Angola oil accounts 90% of its exports
- On the other hand, US has capitalized on soil rich regions for agricultural
production and exporting these products and taking advantage of large
population and labor force.
- Labor is a key input of most products, from agriculture to cellphones and
its characteristics affect a country’s comparative advantage.
- An abundant labor force means that a country has a lower opportunity
cost of specializing in labor intensive activities.
- A highly skilled labor force is more expensive and more productive than
unskilled labor force e.g. China labor force has grown more skilled,
wages have risen and china has begun specializing in more complex
manufactured goods.

Importance of the factor endowment theory

The following reasons make a factor endowment theory

1) Different factor endowment determines comparative advantage

2) The factor endowment theory links International trade to the
domestic allocation of resources and distribution of income.
(hence there will be utilization of resources)
3) The theory helps in the examination of the relationship between
international trade and economic growth and development between
trading countries and international capital movements.
4) The theory can be made conceptually general to include many other
explanations

Assumptions of Heckscher Ohlin theory

The following are the assumptions upon which the Heckscher Ohlin is based:

29
 1. There are two nations ( nation1 & nation 2), two commodities (commodity 1
& commodity 2) & two factors of production( labor & capital)
2. Both use the same technology in production
3. Commodity X is labor intensive and community Y is capital intensive in
both nations
4. Both commodities are produced under constant returns to scale in both
nations.
5. There is incomplete specialization in production of both commodities.
6. Tastes are equal in both nations.
7. There is perfect labor mobility within each nation but no international
mobility
8. There is perfect competition in both commodities and factor markets in both
nations.
9. There are no transportation costs, tariffs or other obstructions to the free
flow of international Trade.
10.All resources are fully employed in both nations
11.International Trade between the two nations is balanced.

Factor Endowment concepts

1. Factor Intensity

2. Factor Abundance

Factor Intensity

It is stated that in a world of two commodities (X and Y) and two factors of production (labor
K
and capital), it is said that commodity Y is capital intensive if the capital-labor ratio ( L ) used
K
in the production of Y is great than L used in the production of X.

Example: If two units of capital (2K) two units of labor (2L) are required to produce one unit of
2
commodity Y, the capital labor ratio is one. That is, K/L= 2 = 1 in the production of Y. If at the

30
 K 1
same time 1K and 4L are required to produce one unit X, L= 4 for X, we say that Y is K

intensive and X is L intensive.

It is to be noted that it is not the amount of capital and labor used in the production of
commodities X and Y that is important in measuring the capital and labor intensity of the two
K
commodities, but the amount of capital per unit of labor ( L ). As an example, suppose that 3K

and 12L (instead of 1K and 4L) are required produce 1X, while to produce 1Y required 2K and
2L (as indicated earlier). Even though to produce 1X requires 3K, while to produce 1Y requires
K
only 2K, commodity Y would still be the K intensive commodity because L is higher for Y,

K 3 1
but L = 12 = 4 for X.

Figure 3.1 shows a plot of capital (K) along the vertical axis and labor (L) along the horizontal
axis. If production took place along a straight line, ray from the origin, the slope of the line
K
would measure the capital-labor ratio L in the production of the commodity.

Figure 3.1 Factor intensities for commodities X and Y in nations 1 and 2.

K Nation 1

K
6 L in Y=1

4 2Y

K 1
2 1Y L in X= 4

31
 1 1X

0 2 4 6 8 10 12 L

K Nation 2

K
8 L in Y= 4

6 2Y

K
4 1Y 2X L in X=1

2 1X

0 1 2 4 6 L

K K 1
In nation 1, the capital-labor ratio ( L ) = 1 for commodity Y and L = 4 for commodity X.

These are given by the slope of the ray from the origin for each commodity in nation 1. Thus
K K
=4
commodity Y is the K- intensive commodity in Nation 1. In nation 2, L for Y, L for Y
K
=1
and L for X. Thus commodity Y is the K-intensive commodity and commodity X is the L-
K
intensive commodity in both nations. Nation 2 uses a higher L than nation 1 in the production

of both commodities because the relative price of capital/labor (r/w), is lower in nation 2. If r/w
declined, producers would substitute K for L in the production of both commodities to minimize
their costs of production. As a result, K/L would rise for both commodities.

Factor Abundance

There are two ways to define factor abundance.

32
(i) Physical units (i.e. in terms of the overall amount of capital and labor available to each
nation).

(ii) Relative factor prices (i.e., in terms of the rental price of capital and the price of labor time in
each nation).

According to the physical units’ definition, Nation 2 is capital abundant if the ratio of the total
TK
amount of capital to the total amount of labor ( TL ) available in Nation 2 is greater than that
TK TK
in Nation 1 (i.e. if TL for nation 2 exceeds TL for nation 1).

According to the definition in terms of factor prices; Nation 2 is capital abundant if the ratio of
PK
the rental price of capital to the price of labour time ( PL ) is lower in Nation 2 than in Nation

PK PK
1(i.e., if PL in Nation 2 is smaller than PL in Nation 1). Since the rental price of capital is

usually taken to be the interest rate (r) while the price of labour time is the wage rate (w), P K / P L

=r/ w .

Factor Abundance and the shape of the production Frontier

Since Nation 2 is the K-abundant nation and commodity Y is the K-intensive commodity, Nation
2 can produce relatively more commodity Y than Nation 1. On the other hand, since Nation 1 is
the L-abundant Nation and commodity X is the L-intensive commodity, Nation 1 can produce
relatively more of commodity X than Nation 2. This gives a production frontier for Nation 1 that
is relatively flatter and wider than the production frontier for Nation 2. These frontiers are shown
in figure 4.2.

33
Figure 3.2 The Shape of the Production Frontiers of Nation 1 and Nation 2

Y 140Y

120 Nation 2

100

80 Nation 1

60

40

20

0 20 40 60 80 100 120 140 X

The Heckscher –Ohlin Theorem

The Heckscher – Ohlin theorem scales 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 relatively scarce and
expensive factor. In short, labour- rich nation exports the relatively labour-intensive commodity
and imports the relatively capital-intensive commodities.

The Factor-Price Equalization Theorem

34
The factor-price equalization theorem, also known as the H.O.S theorem, can be stated as
follows:

International trade will bring about equalization in the relative and absolute returns to
homogeneous factors across nations. As such, international trade is a substitute for the
international mobility of factors.

The above statement means that international trade will cause the wages of homogeneous labour
(i.e. labour with the same level of training, skills and productivity) to be the same in all trading
nations (if all of the assumptions referred to earlier hold). Similarly, international trade will cause
the return to homogeneous capital (i.e. capital of the same productivity and risk) to be the same
in all trading nations.

The Stelpher-Samuelson Theorem

The above theorem states that an increase in the relative price of a commodity raises in terms of
both commodities and the real reward of the factor used intensively in the production of the
commodity reduces, in terms of both commodities.

An example is that if the cloth and steel are the two commodities under consideration, then an
increase in the price of cloth (a labour-intensive commodity) raises the real wage rate in terms of
cloth and steel and lowers the real rental rate for capital services in terms of cloth and steel.

The Rybczynski Theorem

The theorem states that when the coefficients of production are given and factor supplies are
fully employed, an expansion in the endowment of one factor of production raises the output of
the commodity that uses the expanded factor intensively and reduces the output of the other
commodity.

Example: Given the labour and capital requirement for cloth and steel, an expansion in the
supply of labour will raise the output of cloth (a labour intensive commodity) and lower the
output of steel (a capital-intensive commodity).

Empirical Tests of the Heckscher-Ohlin model

35
Economists commonly agree that a model must be successfully tested empirically before it is
accepted as a theory. If a model is contradicted by empirical evidence, it must be rejected and an
alternative one drawn up. This procedure was applied to the Heckscher- Ohlin model during the
early 1950s.

Most economists point out that the original empirical test of the Heckscher- Ohlin model was
conducted by Prof. Wassily Leontief in 1951. For the test Leontief used United States data for
the year 1947. Since the United States was the most capital abundant nation in the world,
Leontief expected to find that it exported K-intensive commodities and imported L-intensive
commodities.

For the test Leontief utilized the input-output table of the US economy to calculate the amount of
labour and capital in a “representative bundle” of & 1 million worth of U.S. exports and import
substitutes of the year 1947. Note that the input-output table is a table showing the origin and
destination of each product in the economy.

It is to be noted that Leontief estimated K / L U.S import substitutes rather than for imports.
Import substitutes are commodities such as automobile (motor vehicles) that the United States
produces at home but also imports from abroad because of incomplete specialization in
production.

Empirical Results- The Leontief Paradox

The result of Leontief’s empirical tests of the Heckscher- Ohlin model were startling. Leontief
found that U.S. import substitutes were about 30 percent more capital- intensive than U.S.
exports.

In other words, the United States seemed to export labour-intensive commodities and import
capital-intensive. This was the opposite of what the H.O model predicted and as such it became
known as the Leontief Paradox.

Since Leontief’s results seemed to conflict with the model, many attempts were made to
reconcile them with the model and in the process numerous other empirical tests were
undertaken. Research in this area continues.

36
Economic Growth and International Trade

Definition of Economic Growth In this topic, we show how a change in factor endowments
and/or an improvement in technology affect the nation’s production frontier. We also examine
some aspects of the “new theories of endogenous growth.”

According to economists, economic growth simply means that the average citizen has more and
more goods and services. In that case, therefore the economic growth occurs when an economy
is able to produce more and more goods and services for each consumer.

By deciding how large a quantity of resources to devote to future needs rather than to current
consumption, society in effect chooses (within limits) how fast it will grow.

Below is an illustration of economic growth by two nations (the United States and Japan) at
different growth levels in the production of capital and consumption goods in their respective
economies.

Figure 3.3 Growth in two Economies

Consumption

goods Next year’s production

N .N

This year’s production

F G

Capital goods X

(a) United States

37
 Y

Consumption of G Next year’s production possibilities

goods F

This year’s production

Capital goods F X

(b) Japan

The above figure shows that in (a) after growth has occurred, it is possible to produce the
combination products represented by point A. Before growth had occurred, point N was beyond
the economy’s means because it was outside the production possibility frontier FF.

It is to be noted that if the shifts in the production possibility frontiers of both economies occur in
the same period of time, then the Japanese economy would be growing faster than that of the
United States because the outward shift in (b) is much greater than the one in (a)

Economic Growth and International Trade

In this topic, we show how a change in factor endowments in and/or technology affect the
nation’s production frontier.

38
Growth of Factors of Production

Analysts point out that through time, a nation’s population usually grows and with the size of its
labour force. By utilizing part of its resources to produce capital equipment, the nation increases
its stock of capital. In this case capital refers to all man-made means of production such as
machinery, factories, office buildings, transportation and communication and also the education
and training of the labour force. All of these things greatly enhance the nation’s ability to
produce goods and services.

What economists mean, in other words, is that growth in any nation depends on the following
factors:

1) Capital accumulation
2) Population and labour force growth
3) Technological progress

Labour Growth and Capital Accumulation over Time

Economists generally agree that an increase in the endowments of labour and capital overtime
causes the nation’s production frontier to shift outwards. The type and degree of the shift
depends on the rate at which L and K grow. If L and K grow at the same rate, the nation’s
production frontier will shift out evenly in all directions at the rate of the factor growth. This is
the case of balanced growth

If only the endowment of L grows, the output of both commodities grows because L is used in
the production of both commodities and L can be substituted for K to some extent in the
production of both commodities. However, the output of commodity X (the L-intensive
commodity) grows faster than the output of commodity Y (the K-intensive commodity). The
opposite is true if only the endowment of K grows. If L and K grow at different rates, the
outward shift in the nation’s production frontier can similarly be determined.

Figure below shows various types of hypothetical factor growth in Nation 1

Figure; Growth of Labour and Capital Over Time

39
Y

140

70

60 A B1

0 50 130 140 260 280 X

130

80

70 A

140 150 275 X

40
In the above figure, the first panel shows the case of balanced growth with K and L doubling
under constant returns to scale. The two production frontiers have identical shapes and the same

slope, or
P x / PY , along any ray from the origin. The second panel shows the case when only L or
only K doubles. When only L doubles, the output of commodity X (the L-intensive commodity)
grows proportionately more than the output of commodity Y, but less than doubles. Similarly,
when only K doubles, the output of Y grows proportionately more than that of X but less than
doubles (see the dotted production frontier)

Technical progress

According to economists several empirical studies have shown that most of the increases in per
capital income in industrial nations is due to technical progress and much less to capital
accumulation. It is emphasized, however, that the analysis of technical progress is much more
complex than that of factor growth because there are several definitions and types of technical
progress. These can also take place at different rates in the production of either or both
commodities.

It is to be noted that the aspects of technical progress considered in this section were advanced
by Prof. John Hicks, the British economist who shared the 1972 Nobel Prize in the economics.

Definition

Technical progress is generally used by economists to refer to ‘the increased application of new
scientific knowledge in form of inventions and innovations with regard to capital, both physical
and human.

Classification of Technical Progress

Technical progress is usually classified into neutral, labour-saving or capital-saving components.

For economists, all technical progress regardless of this type, reduces the amount of both labour
and capital required to produce any level of output.

41
Neutral Technical Progress

This type of technical progress increases the productivity of L and K in the same proportion so
that K/L remains the same after the neutral technical progress takes place as it was before, at
unchanged relative factor prices (w/r)

Labour-saving technical progress

This component of technical progress increases the productivity of K proportionately more than
the productivity of L. As a result, K is substituted for L in production and K/L rises at uncharged
w/r.

Capital-saving technical progress

This category of technical progress increases the productivity of L proportionately more than the
productivity of K. As a result, L is substituted for K in production and L/K rises at unchanged
w/r.

Technical Progress and the Nation’s Production Frontier

Economists point out that as in the case of factor growth, all types of technical progress cause the
nation’s production frontier to shift outwards. The type and degree of the shift depend on the
type and rate of technical progress in either or both commodities.

In the case of only neutral technical progress, with the same rate of technical progress in the
production of both commodities, the nation’s production frontier will shift out evenly in all
directions at the same rate at which technical progress takes place. This has the same effect on
the nation’s production frontier as balanced factor growth. Thus the slope of the nation’s old and
new production frontiers will be the same at any point from the origin.

Figure below shows Nation’s 1 production frontier before technical progress and after the
productivity of L and K doubles in the production of X only or in the production of commodity
Y only (the dotted production frontier

42
Figure 3.5 Neutral Technical progress

140

70 A’

60 A B1

20

0 50 100 140 260 280 X

The above figure shows Nation 1’s production frontier before and after the productivity of L and
K doubled in the production of commodity X only, or in the production of commodity Y only
(the dotted line). Note that if Nation 1 uses all of its resources in the commodity in which the
productivity of L and K doubled, the output of the commodity doubles. On the other hand, if

43
Nation 1 uses all of its resources in the production of the commodity in which no technical
progress occur the output of that commodity remains unchanged.

TOPIC 4; PROTECTIONISM AND INTERNATIONAL TRADE

The Basis for protection

In previous topic, we have observed that in general, free trade maximizes world welfare and
benefits all nations. It is clear, however, that although free trade is the preferred alternative,
practically all nations impose some restrictions on the free flow of international trade, because
these restrictions and regulations deal with the nation’s trade on commerce, they are generally
known as trade or commercial policies.

Some economists argue that while trade restrictions are invariably rationalized in terms of
national welfare, they are in reality, usually advocated by special groups in the nation that stand
to benefit from such restrictions.

In this topic, we examine two major forms of protection or trade restrictions:

1. Tariffs trade barriers

2. Non-tariffs trade barriers

Details of the two forms of protection follow.

Trade Restrictions Tariffs

Economists generally agree that the most important type of trade restriction has histrorically
been the tariff. A tariff is defined as a tax or duty levied on the traded commodity as it n crosses
a national boundary.

Basic Concepts or Types of Tariff

The following are the various types of tariff reviewed in this section:

44
 1. An import tariff is a duty on the imported commodity
2. An export tariff is a duty on the exported commodity

Note that import tariffs are more important than export tariffs.

3. Ad valorem tariff. This type of tariff is expressed as a fixed percentage of the value of
the traded commodity.

4. The specific tariff is expressed as a fixed sum per physical unit of the traded
commodity.

5. A compound tariff is a combination of an ad valorem and a specific tariff.

Example: A10% and valorem tariff on imported bicycles would result in the payment to customs
officials of the sum of $10 on each $100 worth of imported bicycles and the sum of $20 on each
$200 of imported bicycles means that customs officials collect the fixed sum of $10 on each
imported bicycle regardless of its price. Finally, a compound duty of 10% ad valorem and a
specific duty of $10 on imported bicycles would result in the collection of $20 by customs
officials on each $100 batch of bicycles and $20 on each $200 batch of imported bicycles.

Economists state that the U.S uses the ad valorem and the specific tariff with about equal
frequency. European countries rely mainly on the ad valorem tariff.

6. The optimum tariff

This is the rate of tariff that maximizes the net benefit resulting from an improvement in the
nation’s terms of trade against the negative effect resulting from a reduction in the volume of
trade. This means that as the nation starts from the free trade position, it increases its tariff rate
and its welfare increases up to a maximum (the optimum tariff) and then declines as the tariff
rate is raised past the optimum. Eventually the nation is pushed back towards the autarky point
with a prohibitive tariff.

As the terms of trade of the tariff imposing nation improve, those of the trade partner deteriorate.
This is because they are the inverse or reciprocal of the terms of trade, the trade partner’s welfare
definitely declines. As a result, the trade partner is likely to retaliate and impose an optimum
tariff of his own. While recapturing most of its losses with the improvement in the terms of trade,

45
retaliation by the trade partner will certain reduce the volume of trade even further. The first
nation may then itself retaliate. If the process continues, all nations end up losing all or most of
the gains from trade.

It is to be noted that even if the trade partner does not retaliate when one nation imposes the
optimum tariff, the gains of the tariff-imposing nation are less than the losses of the trade partner.
In the final analysis, the world as a whole is worse off than under free trade. It is for this reason
that free trade maximizes world welfare.

NON-TARIFF TRADE BARRIERS AND THE NEW PROTECTIONISM

Introduction

Economists explain that though tariffs have historically been the most important form of trade
restriction, there are many other types of trade barriers. Examples include import quotas,
voluntary export and restraints and antidumping actions. These are briefly described as follows:

Import Quotas

For economists, a quota is the most important non-tariff trade barrier. It is a direct quantitative
restriction on the amount of a commodity allowed to be imported.

Voluntary Export Restraints

This is one of the most important of the non-tariff trade barriers or NTBS is voluntary export
restraints (VERs). These refer to the case where an importing country induces another nation to
reduce its exports of a commodity “voluntarily” under the threat of higher all-round trade
restrictions when these exports threaten an entire domestic industry.

International Cartels

An international cartel is an organization of suppliers of a commodity located in different nations

(or a group of governments) that agrees to restrict output and exports of the commodity with the

46
aim of maximizing or increasing the total profits of the organization. The most notorious of the
present-day international cartels is OPEC (Organization of Petroleum Exporting Countries)

Dumping

Dumping is the export of a commodity at below cost or at least the sale of a commodity at a
lower price abroad than domestically. Dumping is classified into persistent, predation and
sporadic.

Persistent dumping or international price discrimination is the continuous tendency of a

domestic monopolist to maximize total profits by selling the commodity at a higher price in the
domestic market (which is insulated by transportation costs and trade barriers) than
internationally (where it must meet the competition of foreign producers).

Predatory dumping is the temporary sale of a commodity at below cost or at a lower price
abroad in order to drive foreign producers out of business, after which prices are raised to take
advantage of the newly acquired monopoly power.

Sporadic dumping is the occasional sale of a commodity at below cost or at a lower price
abroad than domestically in order to unload an unforeseen and temporary surplus of the
commodity without having to reduce domestic prices.

Export subsidies

Export subsidies are direct payments or the granting of tax relief and subsidized loans to the
nation’s exporters or potential exporters and/or low interest loans to foreign buyers so as to
stimulate the nation’s exports. As such, export subsidies can be regarded as a form of dumping.

Arguments for Protectionism

The following arguments are cited as justifying protectionism in most nations:

1) Trade restrictions are needed to protect domestic labour against cheap foreign labour

47
 2) Protection is needed to reduce domestic unemployment
3) Protectionism is needed to cure or reduce a deficit in the nation’s balance of payments.
4) Protectionism is required to enable infant industries to grow and meet foreign
competition, achieve economies of scale and reflect the nation’s long-run comparative
advantage.
5) The scientific tariff. This is the tariff rate that would make the price of imports equal to
domestic prices and also allow domestic producers to meet foreign competition. It argued
that this would eliminate international price differences and trade in all commodities
subject to such scientific tariff.

INTERNATIONAL GAINS FROM TRADE

International Trade and New Theories of Endogenous Growth

Economic research indicates that recent developments in the theory of endogenous growth,
starting with Romer in 1986 and Lucas in 1989, provide a more convincing and rigorous
theoretical basis for the relationship between international trade and long-run economic growth
and development. Specifically, the new theory of endogenous economic growth postulates that
lowering trade barriers will rate speed up the rate of economic growth and development in the
long run by:

1. Allowing developing nations to absorb the technology developed in advanced nations at

a faster rate than with a lower degree of openness.
2. Increasing the benefits that flow from research and development (R&D).
3. Reducing price distortions and leading to a more efficient use of domestic resources
across sectors.
4. Encouraging greater specialization and more efficiency in the production of intermediate
inputs.

Economists define endogenous growth as persistent GNP growth that is determined by the
system governing the production process.

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It is to be noted that many of the ways cited above by which free trade can stimulate growth and
development had been recognized earlier. The new theory of endogenous growth, however,
probes deeper and seeks to paint out more rigorously and in greater detail, the actual channels or
the ways by which lower trade barriers can stimulate growth in the long-run.

In spite of the progress made by the new theories so far, it has been difficult to test the links to
growth explicitly in the real world because of lack of more detailed data. According to some
economists, most empirical tests to date have been based on broad cross section data for groups
of countries. As such they are not very different from the empirical studies conducted earlier. In
other words, the new empirical studies have generally shown that openness leads to faster
growth, but they have not been able to actually test in detail, the specific channels by which trade
is supposed to lead to growth in the long run. In this case, more specific industry studies
examining the relationship between innovation, trade and growth are needed.

Alleged Reasons for Deterioration in the Commodity Terms of Trade

According to Salvatore, economists such as Prebisch, Singer and Myrdal have argued in the past
that the commodity terms of trade of developing nations tend to deteriorate over time.

The reason is that most or all of the productivity increases that take place in developed nations
are passed onto the workers in the form of higher wages and income. On the other hand, most or
all of the productivity increases that take place in developing countries are reflected in lower
prices. As such, the developed nations have the best of both world. This is because of the
following reasons;

1) They retain the benefits of their own productivity increases in the form of higher wages
and income for their workers.
2) They also reap most of the benefits from the productivity increases taking place in
developing nations through the lower prices that they are able to pay for the agricultural
exports of developing nations.

It is claimed that the very different response to productivity increases in developed and
developing nations is due to the widely differing conditions in their internal labour markets in
developed nations are extracted by labour in the form of higher wages, leaving costs of

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production and prices more or less unchanged. In fact, labour in these nations is often able to
extract wage increases that are even higher than their productivity increases. This raises costs of
production and the prices of manufactured goods that developed nations export. Because of
surplus labour, large unemployment and weak non-existent labour unions in most developing
nations, on the other hand, all or most of the increases in productivity taking place in these
nations are reflected in lower prices for their agricultural exports.

Another reason cited by economists for expecting the terms of trade of developing nations to to
deteriorate is that their demand for the manufactured exports of developed nations tends to grow
much faster than the latter’s demand for the agricultural exports of developing nations. The
reason for this is that the income elasticity of demand for manufactured goods is much higher
than for agricultural commodities.

Export Instability and Economic Development

Economists point out that independently of deteriorating long-run or secular terms of trade,
developing nations may also face large short-run fluctuations in their export prices and earnings
that could seriously hamper their development.

Causes and Effects of Export Instability

Economists are in agreement that developing nations often experience wild fluctuations in the
prices of their primary exports. This is due to both inelastic and unstable demand and supply.
According to Figure 5.1 D and S represent, respectively, the steeply inclined (inelastic)
hypothetical demand and supply curves of developing nations’ primary exports. With D and S,
the equilibrium price is P. If, for any reason D decreases (shifts to the left) to S’, the equilibrium
price falls sharply to P’. If both D and S shift at the same time to D’ and S’, the equilibrium price
falls even more to P’’. If then D’ and S’ shift back to D and S, the equilibrium price rises very
sharply and returns to P.

Thus, inelastic (steeply inclined) and unstable (shifting) demand and supply curves for the
primary exports of developing countries can lead to wild fluctuations in the prices that these
nations receive for their exports.

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 Price S S’

P’

P’’ D

D’

Quantity

Current Problems and Demand of Developing Countries

Problems

According to Salvatore, the most serious problems facing developing countries today are as
follows;

1) The conditions of Stark poverty prevailing in many countries, particularly those of

Sub – Saharan Africa .

2) The huge international debt of most developing countries, especially those of Latin
America.
3) The trade protectionism of developed countries’ exports.

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As regards all these problems developing countries have tried to overcome them by demanding a
new international economic order based on the establishment of international commodity
agreements, increased access of their exports to developed counties’ markets and the increased
flow of foreign aid.

4.) Demands for a New International Economic Order

Salvatore states that in June 1974, the General Assembly of the United Nations called for the
creation of a New International Economic Order (NIEO). It did so because of the great poverty
in most developing nations and because of the widely held belief that the world economy worked
in a way that was unfair to developing countries. Most of the demands incorporated in the NIEO
had been made previously at United Nations Conferences on Trade and Development
(UNCTAD) in Geneva in 1964, New Delhi in 1968 and Santiago in 1972. They were repeated in
Nairobi in 1976, Manila in 1979 Belgrade in 1983, Geneva in 1987 and Cartagena in 1992.

Developing countries’ demand for the NIEO include :

1) Establishment of international agreements for many commodities. These are aimed at

stabilizing and increasing the export earnings of developing nations. They are to be
financed primarily by developed nations.
2) Preferential access in developed nations markets to all the manufactured exports of
developing nations.
3) Removing trade barriers on agricultural products in developed nations.
4) Increasing the transfer of technology to developing nations and regulating multinational
corporations.
5) Increasing the yearly flow of foreign aid to developing nations/creates dependency
6) Allowing developing nations a greater role in international decision making.

The Infant Industry and other Arguments for Protection

Some economists point out that one argument for protection that stands to close economic
scruting is the infant industry argument. This argument holds that a nation may have a potential
comparative advantage in a commodity but because of lack of know-how and the initial small
level of output, the industry will not be set-up. If already started, that industry cannot complete

52
successfully with more established foreign firms. Under these circumstances, temporary trade
protection is then justified to establish and protect the domestic industry can meet foreign
competition, achieve economies of scale and reflect the nation’s long run comparative advantage.

Economists generally agree that the infant industry argument for protection is correct but
requires several important qualifications. These include:

1. The argument is more justified for developing nations than for industrial nations.
2. It may be difficult to identify which industry or potential or potential industry qualifies
qualifies for this treatment.
3. Most importantly, it is argued that which trade protection can do, an equivalent
production subsidy to the infant-industry can do better.

THE IMPORTANCE OF TRADE TO DEVELOPMENTS

Trade Theory and Economic Developments

Economists state that according to traditional trade theory, if each nation specializes in the
production of the community of its comparative advantage, world output will be grater. Through
trade, it is argued that each nation will share in the gain. It is also explained that with the present
distribution of factor endowments and technology between developed and developing nations,
the theory of comparative advantage that prescribes that developing nations should continue to
specialize in the production and export of raw materials, fuels, minerals and food to developed
nations in exchange for manufactured products.

Its much as the above approach may maximize welfare in the short run, developing nations
believe that this pattern of specialization and trade relegates them to a subordinate position
namely developed nations. It also keeps them from responding the dynamic benefits of industry
and maximizing their welfare in the long run. The dynamic benefits include a more trained
labour force, more innovations, higher and more stable prices for the nation’s exports and higher
income for its people. If developing nations specialize in primary commodities and developed
nations specialize in manufactured products, all of or most of these dynamic benefits of industry
and trade accrue to developed nations, leaving developing nations poor, undeveloped and
dependent.

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In view of the above evidence, developing static and irrelevant to the development process

Trade as an Engine of Growth

Economists observe that during the nineteenth century, most of the world’s modern industrial
production was concentrated in Great Britain. It is also furthermore to be noted that large
increases in industrial production and population in resource-poor Britain led to a rapidly rising
demand for the feed and raw material exports of the regions of recent settlement (the United
States, Canada, Australia, New-Zealand, Argentina, Urugway and South Africa). It is indicated,
for example, that from1815 to 1913, Britain’s population tripled, its real GNP increased 10 times
and the volume of its imports increased 20 times.

According to these developments, growth spread to the rest of the economy of these newly
settled lands through the accelerator multiplier process. It is noted further that according to
nursue, this expert sector has the leading sector growth and development. In other words,
international trade functioned as an engine of growth for these nations during the nineteenth
century. The main reason for the rapid growth and development of the newly settled areas during
the nineteenth century, namely the demand for food and raw materials is growing much less
rapidly today, several reasons around account for this, slow growth:

1) The income elasticity of demand in developed nations for many of the food and
agricultural raw, materials experts of developing nations for less than 1. This means that
as income rises in developed nations, their demand for the agricultural exports of
developing nations increases proportionately less than the increase in income.
2) The development of synthetic substitutes has reduced the demand for natural raw
materials.
3) Technological advances have reduced the materials content of many products.
4) The output of services (with lower raw material requirements than commodities) has
grown faster than the output of commodities in developed nations.
5) Developed nations have imposed trade

The Contributions of Trade to Development

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Economists explain that the following are the important beneficial effects that international trade
can have on economics development:

1. Trade can lead to the full utilization of otherwise underemployed domestic resources. In
that case trade represents a vent for surplus or an outlet for the nation’s potential surplus
of agricultural commodities and raw materials.
2. By expanding the size of the market, trade makes possible the division of labour and
economies of scale.
3. International trade is the vehicle for the trade mission of new technology and new
management and other skills.
4. Trade stimulates and facilitates the international flow of capital from developed to
developing nations.
5. In several large developing nations such as Brazil and India, the importation of new
manufactured products has stimulated domestic demand until efficient domestic
production of these goods became feasible.
6. International trade is an excellent antimonopoly weapon, when allowed to operate,
because it stimulates greater efficiency by domestic producers to meet foreign
competition.

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