Tutor: Issar Arman Unit: Theories of Commerce

LESSON: FIVE
TOPIC: BASIC COMPONENTS OF INTERNATIONAL TRADE

Introduction
International trade is the exchange of goods and services between one country and another. The
exchange of goods and services across international boundaries has enabled the principle of
division of labor to be extended to the international sphere. International Trade is the backbone of
our modern commercial world as producers in various nations try to profit from an expanded
market rather than be limited to selling within their own borders. There are many reasons that trade
across the national borders occurs, including lower production costs in one region versus another,
specialized industries, lack or surplus of national resources, consumer tastes, production of
different kinds of goods requires different kinds of resources used in different proportions, various
types of economic resources are unevenly distributed through the world and international mobility
of resource is extremely limited.

Basic Advantages of International Trade

International trade leads to an increase in the standard of living of all people in the countries
themselves. It enables consumers in all countries to have a larger quantity of goods and
services than they would have had if they tried to be self-sufficient and specialization itself
increase output.

Some countries are able to sell their resources for foreign exchange which is used to import
machinery and other factor inputs necessary for industrialization. Exports, therefore,
generate valuable foreign exchange for economic development.

International trade also encourages efficiency since all producers involved in international
trade will try to be more efficient in order to be competitive both in domestic and foreign
markets.

International trade will also promote peace and security. This is because countries are
mutually interdependent and so they will try to avoid the outbreak of war.

International trade broadens the consumer’s choice, providing them with access to a wider
range of commodities from a broad. This greater variety increases the utility of consumers.

International trade will also enlarge the commodity market for a country’s commodities
which will result in each country achieving economies of scale due to the advantage of a
large market. Economies of scale will contribute to fuller utilization of capacity and new
Tutor: Issar Arman Unit: Theories of Commerce

industries may be set up which were not possible before because of a limited domestic
market.

The basic components of International Trade include; -

i. The lower costs of production of Developing Nations
There is currently a great deal of concern over jobs being taken away from the United
States, member countries of the European Union by rapid developing nations such as
China,Korea & India. Indonesia and other Asian countries produce goods and services at
much lower costs. The united states and the European Union have imposed severe
restrictions on Imports from Asian Nations to try to and stem this tide.

ii. Specialized Industries

Even though many consumers prefer to buy less expensive goods, some international trade
is fostered by a specialized industry that has developed due to national talent and/or
tradition. Swiss watches, for example, will never be price-competitive with mass produced
watches from Asia. There is a strong market among certain consumer groups for the
quality, endurance and even “snob appeal” that owning a Rollex-Patek-Phillip or
Audemars Piquet offers.

German cutlery, Scottish wool, fine French silks such as Hermes and other such products
always find their way onto the international trade scene because consumers in many parts
of the world are willing to foster the importation of these goods to satisfy their concept that
certain countries are the best at making certain goods.

TERMS OF TRADE
Terms of trade is a quantitative measure of the rate at which a country’s export exchange for its
imports. It is a measure of the purchasing power of its exports expressed in its imports expressed
in terms of its exports. This concept relates to the rate at which one nation’s goods exchange against
those of other countries. Its a measure of a country’s ability to exchange its own products for those
of other countries.

The concept of terms of trade applies not only to trade between nations but also to trade or
exchange between individuals or between two sectors of the economy within one country. For
example ,if farmers can obtain a higher unit price for their maize ,they can purchase more cloth
and we say that terms of trade between farmers and cloth makers has changed, becoming more
favorable for farmers but “deteriorating” for cloth makers whose cloth per unit ,will purchase a
smaller volume of maize than before.
Tutor: Issar Arman Unit: Theories of Commerce

The terms of trade is said to be favorable if for some given imports a country pays with smaller
exports or if for some given exports, it gets more imports. In other words, terms of Trade is
basically expressed as a relationship between a unit price of a country’s export to a unit price of
the country’s’ import.

Essential Features of Terms of Trade

An average;-It should be carefully noted that when a country is trading in more than one item a
measure of its terms of trade represents an average with prices of individual items of trade scattered
around. This is because the measure is derived with the help of price index numbers. Which are
themselves average of scattered values.

Derivative;-Being a derivative of price index numbers a measure of terms of trade is bound to

suffer from all the limitations which are inherent in the compilation of price index numbers e.g
choice of base period, the choice of weights, the method of averaging and so on.

COMMON TERMS IN INTERNATIONAL TRADE

Balance Of Payments ;-This refers to a systematic record of the economic transactions between
the residents of the country and the rest of the world over a period of time, usually an year.(Balance
of payments=(All exports – All Imports).

Balance Of Trade; -refers to the difference between the value of goods and services sold by
residents of the home country to foreigners and the value of goods and services purchased from
foreigners.(Balance of Trade=Visible Exports – Visible Imports)

Opportunity cost; -This is simply the value of using a resource;-measured in terms of the value
of the best alternative for using that resources. International trade occurs because no single country
has the resources to produce everything well. The products a country decides to produce depend
on what must be scarified to produce them; that is, whatever resources a country uses to produce
one product are no longer available for producing some other product. Those things we have to
give up in order to get more of what we want are called opportunity cost and they determine what
countries produce for trade.For example; Saudi Arabia exports crude oil. The Saudis could have
chosen to export wheat, but they lack the resources (the arable land, the water and climate) to grow
wheat efficiently.

Factor endowment consists of differences in capital, labour and land e.g ;a rich nation like USA
has a large amount of expensive capital equipment hence can specialize in goods such as chemicals
& automobiles. Other nation with an abundant labour supply like japan finds it efficient to
concentrate on making television sets, which require the assemblies of components by hand.
Tutor: Issar Arman Unit: Theories of Commerce

BARRIERS TO INTERNATIONAL TRADE

The international trade is based on free trade in which there are no trade inhibitions among nations;
but the government of a country may however decide to limit the amount of some products coming
into import of these goods. This concept is what is known as Trade restrictions. The following are
the technical and economic International trade restrictions; -

i. Tariffs
Tariffs are tax imposed on imported goods. It’s also called customs duty. Sometimes a
custom duty is levied as a percentage of the value of the product. The higher the tariff rate,
the more restrictive the tariff and vice versa. Obviously, if the tariff rate is set higher enough
it may stop all imports of that item.

ii. Import Quotas

Quota work the same way as tariffs. The major difference is that while tariffs work through
prices, quotas restrict quality of the products. Quotas protect domestic producers and
benefit importers who manage to get some of this scarce import at low foreign prices and
resell at the higher domestic prices, quotas lead to the increase of quality of products.

iii. Exchange control

Refers to a system whereby the state exercises control over some or all the transactions in
foreign countries undertaken by its nationals. Exchange controls may require foreign
currencies earned by exporters to be surrendered to the central bank which will pay for
them in domestic currency. Importers who require foreign currency may be required to
apply to the central bank which in turn allows it to exert control over the composition and
volume of exports.

iv. Bureaucratic export procedures

The imposition of complex and time consuming bureaucratic procedures for goods entering
a country may increase the difficulty and costs of exporting.

v. Voluntary Export Restraints (VERS)

Voluntary export restraints refer to the voluntary imposed limits by a government of an
exporting country on the exports of certain commodity aimed at forestalling official
protective action on the part of the importing country. They are bilaterally negotiated
between an exporting and importing nation. Japan, has for example, entered into a number
of VERs with the USA and EU countries relating to the export of its cars.
Tutor: Issar Arman Unit: Theories of Commerce

vi. Subsidies
Subsidies constitute an indirect measure that may provide protection from overseas
producers by making domestic products more attractive relative to imports. Governments
may subsidies specific domestic industries as a means of protecting them from foreign
competition. The effect of a subsidy is to reduce the price of the domestic product and
hence make it more difficult for a foreign product to compete.

Vii Product standard specifications

Health and Safety regulations can be used to limit imports, especially where they differ
Substantively from those in the exporting countries and compliance can therefore raise the
exporter’s cost. Imports can be restricted on the basis that they have not met the quality
standards.

FORMS OF INTERNATIONAL TRADE

There are a number of ways in which nations can participate in international trade.

Direct Exporting
This form of international trade involves soliciting orders from foreign countries for goods and
services that are made in a country and then shipped abroad. For example, without international
trade, the market for the Nigerian crude oil, Columbite, cocoa, rubber e.t.c would have been limited
to domestic economy. Exports of goods and services act as foreign exchange earners to the
domestic economy. Foreign exchange availability is essential requirement for the survival of any
national income.

Direct Importing;
Students should explain.

Foreign Licensing
This is another important form of trade that exists between two or more countries. It involves a
country soliciting another country to produce and sell her product to them in a fee and after due
procedural arrangement have been made which binds the elements of such countries contract. This
is generally used for goods with established brand names.

Franchising
This is a system of marketing goods and services or technology, which is based upon a close and
ongoing collaboration between legally and financially separate and independent undertakings. The
Franchisor and its individual Franchisees, whereby the Franchisor grants its individual Franchisee
the right to exchange for a direct or indirect financial use of the franchisors; trade name/trade mark
or services mark
Tutor: Issar Arman Unit: Theories of Commerce

MUTUAL DUTIES AND SERVICES OF THE FRANCHISEE AND FRANCHISER

FRANCHISEE FRANCHISER
Optimises his sales on his allocated territory or Steering the business overall development
customer group strategy

Provide the requested information as well as Developing and improving its start-up and
allow personally developed improvements to continued assistance to the franchisee in the
be integrated into the company know how for course of the agreement. It provides the
the benefit of the network. marketing operations instructions to enable the
franchisee to carry out the business.

Cooperate with new promotion programs as Developing responsible recruitment strategies

well as upgrades of the format/system. of franchisees.

Guaranteeing the end-customer the best Ensuring the promotion of the brand on the
possible service. market through appropriate advertising

Pay the fees according to the contractual Develop efficient record –keeping systems for
schedule. purposes of control, adjustment, advice &
benchmarking.

.
Tutor: Issar Arman Unit: Theories of Commerce

THEORIES OF INTERNATIONAL TRADE

Introduction
Any theory of International or foreign trade must explain reasons for trade and gains for trade or
why international trade takes place. There were lots of evolutionary theories of international trade
in the past centuries. Some of which were; era of mercantilism, feudal society & era of classical
trade theory. Owing to the dynamism and the shifting which focus from the country to the firm,
from costs of production to the market as a whole and from the perfect to the imperfect markets,
we shall focus on;-

 The theory for Absolute Advantage

 The theory of Comparative Advantage
 The rent for surplus theory
 The theory of Factor Production
 The theory of Competitive Advantage

THEORY OF ABSOLUTE ADVANTAGE

The classical economists; Adam Smith said that the basis of International Trade falls along the
division of absolute advantage, which may be defined as the good or services in which a country
is more efficient or can produce the same amount with other country using fewer resources.
In economics, principle of absolute advantage refers to the ability of a party/country to produce
more of a good or service than competitors, using the same amount of resources. Adam smith
developed the principle of absolute advantage in the context of international trade, using labor as
the only input.
Since absolute advantage is determined by a simple comparison of labor productivities, it is
possible for a party to have no absolute advantage in anything; in that case, according to the theory
of absolute advantage, no trade will occur with the other party.
This theory was proposed in 1776, by Smith Adam. He also stated that trade between two countries
will take place if each of the two countries can produce one commodity at an absolute lower cost
of production than the other country. Smith argued that it was impossible for all nations to become
rich simultaneously by following mercantilism because the export of one nation is another nation
import. Smith also stated that the wealth of nations depends upon the goods and services available
to their citizens, rather than their gold reserves. For instance; -
Tutor: Issar Arman Unit: Theories of Commerce

Illustration One
Party Widgets per hour Number of Employees
A 5 3
B 10 5

Party A can produce 5 widgets per hour with 3 employees. Party B can produce 10 widgets per
hour with 3 employees. Assuming that the employees of both parties are paid equally, Party B has
an absolute advantage over party A in producing widgets per hour. This is because party B can
produce twice as many widgets as party A can with the same number of employees.

Illustration Two
Country Parts Per Hour Number of Workers
Country A 1000 200
Country B 2500 200
Country C 10,000 200

Country A can produce 1000 parts per hour with 200 workers. Country B can produce 2,500 parts
per hour with 200 workers. Country C can produce 10,000 parts per hour with 200 workers.
Considering that labor and material cost are all equivalent, country C has the absolute advantage
over both country B and Country A because it can produce the most parts per hour at the same cost
as other nations. Country B has an absolute advantage over country A because it can produce more
parts per hour with the same number of employees. Country A has no absolute advantage because
it can’t produce more goods than either country B or Country C given the same input.

Illustration Three
Let’s assume a little mini economy with two producers (Christine and Foustine) and two goods
(Chips and Salad). Their production possibilities are; -
Making Only Chips Making only Salad
Chips Salad Chips Salad
Christine 10 0 0 10
Foustine 5 0 0 15

Christine has an absolute advantage in making chips (she can make 10 bags in a day. While
Foustine can only make 5). Foustine on the other hand, has an absolute advantage in making Salad
(She can do 15 jars in day, while Christine can only make 10 jars). By allowing them to trade, they
can each specialize in making what they’re best at making. If they weren’t allowed to trade, each
person might spend half of their time on each good. Christine would have 5 bags of chips and 5
jars of Salad, Foustine would have 2.5 bags of chips and 7.5 jars of Salad.so the total output of the
economy would be 7.5 bags of chips and 12.5 jars of Salad. If they trade and both specialized in
Tutor: Issar Arman Unit: Theories of Commerce

production, the total output of the economy would be 10bags of chips and 15jars of Salsa, which
is higher than the total output before we considered the option of trade.

Illustration Four
Nigeria can produce one unit of cocoa with 10 labor hours and one unit of textile material say lacer
with 20 labor hours while Australia can produce one unit of cocoa with 20 labor hours and one
unit of lace textile material with 10 labor hours.
Note that from the above given example, it would be to their mutual advantage. If Nigeria produces
only cocoa and Australia produced only lace textile material with the former exporting her surplus
Cocoa to Australia while Australia exporting her surplus production of lace textile material to
Nigeria. This shows that there is absolute difference in terms of cost since each country can
produce one commodity (Nigeria Cocoa and Austria lace textile material) at an absolute lower cost
than the other country.

THE THEORY OF COMPARATIVE ADVANTAGE

The theory of comparative advantage refers to the ability of a party/country to produce a particular
good or service at a lower marginal cost and opportunity cost than another country. Comparative
advantage explains how trade can create value for both parties even when one can produce all
goods with fewer resources than the other. The net benefits of such an outcome are called gains
from Trade.

The theory of comparative advantage is one of the most praised theories in economics since David
Ricardos’ formulation of it and has become ‘something of an article of faith’ in modern economics.
David Ricardo might not be the first who developed the theory of Comparative advantage. Many
attributes have also been given to Robert Torrens.
Comparative advantage of a country is relatively more efficient in the production of a good than
another country or individual. Comparative advantage measures efficiency in terms of relative
magnitudes. Since countries have limited resources and level of technology they tend to produce
goods or services in which they have a comparative advantage. Comparative advantage implies an
opportunity cost associated with the production of one good compared to another. That is why
countries tend to specialize in production of certain products. This notion is called International
division of labour.

Trade occurs because of differences in prices, but why does price differ? It could be because of
differences in supply and demand. Supply differs between countries due to technological
differences and resources availabilities. The technological difference is explained by the Ricardo’s
theory of Comparative advantage. The resource and endowments differences are explained by
Heckscher-Ohlin model.
Tutor: Issar Arman Unit: Theories of Commerce

Illustration 1
Taking two countries ,A & B each producing 2 commodities X and Y .Country A is said to have
a comparative advantage in the production of X.If it can produce commodity X at a relatively
lower opportunity cost than country B. This implies that its absolute margin is grater or its absolute
disadvantage is less in commodity X than in Y.

If it is assumed that country A is more efficient

Assumptions of Ricardian Model

 Two countries, denoted as home and foreign
 Two final Products, good M and good F
 Each good use only one input(Labor) in production. Labour is homogeneous in quality.
 Labour is in elastically supplied in each country.
 Labor is perfectly mobile within each country but internationally immobile
 Constant labor requirement per-unit of output.
 Technologies differ between the two countries, i.e per unit input requirement differs across
countries.
 No cost of transportation, no trade barriers
 Perfect Competition in factor and product markets.

THE RENT FOR SURPLUS THEORY

It was first propounded by Adam Smith. According to smith. A country carries out that surplus
part of the produce of their land and labour for which there is no demand ;-it gives a value of these
surplus by exchanging them for something else, which may satisfy a part of their wants and
increase their enjoyment. The important aspect of the rent surplus theory include;-

 International trade does not necessarily reallocate factors of production but enables the
output of the surplus resources to be used to meet foreign demand.

 The population density of a country largely determines is exports potential since the total
volume of production is based on available labour so also is internal consumption level as
well as what will be the surplus to be exported.

 The surplus productive capacity of resources enables farmers to produce export crops
without necessarily compromising the production of food crops which enter into the
domestic market.
Tutor: Issar Arman Unit: Theories of Commerce

THE THEORY OF FACTOR PROPORTIONS

It is also known as Hecksher-Onlin theory. The theory was based on a modern concept of
production. One that raised capital to the same level of importance as labor. Hecksher-Onlin theory
states that the differences in the relative prices of commodities in the two isolated regions depend
upon the commodities of the demand and the supply of the commodities in the two regions.

This theory is based on four basic assumptions which are;-

 The theory assumes two countries, two products and two factors of production hence, the
so-called 2*2*2 assumption.
 The markets for the inputs and the outputs are perfectly competitive. That is the factors of
production, labour and Capital were exchanged in markets that paid them only what they
were worth, hence perfect competition ensured between the two countries involved with
no on one having market power over the other.
 Third assumption says, increase in the production of a product can experience a
diminishing return. This means that as a country increasingly specialized in the production
of one of the two outputs ,it eventually would require more and more inputs per unit of
output.
 Lastly, assuming both countries make use of identical technologies, each production was
produced in the same way in both countries. This meant that, the only way in which a good
production can be produced more cheaply in one country than the other is when the factors
of production used (Labour & Capital) are cheaper.