International Trade

Chapter One Concepts of International Trade

 Before going to the concept of international trade it is important to
see what international economics mean.
 International economics is a branch of applied economics that deals
with the economic interaction of one nation with other nations.
 In other words, it studies how a number of distinct economies
interact with one another in the process of allocating scarce
resources to satisfy human wants.
 Concepts of International Trade cont’
 International trade is a field of economics which applies
microeconomic models to understand international economy.
 It can be defined as the exchange of capital, goods, and
services across international borders or territories.
 Without international trade, nations would be limited to goods
and services produced within their own borders.
 The Difference between Domestic and International Trade
 The main difference is that:
 Cost they incur, international trade is typically more costly than
domestic trade.
 The reason is that a boarder imposes additional costs such as tariff,
time and costs associated with country differences.
 Mobility in Factors of production, such as capital and labor are
typically more mobile within a country than across countries (factor
immobility).
 Usage of currencies (monetary units), In domestic trade there is no
currency complication or convertibility problem since they used a
 Cont’d….
 Markets access, number of market in IT is greater than in domestic
market due to high number of population, more production and etc.
 Language, cultural and other barriers, the barrier which is occur
either in culture, language, economic, political and other challenges
is less in domestic trade.
 Commonly Used Terminologies In International Trade
The two extreme conditions could potentially be created by national
government policies are:

1. At one extreme, a government could pursue a "laissez faire" policy

with respect to trade and thus impose no regulation whatsoever that
would impede (or encourage) the free voluntary exchange of goods

between nations. We define this condition as free trade.

2. At the other extreme, a government could impose such restrictive

regulations on trade as to eliminate all incentive for international
trade. We define this condition in which no international trade
occurs as national autarky. 5
 Cont’d….
(See Figure).

 Probably, a pure state of free trade or autarky has never existed in

the real world.

 All nations impose some form of trade policies.
 Probably no government has ever had such complete control over
economic activity as to eliminate cross-border trade entirely.

6
 Cont’d….
 Since every country today is somewhere in the middle of these two
extremes, discussions focus on whether policies should move the
nation in the direction of free trade or in the direction of autarky.
 Protectionism is a movement in the direction of autarky occurs
whenever a new trade policy is implemented if it further restricts
the free flow of goods and services between countries.
 Trade liberalization is a movement in the direction of free trade
occurs when regulations on trade are removed.
 Since the elimination of trade policies will generally increase the
amount of international trade, it is referred to as trade liberalization.
7
 Why nations trade?
 The immediate cause for trade among nations is difference in the prices of
goods and services among nations.
 But there are different reasons for the commodity being traded among nations.

 Countries differ in natural resource endowments.

 Differences in climatic conditions and geographical locations.

 Differences in technological advancement & technical capabilities.

 Differences in labor and capital resources.

 Development of entrepreneurial and managerial skills.

 Differences in Demand

 Existence of Government Policies

 Existence of Economies of Scale in Production. 8

 Significance (gains) of international trade (IT)

1. IT enabled the world nation to consume those goods and services

which they themselves could not produce.
2. It helps domestic firms to exploit economies of large scale
production through expanding markets.
3. Each trading nation will gain as a world output increases b/c of
specialization and division of labor.
4. Cultural exchange and ties among different countries develop when
they inter in to mutual trading.
5. It help in harmonizing international political relations

6. It prevents monopolies. It is beneficial to consumers by providing

9
 Cont’d….
 Thus the gains from international trade can be broadly classified into
two;
1. Static gains: arise from optimum use of the country’s factor
endowments or human and physical resources, so that the national
output is maximized resulting in increase in social welfare.
2. Dynamic gains: refers to those benefits, which promote economic
growth and economic development of the participating countries.
 Therefore, international trade increases national income and
facilitates saving and opens out new channels of investment.

10
 CHAPTER TWO
THEORIES OF INTERNATIONAL TRADE
2.1. Pre-Classical theory of International Trade (Mercantilism)
 The economic philosophy that prevailed during the 17th and 18th
centuries was that of the Mercantilism.
 Mercantilism: a school of economic thought developed in England.

 The main feature of the mercantilist doctrine was that a country could
grow, rich and prosperous by acquiring more and more precious metals
especially gold and,
 therefore, all the efforts of the state should be directed to such economic
activities that help a country to acquire more and more precious metals.
 Mercantilism
 According to the mercantilist school of economists, if international
trade is not properly regulated then people might exchange gold
for commodities of daily use.
 This would lead to the depletion of the stock of precious metals
within the nation.
 To accumulate large amount of gold, and precious metals a country
should export more and import less.
 Increasing export will enable a country obtain large amount of gold
and precious metals; whereas decreasing imports will save the
amount of gold and precious metals to be spent.
 Mercantilism cont’
 Therefore, in any event, mercantilists advocated strict government
control of all economic activity and preached economic
nationalism,
 Because they believed that a nation could gain in trade only at the
expense of other nations.
 The mercantilists used to advice tariffs, quotas and other
commercial policies to minimize imports and to protect a nation’s
trade positions.
 They used to view trade as a “gamble”.
 Flaws of Mercantilism
 The first attack against mercantilists’ economic policies came from

David Hume.

 According to Hume, favorable trade balance was possible only in

the short run, for over time it would automatically be eliminated.

 The other flaw of Mercantilism was that trade was regarded as a

“Zero-sum game”, but trade is actually a positive-sum game.

 Adam Smith & David Ricardo demonstrated that trade was a

positive-sum game in which all trading nations can gain even if

some benefit more than others.

 2.2. Trade Theory of the Classical School
(Theories of Absolute And Comparative Advantage)
 Adam Smith (1723–1790) provided the basic building block for the
construction of the classical theory of international trade.
 He articulated the theory in terms of what is called Absolute Advantage
model.
 Another well-known classiest, David Ricardo (1722–1823), articulated
it and expanded it further into what is called comparative advantages
model.
 The models of Smith and Ricardo together constitute what is
sometimes referred to as the supply version of the classical theory of
 2.2.1. Adam Smith’s theory of absolute
advantage
 Smith was the first economist to show that goods, rather than gold,
were the true measure of the wealth of a nation.
 He argued that the wealth of a nation would expand most rapidly if
the government would abandon mercantilist controls over foreign
trade.
 Smith also exploded the mercantilist myth that in international trade
one country gains at the cost of other countries.
 He showed how all countries would gain from international trade
through the international division of labor.
 Adam Smith’s theory of absolute advantage
cont’
 According to Smith, if one country has an absolute advantage over
another in one line of production, and the other country has an
absolute advantage over the first country in another line of
production, then both countries would gain by trading.
 According to him, with free trade nations could concentrate their
production on those goods they can produce most cheaply, and
import the remaining goods from other countries at relatively lower
price.
 He maintained that productivities of factor inputs represent the major
determinant of production costs.
 Adam Smith’s theory of absolute advantage cont’
 Smith reasoned that trade between countries shouldn’t be regulated or
restricted by government policy or intervention.
 He stated that trade should flow naturally according to market forces.
 In a hypothetical two-country world, if Country A could produce a
good cheaper or faster (or both) than Country B, then Country A had
the absolute advantage and could focus on specializing on producing
that good.
 Similarly, if Country B was better at producing another good, it could
focus on specialization as well.
 By specialization, countries would generate efficiencies, because
 Assumption of Adam Smith
 Labor is the only factor of production and is homogeneous

 The cost or price of a good depends exclusively up on the amount of

labor required to produce it.
 Labor was completely free to move within a single country only

 Both countries can produce both commodities

 No transportation costs were involved in trade

 There existed no other barriers, such as tariffs and quotas etc.

 In a two-nation, two–product world, international trade and

specialization will be beneficial when one nation has an absolute cost
advantage (that is, uses less labor to produce a unit of a product) in one
good and the other has an absolute cost advantage in the other good.
 Illustration of absolute advantage
 Imagine a hypothetical world composed of only two countries,
country A and country B.
 Both countries produce significant quantities of two commodities,
wheat and oil for domestic consumption, and there are absolutely no
trade relations, factor movements, or other economic ties between
them; i.e.(autarky).
 Assume for the moment also that the entire value of the two
commodities is the amount of labor used in their production.
 Now suppose, further, that one man-hour of labor can produce the
following quantities of wheat and oil in the two respective countries:
20
 Example cont’

Commodity Country A Country B World

Wheat
5 10 15
(Quintals)
Oil (barrels) 10 5 15

PPC of Country ‘A’

PPC of Country ‘B’

 Cont’

 In this case, a quintal of wheat in country A has twice the value of a

barrel of oil and a barrel of oil in country B has twice the value of a
quintal of wheat.
 Country A has an absolute advantage in the production of oil (10
barrel is greater than 5 barrel),
 And country B has an absolute advantage in the production of
wheat (10 quintal is greater than 5 quintal).
 Before trade both countries produce only 15 units each of the two
commodities by applying one labor-unit on each commodity.
 Example cont’
 If A were to specialize in producing in oil production and use both units of
labor on it, its total production will be 20 barrels of oil.
 Similarly, if B were to specialize in the production of wheat alone, its total
production will be 20 quintals of wheat.
 The combined gain to both countries from trade will be 5 barrel of oil and
5 quintals of wheat for country A and B, respectively.

Production Production
Gain from trade
before trade After trade
Commodity Country Country
Country Country Country Country
A A B A
B B
Wheat
5 10 - 20 -5 +10
(Quintals)
Oil (barrels) 10 5 20 - +10 -5
 Cont’
 As a result of trade, both countries become richer or have become
better off in terms of production, without making any country worse
off.
 According to smith, each nation benefits by specializing in the
production of the good that it produces at a lower cost than the other
nation, while importing the good that it produces at a higher cost.
 Because the world uses its resources more efficiently as the result of
specializing according to the principle of absolute advantage,
 there occurs an increase in the world output, which is distributed to
the two nations through trade.
 Criticism on theory of absolute advantage
 Smith has been criticized for his vagueness and lack of clarity.
 Accordingly, Smith assumes without argument that international
trade requires an exporting country to have superiority with a given
amount of capital and labor to produce a larger output than any
rival.
 But this basis of trade is not realistic because there are many
underdeveloped countries which do not possess absolute advantage
in the production of any commodity, and yet they have trade relations
with other countries.
 Thus, Smith's analysis is weak and unrealistic.
David Ricardo: Theory of Comparative Advantage
 David Ricardo (1722-1823)

 Comparative advantage is an economy's ability to produce a

particular good or service at a lower opportunity cost than its trading
partners.

 Comparative advantage is used to explain why companies, countries,

or individuals can benefit from trade.

 Ricardo argued that even if two countries did not have absolute
advantage in any line of production over the other, international trade
would be beneficial, bringing gains from trade to all the participating
countries. 26
 Assumptions of the Ricardian Theory
1. Labour is the only element of cost of production.
2. Goods are exchanged against each other
3. Labour is perfectly mobile with in the country, but perfectly
immobile b/n countries
4. Labour is homogenous
5. There is full-employment
6. There is perfect competition
7. International trade is free from all barriers
8. Production is subject to the law of constant returns
9. There are only two countries & two commodities
10. There is no transport cost.
27
 Cont’d
 According to David Ricardo, differences in the comparative cost of
production of commodities between nations can result in trade.
 The law of comparative advantage indicates that a country should
specialize in the production of those goods in which it is more
efficient and leave the production of the other commodity to the
other country.
 The two countries will then have more of both goods by engaging in
international trade.
 The following table illustrates Ricardo’s comparative advantage
principle when one nation has an absolute advantage in the
28
production of both commodities.
 Cont’d
Nation Out put per labor hour
Wine Cloth

England 120 100

Portugal 80 90

 The table shows that the production of a unit of wine in England

requires 120 men for a year while a unit of cloth requires 100 men
for the same period.
 On the other hand, the production of the same quantities of wine and
cloth in Portugal requires 80 and 90 men respectively.
 Thus, England uses more labor than Portugal in producing both
29
 Cont’d
 In other words, the Portuguese labor is more efficient than the
England labor in producing both the products.
 So Portugal possesses an absolute advantage in both wine and
cloth.
 However, Portugal would benefit more by producing wine and
exporting it to England because it possesses greater comparative
advantage in it.
 This is because the cost of production of wine (80/120 men) is less
than the cost of production of cloth (90/100 men).
 Cont’d
 On the other hand, it is in England’s interest to specialize in the
production of cloth in which it has the least comparative
disadvantage.
 This is because the cost of cloth production in England is less
(100/90 men) as compared with wine (120/80 men).
 Thus, trade is beneficial for both the countries if each nation
specializes in and exports that good in which it has a comparative
advantage-the England in cloth, the Portugal in wine.

31
 Gains from trade and their distribution
 The opportunity for gain can be seen immediately by

comparing the real exchange ratios that will prevail in each

country in the absence of interna­tional trade.
 In Portugal, in isolation 1 unit of cloth will exchange for

1.13 barrels of wine

England Portugal

Wine 120 : 100 Cloth (1 : 1.2) Wine 80 : 90 Cloth (1 : 0.89)

Cloth 100 : 120 Wine (1 : 0.83) Cloth 90 : 80 Wine (1 : 1.13)

32
 Gains from trade cont’
 Suppose now, that both countries are offered the chance to trade at
the barter exchange ratio 1 cloth for 1 wine.
 Portugal will find such trade an attractive way to acquire cloth
instead of giving up 1.13 barrels of wine to obtain 1 cloth, it need
give up only 1 barrel of wine.
 It saves 0.13 barrel of wine on each unit of cloth acquired.
 Similarly, England will benefit because for one cloth it can obtain a
barrel of wine, instead of only 0.83 of a barrel as in direct
production.
 Thus Ricardo showed that both countries gain, even though Portugal
 Gains from trade cont’

 In the figure below where the line C1W2 depicts the domestic
exchange ratio 1 unit of cloth = 0.83 unit of wine of England, and the
line WI C2 that of Portugal at the domestic exchange ratio 1 unit of
wine = 0.89 unit of cloth.
 The line C1 W1 shows the exchange rate of trade of 1 unit of cloth = 1
unit of wine between the two countries.
 At this exchange rate, England gains W2W1 (0.17 unit) of wine, while
Portugal gains C2C1 (0.11 unit) of cloth.
Domestic exchange ratio England
The exchange ratio when both
trade

Domestic exchange ratio Portugal

 Criticisms on the comparative cost advantage theory
1. The most severe criticism of the comparative advantage doctrine
is that it is based on the labor theory of value.
2. Labor is also not used in the same fixed proportion in the pro­
duction of all commodities.
3. Ricardo ignores transport costs in determining comparative
advantage in trade.
4. Another serious weakness of the doctrine is that it assumes perfect
and free world trade. But, in reality, world trade is not free.
5. The theory neglects the role of technological innovations in
international trade.
6. The theory simply explains how two countries gain from
international trade. But it fails to show how the gains, from trade
are distributed between countries.

35
 Offer Curve and Terms of Trade (ToT)
 The offer curve of a nation shows the willingness of the nation to
import and export at various re1ative commodity prices.
 It is known as the law of reciprocal demand offer curve.
 The terms of trade or offer curve of the countries are determined by
the intensity of domestic demand for foreign goods and of the
foreign demand for domestic goods.
 The equilibrium ToT is determined at the point where the offer
curves of the two countries intersect.
 Table below indicates that textile is country A’s exportable product,
and rubber is its importable product from country ‘B’.
 Textile Rubber (Importable) Terms of Trade
(Exportable) ‘A’ ‘B’ ratios
25 5 5:1
40 10 4:1
60 20 3:1
80 40 2:1
100 100 1:1
90 120 0.75:1

Country A has completely specialized in the production of textile,

because it has an absolute or comparative advantage in this line of
production.
If consumers in country A want to consume rubber, it can be fulfilled
only by importing it from country B, which has achieved complete
specialization in rubber production.
 Offer Curve and Terms of Trade (ToT)
 Initially the marginal utility of rubber for country A is so high that it
is willing to offer 5 units of textile (export) in exchange for 1 unit of
rubber (import).
 But as trade continues and country A consumes more and more of
the imported product (rubber), the marginal utility from additional
consumption of rubber goes down.
 This is explained by the decrease in the ToT ratios in column 3 of
above table from 5:1 to 1:1.
 We can plot the information in table above and draw the offer curve
of country A as shown below.
Graphically

Textile

5
100 6
90
80
3 4
60 OA
40 2
1
20

Rubber
20 40 60 80 100 120

Figure 2.6: Derivation of an offer curve

 Offer Curve and Terms of Trade (ToT)
 The continuous line which is drawn from the point of origin connecting all
the five points, 1,2,3,4, and 5 is the offer curve of country A and is
designated as OA.
 Its positive slope derives from country A's desire to trade more and more,
though at different terms of trade.
 Up to point 5 its slope continues to be positive and at this point country A is
willing to offer 100 units of textiles in exchange for 100 units of rubber
imports.
 Beyond point 5, however, the offer curve has a negative slope and this
indicates that at its capacity to export more textiles is exhausted.
 Offer Curve and Terms of Trade (ToT)
 Therefore, trade cannot be effectively takes place beyond point 5.
 Let as see terms of trade at point 6 in the diagram, country A is
willing to accept or import 120 units of rubber at a price of only
90 units of textile exports.
 But this will not be acceptable to country B; because, for country
B it is better to sell 100 units of rubber and receive100 units of
textiles at point 5 than trading at point 6.
 Offer Curve and Terms of Trade (ToT)

 Thus, we can have the following properties of offer curve of a

country.
I. The relevant portion of the offer curve is positively sloped
II. The offer curve is not a straight line, it is a non-linear
curve. This property follows from the law of diminishing
marginal utility for the purchased goods.
I. The offer curve is a composite curve (both demand and
supply).
 Change in terms of trade
 Since in a two­nation world, the exports of a nation are the imports of
its trade partner, the terms of trade of the 'latter are equal to the terms
of trade of the former.
 These terms of trade are often referred to as the commodity or net
barter terms of trade.
 As supply and demand considerations change over time as a result of
factors affecting demand and supply of tradable, offer curves will
shift, changing the volume and the terms of trade.
 For example, the domestic demand for foreign goods may change
due to changes in tastes, incomes, foreign prices of the goods etc.
 Graphical
Textile b
OB1
OB2 OA2
3 e

OA1
1

O
Rubber
Figure 2.8: Changes in terms of trade
 Cont’

 Figure above demonstrates the effects of such dynamic changes on the

equilibrium terms of trade and size of international trade.
 OA and OB are the offer curves of countries A and B respectively.

 Point 1 determines equilibrium size of international trade in the static

sense; Oe line represents static terms of trade.
 A leftward shift in country B's offer curve from OB1 to OB2 would shift

the terms of trade line from Oe to Ob.

 This would shift the trade equilibrium position from point 1 to point 2.

 Such a shift causes terms of trade to improve for country B and worsen
for country A.
 Cont’
 This may have been the as a result of several factors like:

 A drop in the taste in country B for the product of country A.

 Country B might have diverted its trade direction away from

country A to some other country in the world. This will reduce

country B's demand for country A’s product.

 Country B might have launched a program of import substitution

as a result of which it has started' producing country A's product

domestically within country B itself.

 The Modern Theory of International Trade
Heckscher-Ohlin Theory of Trade
 The H.O theory states that the main determining factor for the pattern
of production, specialization and trade among countries is the
relative availability of factor endowments and factor prices.
 Countries have different factor endowments and therefore have factor
prices. Some countries have much capital, others have much labor.

 The H-O theory can be presented in the form of two theorems:

 The H-O theorem factor endowment and,

 The factor-price-equalization theorem (which deals with the effect of

international trade on factor prices).

 Assumptions of the Theory
1) There are two nations (1&2), two commodities (X&Y), two factors
of production (labor & capital).
2) Both nations use the same technology in production.
3) Commodity X is labor intensive and 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 in both nations
6) Tastes are equal in both nations.
7) There is perfect competition in both commodities and factor markets
in both nations.
8) There is perfect factor mobility within each nation but no
international factor mobility.
9) There are no transportation costs, tariffs, or other obstructions to the
free flow of international trade.
 Factor Intensity, Factor Abundance, and the Shape
of the Production Frontier (PF)
A. Factor Intensity
 In a world of 2 commodities and 2 factors, Y is capital intensive if
its (K/L) is greater than (K/L) of X.
 If production of Y requires 2K and 2L, then K/L=1.
 If production of X requires 1K and 4L, then K/L=1/4.
 We say that Y is K intensive and X is L intensive.
 Measuring K and L intensity depends on K/L rather than the
absolute amount of K and L.
 In figure that follows, Nation 1 can produce 1Y using 2K-2L, and
2Y using 4K-4L. Thus, K/L=1, this gives the slope of Y in Nation 1.
 Factor Intensity

Factor Intensities for Commodities X and Y in Nations 1 and 2.

 Factor Intensity cont..
 Nation 1 can produce 1 unit of X using 1K-4L, and 2X using 2K-8L.
Thus, K/L=1/4, this gives the slope of the ray of X in Nation 1.
 In Nation 2, K/L=4 for Y and 1 for X.
 Therefore, Y is the K-intensive commodity, and X is the L-intensive
in Nation 2 also. This is shown by the fact that the ray from the origin
for good Y is steeper than that of X in both nations.
 Even though Y is K-intensive relative to X in both nations, Nation 2
uses a higher K/L than Nation 1.
 For Y, K/L=4 in Nation 2 but K/L=1 in Nation 1.
 For X, K/L=1 in Nation 2 but K/L=1/4 in Nation 1.
  Factor Abundance

 Two ways to define factor abundance: 1) In terms of physical units

(i.e. overall amount of K&L (TK/TL) available to each nation).
 According to this definition, Nation 2 is capital abundant if the
ratio of total amount of capital to total amount of labor available in
Nation 2 is greater than that in Nation 1.
 The ratio of TK/TL what is important , not the absolute amount of
K&L available in each nation.
 Thus, Nation 2 can have less K than Nation 1 and still be the
capital abundant nation if TK/TL in Nation 2 exceeds TK/TL in
Nation 1.
 Factor Abundance cont..

2) In terms of relative factor prices (i.e. rental price of K (PK) and the price of

L time (PL) in each nation).

 According to this definition, Nation 2 is K abundant if (PK/PL) is lower in

Nation 2 than in Nation 1.

 Since rental price of K is taken to be the interest rate (r) and the price of

labor time is wage (w), then PK/PL= r/w.

 The ratio r/w what is important , not the absolute level of r that determines
whether a nation is K abundant.
 The first definition considers only the supply of factors, while the second
definition considers both demand and supply.
 The demand of the factor is derived from demand for the final commodity
 Factor Abundance and the Shape of the Production Frontier
 Since Nation 2 is K-abundant and Y is K-intensive, Nation 2 can
produce relatively more of Y than Nation 1.
 Since Nation 1 is L-abundant and X is L-intensive, Nation 1 can
produce relatively more of X than Nation 2.
 This gives a production frontier for Nation 1 that is relatively
flatter and wider that that of Nation 2.
B, The factor-price equalization theorem

 The factor-price equalization theorem states that free international

trade equalizes factor prices b/n countries relatively and
absolutely, which serves as a substitute for international factor
mobility.
 International trade increases the demand for abundant factors
(leads to increase in their prices) & decreases the demand for
scarce factors (leads a fall in their prices).
 Thus the price for factors become equalizes.
  Illustration of the Heckscher-Ohlin Theory
 Since the two nations have equal tastes, they face the same indifference map.
 Indifference curve I is the highest IC that Nation 1 and Nation 2 can reach
in isolation, and points A and A/ represent their equilibrium points of
production and consumption in the absence of trade.
 The tangency of IC I at points A and A/ defines the no-trade equilibrium
relative commodity prices of PA in Nation 1 and PA/ in Nation 2.
 Since PA<PA/, Nation 1 has a com-adv. in X & Nation 2 has a com-adv. in Y.
 Heckscher-Ohlin Theory cont..
 The right panel shows that with trade Nation 1 specializes in X and
Nation 2 in Y.
 Specialization continues until Nation 1 reaches point B and Nation 2
B/, where the transformation curves are tangent to the common
relative price line PB.
 Nation 1 exports X in exchange for Y and consume at point E on IC
II. Nation 2 exports Y for X and consume at point E/ (which
coincides with point E).
 Note that Nation 1’s exports of X equal Nation 2’s imports of X (i.e.
BC=C / E /).
 Similarly, Nation 2’s exports of Y equal Nation 1’s imports of Y (i.e.
B / C / =C E).
 CHAPTER THREE
INTERNATIONAL TRADE POLICIES

3.1 concept of Free Trade

Free trade means unrestricted trade or exchange of goods and
services between countries
In free trade no intervention of the government in international
trade.
It is situation in which there are no artificial barriers in the form of
quotas and tariffs to the movement of goods and services between
countries.
 3.2 Advantages of Free Trade
1. Efficiency: With free trade, domestic firms face competition from
abroad and therefore there will be more incentives to cut costs and
increase efficiency.
2. Consumption: Free trade enables an increase in consumption as
countries can consume combinations of goods outside their
production possibility curve.
3. Market power: Without trade barriers, free trade decreases market
power of monopolies as they are competing at a global level.
4. Technology: Technology can cross over borders more easily with
free trade, and this often accelerates improvements in technology.
5. Specialization: Free trade leads to specialization, where a country
only produces goods that they are efficient.
6. Economies of scale: If countries can specialize in certain goods
they can benefit from economies of scale and lower average costs
3.3 Disadvantages of Free Trade
 Several disadvantages of free trade are:
 Increases unemployment
 Stagnating wages
 Poor working condition.
 Reduces revenues from tax.
 Hurts domestic industries
 Trade Protection
 Protection implies granting a protective cover to the home
industries against foreign competition either; by imposing duties
(fixing quotas) on the foreign goods or
 by helping the domestic industries by giving subsidies to enable
them to compete with cheap foreign goods.
 The objective of trade protectionism is to protect a nation’s vital
economic interests such as its key industries, commodities, and
employment of workers.
 There are various methods of trade protectionism whose goal is to
protect a nation’s economic well-being.
 Methods of trade protectionism
1. Tariffs: the taxes or duties imposed on imports are known as import
tariffs.
2. Quotas: are re restrictions on the volume of imports for a particular
good or service over a period of time. Quotas are known as “non-tariff
trade barrier.”
3. Subsidies: are government payments to domestic producers or is a
negative taxes that are given to domestic producers by the government.
4. Standardization: The government of a country may require all
foreign products to follow to certain guidelines.
For instance, the UK government may demand that all imported shoes
 Methods of trade protectionism cont..
5. Local content requirements: may be imposed by a nation seeking
to decrease imports by setting a manufacturing requirement in which a
stated part or parts of a product must be made domestically.
6. Administrative trade policies: consist of bureaucratic rules, laws,
and regulations designed to create serious difficulties for an importer of
goods or commodities into a particular nation.
8. Exchange rate controls: can be used to make a nation’s product
cheaper abroad by lowering the value of its currency in the foreign
exchange markets.
 Methods of trade protectionism cont..
 Methods(means) of Trade Restriction to free trade between
countries are natural barriers and man-made barriers.
 Natural barriers: arise on account of the cost and the distance
involved in moving goods and services from one country to
another.
 Man-made barriers is further classified into tariff and non-tariff
(hidden) barriers.
 But the reasons of trade protection(restriction) are;

I. To protect domestic producers from foreign competition.

II. To generate government revenue.
 Types of and Effects of tariff
There are four major types of tariffs

1. Specific Duty: It is a fixed sum of money imposed as a duty on a com­

modity according to its weight or measurement (physical dimensions) as
Birr. X per unit
2. Ad valorem Duty: It is imposed as a percentage of the value of the im­
ported commodity. The value is inclusive of insurance plus freight charges,
that is, cost of the commodity plus insurance and freight charges, represent
the total value of a commodity on which, the duty is charged.
3. Compound Duty: A combination of both specific and ad valorem duties
levied on a commodity.
4. Sliding Scale Duty: It is levied on the basis of the price of the imported
commodity rising and falling with an increase or decrease in the price.
 Effect of tariff
To analyze a tariff’s economic effects, we need to separate the effect
on consumer and on producers.
To separate these, we use a supply and demand model, i.e, tariff is a
tax on an imported good.
For each group, a measure of national welfare is needed and we use
the consumers and producers surplus.
Consumers’ surplus is the difference between the maximum amount
buyers are WTP for a given quantity of a good and the amount
actually paid. Graphically, consumer surplus is represented by the
area under the demand curve and above the good’s market price.
 Effects of tariff Cont..

Producers’ surplus, on the other hand, is the revenue

producers’ receive over and above the minimum necessary for
production.

Graphically, the producer surplus is represented by the area

above the supply curve and below the good’s market price.

The following figure illustrates the DD for cloth the consumer

be willing and able to pay for a given quantity of cloth, which
slopes downward to the right, indicating that as the price of
cloth falls, consumers are willing and able to buy more cloth.
 Effects of tariff Cont..
 Consumer surplus is represented graphically by the triangle area
P1EPc.
 This area represents the difference between total amount of money
consumers were willing to spend on cloth and what consumers
actually spent on purchasing cloth
 Producer surplus is represented graphically by the triangle area
P2EPc.
 This area represents the difference between total amount of money
producers were willing to accept for cloth and what producers
actually receive for selling cloth.
To measure the effects of imports and free trade on a country’s welfare,
consider the market for cloth as shown in figure below.
This figure illustrates the domestic demand for and supply of cloth in the US.
In autarky equilibrium (E) the price of cloth would be Pc and the quantity
consumed and produced domestically would be Qc.
 The effects of a tariff for a small country
This small nation would be a price taker, facing a constant world
price level for its import commodity.

In fact, this is not a rare case; many nations in the world are not
large enough to influence the terms at which they trade.
 Referring to the following figure, the small nation before trade
produces at market equim point E, as determined by the
intersection of its domestic supply and demand schedules.
 At equlbruim price $ 9,500, the quantity supplied and demanded is
50 units.
 The effects of a tariff for a small country
 Now suppose that the economy is opened to foreign trade and

that the world auto price is $ 8,000, less than the domestic price.

 Because the world market will supply an unlimited number of

autos at price $ 8,000, the world supply schedule would appear

as a horizontal line.

 Line Sd + w shows the supply of autos available to the small

nation consumers from the domestic and foreign sources

combined.

 This over all supply is the one that would prevail in free trade.
The effects of a tariff for a small country0
 The effects of a tariff for a small country cont..
 From above figure, when we compare the situation before trade
occurred, free trade results in:
 A fall in the domestic price from $ 9,500 to $ 8,000.
 Consumers are better off b/c they can import more autos at a
lower price.
 Domestic producers are worse off b/c fewer autos sold at lower price.

 Consumer surplus increased by areas a,b,c,d,e,f and G.

 Producer surplus decreases by areas a and e.
 The overall increase in welfare is b,c,d and f.
 The effects of a tariff for a small country cont..
 However, the introduction of the tariff raises the home prices of imports by the
full amount of the duty, and the increase falls entirely on the domestic
consumers.
 As a result, the overall supply curve shifts upward by the amount of tariff, from
Sd + w to Sd + w+t.
 The protective tariff results in a new equilibrium quantity at point G, where:
Domestic auto price is $ 9,000,
 Domestic production increases by 20 units, where as domestic consumption
falls by 20 units, and
 Imports decrease from their pre tariff level of 60 units to 20 units.

 This reduction can be attributed to falling domestic consumption and rising

domestic production.
 The effects of a tariff for a small country cont..
 The effects of tariff can be decomposed in to revenue effects, a
redistribution effects, protective effect and a consumption effect.
 From the above graph those effects are indicated by:
 c = revenue effect = lost consumer surplus now government rev.
 a = redistributive effect = shift from consumer to producer surplus
 b = protective effect
 d = consumption effect
 But b + d = deadweight loss = benefits lost to all parties

1. The revenue effect: the government revenue equals area ‘c’ (w/c can be
found by multiplying the quantity imported by the specific tariff.
 This represents the portion of the loss of consumer surplus, the revenue

effect does not result in an overall welfare loss.

 The effects of a tariff for a small country cont..
2. The redistributive effect: This represents part of consumer surplus
that is transferred to the domestic producers of import competing
industry which is in area ‘a’.
 It represents a transfer of income from consumers to producers and

like the revenue effects, it does not result in an overall loss of

welfare for the nation.

3. Protective effect: was lost by the economy because of inefficient

domestic production.
 Area ‘b’, which depicts the protective effect, thus represents a real

welfare loss to the economy.

 The effects of a tariff for a small country cont..
4. The Consumption effect: It arises from the increased price and lower
consumption resulting from tariff imposition and represented by area ‘d’.
 Like the protective effect, the consumption effect represents a real cost to
the society, not a transfer to other sectors of the economy.
 Together, these two effects (b+d) equal the dead weight loss of the tariff.
The effects of a tariff for a small country cont..
 Example

• From the figure above, calculate:

i. Revenue effects,
ii. A redistribution effects,
iii. Protective effect and
iv. A consumption effect
v. Deadweight loss
 Activity
1. From figure below, domestic equilibrium price $60(million) before
trade &quantity supplied is 60 autos world price of auto after trade
is 40$. Now home nation introduce 10(million dollar) import tariff.
 Calculate :

i. consumer surplus before &after tariff

ii. producer surplus before &after tariff
iii. dead weight loss
iv. government revenue
Graph
 The effects of a tariff for a large country
 The difference between the large country and small country
assumption is that in the case of a large country, changes in the
quantity imported influences the world price of the product.
 Figure below illustrates the economic effects of a tariff in a large
country.
 The domestic supply and demand of cloth is illustrated by S and D
under autarky, equilibrium would occur at point E with the price and
quantity of Pc and Qc.
 Under conditions of free trade, the US would have a total supply of
cloth composed of domestic production and imports.

 The effects of a tariff for a large country cont..
 This total supply curve is upward slopping because the foreign supply
price depends on the quantity.
 At point F, the price declines from Pc to Pf and the quantity of cloth
that consumers are willing and able to buy increases from Qc to Qd.
 In addition, domestic production under free trade declines from Qc to
Qs as the price of cloth falls cloth imports expand to fill the gap from
Qs to Qd.
 Now assume that the US imposes a tariff- T- on imported cloth.

 The addition of the tariff shifts the total supply of cloth from (S+M) to
(S+M+T), and the equilibrium changes from point F to point G, the
price of cloth increases from Pf to Pt.
 The effects of a tariff for a large country cont..
 US consumer surplus falls by
areas “a+b+c+d”.
 Remember, area ‘a’ represents
the redistribution.
 In the case of a large country,
the welfare effects of a tariff
are:
 The loss of consumer surplus,

area ‘b+d’, and

 The gain of welfare through the

terms of trade effect, area ‘e’

 The effects of a tariff for a large country cont..
 From the above graph, the revenue of the import tariff includes two
components.
 The first component is the amount of the tariff revenue that is shifted from
domestic consumers to US government.
 This amount is illustrated by area ‘c’ and is determined by the increase in
the price of cloth from Pf to Pt multiplied by the amount of cloth imported,
Qs’ to Qd’.
 The second component is the amount of the tariff revenue that is shifted
from foreign producers to the US government.
 This amount is illustrated by area ‘e’ and is determined by the decreased in
the price received by the foreign firm after the tariff is paid, Pf to P’,
multiplied by the quantity imported, Qs’ to Qd’.
 Trade and welfare effects of import quota
 Like a tariff, an import quota affects an economy’s welfare.

 The following figure represents the case of cheese, involving the U.S in
trade with European Union.
 Suppose the United States is a “small” country in terms of the world
cheese market.
 Assume that Su and Du denote the supply and demand schedules of
cheese in U.S. Se denotes supply schedule of European Union.
 Under free trade, the price of European Union cheese and U.S cheese
equals $ 2.50 per unit.
 At this price, U.S firms produce 1 unit, U.S. consumers purchase 8
units, and imports from the European Union total 7 units.
Graph
 Trade and welfare effects of import quota cont..
 Suppose the U.S. limits its cheese imports to fixed quantity of 3
units by imposing an import quota.
 At each price, the total U.S supply of cheese now equals U.S.
production plus the quota.
 This is illustrated in the figure by a shift in the supply curve from
Su to Su +Q .
 The reduction in imports from 7 units to 3 units raises the
equilibrium price to $ 5; this leads to an increase in the quantity
supplied by U.S. firms from 1 units to 3 units, and a decrease in
U.S. quantity demanded from 8 units to 6 units.
 Trade and welfare effects of import quota cont..
 Because the quota results in a price increase to $ 5 per unit, U.S
consumer surplus falls by an amount equal to areas a + b + c + d.
 Area ‘a’ represents the redistributive effect
 Area ‘b’ represents the protective effect, and
 Area ‘d’ represents the consumption effect.
 The dead weight loss of welfare to the economy resulting from the
quota is depicted by the protective effect plus the consumption effect
(b + d).
 Trade and welfare effects of import quota cont..

 But what about the quota’s revenue effect, denoted by area C?

 This amount arises from the fact that U.S. consumers must pay an
additional $2.50 for each of the 3 units of cheese imported under
the quota, as a result of the quota – induced scarcity of cheese.
 It is the welfare loss to the importing nation.
 Trade and welfare effects of domestic subsidy
 The following figure illustrates the trade and welfare effects of a
production subsidy granted to import- competing manufacturers.
 Assume that the initial supply and demand schedules of the U.S for

steel are depicted by curves Su and Du, so that the market

equilibrium price is $430 per ton.
 With a free trade price of $400 per ton, the United States consumes
14 tons of steel, produces 2 tons, and imports 12 tons.
 To partially insulate domestic producers from foreign competition,
suppose the U.S government grants them a production subsidy of
$25 per ton of steel.
Trade and welfare effects of domestic subsidy cont..
 The cost advantage made possible by the subsidy results in a shift in the

U.S supply schedule from Su to Su+s.

 Domestic production expands from 2 to 7 million tons, and imports fall
from 12 to 7 million tons.
 Trade and welfare effects of domestic subsidy cont..
 The net price to the steel maker is $425- the sum of the price paid by
the consumer ($ 400) plus the subsidy ($25).
 To the U.S government, the total cost of protecting its steel makers
equals the amount of the subsidy ($25) times the amount of output to
which it is applied (7 million tons) or $ 175 million, which is
represented by are at a+b.
 Note that, because consumers pay the same price before and after
subsidy, there is no consumer surplus loss due to subsidy.
 CHAPTER FOUR
ECONOMIC INTEGRATION AND REGIONAL

TRADE ORGANIZATIONS
 What is economic integration?
 Economic integration is a process of eliminating restrictions on
international trade, payments and factor mobility.
 Economic integration thus results in the uniting of two or more
national economies in a regional trading arrangement (RTAs).
 Types of regional trading arrangements

 RTAs divided into several basic categories according to the degree

of economic integration they provide;

1. Free- trade area: is association of trading nations whose members

agree to remove all tariff and non- tariff barriers among themselves.
 Each member, however, maintains its own set of trade restrictions

against outsiders.
 An example of this stage of integration is the North American

Free Trade Agreement (NAFTA), consisting of Canada, Mexico

and the US.
 Types of regional trading arrangements cont..

2. Customs Union: A second stage in the process of economic

integration is the formation of customs union.
 Like a free trade association, a custom union is an agreement among
two or more trading partners to remove all tariff and non- tariff
trade barriers among themselves.
 In addition, each member nation imposes identical trade
restrictions against non-participants.
 A well example is Benelux, consisting three members- Belgium,
Netherlands and Luxemburg, formed in 1948.
 Types of regional trading arrangements cont..
3. Common Market: further stage in the process of economic
integration is a common market.
 A common market is a group of trading nations that permits

1. The free movements of goods and services among member nations,

2. The initiation of common external trade restrictions against non-
members.
3. The free movement of factors of production across national borders
 The common market, thus, represents a more complete stage of
integration than a free-trade area or customs union.
 The European Union (EU) achieved the status of a common market
 Types of regional trading arrangements cont..
4. Economic Union: This represents an even further step in economic
integration than a common market.
 In addition to permitting free movement of goods, services and
factors of production, and following a common external trade policy
against non-members,
 And national, social, taxation and fiscal policies are harmonized
and administered by a supranational institution in economic union.
 Belgium and Luxemburg formed an economic union during 1920s.
5. Monetary Union: This represents the ultimate degree of economic
integration and it requires the unification of national monetary
policies and the acceptance of a common currency administered by a
supranational monetary authority.
 The U.S. an example of a monetary union. Fifty states are linked
together in a complete monetary union with a common currency.
 Reasons for Regionalism
 Every regional trading arrangement has been the goal of enhanced
economic growth.
 An expanded regional market can allow economies of
large scale production,
foster specialization and learning- by –doing, and
attract foreign investment.
 Regional initiatives can also foster a variety of non-economic
objectives, such as managing immigration flows and promoting
regional security.
 Effects of a Regional Trading Arrangement
 When customs unions are established the flow of trade between
countries involved in the new union and those outside will be
affected.
 Customs unions eliminate barriers to trade between members, which
is assumed to provide a considerable incentive to increase trade
between members and to reduce trade between members and non-
members
 Outside a union, and operating independently, a single nation will
look to exploit its comparative advantage.
 Effects of a Regional Trading Arrangement
 Several factors influence the extent of trade creation and trade
diversion:
 A welfare – increasing trade- creation effect and
 A welfare – reducing trade – diversion effect
 Trade creation: occurs when some domestic production in a
nation that is a member of the customs union is replaced by lower
cost imports from another member nation.
 This increases the welfare of member nations, because it leads to
greater specialization in production based on comparative
advantage.
 Trade Diversion

 Trade Diversion: occurs when lower cost imports from outside the
customs union are replaced by higher cost imports from a union
member.
 Trade diversion; by itself, reduces welfare because it shifts
production from more efficient producers outside the customs union
to less efficient producers inside the customs union
 Trade Agreements
 Trade agreements are when two or more nations agree on the terms of trade

between them. All trade agreements affect international trade.

1. Unilateral trade agreement: it occurs when a country imposes trade

restrictions and no other country reciprocates. It would put the country at a
competitive disadvantage. The US and other developed countries only do this.

2. Bilateral trade agreements: are between two countries and both countries
agree to loosen trade restrictions to expand business opportunities between
them.

3. Multilateral trade agreements: are the most difficult to negotiate and these are
among three countries or more. The greater the number of participants, the more
difficult the negotiations are. Each country has its own needs and requests.
 Major trade agreements
1. General agreement on tariffs and trade (GATT)
 After the world war II, it was realized by the international community that
free trade is the ultimate solution to the problem of growth and employment.
 The USA proposed to establish an International Trade Organization (ITO) in
1945.
 GATT was crafted as an agreement among contracting parties to decrease
trade barriers and to place all nations on an equal footing in trading
relationships.
 GATT is not an institution like WTO. It was basically a forum for
international bargaining on lowering tariff barriers and for reviewing trade
arrangements and practices.
 The GATT objectives and operation system
 The GATT was established with three basic objectives, all of which
may be explained by the desire of the signatories to reverse and
prevent the move to protectionism.
 These are:

1. To provide a frame work for the conduct of trade relations.

2. To provide a frame work for, and to promote the progressive
elimination of trade barriers
3. To provide a set of rules that would inhibit countries from taking
unilateral action
 Exceptions to the GATT principles
A- Balance of payment problems; GATT members are allowed to
apply quantitative import restrictions in order to deal with severe
balance of payments problems.
B. Regional groupings; It allows the establishment of free trade areas
and customs union. However, such economic integrations should not
increase tariffs and other barriers to trade with non members among the
GATT countries.
C. Tariff preferences; GATT has also allowed tariff preferences for
specified groups of countries. Systems of preferences which were in
operation before the signing of the GATT were allowed to continue.
 World Trade Organization (WTO)
 In 1995, GATT was transformed in to WTO.

 The WTO embodies the main provisions of GATT, but its role was
expanded to include mechanism intended to improve GATT’s process
for resolving trade disputes among member nations.
 The major objectives of WTO are the following.

1. Achieving over all sustainable development by promoting the

protection and preservation of environment concerns at different levels
of economic development.
2. Ensuring that the developing countries may get a share in the growth
of international trade consistent with their needs of economic
development.
 Objectives of WTO cont..
3. Settling trade disputes
4. To develop a more viable and durable multilateral trading system
5. Coordinating policies in the field of trade, environment and economic
development.
 CHAPTER FIVE
TRADE AND ECONOMIC GROWTH AND DEVELOPMENT
 The integration of countries into the world economy is often
regarded as an important determinant of differences in income and
growth across countries.
 Trade is thus believed to promote:
 The efficient allocation of resources,
 allow a country to realize economies of scale and scope,
 facilitate the diffusion of knowledge,
 Foster technological progress, and
 Encourage competition both in domestic and international
markets
 that leads to an optimization of the production processes and to
the development of new production
 International Trade and Economic growth
 Given the nation’s factor endowments, technology, and tastes, we
proceeded to determine the nation’s comparative advantage and the
gain from trade.
 However, factor endowments change over time; technology usually
improves; and tastes may also change.
 As a result the nation’s comparative advantage also changes over
time.
 Therefore this section extends the trade model to incorporate these
changes.
 Thus the effect of trade policy on income and growth is more
 International Trade and Economic growth cont..
 On the one hand, lowering trade barriers is likely to foster
international trade by reducing transaction costs, which in turn can
enhance economic growth rates,
 Growth of factors of production
 Labor growth and capital accumulation over time
 Technical progress and the nation’s production possibilities.
 International Trade and Economic Development
 There are important beneficial effects that international trade can have
on economic development.
Trade can lead to full utilization of underemployed domestic
resources.
 International trade is a vehicle for the transmission of new ideas, new
technologies and new managerial and other skills
 Trade also stimulates and facilitates the international flow of capital
from developed to developing nations.
 Economic development considers both quantitative and qualitative
aspects, including factors like education, healthcare, infrastructure,
and environmental sustainability.
 Trade Development Strategies
 The desire of developing nations to industrialize is natural in view of
the fact that all developed nations are industrial while all developing
nations primarily agrarian.
 Having decided to industrialize, developing nations had to choose
between import substitution and export- oriented industrialization.
Both policies have advantages and disadvantages.
 Import Substitution
 It is a way of promoting domestic industrialization, particularly in
consumer goods through import restriction,
 so that domestic market is preserved for domestic products, which can
 Import Substitution cont..
 The main advantages of import substitutions are;

 The risks of establishing a home industry to replace imports are low

because the home market for the manufactured good already exists.

 It is easier for a developing nation to protect its manufacturers

against foreign competitors than to force industrial nations to reduce

their trade restrictions on products exported by the developing

nations.

 To avoid the import tariff walls of the developing country,

foreigners have an incentive to locate manufacturing plants in the

country, thus providing jobs for local workers.

 Disadvantages are:
Because trade restrictions shelter domestic industries from
international competition, they have no incentive to increase their
efficiency.
 Given the small size of the domestic market in many developing
countries, manufacturers cannot take advantage of economies of scale
and thus have high unit costs.
Once investment is sunk in activities that were profitable only because
of tariffs and quotas, any attempt to remove those restrictions is
generally strongly resisted.
Import substitution also breeds corruption.
 Export Promotion
 This strategy involves policies designed to exploit natural
comparative advantage by increasing production of a few export
goods most closely related to the country’s resource base.
 The main advantages of export promotion are the following:
 It overcomes the smallness of domestic market and allows a
developing nation to taken advantage of economies of scale.
 Production of manufactured goods for export requires and stimulates
efficiency throughout the economy.
 The expansion of manufactured exports is not limited ( as in the case
of import substitution) by the growth of the domestic market.
  The two serious disadvantages of export promotion as a
policy are:

 It may be very difficult for developing nation to set up exporting

industries.
 Developed nations often provide a high level of protection for their
simple labor-intensive commodities in which developing nations
already have or can soon acquire a comparative advantage.
THANKS FOR YOUR ATTENTION
THE END OF THE COURSE !!
Blueprint