Course Code : IBO-01

Course Title : International Business Environment

Assignment Code : IBO-01/TMA/2009-10
Ans. 1(a)
Ricardian trade theory is one of the most famous theories of economics but appears
to have been little developed. Many attempts were made to extend the theory to
multi-country, multi-commodity cases, but none succeeded to construct a general
theory that included intermediate goods. A need to include intermediate goods
within the theory was evident, but hurdles to introduce intermediate inputs were
high. Intermediate goods change the entire structure of analysis; when they are
traded, the price of a good is dependent of the prices of imported inputs.
Consequently, prices should be determined simultaneously for prices of all
countries. The present paper has succeeded in overcoming these difficulties and
describes how wages, prices and productions are related. It analyzes the M-country,
N-commodity case with choice of techniques and trade of intermediate goods in
general terms, thus presenting a new basis for international trade theory. New light
was shed on topics like gains and losses from trade, international wage rate
discrepancies, and price and quantity adjustments. On a theoretical plane, the new
construction eliminates a traditional weakness of the Ricardian theory. The
traditional Ricardian theory acknowledged labor as the only input and excluded
capital in any form. The new theory, presented here, analyzes capital goods as
traded intermediate inputs.
The Ricardian AssumptionsBasics
There are:
There are two countries, Home and Foreign
Two goods, Cheese and Wine, and
One resource, Labor
It is used to produce cheese and wine

The Ricardian AssumptionsPreferences

The preferences of all consumers in the world are identical.

For any individual, the Marginal Rate of Substitution is independent of the

scale of consumption.

An individuals MRS of wine for cheese is the maximum amount of wine

that he/she would be willing to pay for one unit of cheese.

Under this assumption, if the amounts of Cheese and Wine being

consumed are, say, doubled, then the MRS remains unchanged.

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10

In other words, the MRS does not change if the ratio of the amounts of
Cheese and Wine consumed, Cheese/ Wine, does not change.

Marginal Rate of Substitution

Note that a consumers MRS of wine for cheese is, simply, a measure of how
much the consumer likes cheese.

We assume that MRS WC decreases as the consumption of cheese increases

relative to the consumption of wine

And remains unchanged if the consumption of cheese remains unchanged

relative to the consumption of wine.
Marginal Rate of Substitution

Cheese consumed
(C)

Wine consumed (W)

Cheese-Wine Ratio
(C/W)

MRSWC

10

20

0.5

600

1200

0.5

10

1.6

The Ricardian AssumptionsTechnology

Goods are produced (out of resources) with technologies that satisfy Constant
Returns to Scale.

That is, if the producer of a commodity, say, doubles the amounts used
of all resources, then the amount produced will also double.

The Ricardian AssumptionsMarkets

There is perfect competition in all markets.

That is, no buyer or seller of a commodity has the power to affect the
price of the commodity by himself.

More specifically, the market for a commodity is said to be perfectly

competitive if:

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10

There are many sellers

There are many buyers

All sellers sell the exact same product

Individuals make decisions so as to maximize happiness, whereas

Firms make decisions so as to maximize profits

The Ricardian AssumptionsGovernments

Governments do not interfere with the smooth functioning of markets; there

are no taxes, subsidies, tariffs, quotas, etc.
Marginal Cost

The Marginal Cost (MC) of a commodity is the additional cost of producing an

additional unit of that commodity

Therefore, the Marginal Cost of, say, cheese can be calculated by

multiplying the labor required to produce a pound of cheese by the
wage that labor must be paid.

Wage
Let the wage rates in Home and Foreign (measured in their respective currencies)
be denoted by:
wHome
wForeign

Unit Labor requirements

Cheese

Wine

Home

1 hour per
pound

2 hours per
gallon

Foreign

6 hours per

3 hours per

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10

pound

gallon

Cheese
MC Home
wHome 1
Wine
MC Home
wHome 2
Cheese
MC Foreign
wForeign 6
Wine
MC Foreign
wForeign 3

Unit Labor requirements

Cheese

Wine

Home

1 hour per pound

2 hours per gallon

Foreign

6 hours per pound

3 hours per gallon

Marginal Cost
(In each countrys currency)
Cheese

Wine

Home

wHome 1

wHome 2

Foreign

wForeign 6

wForeign 3

Price = Marginal Cost

If P > MC at the current level of production, additional production would

increase profit

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10

If P < MC at the current level of production, reduced production would

increase profit

Therefore, profit is maximized only if P = MC

Therefore, if a good is being produced, P = MC must be true

If a good is not being produced, P MC.

Autarky (Nominal) Prices

In autarky, both goods must be produced in both countries

Therefore, P = MC for both goods in both countries

Therefore, the prices, which are also called nominal prices, can be calculated
from the marginal costs that we had calculated earlier

(Nominal) Pricesautarky
Unit Labor requirements
Cheese

Wine

Home

1 hour per pound

2 hours per gallon

Foreign

6 hours per pound

3 hours per gallon

Marginal Cost (In each countrys currency)

Home

Cheese

Wine

wHome 1

wHome 2

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10
Foreign

wForeign 6

wForeign 3

Ans. 1 (b)
Balance of payment is an accounting record of the transactions between the
residents of one country and the residents of the rest of the world over a given
period of time. Transactions in which domestic residents either purchase assets
(goods and services) from abroad or reduce foreign liabilities are considered uses
(out flow) of funds because payments abroad must be made. Similarly, transactions
in which domestic residents either sell assets to foreign residents or increase their
liabilities to foreigners are sources (inflows) of funds because payments from abroad
are received.

One feature of double entry bookkeeping is that flows of money into and out of a country for
various reasons have to balance in total. We can express a simplified view of this point as the
balance of payments:
Current Account = Capital Account + Change in Official Reserves
Here the current account can be thought of as exports minus imports, which is often identified as
the trade balance, plus net income on foreign assets and transfers. This net source of foreign
currency must be offset by either net investment in foreign assets (the capital account) or changes
in official reserves. (A statistical discrepancy is generally also added to account for difficulties
in securing precise measurements of the various items.)
The balance of payments establishes a fundamental link between the factors affects goods
transactions (exports and imports) and the factors affecting financial flows. For example, a
country with a trade deficit (imports greater than exports) must have an interest rate (or other
financial market considerations) that attract an offsetting inflow of capital investment.

Factors affecting balance of payment:

1) The current account :
A country's current account balance can significantly affect its economy; therefore, it is important to
identify the factors that influence it. The most important factors are:

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10
(a) Inflation: If a country's inflation rate increases relative to the countries with which it trades, its
current account would be expected to decrease. Due to higher prices at home, consumers and
corporations with in the country will most likely purchase more goods overseas (due to high local
inflation), while tile country's exports to other countries will decline.
(b) National Income: If a country's national income rises by a higher percentage than those of other
countries, its current account is expected to decrease, other things being equal. As the real income
level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in
consumption will most likely reflect an increased demand for foreign goods.
(c) Government Restrictions: If a country's government imposes a tax on imported goods (often
referred to as a tariff) the prices of foreign goods to consumers effectively increases. An increase
in prices of imported goods relative to goods produced at home will discourage imports and is
expected to increase the current account balance. In addition to tariffs, a government may reduce
its imports by enforcing a quota, or a maximum limit on imports.
(d) Exchange Rate: Each country's currency is valued in terms of other currencies through the use
of exchange rates, so that currencies can be exchanged to facilitate international transactions, The
values of most currencies an fluctuate over time because of market and government forces, If a
countrys current account balance decreases, other things being equal, goods exported by the
country will become more expensive to the importing countries, if its currency strengthens, as a
consequence, the demand for such goods will decline. For example, a refrigerator selling in the
United State for $ 100 require a payment of Rs. 3500, if the dollar were worth Rs.351/- Rs.
1 = $0.028). Yet, if the dollar were worth Rs.401- (Rs. 1 = $ 0.025), it would take Rs,4000
to buy the refrigerator. Which could discourage Indians to buy it? However according to J-curve
theory, a country's trade deficit worsens just after its currency depreciates because rice effects will
dominate the effect on volume of imports in the short run. That is the higher costs of imports
will more than offset the reduced volume of imports. Thus, the J curve theory states that a
decline in the value of home currency should be followed by a temporary worsening in the trade
deficit before its longer term improvement.
2. The Capital Account:
As with the current flows, government policies affect the capital account as well. A country's government
could, for example, impose a special tax on income account by local investors who invested in foreign
markets. A tax would discourage people from sending their funds for investment in the foreign markets and
could therefore, increase the country's capital account. Capital flows are also influenced by capital controls of
various types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries
may affect capital inflows from abroad. Similarly, a reduction in domestic rates may induce people to invest
abroad. '
The anticipated exchange rate movements by investors in securities can affect the capital account. If a home
currency is expected to strengthen, foreign investors may be willing to invest in the country's securities to
benefit from the currency movement. Conversely, a country's capital account balance is expected to decrease,
if its home currency is expected to weaken, other things being equal. While attempting to assess why a
country's capital account changed and how it will change in future, all factors must be considered
simultaneously. A particular country may experience a reduction in capital account even when its interest rates
are attractive, if the home currency is expected to depreciate.

Course Code : IBO-01

Course Title : International Business Environment
Assignment Code : IBO-01/TMA/2009-10

Ans. 2 (a)