BASIS OF INTERNATIONAL TRADE

Dr. Toufic A. Choudhury Professor, BIBM

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Interdependence and Gains from Trade. Theories of International Trade: Absolute and Comparative Advantage Theories.
1. What is International Trade? It is trade between nations. Specifically, it is exchange of goods and services between exporter (seller) and importer (buyer), who are located in two different countries. In terms of international trade, the responsibility of exporter (seller) is to send the goods and that of importer is to send/make payments. A banks role in international trade is i) to facilitate payment; and ii) to provide finance to exporter and importer 2. Why Trade? International trade is essential for the prosperity of the trading nations because: 1. Every country lacks some vital resources that it can get only by trading with others 2. Each countrys climate, labor force and other endowments make it a relatively efficient producer of some goods and an inefficient producer of other goods 3. International Trade leads to specialization which permits larger outputs and can therefore offer economies of large-scale productions 3. Whether to Export or Import: It depends on the difference between domestic price and world market price If WMP > DMP Country will export WMP < DMP Country will import 4. Gains from Trade: How can mere exchange, in which no production takes place, leave both parties better off? The answer is that while trade does not increase the physical quantities of the goods available, it does allow each party to acquire items better suited to their needs and tastes. That is, trade brings about mutual gains by redistributing product in such a way that both parties end up holding a combination of goods which is better suited to their preferences than the goods they held before. Equilibrium without trade: Assume: * A country is isolated from rest of the world and produces steel. * The market for steel consists of the buyers and sellers in the country. * No one in the country is allowed to import or export steel.

Results: * Domestic price adjusts to balance demand and supply. * The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive.

International Trade and the Exporting Country: If the world price of steel is higher than the domestic price, the country will become an exporter of steel when trade is permitted. Domestic producers of steel will like to increase their output because the domestic price moves to the world price. As a result, domestic consumers will have to buy steel at the higher world price. How Trade affects Welfare in Exporting Country: * Domestic producers of the good are better off, and domestic consumers of the good are worse off. * Trade raises the economic well-being of the nation as a whole (D).

International Trade and the Importing Country:

If the world price of steel is lower than the domestic price, the country will become an importer of steel when trade is permitted. Domestic consumers will want to buy steel at the lower world price. Domestic producers of steel will have to lower their output because the domestic price moves to the world price. How Trade affects Welfare in Importing Country * Domestic producers of the good are worse off, and domestic consumers of the good are better off. * Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers (D).

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Arguments in favour of free trade: Increased variety of goods Lower costs through economies of scale Increased competition Enhanced flow of ideas Economies of scale Promotion of competition Resource use efficiency Fostering economic and political cooperation

6. Gains from Free Trade: When a country opens its market to free international trade, it benefits in several ways: First, it enjoys Static Gains from trade which means increase in economic well-being, holding resources and technology constant, which accrue to a country engaging in international trade. Second, free trade also lends to dynamic gains. This refers to increase in economic well-being that accrue to an economy because trade expands the resources of a country or induces increase in the productivity of existing resources. Third, in addition to economic gains, a nation that trades freely may enjoy political gains. Increases in economic well-being that accrue to a country because of expanded trade and economic interdependency may increase the likelihood of reduced international hostility. 3

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Trade Theories: Mercantilists view on Trade:

The economic philosophy known as Mercantilism (from 16th to mid 18th century) maintained that the most important way for a nation to become rich and powerful was to export more than it imported. The difference would be settled by an inflow of precious metal mostly gold. The more gold a nation had, the richer and more powerful it was. Thus mercantilists advocated that the government should stimulate exports and restrict imports. Since not all nations could have an export surplus simultaneously and the amount of gold in existence was fixed at any one time, a nation could only gain at the expense of the other nations. 8. Adam Smith: Absolute Advantage: In 1776, Adam Smith published his famous book. The Wealth of Nations, in which he attacked the mercantilist view on trade and advocated instead free trade as the best policy for the nations of the world. Smith argued that with free trade, each nation could specialize in the production of those commodities in which it had an absolute advantage (or could produce more efficiently than other nations) and import those commodities in which it had an absolute disadvantage (or could produce less efficiently). This international specialization of factors in production would result in an increase in world output which would be shared by the trading nations. Thus a nation need not gain at the expenses of other nations all nations could gain simultaneously. Example: Table 1 shows that the U.S has an absolute advantage over the U.K in the production of wheat and the U.K. has an absolute advantage in the production of cloth . If the U.S specializes in the production of wheat and the U.K in the production of cloth, the combined output of wheat and cloth of the U.S and the U.K would be greater and both the U.S and the U.K would share in this increase through (voluntary) exchange. Table 1 Wheat (bushels/labor-hour) Cloth (yards/labor-hour) U.S 6 1 U.K 1 2

9. (a) With reference to Table 2 indicate in what commodity the U.S and U.K have an absolute advantage ? (b) How much would the U.S and the U.K gain if 6 W were exchanged for 3C? (c) What if 6W were exchanged for 6C? Table 2 Wheat (bushels/labor-hour) Cloth (yards/labor-hour) U.S 6 1 U.K 1 3

(a) The U.S is more efficient than or has an absolute advantage over the U.K in the production of wheat while the U.K. has an absolute advantage over the U.S in the production of cloth. (b) If the U.S. exchanged 6W for 3C with the U.K, the U.S would gain 2C or would save 2 labor hours (since the U.S can only exchange 6W for 1C domestically). The 6W which the U.K. receives from the US is equivalent to or would have required 6 labor hours to

produce in the U.K. These same 6 labor hours can produce 18 C in the U.K (see the table). By exchanging 3C (which require only 1 labor-hour to produce) for 6W, the U.K thus gains 15C or saves 5 labor hours. (c) If the U.S exchanged 6W for 6C with the U.K, the U.S would gain 5C or would save 5 labor hours. Since 6W is equivalent to 18C in the U.K. and the U.K. needs only to give up 6C for 6W, the UK gains 12 C or saves 4 labor hours. 10. How did Adam smith explain his contention that all nations engaged in trade can benefit form trade? Smith explained that if each nation specialized in (or produced more than it wanted to consume domestically of) the commodity in which it was more efficient, and exchanged this excess for the commodity in which it was less efficient, the output of all commodities entering trade would increase. This increase would be shared by all nations that voluntarily engaged in trade. Thus, the gains form trade would arise from specialization in production and trade. Theses gains would be maximized when the government interfered as little as possible with the operation of the domestic economy (laissez faire) and with international trade (free trade). 11. David Ricardo: Comparative Advantage Ricardo writing after 40 years than Smith, stated that even if a nation has an absolute disadvantage in the production of both commodities with respect to the other nation, mutually advantageous trade could still take place. The less efficient nation should specialize in the production of and export of the commodity in which its absolute disadvantage is less. This is the commodity in which the nation has a comparative advantage. On the other hand, the nation should import the commodity in which its absolute disadvantage is greater. This is the area of its comparative disadvantage. This is known as the Law of comparative advantage one of the most famous and still unchallenged laws of economics. Example: Table 3 shows that the U.K has an absolute disadvantage with respect to the U.S in the production of both wheat and cloth. However, its disadvantage is less in cloth than in wheat. Thus the U.K has a comparative advantage with respect to the U.S in cloth and a comparative disadvantage in wheat. For the U.S, the opposite is true. That is, the U.S has an absolute advantage over the UK in both commodities, but this advantage is greater in wheat (6:1) than in cloth (3:2). Thus the U.S has a comparative advantage over the U.K in wheat and a comparative disadvantage in cloth. Mutually advantageous trade could take place with the U.S exchanging wheat (W) for cloth (C) with the U.K. 12. Example: With reference to Table 3, we see that if the U.S could exchange 6W for 6C with the U.K, the U.S. would gain 3C (since the U.S can only exchange 6W for 3C domestically). To produce 6W itself, the U.K would require 6 hours of labor. Instead, the U.K can use the 6 labor-hours to produce 12C exchange 6 of these 12 C for 6W from the U.S and end up with 6C more for itself. Thus by exchanging 6W for 6C, the U.S would gain 3C and the U.K 6C. There are many other ratios of exchange of W for C (besides 6W for 6C) that would be advantageous to both nations. The rate at which exchange actually takes place determines how the gains from trade are shared by the two nations. [What that rate itself will be, depends also on demand conditions in each nation.]

Table 3 Wheat (bushels/labor-hour) Cloth (yards/labor-hour) U.S 6 3 U.K 1 2

13. Determinants of Comparative Advantage: The difference in pretrade relative commodity prices (comparative advantage) between the two nations is based on a difference in factor endowments, technology, or tastes between the two nations. However, even if two nations have exactly the same factor endowments and technology a difference in tastes can be the basis for mutually beneficial trade. 14. Some Important Concepts: i) * * * Open Vs. Closed Economy (Autarky): An open economy interacts with other countries in two ways. It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets A closed economy is one that does not interact with other economies in the world. There are no exports, no imports, and no capital flows.

ii) Index of Openess: A measure of the importance of international trade to an economy, calculated as the ratio of exports over total domestic production. Assignment: 1) Calculate Index of Openness of Bangladesh Economy over the last ten (10) years. Make comments on the trend of openness of Bangladesh economy. 2) Calculate BOT of Bangladesh Economy over the last ten years. Give Comments on Commodity and Country concentrations of Bangladeshs export-import composition. Reference: 1. Husted, S. and Melvin. M. International Economics. 2. Salvatore, Dominick. International Economics.