Gains from Trade

Adam Smiths Theory of Absolute Advantage

Country should specialize in the production of commodities which it can produce most efficiently Lower Cost of Production.

A country tends to specialize in production of commodities in which it has Absolute Advantage

Per Quintal Labour Cost (Man- hour)

Country India Bangladesh Rice 30 50 Jute 60 20

Adam Smiths Theory of Absolute Advantage

Would should countrys be doing?

India

India should specialise in Rice production. As India has to sacrifice 2 Qtl of Rice for 1 Qtl of Jute. It can import jute from Bangladesh 1Qtl of Rice = 1.5 Qtl of Jute (30/20) Per Quintal Labour Cost (Man- hour) Country India Bangladesh Rice 30 50 Jute 60 20

Adam Smiths Theory of Absolute Advantage

Would should countrys be doing?

Bangladesh Should specialise in Jute Import Rice from India As in domestic trade they get 0.4 Qtl of Rice (20/50) for Jute If they trade they get 0.67 Qtl of Rice (20/30) for 1 Qtl of jute Per Quintal Labour Cost (Man- hour) Country India Bangladesh Rice 30 50 Jute 60 20

Ricardo's Insight

What if one country has absolute advantage in both the commodities? Is trade possible? As long as countries have comparative advantage in the production of both the commodities specialisation and trade would always be possible. Per Quintal Labour Cost (Man- hour) Country India Bangladesh Rice 30 50 Jute 60 80

India It can produce both the goods efficiently. It has comparative advantage in rice production. It can produce Rice at 60% (30/50) cost then Bangladesh. It has comparative disadvantage in jute because cost of jute production is twice the cost of rice production.

Bangladesh It has comparative advantage in jute production Relative cost of jute production ( 80/50 = 1.6 Qtl of rice) is less than Indias(60/30= 2Qtl of rice).

Country India Bangladesh

Rice 30 50

Jute 60 80

Gains from Foreign Trade

Internal Exchange Rate (Quintal) India Rice 1 30/60 2 1 1.6 Jute 0.5 Rice Bangladesh Jute

1
50/80

0.625
1

Who Gains from Trade?

Who Gains India or Bangladesh?

It depends upon the determination of commodity exchange rate between two countries. Indias exchange rate ranges between 500Kg to 625 kg of Jute for 1 Qtl of Rice. Bangladesh it ranges between 1.6 to 2 Qtl of Rice for 1 Qtl of Jute. If Exchange rate in foreign trade are same as internal rates then both the country gain.

Heckscher-Ohlin Theory of Trade

The comparative advantage in the cost of production is due to the difference s in the factor endowment of the nations. It refers to the overall availability of usable resources in the country. A country tends to specialise in the export of a commodity whose production requires intensive use of its abundant resources and imports a commodity whose production requires intensive use of its scarce resources.

Balance Of Payments

Definition
It is a systematic record of a countrys economic and financial transactions with the rest of the world, over a period of time.

Transaction of goods and services and income between an economy and the rest of the world.

It standard double- entry book keeping. Credit = Debit

The BOP must always balance. The time period is one year financial or calendar.

Purpose

It provide data for the Economic analysis of the countrys as the partner in International trade. It reveals the changes in composition and magnitude of foreign trade. It predicts future performances on past trade performances. It also revels the weak and strong points in the countrys foreign trade and thereby Govt intervention for corrective measures.

Balance of Trade vs BOP

Balance of Trade : It refers to the difference in value of Imports and Exports i.e Visible Items

Favourable Balance of Trade : Unfavourable Balance of Trade:

X>M X< M

Balance of Payments: Includes both Visible and Invisibles items ( Such as Services by shipping, banking and insurance, interest payment, dividend, expenditure of tourist, foreign investment, external lending and borrowing, NRI deposits etc)

Components of BOP
BOP
Current A/C
Merchandise / Visible Invisible Export / Import

Capital A/C
Short Term Capital Movement

Long Term Capital Movement

Unilateral Transfers

Changes in Gold and Exchange Reserves

Current Account
It includes all transactions which give rise to or use up National Income. Credit : Value which are receivable Debit: Value which are payable. a) Merchandise / Visible Exports and Imports Merchandise Exports : Sales of Good abroad Merchandise Imports: Purchase of Goods from aboard b) Invisible Items Invisible Exports: Sales of Services Invisible Imports: Purchase of Services

c) Unilateral Payments

Gifts, Private remittances, grants , disaster relief

Capital Account
Which increase or decrease countrys total stock of capital.
a) Short Term Capital Movement Purchase of short term securities Speculative Purchase of Foreign Currency Cash balances held by foreigners Net balance ( + /- ) of current account
b) Long Term Capital Movement Direct Investments in Shares, bonds and in real estate and physically assets which investors hold a controlling power. Portfolio investments in stocks and bonds Repurchase and resale of securities Direct export and import of capital goods c) Gold and Foreign Exchange reserves They are maintained to stabilize the exchange rate of the home currency and to make payments to the creditors in case of deficit.

Components of BOP
Current Account Balance

Credit (Receipts)
Export of Goods Export of Services Interest profits and Dividend Received

Debit (Payments)
Import of Goods Import of Services Interest profits and Dividend paid

Unilateral Receipt (Gifts, grants, disaster relief)

Unilateral Payments

Components of BOP
Capital Account Balance

Credit (Receipts)
Foreign Investment Direct, Portfolio Short Term Borrowings Long Term Borrowings Foreign Exchange Reserves (+)

Debit (Payments)
Investment Aboard Direct, Portfolio Short Term Lending Long Term Lending Foreign Exchange Reserves (-)

BOP are always Balance

BOP is based on double entry book keeping in which both sides of a transactions, receipt and payment are recorded. Export: Outflow of goods / Inflow of foreign currency

Import: Inflow of Goods / Outflow of foreign currency

Both outflow and inflow are recorded in BOP A/C

Indias BOP

Capital A/C

Indias BOP

Bop Disequilibrium
BOP Equilibrium : Total Receipt = Total Payment Demand for foreign Exchange = Supply BOP Disequilibrium : Demand > Supply : Demand < Supply :

Deficit Surplus

Deficit in Current A/C is offset by Surplus in Capital A/C Surplus in Current A/C is offset by a deficit in capital A/C
( By loans / borrowings or depleting its gold /foreign exchange reserves)

Causes and Kinds BOP Disequilibrium

1)Economic Factors

a) Price Change Change in Price level causes BOP disequilibrium. The change in price level may be inflationary or deflationary. Inflation makes import cheaper and export costlier. Increase in imports as domestic prices become higher than import prices Decrease in exports as domestic price rises. Deficit in BOP
b) Development Disequilibrium Large scale development expenditure increase the purchasing power Increases demand and prices Increases in large imports. Its common in developing countries as large scale import of capital goods.

Causes and Kinds BOP Disequilibrium

c) Cyclical Disequilibrium

Business cycle fluctuations causes disequilibrium. The countrys which are dependent upon Imports faces large deficit during inflation Moderate deficit or surplus during depression.

d) Structural Disequilibrium

Depletion of Natural Resources Changes in Technology Alternative source of Supply Development of better substitute

Causes and Kinds BOP Disequilibrium

2)

Political Factors

Political Instability may experience large capital outflow and inadequacy of domestic investment and production. War and changes in trade route can also cause disequilibrium.

3)

Other Factors Disturbances or crop failure Rapid growth in population leads to large scale imports of foodgrains. Changes in taste preferences and fashion causes change in export and import.

Correction of Disequilibrium
Correction Of BOP

Automatic Measures

Deliberate Measures

Monetary Measure

Trade Measure

Miscellaneous

Correction of Disequilibrium
A) Automatic Measures

BOP disequilibrium may be automatically corrected If the market forces of demand and supply are allowed to have a free play, in course of time equilibrium would be restored. For ex If there is deficit in BOP Demand for Foreign exchange exceeds its supply This result in increase in exchange rate Fall in value of domestic currency Exports cheaper and import costlier Increase in Exports and fall in imports Equilibrium in BOP

Correction of Disequilibrium
1) Monetary measures
a) Monetary Contraction / Deflation

Contraction or Expansion of money supply For Example: Deficit in BOP Contract the Money Supply Reduces purchasing power Decrease the demand Reduces domestic prices Decrease in imports and increase in exports

Correction of Disequilibrium
b) Devaluation

Reduction of the official rate at which the currency is exchanged for another currency Devaluation is done to improve its BOP Export prices fall, Export increases Import prices goes up, import reduces Deficit of BOP reduces

Condition for the successful working of Devaluation

Elastic demand for imports and exports Structure of Imports and Exports Domestic Price stability ( Should not lead to Price rise) International co-operation Hike in import duties, reduction in export duties, export license, export promotion programme

Correction of Disequilibrium

c) Exchange Control

Central Govt has complete control over foreign exchange reserves. Exporters surrender foreign exchange in exchange of domestic currency. Govt release foreign exchange only for essential imports.

Its not a permanent solution to long run disequilibrium because it suppresses demand for Imports and not cure Deficit.

Correction of Disequilibrium
2) Trade Measures

Export promotion measures and import substitutions

a) Export Promotion: Reducing Export duties Export subsidy Export incentives and facilities. b) Import Control: Increasing Import duties Import quotas Import license and prohibition.

Correction of Disequilibrium
3) Miscellaneous Measures Obtaining foreign loans Development of tourism Incentives to enhance inward remittances Encouraging foreign investment.

100000

200000

300000

400000

500000

600000

700000

19
0

91 -9 2 -9 3 -9 4 -9 5 -9 6 -9 7 -9 8 -9 9 00 92 93 94 95 96 97 98 -2 0

19 19 19 19 19 19 19 19 99

Exports Imports

Post 1991 Trade Trends

20 00 01 20 20 20 20 02 03 04 05 20

F Invest

-0 1 -0 2 -0 3 -0 4 -0 5 -0 6

Movement in Foreign Exchange Reserve