International Economic and Policy_Amity

Author

International Economic and Policy

International Economic and Policy 2015, Author

For Private Circulation only to the Students of ADDOE. All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or copied in any form or by any means, electronic, mechanical, photographic or otherwise, without the prior written permission of the author and the publisher. Published by: Amity Directorate of Distance & Online Education, Noida

Contents

Chapter 1: International Economics: An Introduction 1

Chapter 2: Modern Theories on International Trade 17

Chapter 3: Trade and Development 42

Chapter 4: Equilibrium in International Trade 82

Chapter 5: International Monetary System 114

Chapter 1: International Economics: An Introduction

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Objectives After studying this chapter, you should be able to understand:

1. Meaning of international economics and international trade

2. Bases of international trade

3. Theories of international trade

4. Absolute and comparative cost advantages theories

Introduction International economics, which emerged as a 'specialist' field of economics long ago, has developed in depth and width over time due to a lot of theoretical, empirical and descriptive contributions. International economics has enjoyed a long, continuous and rich development over the past two centuries, with contributions from some of the world's most distinguished economists, from Adam Smith to David Ricardo, John Stuart Mill, Alfred Marshall, John Maynard Keynes and Paul Samuelson. International Economics as a matter of fact encloses the basic principles pertaining to International Trade and Finance. In this introductory unit, an attempt is made to analyze the meaning, nature and scope of international economics and also to discuss the concept of international trade.

1.1 Concepts and Scope International economics deals with the economic interdependence among countries and includes the effects of such interdependence and the factors which affect it. In other words, international economics deals with those international forces which influence the domestic economic conditions as well as those which shape the economic relationship between countries, world economic integration and transition.

In the words of Sodersten and Geoffrey Reed, Even if most people are agreed that international economic relations are of great importance for most countries, it does not necessarily follow that international economics should be studied as a subject independent of other branches of economics.

Further elaborating and interpreting the views of Sodersten and Reed, international economics may be defined specifically in the following words International Economics is that branch of Economics which deals with International Trade and International Finance. International Economics may also be defined as a sub-branch of economic theory that deals with the discussion of the principles related to international trade and finance.

According to Dominick Salvatore, International Economics deals with the economic and financial interdependence among nations. It analyzes the flow of goods, services payments and monies between a nation and the rest of the world, the policies directed at regulating these flows and their effect on the nation's welfare.

1.1.1 International Economics Theoretical Considerations

The theoretical part tries to go beyond the phenomenon to seek general principles and logical frameworks which can serve as a guide to the understanding of actual events (so as, possibly, to influence them through policy interventions). Like any economic theory, it uses for this purpose of abstractions and models, often expressed in mathematical form. The theoretical part can be further divided into pure and monetary theory, each containing aspects of both positive and normative economics, although these aspects are strictly intertwined in our discipline.

The theoretical part of international economics may be divided into pure theory of international trade and international monetary economics.

The pure theory of international trade, which has a micro-economic nature, covers a very wide area.


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The pure theory encompasses mainly the following:

1. The bases or causes of trade and the pattern of trade.

2. Effect of trade on production, consumption and distribution of income.

3. Effect of trade on relative factor prices and product prices.

4. Gains from trade and distribution of the gains.

5. Effect of trade barriers on trade, factor and product prices and income distribution.

6. Effect of trade on economic growth and vice versa.

The international monetary theory, which is of a macroeconomic nature; deals with matters pertaining to balance of payments and international monetary system. It covers areas such as causes and methods of correcting balance of payments disequilibria, exchange rate determination, international liquidity, relationship between balance of payments position and other macroeconomic variables etc.

1.1.2 International Economics Descriptive Considerations

The descriptive part is concerned with the description or international economic transactions just as they happen and of the institutional environment in which they take place. This covers international trade flow of goods and services, flow of international financial and other resources, international organizations like IMF, World Bank, Regional Development Banks, WTO, UNCTAD, etc. International Economic Agreements (including trade blocs) and so on. International trade is only one, though an important part of international economics.

Business strategies, particularly of the large corporations, such as multinational investments, production sharing and global sourcing, joint venturing and other alliances etc. have been increasingly fostering world economic integration and transnationalisation. These forces will gather more momentum in the future. However, the literature on international economics does not appear to be giving due importance to the role of business strategies in shaping the world economic transition.

Subject Matter of International Economics

The subject matter of International Economics comprises of the study of the following:

1. International Trade: This deals with the basis of international trade and the gains from trade.

2. International Trade Policy: International Trade Policy examines the reasons for and the effects of trade restrictions and the concept of new protectionism.

3. The Balance of Payments: The balance of payments measures a nation's total receipts from and the total payments to the rest of the world.

4. Foreign Exchange markets: Foreign Exchange markets are the institutional framework for the exchange of one national currency for others.

5. Open Economy Macroeconomics: Open Economy Macroeconomics deals with the mechanisms of adjustment in balance of payments disequilibria (deficits and surpluses).

More importantly, it analyzes the relationship between the internal and external sectors of the economy of a nation and how they are interrelated or interdependent with the rest of the world economy under different international monetary systems.

International trade theory and policies are the micro-economic aspects of international economics because they deal with individual nations treated as single units and with the (relative) price of individual commodities. On the other hand, since the balance of payments deals with total receipts and payments, as well as with adjustment and other economic policies that affect the level of national income and the general price of the nation as a whole, they represent the macroeconomic aspects of international economics. These are often referred to as Open Economy Macroeconomics or International Finance.


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International economic relations differ from inter-regional economic relations (i.e., the economic relations among different parts of the same nation), thus requiring somewhat different tools of analysis and justifying international economics as a distinct branch of economics. That is, nations usually impose some restrictions on the flow of goods, services and factors across their borders, but not internally. In addition, international flows are to some extent hampered by differences in language, customs and laws. Furthermore, international flows of goods and services and resources give rise to payments and receipts in foreign currencies, which change in value over time.

1.1.3 Nature and Scope of International Economics

The scope of the subject is broad. The need for development of this distinct branch of economics was justified by a number of important factors. Economic activities between countries are made different from those within the countries by the fact that factors of production are generally less mobile between countries than within the country. In fact, international trade theories have been based on the traditional assumption that factors of production are perfectly mobile within the country and completely immobile between countries. Simultaneously, it is assumed that goods are perfectly mobile both within and between countries but for government restrictions in some cases. Indeed, the impact of different types of government restrictions on trade, production, consumption and income distribution is an important area of study in international economics.

1.1.4 Components of International Economics

These days, the subject matter of International Economics comprises a large number of segments which, in turn, can be divided into several parts. It is obvious that the coverage of topics and arrangement and depth of their analysis would depend upon the purpose of the study. Broadly speaking, however, international economics covers the following main components.

Pure Theory of Trade: It tries to explain the reasons for international trade in goods and services, determination of the composition, direction and volume of trade; determination of the terms of trade between exports and imports of a country; determination of rate of exchange and changes in it; concepts and issues relating to balance of trade and balance of payments, as also the concepts of their equilibrium and disequilibrium.

Policy Issues: This portion of international economics covers a wide area of relevant questions and a choice of associated policy alternatives. Examples include (a) free trade vs. protection, (b) methods of regulating trade, capital and technology flows, (c) use of taxation, subsidies and dumping; (d) exchange control and convertibility, (e) issues relating to foreign aid, external borrowings and direct foreign investment, (f) alternative measures of correcting balance of payments disequilibrium and the like.

International Cartels and Trade Blocs, etc: Opening up of international trade and economic flows is accompanied by attempts, with varying degrees of success, of economic integration in the form of international cartels, customs unions, monetary unions, trade blocs, economic unions and so on. The operations of multinational corporations are also pushing the entire world economy into a new pattern. The subject of international economics should cover these dimensions of international economic relations as well.

International Financial and Trade Regulatory Institutions: After the Second World War, a number of international financial and trade-regulatory institutions have come into existence. They deeply influence international economic transactions and relations and, for this reason, their study should be considered a part of international economics in India and the world. For Indian students and others interested in the Indian economy, a study of Indian economy vis--vis the rest of the world should form an integral part of the subject matter of international economics. Such a study helps in formulating an appropriate policy framework for accelerating our economic growth, reducing poverty and unemployment and enhancing our economic welfare.

1.2 International Trade In ordinary language, trade refers to the sale-purchase of goods. The broader meaning of trade, however, is meant to include all those activities as a result of which goods produced in a society are distributed for the purpose of consumption. In other words, trade comprises all human activities which regulate goods from their production to distribution. Trade is normally discussed as inter-regional trade and international trade.


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1.2.1 Meaning of Inter-regional and International Trade

The trade of a company can be divided in two parts:

1. Inter-regional Trade: It refers to the trade which is carried out in different places and regions of the same country. It is also called domestic trade. Trade between Haryana and Punjab or Uttarakhand and Bihar is an example of inter-regional trade.

2. International Trade: It is a trade between two or more than two countries. Trade between India and U.K. is called international or foreign trade. The goods consigned from India to U.K. will be known as India's exports. On the other hand, goods coming from U.K. to India will be called India's imports.

1.2.2 Definitions of International Trade

A few definitions are as under:

1. "International Trade is a trade between nations."- Anatol Murad

2. "International Trade consists of transactions between residents of different countries." - Wasserman and Haltman

3. "International Trade is simply the extension of the trade beyond the boundaries of a nation." - Ellsworth

4. "International Trade means in plain English trade between nations."- Edgeworth

International trade takes place on account of many reasons such as:

z Human wants and countries' resources do not totally coincide. Hence, there tends to be interdependence on a large scale.

z Factors endowments in different countries differ.

z Technological advancement of different countries differs. Thus, some countries are better placed in one kind of production and some others superior in some other kind of production.

z Labour and entrepreneurial skills differ in different countries.

z Factors of production are highly immobile between countries.

In short, international trade is the outcome of territorial division of labour and specialization in the countries of the world.

1.2.3 Salient Features of International Trade

The following are the distinguishing features of international trade:

z Immobility of Factors: The degree of immobility of factors like labour and capital is generally greater between countries than within a country. Immigration laws, citizenship, qualifications, etc. often restrict the international mobility of labour. International capital flows are prohibited or severely limited by different governments. Consequently, the economic significance of such immobility of factors tends to equality within but not between countries. For instance, wages may be equal in Mumbai and Pune but not in Mumbai and London. According to Harrod, it, thus, follows that domestic trade consists largely of exchange of goods between producers who enjoy similar standards of life, whereas international trade consists of exchange of goods between producers enjoying widely differing standards. Evidently, the principles which determine the course and nature of internal and international trade are bound to be different in some respects at least.

In this context, it may be pointed out that the price of a commodity in the country where it is produced tends to equal its cost of production. The reason is that if in an industry the price is higher than its cost, resources will flow into it from other industries, output will increase and the price will fall until it is equal to the cost of production. Conversely, resources will flow out of the industry, output will decline, and the price will go up and ultimately equal its cost of production.

But, as among different countries, resources are comparatively immobile; hence, there is no automatic influence equalizing price and costs. Therefore, there may be permanent difference between the cost of production of a commodity


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in one country and the price obtained in a different country for it. For instance, the price of tea in India must, in the long run, be equal to its cost of production in India. But in the U.K., the price of Indian tea may be permanently higher than its cost of production in India. In this way, international trade differs from home trade.

z Heterogeneous Markets: In the international economy, world markets lack homogeneity on account of differences in climate, language, preferences, habit, customs, weights and measures, etc. The behaviour of international buyers in each case would, therefore, be different.

z Different National Groups: International trade takes place between differently cohered groups. The socio-economic environment differs greatly among different nations.

z Different Political Units: International trade is a phenomenon which occurs among different political units.

z Different National Policies and Government Intervention: Economic and political policies differ from one country to another. Policies pertaining to trade, commerce, export and import, taxation, etc., also differ widely among countries though they are more or less uniform within the country. Tariff policy, import quota system, subsidies and other controls adopted by governments interfere with the course of normal trade between one country and another.

z Different Currencies: Another notable feature of international trade is that it involves the use of different types of currencies. So, each country has its own policy in regard to exchange rates and foreign exchange.

Check Your Progress 1

State whether the following statements are true or false:

1. International Economics can be defined as a sub-branch of economic theory that deals with the discussion of the principles related to international trade and finance.

2. Pure theory and International monetary theory are both the same.

3. International flows of goods and services and resources give rise to payments and receipts in foreign currencies, which change in value over time.

4. The degree of immobility of factors like labour and capital is generally lesser between countries than within a country.

1.3 Basis of International Trade The basic foundations of international trade are as under:

1. International Specialization: One of the basic foundations of international trade is international specialization. It means that different countries of the world specialize in the production of those goods in whose production they possess special resources. International specialization is the result of division of labour. According to Prof. Harrod, ordinarily exchange is the necessary consequence of division of labour. When division of labour crosses national boundaries, there arises foreign trade. International trade, therefore, is an inevitable result of division of labour.

2. Non-availability of a Specific Factor: Every country does not possess all kinds of resources. Some resources may be available in some countries while other countries may be in possession of other resources. For instance, the USA lacks the soil and climate to produce tea and Japan has no iron mines. They have to import these goods. Likewise India has to import tin, as the same is not available here.

3. Difference in Costs: One of the significant causes of international trade is the difference in costs of different goods in different countries. Such a difference may be of two kinds:

(i) Absolute Cost Difference: It means that a country can produce a commodity at an absolutely cheaper cost than the other country. According to the eminent economist Adam Smith, the main basis of international trade is the difference in absolute costs.


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(ii) Comparative Cost Difference: It means that a country can produce all goods at a lower cost than the other country, yet the cost of producing some goods is comparatively less than all other goods. According to Ricardo the main cause of international trade is the comparative difference in costs.

4. Product Differentiation: It is often observed that, a country does import a commodity that she herself can produce. For instance, India produces cloth on a large scale and also exports it; nevertheless she imports different varieties of cloths, such as saris made in Japan and other countries. It is to enable the Indians to consume larger varieties of goods.

1.4 Theories of International Trade

1.4.1 Classical Theories

Theory of Mercantilism (1500-1700)

Mercantilism became popular in the late seventeenth and early eighteenth centuries in Western Europe and was based on the notion that governments (not individuals who were deemed untrustworthy) should become involved in the transfer of goods between nations in order to increase the wealth of each national entity. Wealth was defined, however, as an accumulation of precious metals, especially gold.

Consequently, the aim of the government was to facilitate and support all exports while limiting imports, which was accomplished through the conduct of trade by government monopolies and intervention in the market through the subsidisation of domestic exporting industries and the allocation of trading rights.

The concept of mercantilism incorporates two fallacies. The first is the incorrect belief that old or precious metals have intrinsic value, when actually they cannot be used for either production or consumption. The second fallacy is that the theory of mercantilism ignores the concept of production efficiency through specialisation.

Neomercantilism corrected the first fallacy by looking at the overall favourable or unfavourable balance of trade in all commodities, that is, nations attempted to have a positive balance of trade in all goods produced so that all exports exceeded imports. The second fallacy, a disregard for the concept of efficient production, was addressed in subsequent theories, notably the classical theory of trade, which rests on the doctrine of comparative advantage.

Adam Smith Theory (1800)

Being influenced by individualism around the beginning of the nineteenth century and by the industrial revolution, Adam Smith emphasised the importance of individual freedom. He believed that if the individual was permitted to pursue his or her own interest without interference from the state, he or she would promote the well-being of all by the invisible hand. In his famous book The Wealth of Nations (published in 1776), Adam Smith put forward the theory that international trade would occur in situations where nations had absolute advantages over rival states, i.e. they could produce, with a given amount of labour and capital, larger outputs of certain items than any other country. The flaw in this argument is that it fails to explain why countries with an absolute disadvantage in all their products (i.e. countries which produce less of everything made within the country, using a given amount of labour and capital, than other nations) still engage in international trade. A possible resolution of this question was suggested by the eminent economist, David Ricardo, who, in 1817, alleged that trade among nations resulted from differences in the comparative advantages of countries in the production of various items, not differences in absolute advantage. Ricardo assumed that the cost of producing any good depended only on the amount of labour used in its production, and that firms and workers could not move freely between nations (a reasonable assumption for the early 1800s).

Classical Economic Theory

This theory was based on the economic theory of free trade and enterprise that was evolving at the time. In 1776, in The Wealth of Nations, Adam Smith rejected as foolish the concept of gold being synonymous with wealth. Instead, Smith insisted that nations benefited the most when they acquired, through trade, those goods they could not produce efficiently and produced


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only those goods that they could manufacture with maximum efficiency. The crux of the argument was that costs of production should dictate what should be produced by each nation or trading partner.

Under this concept of absolute advantage, a nation would only produce those goods that made the best use of its available natural and acquired resources and its climatic advantages. Some examples of acquired resources are available pools of appropriately trained and skilled labour, capital resources, technological advances, or even a tradition of entrepreneurship.

Classical theory holds that expanding the labour pool leads to decline in the accumulation of capital per worker, lower worker productivity and lower incomes per person, eventually, causing stagnation or economic decline. Naturally, this theory was proven incorrect by numerous scientific and technological discoveries, which provided for greater efficiencies in production and greater returns on inputs of land, capital and labour. It was also knocked awry by the growing acceptance of birth control as a means of limiting population size.

Factor Endowment Theory

The Eli Heckscher and Bertil Ohlin theory of factor endowment addressed the question of the basis of cost differentials in the production of trading nations. They posited that each country allocates its production according to the relative proportions of all its production factor endowments land, labour and capital on a basic level, and, on a more complex level, such factors as management and technological skills, specialised production facilities, and established distribution networks.

Thus, the range of products made or grown for export would depend on the relative availability of different factors in each country. For example, agricultural production or cattle grazing would be emphasised in such countries as Canada and Australia, which are generously endowed with land. Conversely, in small land mass countries with high populations, export products would centre on labour-intensive articles. Similarly, rich nations might centre their export base on capital-intensive production.

Economist Paul Samuelson extended the factor endowment theory to look at the effect of trade upon national welfare and the prices of production factors. Samuelson posited that the effect of free trade among nations would be to increase overall welfare by equalising not only the prices of the goods exchanged in trade, but also of all involved factors. Thus, according to his theory, the returns generated by use of the factors would be the same in all countries.

In 1933, drawing upon the work of Eli Heckscher, Bertil Ohlin took the Ricardo model a significant step further by linking the source of a countrys comparative advantage to the endowment of its factors of production. This theory, known as the Heckscher-Ohlin model of international trade (or simply, the H-O model) is probably the most widely accepted form of the comparative advantage theory today.

The H-O model focused on two assumptions (1) Goods differ in how much they use certain types of factors of production that is, different goods have different factor intensities; for instance, the manufacture of textiles is labour intensive, while the manufacture of semiconductors is capital intensive; (2) Countries differ with respect to their factor endowments; for instance, one might reasonably argue that India has an abundant supply of labour relative to capital, while the reverse is true of the US. Further, H-O assumed (as Ricardo did) that markets are perfectly competitive and factors are perfectly mobile, but it relaxed the assumption of constant returns to scale in order to allow for decreasing returns to scale. Putting these assumptions together, the main proposition of the H-O model is the following: A country exports those goods that use intensively its relatively abundant factor of production. That is, countries export those goods that they are best suited to produce, given their factor endowments.

Apart from these classical theories, there are two more theories, absolute and comparative cost advantage theories that we will discuss in the next section.

1.4.2 Modern Trade Theories

Strategic Trade Theory

In the last two decades, a new set of models has come into being, using he perspectives of game theory and theories of industrial organisation. While there is no one overarching model, this broad collection of theories and ideas has come to be


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known as strategic trade theories. Most of the models of strategic trade are motivated by the attempt to relax (and explore systematically the implications of) the seemingly restrictive assumptions of the Ricardian and H-O models, such as those relating to perfectly competitive markets, constant or decreasing returns to scale, product homogeneity, per factor mobility, no externalities or spillover effects, and so forth. In the process of doing so, a fresh new set of insights relating to international trade and trade policy has emerged.

The essence of almost all the new models of trade is the recognition that industries are characterised by any or all of the following features: scale, economies (both dynamic and static), product differentiation, imperfect competition, externalities and spillover and, in cases, irreversible investments. Some of the main insights from this literature are as follows:

1. Increasing returns to scale provide a justification for trade for reasons other than comparative advantage, since firms will have the incentive to produce and export in order to lower costs by attaining greater scale economies; an example of a industry where this is an important issue is the commercial airframes industry.

2. Product differentiation can result in intra industry trade, since, within the same industry, the same product can have different brand identities; for example, the US will export certain types of automobiles (Ford Escort) and it will import other types of automobiles (BMWs).

3. Imperfect competition creates rents, and trade policy could shift rents from the foreign country to the home country. For example, the imposition of quotas will increase domestic prices and thus can create rents for foreign producers; the home country government may try to counterbalance it with a subsidy to domestic producers, so as to put price pressure on foreign producers.

4. Externalities and spillover effects (particularly in innovation and R & D) may sometimes provide a justification for industry protection for reasons other than industry infancy or national security. For instance, if process innovations in commodity chip production can create spillovers in the manufacture of specialised chips, then the government may have an incentive to protect the manufacture of commodity chips.

5. Irreversible investments induce an asymmetry between entry and exit costs and can, therefore, lead to hysteretic responses to price or quantity shifts. For instance, firms in the US earth-moving equipment industry (for example, Caterpillar Tractor Company) lost substantial market share in the early 1980, when the US dollar appreciated 35% in real terms against the Japanese yen. Yet firms could not exit markets because the costs of re-entry (for example, rebuilding distribution networks) would be prohibitive. Thus, they had to stay on in many markets despite the fact that they were incurring losses.

Modern Investment Theory

Other theories explain investing overseas by firms as a response to the availability of opportunities not shared by their competitors, that is, they take advantage of imperfections in markets and only enter foreign spheres of production when their comparative advantages outweigh the costs of going overseas. These advantages may be production, brand awareness, product identification, economies of scale, or access to favourable capital markets. These firms may make horizontal investments, producing the same goods abroad as they do at home, or they may make vertical investments, in order to take advantage of sources of supplies or inputs.

Going a step further, some believe that firms within an oligopoly enter foreign markets merely as a competitive response to the actions of an industry leader and to equalise relative advantages. Oligopolies are those market situations in which there are few sellers of a product that is usually mass merchandised. Two examples are the automobile and steel industries. In these situations no firm can profit by cutting prices because competitors quickly respond in kind. Consequently, prices for oligopolistic products are practically identical, and are set through industry agreement (either openly or tacitly).

Thus, firms within an oligopoly must be keenly aware of the actions, market reach, and activities of their competitors. Unless their response to the actions of competitors is following the leader, they will yield precious competitive edges to their competitors. Therefore, it follows that when a market leader in an oligopoly establishes a foreign production facility abroad, its competitors rush to follow suit.


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Thus, the impetus for a firm to go abroad may come from a wish to expand for internal reasons to use existing competitive advantages in additional spheres of operations, to take advantage of technology, or to use raw materials available in other locations. Alternatively, the motive might arise from external forces such as competitive actions, customer requests or government incentives. The final determinant, however, is based in a cost benefit analysis. The firm will move abroad if it can use its own particular advantages to provide benefits that outweigh the costs of exporting or production abroad and provide a profit.

International Product Life Cycle Theory

The international product life cycle theory puts forth a different explanation for the fundamental motivations for trade between and among nations. It relies primarily on the traditional marketing theory regarding the development progress and life span of products in markets. This theory looks at the potential export possibilities of a product in four discrete stages in its life cycle. In the first stage, innovation, a new product is manufactured in the domestic arena of the innovating country and sold primarily in that domestic market. Any overseas sales are generally achieved through exports to other markets, often those of industrial countries. In this stage, the company generally has little competition in its markets abroad.

In the second stage the growth of the product sales tend to increase. Unfortunately, so does competition as other firms enter the arena and the product becomes increasingly standardised. At this point, the firm begins some production abroad to maximise the service of foreign markets and to meet the activity of the competition.

As the product enters the third stage, maturity, exports from the home country decrease because of increased production in overseas locations. Foreign manufacturing facilities are put in place to counter increasing competition and to maximise profits from higher sales levels in foreign markets. At this point, price becomes a crucial determinant of competitiveness. Consequently, minimising costs becomes an important objective of the manufacturing firm. Production also frequently shifts from being within foreign industrial markets to less costly lesser-developed countries to take advantage of cheaper production factors, especially low labour costs. At this point, the innovator country may even decide to discontinue all domestic production, produce only in third world countries, and re-export the product back to the home country and to other markets.

In the final stage of the product life cycle, the product enters a period of decline. This decline is often because new competitors have achieved levels of production high enough to affect scale economies in the production that are equivalent to those of the original manufacturing country.

The international product life cycle theory has been found to hold primarily for such products as consumer durables, synthetic fabrics and electronic equipment, that is, those products that have long lives in terms of the time span from innovation to eventual high consumer demand. The theory does not hold for products with a rapid time span of innovation, development and obsolescence.

The theory holds less often these days because of the growth of multinational global enterprises that often introduce products simultaneously in several markets of the world. Similarly, multinational firms no longer necessarily first introduce a product at home. Instead, they might launch an innovation from a foreign source in the domestic markets to test production methods and the market itself, without incurring the high initial production costs of the domestic environment.

1.5 Absolute and Comparative Cost Advantages Theories The theory of relative advantage deals with the trade of goods and commodities. It is based on the promise that a nation gains by trading with other nations in those goods in which it has an advantage over the other nations in terms of cost of production. This advantage in terms of cost of production could be absolute or comparative.

1.5.1 Theory of Absolute Cost Advantage

In 1976, Adam Smith propounded the theory of absolute cost advantage to combat against the theory of mercantilism.

The concept of absolute cost advantage states that when goods can be produced more cheaply in one country than in another, the first is said to have an absolute cost advantage over the other country. It would be in the interest of both these countries to specialise in the production of the commodity, in which it has an absolute cost advantage and trade. This way the productivity


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of both nations increases and thereby both nations stand to gain. Thus while India can produce tea more cheaply than Great Britain and the latter can produce engineering goods more cheaply than India, it would be in the interest of both countries to concentrate in the production of the goods in which they have absolute cost advantage and then to trade. Of course the cost advantage in production must be greater than the cost of transportation incurred in moving the goods.

Figure 1.1: Absolute Advantage of Trade

Suppose that USA can produce wheat, but not cloth more cheaply than the rest of the world, as follows: 50 bushels of wheat or 25 yards of cloth or any combination of wheat and cloth in between. In the rest of the world, one unit of inputs can produce 40 bushels of wheat or 100 yards of cloth, or any combination in between. From Figure 1.1 it is clear that trade allows both countries to consume at C, out beyond the confines of wheat they can produce themselves. Instead of producing and consuming at points like S0, each country specialises producing at S1. By trading away some of its special product for the one it no longer produces, each is at a better point than S0.

Check Your Progress 2

Fill in the blanks:

1. . wrote the book Wealth of Nations, wherein he mentioned about the invisible hand.

2. As per the ..Advantage Theory, the country should produce wheat if it is the best thing it can do.

3. The final stage in the product life cycle is the stage of .

4. As per principle of . advantage, country should export a commodity that can be produced at a lower cost than can other nations.

1.5.2 Theory of Comparative Cost Advantage

David Ricardo developed the important concept of comparative advantage in considering a nations relative production efficiencies as they apply to international trade. In Ricardos view, the exporting country should look at the relative efficiencies of production for both commodities and make only those goods it could produce most efficiently.

Suppose, for example, in our illustration, that Greece developed an efficient manufacturing capacity so that martini glasses could be produced by machine rather than being hand-blown. In fact, since the development of the productive capacity and capital plants which were newer than those in Sweden, Greece could produce 100 crates of martini glasses using only 200 resource units as opposed to the 300 units required by Sweden. Thus, Greeces comparative costs would fall below that of


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Sweden for both products and its comparative advantage vis--vis those products would be higher. Therefore, the resource units required to produce olives and glasses would now be:

Country Olives (500 crates) Martini Glasses (100 crates)

Sweden 100 units 200 units

Greece 600 units 300 units

Logically, Greece should be the producer of both olives and martini glasses, and Swedens capital and labour used in making these happy-hour supplies should be directed to Greece, so that maximum production efficiencies are achieved. Neither capital nor labour is entirely mobile, however, so each country should specialise Greece in olives at 100 resources units per 500 crates and Sweden in glass production at 300 resource units per 100 crates. Greece is still better off at maximising its efficiencies in olive production. By doing so, it produces twice as many goods for export with the same amount of resources than if it allocated production level.

While Swedens production costs for glasses are still higher than those of Greece at 300 units, the resources of Sweden are better allocated to this production than to expensive olive growing. In this way, Sweden minimises its inefficiencies and Greece maximises its efficiencies. The point is not that a country should produce all the goods it can more cheaply, but only those it can make cheapest. Such trading activity leads to maximum resource efficiency.

The concepts of absolute advantage and comparative advantage were used in a subsequent theory developed by John Stuart Mill who looked at the question of determining the value of export goods and developed the concept of terms of trade. Under this concept, export value is determined according to how much of a domestic commodity each country must exchange to obtain an equivalent amount of an imported commodity. Thus, the value of the product to be obtained in the exchange was stated in terms of the amount of products produced domestically that would be given up in exchange. For example, Swedens terms with Greece would be exporting of 100 crates of glasses for an equivalent 500 crates of olives.

Weaknesses

While the work of Smith, Ricardo and Mill went far in describing the flow of trade between nations, classical theory was not without its flaws. For example, the theory incorrectly assumed.

z The existence of perfect knowledge regarding international markets and opportunities.

z Full mobility of labour and production factors throughout each country.

z Full labour employment within each country.

The theory also assumed that each country has, as its objective, full production efficiency. It neglected such other motives as traditional employment and production history, self-sufficiency or political objectives.

In addition, the theory is overly simplistic in that it deals only with two commodities and two countries. In reality, given the full range of production by many countries and interplay of many motives and factors, the trade situation is actually an ongoing dynamic process in which there is interplay of forces and products.

The largest area of weakness in classical theory is that while all resource units used in production were considered, the only costs considered by classical economists were those associated with labour. The theorists did not account for other resources used in the production of commodities or manufactured goods for export, such as transportation costs, the use of land and capital. This failing was addressed by subsequent trade theorists, who, in modern theory, include all factors of production in looking at theories of comparative advantage.


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Case Study

Core Complexities

Raj Abrader Singh, the 55-year-old CEO of the ` 353 crore Bharat Synthetics, was taken aback at the tone of the letter he had just received from his creditors. Expressing concern at the lack of seriousness in initiating a turnaround strategy, and the inordinate delays in the repayment of loans, it said that Singh should now make way for a new CEO. In the considered view of the consortium of lenders, it said, only a professional manager can steer Bharat Synthetics towards growth. The news was worrisome. Clearly, the letter was a vote of no confidence in Singhs ability to lead the 35-year-old company in a highly competitive market place.

Damn liberalisation! swore Singh. Why did it have to rock my coy world? The economy had opened up all right, but, to his dismay, it had left Bharat Synthetics in a limbo. Or had it? Perhaps I did not read the signals right, he said to himself. After all, economic liberalisation had also created a world of opportunities that many entrepreneurs had grabbed quickly. He wondered if he had done anything wrong by refraining from diversification. Recalling the time, only four years ago, when Bharat Synthetics was perceived as a good investment opportunity, Singh was troubled at the way the tide had changed.

Later, at a luncheon meeting with Abhinav Paul, 54, executive director of the management consultancy firm, Quotient, Singh ruminated. It does not make any sense, he told Paul, who was a childhood friend. I have been practising for years all that management consultants have been preaching Core competence. No unrelated diversification. I was doing well without these fancy buzzwords. I have stuck to man-made fibres throughout my career. Why, then, am I in this mess? And look at my competitors. They did everything that went against present business wisdom. They diversified into unrelated areas one of them even set up a cement plant without giving a damn about core competence. Another ventured into financial services and hoteliering. Still, they seem to prosper.

Interesting, said Paul. You know, although we have never discussed business, I have been tracking Bharat Synthetics progress. Its predicament is typical of what has been happening to many commodity businesses since the economy opened up. Costs, you must understand, are driven by two factors: economies of scale and technology. Bharat Synthetics products are out-priced and no longer competitive. I am aware that after recording profits of ` 34 crore in 1994-95, Bharat Synthetics today has accumulated losses of ` 27 crore, and is unable to service its total debt of ` 60 crore. You have a big crisis on hand. But we could find a way out of the mess. Why did you think of man-made fibres in the first place? Did you have any expertise?

We took the plunge into rayon filament yarn simply because we had a licence to make the product, said Singh. In those days, if you remember, the choice of business was determined by official approvals not market needs. You needed a licence to be competitive. Of course, being a cellulose derivative, rayon was a perfect substitute for cotton. So its manufacture made good business sense. It was also a sellers market. We could sell everything we produced. So we set up a plant in 1963 at Surat, to make rayon yarn. Profits posed no problem, since pricing was done on a cost-plus basis.

I was also keen on improving the quality of our products. So, in 1966, we collaborated with a Japanese company. We also began trading in finer deniers of rayon filament yarn, which are used in the manufacture of chiffon and georgette. A decade later, we commissioned a nylon filament yarn plant in collaboration with an Italian company. Simultaneously, we went into the manufacture of polyester filament yarn (PFY). And, in 1984, we started making nylon cord which is consumed by the tyre industry in collaboration with a Japanese firm. Today, we have four product categories: rayon yarn, which has a capacity of 4,500 tonnes per annum (tpa); nylon yarn (2500 tpa); nylon cord (4000 tpa); and PFY (15000 tpa). And we have been operating at full capacity for years.

Frankly, those capacities look minuscule, said Paul, in relation to global scales of 100,000 plus tpa. And India is gradually becoming a global market. In fact, you are incurring losses despite optimum capacity utilisation. This is a clear indication of poor economies of scale. Was there any synergy among the four products? No, replied Singh. It was the availability of a licence that influenced the choice of products. Each product line is characterised by its own value

Contd


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chain. Except rayon, all others are derived from naphtha. So, a common feedstock was the only link between the products. Which meant that synergy lay in backward integration up to the feedstock.

You mentioned poor economies of scale, continued Singh. That, precisely, is the root of our problems. The government did not permit large capacities when we started because of apprehensions of creating monopolies. Capacities and market shares were fragmented across small players. There are 30 players in the industry today. Scale did not matter for decades because we had large tariff barriers. The import duty on PFY, for instance, was 150 per cent. But with liberalisation, the duty has fallen to 32 per cent today. I dont see any reason why a customer should buy from Bharat Synthetics.

But why didnt you augment capacity even after the licence-permit era ended? asked Paul. After all, most of your competitors have gone in for capacities over 50,000 tpa. For instance, Vimoline Industries has not only set up a 200,000 tpa capacity, it has also integrated backwards, right up to the primary feedstock.

A valid point, conceded Singh. You know, Bharat Synthetics was doing well till the mid-1990s, with operating margins of up to 40 per cent. We were declaring dividends of between 20 and 25 per cent for years, and Bharat Synthetics carried a premium. Our credibility with bankers was high. We rode the textile boom all through the 1980s. We thought the good times would last. We were in no mood to see the flip side.

The classic trap of success, said Paul.

On hindsight. Yes, said Singh. It was only in 1995 when profits began to decline that we thought of expanding polyester capacity. Paradoxically, it triggered off a spiral from which we have not recovered as yet. Since the primary market was languishing, we decided on a rights issue of ` 70 crore in mid-1995 to fund capacity expansion in PFY, and backward integration into polyester chips. But the rights issue flopped. All major shareholders, including our collaborators, renounced their entitlements. The trouble was that we had already taken a bridge loan of ` 40 crore from financial institutions. As the original promoter, I was forced to subscribe to more than 80 per cent of the issue, increasing my stake from 12 to 34 per cent. Unfortunately, the proceeds of the issue were frozen following a court order. Unsure of getting their money back, the institutions had taken the matter to court. Sooner than we realised, we got into working capital problems. And while servicing the debt, our business priorities went haywire. One example: although we imported the plant and machinery, it could not be commissioned for two years for lack of funds.

It is a typical trap that most companies get into, said Paul. I have seen how companies get trapped when cash flows go haywire. The choice of the product is decided by the availability of working capital. You end up making something that costs less to produce but is not the most profitable product. You are compelled to source cheaper raw materials, affecting quality and revenues. Exigency becomes all. I dont know if you have also been facing that situation at Bharat Synthetics.

That is just the paradox at Bharat Synthetics, said Singh. But the fact is that, despite a range of businesses, were a small player in each of them. And none of these businesses is sustainable in the long run because of scale and technology. Take nylon tyre cord. It does not have a future because most tyre manufacturers are now switching to radials that do not use nylon cord. As far as polyester is concerned, there is a glut in India. And our scale is not large enough to warrant a full-fledged business unit. Nylon is threatened by a substitute: polypropylene fibre yarn. And although rayon is the only substitute for cotton, the rate of growth in demand has been a measly 4 per cent per annum. Unfortunately, there are simply no buyers around.

The threat is obvious: technology is changing the rules of the game. Without large-scale economies, you are extremely vulnerable. Your immediate priority is to prevent bleeding. Do you have an action plan? asked Paul. On the operations front, yes, replied Singh. It centres on diversifying the client base and enlarging the end uses of our products. We have developed and successfully test-marketed several types of industrial products. Flame-retardant polyester, in particular, has a big demand. Bharat Synthetics has also developed adhesive-activated polyester industrial yarn, which is used in rubberised goods. We are also making fancy yarn by combining various types of filament yarns. All these products have improved our cash flow substantially.

Contd


14

To cut costs, we are recycling solid waste from the nylon tyre cord and the polyester plants to produce chips and industrial yarn. But none of these initiatives can solve the fundamental problem. The Return on Capital Employed (ROCE) in our business is a measly 3 per cent. There are two redeeming features, though. We have fixed assets worth ` 130 crore. And we have a locational advantage. Surat has one of the largest concentrations of power looms, and one of the largest segments of synthetic yarn users. We are close to the customer.

Close to the customer, repeated Paul. That is interesting. How about the long-term? Well, there are several options, said Singh. In order to generate some quick resources, we will be selling off some unproductive assets like our corporate office in Mumbai. We are also negotiating with some firms for the sale of some of our existing businesses. In fact, that is what the consortium of lenders has proposed. Of course, once we clear our debt, newer options will open up. One option: forward integration, from polyester into textiles and finished products. Another: a joint venture with our technology partner to produce and market polyester yarn. We are also open to the idea of entering into non-textile-related businesses like chemicals and engineering. Bharat Synthetics is also considering a proposal to become a contract manufacturer for a larger player like Vimoline, which is already operating at full capacity.

It is noteworthy that the ROCE is less than the average cost of fresh capital, continued Singh. So, we might be better off selling the business and investing in risk-free financial instruments than in remaining in a business which does not have inherent long-term strengths.

You spoke of Bharat Synthetics being close to the customer, said Paul. There could be a clue there. You also spoke earlier about how you stuck to what you believed was your core competence. Tell me, what do you understand by core competence? Core competence, said Singh, is a process by which you have an edge over the competitor, and which you do well, along with the customer, to create superior value. Bharat Synthetics strength is product quality and customer loyalty. Most power looms in Surat preferred to deal with us than with our competitors. Liberalisation changed those equations. We are no longer cost competitive.

Frankly, said Paul, I dont think you have a clear understanding of the concept of core competence. India is acknowledged to be one of the few countries in the world possessing a natural advantage in processing cotton and cellulose derivatives. That was a start up advantage. But did you build on it? Did you make any attempt to identify the skills that could set you apart from competition? You accessed newer technologies, but did you leverage them fully? Did you strengthen your locational advantages? Did you ever find out where the Indian synthetics market was heading? You have been in the synthetics business for 35 years. How could you not anticipate its future? If you had done that exercise, you would not be in this situation today.

Questions

1. Is there hope for Bharat Synthetics? Are its problems a result of circumstances alone? Or is it all its own doing? Do its business portfolio and product range need a fresh look?

2. What is the impact of Bharat Synthetics products in relation to theory of comparative advantage?

Source: International Marketing: 3rd Edition, P K Vasudeva, Excel Books

1.6 Let us Sum up z International economics deals with the economic interdependence among countries and includes the effects of such

interdependence and the factors which affect it.

z Business strategies, particularly of the large corporations, such as multinational investments, production sharing and global sourcing, joint venturing and other alliances etc. have been increasingly fostering world economic integration and transnationalisation.

z International trade theories have been based on the traditional assumption that factors of production are perfectly mobile within the country and completely immobile between countries.

z International specialization, non availability of factors, difference in costs and product differentiation are bases of international trade.


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z Some of the popular theories of international trade are: Classical theories- Theory of Mercantilism, Adam Smiths Theory, Classical Economic Theory, and Factor Endowment Theory, and Modern theories- Strategic Trade Theory, Modern Investment Theory and International Product Lifecycle Theory.

z More meaningful are relative production costs, which determine whether trade should take place and what items to export or import. According to Ricardos Principle of relative (or comparative) advantage, a country may be better than another country in producing many products but should only produce what it produces the best.

z The Ricardian Model of Comparative Cost is based only on production. Manufacturing centres can move from the developed to the developing countries, which have low labour cost.

1.7 Student Activity Find out more about Adam Smith and his book, The Wealth of Nations.

1.8 Keywords International economics: It is concerned with the effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them.

International trade: Exchange of capital, goods, and services across international borders or territories.

International trade policy: A governmental policy governing trade with third countries.

Balance of payments: A system of recording all of a country's economic transactions with the rest of the world over a period of one year.

Open economy: An economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border.

Absolute Cost Difference: It means that a country can produce a commodity at an absolutely cheaper cost than the other country.

Comparative Cost Difference: It means that a country can produce all goods at a lower cost than the other country, yet the cost of producing some goods is comparatively less than all other good.

1.9 Review Questions 1. What do you think should constitute the subject matter of International Economics?

2. Distinguish between inter-regional and international trade.

3. 'International Trade is only a special case of inter-regional trade'. Do you agree with this view of Ohlin? Give arguments in support of your answer.

4. Explain the basis of international trade.

5. What do you understand by the term "International Economics"? Differentiate it from "international trade".

6. Contrast absolute and comparative cost advantage theories.

7. Discuss the Modern Investment theory and International Product Life Cycle theory.


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Check Your Progress: Model Answers

CYP 1

1. True

2. False

3. True

4. False

CYP 2

1. Adam Smith

2. Relative

3. Downfall

4. Absolute

1.10 Further Readings Kumar, Raj, International Economics, Second Edition, Excel Books, 2011

Sodersten, BO and Reed, Geoffrey, International Economics, Third Edition, Macmillan Press Ltd, 1994

Salvatore, Dominick, International Economics, Eighth edition, Chapter 1

Krugman, Paul R. and Obsfeld, Maurice, International Economics, Theory and policy, 5th Edition, Addison Wesley, Indian Reprint, 2000, Part 1

Chapter 2: Modern Theories on International Trade

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Objectives After studying this chapter, you should be able to understand:

1. The Heckscher-Ohlin model

2. Samuelson models

3. The points of difference between modern theories and classical theories

4. Terms of trade

Introduction The Modern Theory of International Trade was propounded by the Swedish economist Heckscher in an article published in 1919. It was further improved upon by his student Bertil Ohlin in a research paper published in 1924 and later in his book International and Inter-regional Trade published in 1933. This theory does not contradict Comparative Cost Theory of International Trade, rather supports it. According to Comparative Cost Theory, international trade takes place because of difference in comparative costs. But it throws little light on the factors accounting for the difference in comparative costs. On the contrary, modern theory of international trade reveals the causes responsible for difference in comparative costs that account for the international trade.

2.1 Heckscher-Ohlin Model According to this theory, there is difference in factor endowments among different countries of the world. For instance, certain countries have comparatively large supply of labour while in others the supply of capital is relatively large. Because of difference in factor endowments, there is difference in the prices of the factors. Difference in the prices of the factors depends on their relative scarcity or abundance. Owing to difference in the prices of the factors, there is difference in the costs of the goods. Hence this theory states that the main cause of difference in comparative costs is the difference in factor endowment. Thus, international trade takes place because of diversity in factor endowments and hence difference in prices. Each country will export that commodity in the production of which such factor is used whose supply is relatively abundant and price is relatively cheaper. On the other hand, it will import that commodity in the production of which that factor is used whose supply is relatively scarce and price is relatively dearer. According to this theory, conditions of supply alone determine the pattern of international trade. BO Sodersten, writes that some countries have much capital, others have much labour. The theory now says that countries that are rich in capital will export capital intensive goods and countries that have much labour will export labour intensive goods!

2.1.1 Definitions

In the words of Salvatore, The Heckscher-Ohlin Theory states that difference in relative factor endowments and factor prices between nations is the most important cause of trade. This theory predicts that each nation will export the commodity in the production of which a great deal of relatively abundant and cheap factor is used and import the commodity in the production of which a great deal of its relatively scarce and expensive factor is used. The theory also predicts that trade will lead to the reduction in the difference in factor prices between nations.

According to Ohlin, The immediate cause of inter-regional trade is always that goods can be bought cheaper in terms of money than they can be produced at home and here is the case of international trade.


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2.1.2 Assumptions of the Theory

Assumptions of this theory are:

1. This theory relates to two countries, two commodities and two factors. It is, therefore, called 2 x 2 x 2 model.

2. There is same production function for each commodity in two countries.

3. Factors are mobile within the country but immobile between two countries.

4. There is perfect competition in all markets. As a result (a) all factors are fully employed (b) factors get their reward in accordance with their marginal productivity (c) prices of the commodities are equal to their marginal productivity.

5. No restriction is imposed on the exchange of goods, i.e., free trade exists between two countries.

6. Consumers tastes and preferences are identical in the two countries.

7. Technique of production employed in both countries is the same.

8. There is lack of transport costs.

9. Factor endowments are different in both countries.

10. Goods can be classified on the basis of factor intensity, such as capital intensive goods and labour intensive goods etc.

11. Production function of all goods is homogeneous of the first degree. It means that output will be doubled if all factors of production are doubled.

2.1.3 Explanation of the Theory

According to Ohlin International trade is but a special case of inter-regional trade. Different regions have different factor endowments, that is, some regions have abundance of labour but scarcity of capital while other regions have abundance of capital but scarcity of labour. Different goods have different production functions, that is, factors are combined in different proportions to produce different commodities. Some goods are produced by employing relatively large proportion of labour and relatively small proportion of capital. Still other goods are produced by employing relatively small proportion of labour and relatively large proportion of capital. In this way, each region is suitable for the production of those goods for whose production it has relatively abundant supply of the required factors. A region is not suitable for the production of those goods for whose production it has relatively scarce or zero supply of the essential factors. Hence different regions have different capacity to produce different commodities. Difference in factor endowments is, therefore, the main cause of international trade along with inter-regional trade.

According to Ohlin, The immediate cause of inter-regional trade is always that goods can be bought cheaper in terms of money than they can be produced at home and here is the case of international trade. Heckscher in his article, The effect of Foreign Trade on the Distribution of Income published in 1919 had supported the classical theory of comparative costs and maintained that international trade took place because of differences in comparative costs. But classical theory did not explain why there was difference in comparative costs. Answering to this question, Heckscher cites the following causes for difference in comparative costs:

1. Difference in Factor Endowments

2. Difference in Factor Intensities.

According to the Heckscher-Ohlin Theory of International Trade, the immediate cause of international trade is the difference in relative commodity prices. The cause of difference in the relative prices of the goods is the difference in the amount of factor endowments, like capital and labour, between the two countries. As a result, there is difference in the relative demand and supply of factors. These differences cause difference in the prices of the factors. It is due to difference in factor prices that difference in the relative prices of the commodities takes place and it is this difference that constitutes the main cause of international trade. Goods which require scarce factors on a large-scale are imported, because their domestic prices are high. On the contrary, goods which require abundant factors on a large scale are exported, as their domestic prices are low.


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For instance, if capital is abundant in the US, it will be relatively cheap. Hence, the US will export those goods which are capital intensive. On the contrary, if labour is abundant in India, it will be relatively cheap. Hence, India will export those goods which are labour intensive.

2.1.4 Concept of Relative Factor Endowment

Abundance or scarcity of factors in the Heckscher-Ohlin theory has been explained on the basis of two criteria: (i) Price Criterion of Relative Factor Endowment, and (ii) Physical Criterion of Relative Factor Endowment. We shall explain Heckscher-Ohlin theory on the basis of these two criteria.

Price Criterion of Relative Factor Endowment

Price criterion of factor endowment means that a country, where capital is relatively cheap and labour relatively dear, will be called a capital abundant country, even if the quantity of capital in that country is relatively less. On the contrary, if capital is relatively dear and labour relatively cheap, such a country will be called a capital scarce country, even if the quantity of capital in such a country is relatively more. In other words, the criterion of factor abundance or factor scarcity is not the quantum of the factor but its price.

On the basis of price criterion, international trade theory can be explained with the help of an example.

Diagrammatic Explanation: Let us take the US and India as two trading countries. It is assumed that the US is a capital-intensive country and India is a labour intensive country. So that capital is cheaper in the US in relation to labour; and labour is cheaper in India in relation to capital. This can be expressed in terms of the following equation:

US India

K

L

P

P

(Here Ku = Quantity of Capital in US; Lu = Quantity of Labour in US; Ki = Quantity of Capital in India; Li = Quantity of Labour in India)

The US will produce capital intensive and India, labour intensive goods. It is illustrated in Figure 2.2, UU1 is the production possibility curve of the US and II1 is the production possibility curve of India.

Figure 2.2: Physical Criterion of Relative Factor Endowment

Y

R

E

F

I

U 2

XP2P1I1U1

Shirts O

P 1

Wat

ches

P

Labour intensive production i.e., shirts is shown on the OX-axis and capital intensive production, i.e., watches is shown on the OY-axis. If both the countries produce both the goods in the same ratio, then they will produce along OR-ray. The US will produce at point E of its production possibility curve UU1 and India will produce at point F of its production possibility curve II1. It is evident from this figure that at point E, the slope of production possibility curve of the US is steeper and at point F while the slope of production possibility curve of India is flatter. It is clear from the fact that P1P1 price line of the US is steeper than P2P2 price line of India. It proves that watches are cheaper in the US and shirts are cheaper in India. The US should produce more of capital intensive goods viz. watches. It may, however, be noted that the above analysis does not clarify whether the US will export watches and India shirts. Answer to this question depends on the demand for these goods. If the domestic demand of the US for watches is less than the supply, then alone it will export watches, otherwise not. Likewise, India too will export shirts only if domestic demand for shirts is less than the supply.

2.1.5 Factor Price Equality and International Trade

According to modern theory, international trade is responsible for bringing about equality in the factor prices of the countries concerned. Supposing, there is, trade between two countries, namely India and the US. Because of abundant supply of labour wage-rate in India will be low and as such labour intensive goods will be produced. On the other hand, because of abundant supply of capital, interest-rate in the US will be low and as a result, capital intensive goods will be produced. In this way, India will export labour intensive goods to the US and the US will export capital intensive goods to India. As India will export more and more of labour intensive goods, demand for labour will go on increasing and hence wages will also go on rising. Likewise, as India will import more and more of capital intensive goods, demand for capital in India will go on decreasing and hence the price of capital, i.e., rate of interest will go on falling. Similarly, capital will become expensive and labour cheap in the US. Ultimately, a stage will come when rising wages in India will become equal to falling wages in the US. It can, therefore, be said that prices of the factors in India and the US will become equal owing to international trade.


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2.1.6 Main Implications of Heckscher-Ohlin Theory

The discussion of Heckscher-Ohlin theory of international trade reveals the following main points of implications:

1. Ohlin has highlighted in his theory The Principle of Mutual Interdependence.

2. The basis of international trade between two countries is The Difference in Factor Endowments.

3. The causes of difference in comparative costs are due to Difference in Factor-Endowments.

4. International Trade is a Special Case of Inter-regional Trade.

5. According to Ohlins theory International Trade promotes Factor price Equalization in the long run in the Trading Countries.

2.2 Samuelson Models Paul Samuelson is considered by many to be the founder of neoclassical economics. In welfare economics he helped to establish the criteria for deciding whether an action will improve welfare; these criteria came to be known as the Lindahl-Bowen-Samuelson condition. Samuelson is predominantly acknowledged for his public finance theory on determining the optimal allocation of resources in the presence of both public goods and private goods. Finally, Samuelson has influenced international economics through two important theories of international trade: the Balassa-Samuelson effect (consumer price levels are systematically higher in wealthier countries than in poor countries) and the Hecksher-Ohlin model (a General equilibrium mathematical model of the macro economy in international trade), in which the Stolper-Samuelson theorem (a basic theorem in trade theory which describes a relation between the relative prices of output goods and relative factor rewards) is utilized.

2.2.1 Balassa-Samuelson Effect

It has become conventional wisdom in economics that richer countries tend to have higher overall costs of living than poorer countries. Typically this is measured in terms of the real exchange rate, which compares the consumer price indexes of two countries converted to a common currency using the nominal exchange rate. This empirical observation has been referred to as the Penn effect, after the Penn World Tables data used to measure it, or alternatively as the Balassa-Samuelson effect, after the economists who wrote about the observation and endeavored to explain it. One important implication of this observation is that it indicates a systematic deviation from the theory of purchasing power parity, which is a building block in exchange rate theory. It indicates that there is a role for economic fundamentals such as relative income levels in explaining long-run real exchange rate behavior.

Although numerous theories have been proposed over time to explain this systematic relationship between the real exchange rate and income levels, by far the most influential is that proposed in 1964 in two separate papers by Bela Balassa and Paul A. Samuelson. The theory is based on the divergence of productivity levels in a world of traded and non-traded goods, explaining that rich countries specialize in and produce goods that are characterized by higher productivity and that are easily traded internationally. (Because this basic idea is also found in an earlier book by Roy F. Harrod in 1933, the theory is sometimes referred to as the Harrod-Balassa- Samuelson effect. This entry will follow the convention of referring to the empirical observation and the theoretical explanation jointly as the Balassa- Samuelson effect.)

Many early empirical studies failed to find statistical support for the connection between relative prices and income levels. It was even more difficult to find statistical evidence of a linkage to the underlying causal factors that the Balassa-Samuelson hypothesis said should be at work, such as between exchange rates and relative productivity levels (see Officer 1982). It appears, however, that the strength of the Balassa-Samuelson effect has grown steadily over time. Recent statistical studies of the second half of the 20th century find that for a large sample of countries the relationship between relative national price levels and income levels became positive as well as statistically significant only in the 1960s, thus validating the Balassa-Samuelson hypothesis (for instance, see Bergin, Glick, and Taylor 2006). It may not be a coincidence that Balassa and Samuelson began writing on the subject at this time. Further, the correlation between these two variables appears to have quadrupled over the half-century since then, and it is very strongly significant statistically in current data.


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The Theory of Balassa-Samuelson

How exactly are positive correlations between national price levels and income levels related to the Balassa-Samuelson effect? There is a specific way of explaining these correlations, based on differences in productivity levels across countries and goods. Here is a simple version of the theory with an intuitive example to follow.

Consider two countries, home and foreign, where foreign variables are denoted with an asterisk (*). Let there be two goods produced in these countries, where one good (t) can be traded internationally, and the other is a non-traded good (n). Traditional, albeit imprecise, examples of this distinction would be manufactured goods as traded and services as non-traded. For simplicity, suppose these goods are produced competitively in each country, using only labor as an input, with wages W and W* in each country. Denote the labor productivity in each sector as AT and AN at home, and AT and AN in the foreign country.

If one assumes that trade is costless for the traded good, its price will be equalized in the two countries. Conveniently, this also pins down the relative wage levels in the two countries, since WAT = PT = P*T = W* A*T. The wage levels, in turn, pin down the non-traded goods prices with WAN = PN and W*A*N = P*N. Now construct a simple consumer price index, say, where the share of expenditure on non-traded goods in consumption is constant at the value y in both countries. Then the relationship between the price levels of the two countries is given by:

This equation predicts that a country will have a higher overall price level if it is highly productive in traded goods, relative to its own non-traded goods, and relative to the traded goods of the foreign country. If one country is richer than the other, this higher income level can be due to higher productivity in the non-traded goods, the traded goods, or some combination of the two. The theory says that the larger the role of productivity growth specifically in the traded sector, the more likely it will be that high relative income levels will be associated with high relative price levels. On the other hand, if a country is richer due to higher productivity in the non-traded sector, or high productivity equally over both sectors, then the model will not predict that the rich country will have a higher overall price level.

As an intuitive and commonly invoked example of the Balassa-Samuelson effect at work, suppose that the home country is rich because it is very good at producing a manufactured good like automobiles, but it has no productivity advantage relative to the foreign country in terms of a non-traded service like haircuts. The high productivity of home workers in the auto industry affords them a high wage. But it also requires that the wage be high for haircuts, or else no worker would be willing to provide this service, preferring instead to work in the auto industry. Given that a haircut requires the same amount of labor time in each country, but the wage rate paid to the haircutter is higher at home, it is clear that the price of haircuts will be higher at home. Since the purchase price of autos is the same across countries due to arbitrage through trade, the higher price of haircuts makes the overall cost of living higher in the home country.

Implications and Assessment of the Theory

The Balassa-Samuelson theory is used regularly by economists and policymakers to interpret a range of applied issues. Note that a straightforward extension of the theory from levels to changes would imply that countries with faster growth rates in the traded sector would have real exchange rates that are appreciating over time. For example, it predicts that China or other rapidly developing countries might expect pressure for their real exchange rates to appreciate as a natural counterpart to their rapid growth in productivity. Similarly, the theory predicts that if new accession countries joining the European Monetary Union experience a period of accelerated growth as they catch up to richer European countries, they likewise should expect pressure for real appreciation. Since a monetary union effectively implies that the exchange rate is fixed, this pressure should be expressed in this case as a higher inflation rate for countries with higher growth rates. The principle remains the same: higher rates of growth are associated with a rise in the relative cost of living.

The prevalence of the theory behind the Balassa-Samuelson effect in economics owes much to its elegant explanation of the basic price-income relationship. But it has received criticism for the assumptions needed to derive it. There is evidence that productivity gains, especially recently, are not limited to manufactured goods, but that the wealth of relatively rich countries is


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in part attributable to significant productivity gains in many services, such as information technology and retail. Furthermore, it also appears to be true that many services, especially information services, are becoming more tradable due to new telecommunications technologies. As changes in technology and transportation costs lead to significant changes in the volume of trade and even the types of goods and services that are most traded, it is not entirely clear what the future holds for the Balassa-Samuelson effect.

2.2.2 Stolper Samuelson Theorem

The Stolper-Samuelson theorem is a remarkable theorem: it says that in a world with two goods and two factors of production, where specialization remains incomplete (plus a few more technical assumptions); one of the two factorsthe one that is "scarce"must end up worse off as a result of opening up to international trade. Not in relative terms, but in absolute terms. But the theorem is also quite limited in its applicability. It applies only to a case with two goods and two factors that is why its real world relevance is always in question.

But there is a version of the theorem that is remarkably general and powerful. It says that regardless of the number of goods and factors, at least one factor of production must experience a decline in real income from trade as long as trade induces the relative price of some domestically produced good(s) to fall (and as long as the productivity benefits from trade are restricted to the traditional, inter-sectoral allocative efficiency improvements, about which more later). All that this result requires is a very mild assumption, namely that goods be produced with varying factor intensities (i.e., use different combination of factors). The stark implication is that someone will lose, even if the nation as a whole becomes richer.

Case Study

BPO: Bane or Boon for Indian Companies?

Several MNCs are increasingly unbundling or vertical disintegrating their activities. Put in simple language, they have begun outsourcing (also called business process outsourcing) activities formerly performed in-house and concentrating their energies on a few functions. Outsourcing involves withdrawing from certain stages/activities and relaying on outside vendors to supply the needed products, support services, or functional activities.

Take Infosys, its 250 engineers develop IT applications for BO/FA (Bank of America). Elsewhere, Infosys staffers process home loans for green point mortgage of Novato, California. At Wipro, five radiologists interpret 30 CT scans a day for Massachusetts General Hospital. 2500 college educated men and women are buzzing at midnight at Wipro Spectramind at Delhi. They are busy processing claims for a major US insurance company and providing help-desk support for a big US Internet service providerall at a cost up to 60 percent lower than in the US. Seven Wipro Spectramind staff with Ph.Ds in molecular biology sifts through scientific research for western pharmaceutical companies.

Another activist in SPO is Evalueserve, headquartered in Bermuda and having main operations near Delhi. It also has a US subsidiary based in New York and a marketing office in Australia to cover the European market. As Alok Aggarwal (co-founder and chairman) says, his company supplies a range of value-added services to clients that include a dozen Fortune 500 companies and seven global consulting firms, besides market research and venture capital firms. Much of its work involves dealing with CEOs, CFOs, CTOs, CIOs, and other so -called C-Level executives.

Evalueserve provides services like patent writing, evaluation and assessment of their commercialization potential for law firms and entrepreneurs. Its market research services are aimed at top-rung financial service firms, to which it provides analysis of investment opportunities and business plans. Another major offering is multilingual services. Evalueserve trains and qualifies employees to communicate in Chinese, Spanish, German, Japanese and Italian, among other languages. That skill set has opened market opportunities in Europe and elsewhere, especially with global corporations.

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