Lecture 1 introduction to international trade

IntroductionWhat Is International Trade?

• International trade is the exchange of goods and services between countries

• Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available in their own countries.

•Almost every kind of product can be found on the international market: food, clothes, spare parts, oil, jewelry, wine, stocks, currencies, water.. etc.

• Services are also traded: tourism, banking, consulting and transportation

• If there is a trade of goods and services, then there will be a money flow; inflow and outflow

• Reason for Trade #1: Differences in Technology

Advantageous trade can occur between countries if the countries differ in their technological abilities to produce goods and services.

Technology refers to the techniques used to turn resources (labor, capital, land) into outputs (goods and services).

• Reason for Trade #2: Differences in Resource Endowments

Advantageous trade can occur between countries if the countries differ in their endowments of resources.

Resource endowments refer to the skills and abilities of a country’s workforce, the natural resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital stock (machinery, infrastructure, communications systems).

• Reason for Trade #3: Differences in Demand Advantageous trade can occur between countries if

demands or preferences differ between countries. Individuals in different countries may have different preferences or demands for various products.

For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price.

Canadians may demand more beer,

The Dutch more wooden shoes, and The Japanese more fish than Americans would, even if

they all faced the same prices.

• Reason for Trade #4: Existence of Economies of Scale in Production

The existence of economies of scale in production is sufficient to generate advantageous trade between two countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as “increasing returns to scale.”

• Reason for Trade #5: Existence of Government Policies

Government tax and subsidy programs alter the prices charged for goods and services.

These changes can be sufficient to generate advantages in production of certain products.

In these circumstances, advantageous trade may arise solely due to differences in government policies across countries.

• Some Important Concepts

Export and Import: A product that is sold to the global market is an export, and a product that is bought from the global market is an import. Imports and exports are accounted for in a country's current account in the balance of payments.

Trade surplus: An economic measure of a positive balance of trade, where a country's exports exceeds its imports.

Sri Lanka Trade Last Previous Highest Lowest UnitBalance of Trade

-702.90 -782.90 -50.10 -1100.70 USD Million [+]

Exports 882.50 707.50 1069.90 304.80 USD Million [+]Imports 1585.50 1490.50 1986.40 408.00 USD Million [+]Current Account -88525.00 -109512.00 30854.90 -189897.00 LKR Million [+]

Current Account to GDP

-2.70 -3.70 -0.40 -19.30 percent [+]

External Debt 3069400.00 3113100.00 3272700.00 70173.30 LKR Million [+]Terms of Trade 94.30 116.40 161.24 74.50 Index Points [+]

Tourist Arrivals 1527153.00 1274593.00 1527153.00 39654.00 [+]Gold Reserves 23.10 22.23 23.10 3.63 Tonnes [+]

Foreign Direct Investment

128.00 351.00 386.00 20.00 USD Million [+]

Remittances 537.70 585.90 708.84 241.34 USD Million [+]

Trade openness index

• index (also often called the openness index ) is a measure of the importance of international trade in the overall economy. It can give an indication of the degree to which the economy is open to trade. Formula is (Exports + Imports)/(Gross Domestic Product)

• Eg: Sri Lanka 53 in 2014

Efficiency of Trading Globally

• Global trade allows wealthy countries to use their resources - whether labor, technology or capital - more efficiently. Because countries are endowed with different assets and natural resources (land, labor, capital and technology).

• some countries may produce the same good more efficiently and therefore sell it more cheaply than other countries.

• If a country cannot efficiently produce an item, it can obtain the item by trading with another country that can. This is known as specialization in international trade.

• Balance of payments (BOP): The balance of payments of a country is the record of all economic transactions between the residents of a country and the rest of the world in a particular period (over a quarter of a year or more commonly over a year). These transactions are made by individuals, firms and government bodies.

Relation of Foreign Trade to National Income:

•The impact of international trade can be judged from the balance of payments of a country.

•When the exports of a country exceed its imports, there is a flow of money income into the country and the level of national income and employment goes up. On the other hand, when imports exceed exports, there is a withdrawal of national income.

•How much the volume and value of exports of a country will be depends upon the extent of the market for the goods of the country

The national income equation thus is:

Y = C + I + G + (X – M)  X and M stand for export and import respectively

Advantages of international trade

• Nations with strong international trade have become rich and have the power to control the world economy.

• The global trade can become one of the major contributors to the reduction of poverty.

• The rise in the international trade is essential for the growth of globalization

Some more advantages• (i) Economy in the Use of Productive Resources: Each

country tries to produce those goods in which it is best suited. As the resources of each country are fully exploited, there is thus a great economy in the use of productive resources.

• (ii) Wider Range of Commodities: International trade makes it possible for each country to enjoy wider range of commodities than what is otherwise open to it. The commodities which can be produced at home at relatively higher cost can be brought from the cheaper market from abroad and the resources of the country thus saved can be better employed for the production of other commodities in which it is comparatively better fitted.

• (iii) Scarcity of Commodities: If at any time there is shortage of food or scarcity of other essential commodities in the country, they can be easily imported from other countries and thus the country can be saved from shortage of commodities and low standard of living.

• (iv) Promotes Competition: International trade promotes competition among different countries. The producers in home country, being afraid of the foreign competition, keep the prices of their products at reasonable level.

• (v) Speedy Industrialization: International trade enables a backward country to acquire skill, machinery; and other capita! equipment from industrially advanced countries for speeding up industrialization.

• (vi) Fall of Prices prevented: A country can export her surplus products to a country which is in need of them. The home prices are, thus, prevented from falling.

• (vii) Extension of Means of Transport: When goods are exchanged from one county to another, it leads to an extension of the means of communication and transport.

• (viii) Socio-Economic intergration: International trade offers facilities to the citizens of every country to come in contact with one another. it makes them realize that no country in the world is self-sufficient. It thus promotes peace and goodwill among nations.

Disadvantage of international trade• International trade has its own demerits/disadvantages. These,

in brief are as follows: • (i) Exhaustion of Resources: In order to earn present export

advantages a country may exploit her limited natural resources beyond proper limits. This may lead to exhaustion of essential material resources like iron, coal, oil, etc. The future generation thus stands at a disadvantage.

• (ii) Effect on Domestic Industries: If no restrictions are placed on the foreign trade, it may ruin the domestic industries and cause widespread distress among the people.

• (iii) Effect on Consumption Habits: Sometimes it so happens that the traders in order to make profits import commodities which are very harmful and injurious to the people For instance, if opium, wine, etc., are imported, it will adversely affect the health and morale of the people.

• (iv) Times of Emergency: If each country specializes in the production of those commodities in which it has comparative advantage over other countries, it may prove very dangerous rather fatal during times of emergency like war. The country may not be able to get essential supplies Thus the whole economy may be crippled.

• (v) Provides Foothold to the Foreigners: Foreign trade provides foothold to the foreigners in the country. It is in fact a pretext for a thorough political and economic subjugation of the weak by the powerful country Pakistan and India cannot forget as to how the Britishers came under the garb of traders here.

• We cannot deny this fact that international trade has certain evil consequences but if it is properly controlled, it can prove very beneficial for all the countries of the world.

• The general opinion is that an excess of imports over exports, a trade deficit, is bad for an economy while an excess of exports over imports is considered to be good economic news.

• However, to clarify the role of imports and exports in an economy, it is better to examine the interactions among the components of GDP.

Trade Balance and the National Income Accounting

• Since the balance of payments is an important component of GDP the BOP is also important of interest of business people and policy makers.

• For business people trying to keep track of the performance of the economies in which they do business, information on BOP and its components is important.

National Income Accounting

• National Income Accounting refers to the calculation of GDP and the subdivision of GDP into various components. Included in the various components of GDP are exports and imports

• Understanding these relationships will make it easier to interpret how economic events affect not only international trade but also the overall economy.

• The Measurement of GDP: GDP is the market value of all final goods and services a country produces in a year.

• In other words, GDP is a country’s total output, measured in the country’s currency, with each good or service valued at its current market price.

• Another way of looking at GDP is to consider it as the summation of expenditures by different components of the economy.

• GDP is composed of four components that are public consumption (C); gross private domestic investment (I); government spending on goods and services (G); net exports (X-M).

• Exports and imports are just a part of total economic activity (GDP) but putting them together simultaneously with the other components of GDP allows us to understand their role as a part of the total.

• GDP in a closed economy: Y=C+I+G

• GDP in an open economy: Y=C+I+G+ (X-M)

• Why we subtract the value of imports from? because consumers in an open economy may buy

imported goods and services.

• What happens if the domestic demand for goods and services is larger than the economy is capable of producing?

• The economy would have to import the difference from other countries. This would produce a trade deficit, as imports would exceed exports.

• The reverse would be true if the economy were producing more goods and services than are consumed domestically.

• A country GDP measures not only the final output of goods and services it produces, but also measures a country’s total income. This stream of income goes to the factors of production in the form of rent, wages, interest, and profits.

• The public in turn spends this income on goods and services. Money moves in a circular flow from business to the public and back again.

• Although a country’s total income is equals GDP, not all income flows are immediately spent on goods and services.

• Some income is temporarily withdrawn from this circular flow. This income referred to as outflows of income.

• There are three sources for outflows of income. 1. savings- a withdrawal of spending on goods and

services. 2. Government taxes 3. Imports-reduced spending on domestically

produced goods and services.

• These outflow of income don’t disappear from the economy, but will be injected back to the economy.

• These activities can be thought of as injections of income back into the circular flow.

• Injections Savings—Investment Taxes-Government spending The last injection of spending into the economy is

foreigners’ purchases of domestically produced goods and services. Therefore

Imports-Exports The injection of exports can be thought of as a potential

offset to, or replacement for, the outflow, imports.

• For any economy the sum of the outflows of income must equal the sum of the injections of income:

S+T+M=G+I+XRearranging the equation X-M = S-I+T-GIn this case, some time the trade balance becomes the

mismatch between private saving (S), government saving (T-G), and investment (I).

When the outflows (S+T) are greater than the injections of spending (G+I), then the trade balance (X-M) will be positive.

When the sum of saving and taxes is less than the sum of government spending and investment, the trade balance (X-M) will be negative.

This equation shows that the trade balance is just the difference between the sum of outflows of income (S+T) and domestic injections of income (G+I)

Strategies to Reduce Trade Balances With the equation X-M=S-I+T-G, It is widely

suggested that country with trade deficit or surplus has four strategies to reduce the imbalance.

Methods Available Reduce Trade to Imbalance

Country has TradeDeficit SurplusIncrease private savings

Decrease private savings

Increase government taxes

Decrease government taxes

Decrease business investment

Increase business investment

Decrease government spending

Increase government spending

• First, everything else being equal, increasing the level of saving would tend to reduce the trade deficit. As S increases on the right hand side of the equation, there would have to be a change in X-M

E.g: in the U.S., savings declines from 8% to 5% during 90s contributed trade deficit.

This strategy is difficult for the government policy to increase the amount of saving.

• The second strategy would be to change the level of business investment. If I falls with no change in savings or the government budget, then the trade balance would tend to move from a larger negative number to a smaller negative number.

• Since potential GDP’s growth rate is positively correlated to the amount of investment, economic policy makers do not advocate this type of strategy.

• The short-run solution of decreasing investment spending might cause long-run economic growth decline.

• Therefore increasing the level of investment relative to saving may worsen the trade deficit, but it may improve economic growth.

• The third strategy to reduce the trade deficit would be to increase taxes. Increasing taxes without increasing government spending would either reduce the government budget deficit or produce surplus.

• The results of increasing tax without increasing government spending is similar to an increase in the level of saving. In this case the means of increasing the level of saving is clear. This would tend to reduce a trade deficit in the same way that increasing the level of saving does.

• Changing government spending is the fourth strategy. Reducing the level of government spending would tend to reduce the trade deficit, and reducing government spending in conjunction with raising taxes has the potential to reduce the trade deficit to a greater extent than either policy used in isolation.