Lecture 1 introduction to international trade

Introduction
What 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 Unit
Balance 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 [+]

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+X
Rearranging the equation
X-M = S-I+T-G
In 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 Trade
Deficit Surplus
Increase 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.

Lecture 1 introduction to international trade

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