UNIT 2: TERMS OF TRADE.►

UNIT 1: INTERNATIONAL TRADE THEORIES.

  • UNIT 1: INTERNATIONAL TRADE THEORIES.

    Key unit competence: 
    Analyze the importance of international trade to the development of the 
    economy.
    Introductory Activity
    International trade is in principle, not different from domestic trade as the 
    motivation and the behaviour of parties involved in a trade do not change 
    fundamentally regardless of whether trade is across a border or not. 
    However, in practical terms, carrying out trade at an international level is 
    typically a more complex process than domestic trade. The main difference 
    is that international trade is typically more costly than domestic trade. This 
    is due to the fact that a border typically imposes additional costs such as 
    tariffs, time costs due to border delays, and costs associated with country 
    differences such as language, the legal system, or culture (non-tariff 
    barriers). (Source: https://en.wikipedia.org 10/12/2019)
    Required:
    i) iWhat do you understand by the terms international trade and 
    domestic trade?
    ii) What makes the two types of trade different?
    iii) How do countries get involved in international trade? 
    iv) From the above extract, what makes international trade costlier than 
    domestic trade? 
    v) According to the extract above, if in practical terms, carrying out 
    trade at an international level is typically a more complex process 
    than domestic trade, why then, do countries go ahead to take part 
    in it?
    1.1. International trade
    Activity 1.1
    Analyse the images below and answer the questions that follow.

    Category A

    Category B 
    Required:
    a. In terms of trade, how are the two categories above different?
    b. Supposing those commodities shown in the categories above are 
    either entering or leaving out of the country, what specific name is 
    given to each case?
    c. How do we call that trade in such commodities, in case they are 
    exchanged;
    i) Within the boundaries of a country where they are produced?
    ii) Across the borders of the country of production?
    d. What makes it different to trade within the country’s boundaries and 
    across her territories?
    1.1.1: Meaning of International trade.
    International trade is the exchange of capital, goods, and services across 
    international borders or territories, which could involve the activities of 
    the government, companies and individuals. In most countries, such trade 
    represents a significant share of gross domestic product (GDP). Almost every 
    kind of product can be found on the international market: food, clothes, spare 
    parts, oil, jewelry, wine, stocks, currencies and water. Services are also traded: 
    tourism, banking, consultancy and transportation. Therefore, trading globally 
    gives consumers and countries the opportunity to be exposed to new markets 
    and products.
    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. Without international trade, 
    nations would be limited to the goods and services produced within their own 
    borders. Whereas International trade constitutes those activities involving the 
    exchange of goods and services across national boundaries, domestic trade 
    involves exchange of commodities within the boundaries of a country. Therefore, 
    international trade differs from domestic trade in the following aspects:
    - Transactions in domestic trade involve the use of one currency, normally 
    the national currency or legal tender. While for international trade though, 
    various currencies may be involved. 
    - Trade within a country is not subjected to barriers restricting the movement 
    of goods internally. On the contrary, movements of goods across national 
    boundaries are subjected to varying degrees of restrictions, i.e. tariffs, 
    quotas. 
    - Goods exchanged in domestic trade tend to be more standardized than 
    goods in international trade. For instance, they are legally all measured 
    either in metric or imperial standard measurement. If they are vehicles, they 
    may have to conform to either being left-hand or right-hand drive vehicles. 
    Hence, local production is for a standardized market. But in international 
    trade, producers are confronted with different markets and may have a 
    variety of different standards for different markets to fulfill.
    - The paper work involved in domestic trade is normally less voluminous 
    compared to that involved in international trade. There is hardly any paper 
    work involved in the domestic trade.
    - International trade is typically costlier than domestic trade. The reason is 
    that a boarder typically imposes additional costs such as tariffs, time costs 
    due to boarder delays and costs associated with country differences such 
    as language, the legal system or culture which isn’t the case with domestic 
    trade.
    - Factors of production such as capital and labour are typically more mobile 
    within a country than across countries. 
    1.1.2: Forms of international trade:
    Activity 1.2
    Visit the library or any other economics resource Centre, make research on 
    international trade and thereafter, answer the following questions herein.

    Basing on the photos above: 
    i) Describe the trade relations involved in the images A, B, C and D. 
    ii) Identify the countries involved in the trade relations according to 
    images A, B C and D.
    iii) Identify and explain different terms used in international trade.
    There are majorly two forms of international trade, namely;
    a) Bilateral trade; 
    Bilateral trade or clearing trade or side deal is the exchange agreement between 
    two nations or trading groups that gives each party favored trade status 
    pertaining to certain goods obtained from the signatories. Or the exchange 
    agreement of goods and services between two nations promoting trade and 
    investment. The two countries will reduce or eliminate tariffs, import quotas, 
    export restraints, and other trade barriers to encourage trade and investment. It 
    varies depending on the type of agreement, scope, and the countries that are 
    involved in the agreement. 
    Examples of bilateral trade agreements in Rwanda include, 
    The United States and Rwanda signed a Trade and Investment Framework 
    Agreement (TIFA) in 2006, and a Bilateral Investment Treaty (BIT) in 2008. 
    Rwanda has active bilateral investment treaties with Germany (1969), Belgium-
    Luxemburg Economic Union (1985), and the Republic of Korea (2013). Rwanda 
    signed bilateral investment treaties with Mauritius (2001), South Africa (2000), 
    Turkey (2016), Morocco (2016), the United Arab Emirates (2016), and Qatar 
    (2018). The goals of bilateral trade agreements are to expand access between 
    two countries’ markets and increase their economic growth. 
    b) Multilateral trade; 
    Multilateral trade refers to the exchange of commodities among more than 2 
    countries or multilateral agreements are commerce treaties among three or 
    more nations. The agreements reduce tariffs and make it easier for businesses 
    to import and export. Since they are among many countries, they are difficult to 
    negotiate. That same broad scope makes them stronger than other types of 
    trade agreements once all parties sign. Some regional trade agreements are 
    multilateral, for example, The African Continental Free Trade Area (AfCFTA), The 
    East African Community (EAC), The Common Market for Eastern and Southern 
    Africa (COMESA) and all global trade agreements are multilateral. The most 
    successful one is the General Agreement on Trade and Tariffs [GATT]. 
    1.1.3: Terminologies used in international trade.
    i) Exports; these are commodities sold from one country to other countries.
    ii) Imports; these are commodities that are bought from one country to 
    another country.
    iii) Export trade; this is the selling of commodities from one country to 
    another.
    iv)Import trade; this is the buying of commodities from one country to 
    another.
    v) Visible trade; this is the exchange of commodities that involve only 
    goods. i.e. exchange of tangible or physical commodities between or 
    among countries.
    vi)Invisible trade; this is the exchange that involves only services. i.e. 
    exchange of intangible commodities like education, insurance, health, 
    tourism etc.
    vii) Entrepot trade; this is the type of trade where goods are imported by a 
    country for purposes of re-exporting them to another country.
    viii)Balance of trade; this is the relationship between visible exports and 
    visible imports. The relationship can be positive, thus favourable balance 
    of trade or negative, thus unfavourable balance of trade.
    ix)Vent for surplus; this refers to the theory which emphasizes increased 
    exploitation of domestic idle resources so as to increase exports or foreign 
    exchange hence increasing country’s GDP.
    x) Open economy; this is an economy which is involved in international 
    trade.
    xi)Closed economy; this is an economy which is not engaged in 
    international trade at all.
    xii) Gains from trade; these are advantages which accrue from international 
    trade.
    Application activity 1.1
    1. Why do you think Rwanda participates in international trade?
    2. Examine the arguments for and against each trade relations named 
    above.
    1.2. Advantages, disadvantages and limitations of 
    international trade.
    Activity 1.3
    International trade allows countries, states, brands, and businesses to buy 
    and sell in foreign markets; this diversifies the products and services that 
    domestic customers can receive. However, international trade is not without 
    its problems. One country can profit greatly from it by exporting, but not 
    importing goods and services. It can also be used to undercut domestic 
    markets by offering cheaper, but equally valuable goods. (https://vittana.org)
    Required:
    c) Identify some of the benefits and costs of international trade cited 
    above.
    d) What other benefits and costs are likely to come out of international 
    trade.
    e) Explain what you think might be the hindrances to smooth international 
    trade.
    1.2.1: Advantages or arguments for International Trade.
    International trade is a basic feature of economic activities in every country. At the 
    same time, nearly every country in the world seeks to participate in international 
    trade. Ideally, participation in international exchange confers several benefits 
    or advantages to the participants and these may include among others the 
    following;
    - It permits and fosters international specialization in order to maximize 
    output and minimize costs of production. This therefore leads to increased 
    national income, savings, investment and employment opportunities for 
    the participating countries.
    - It overcomes shortages i.e. if a country engages in international trade it 
    overcomes such shortages brought by for example natural disasters.
    - Market expansion; i.e. international trade widens markets for the 
    participating countries e.g. LDCs raw materials thus assured markets for 
    their raw materials. This has encouraged LDCs to move from subsistence 
    production to a monetary one.
    - Vent for surplus; International trade enables a country to utilize her 
    resources thus full utilization of resources due to assured markets.
    - International trade offers an opportunity to a country to sell a surplus of 
    products and to make use of available land and labour. Many countries 
    have products, which are surplus to their own requirements. It is only by 
    exporting these products that they have any value at all. Without trade, the 
    land and the labour used in their production would be idle. International 
    trade therefore gives the country the opportunity to sell these products 
    and to make use of the available land and labour.
    - International trade stimulates competition and forces home producers 
    to become more efficient which leads to better quality, lower prices and 
    more output.
    - It leads to introduction of new ideas, technologies, knowledge and skills, 
    entrepreneurship and social change. Thus, the dynamic effects of trade 
    which stimulate economic development in the long run.
    - International trade provides revenue to the government from import and 
    export duties. This revenue can be used to finance different development 
    activities in the economy.
    - Creation and maintenance of employment i.e. once countries specialize 
    for international trade in production of certain goods for export, it follows 
    that there will be employment in those sectors.
    - Promotes cultural and political ties between or among countries since 
    there is understanding among trading partners which creates global peace 
    and harmony among countries.
    - International trade avails wide variety of commodities which increase the 
    choice of consumers and their standard of living.
    - It increases capital inflow i.e. foreign exchange which it can use to pay off 
    its foreign debts, pay contributions to international organizations and carry 
    out development programs.
    - It enables a country to get relief supplies by importing from other countries 
    e.g. in case it is hit emergencies like drought, floods and earthquakes.
    - It enables factor mobility which promotes exchange of ideas and information 
    thus increase labour efficiency, solves unemployment problems and brings 
    about development in the long run.
    1.2.2: Disadvantages/ Arguments against International 
    Trade
    Despite the above-mentioned advantages of international trade, it comes with 
    several demerits which include among others the following;
    - It encourages dumping which causes price instabilities in the domestic 
    country/ market.
    - Development of local industries is retarded i.e. local industries may be 
    outcompeted by more efficient foreign firms and this leads to increased 
    unemployment in the domestic economy.
    - If a country trades with another that is affected by inflation, this may result 
    into imported inflation by the importing country.
    - Loss of social economic and political sovereignty or independence 
    especially by LDCs because MDCs always dictate unfair trading terms to 
    LDCs.
    - Loss of culture through demonstration effect as consumers of imported 
    goods adapt to foreign consumption habits and cultures.
    - International trade may result into over exploitation of domestic resources 
    due to wider markets.
    - Dangerous commodities may find their way into the country e.g. guns, 
    drugs etc. which may worsen health and standard of living of people.
    - Balance of Payment position may worsen where import expenditure may 
    exceed export revenue.
    - It may limit employment opportunities in the country by the domestic 
    people who are outcompeted by foreigners who might have superior skills 
    over locals.
    1.2.3: Limitations of International Trade
    A number of both social economic and political factors can hinder a country to 
    participate fully in international trade. These factors are either internal or external 
    influences and can be avoidable and or inevitable. These include among others 
    the following; 
    - Rapid depletion of exhaustible natural resources: It could lead to 
    a more rapid depletion or exhaustible of natural resources. As countries 
    begin to rise up their production levels, natural resources tend to get 
    depleted with the time and it could pose a dangerous threat to the future 
    generation.
    - Import of harmful goods: Foreign trade may lead to import of harmful 
    goods like cigarettes, drugs, etc., which may harm the health of the 
    residents of the country.
    - It may exhaust resources: International trade leads to intensive 
    cultivation of land. Thus, it has the operations of law of diminishing returns 
    in agricultural countries. It also makes a nation poor by giving too much 
    burden over the resources.
    - Over specialization: Over specialization may be disastrous for a country. 
    A substitute may appear and ruin the economic lives of millions.
    - Danger of starvation: A country might depend for its food mainly on 
    foreign countries. In times of war, there is a serious danger of starvation 
    for such countries.
    - One country, gains at the expense of others: One of the serious 
    drawbacks of foreign trade is that one country may gain at the expense of 
    other due to certain accidental advantages.
    - May lead to war: Foreign trade may lead to war; different countries 
    compete with each other in finding out new markets and sources of raw 
    material for their industries and frequently come into clash. This was one 
    of the causes of first and Second World War.
    - Language diversity: Each country has its own language. As foreign 
    trade involves trade between two or more countries, there is diversity of 
    languages. This difference in language creates problem in foreign trade.
    - Differences in laws and regulations i.e. different countries have 
    different laws and regulations that govern trade that do not coincide 
    with laws of other countries which make it hard for traders from different 
    countries to cope with those laws from other countries thus hindering 
    international trade.
    - Competition to domestic producers: since goods are not only 
    exported but also imported people are usually attracted to foreign goods 
    and prefer to buy them instead of goods that have been produced within 
    the nation. Domestic producers face a loss due to this.
    - Cost incurred for exporting: a lot of money on transportation facilities 
    has to be incurred when goods are exported to other countries.
    - Too much dependence: when countries develop a habit of importing 
    certain kinds of goods from another country they usually reduce the 
    amount of production of the same good within the country so if the country 
    that exports has a problem and is unable to export goods then the country 
    that imports goods will suddenly face a shortage of goods.
    - Differences in standards of measurement. Different countries use 
    different weights and measures.
    - Lack of standard currency to exchange commodities for i.e. there 
    is no convenient means for buyers and sellers to exchange commodities 
    since they both have different currencies. Exchanging to convertible 
    currencies may distort the relative prices.
    - Inadequate information about goods available, their prices, quality etc. 
    which hinders smooth international trade.
    - Trade barriers which governments normally impose on flow of international 
    commodities like tariffs, quotas, foreign currency, self-sufficiency etc. all 
    limit international trade.
    1.3: Theories of international trade.
    Application activity.1.2
    Study the images below and answer the questions that follow;

    With reference to Rwanda’s economy based on the photos above; 
    a) Name what each photo portrays.
    b) Identify the exports and imports of Rwanda shown in the above 
    photos.
    c) Analyze the impact of international trade to her development process.
    There are different theories of international trade as put forward by different 
    economists trying to explain the gains from international trade between or among 
    countries involved. There are two basic principles or theories of international 
    trade, and these include the following;
    - Theory of absolute advantage
    - Theory of comparative advantage

    1.3.1: Theory of absolute advantage:
    Activity 1.4
    Analyse the case study below, use it to undertake research on international 
    trade theories and answer the questions that follow:
    Rwanda and Kenya can both produce washing soap, but Kenya can 
    produce it with a higher quality and at a faster rate with greater profit 
    than Rwanda. In the same context, both countries can both produce juice, 
    but Rwanda can produce it with a higher quality and at a faster rate with 
    greater profit than Kenya.
    a) What theory of international trade is portrayed in the case study 
    above? Justify your answer.
    b) How will international trade between the two countries be made 
    possible?
    c) Describe how the two countries will benefit from trade?
    1.3.1.1: Meaning of absolute advantage:
    The theory of absolute advantage, was put forward by Adam Smith to explain the 
    gains from international trade as a result of specialization between countries. The 
    law of absolute advantage states that “Given two countries and same amount 
    of resources, a country is said to have an absolute advantage over another 
    in production of a given commodity if it can produce that commodity more 
    efficiently at a lower input cost”. According to Adam Smith, the law of absolute 
    cost advantage for international trade, operates in such a way that countries 
    will benefit if one of them has an absolute (cost) advantage in producing one 
    commodity while the other has an absolute (cost) advantage in producing the 
    other commodity.
    A country that can produce a good at a lower cost than another country is 
    said to have an absolute advantage in the production of that good. Absolute 
    advantage is therefore, the ability of an individual, a household or a firm or a 
    country to produce some particular good or service with a smaller total input of 
    labor, capital, land, etc. per unit of output than other economic actors.

    When two countries have absolute advantages in different goods, there are gains 
    from trade to be reaped. According to the absolute cost advantage doctrine 
    of Adam Smith, each country produces those goods for whose production is 
    especially suited on account of its climate, fertility of its land and its natural 
    resources, and acquired capacity of its people, such as plants, buildings, 
    means of transport, education and health. It will concentrate on the production 
    of such commodities, producing more than its requirement, getting the surplus 

    exchanged with goods and commodities from other countries.

    The principle of absolute advantage involves comparing the quantities of a 
    specific product that can be produced using the same quantity of resources 
    in two different countries. For example, Rwanda is said to have an absolute 
    advantage over Uganda in the production of Tea when an equal quantity of 
    resources can produce more of Tea in Rwanda than in Uganda. Suppose that 
    Rwanda has an absolute advantage over Uganda in one product, while Uganda 
    has an absolute advantage over Rwanda in another, this is a case of reciprocal 
    absolute advantage. This implies that each country has an absolute advantage 
    in one product. In such a situation, the total production of both countries can 
    be increased (relative to a situation of self-sufficiency) if each specialises in the 

    product in which it has an absolute advantage.

    1.3.1.2: Assumptions of absolute advantage.

    The assumptions underlying the principle of absolute advantage include the 

    following:

    - Lack of Mobility for Factors of Production: Adam Smith assumes 
    that factors of production cannot move between countries implying that 
    the Production Possibility Frontier of each country will not change after 

    the trade.

    - Trade Barriers: There are no barriers to trade for the exchange of goods. 
    Governments do not implement trade barriers to restrict or discourage the 

    importation or exportation of a particular good.

    - Trade Balance: Smith assumes that exports must be equal to imports. 
    This assumption means that we cannot have trade imbalances, trade 

    deficits, or surpluses.

    - Constant Returns to Scale: Adam Smith assumes that we will get 
    constant returns as production scales, meaning there are no economies 
    of scale. However, if there were economies of scale, then it would become 
    cheaper for countries to keep producing the same good as it produced 

    more of the same good.

    Given the above assumptions, an exchange of goods will occur (assuming a 
    two-country two-commodity case), if each of the two countries can produce 

    one commodity at an absolutely lower labour cost of production than the other.

    Let us take a two-country two-commodity case. E.g. Rwanda and Kenya 

    producing Tea and Cooking oil respectively.

    Table 1: Reciprocal absolute advantage production schedule.

    This information can be represented using production possibilities curve as 

    below;

    Figure 1: Absolute advantage between Rwanda and Kenya using a production 

    possibilities curve.

    In our Absolute Advantage example, we assume that there are two countries e.g. 
    Rwanda and Kenya, which are represented by a red and blue line respectively. 
    We also assume that only two goods are produced e.g. Tea and cooking Oil. 
    From the table 1 above; we can determine how many units of each commodity 

    each country produces using the same resources. 

    Rwanda has an Absolute Advantage in the production of Tea (15 tons) because 
    it incurs less input costs to produce a unit of Tea than Kenya, which produces 6 

    tons of the same commodity, using the same input costs.

    Kenya has an Absolute Advantage in the production cooking oil (10 tons) than 

    Rwanda which produces 5 tons, using the same input costs.

    As a result, Rwanda will be better off if it specializes in the production of Tea 
    and Kenya will be better off if it specializes in production of cooking oil. This is 

    the case of reciprocal absolute advantage.

    As you can see from our example, it makes sense from businesses and countries 
    to trade with one another. All countries engaged in open trade benefit from 

    lower costs of production.

    On the other side, given equal quantity of resources one country can produce 
    both commodities better than another. Thus one country can have absolute 
    advantage in production of both commodities than the other.This indicates a 

    case of non-reciprocal absolute advantage.

    Table2: non-reciprocal absolute advantage between Kenya and Rwanda 

    production schedule.

    The above information can be illustrated on the graph as below;

    Figure 2: Absolute advantage between Kenya and Rwanda using a production 

    possibilities curve.

    From the above information in the table and graph, it can be seen that if Kenya 
    decided to produce only Tea, it would produce 120 tons and if it decided to 
    produce only Cooking oil, it would produce only 150 tons. Similarly, if Rwanda 
    decided to produce only tea, it would produce only 80 tons, and if it decided to 
    produce only cooking oil, it would produce 100 tons. Each country has several 
    possible combinations of tea and cooking oil it can produce as shown along the 

    production possibilities curve.

    Because the Production possibilities frontier for Kenya is above that of Rwanda, 
    it means that Kenya has absolute advantage over Rwanda in production of both 
    tea and cooking oil. In this case of non-reciprocal absolute advantage, gains
    from trade can be realized when countries specialize basing on the opportunity 
    cost of producing each commodity. This is explained by the theory/ principle of 

    comparative advantage.

    1.3.2: The theory of comparative advantage:

    Activity .1.5

    Analyse the case study below and answer the questions that follow.

    Consider a college principal and his secretary. The College Principal is 
    better at administering and managing college affairs than the secretary 
    and is also a faster typist and organizer. In this case, the College Principal 
    has an absolute advantage in both the administration and management 
    services and secretarial work. Suppose the College Principal produces 
    Rwf100, 000 per day in administration and management services and 
    Rwf40,000 per day in secretarial duties. The secretary can produce Rwf0 
    in administration and management services and Rwf30,000 in secretarial 

    duties in a day.

    a) Which theory of international trade is manifested in the case study 

    above? Justify your answer.

    b) How will service delivery be possible?

    c) Between the College principal and his secretary, who should 

    specialize in which service and why?

    d) What is the basis of specialisation by the two parties named above?

    e) To what extent is the theory applicable in real life experience?

    1.3.2.1: Meaning of comparative advantage.

    Theory of comparative advantage was advanced by David Ricardo in 1817. 
    It followed Adam Smith’s theory of absolute advantage and said that even in 
    the absence of absolute cost advantage, international trade was possible. 
    He postulated that even where one country had an absolute advantage in the 
    production of both commodities, both countries would benefit, if the first country 
    concentrated only on the production of the most advantageous commodity, 
    leaving the second country to produce the other commodity. Comparative 
    advantage is the ability of a country to produce a commodity at less opportunity 
    or real cost than another. Thus, a country has comparative advantage over 
    another when it incurs less opportunity cost than another in the production of a 

    given commodity.

    The theory thus states that “Given 2 countries and 2 commodities, with a given 
    amount of resources, a country should specialise in producing a commodity 
    where it has a least opportunity cost compared to another country”. The 
    specialising country would benefit from trade if it exchanges the surplus of its 

    products for other products in which it has a higher opportunity cost.

    1.3.2.2: Assumptions underlying comparative cost advantage

    The theory of comparative cost advantage is based on the following assumptions:

    - There is no intervention by the government in economic system, meaning 

    there is free trade between two countries.

    - Perfect competition exists both in the commodity and factor markets.

    - There are static conditions in the economy. It implies that factor supplies, 
    techniques of production, exchange rates and tastes and preferences are 

    given and constant.

    - Production is governed by constant returns to scale; i.e. Production 
    function is homogeneous which implies that output changes exactly in the 

    same ratio in which the factor inputs are varied. 

    - Labour is the only factor of production and the cost of producing a 

    commodity is expressed in labour units.

    - Labour is perfectly mobile within the country but perfectly immobile among 

    different countries.

    - Transport costs are absent so that production cost, measured in terms of 

    labour input alone, determines the cost of producing a given commodity.

    - There are only two commodities to be exchanged between the two 

    countries.

    - Money is non-existent and prices of different goods are measured by their 

    real cost of production.

    - There is full employment of resources in both the countries.

    - Trade between two countries takes place on the basis of barter. Thus, the 
    two countries have a double coincidence of wants with barter system of 

    trade.

    Table 3: Example; production possibilities between Rwanda and Kenya.

    Kenya has absolute advantage in the production of both commodities, Tea 
    and cooking oil over Rwanda. Kenya has the absolute advantage in Tea than 
    Rwanda (4:1) and it has an absolute advantage in cooking oil than Rwanda 
    (5:4). However, if we examine the domestic opportunity cost ratios, it is clear 
    that each country has a relative or comparative advantage in the production of 

    one commodity.

    To get to know of who should specialise in what, we must calculate the 

    opportunity cost of one commodity for the other. This is done by the formula;

    Opportunity cost= 

    From the above example it can be calculated as;

    i. In Rwanda to produce Tea they forego cooking oil 

    Thus = quantity of cooking oil/ quantity of tea = 80/10= 8

    ii. In Rwanda to produce cooking oil, they forego Tea, 

    Thus = quantity of Tea/ quantity of cooking oil = 10/80= 0.125

    iii. In Kenya to produce Tea, they forego cooking oil, 

    Thus = quantity of cooking oil/ quantity of tea = 100/40= 2.5

    iv. In Kenya to produce cooking oil they forego Tea, 

    Thus = quantity of tea/ quantity of cooking oil = 40/100= 0.4

    This can be tabulated as;

    Table 4: production schedule showing opportunity cost between Rwanda and 

    Kenya

    In Rwanda, the domestic opportunity cost ratio is such that only 8 tons of 
    cooking oil must be given up for each ton of Tea produced. The opportunity cost 
    of producing one unit of cooking oil is 0.125 tons of Tea that must be foregone. 
    However, in Kenya, the domestic opportunity cost ratio is such that 2.5 tons of 
    cooking oil must be given up for each ton of Tea produced. The opportunity cost 

    of producing one ton of cooking oil is 0.4 tons of Tea.

    Rwanda therefore has a comparative advantage in the production of cooking 
    oil since for each ton of cooking oil that is produced fewer units of tea are 
    sacrificed than in Kenya. Similarly, Kenya, has a comparative advantage in the 
    production of Tea since, for each ton of Tea that is produced; less cooking oil is 

    sacrificed than in Rwanda. 

    If now Kenya concentrates on Tea and Rwanda on Cooking oil, then the two 
    countries are bound to benefit assuming that the value of one ton of Tea is the 

    same as that of one ton of cooking oil.

    After specialization, the situation looks as indicated in the table below. The 

    assumption is that resources have doubled in each country.

    Table 5: Production after specialization.

    The production of Tea has increased by 50 and the production of cooking oil 

    has increased by 40 tons. 

    1.3.2.3: Relevance/applicability of the comparative cost 

    advantage.

    - Developing countries have tended to specialize in producing primary 
    products where they have a least opportunity cost e.g. Rwanda exports 

    raw materials.

    - Developing countries still have barter trade among arrangements 

    themselves.

    - Developing countries use labour intensive technology while developed 
    countries use capital intensive technology so the assumption of no change 

    in technology is realistic.

    - There is some degree of mobility of factors of production among developing 

    countries especially labour.

    - Developing countries import manufactured commodities where they have 

    a high opportunity cost.

    - There are some cases of free trade among developing countries especially 

    in economic integrations.

    1.3.2.4: Criticisms/ limitations of the comparative cost advantage.

    Though the theory of comparative advantage appears to explain the basis of 
    choice for a country in terms of what to produce, what to export and import from 
    others, it has been criticized by a number of writers on a number of the following 

    accounts;

    - The model deals only with the situation in which trade takes place between 
    two countries and in two commodities. However, this is a hypothetical 
    situation which does not exist in real life since international trade takes 
    place among more than two countries and in more than two commodities. 
    The world of only two countries producing only two commodities is a very 
    unrealistic assumption. The real world is made up of a large number of 

    countries engaged in production of a wide range of commodities.

    - The theory assumes that people all over the world have similar tastes. But 
    this is untrue. People belonging to different levels of income have different 
    tastes. In addition, the tastes also change according to the growth of an 
    economy and with the opening of world markets and development of trade 

    relations.

    - The theory does not recognise the role of technological innovations 
    in international trade. Which help in decreasing the cost of goods 
    and increasing their supply not only in inter-regional trade but also in 

    international trade.

    - The theory rests upon the assumption that there is complete specialisation 
    or division of labour. However, in the real world, complete specialisation is 
    not possible. Let us take an example of two countries; one small and the 
    other large in terms of total output. The small country can specialise in the 
    production of one good, but the large country will have to produce both 
    goods, because the small country can neither supply the full requirements 
    of the larger country nor can it absorb the surplus output of the larger 

    country. 

    - It is wrong to assume the existence of free world trade. Countries do not 
    always trade freely with each other. Different countries have always imposed 
    different restrictions on the free movement of goods to other countries 
    from time to time. This has certainly affected the volume and direction of 
    imports and exports and thus limiting the scope for specialisation between 

    or among countries.

    - In his theory, Ricardo has shown no consideration for transport costs, 
    which play an important role in determining the profitability and pattern of 
    international trade. However big the difference between the cost ratios of 
    the two commodities entering into trade may be, if it is narrowed down by 
    the high cost of transporting the commodities, trade may not occur. The 
    existence of transport costs gives rise to another class of goods besides 
    those entering into trade, known as ‘domestic goods.’ Some writers 
    have, therefore, suggested that the cost of production should include the 

    transportation cost.

    - The prevalence of perfect competition in international trade is also an 
    unrealistic assumption. The conditions of perfect competition cannot be 

    achieved in the real world.

    - The assumption that all units of factors of production are equally efficient 
    is too simplistic. It is very difficult to find factors of production, which are 

    equally efficient.

    - The theory assumes that countries can shift resources from the production 
    of one good to the production of another good. In practice, there is likely 
    to be a certain amount of factor immobility, which prevents this, especially 

    in the short run.

    - The theory assumes the operation of the law of constant costs or returns 
    which is entirely unrealistic. In practice, the usual rule in the production 
    of goods is the operation of the law of increasing costs or diminishing 
    returns, that is, beyond a certain point additional output can be obtained 
    only at an increasing per unit cost. When the production takes place under 
    the operation of this law, the cost ratios in both countries will not remain 

    constant.

    - The theory assumes similar needs. E.g. Uganda must want Rwanda’s Tea, 
    and Rwanda must want Uganda’s Rice. This, however, may not be true in 
    reality. For one reason or another, the cheapest source may not appeal 
    to the customer country such that the customer prefers to buy from an 
    expensive source. It should also be noted that two different currencies are 

    used. However, the theory mentions nothing about them.

    - It is possible that the two countries may incur the same cost in the 
    production of certain commodity. In such a case, it is hard to find which 

    country should specialise in a particular commodity.

    - The principle of comparative advantage has been criticized by developing 
    countries on the grounds that if adhered to, it would perpetually commit 
    them to being producers of raw materials. Hence, condoning them to 

    eternal poverty. 

    1.3.2.5: Factors and benefits of comparative cost advantage:

    Activity 1.6

    Carry out research from any economic source about theories of international 
    trade, examine and discuss together in class the;
    i) Factors for comparative advantage.

    ii) Benefits of comparative advantages.

    Factors that determine comparative advantage.

    Comparative Advantage is when a country may produce goods at a lower 
    opportunity cost, but not necessarily have an absolute advantage in producing 
    that good. This simply means that a country can produce a good at a lower cost 
    than another country. Having a comparative advantage is not the same as being 
    the best at something. In fact, someone can be completely unskilled at doing 
    something, yet still have a comparative advantage at doing it! Comparative 
    advantage is a dynamic concept meaning that it changes over time. Comparative 
    advantage is what actually determines whether it pays to produce a good or 
    import it. For a country, some of the factors below are important in determining 

    the relative unit costs of production:

    - The quantity and quality of natural resources available for example 
    some countries have an abundant supply of good quality soils, waterbodies, 
    minerals farmland, oil and gas, or easily accessible fossil fuels which 
    makes them able to have a comparative advantage than other countries 
    which don’t have or have little quantities or poor quality of such resources. 
    The more available quantity and quality natural resources a country has, 

    the more the comparative cost advantages and vice versa.

    - Demographics: A country that has a bigger and highly educated and 
    skilled working-class group with a higher participation of women in 
    productive activities, has a more comparative advantage than another 
    which has an ageing or young population, high net outward and less 
    educated and skilled labourforce and few women’s participation in the 
    labour force. This has an effect on the quantity and quality of the labour
    force available for industries engaged in international trade hence affecting 

    a country’s comparative advantage.

    - Rates of capital investment including infrastructure: Greater public 
    infrastructure investment can reduce trade costs and hence increasing 
    supply capacity of a country hence its comparative advantage over another 
    country which does not have such infrastructures. Investment in roads, 
    ports and other transport and ICT infrastructure strengthens productive 
    and competitive capacity of a country for internal and international 

    exchange.

    - Market levels: Rising demand/market helps countries to encourage 
    specialisation, higher productivity and internal and external economies 
    of scale. These long-run scale economies give regions and countries a 
    significant unit cost advantage than those countries with less demand or 

    market for their commodities.

    - Investment in research & development which can drive innovation 
    and invention. A country that invests much in research and development, 
    promotes mushrooming production techniques hence giving a greater 

    comparative advantage than another which doesn’t.

    - Foreign exchange rate stability: Fluctuations in the exchange rate 
    affect the relative prices of exports and imports and cause changes in 
    demand from domestic and overseas customers hence putting such 
    affected countries at a less comparative advantage than another whose 

    exchange rate is stable for long period of time.

    - Import controls such as tariffs, export subsidies and quotas – 
    these can be used to create an artificial comparative advantage for a 

    country’s domestic producers.

    - Non-price competitiveness of producers - covering factors such 
    as the standard of product design and innovation, product reliability, 
    quality of after-sales support. These help a country to win market for 
    their commodities hence giving such countries products a comparative 
    advantage than others. Many countries are now building comparative 
    advantage in high-knowledge industries and specializing in specific 

    knowledge.

    - Institutions: Availability of institutions that facilitate production are 
    important for comparative advantage and for growth of a given country. 
    E.g. banking systems needed to provide capital for investment and export 
    credits, legal systems that help to enforce contracts, political institutions 
    and the stability of democracy is a key factor behind decisions about where 
    international capital flows. These institutions provide a strong milestone 
    to a country’s production capacity hence its comparative advantage than 

    another which has weak or non-existent institutions.

    - Size of entrepreneurial class: A bigger size of entrepreneurs in a country 
    develops a new comparative advantage in a product either because they 
    find ways of producing it more efficiently or they create a genuinely new 
    product that finds a growing demand in home and international markets 

    than a small size entrepreneurial class.

    - Trade Barriers: Subsidies and taxes implemented by the government 
    create an artificial comparative advantage in a sense that a subsidy makes 
    exports more competitive and a tax would discourage imports thus giving 

    countries comparative advantage.

    - Inflation: An increase in the rate of inflation would make exported goods 
    more expensive and imported goods cheaper thus putting the affected 

    country at a lesser comparative advantage than the other.

    - Tradition: Sometimes comparative advantage maybe largely the result of 
    acquired skills and tradition. People get used to doing a thing and keep 
    on doing it, generation after generation. For example, the Swiss have 
    a tradition of making watches, the Norwegians of operating a far-flung 
    merchant fleet, and the French, of producing cheeses. Each of these 
    traditions is certainly consistent with the resource endowment of the 

    country in question, but it is not an inevitable outcome of it.

    - Technology: Technological differences between countries account for 
    differences in labour productivity. The countries with the most advanced 
    technology will have a comparative advantage with regard to those goods 

    that can be produced most efficiently with modern technology.

    - Factor Abundance: Goods differ in terms of the resources, or factors 
    inputs, required for their production. Countries differ in terms of the 
    abundance of different factors of production: land, labour, capital and 
    entrepreneurial ability. So, it is quite obvious that countries would have 
    an advantage in producing those goods that use relatively large amounts 
    of their most abundant factor of production. Certainly, countries with a 
    relatively large amount of farmland e.g. developing countries, would have a 
    comparative advantage in agriculture, and countries with a relatively large 
    amount of capital i.e. developed countries, would tend to specialise in 
    the production of manufactured goods. Or Countries with a huge supply 
    of relatively cheap labour would specialise in labour-intensive products 
    and countries with abundant capital would specialise in the production of 

    capital-intensive products.

    - Human Skills: Countries with a relatively abundant stock of highly-skilled 
    labour will have a comparative advantage in producing goods that require 
    relatively large amount of skilled labour. Likewise, developing countries 
    would be expected to have a comparative advantage in industries requiring 
    a relatively large amount of unskilled labour. 


    - Product Life Cycles: The product-life-cycle theory is related to 
    international comparative advantage in that a new product will be the 
    first produced and exported by the nation in which it was invented. As 
    the product is exported elsewhere and foreign firms become familiar with 
    it, the technology is copied in other countries by foreign firms seeking 
    to produce a competing version. As the product matures, comparative 
    advantage shifts away from the country of origin, if other countries have 
    lower manufacturing costs for using the now-standardised technology. 
    For example, the history of colour-television production shows how 
    comparative advantage can shift over the product life cycle. It was invented 
    in the US, and US firms initially produced and exported them. Over time, 
    as the technology manufacturing them became well-known, countries like 
    Japan and Taiwan came to dominate the business and had a comparative 
    advantage over US firms in the manufacture of colour TVs. Once the 
    technology is widely available, countries with cheaper assembly lines, due 
    to lower wages, can compete effectively against the higher-wage nation 

    that developed the technology.

    Benefits of comparative advantage.

    - It encourages competition and improvement in efficiency so as to reduce 

    costs of production.

    - It encourages specialisation and exchange.

    - It increases global output of commodities due to specialisation.

    - It encourages economic cooperation and free trade among countries.

    - It encourages mass production and reaping of economies of scale.

    - It discourages duplication of industries i.e. setting up of industries which 

    already exist in other countries.

    - It widens market for exports between o among countries.

    - It enables countries to get commodities which they cannot produce, thus 

    increasing consumers choice.

    - It enables countries to get foreign exchange through increased exports 

    and other form of capital inflow.

    - Specialisation results into effective utilisation of resources some of which 

    would be idle.

    Application activity 1.3

    Analyse the figures below and answer the questions that follow.

    a) In each figure, identify the theory of international trade portrayed with 

    supporting reason.

    b) What makes a difference between the two figures above? 

    c) In which commodity should each country specialise and why?

    d) Why do you think, based on the comparative cost advantage 
    developing countries are not able to benefit from international trade 

    as much as developed countries?

    End unit assessment

    1. Why would you advise your country to engage in international 

    trade? 

    2. Why do we buy goods from abroad if we can make them locally?

    3. Discuss the view that where there is no comparative advantage 

    there is nothing to gain from international trade.

    4. Consider the view that gains from international trade are biased in 

    favour of advanced industrial countries.

UNIT 2: TERMS OF TRADE.►