• Topic Area 4: International Economics ,Sub-Topic Area 4.1: International Trade,Unit1:International Trade Theories

    Key unit competence: Learners will be able to analyse the importance
    of international trade to the development of the
    economy.

    My goals

    By the end of this unit, I will be able to:

    ⦿ Explain the different terminologies used in international trade.

    ⦿ Discuss the advantages and disadvantages of international trade and its
       limitations.

    ⦿ Differentiate between absolute advantage and comparative advantage
        theories of international trade.

    ⦿ Assess the gains from international trade basing on its forms.

    ⦿ Analyse the determining factors of comparative advantage theory.

    ⦿ Use calculations from production schedule to explain the theory of
        comparative advantage.

    ⦿ Analyse the applicability of the comparative advantage theory in LDCs/
        Rwanda.

    ⦿ Advocate for efficient use of available resources to increase gains from
       the international trade.

    1.1. Meaning of International Trade

       Activity 1

    Mutangana, a business man in Muhanga sells his produce in different districts in Rwanda like Muhanga, Kigali, Rubavu, Nyagatare and other different parts. He also crosses borders
    and sells to outside countries like Tanzania, Uganda, Kenya and others. Mutangana also buys some commodities he cannot produce himself from different parts of the country and from
    outside the country. Basing on the above case study on Mutangana’s business, analyse
    his business actions and share as a class about the following:

    (i) How you would call the act of selling and buying  by Mutangana.

    (ii) What economic term you would call the act of selling   and buying of commodities within the country by
         Mutangana.

    (iii) What economic term you would call the selling and buying of commodities between or among countries  by Mutangana.

    (iv) How nations can get commodities they cannot  produce on their own.

    (v) ………… are commodities bought from other  countries while……. are commodities sold to other
         countries.

    (vi) What you think distinguishes trade within Rwanda  and trade between Rwanda and other countries.


    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). While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent centuries. It is the presupposition of international trade that a sufficient level of geopolitical peace and stability are prevailing in order to allow peaceful exchange of trade and commerce to take place between nations.

    Facts

    Trading globally gives consumers and countries the opportunity to be exposed to new markets and products. 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, consulting and transportation. 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.

    1.1.1 Differences between international trade and domestic trade

    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 boarder or not. International trade constitutes those activities involving the exchange of goods and services across national boundaries. It differs from domestic trade in the following aspects.

    Use of Currency

    Transactions in domestic trade involve the use of one currency, normally the national currency or legal tender. For example, in Rwanda’s domestic trade, it is the Rwandan francs which must be used for buying whatever is being sold. For international trade though, various currencies may be involved. For instance, if a Rwandan businessman wants to import cars from Japan, the Japanese exporter, who may not be interested in the Rwandan francs, would demand to be paid in Japanese yen or any other hard currency like the US Dollar.

    Barriers

    Trade within a country is not subjected to barriers restricting the movement of goods internally. Goods produced in Rusizi are expected to have free movement to be sold anywhere in Rwanda. On the contrary, movements of goods across national boundaries are subjected to varying degrees of restrictions — tariffs, quotas. Goods involved in international trade have to pass through designed customs posts.

    Standardised goods

    Goods exchanged in domestic trade tend to be more standardised 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 standardised market. But this need not be the case in international trade, where the producers confronted with different markets may have a variety of different standards for different markets to fulfill.

    Paper work

    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.

    Costs involved

    International trade is typically more costly 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.

    Mobility of factors of production

    Factors of production such as capital and labour are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labour or other factors of production. Trade in goods
    and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it.

    1.2 Forms of International Trade

    Activity 2

    Shyaka, a bee farmer from Rwanda, secured market for his honey in Tanzania just like Neema, a cosmetics producer from Tanzania, also secured market for her cosmetics in Rwanda and there has been exchange of their commodities between the two countries for a long period of time. However, Rwanda has gone ahead to secure market for Mr. Shyaka’s honey in various countries in the world, both developed and developing countries. This has created peace and harmony between Rwanda and
    the partners in trade.

    From the research carried out about international trade in activity 1 in this unit, and using Shyaka and Neema’s example, in the case study above, in activity 2, how would you express the following?

       (a) The term used to explain trade between Rwanda and Tanzania and the trade between Rwanda and more countries.

       (b) The commodities being exchanged in figure 1 (d).

      (c) What are the examples of goods and services that Rwanda  exchanges with other countries?

      (d) Why do you think it is necessary to create and maintain  peace and harmony between or among countries trading amongst themselves?

    There are majorly two forms of international trade, namely;

    (a) Bilateral trade; this is the exchange of commodities between two  countries. For example, trade between Rwanda and Tanzania is an example of bilateral trade.

    (b) Multilateral trade; this is the exchange of commodities among  more than two countries.

    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  other countries and brought to a particular 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 other  countries and brought to a particular country.

    (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 emphasises   increased exploitation of domestic idle resources so as to  increase exports or foreign exchange hence increasing a  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.

    1.4 Need for International Trade

      Activity 3

    As seen in Activity 2 of this unit, Rwanda exchanges goods and services between or among different countries. In pair, think, share and make presentations to the class giving reasons you think Rwanda had to join international trade.

    Facts

    It is important to note that if all nations had all the goods they require, wereequally efficient, and had unchanging tastes, there would be no need for international trade. Since it is impossible to have all such situations in any one country in the world, there is need for international trade between or among individuals, companies and governments of different countries and this is due to the following reasons;

    Differences in natural resource endowments

    Different countries have differences in factor resource endowments because Mother Nature has not been equally kind to every region or country in the world in her distribution of resources. Since different countries have different types of natural resources and of which are non-transferable, like climate,
    minerals, oil, etc., and in differing quantities, it is important to participate in international trade to acquire and enjoy the benefits of these resources. This helps a country like Rwanda to preserve her natural resources for environmental sustainability since she can get such commodities outside the country than over exploiting and exhausting the little available nonrenewable resources.

    Lack of self-sufficiency

    A country may be producing a commodity but not in sufficient quantities that it requires, and hence a need for international trade to overcome the shortage. For instance, Rwanda produces sugar but not in sufficient quantities, hence the need to import it. On the contrary, some goods cannot be found in the
    country at all may be due to lack of natural resources, capital and skilled labour. On top of that, a country may want to get better quality or standard commodities which she cannot produce as a result of lack of skilled labour or technology to produce them. It’s the role of the government to avail standard or better commodities for its citizens for better standards of living. Therefore, such a country may engage in international trade in order to acquire the goods it cannot produce.

    Need to dispose-off surplus

    A country may produce a commodity in excess of what can be consumed by the domestic market. Where the economic exploitation of the resource or commodity requires a larger market than the domestic market, international trade will develop in order to avoid wastage. Similarly, in a situation where
    a country possesses a resource it does not demand at all but is demanded by other countries, the country would exchange its resources so as to acquire what it needs from other countries. This is known as the vent-for-surplus cause of international trade.

    Lack of co-operant factors

    A country may be well endowed with natural resources but unable to exploit them either for its own direct utilisation or for exchange to acquire what they need from other countries. This may be due to lack of skills, technology, capital, etc. Exploitation of such resources would inevitably make the
    country to engage in international trade so as to acquire the vital missing co-operant factors. With international trade, standardised commodities are required in the world market, therefore, if such co-operant factors miss in a country, production won’t meet world standards which earns it less from
    international trade. This makes it a pressing issue for such a country to join international trade to acquire such required factors and meet international standards for the gains from international trade.

    Differences in skills

    Different people have different skills that may be natural or acquired by training which results into production of different products. The desire for those products beyond one’s productive capacity leads to international trade. For example, Rwanda has for long lacked indigenous skilled manpower thus
    has been hiring expatriates to be used in different sectors of the economy. This has promoted skills development among the indigenous population who work with such experts, a reason behind “made in Rwanda campaign” since most Rwandese have emulated such skills from the expatriates and can apply
    them in their home country. This has promoted pride and fraternity among the citizens of the country as they consume their own made commodities.

    Differences in technology

    Nations have differences in technology that enable them to produce different goods and hence international trade arises. For example, Rwanda joined international trade to acquire a better technology to exploit her natural resources, increase production, expand employment opportunities for her
    population and improve their welfare. This has enabled Rwanda to achieve some of her objectives of development; like achieving sustained economic growth, reducing unemployment and improving standards of living of people thus promoting confidence in the government, togetherness, unity and love
    for the country by the citizens.

    Differences in tastes or demand

    International trade might also arise because of differences in tastes. With development, people’s standards of living increase and they may demand for not only high quality products but also for a wider variety of goods and services. Thus, even if one country can produce a certain commodity,
    importation may still take place due to people’s desire for a better quality product from abroad. This connects with the idea of competitive forces and the exercise of choice. In a free market economy, consumers are free to choose which goods to buy. A foreign good may be more appealing. This
    is not necessarily a matter of it being cheaper, but may simply reflect the consumer’s tastes.

    Comparative advantage

    International trade might arise out of the need to minimise the costs of production. It is always wise for one to purchase a commodity if one finds it economical/cheaper to buy than to produce. Thus, when one country finds it cheaper to consume imported goods and services than consuming
    those domestically produced, it would be engaged in international trade. Some countries may be able to produce given commodities but at relatively higher costs than others may. Therefore, those countries at a relative cost disadvantage may initiate and engage in exchange relations with those countries having a relative cost advantage so as to minimise their costs. This is exchange based on comparative cost advantage.

    Need to acquire foreign exchange

    Some countries trade because they want to acquire foreign exchange to finance development. Many African countries export their produce to earn foreign exchange. Where domestic revenue isn’t sufficient to meet recurrent and development budgets, a country joins trade to exchange her commodities through exports to get revenue to supplement the local sources.

    Need to strengthen political ties

    Sometimes, international trade may arise simply to promote political ties between the trade participants or to extend a form of political ideology from one country to another. Two similarly ideologically disposed countries may promote trade between themselves even when it is not necessary. However, it would have been advantageous to one country to trade with another country, which is not ideologically favourable. This promotes international unity, peace and harmony which increases the gains from international trade by different countries since it is easy to access markets worldwide.

    Need to increase competition and efficiency

    Countries need to join international trade in order to increase competition and efficiency between or among themselves. This lowers prices and reduces local monopolies who might cheat consumers through high prices. Competition avails a variety of commodities of good quality since a certain standard has to be met to get market for a country’s commodities. This promotes the culture of standardisation among producers so as to maximise their profits through producing what is required by international standards.

    Need to reduce subsistence sector

    Countries participate in international trade to produce for the market through exporting their commodities which reduces on the subsistence sector and its negative effects. For example, Rwanda participates in international trade with the development goal of transforming the economy from subsistence
    production to a monetary one. This promotes commercial production and reduces subsistence production. It has also created and expanded employment opportunities to most people thus reducing income gap in the economy. In this case, all people see themselves as important citizens
    to the economy as the government facilitates them in transforming from low income subsistence status to high status commercial production, thus increasing love and general peace in the country.

    Need to promote employment opportunities

    International trade promotes employment directly or indirectly i.e. those involved in handling international trade at border posts, collecting taxes, checking standards and those producing for exports.

    Vent for surplus

    Countries need international trade in order to exploit their idle resources so as to increase their export level and provide employment. International trade widens market, avails skills and techniques of production, all these increase the capacity to exploit resources by a nation. Nations should, properly and
    efficiently utilise idle resources to compromise environmental sustainability, especially with the non-renewable resources. Otherwise, there could come up global warming which affects the entire world directly or indirectly.

    Need for specialisation

    Countries prefer to specialise in few commodities in which they are efficient so that they can maximise output and preserve resources. Thus, international trade arises due to the fact that a country would exchange what it produces efficiently for what it cannot. This avoids wastage of resources, little foreign exchange and time in producing a commodity a country is not good at. Therefore, a country has to specialise in production of a commodity where it incurs less real costs or opportunity cost and exchange with others who produce what she cannot produce due to incurring high real or opportunity cost.

    1.5 Arguments for International Trade

    Activity 4

    Basing on Activity 3 of this unit, having seen that Rwanda has participated in international trade since time immemorial, agree together as a class on opposing and proposing sides, and debate on the view that “Rwanda’s participation in international trade has been more beneficial than harmful to her economic development”.

    Facts

    International trade is a basic feature of economic activities in every country. 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 specialisation in order to maximise  output and 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 are assured of 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 utilise her  resources thus full utilisation of resources due to assured markets.

    • International trade provides 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 a culture of standardisation   thus 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 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, of which revenue would not
     be enough had there not been international trade.

    • Creation and maintenance of employment: i.e. once countries specialise   in production of certain goods for export, it follows that there will be   employment in those sectors. This increases incomes of people and  raises their purchasing power thus promoting more investments in  the country.

    • 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 a 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 organisations  and carry out development programmes.

    • It enables a country to get relief supplies by importing from other  countries e.g. in case it is hit by emergencies like drought, floods and   earthquakes.

    • It enables factor mobility which promotes exchange of ideas and   information thus increase in labour efficiency, solves unemployment  problems and brings about development in the long run.

    1.6 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. It also reduces the spirit of love for the locally made  commodities which kills domestic production capacity by local
        producers. This is because most of the dumped commodities are    either cheaper or of high quality than the home made commodities. This affects the development path of the country where commodities
       are dumped.

    • Development of local industries is retarded i.e. local industries may  be outcompeted by more efficient foreign firms and this leads to  increased unemployment and worsens the living standards of people
      in the domestic economy.

    • If a country trades with another that is affected by inflation, it may  result into imported inflation on the importing country.

    • Loss of social economic and political independence 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. People change   towards the imported commodities with a view that they are better than  theirs. This reduces love for their country as they reject consuming its  locally made commodities.

    • International trade may result into over exploitation of domestic  resources due to wider markets.

    The desire to serve the wider market leads to the cutting down of forests, draining marsh lands, poaching etc. all which are anti-environmental protection and preservation and anti-environmental sustainability.

    • Dangerous commodities may find their way into the country e.g. guns,   drugs etc. which may worsen the health and the standard of living of people.

    • BOP position may worsen where import expenditure may exceed export  revenue. People, due to demonstration effect, free flow of goods and  services in the country. This may lead to import expenditure exceeding   export earnings thus worsening the BOP position of the country.

    • It may limit employment opportunities in the country by the domestic  people who are outcompeted by foreigners who might have superior  skills over locals.

    1.7 Limitations of International Trade

    Activity 5

    Having seen the reasons countries would want to participate in international trade in Activity 3 of this unit, and the expected benefits from it, what do you think would limit a country like Rwanda from
    participating fully in international trade?

    Facts

    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 and can be avoidable or inevitable. These include among others the following:

    1. Rapid depletion of exhaustible natural resources: It could lead to a more   rapid depletion of exhaustible natural resources. As countries begin to  increase their production levels, natural resources tend to get depleted  with time and it could pose a dangerous threat to the future generation.

    2. Import of harmful goods: Foreign trade may lead to importation of  harmful goods like cigarettes, drugs, etc., which may harm the health  of the residents of the country.

    3. 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.

    4. Over specialisation: Over specialisation may be disastrous for a country.   A substitute may appear and ruin the economic lives of millions.

    5. Danger of starvation: A country may depend mainly on foreign  countries for its food. In times of war, there is a serious danger of  starvation for such countries.

    6. 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 others due to certain accidental advantages.

    7. 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 the First and Second World War.

    8. 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 a problem in foreign trade.

    9. 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. This makes it hard for traders from
       different countries to cope with those laws from other countries thus    hindering international trade.

    10. 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.

    11. Cost incurred for exporting: A lot of costs on transportation facilities   has to be incurred when goods are exported to other countries.

    12. 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 the goods will suddenly face a shortage of those goods.

    13. Differences in standards of measurement: Different countries use  different weights and measures.

    14. Lack of standard currency to exchange commodities: 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.

    15. Inadequate information about goods available, their prices, quality etc. which hinders smooth international trade.

    16. Trade barriers which governments normally impose on flow of
    international commodities like tariffs, quotas, foreign currency, selfsufficiency etc. all limit international trade.

    1.8 Rwanda’s International Trade

    1.8.1 Rwanda’s total trade

    In 2014, Rwanda’s total trade increased by 3.4 percent to 2,356.6 millions USD from 2,278.9 million USD registered in 2013. Exports increased by 4.9 percent from 622.0 million USD in 2013 to 652.2 million USD in 2014. During the same period, imports increased by 2.8 percent from 1,658.0
    million USD to 1,704.4 million USD.

    Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda

    1.8.2 Rwanda’s imports

    Rwanda’s imports increased by 2.8 percent to 1,704.4 million USD in 2014 from 1,657.0 million USD in 2013. Rwanda’s imports in 2014 were dominated by electrical machinery, nuclear reactors, boilers, mechanical appliances; pharmaceutical products, vehicles, cereals, mineral fuel, salt,
    animal or vegetable fats and iron and steel which accounted to 53.4 percent of the total imports. The main sources of Rwanda’s imports were EAC, EU, China, India and United Arab Emirates which contributed 78.4 percent of the total imports.

    Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda

    1.8.3 Rwanda’s domestic exports

    Rwanda’s domestic exports decreased by 5.7 percent from 480.2 million USD in 2013 to 453.1 million USD in 2014. The main domestic exports included ores, slag and ash; coffee, tea, mate and spices; products of milling industry, raw hides and skins; iron and steel and natural or cultured pearls; which accounted to 84.2 percent.

    Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda

    1.8.4 Rwanda’s re-exports

    The share of Rwanda’s re-exports to total exports increased from 22.8 percent in 2013 to 30.5 percent in 2014. The value of re-exports went up by 40.4 percent from 141.7 million USD in 2013 to 199.1 million USD in 2014. The main re-export products included mineral fuels, nuclear reactors, cereals,
    animal and vegetable fats and motor vehicles and electrical machinery which accounted to 85.6 percent of the total re-exports in 2014.

    Rwanda’s re-exports to the EAC Partner States increased by 4.2 percent from 86.3 million USD in 2013 to 89.9 million USD in 2014. The main re-exports to EAC region were mineral fuels, fats and vehicles.

    Source: RRA and NISR

    Figure 9 above is a graph showing Rwanda’s re-exports to total
    exports between 2010 to 2013.

    1.9 Theories of International Trade
    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

    1.9.1 Theory of absolute advantage

    Activity 6

    Using your knowledge from the research on international trade theories in Activity 1 of this unit, analyse the case study below and share ideas with the class;

    Given the same conditions, Gicumbi farmers in Rwanda can produce 1000 tons of maize and 500 tons of Irish potatoes while Kabale farmers in Uganda can produce 800 tons and 2000 tons of maize and irish
    potatoes respectively.

    If trade is to take place between the two groups of farmers in both countries, they must specialise so as to have effective exchange.

    (a) Which theory of international trade is portrayed in the case study above?

    (b) What does the theory state?

    (c) Which of the farmers should specialise in which commodity  and why?

    (d) Describe how the two countries would benefit using them theory of absolute advantage.

    Fact

    Meaning of absolute advantage

    This theory, put forward by Adam Smith, was developed to explain the gains from international trade as a result of specialisation 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 lawof 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 a country to produce more of a commodity than its competitors using the same amount of resources.

    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 whose production is specially 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.

    Assumptions of absolute advantage

    There are two main assumptions underlying the principle of absolute
    advantage:

    • Labour is the only factor of production;

    • Labour is mobile within the country but immobile between countries.

    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 Uganda producing tea and rice respectively:

    Table 1: Reciprocal absolute advantage production schedule.


    This information can be represented using a production possibilities curve
      as below;

    Basing on the information from the table and graph above,Rwanda will confine itself to the production of tea since it has an absolute cost advantage in producing tea. Through specialisation
    it will produce tea in larger quantity than its home requirement, getting the surplus exchanged for rice from Uganda. Similarly,

    Uganda will specialise in the production of rice and, will exchange part of it for tea from Rwanda.

    Thus, both countries would have more of both products by trading among themselves, through the application of the principle of division of labour, producing only that product in which each has an absolute advantage over the other. After specialisation, the total production of tea is 100 tons and
    that of rice is 120 tons.

    On the other hand, 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.

    Table 2: Non-reciprocal absolute advantage between Uganda and
                 Rwanda production schedule.


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


    From the above information in the table and graph, it can be seen that if Uganda decided to produce only tea, it would produce100 tons and if it decided to produce only rice, 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 rice, it would produce 70 tons. Each country has several possible
    combinations of tea and rice it can produce as shown along the production possibilities curve.

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

    1.9.2 The theory of comparative advantage

    Activity 7
    Research from the library, the internet or any other economics sourceabout international trade theories, and critically analyse the case study below and share your views as a class.
    Given the same conditions, Gicumbi farmers in Rwanda can produce 1000 tons of carrots and 2000 tons of oranges. While Kabale farmers in Uganda can produce 800 tons and 1500 tons of carrots and oranges respectively. If trade is to take place between the two groups of farmers in both countries, they must specialise so as to have effective exchange.

    (a) Which theory of international trade is portrayed in the case study above?

    (b) Which farmers should specialise in which commodity and why?

    (c) State the theory of comparative cost advantage.

    (d) Critically analyse the applicability of the theory of  international trade to Rwanda’s economy.

    Facts

    Meaning of comparative advantage

    The 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 a less opportunity cost than another. Thus a country has a comparative advantage over the other when it incurs less opportunity cost than the other 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 the other 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.

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

    • Labour is the only factor of production.

    • All labour is homogeneous and freely transferable from one commodity  to another.

    • The cost ratios between two commodities remain constant.

    • Trade takes place between two countries and in two commodities.

    • There are no transport costs and no restrictions on trade.

    • There is perfect mobility of the factors of production within a country
        and perfect immobility internationally.

    • The theory assumes constant technology.

    • Constant returns to scale.

    • The exchange rates of the two countries remain the same.

    • The two countries have a double coincidence of wants with barter  system of trade.

    • Tastes and preferences between the two countries don’t change.

    • There is full employment of factors of production.

    • There is free trade between two countries.


    Uganda has an absolute advantage in the production of both commodities, Tea and Rice over Rwanda. Uganda has the absolute advantage in Tea (5:4) and it has an absolute advantage in Rice (4:3). 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 which country should specialise in what, we must calculate the opportunity cost of one commodity for the other. This is done by the formula;



    In Rwanda, the domestic opportunity cost ratio is such that only 7.5 tons of rice must be given up for each ton of tea produced. The opportunity cost of producing one ton of tea is 0.133 tons of rice. However, in Uganda, the domestic opportunity cost ratio is such that 8 tons of rice must be given up
    for each ton of tea produced. The opportunity cost of producing one ton ofrice is 0.125 tons of tea.

    Rwanda therefore has a comparative advantage in the production of tea since for each ton of tea that is produced fewer rice is sacrificed than in Uganda. Similarly, Uganda, has a comparative advantage in the production of rice, since, for each ton of rice that is produced; less tea is sacrificed than
    in Rwanda. For each ton of rice produced, Uganda must sacrifice 0.125 tons of tea, whereas in Rwanda, for each ton of tea, 7.5 tons of rice must be sacrificed. If now Uganda concentrates on rice and Rwanda on tea, then the two countries are bound to benefit assuming that the value of one ton of rice is the same as that of one ton of tea.

    After specialisation, the situation looks as indicated in the table below. The assumption is that resources have doubled in each country.


    The production of tea has reduced by 2 and the production of rice has increased by 20 tons. On the average, however, the two countries have benefited by 18 tons of rice in terms of value, assuming the price of 1 ton of tea is equal to that of 1 ton of rice.

    Relevance/applicability of the comparative cost advantage

    • LDCs have tended to specialise in producing primary products where they have a least opportunity cost e.g. Rwanda exports raw materials.

    • LDCs still have barter trade arrangements among themselves.

    • LDCs use labour intensive technology while MDCs 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 LDCs  especially labour.

    • LDCs import manufactured commodities where they have a high  opportunity cost.

    • There are some cases of free trade among LDCs especially in economic  integrations.

    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 criticised by a number of writers on the following accounts:

    Two-country and two-commodity model

    The model deals only with the situation in which trade takes place between two countries and in two commodities. This is a hypothetical situation which does not exist in real life. We are aware of the fact that international trade takes place between 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.

    Differences in tastes

    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.

    Role of technology is neglected

    The theory does not recognise the role of technological innovations in international trade. It’s however known that technological changes help in decreasing the cost of goods and increasing their supply not only in interregional trade but also in international trade.

    Assumption of complete specialisation

    The theory rests upon the assumption that there is complete specialisation or division of labour. 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. Another situation could be when the two commodities are not of comparable values i.e. one commodity is of high value and the other of a low value. The country producing a high value commodity can specialise but it will not be profitable for the country producing a low-value commodity to specialise.

    Assumption of free trade is unrealistic

    It is wrong to assume the existence of free world trade. Countries do not always trade freely with each other. History provides ample evidence of the fact that different countries have imposed different restrictions on the free movement of goods to other countries from time to time. There are
    political, social or strategic reasons why governments will not permit free trade. Tariffs, quotas, exchange controls and other restrictions are imposed on trade. These restrictions have certainly affected the volume and direction of imports and exports. The existence of such restrictions on trade clearly
    limits the scope for specialisation between countries.

    No consideration for transport costs

    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.

    Perfect competition

    The prevalence of perfect competition in international trade is also anunrealistic assumption. The conditions of perfect competition cannot be achieved in the real world.

    Equal efficiency of all factor inputs

    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.

    Perfect factor mobility

    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.

    Assumption of constant costs

    The theory assumes the operation of the law of constant costs or returns. The assumption 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.

    Coincidence of needs

    The theory assumes coincidence 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.

    Equal costs in the countries

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

    Eternal poverty

    The principle of comparative advantage has been criticised by LDCs on the grounds that if adhered to, it would perpetually commit them to being producers of raw materials. This might condemn them to eternal poverty. The present international economic structure is divided into the rich and the poor
    nations. The rich nations are the industrialised ones while the poor ones are the producers of primary products. The poor nations therefore believe that if they are to escape from the vicious cycle of poverty, they must industrialise. Unfortunately, the theory of comparative advantage places their advantage
    in the production of primary products which are faced with low prices and unfavourable terms of trade. MDCs have a comparative advantage in the production of manufactured goods which are faced with high prices and favourable terms of trade. This therefore implies that LDCs will forever remain poor.

    Benefits of comparative cost advantage

    • It encourages competition and improvement in efficiency. This reduces  costs of production.

    • It encourages specialisation and exchange.

    • It increases global output of commodities.

    • 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.

    • It enables countries to get commodities which they cannot produce.

    • It enables countries to get foreign exchange.

    • Specialisation results into effective utilisation of resources some of
      which would be idle.

    Factors that determine comparative advantage

    Comparative advantage is a dynamic concept meaning that it changes over time. For a country, some of the factors below are important in determining the relative unit costs of production:

    1. The quantity and quality of natural resources available: Some countries  have an abundant supply of good quality farmland, oil and gas, or  easily accessible fossil fuels. Climate and geography have key roles

    in creating differences in comparative advantage. More recently the whale gas revolution in the United States and elsewhere is leading to shifts in the future pattern of world energy production and trade as
    North America becomes more energy sufficient. Severe worries about water scarcity in the future in large parts of the developing world might have hugely significant effects on their ability to export products.

    2. Demographics: An ageing population, net outward or inward   migration, educational improvements and women’s participation in   the labour force will all affect the quantity and quality of the labour
        force available for industries engaged in international trade.

    3. Rates of capital investment including infrastructure: Greater public   infrastructure investment can reduce trade costs and hence increasing  supply capacity. Investment in roads, ports and other transpor  infrastructure strengthens regional trade ties. ICT infrastructure is   particularly important for countries wanting to build a competitive advantage in information-intensive sectors such as mobile
        telecommunications, gaming and financial services.

    4. Increasing returns to scale and the division of labour: Increasing   returns occur when output grows more than proportionate to inputs.   Rising demand in markets where trade takes place helps to encourage   specialisation, higher productivity and internal and external economies
    of scale. These long-run economies of scale can give regions and countries a significant unit cost advantage.

    5. Investment in research and development which can drive innovation and invention.

    6. Fluctuations in the exchange rate which affect the relative prices of  exports and imports and cause changes in demand from domestic and  overseas customers.

    7. 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.

    8. Non-price competitiveness of producers: Covering factors such as the  standard of product design and innovation, product reliability, quality  of after-sales support. Many countries are now building comparative
       advantage in high-knowledge industries and specialising in specific   knowledge sectors – an example is the division of knowledge in the

      medical industry, some countries specialise in heart surgery, others  in pharmaceuticals – health tourism is becoming more important.

    9. Institutions: These are important for comparative advantage an  for growth too. Banking systems are needed to provide capital for   investment and export credits, legal systems help to enforce contracts,
        political institutions and the stability of democracy is a key factor   behind decisions about where international capital flows.

    Glossary

    ཀྵཀྵ Absolute advantage: The ability of a country to produce a good or a service at a lower cost per unit than the cost another   produces the same good or service.

    ཀྵཀྵ Bi-lateral trade: Trade between two countries.

    ཀྵཀྵ Comparative advantage: The basis of trade between nations   where opportunity cost of producing the good is lower than  the opportunity cost of producing the same good or service in
           other trading nations.

    ཀྵཀྵ Exports: Goods/services produced within a country and sold to  other countries.

    ཀྵཀྵ Export incentives: Favourable conditions put in place to boost   exports of a country.

    ཀྵཀྵ Export potential: The amount of unused resources in a country that  can be exploited for the external market e.g. forest, mineral etc.

    ཀྵཀྵ Imports: Imports are goods/services which are produced in other countries and brought into one country.

    ཀྵཀྵ Import surplus: A situation that exists when the value of imports   exceeds that of imports (unfavourable trade balance).

    ཀྵཀྵ Individualism: This is a belief that individuals are the best judges  of their own interests.

    ཀྵཀྵ Invisible commodities: Items that are not tangible and these are  services e.g. insurance, tourist expenditures etc.

    ཀྵཀྵ Invisible trade: Trade in services e.g. tourism, education, banking etc.

    ཀྵཀྵ Multi-lateral trade: Trade among several countries.  International Trade Theories 39

    ཀྵཀྵ Trade gap: This occurs when the quantity of imported goods  exceeds that of visible exports. It is the amount by which  visible imports exceed visible exports.

    ཀྵཀྵ Unrequited exports: These are exports that do not earn any   foreign exchange. Such exports arise out of a debt owed by a  country to another. i.e. used to pay off the debt.

    ཀྵཀྵ Vent-for-surplus: This explains the view that exploitation of idle  domestic resources for exports can lead to national income.

    ཀྵཀྵ Visible trade: Trade in goods.

    Unit summary

    • International trade

    • Meaning

    • Forms, and terminologies used

    • Advantages, disadvantages and limitations

    • Theories of international trade

    • Absolute advantage

    • Comparative advantage





Unit2:Terms of Trade