eco211 chapter 7

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INTERNATIONAL

ECONOMICS

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International trade refers to the exchange of goods and servicesbetween the people of two countries

International trade can increase world production and gives consumersa greater variety of products

Every country involves in international trade for the same reason whichis specialization

When countries specialize, total world output increases and worldconsumption also increases

Through the international trade, a country can consume acombinations of goods that lie outside the boundary of that country International trade occurs because a country may not be able to

produce all goods and services itselfAn international market increases competition and through

competition, efficiency increase

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Reasons for International Trade

Trade may take place because of the diversity in conditions of productionsamong countries. Countries with tropical climates will naturally specializes inbanana & papaya while freezing countries will specialize in grape or strawberry.

International trade which involves a vast global market, may also take placebecause of increasing return to scale. For example, Japan, which has been aleader in the production of consumers electronics, exports its products andenjoys economies of scale due to its cost and technological advantage overothercountries

Even if conditions of production will identical in all regions, countries mightengaged in trade if their tastes for goods were different. For example, Chinamight trade local oranges from New Zealand if both countries is likeness foreach others product

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A country is said to have an absolute advantage in theproduction of a good when it can produce more of thatgood than another country, using the same amount of

resources

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Country Cotton (ton) Rice (ton)

Malaysia 20 60

China 40 20

Total 60 80

Table 16.1

*Both countries allocate 50% of the their resource to produce cotton and

rice


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Cotton (ton)

Rice (ton)

20

40

6020

AB Chinas PCC

CD Malaysias PCC

ACountry Cotton

(ton)Rice(ton)

Malaysia 20 60

China 40 20

Total 60 80

D

C

B


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Conclusion:1. Malaysia have absolute advantage in producing rice2. China have an absolute advantage in producing cotton

Since both countries have a mutual absolute advantage in theproduction of cotton and rice, specialization can take place.

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Malaysia 20 60

China 40 20

Total 60 80


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After specialization:1. Malaysia can fully utilize their resource to produce 120

ton of rice2. China can use all their resource to produce 80 ton of

cotton.

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Malaysia 0 120

i a 0 0

Total 0 120

Table 16.2 after specializatio


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With specialization, both countries are able to trade witheach other in order to consume both products.

Assume that there is arrangement to trade 1-ton of cottonfor 1-ton of rice.

Malaysia need to give 20-ton of rice if need 20-ton ofcotton.

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Malaysia 20 100

China 60 20

Total 80 120


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1. There are only two countries in the world that involve ininternational trade. For example Malaysia and China.

2. There are only two goods produced by two countries. For

example rice and car. They used all of their resources to produce those two goods only. No other goods areproduced

3. Free trade exist between these two countries

4. No transportation costs are involved5. There is constant cost of production

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According to David Ricardo, when there are two countries, acountry should specialize (export) in the production of goodsand services in which the country has a greater comparativeadvantage or lower opportunity cost and imports the

commodity where the opportunity cost is higher orcomparative advantage is less.

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Malaysia 60 10

China 20 10

Total 80 20

Table16.4


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To determine which country is to specialize in rice or cotton,the must be calculated.

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CountryCotton(ton)

Rice (ton)

Malaysia 60 10

China 20 10Total 80 20


Malaysia60 C = 10 R1 C = 0.17 R

10 R = 60 C1 R = 6 C

China20 C = 10 R1 C = 0.5 R

10 R = 20 C1 R = 2 C

Table 16.5


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Conclusion:

i. Malaysia has the lower opportunity cost in producing of cotton*

ii. China has the lower opportunity cost in producing of rice*

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CountryCotton(ton)

Rice (ton)

Malaysia 0.17* 6

China 0.5 2*

*Compare thelowest opportunitycost

Table 16.5


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y Terms of trade refers to the rate at which goods are exchanged.

y For international trade to be mutually beneficial for each country, theterms of trade for bothcountry.

y We calculate the terms of trade as an index number using the followingformula:

y If are rising faster than import prices, the terms of trade index willrise. This means that fewer exports have to be given up in exchange for a givenvolume of imports.

y If rise faster than export prices, the terms of trade havedeteriorated. A greater volume of exports has to be sold to finance a given

amount of imported goods and services. 17

Terms of Trade (%) = Average price of exports

Average price of importsv 100%


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*Malaysia export cotton*China export rice

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Malaysia *1 C = 0.17 R 1 R = 6 C

China 1 C = 0.5 R *1 R = 2 CTable 16.5

Cotton Rice

Malaysia 1C = 0.17R

China 1C = 0.5RWhich mean trade is in between;0.17R < 1 C < 0.5R

To be accurate, calculate theaverage:

0.17 + 0.5

2

Malaysia 1R = 6C

China 1R = 2CWhich mean trade is in between;6C < 1 R < 2C

To be accurate, calculate theaverage:

6 + 2

2

range of trade range of trade

= 0.34 R = 4 C1 C = 1 R =


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1. Specialization & trade brings about increased worldoutput and gains for the individual country.

2. Consumers enjoy a wide variety of goods & services to

choose from and this means a higher standard of living.

3. Trade generates income and brings about higher income& economic growth. The production of goods for exportsalso creates employment.

4. Relationship among trading partners can be improved,political differences can be minimizedand compromisescan be made easily through ASEAN, EEC and othertrading bodies. It also promotes travel andunderstanding through visits and exchanges.

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5. Trade also brings about the sharing of knowledge,information & technology among trading nations.

6. It leads to proper resource allocationwhen the resources

are used according to the comparative advantage of thecountry.

7. With international trade, there will be keen competition,which leads to efficiency and cost-effectiveness. Thismay also prevent the formation of monopoly in a

country.

8. Through trade, international indebtedness can be solved.Earning foreign exchange through an increase in exportscan reduce a deficit in the balance of payments.

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The continuous export of raw materials such as oil may deplete anation's reserve of the deposit in the long run. If this happens, it willaffect the nation's growth in the long run.

Economic specialization may lead to a nation having to depend onother countries for other goods. This makes the country vulnerable toexternal forces. A f luctuation in price employment may affect

economicgrowth.

If transportation costs are too high, then international trade will not bea profitable venture for some countries.

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Taxes imposed on imported goods.

Ad-volerem- based on the value/price of the goods Specific tariff- based on the quantity of the goods.

Legal limit of number of units that can be imported.

Total ban on imported goods

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Requirement of the import license

High license fees and delays in the processing applications

forms may discourage producers from importing these gods

and services

Control the amount of money to be brought into or out of the

country.

Restriction on the sale or purchase of foreign currencies

Government give subsidy to protect domestic company by

reducing the cost of production and hence increasing

government revenue.

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Balance of payments is a statement showing the netexchange of that nation currency for foreign currenciesfrom all transactions between that nation and foreign

nations in a given year.Balance of payment is also a summary record of a country

economic transaction in a given period of time.

The major components of that activity:

1. Current Account Balance,2. Capital Account Balance and

3. OfficialFinancing Account.

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Service /invisiblebalance

Transferpaymentbalance

Net income

Tra e /visible

balance


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1. Trade / visible balance is the difference of export and import of physical goods.

2. Service / invisible balance is the difference of receipts and expenditures fromservices like insurance, tourism, freight, interest, dividends etc.

3. Net Income

refers to the difference between investment income flows into and out of a

country. Such as compensation paid to employees, investment on income.

3. Transfer payments may come from private or government. Net private transfermay include any flow or transfer of money by foreign workers to their familiesin their own countries. Net government transfer includes military or financialaid or gifts by one government to another.

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Deficit Trade Balance Import > Export

Surplus Trade Balance Export > Import


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Refers to long term loans (more than a year) made by a government.A government may borrow from other nations or from IMF

(International Monetary Fund) or World Bank. Only the principalamount of the borrowing or the repayment of the principal value willbe included.

May come from direct (physical) investment or portfolio investment.Direct investment is investment on capital goods, for exampleTelekom invests in telecommunication goods in Thailand, or Protonsets up a factory in United Kingdom. Portfolio investment isinvestment in foreign stocks or foreign exchange market.

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The flow of money from commercial banks or

other financial institutions.For example, an American deposits a sum of money in our local bank.

Errors and omissions are also included in short-

term capital. This includes illegal transactions,unrecorded flow of money or any missing items.It acts as the balancing item.

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Official financing consists of government's goldand foreign currency reserves as well as

government's account with IMF and BNM Reserve.

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Occurs when there is a deficit or surplus in thebalance of payment

Factors that contribute to the disequilibrium:1. Development programs

2. Income

3. Price effect

4. Elasticity of demand for exports and imports5. Population growth

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1. Export PromotionStrengthening the competitiveness of exports, which can be achieved bydeveloping the use of products and using good pricing & marketingstrategies, can do this.The government may also help by giving subsidies or tax holidays toexporters or abolishing export duties. Government may also promote local

goods in international markets and provide information that may helpexporters market their products.

2. Discourage ImportThe government may discourage imports and substitute imported goodswith locally produced goods.

This can be done by imposing or increasing tariffs or quota on imports,which will lead to an increase in the price of imported goods. By inculcatinga sense of loyalty among locals to buy local goods and controlling theamount of foreign currencies that can be held by individuals or importerswill also discourage imports and lead to expenditure switching from importgoods to local goods.

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3. Control on InflationThe reason people buy import goods could be inflation.Inflation or the increase in prices of local goods makesforeign goods more attractive, while foreign investorsmight not be interested to invest because of highproduction costs. Thus, to solve a deficit in the balanceof payments, inflation problem needs to be taken care offirst.

4. Using The Governments ReserveGovernment's gold and foreign currency reserves areoften used to balance any deficit in the balance ofpayments. However, this is a short-term solution toimprove the deficit problem. Continuously using thereserves will deplete them in the long run.

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5. Devaluation

Devaluation means the deliberate policy of thegovernment to reduce the par value of the country's

currency vis-a vis other currencies. This method isusually taken as a last resort.

6. Undertake Accommodating Transaction

This means transactions that are meant to balance thebalance of payments. This can be done by restrictinglocals from visiting foreign countries, stopping aid &grants, selling property and encourage capital inflowsfrom foreign investment.

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The price of one currency in terms of anothercurrency

As an example RM 3.00 = US $1, meaning, theprice of a Ringgit equal to US 0.33 cents.

There are of exchange rate systems used

by nations until today:1. The Gold Standard2. The Bretton Woods System (Fixed Exchange Rate)

3. Flexible Exchange Rate System

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I. The gold standard was the major system of exchange ratedetermination before 1914. All currencies were priced in terms ofgold - that is, an ounce of gold was worth so much in each currency.

II. When all currencies exchanged at fixed ratios to gold, exchange rates

could be determined easily. For instance, one ounce of goldwasworth $ 20 U.S.: that same ounce of gold exchange for 4 Britishpounds. Since $20 and 4 were each worth one ounce of gold, theexchange rate between dollars and pounds was $20 / 4, or $5 to 1.

III. For the gold standard to be effective, however, it had to be backed upby the country's willingness to buy and sell gold at the determinedprice.

IV. As long as countries maintain their currencies at a fixed value interms of gold and as long as each is willing to buy and sell gold.

V. One major problem with the gold standard is that a countryhad littlecontrol over its money supply.

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y Under the Bretton Woods system countries were to peg their currencies interms ofU.S. dollar instead of gold. U.S. dollars was then pegged directly togold which is $35 to an ounce of gold. The US guaranteed that it would freelyconvert dollars (US$) into gold. It was hoped that this would encouragecountries to hold dollars as their major reserve currency. After all, if dollarswere freely convertible into gold, they were as good as gold. So all the other

countries continue to peg their currency to US dollar. From time to time,however they would revalue or devalue their currency against the dollars. TheBretton Woods system allowed for different types of adjustment to balance ofpayment disequilibrium depending on the severity of their economic problem.

y If Malaysia were to trade with Japan and need to import Japanese goods worth100 million, the payment using the exchange rate would be:

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y Under this system, the exchange rate is permitted to varywith market demand and supply conditions. Under asystem of flexible exchange rate, the exchange moves up ordown to choke off any excess supply or demand for foreignexchange. With flexible exchange rates, the quantity offoreign exchange demand equal to the quantity supplied.

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y For the same reason there is no need for foreign exchange reserves. Althoughflexible exchange rate eliminates balance of payment and foreign reserveproblems, it cannot solve all problems of international trade experienced by acountry.

y Exchange rate movement associated with flexible rate may disrupt import andexport flows. As noted before, depreciation of the dollar, raises the price of allimported good.

y The price increase may lead to increase in domestic price causing inflation.Further more local businessmen that sell imported goods or use importedgoods in their production may suffer sales losses. On the other hand,appreciation of the dollar raises the foreign price of US goods and reduces thesales of US exports.

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eco211 chapter 7

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