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International Economics Essays

HOME > ESSAYS > INTERNATIONAL ECONOMICS International Economics International trade, Economics, Free trade










LECTURE ONE 6 1.0 INTRODUCTORY LECTURE6 1.1 Why We Study International Economics8 1.2 The Subject Matter of International Economics 11


2.0 FIRST INTERNATIONAL TRADE THEORY 14 2.1Introduction 14 2.2Early Trade Theory: The Mercantilist Doctrine 15 2.3Mercantilist Beliefs 16 2.4How Mercantilists Achieved Their Objectives 18 2.5Commentary on Mercantilism 18


3.0CHALLENGES TO MERCANTILIST DOCTRINE20 3.1Introduction 20 3.2Free Trade Theory21 3.3Adam Smith’s Contribution to the Theory of Trade22 3.3.1Smith’s Theory of Absolute Advantage23 3.4David Ricardo’s Contribution to the Theory of Trade24 3.4.1Ricardo’s Theory of Comparative Advantage25 3.4.2 Use of Modern Concept of Opportunity Cost to Explain the Theory of Comparative Advantage26 3.5Group Activity in Class27


4.0THE RICARDIAN MODEL28 4.1Production in Autarky30 4.2Summary34 4.3Developing Community Indifference Curve 34 4.3.1 Consumption in Autarky34 4.3.2 Why Community Indifference Curves (CIC) Are Used36 4.4Equilibrium in Autarky37 4.5The Ricardian Model with Trade38 4.6Modern Presentation of Adam Smith’s and David Ricardo’s Theories of Absolute and Comparative Advantages40 4.6.1Adam Smith’s Theory40 4.6.2David Ricardo’s Theory41 4.7Group Assignments44



5.1 Consumption and Production Gains from Trade50 5.2Some Important Assumptions in the Analysis52 5.2.1Costless Factor Mobility52 5.2.2 Full Employment of Factors of Production Assumption 53 5.2.3 Community Indifference Curve Showing Welfare Changes 53


6.0THE NEO-CLASSICAL MODEL55 6.1Neo-Classical Model in Autarky56 6.2Production Function: Isoquants and Isocosts58 6.3Capital/Labor Ratio63 6.4Equilibrium in Autarky with Increasing Costs67 6.5The Neo-Classical Model with Trade70 6.5.1 Productive Specialization Under Increasing Costs70 6.5.2International Equilibrium with Free Trade and Increasing Costs74


7.0OFFER CURVES78 7.1The “Trade Triangle Approach” to Deriving Offer Curves79 7.2The “Tabular Approach” to Deriving Offer Curves85 7.3Trading Equilibrium89


8.0THE HECKSCHER-OHLIN (H-O) MODEL90 8.1Introduction90 8.2The Role of Factor Endowment in Determining Comparative Advantage90 8.2.1The Heckscher-Ohlin Model/Theorem90 8.2.2Factor Abundance91 8.2.3What H-O Theorem says92 8.2.4The Role of Taste in Determining Comparative Advantage94 8.3 Group Activity99


9.0EMPIRICAL TESTING OF TRADE THEORIES 100 9.1Introduction 10094 9.2Empirical Testing of Trade Theories100

9.2.1Test of the Heckscher-Ohlin Theory101 9.2.2Leontief Test of H-O and the Leontief Paradox102 9.3Modification of H-O Model to Explain Patterns of Trade103 9.3.1The Role of Tastes103 9.3.2The Role of Trade Barriers104 9.3.3Classification of Inputs105 9.3.4Intra-Industry Trade106 9.3.5Trade with Economies of Scale106 9.3.6Effect of Transport Costs on Trade107 9.3.7Effect of Location of Industry on Trade108 9.4Factor Intensity Reversal and H-O Theory108 9.5Paul Samuelson’s Factor Price Equalisation Theory (1948)109 9.6The Stolper-Samuelson Theorem: The Relationship Between Output Prices and Factor Prices111


10.0 ALTERNATIVE THEORIES OF TRADE 117 10.1 Introduction 117 10.2 The Imitation Lag Theory of Trade 117 10.3 The Product Cycle Theory of Trade 119 10.4 The Linder Theory of Trade 121 10.4 Further Readings 122


11.0PROTECTIONISM123 11.1Introduction123 11.2Trade Barriers to Trade123 11.2.1Tariffs123 11.2.2Types of Tariffs124 11.2.3Effects of Tariffs Imposed by a Small Country125 11.2.4Partial Equilibrium Welfare Effects of a Tariff128


12.0MEASUREMENT OF TARIFF EFFECTS131 12.1Effective Rate of Protection (ERP)131 12.2The Height of a Tariff136


13.0NON-TARIFF BARRIERS AND NEW PROTECTION138 13.1Production Subsidies138 13.2Quotas139 13.3Voluntary Export Restraint (VER)141 13.4 Export Subsidies and Counter-veiling Duties142 13.5Administrative and Technical Standards143 13.6Government Procurement Rules and Policies144 13.7National Security or Defence (Strategic Industries)144 13.8Dumping144 13.9Types of Dumping145 13.9.1Sporadic Dumping145 13.9.2Persistent Dumping146 13.9.3Predatory Dumping146


14.0IMPORT SUBSTITUTION: THE INFANT INDUSTRY 148 14.1Introduction148 14.2Import Substitution Strategy of Industrial Development in Developing Countries149 14.2.1The Infant Industry Argument149



LECTURE ONE 1.0 INTRODUCTORY LECTURE International trade is the exchange of goods and services between countries. The world wide trend in the volume of trade (exports and imports) in goods and services has been rising from US$200 billion in 1965, to US$900 billion in 1975, to US$2 trillion in 1985 (Yarbrough and Yarbrough, 1988), to US$9.1 trillion in 2003 (Encarta, 2005), and to US$ 27.567 trillion in 2010 (WTO/Wikipedia, Website, 2010). (Note: US$1,000 billion = 1 trillion) Total international trade in 2010 was US$ 27.567 trillion of which: European Union (22 countries) accounted for US$ 3,764 billion USA ” ” ” 3,225 billion China (Mainland) accounted for US$ 2,908 ” Germany ” ” 2,402 ” Japan ” ” 1,404.3 ” France ” ” 1,107.8 ” United Kingdom ” ” 971.9 ” Italy ” 921.5 ” Netherlands ” ” 914.9 ” South Korea ” ” 886.7 ” Hong Kong (part of China since 1997) ” ” 825.6 ” Canada ” ” 793.7 ” Singapore ” ” 668.8 ” Russia ” ” 648.8 ” India ” ” 606.7 ” Mexico ” ” 604.5 ” Belgium ” ” 569.3 ” Spain ” ” 568.3 ” Taiwan ” ” 406.1 ” Switzerland ” ” 458.9 ” Australia ” ” 406.1 ” Brazil ” ” 383.6 ” It can be observed from the above list that the top 20 trading countries plus 22 European Union members accounted for US$ 25,566.2 billion or (92.7%) of the total international trade of US$ 27,567 billion in 2010. The rest of the 193 members of the World Trade Organisation (WTO) accounted for just over US$ 2 trillion. Kenya’s total international trade in 2010 was (exports US$ 5.122 billion; imports US$ 11.842 billion) US$ 16.965 billion (Republic of Kenya, 2011). Trade plays an important part in improving the welfare of society by increasing the availability of goods and services to consumers and by increasing incomes of those involved in production and distribution of exports and imports. Thus trade:

Is always a major force behind economic and political relations between countries. Encourages economic development by increasing the size of the market to which products can be sold. Provides goods and services to cover the gap caused by resource endowment. Is a source of income to producers of exports and distributors of imports. Facilitates specialization in the production of goods and services based on resource endowment. Can provide the engine of growth for the whole economy.

During the 18th, 19th and most part of the 20th centuries, growth in trade in manufactured goods grew faster than any other sector. The last quarter of the 20th century has seen growth of trade in services overtake trade in manufactured goods. However, trade has also its negative effects:

Trade has triggered wars all over the world Trade was the main cause of colonialism and slave trade

Trade enhances the strong economies’ desire to control the resources of the weak ones. Since Economics is defined as the study of the allocation of scarce resources among unlimited competing uses, the importance of international trade in international issues has made the study of economics an absolute necessity. The more a country’s international trade grows, the more that country is dependent on other countries because of the growth of interdependence among producers and consumers of those countries. However, this interdependence is not necessarily mutually beneficial: Between 1981 and 1982, for example, European economies bitterly resented the spillover effects of US anti-inflationary policies (contractionary policies pursued by the USA government like increase in interest rates, and a strong dollar which made US goods expensive) because the effects of those policies impacted negatively on their economies. Third World countries, on their part, resent the flooding of their markets with cheap manufactured goods from the advanced economies under the IMF-driven crusade of liberalized trade under structural adjustment programmes (SAPs). Ideally, trade exports should be composed of surpluses of local production and this is what happens in most advanced countries. However, in developing countries most exports are composed of what the locals do not consume or use (primary products), while they consume manufactured imports, which they do not produce (Samir Amin, 1972). The developing countries export primary products as raw materials, with very little value added, while they import manufactured goods, which are, in most cases, produced using the same primary products from developing countries, but this time with value added by firms in the advanced countries.

1.1 Why We Study International Economics One can argue that international economics could be studied as part of macroeconomics courses. This is a valid argument, as you will find such topics as National Accounts, Macroeconomic Policy in Open and Closed Economy, are covered in both. Economists working specifically on international economics problems developed many of the analytical tools economists use in macroeconomics. A good example of this is Wassily Leontief’s input-output analysis is now a planning tool in macroeconomics. However, the study of international economics continues to be differentiated from other economics courses because of the economic significance of political boundaries. The underlying objective of the main players in the crusade for globalisation is to try to diminish the importance of political boundaries so that the world becomes a global village. The study of International economics I (AEC 306) and International II (AEC 315) should help students to decide whether globalisation is good or not. The significance of political boundaries cannot be over-emphasized. For example, a Kenyan living in Mombasa and one in Marsabit share a lot of things in common between them although they differ radically in others: They all use a common currency in daily purchases

They are all subject to the same laws made by parliament They all speak Kiswahili as the national language The constituency development fund (CDF) is from the same source A Kenyan in Marsabit is free to migrate to Mombasa in search of a job or permanent residence and vice versa. As a result of being in the same political boundary the economic activities between residents of Marsabit and Mombasa, who are almost 1000km apart, face fewer trade barriers than say, exporters of sugar from the Nzoia sugar factory to Tororo town in Uganda, yet the two are less than 50 kms apart. National boundaries are economically important in determining: Legal, language and currency barriers to trade.

Economic policy that influences both production and trade. The policy-making process and policies pursed by a country greatly influence international trade transactions. This is one major reason why International Economics has remained a separate course of study in Economics. Some universities are offering the course as an independent subject separate from normal Economics courses. On their part, some governments have responded to globalization by jealously guarding their separate policy making powers (e.g. away from IMF, WB, WTO) in order to protect their sovereignty. The result is that policies regarding international trade are typically based largely on the interests of domestic residents in the political process rather than in the interest of world trade as a whole. When making policy decisions, governments have to assess whether decisions are globally beneficial or harmful. As it happens some decisions that are globally beneficial (like those on free trade) are domestically harmful (those that lead to collapse of local industries) Conversely, some policies that are globally harmful (like protectionist policies) are domestically beneficial. The study of International Economics I helps to equip students with tools of analysis to be able to evaluate which policies can balance global interest with national interest. The popular notion in international trade policy is the perception that trade policy must pit the interest of one nation against the competitors. The first theory of international trade (mercantilist trade theory) was based on this view. While David Hume poked holes in some aspects of mercantilist trade theory, and was followed by Adam Smith who provided a solid theory of free trade, this did not stop subsequent prominent economists from coming up with arguments to support some aspects mercantilist doctrines e.g. the infant industry argument for protection of domestic industry. It was Alexander Hamilton of USA in his Report on Manufactures (1791) and Friendrich List of Germany (1840) in his Das Nationale who provided economics with the more advanced arguments for protection than mercantilists. Hamilton and List’s arguments became the basis of the modern Import Substitution Industries (ISI) policy. International trade policy affects greatly the income distribution within each country. This is why trade policy can benefit some people and harm others. (e.g. protection of local industry benefits only producers or investors but harms local consumers who pay higher prices) The basis of Adam Smith’s theory of free trade was that individuals act (invest) in their own self-interest (to make profit). He urged further that national policy to protect investors does not help the nation, but individuals. Therefore, one of the tasks in the study of International Economics is to analyze the effects of various international trade policies (e.g. tariffs on imports) on different groups within the country. Thus so long as countries continue to exist and trade with each other, the study of International Economics I (trade) and International Economics II (finance) remains relevant. In fact, many multinational companies and banks will not employ anybody as an economist if he/she has not studied International Economics.

1.2 The subject Matter of International Economics

The subject matter of International Economics is traditionally divided into two parts. The first part is International Trade Theory or International Economics I, which extends microeconomic analysis to international questions: Here, we consider the decisions made concerning the quantities of various goods to be produced, consumed and traded. We will see that consumers enjoy goods and services available to the maximum when each country specializes in producing these goods and services efficiently. Trade then allows residents of each country to import what they cannot produce efficiently (i.e. the surplus of each country producing efficiently). These production and consumption decisions determine the relative prices of goods and factors of production (such as land, labor and capital, raw materials, technology and entrepreneurship) Like microeconomics, in general, trade theory traditionally ignores monetary issues by expressing all costs and prices in terms of goods and services rather than monetary units (shillings, pounds or dollars). In other words, goods exchange for goods directly (2 bags of maize for 1 bag of wheat, or twenty computers for one car). This means that you examine the impact of trade on the relative prices of different goods and factors of production. By so doing, the study of trade theory highlights the distributional effects of trade. You will find that because unrestricted trade (or free trade) changes relative prices (abundant supply of goods leads to a drop in prices) it also changes the distribution of income among various groups. Producers of a domestically produced good lose income when cheap imports elbow their goods out of the market. Consumers pay less for cheap imported substitutes and therefore have spare income to spend on other goods or save for the future. An understanding between this interrelationship between trade and income distribution is essential to make sense of pressures for: Protectionist policies by domestic producers or investors

Free trade policies by domestic consumers and local importers The second branch of International Economics is known as International Finance or International Economics II. This branch of international economics is sometimes known as Open-economy Macroeconomics. It applies macroeconomic analysis to aggregate international problems. The major concerns here include:

Level of income and employment in a country Output in each national economy Change in prices of internationally traded goods and services Relative prices of currencies, or exchange rates. Balance of payments The most basic issue to be studied is the interaction of international goals with domestic goals (free trade Vs. balance of payments or job creation in a country) in determining macroeconomic performance or policy. Like was the case in microeconomic analysis, in trade policies, we will discover that macroeconomic policies have income distribution effects. For example, you will discover that policy choices that are presented in terms of the interests of domestic residents versus foreign residents are actually the interests of various groups within the country (e.g. producers, consumers or importers).

LECTURE TWO 2.0 INTERNATIONAL TRADE THEORY 2.1 Introduction In this course, when we say “nation” or “country” engaging in trade and making “production” and “consumption” decisions, it should be understood that in reality, it is the “individuals” or “firms” and “consumers” making decisions and not countries or governments. This is especially so, where market oriented economies dominate, although governments still do make important decisions about what to produce (ammunition factory in Eldoret) and what to import (security related government purchases). Nations engage in trade because it is beneficial for them to do so. However,

It is however important to know in advance that there are gains from trade, just as there are losses. There are goods and services that are such that even if a country wanted to produce them domestically, it cannot do so efficiently due to natural endowment and geographical location. Trade therefore fills the gap.

This is where the idea of benefits from productive specialization and trade becomes easy to see at an individual level. That is, you specialize in producing a good (a cobbler making shoes) in order to exchange with what you cannot produce efficiently (baker making bread). Any individual attempting self-sufficiency by producing everything that he or she consumes could not only find it very difficult, but will also discover that this is one sure way of sentencing oneself to perpetual backwardness - like peasant farmers in the rural areas who face such a condition. In a rural village, one can provide for his own necessities e.g. generate own energy using firewood, can grow his own food, provide his own transport by walking, build his own hut - that is partly the reason why he remains poor. The peasant just doesn’t have the time and expertise to perform all these tasks efficiently. For the peasant, specialization means sharpening his skills in only one of those tasks and exchange the surplus with what others are specializing in. The fact that political boundaries divide the world into nation-states, does not alter the basic principle behind trade: expand output by producing efficiently through specialization and trade the surplus. However, for a long time, until Adam Smith and David Ricardo came on the scene, it was difficult to convince policy makers that trade was beneficial to both trading parties. 2.2 Early Trade Theory: The Mercantilist Doctrine

Although international trade was important in ancient times, it acquired greater importance after around 1500 AD when European states started consolidating their power by acquiring colonies and forming empires. From that period, trade became an arm of government policy. The wealth of a country was measured in terms of the goods it possessed, particularly so the precious metals, gold and silver, collectively known as specie. This form of international trade, whose main objective was to accumulate as much specie as possible, was driven by doctrine known as mercantilism. The origin of mercantilism is Europe.

The doctrine of mercantilism was a set of theories, which explained the beliefs and practices of European statesmen and merchants during the period of 1500 to 1750. The statesmen and merchants of that period were consumed by the desire to accumulate as much wealth (specie) as possible. There were only two possible ways available to them to do so: 1. To own gold and silver mines from which they could extract the precious metals 2. To export goods abroad which were paid for in gold and silver (specie). As a result, the statesmen, with the support of merchants set out to initiate policies, and put in practice measures that facilitated acquisition of specie. These policies and measures included:

2..1. Acquisition of colonies abroad, which were rich in minerals and other raw materials: These colonies were to be the sources of raw materials, precious metals, and slaves. Slaves were to be used as labor in the plantation farms, where raw materials like cotton, sugar, tobacco were grown in overseas colonies. The colonies were also to provide markets for manufactured goods from the metropolis. On the home front, policies had to be put in place to facilitate surplus production for export: Thus, the manorial system (feudal system) that was sustained by subsistence and self-reliance had to give way to commercial production under the enclosure system. Better methods of production in agriculture were introduced. Crop-rotation replaced shift agriculture with relevant crops Wage system replaced subsistence as reward for labor (serfs became wage workers) New and better methods of marketing agricultural produce were introduced Competition for markets emerged within and outside the country Competition outside the country encouraged growth of nationalism and the outcry for protection. Production was now purely for profit and not subsistence.

It is the fierce competition encountered by merchants abroad that gave birth to the first Theory of international trade: mercantilism, with protectionism as the cornerstone of the theory.

2.3 Mercantilist Beliefs A number of beliefs and practices collectively constitute the mercantilist doctrine: 1. Production was for profit: therefore trade both internal and external must be promoted by the state to facilitate earning profit. 2. Mercantilist equated wealth with specie.

3. According to mercantilists, for a country to become wealthy, it must accumulate as much specie as possible. 4. It was therefore the responsibility of the state to go all out to support individual merchants to accumulate specie. 5. To do this the state must encourage exports while it discourages imports. 6. Once a country has acquired specie, the state must control the outflow of specie while at the same time encouraging the inflow of specie. 7. When trading, merchants’ main aim must be: to export as much as possible abroad to facilitate inflow of specie, and import as little as possible from abroad to avoid outflow of specie. 8. The state must encourage domestic manufacturing by:

Discouraging or banning export of raw materials. Discouraging and banning export of skilled manpower. 9. In order to be competitive abroad mercantilist believed in: The iron law of wages to subsist in order to keep the cost of production low. The production of high quality goods unmatched by competitors 10. Mercantilists believed in a dense population for a country in order: To provide cheap labor.

To provide soldiers without depleting the labor force. 11. Mercantilists believed in self-sufficiency at national level as this reduced the need for imports. 12. However, mercantilists grudgingly accepted export of specie if such export facilitated import of necessities (like salt, spices) and raw materials (like silk from the East Indies). 13. If the country has to allow outflow of specie to import necessities and inputs, it must do so with objective of maintaining a positive balance of trade (i.e. overall exports must exceed a country’s imports). 14. Mercantilists believed that trade was a zero-sum game where one country’s gain was another country’s loss. 2.4 How Mercantilists Achieved Their Objectives

1. Mercantilists were to work hand in glove with the state to achieve their set objectives, which included accumulation of specie for themselves and a strong state made so by their wealth. 2. Export high value goods i.e. manufactured goods.

3. Export final consumption goods e.g. textiles not wool, flour and not grain. 4. Encourage manufacturing at home by banning export of skilled manpower. 5. Create employment at home in order: To avoid export of skilled labor. To create demand for domestic goods and services. 6. The state must regulate wages to keep the iron law of wages in operation. 7. State must regulate cargo shipment (enact laws) such that only national vessels carry all imports (e.g. England’s Navigation Acts of the sixteenth century). 2.5 Commentary on Mercantilism

Mercantilism provided the conceptual basis of protectionist theories and policies in international trade. Mercantilism provided international trade with the theory of balance of trade. Mercantilism is associated with formation and consolidation of nation -states. Although advancing individual and company interests of merchants, policies pursued by the state to support mercantilists’ interests ended up strengthening the state. Even today, the USA ‘s external policies are heavily influenced by multinational corporations (MNCs ). In the process, the state became the champion and active implementer of mercantilist policies and practices. While the state created a conductive environment for healthy competition domestically, local merchants looked at the state for protection against foreign competitors. The state benefited from protection by earning revenue from import tariffs. Expansion of commerce abroad earned profits for merchants but it also benefited domestic workers by creating jobs and keeping them in employment. By exports creating jobs locally, incomes earned by workers increased domestic demand for consumption goods. This meant that wages were both a cost of production and a source of demand for consumer goods. The stronger a group of merchants were, the stronger their hold on the state and enforcement of their policies e.g. the East India Company of Britain’s hold on Govt. policies was formidable. In the final analysis, the strengthening of the state was done in the name of national interests but in reality, it was for the merchants to make profits. Modern theories of protectionism and government intervention such as tariffs, quotas, voluntary export restraint, subsidies, dumping and other non-tariff barriers to trade have their origins in mercantilist doctrines.


3.0 CHALLENGES TO MERCANTILIST DOCTRINES 3.1 Introduction In the middle of the 18th century, the mercantilist doctrine came under serious attack from intellectual leaders of the emerging science of political economy economics).Although many people had raised issues with some aspects of mercantilist doctrines, it was David Hume who, in his Political Discourses (1752) raised serious doubts about the soundness of mercantilist arguments. David Hume pointed out two weaknesses in the mercantilist arguments: First, he urged that individuals derive satisfaction, not from accumulation of specie, but from consumption of goods and services they purchase using specie Second, he highlighted doubts about the long-run viability of mercantilist policies. Hume posed the question: What would happen if the rest of the world (the importing countries) accumulated all the surplus output of goods and services while the mercantilist countries accumulated all the specie? He urged that if a country succeeded in accumulating a lot of specie as a result of exporting more than it imported, the surplus specie inflow would raise both the money supply and the country’s level of prices. This is when he came up with the famous theory of the specie-flow mechanism. Hume’s specie-flow mechanism was originally presented in 1752, to counter mercantilist arguments for restricting imports into a country while at the same time encouraging exports of a country. According to mercantilists, accumulation of specie was a goal to be pursued tirelessly as the source of wealth and power. But Hume argued that if the mercantilist arguments were stretched to their logical conclusion, the logical sequel would be a scenario in which international flows of specie (foreign currency) would automatically correct the balance of payments equilibrium, as follows: Suppose Kenya, due to applying mercantilist policies to the fullest extent, succeeded in exporting a lot of goods to Uganda ($370 million in 2005) and Uganda exported very little to Kenya ($17 million, in 2005). This would mean that Uganda will not only run out of specie to use for importing Kenyan goods, but Kenya would be flooded with specie when Uganda has a shortage. As a result, excess supply of specie will make Kenyan goods expensive, while shortage of specie will make Ugandan goods cheaper. Due to the high prices of Kenya goods, Uganda goods will become attractive to Kenyan consumers leading to imports of Ugandan goods to Kenya. Uganda will produce more to meet the demand from Kenya

In the long run, the outflow of specie from Kenya to Uganda will equalize the amount of specie in both Kenya and Uganda. Note that under the mercantilist doctrine, each country aimed at self-sufficiency and therefore tried to produce everything it required. 3.2 Free Trade

Mercantilism ushered in a new culture and a new mode of productive forces that bred the seeds of the system’s own destruction. The profit motive was a very powerful force Competition produced efficient producers who survived while the inefficient ones disappeared. The search for markets became an obsession resulting from the “fear of goods” disease. This is a disease that afflicted merchants who were caught stranded with goods they could not sell Merchants (especially so the money lenders) struck terror into other merchants (traders and producers of goods) who borrowed money but failed to repay the loans - remember the story of Shylock, the merchant of Venice, by William Shakespeare. Mercantilist, in their desire to acquire cheap raw materials and markets for exports, gave birth to colonialism and the slave trade. Mercantilist economic activities led to improved transportation The factory system was born to mass-produce at low cost.

Result: Industrial revolution starting with the 18th century inventions. It is around this time that Adam smith studied the mercantilist system and its antithesis in France - Physiocracy. The product of Smith’s study is The Wealth of Nations – published in 1776. The same year (1776) USA declared independence from Britain. For Britain this was a loss of a major colony that seriously undermined her economic and political international standing. 3.3 Adam Smith’s Contribution to the Theory of Trade

In his book, The Wealth of Nations (1776) Adam Smith attacks mercantilist beliefs and practices particularly protectionism. Instead, he advocated for free trade as the new philosophy He glorified and praised the profit motive, which delighted industrialists so much, because it was due to Smith’s arguments that that it was no longer considered sinful to acquire riches through profit making. Until now, profit making was equated with usury, which canon law forbade. Adam smith’s main mission in his wealth of Nations was to call into question mercantilist’s policies and propound a new theory of free trade. He focused his attacks on mercantilist assumption that:

Trade was a zero sum game. Foreign trade was the main source of wealth. Smith starts from the premises that labour is the origin of wealth. The contents of wealth, he argued, are all products of labor. According to Smith, human beings are driven by the following motives: Everyone acts on the basis of self-interest

Everyone wants to improve ones condition Man has certain instincts that serve his desires e.g. the instinct to barter and exchange one thing for another. Smith believed that the interest of different economic units were in harmony with each other and not in conflict – very contentious. Smith believed in the existence of the invisible hand to harmonize individual interest to benefit society: e.g. A baker makes bread to make profit

A butcher sells meat to make profit A brewer makes wine to make profit But they all serve / benefit the society. Because of the above 5 points Smith concluded that everyone is the best judge of his own interest. From the above argument Smith concluded that the state and its agents should be limited to three roles: Provide defense from foreign aggression

Establish an exact administration of justice Maintain such public works and institution as would not be maintained by any individual or group of individuals for lack of profit. Smith observed that individuals are by nature differently talented. Countries are also differently endowed with resources.

Therefore, individuals should specialize in what they are most talented to produce (division of labour) Similarly, countries should specialize in the production of goods and services by optimizing on the use of their natural endowment or resources. It is on the basis of the above arguments that Adam Smith propounds his theory of absolute advantage. 3.3.1 Smith’s Theory of Absolute Advantage

As pointed out above, Adam Smith urged that countries are endowed with different resources, just like humans are endowed with different talents. Like division of labour in humans, countries can specialize in production of goods and services to derive maximum benefits from their endowment. Smith gave an example of Portugal and England, both of which produced wine and cloth. He used the following cost of production analysis to make his case:

WINE CLOTH To produce 1 unit of wine: To produce1 unit of cloth: Portugal: uses 10 units of labour20 units of labour England: uses 20 units of labour10 units of labour According to smith, if the two countries specialized, they would efficiently produce three units of wine and cloth, respectively, and exchange the surplus at the ratio of 1:1. Before specialization, each country could produce only one unit of each good. It is on the basis the above argument that Smith introduced his concept of absolute advantage, which he used as a basis of advocating for free trade. Adam Smith’s theory of absolute advantage states that:

A country should specialise in the production of a good where it enjoys an absolute advantage and import from others those goods in whose production it has an absolute disadvantage. For this to happen, there must be free trade between the specializing countries for them to benefit from specialisation. 3.4 David Ricardo’s Contribution to the Theory of Trade

Unlike Adam Smith who was an academic – a professor of logic and moral philosophy – who intellectualized and made profit making respectable, David Ricardo was a businessman or moneymaker in practice. Ricardo dropped out of school aged 14 to join his father’s brokerage firm. Ricardo’s most famous work, The Principals of Political Economy and Taxation, was published in 1817. Though unschooled in academic analysis, he produced a very rigorous analytical work, which was too technical for the day. His ‘let us suppose’ approach introduced abstract analysis into Economics. He is rightly known as the father of deductive method of analysis while Adam Smith’s historical approach is known as the inductive method of analysis. 3.3.1 Ricardo’s Theory of Comparative Advantage

Ricardo viewed Adam Smith’s theory of absolute advantage as too optimistic, if not simplistic. He asked: what will happen if country A possessed an absolute advantage in all lines of production over country B? Does country B still benefit from trade?

Ricardo’s answer was, yes, so long as country B is not equally less productive in all lines of production. Ricardo used the same labour cost of production analysis, same countries and same products as Adam Smith to make his case: WINE CLOTH

1 unit of wine 1 unit of cloth Portugal: uses 80 units of labour 90 units of labour England: uses120 units of labour 100 units of labour According to Ricardo, Portugal has an absolute advantage over England in the production of both wine and cloth. However, Portugal has a comparative advantage in the production of wine because it produces one unit of wine with only 80/120 x 100 = 67% of England’s effort (in man hours). On the other hand, it takes Portugal 90/100 x 100 = 90% of England’s effort to produce one unit of cloth. Therefore, Portugal vis-à-vis England is more efficient in the production of wine than cloth. Portugal should therefore specialize in the production of wine and export the surplus to facilitate importation of cloth. Analogously, England has an absolute disadvantage in the production of both cloth and wine. It takes England 120/80 x 100 = 150% of Portugal’s effort (in man hours) to produce one unit of wine. But it takes England 100/90 x 100 = 111% of Portugal’s effort (in man hours) to produce one unit of cloth. It is clear from the above example that England’s relative disadvantage is smaller in cloth production than in wine production. Thus because the absolute disadvantage of England is greater in the production of wine, England has a comparative advantage in the production of cloth. England should therefore specialize in cloth production and export the surplus to facilitate the importation of wine. The principal of comparative advantage states that it will be beneficial for a country to specialise in production the good in which it has a comparative advantage and to trade in what it ha a comparative disadvantage. Country A is said to have a comparative advantage in the production of a good X, if, in order to produce an additional unit of good X in that country, it is necessary to give up fewer units of good Y, than it is possible to produce an additional init of X in country B. 3.4.2 Use of the Modern Concept of Opportunity Cost to Explain the Theory of Comparative Advantage Professor Gottfried Haberler was the first to lucidly apply the economic concept of opportunity cost (OC) in 1933 to explain David Ricardo’s theory of comparative advantage. The opportunity cost of producing good X is the amount of other goods that have been given up in order to produce one additional unit of good X. Given the figures used by Ricardo for Portugal and England above, it is possible to use the concept of OC to demonstrate that trade between Portugal and England is beneficial to both countries. The Opportunity cost of Producing wine cloth

By Portugal, it is80/90 = 89% 90/80 = 112.5% By England, it is 120/100 = 120%100/120 = 83% A country has a comparative advantage in the production of a good if the opportunity cost of producing an extra unit of a good is lower at home than abroad. In this case, Portugal has a lower opportunity cost in making wine i.e. 89% versus 112.5% in making cloth. On the other hand, England has a lower opportunity cost in making cloth i.e. 83% versus 120% in making wine. Thus, as long as the two countries’ opportunity costs for one good differ, then comparative advantage exists to influence a decision about specialization, which will make both countries benefit from trade. From the analysis above, it ca be seen that the principal of comparative advantage can better be explained by the concept of opportunity cost. Thus, country A is said to have a comparative advantage in the production of a good X, if, in order to produce an additional unit of good X in that country, it is necessary to give up fewer units of good Y, than it is possible to produce an additional init of good X in country B.

3.5 Group Activity in Class USE the modern concept of opportunity cost to explain Ricardo’s theory of comparative advantage. Define opportunity cost. Use Ricardo’s own figures for Portugal and England and the opportunity cost concept to Portugal has comparative advantage in wine production. England has a comparative advantage in cloth production Portugal has a comparative disadvantage in cloth production England has a comparative disadvantage in wine production What are the flaws in Adam Smith and Ricardo’s theories when applied to reality in Kenya today?

LECTURE FOUR 4.0 THE RICARDIAN MODEL It is time to examine the modern use of Adam Smith and David Ricardo’s theories of free trade. We start with the Ricardian model. To develop the Ricardian model, Economists make the following assumptions: 1. Perfect competition prevails in both the output and factor markets; that is: a.i.1. Each buyer’s share of the market is so small that he cannot influence the market price (that is, market price is given) a.i.2. Each commodity is homogeneous – all units of the traded goods are identical a.i.3. Buyers and sellers have good information of market conditions a.i.4. Entry into and exit out of the market are easy and unrestricted. a.i.5. Decision-making is governed by rationality.

a.i.5.a. The assumption of perfect competition is important because it implies that the price of each good will be equal to the good’s marginal cost of production. (i.e. the change in total costs due to production of one additional unit of output). 2. Each country has a fixed endowment of resources at its disposal and these resources are fully employed and homogeneous; that is: The problem faced by each country is that of allocation of the fixed quantities of resources. This allocation is for the production of the various goods that the residents wish to consume. 3. Technology is assumed to be the same in all countries and unchanging; that is: Different countries utilize same technology to produce similar goods The technology to produce good X is the same in country A as in B The technology to produce good Y (while different from that of good X) is the same in country A as in B. 4. Transport costs are assumed to be zero.

The fourth assumption implies that consumers will be indifferent in the choice between domestically produced and imported versions of good X or Y when domestic prices of each are the same. Nationalism and taste preferences are ignored.

5. Factors of production are assumed to be completely mobile among local industries in the country, but completely immobile between countries. The fifth assumption is a complete contradiction of free trade, which Smith and Ricardo’s theories (of absolute and comparative advantage) were supposed to advance. Free trade a la Adam smith and Ricardo included international trade in factors of production.

6.The two countries (A and B) each use a single input – labour - to produce the two commodities X and Y. The assumption of one input (labour) characterizes the Ricardian model because David Ricardo originally formulated a trade model in which labour was assumed to be the only input. To show that international trade benefits participant, we have to compare a world without trade and one with trade. A country that is self-sufficient operates under autarky i.e. it produces all goods that its residents consume (Robinson Crusoe’s story of a person marooned on an island alone, where he must produce whatever he consumes). Thus under autarky, a decision to produce is simultaneously a decision to consume (no exports no imports) A country must therefore consider a production trade off between good X and Y that are possible given the available resources and technology. A country must also consider its residents’ subjective trade-offs between consumption of goods X and Y.

4.1 Production in Autarky The various combinations of good X and good Y that can be produced in country A can be shown by developing a production possibilities frontier, (PPF). A production possibilities frontier (PPF) represents all the alternative combinations of good X and good Y that country A is able to produce given its fixed resource endowment. To do this one must know the quantity of resources (labour) available in country A. One must also know the technology available to transform that labour input into outputs, goods X and Y. We denote country A’s labour endowment as LA

The technology used in production is summarized by two input coefficients aLX and aLY. The input coefficients tell us how many units of labour are required to produce one unit of each good X and Y. To produce one unit of good X in country A requires aLX units of labour. To produce one unit of good Y in country A requires aLY units of labour. What is the meaning of input coefficients aLX, aLY?

The first letter a refers to the country; the first subscript L refers to the input; while the second subscripts X and Y represent outputs produced. If country A chooses to use all its labour (LA) in the production of good X only, then LA/aLX units of X (and zero units of Y) will be produced. On the other hand, if country A chooses to produce only good Y it will be LA/aLY units of Y (and zero units of X) Let us assume that country A has 100 units of labour i.e. LA = 100. Let us also assume that in country A, 2 units of labour are required to produce 1 unit of good X i.e. (aLX = 2). Let us also assume that in the same country A, 5 units of labour are required to produce one unit of good Y i.e. (aLY = 5). If country A chooses to use all its labour in the production of good X, it will produce LA/aLX = 100/2 = 50 units of X If it chooses to use all its labour in the product of good Y, it will produce LY/aLY = 100/5 = 20 units of Y. A variety of combinations is possible to produce both X and Y. For every unit of X that is foregone (dropped from production), 2 units of labour are released and made available for use in production of 2/5 of good Y. This is because you need 5 units of labour to produce one unit of Y, while you need only 2 units of labour to produce one unit of X. All possible production choices can be represented graphically as country A’s production possibilities frontier (PPF) as shown as Graph A in figure 4.1 below.

Figure 4.1: Production Possibilities Frontier (PPF) of country A


LA/aly Slope Y/ X = -(alx/aly) = MRT

0 XA LA/alx Graph A (using algebraic notation)

The fact that the PPF is downward sloping reflects the fact that the input (labour) is scarce. This means that the only way to produce more of one good (X) is by producing less of the other good (Y).

The same Figure 4.1 can be drawn using numerical figures as Graph B below.

Figure 4.1: Production Possibilities Frontier (PPF) of Country A YA

20 III

12 I II Slope= - 2/5 = PPF 0 10 20 50 XA

Graph B (using numerical figures)

In figure 4.1’s Graph A, the slope (Y/ X) = (- aLX/aLY) = marginal rate of transformation (MRTA) in a country A. The marginal rate of transformation (MRT) is also the production possibilities frontier (PPF), a concept first used in 1933 by Gottfried Harberler to analyze international trade. The PPF tells us how the available resources (labour), and technology (skills/knowledge), are combined by the country to produce the goods and services it requires. What Graph B in Figure 4.1 shows is that country A can use all its labour (LA=100) and technology (aLX =2) to produce 50 units (100/2 = 50) of good X, which is represented on the horizontal axis. Graph B also shows that country A can also choose the option of using all its labour (LA =100) and technology (aLY =5) to produce 20 units of good Y (100/5=20), which is represented on the vertical axis. The line that joins the point 20 on the Y-axis and point 50 on the X-axis is the slope of the PPF (-aLX/aLY) in Graph A, or –2/5 in Graph B. That line or slope gives the opportunity cost or the rate at which good X can be transformed into good Y. A variety of alternative combinations containing some of both goods (X, Y) can also be produced such that for every unit of X forgone (aLX/aLY in graph A) or (2/5 in graph B) additional units of good Y can be produced i.e. By producing one less unit of good X, two units of labour (aLX) are released, enough to produce 2/5 of a unit of good Y, since five units of labour (aLY) are required to produce one unit of Y. All the possible production choices along the PPF can also be represented as change in Y over change in X, which is the marginal rate of transformation of good X into good Y. The PPF is defined by the requirement that all labour (L=100) be fully employed. This can be expressed as LA = aLX . X + aLY . Y. i.e.

The total amount of labour in country A must be employed to produce goods X and Y. In order for the full employment condition to continue to hold, when output levels of good X and Y are varied, it must be true that:

LA = aLX . dX + aLY . dY = 0 If you re-arrange this expression, it must be true that: dY/ d X = - (aLX/aLY) which gives the slope of the PPF. What this means is that in autarky, country A residents can choose to produce any combination of good X and Y that lies on the PPF. However, it is also possible to produce at points inside the PPF e.g. at point I in Graph B i.e. 10 units of good X and 12 units of Good Y

This would mean using a total of (2x10) + (5x12) = 80 units of labour. But this would mean 20 units of labour will be unemployed, therefore an inferior choice or inefficient use of resources. Points outside the PPF, while desirable, like point III in graph B, are unattainable due to the constraint imposed by resources (labour and technology) i.e. At point III, in order to produce 20 units of good X, and 20 units of good Y requires (2x20) + (5x20) = 140 units of labour when only 100 units of labour are available to country A. 4.2 Summary

The Ricardian model implies that the PPF is a straight line. The slope of the PPF represents the opportunity cost of good X (given by the aLX/aLY), which is also the marginal rate of transformation. A straight line PPF implies that costs are fixed or constant. That is why the Ricardian model is also known as the constant cost model.

4.3 Developing Community Indifference Curves 4.3.1 Consumption in Autarky: The Individual Indifference Curves The PPF concept we have examined above tells us one half of the autarky story, by revealing which combination of X and Y is possible to produce, given the available labour and technology (skills). To determine which of the many possible points to be chosen, it is necessary to introduce tastes or preferences of residents of country A. We assume that the level of satisfaction or utility enjoyed by residents of country A depends on the quantities of goods X and Y available for consumption. We also assume that the production /consumption decision is made in such a way as to maximize utility. A graphic technique called indifference curves shows all the different combinations of good X and Y that result in a given level of utility. Indifference curves have 4 properties:

They are downward sloping They are convex or bowed towards the origin of the graph They never intersect Higher indifference curves represent higher levels of utility.

Figure 4.2: Indifference Curves

Y1 1 slope = Y/ X = MRSA

MRS = marginal rate of substitution

Y2 2 UA2 UA1 0 UA0 X1 X2 XA In figure 4.2, each curve (UA0, UA1, UA2) shows all combinations of good X and Y that produce given levels of utility. At point 1, an individual consumes more of good Y (OY1) and less of good X (OX1). At point 2, individuals consume more of good X (OX2) and less of good Y (OY2). Points 1 and 2 on indifference curve UA0 represent the possibility of substituting one good (X) for another (Y) without changing overall level of utility. The slope of the indifference curve represents the rate at which individuals are willing to trade off consumption of X with Y. This rate is called the marginal rate of substitution (MRS). Convexity of the indifference curves implies that the MRS changes with movement along indifference curves. As more of good X and less of good Y are consumed moving downwards, good Y becomes valued relative to good X, because much less good Y is given up in order to consume larger quantities of X. Suppose good X is food and good Y is clothes.

At point 1, a large amount of clothing and very little food is available to an individual. Therefore, most individuals would probably be more willing to trade a substantial amount of clothes in order to get one additional unit of food. At point 2, more food and less clothing are available.

Individuals are now willing to give up very little clothing in return for an additional unit of food. Finally, a move from indifference curve UA0 to UA1 or UA2 means that the individual has moved to higher levels of utility, may be because of increase in income, which leads him to consume more of each good X and Y, and therefore the higher levels of utility are preferred to those of the lower indifference curves.

4.3.2 Why Community Indifference Curves (CIC) Are Used Indifference curves were originally developed in 1881 by Francis Y. Edgeworth to represent tastes or preferences of an individual consumer. In international trade, indifference curves (ICs) are used to represent aggregate tastes of a community, thus the name community indifference curves (CIC). Community indifference curves have exactly the same characteristics as individuals’ indifference curves: They slope downwards, meaning that residents of a country must be compensated for loss of one good by another good in order to maintain the same level of satisfaction CICs are convex such that the more of good X and less of good Y are consumed as one moves downwards the CIC, the more good Y becomes more highly valued, relative to good X. This is also known as the marginal rate of substitution (MRS) This means that the amount of additional X required to compensate for further reducing consumption of Y increases as demonstrated in figure 4.3 below.

Figure 4.3 Community Indifference Curves




Y3 CIC2A Y4 CIC1A CIC0A XA 0 X1 X2 X3 X4

4.4 Equilibrium in Autarky How does one achieve equilibrium?

We earlier said under assumption 6 above, that in autarky, a country’s production decision is also a consumption decision. This can be illustrated by combining the PPF graph (fig. 4.1) and the community indifference curve graph (fig. 4.3) to get figure 4.4 below.

FIG. 4.4 Autarky Equilibrium for Country A.


Slope = MRTA LA/aly Slope = MRSA


X1A LA/alx In figure 4.4, Point A* puts residents on indifference curve CICA1, representing highest level of satisfaction that is attainable given country A’s resource endowment (LA) and available technology (aLX and aLY). Therefore point A is the country’s autarky equilibrium.

4.5 The Ricardian Model With Trade Under autarky, all production and consumption decisions are made within country A. With trade, country B is introduced as a trading partner. This means that the decisions of production and consumption are made in two different countries. Before trade, country B’s autarky situation is similar to that of a country A. i.e. Consumption possibilities of country B are limited to its production possibilities The resource endowment LB and available technology blx and bly define country B’s production possibilities. It is unlikely that country A and B will have identical quantities of labour or use the same technology i.e. LB is not identical to LA and (LB is not equal to LA)

blx and bly are not identical to alx and alx; (blx and bly are not equal to alx and aly) This means that the PPF of country B will be different from that of country A in order to facilitate trade as in figure 4.5 below.

Fig. 4.5: Autarky’s Equilibrium for Country B


LB/bly Slope = MRSB


CICB0 0 X12 LB/blx XB

Point B* on the CICB0 is country B’s autarky equilibrium just like point A* was in country A in figure 4.4.

4.6 Modern Presentation of Adam Smith’s and David Ricardo’s Theories of Absolute and Comparative Advantages.

4.7.1 Adam Smith’s Theory Country A is defined as having an absolute advantage in the production of good X if: alx < bl x , or bl x > al x. i.e.

It takes fewer units of labour to produce one unit of good X in country A than in B. Similarly, country B is defined as having an absolute advantage in the production of good Y if: bly < aly or aly > bl y.

Production technologies in country A and B under Smith’s Absolute Advantage theory are represented as follows:

Table 4.1 General case Numerical example

Country A Country B Country A Country B

Labour units required to Produce good X alx < blx2 < 3 Labour units required to Produce good Y aly > bly5 > 4

Therefore the two countries should specialize in the production of the good in which they possess absolute advantage and export the surplus to facilitate the importation the good in which they possess absolute disadvantage.

4.7.2 David Ricardo’s Theory Earlier, we pointed out that while acknowledging Smith’s contribution to justify free trade with his theory of absolute advantage, Ricardo saw limitations of Smith’s theory. The question he posed was: what would happen to trade if one country had an absolute advantage in the production of both goods X and Y such that: Table 4.2

General caseNumerical case Country ACountry B Country A Country B Good Xalx/aly <blx/bly 2 <8 Good Yaly/alx <bly/blx 5 <10

One of Ricardo’s greatest contribution to economics which later became the source of the opportunity cost concept was his demonstration that mutually beneficial trade was still possible even if one of the potential trading partners had an absolute advantage in the production of both goods X and Y. Ricardo’s concept of comparative advantage states that country A has a comparative advantage in the production of good X if: (alx/aly) < (blx/bly).

In the general and numerical examples above, this would translate into: Table 4.3 General CaseNumerical Example Country A Country B Country A Country B Good X alx/aly blx/bly 2/5 = 0.4 8/10 = 0.8 Good Y alx/aly blx/bly 5/2 = 2.5 10/8 = 1.25

This means that the opportunity cost of producing goods X in country A is 2/5 = 0.4 units of Y. Similarly, the production of an additional unit of Y in country A is possible only if production of X is reduced by 5/2 = 2.5 units of X. In country B, the opportunity cost of producing good X is 8/10 = 4/5 = 0.8 units of Y, while the opportunity cost of producing Y in the same country (B) is 10/8 = 5/4 = 1.25 units of X. By definition, the opportunity cost of producing each good in each country is the number of units of labour required to produce a unit of the good, divided by the number of units of labour required to produce a unit of the other good. Therefore, in our example above, country A has a comparative advantage in production of good X, while country B has a comparative advantage in the production of good Y. It should be noted that a country cannot have a comparative advantage in the production of both goods. It should also be noted that tastes are irrelevant in determining comparative advantage under constant costs because the slopes of the PPFs are also constant. However, tastes affect the particular point at which a country will choose to produce, i.e. the comparison of opportunity costs in the two countries is the same regardless of tastes. The theory of comparative advantage states that it will be beneficial for a country to specialize in production of the good in which it (the country) has a comparative advantage, and to trade for the good in which it has a comparative disadvantage. Such specialization and trade make both countries potentially better off by expanding their consumption opportunity sets. Therefore specialization and trade enable a country’s consumption opportunity sets to increase beyond its production opportunity set. In autarky, the domestic PPF defines the production and consumption opportunity sets and its slope defines both the opportunity costs and the relative prices for good X and Y. We can now demonstrate that specialization and trade along the lines of comparative advantage can increase the total world output of the two goods (X, Y) available for consumption. In table 4.2 country A has a comparative advantage in good X while country B has a comparative advantage in good Y Suppose both countries specialize:

Country A will produce more of good X, by giving up producing good Y Country B will produce more of good Y, by giving up producing good X Since each country uses more resources to produce the good it is giving up, it will produce more of the good it is specializing in. Therefore, total world output will increase making more goods available for consumption. If specialization is done to the extent that each country produced only that good where it has a comparative advantage, the result will be as in figures 4.6 (A) and (B).

Figure 4.6 Productive Specialization According to Comparative Advantage COUNTRY A


Slope –(alx/aly)


A Ap 0 LA/alx XA Graph A




Slope – (blx/bly)

0 LB/blx XA Graph B

With complete specialization, country A will produce at point Ap in Graph A while country B will produce at point Bp in Graph B.

4.8 Group Assignments 1) List resources (or endowment) in which Kenya has an absolute advantage over other countries, which are potential or actual trading partners. Give reasons for each resource cited. 2) List products (goods and services) where you think Kenya has an absolute advantage over other countries, which are potential or actual trading partners. Give reasons for each product /service. 3) Repeat (2) above using David Ricardo’s comparative advantage. 4) Looking at the level of development of Britain vis-à-vis her trading partners at the time Smith and Ricardo propounded their theories (1750-1850), can you cite motivations other than pure intellectual advance that could have influenced Adam Smith and Ricardo to come up with their theories?

LECTURE FIVE 5.0 INTERNATIONAL EQUILIBRIUM WITH FREE TRADE Once countries have specialized production according to comparative advantage and trade has been opened, at which relative price ratio will trade occur? The equilibrium price ratio (PX/PY) at which trade occurs is known as terms of trade. The equilibrium price ratio or terms of trade must lie between the two autarky price ratios. i.e. (PX/PY)A < (PX/PY)tt < (PX/PY)B

Where tt = terms of trade. This is so because, ceteris paribus, a country would not voluntarily trade at international terms of trade that were less favourable than the autarky price ratio. Put in another way, it is not rational to import good and services at prices higher than those prevailing domestically for the same goods. This can graphically be represented as in figure 5.1, Graphs A and B below:

Figure 5.1 Graph A Restriction placed on international terms of trade by Country A. YA


0 AP XA LA/alx

Figure 5.1 Graph B Restrictions placed on international terms of trade by Country B


LB/bly BP

0 XB LB/blx

From the point of specialisation at AP, country A can transform good X into good Y, through domestic production at a rate of alx / aly = (PX/PY)A units of Y obtained per unit of good X given up. For country A to choose instead to continue specializing in producing good X and trade the surplus in exchange for good Y from country B, the trade with country B must give country A at least: alx/ aly = (PX/PY)A additional units of good Y for each unit of good X traded. Using the Graphs A and B in figure 5.1, country A will only find trade with country B beneficial if trade occurs at a relative price that can be represented by a PPF from AP which is steeper than country A’s PPF (see arrows from AP) i.e. Residents of country A will import good Y from country B if they can do so at a price lower than the autarky price of good Y or (PY/PX)A. Residents of country B face a similar choice as residents of country A in their desire to import good X from country A i.e. For residents of country B to import good X from country A, the price of good X from country A must be lower than the autarky price of good X in country B or (PX/PY)B. The international terms of trade must satisfy an additional set of conditions beyond those shown in figure 5.1 that is: the equilibrium price ratio must also be the market–clearing price for the two goods. What this means is that the quantity of good X that country A wishes to export at the terms of trade must exactly equal the quantities of good X that country B wishes to import at the same terms of trade. The same applies to country B for good Y.

With trade, each country chooses its consumption in such a way as to maximize utility, just as was the case with autarky except that this time the consumption opportunity set is no longer limited or constrained to the equal production opportunity set. Once country A specializes in producing good X and opens up trade with country B, residents of country A can choose to consume any combination of X and Y that lies on the terms of trade line through the production point AP. Similarly, once country B specializes in producing good Y and opens up trade with country A, residents of country B can choose to consume any combination of Y and X that lies on the terms of trade line through the point BP. Each country takes advantage of the new opportunities by locating at the point of tangency of the highest community indifference curve and the terms of trade line as shown in figure 5.2.

Figure 5.2 Free Trade Equilibrium in Country A


Slope = - (PX/PY)tt

Slope = - (PX/PY)A = MRTA

LA/aly AC


U1A 0 AP

A LA/alx XA EXPORTS OF X EXPORTS OF X Figure 5.2 Free Trade Equilibrium in Country B


LB/blyBpSlope = - (PX/PY)tt

Exports of Y Slope = -(PX/PY)B = MRTB

B Bc B* U2B


0XB LB/blx Imports of X

The shaded triangles in figure 5.2 are known as trade triangles. Trade triangles summarize each country’s imports and exports as well as the terms of trade. It should be remembered that we defined terms of trade as the equilibrium price ratio (PX/PY) at which trade occurs. For country A, in the base triangle AAcAp, line AAp represents exports of good X and the height, line AAc represents imports of good Y. The slope of the line AcAp measures the equilibrium terms of trade. Triangle BBpBc summarizes the analogous information of exports and imports and the equilibrium terms of trade. Much as we have demonstrated above that trade will be mutually beneficial to both country A and B, this does not mean that the gains from trade will necessarily be shared equally by the two trading partners. To specify the precise division of gains from trade between the two countries requires more information.

5.1 Consumption and Production Gains from Trade. As we have observed in figure 5.2, residents of a country gain from trade because trade enables them to move to a higher consumer indifference curve and therefore higher levels of welfare are attained with trade. Economists divide the total gain from trade in to two parts: The consumer gain or gains from exchange

The production gain or gains from specialization The consumption gain from trade refer to the fact that the exposure to new relative prices (cheaper imports), even without changes in production, enhances the welfare of residents of the country, as shown in figure 5.3 below:

Figure 5.3 Gains from Exchange and specialization with trade

Good Y C’ C(PX/PY)2


E’ (PX/PY)1 0 Good X

In figure 5.3, points E, E’, and C’ are the autarky prices (PX/PY)1, and the trading prices (PX/PY)2. When the country is in autarky, (has no international trade) it is located at point E for both production and consumption on CIC1. Immediately the country is introduced to international trade prices, represented by a steeper price line which is a new trading line (PX/PY)2, the country’s production will remain at point E, but consumption will move to a higher community indifference curve CIC2, at point C, where there’s a tangency between the new price line and CIC2. At point C on the new trading line, consumers have gained from trade even though production has not changed due to their access to cheaper imports of good Y. In addition to the consumer gain, a further welfare gain occurs, because production changes, due to the new relative prices, provide an incentive to produce more of the good X and less of the good Y. Production of good X now switches from point E in autarky to point E’ in accordance with comparative advantage. Moving production of good X from autarky point E to terms of trade point E’ is a production gain, or gain from specialization due to comparative advantage. Further, moving production of good X to point E’ of comparative advantage leads to increases in real income, thus allowing consumers to move from point C to point C’ on a new and higher utility CIC3 .

5.2 Some Important Assumptions in the analysis. Three important assumptions in the analysis of the Ricardian model and the neo-classical theory need to be taken into account when examining the real world. This is because few, (if any) principles in economics, are as universally accepted by economists as the basic principles of comparative advantage, and the two gains from international trade: consumer and producer gains. The three assumptions are:

I. Costless factor mobility II. Full employment of factors of production III. The community indifference curve map can show welfare changes.

5.2.1 Costless Factor mobility One important assumption in the above analysis is that factors of production can readily and costlessly shift along the PPF as relative prices change due to opening of trade. However, in the real world, it may not be possible to adjust to the changed relative prices immediately. Thus, a movement from the autarky production point (point E in figure 4.9) to the trade production point (point E’) may first involve a movement inside the PPF as workers and equipment are to be switched and need to adapt and /or be trained respectively in order to move from the import- competing industry producing good Y and be absorbed in the export producing industry of good X. Only after time passes will the unused factors (from good Y industry) be able to take up employment in the export (good X) industry. If factor movement does occur slowly, there must be a cost involved before the X good industry benefits from the employment of factors released from good Y industry. Many (interventionists) economists argue that government assistance should be provided to facilitate the switch in factors – indeed, many governments have training programmes of employees in this way. e.g. Since 1962, the USA had a programme of trade adjustment assistance to workers in need of transition. Britain has had a similar programme for many decades.

These factor mobility problems are assumed away in the theory presented above.

5.2.2 Full Employment of factors of production Assumption This assumption is related to the problem of adjustment discussed above but applies in general and not only on employees made redundant by imports. Full employment assumption is a general one in microeconomic theory, not just in trade theory. In microeconomics, it is assumed that the macroeconomic problem of unemployment has been solved through monetary and fiscal policies. However, in the real world, no country reaches full employment since there are institutional characteristics that make this impossible. Therefore this assumption is made, not for purposes of ignoring real world problems, but rather to conceptually separate the problem of efficiency and welfare from the problem of idle capacity.

5.2.3 Community Indifference Curve Map Showing Welfare changes In our earlier analysis, we gave one of the characteristics of community indifference curves as not intersecting each other i.e. they are parallel. In the real world, it is possible for them to intersect if, on the redistribution of incomes due to trade, such incomes go to consumers with radically different tastes. This assumption is itself based on two other assumptions:

That individuals within the economy have reasonably similar tastes. That opening the economy to trade does not radically alter income distribution in the country.

LECTURE SIX 6.0 THE NEO-CLASSICAL MODEL Economists who were followers of Adam Smith and Ricardo school of thought are called the classical economists, with John Stuart Mill widely acknowledged as the last classical economist. Economists who followed in their footsteps are known as neo-classical economists. The latter improved on the absolute and comparative advantage theories using modern economic theory and tools. Neo- classical economists objected to Ricardo’s assumption of constant (fixed) opportunity costs in his model. Their objections were based on the fact that:

In the real world, industries are most of the time faced with increasing production costs rather than constant (fixed) marginal costs. This meant that more and more of the one commodity had to be given up in order to produce one extra unit of a competing good. Each industry, independent of what happened elsewhere, may have diminishing returns or rising costs. As a result different industries use different input proportions to produce output. In addition, a switch of inputs from one industry to another might not necessarily gives you the same ‘constant returns to scale’. Despite countries having obvious comparative (even absolute) advantages in the production of certain goods, this has not stopped each country trying to produce everything possible domestically e.g. Japan ignores the benefits of specialization and continues to produce steel for the motor industry; wheat and rice for food irrespective of her resource endowment suggesting otherwise. The neo-classical model assumption is therefore that of rising (not constant) opportunity cost, as more specialization is undertaken by an industry. This means that as an industry undertakes more specialization it has to forego more and more of the other good (s), in order to produce an extra unit of the expanding output. In the neo-classical model, the shape of the PPF under increasing costs can be represented as in figure 6.1 below:

Figure 6.1: Shape of the PPF Under Increasing Costs (concave)





How this concave shape of the PPF comes about will be explained later in fig 6.6. 6.1 Neoclassical Model in Autarky In order to grasp the concept of increasing costs, we need a new element into the model: a second factor of production – capital. In the Ricardian model, it is assumed that labour is the only factor of production. Capital is assumed to be dead labour, or embodied labour.

How can production technology be represented when there are two inputs? For some products, it may be necessary to use the two inputs in fixed proportions like is the case with recipes for food or drinks: a cake recipe specifies 2 cups of flour, 1 cup of milk, reverse this and you don’t get a cake. However, most production processes have very wide opportunities for substituting one input for another e.g. making cars or textiles. The two factors of production in the new model are not perfect substitutes of each other, as was assumed in the case of the Ricardian model. Capital, when used in trade theory, refers to manufactured durables, such as machines, buildings and tools. In figure 6.1, suppose good X (cloth) is the capital-intensive good, and Y (wine), the labour intensive good. Suppose country A is producing at point I on the PPF.

This will mean that country A is producing a larger amount of good Y (OY1A) and smaller amount of good X (OX1A) Suppose country A decides to move its production point from point I along the PPF towards point II. This will reduce the production of good Y (the labour intensive) good, in order to produce more of good X (the capital intensive good). As shown in figure 6.1, it will mean releasing relatively large amount of laobur and small amounts of capital. The resources thus released are in ‘wrong’ proportions for the X producing industry, which is the capital-intensive industry. The further you move down away from point I, the more of good Y reduction is needed in order to produce even less X. In reality, what this means is that the labour (workers) that is efficient in the production of good Y is not necessarily equally efficient in the production of good X. It takes time (including new training on the job) for workers from industry Y to be able to start being efficient in the production of good X. This scenario is represented in figure 6.1 by the concavity of the PPF.

6.2 Production Function: Isoquants and Isocosts. For each industry, the rule specifying the maximum output that can be produced with given quantities of inputs is called the production function. The production function for the industries producing goods X and Y in country A are denoted by: XA = fxA (LxA, KxA) and

YA = fyA (LyA, KyA) Suppose fyA is defined as XA = 2LxA KxA Then if in country A we employ 3 units of labour and 2 units of capital to produce good X, we get XA = 2 . 3 . 2 = 12 units of output A given quality of output (in this case 12 units) can be produced using a variety of combinations of labour and capital because the inputs are substitutes of each other (although not perfect substitutes). The 12 units of output can also be produced using 6 units of capital and 1 unit of labour i.e. XA = 2 . 6 . 1 = 12 units.

The same 12 units of output can be produced with or 2 units of labour and 3 units of capital i.e. XA = 2 . 2 . 3 = 12. The graphic technique of representing these substitution possibilities is called isoquants (or same quantity) map (see fig 6.2 below) Each isoquant shows all the possible combinations of labour and capital that can produce a given output.

Figure 6.2: Isoquant Map for Industry X in Country A


Slope = d KXA/d LXA = MRTSXA =Marginal Rate of Technical Substitution of good X in country A

Isoquants XA1= 125 units

XA0 = 100 units 0 LXA

Each isoquant is down sloping and convex, reflecting substitutability of inputs. Higher isoquants represent higher levels of output (XA1 > XA0). A negative slope of the isoquant represents the fact that the two inputs substitute each other. Convexity of the slope means that more of the other input must be used in order to remain on the same isoquant; i.e. Using less of one input requires the use of more of the other input. Given all the possible combinations of labour and capital to produce good X in country A, it is now necessary to specify how a firm producing good X chooses a particular production process. The assumption is that each firm produces it’s level of output at minimum costs, to maximize profits (as emphasized by Adam Smith) Because profits are equal to (total revenue minus total costs) any firm that does not minimize costs will not maximize profits, ceteris peribus. Given the model’s assumption that there are only two inputs, good X-producing firm ‘s total costs are: [Wage rate paid to labour in country A (WA) multiplied by number of employees (LXA)] plus [price of capital (rA) multiplied by quantity of capital (KAX)] i.e.

Total costs C = [WA . LXA] + [rA . KXA] For example, if the wage rate is Ksh. 100 per unit of labour, and the price or interest rate of capital is Ksh. 150 per unit, the total cost of a firm employing 3units of labour and 2 units of capital would be:

C = (Ksh. 100 x 3) + (Ksh. 150 x 2) = Ksh. 600/=

By using the expression of total costs, a line representing any level of costs can be drawn on a graph. If a firm hired only capital, how many units of capital would it hire? C/rA = 600/150 = 4 units of capital.

This would form the vertical intercept of the iso-cost (same cost). Similarly if the firm hired only labour, how many units of labour could it hire? C/WA = 600/100 = 6 units of labour. This forms the horizontal intercept of the isocost line. It is now possible to draw a graph showing the isocost line for industry X in country A by connecting the two intercepts; (see Figure 6.3).

Figure 6.3 (a): Isocost Line for Industry X in Country A. KXA General Case C/rA Slope = - (WA/rA) = isocost


Figure 6.3 (b): Graph (a) Using a Numerical Example KXA

600/150 = 4 Slope = - (100/150) = - 2/3

Isocost, or same cost line

0LXA 600/100 =6

The isocost line gives all possible combinations of labour and capital, that a firm could hire for a total cost of C given the factor prices of WA (for wages) and rA (as interest rate) on capital. The slope of the isocost is: – (WA/rA) or –2/3.

If you combine the isoquant and isocost graphs, you get the firm’s choice of production process (technique), or technology, as shown in Figure 6.4 below: Figure 6.4 A Firm’s Choice of Technique for Producing Good X in Country A



(K/L) XA Firm’s choice of technology to produce good X in Country A


X1A X0A = Isoquant

Slope – (WA/rA) = Isocost


The graph in figure 6.4 reads: output at point P on level of output X0A is produced using LXA0 units of labour and KXA0 units of capital at the total cost of: C = WA . LXA + rA . KXA

The line rising from the origin to the tangential point P measures the K/L Ratio.

6.3 Capital /Labour Ratio. The capital /labour ratio of the firm gives the mix of capital and labour required to produce a certain level of desired output ceteris peribus. For example a fall in the wage rate (W) relative to the price of capital (r) would cause the firm to use more labour and less capital to produce the desired output i.e. the capital /labour ratio falls. Firms in country A that produce good Y will go through the same process as good X producing firms. The most important point is that the capital / labour ratio of the firms producing good X will be different from that of firms producing good Y, even if both industries face the same relative factor prices. Graphically, this can be represented as in Figure 6.5 below:

Figure 6.5 Capital /labour Ratio of Industry X and Y in Country A


(K/L)Asteel industry

KA steel Steel AO (K/L)Atextile industry

KA textiles Textile AO

0LA LA steelLA textiles

Although industries face the same relative factor prices, they normally choose different capital/labour ratios. The tendency for various industries to utilize factors in different proportions has important implications in international trade. In figure 6.5 above, both steel and the textile industries faced the same relative factor prices but the steel industry uses a higher capital/ labour ratio than the textile one, even if both firms face the same factor prices for labour and capital. If (akx /alx ) > (aky /aly), good X is said to be the capital intensive good and good Y is said to be a labour-intensive good. In figure 6.5, steel is the capital–intensive industry and textiles is the labour –intensive industry. The production technologies summarized by the four input coefficients (akx, alx, aky, aly) provide one of the two pieces of information necessary to sketch country A’s PPF. The other required information is country A’s endowment of labour (LA) and capital (KA). The fact that the two outputs (X, Y) will be produced using two factors in different proportions or different intensities implies that the PPF is no longer a straight line (as in Figure 4.1 of the constant cost model) but is concave or bowed out from the origin; (see Figure 6.6 below). Suppose that good X is capital-intensive, good Y is labour–intensive and country A is currently at point 1 in Figure 6.6, producing a large amount of Y and a small amount of X. As the country changes its production along the PPF from point 1 towards point 2, the reduced production of good Y (the labour-intensive good) releases relatively large amounts of labour and small amounts of capital. These resources are in ‘wrong’ proportions for the X industry, which is capital intensive. What this implies is that successive reductions in good Y production lead to smaller and smaller increases in output of good X.

Figure 6.6: The Shape of PPF Under Increasing Costs


1 Y1A

2 Y2A


The slope of the PPF at each point along the curve represents the opportunity cost of producing good X in terms of good Y foregone or given up. As more and more good X is produced along the PPF with less and less Y being produced, the opportunity cost of X rises. Similarly, the opportunity cost of producing Y increases as more and more Y is produced at the expense of good X. The marginal rate of transformation (MRTA) is no longer constant, as was the case in the Ricardian (constant cost) model. Opportunity costs rise because the two factors (labour and capital) are not perfect substitutes for each other i.e. they are not equally suited to produce both goods. Efficient production of the two goods (X and Y) requires that the two inputs (labour and capital) be used with differing intensities in the two industries.

6.4 Equilibrium in Autarky With Increasing Costs. The community indifference curves (CICs) technique used to represent tastes and preferences in the Ricardian Model can also be used under conditions of increasing costs. The PPF defines the production opportunities set.

In autarky, the country’s consumption possibilities are limited to the same combination of X and Y. The country’s residents will therefore choose the point within the opportunity set that lies on the highest attainable community indifference curve, thereby maximizing utility, subject to the constraint imposed by resource availability and technology.

Figure 6.7 (a): Equilibrium in Autarky With Increasing Costs in country A


Slope = - (Px/Py)A

Slope = MRSA


Slope = MRTA

0 XA XA*

Figure 6.7 (b) Equilibrium in Autarky With Increasing Costs in country B


Slope = MRTB

Slope = - (Px/Py)B

Slope = MRSB


U0B 0 XB* XB

In Figure 6.7 (a), country A chooses to locate at point A* which is the highest attainable level of utility where the community indifference curve U0A is at the tangency with the PPF. The autarky equilibrium involves the production and consumption of XA* units of good X and YA* units of good Y. In this autarky equilibrium, the MRTA = MRSA = - (PX/PY)A.

These conditions ensure that country A is producing in such a way as to achieve the highest possible level of output and satisfaction given the available resources and technology. The same analysis of country A in Figure 6.7(a) can be extended to country B in Figure 6.7(b) except that country B is better endowed to produce good Y, while country A is better endowed to produce good X.

6.5 The Neo-classical Model of Trade: The Heckscher – Ohlin Theorem In autarky, under increasing cost model, otherwise known as the neo-classical model, the production opportunity set is identical to the consumption opportunity set. Opening trade between country A and B creates an opportunity for residents of each country to consume combinations of the two goods that lie outside their respective PPFs. Just as in the Ricardian or fixed cost model, the key to the increased consumption due to trade is to be found in the difference between the autarky prices of goods X and Y in the two countries.

6.5.1 Productive specialization Under Increasing Costs. In the neo-classical model, country A is defined as having a comparative advantage in production of good X if the relative price of X in country A, (Px/Py)A is lower than (Px/Py)B in B. Because all markets are assumed to be perfectly competitive, this condition also implies that the opportunity cost of good X in country A is lower than in country B. Graphically, country A has a comparative advantage in good X if the slope of the relative price line representing A’s autarky equilibrium is flatter than that representing country B as in Figure 6.7(a) and (b) above. Just as was the case in the Ricardian (constant cost) model, comparative advantage is a natural extension of the concept of opportunity cost. However, in the neo-classical (increasing cost) model, comparative advantage is defined by comparing autarky relative prices (which reflect opportunity cost), rather than directly comparing opportunity costs. The main reason for this is that under the neo-classical model, opportunity costs change along the PPF, and are not constant as in the Ricardian model. You will recall we defined the PPF as the line or curve that represents all alternative combinations of good X and good Y that can be produced in a country, given its fixed resource endowment. By using autarky relative prices, we specify specific points along the two PPFs, to compare the opportunity costs of producing good X and Y in the two countries. This point highlights one of the important differences between the constant and the increasing cost models. In both models, determining the direction of comparative advantage involves comparing the slopes of the PPFs. Under the Ricardian model the slope of each PPF is constant. Figure 6.8 reminds us of the Ricardian model’s PPF for countries A and B. Figure 6.8: PPF of the Ricardian (Constant Cost) Model.


20 Slope = MRTA = PPF = - (alx / aly) where:L =100 12alx = 2 10aly = 5 8

0 XA 20 25 30 50 COUNTRY B YB

16Slope = MRTB = PPF = - (blx/bly) 12 where L = 160 blx = 8 8 bly = 10

0XB 51020

This means that the determination of comparative advantage does not depend on the country’s particular location along the PPF. What this implies is that tastes or preferences play no role in determining the comparative advantage in the Ricardian/constant cost model. To put it differently, in the Ricardian model, comparative advantage is determined on the supply side of the model, by technology rather than on the demand side by tastes. In the constant cost model, the process of specialization continues until each country produced only its good of comparative advantage. Under the neo-classical (increasing cost) model the determination of comparative advantage requires that we specify exact points on the PPF at which the opportunity cost should be compared because of cost changes along the PPF. The question is: Will the complete specialization outcome observed under the constant cost model continue to hold under the increasing cost model? The answer is NO as shown in Figure 6.9 below

Figure 6.9: Productive Specialisation Under Increasing Costs COUNTRY A


YA* A*





YB* B*

0 XB XBP XB* Under the neo-classical model, as each country begins to specialize by moving along its PPF in the direction of its comparative advantage, the cost of producing that good rises and the cost of producing the good of its comparative disadvantage falls. As the cost of producing good X rises in country A and falls in country B, eventually the two costs are equalized. Similarly, as the cost of producing good Y rises in country B and falls in country A, the costs eventually converge. When the cost of producing each good becomes equal in the two countries, the advantage to further productive specialization disappears. In Figure 6.9 graphs for country A and B, the optimal degree of productive specialization occurs at points AP and BP, where the slopes of the two production PPFs are equal. Country A produces XAP and YAP and country B produces XBP and YBP. At AP and BP there would be no comparative advantage and no need to move further on the PPFs in search of further specialization. The position shown in Figure 6.9 ensures that productive specialization attains efficiency between the two countries according to comparative advantage. Thus, under increasing costs, a country has comparative advantage in the production of a good if a good’s relative price is lower in that country than in the other country. This result is known as the Heckscher -Ohlin (H-O) theorem.

However, a theory of trade based solely on productive bias due to factor endowment is artificial. Under conditions of increasing costs, tastes and technology interact to produce comparative advantage.

6.5.2International Equilibrium With Free Trade and Increasing Costs. Once productive specialization has occurred such that the opportunity cost of the two goods are equalized between the two countries, relative prices of the two goods will also be equal in the two countries. Of all the possible sets of relative prices, at what price will trade actually occur? The market clearing price, or the equilibrium terms of trade will be the ones at which the quantity of good X that country A wishes to export just equals the quantity of X that country B wishes to import. This is the international economics version of the definition of the equilibrium price of a good: the price at which the quantity demanded equals the quantity supplied. Figure 6.10 International Equilibrium With Trade and Increasing Costs.










In Figure 6.10, country A can trade along the common relative price line representing the international terms of trade to the point of tangency with the highest attainable indifference curve, U1A. This occurs at point AC, at which point country A produces at point Ap, exports (XAP – XAC) units of X to country B, and imports (YAC-YAP) units of Y from country B. Country B’s residents can trade with those of A along the terms of trade line where utility –maximizing consumption choice is BC. Country B’s imports (XcB-XpB) from country A are exchanged for B’s exports (YPB-YCB) to country A. Thus, free trade expands each country’s consumption set by allowing residents to trade at the international terms of trade. This enables both countries to obtain consumption combinations that could not be produced domestically because they lie outside their PPFs. As Figure 6.10 shows, it would be impossible for country A to produce XAC units of good X and YAC units of good Y, and for country B it cannot produce XBC and YBC. Trade also equalizes the opportunity cost of each good in both countries by increasing production of each good in the low-cost country and decreasing production in the high–cost country.

LECTURE SEVEN 7.0 OFFER CURVES In our analysis of the Ricardian and Neo-classical models, we made some simplifications without explaining how some international prices were determined. For example, Ricardo assumed that one unit of wine could exchange for one unit of cloth without telling us the factors that determined this relative price ratio. Similarly, in the neo-classical model, drawing the price line (PX/PY) in the PPF–indifference curve diagram, was an artistic trial and error exercise without giving reasons as to how this relative price ratio was arrived at. It is now time to explore how these international prices are determined. The analytical tool to be used to do this is called the offer curve, also known as the reciprocal demand curve. The offer curve of a country indicates the quantity of imports and exports the country is willing to buy and sell in the world market at all possible relative prices. To put it differently, the offer curve shows the country’s willingness to trade at various possible terms of trade. The two-prong nature of the offer curve distinguishes it from most other graphical devises in economics. The offer curve concept was first verbalized by John Stuart Mill (1806-1873), but was put into graphical form by Alfred Marshall (1842-1924) and Francis Y. Edgeworth (1845-1926) There are several methods of deriving an offer curve but we shall content ourselves with looking at only two of the methods. I. The “Trade Triangle Approach” – this is a method, which builds directly upon the PPF – indifference curve diagram of trade triangles in Figures 5.8 and 6.10. II. The “Tabular Approach” which uses a numerical example. Gottfried Haberler popularized the second method, the tabular approach, in his book, The Theory of International Trade (1936).

7.1 The “Trade Triangle Approach” of Deriving an Offer Curve

Figure 7.1 Trade Triangles at Two Possible Terms of Trade of a Country A

COUNTRY A Graph (a) Good YA

Y1 C



(PX/PY) 1

V 0 X1 X2 Good XA Graph (a) of figure 7.1 shows country A’s trading position at world prices (PX/PY)1 where the country is producing at OX2 of good X and OY2 of good Y at point P. Consumption is OX1 of good X and OY1 of good Y at point C.

With production at P and consumption at C, OX2 - OX1of good X is being exported and OY1 - OY2 of good Y are being imported. The volume of trade (i.e. exports + imports) is represented by the trade triangle RCP, with length RP representing exports of good X and height RC representing imports of good Y, that country A is willing to undertake at the given terms of trade (PX/PY)1.

COUNTRY A Graph (b) Good Y A

Y3 C’


Y4 R’ P’


V’ 0 X3 X4 Good XA

In Graph (b) of Figure 7.1, the country now faces a steeper world price line (PX/PY)2 than in Graph (a) such that its production and consumption points have correspondingly adjusted. Since (PX/PY)2 in graph (b) is greater than (PX/PY)1 in graph (a), producers respond to the relatively higher price of good X (and relatively lower price of good Y) by increasing their production of good X and decreasing their production of good Y. Production in Graph (b) takes place at P’ with 0X4 of good X being produced and OY4 of good Y being produced. At (PX/PY)2 prices, consumption takes place at point C’ with OX3 of good X and OY3 of good Y being consumed. Hence exports of country A are now, OX4 - OX3 of good X and imports are OY3 - OY4 of good Y. The volume of trade is represented by the trade triangle R’C’P’. It is now clear that for country A, different trade volumes exist at the two different sets of relative commodity prices. The offer curve diagram takes the information from graphs (a) and (b) of Figure 7.1 and plots it onto a new diagram as in Figure 7.2. This graph does not show production or consumption but only the quantities of exports and imports at two sets of prices.

Figure 7.2 Terms of Trade and Export and Import Combination on the Offer Curve

OCA (PX/PY) 3 Imports of good YA (PX/PY) 2

(PX/PY) 1 (PX/PY) 0


Y5 T

O X5 X6Exports of good XA

The key geometrical difference between the two graphs, Figures 7.1 and Figure 7.2, is that the (PX/PY) price ratios are represented in different fashion – they are upward (positively) sloped in the latter (Figure 7.2) rather than negatively (downward) sloped in the former (Figure 7.1) Thus, (PX/PY)1 in Figure 7.2 is the same as (PX/PY)1 in Figure 7.1(a). If the two figures were drawn on the same scale, the angle OVC in figure 7.1 (a) is the same size as the angle formed at the origin in figure 7.2 between (PX/PY)1 and the X-axis. At this set of prices, the country exports quantities OX5, which is drawn to be equal to the length X1 X2 in Figure 7.1 (a) Similarly, the country’s imports in Figure 7.2 are OY5, which in Figure 7.1 (a) is drawn to be equal to the height Y2 Y1. With country A’s exports and imports thus plotted, point T represents the volume of trade associated with (PX/PY)1 price ratio. Point T is a point that corresponds to the volume of trade indicated by the horizontal and vertical sides of the trade triangle RCP in Figure 7.1 (a). The higher relative price ratio (PX/PY)2 of Figure 7.1 (b) is represented by the steeper price line in Figure 7.2, just as it was in Figure 7.1 (b). At this higher price of good X on the world market, greater quantities of good X are exported – such that OX6 in Figure 7.2 corresponds to X3X4 in Figure 7.1(b). At the new higher price of good X, good Y is relatively lower priced, such that imports OY6 in figure 7.2, which is drawn equal to imports Y4Y3 in figure 7.1 (b) is greater than imports 0Y5 The volume of trade at price (PX/PY)2 is thus represented by point T’ in Figure 7.2. We have now obtained two points on country A’s offer curve. To get more points on the offer curve, you have to get more trade triangles for Figure 7.1 at different (PX/PY) price ratios like (PX/PY)0 and (PX/PY)3 in Figure 7.2. The construction of country A’s offer curve is completed by connecting the possible “willingness to trade” points resulting in the curve labeled 0CA in Figure 7.2. The most useful feature of the offer curve diagram is that it can bring two trading countries together onto one diagram. The necessary step towards achieving this result is to develop the offer curve of country A’s trading partner, country B, by going through the same process as we did with country A starting with trade triangles. The only difference will be that country B will be exporting good Y and importing good X. Thus, country B’s offer curve would appear as in Figure 7.3.

Figure 7.3 Country B’s Offer Curve

Exports of Good YB

(PX/PY)1 (PX/PY)2 (PX/PY)3 OCB

0 Imports of good XB

In country B, a lower (PX/PY)1 is associated with a greater willingness to trade on the part of country B since the lower relative price of good X would mean a greater incentive for country B to import. Similarly, a lower (PX/PY) means a relatively higher price of good Y and should spur country B into greater willingness to export good Y.

7.2: The “Tabular Approach” to Deriving Offer Curves. The second method of deriving offer curves is the “tabular approach” which was popularized by Gottfried Haberler and uses numerical example. This method is demonstrated by developing a hypothetical country A’s offer curve from information contained in table 7.1

Table 7.1: Country A’s Exports and Imports at Various Terms of Trade. Column 1 column 2 column 3 Terms of trade Demand for imports Supply of exports (Assumed) of good Y (Assumed) of good X (Assumed)

1X: 1Y or PX/PY = 1 10 Units 10 units 1X: 2Y or PX/PY = 2 44 units 22 units 1X: 3Y or PX/PY = 3 81 units 27 units 1X: 4Y or PX/PY = 4 120 units 30 units

Column 3 indicates the supply aspect of the offer curve and illustrates the link between exports and imports (e.g. use of offer curves for WTO negotiations where exports are being supplied to the world market in order for a country to be able to purchase imports). In the first row of Table 7.1, 10 units of good Y are being demanded on the world market, and the price of one unit of Y is 1X. Therefore 10 units of X goods must be exported before country A is enabled to import 10 units of good Y in the world market. Similarly, in row two, 44units of good Y are being demanded at a price that requires that one-half unit of good X be given up to get each unit of Y good, (i.e. 22 units of good X must be exported in order to get 44 units of good Y) It can be seen that the figures in column 3 are obtained by dividing the number in column 2 by the relative prices in column 1 (e.g. officials in Kenya’s Ministry of Trade and Industry should use policy and trade figures to arrive at terms of trade hypothetical figures in column 1). From the information in Table 7.1, the offer curve is obtained by plotting the quantities exported and imported at each relative price on the familiar X and Y axes, as in Figure 7.4 below.

Figure 7.4 Country A’s Offer Curve.

Scale: Y-axis 1:1.5mm; X-axis 1:3mm

Imports of Y


1X: 4Y (PX/PY)4 = 4

120 T3 1X: 3Y (PX/PY)3 = 3

81 T2 1X: 2Y (PX/PY)2 = 2

44 T1 1X:1Y(PX/PY)1 = 1

10 0 10 22 27 30 Exports of X

We can now get the offer curve by joining the terms of trade points (T1, T2, T3).

7.3 Trading Equilibrium

Country A’s and country B’s offer curves can now be brought together onto one diagram. We can now indicate the trading equilibrium and show the equilibrium terms of trade as shown in Figure 7.5 below. Figure 7.5: Trading Equilibrium

(PX/PY) E = ToTE A’s Imports of Y B’s Export of YOCA YB B YE OCB E (PX/PY) A = ToTA YA


0 XA XE XB Exports of X by A Imports of X by B

In Figure 7.5, the offer curve of country A, OCA, and the offer curve of country B, OCB are drawn as developed in section 7.1, Figures 7.2 and 7.3. The horizontal axis indicates exports of good X, with reference to country A and imports of good of good X with reference to country B. Similarly, the vertical axis indicates country A’s imports of good Y and country B’s exports of good Y. Trading equilibrium occurs at point E, and the equilibrium terms of trade (PX / PY)E = ToTE are indicated by the slope of the line from the origin passing through point E. The trading equilibrium is at point E because it is at that point that the quantity of exports country A wishes to sell (OXE) exactly equals the quantity of imports that country B wishes to buy (also OXE). In addition, the quantity of imports that country a wishes to import (OYE) exactly equals the quantity of exports that country B wishes to export (also OYE) Relative prices (PX/PY)E are market-clearing prices, since demand for and supply of good X on the world market are equal, as are the demand for and supply of good Y. Why is (ToTE) the market clearing price (equilibrium price) ratio? In figure 7.5, suppose world prices were not at (ToTE) but at the lower point A on the lower (ToT)A: At this point, country a would like to trade at point A – that is country A would like to export OXA of good X and import OYA of good Y. However, at this lower relative price of good X, country B is ready to trade at point B, i.e. it would like to import OXB of good X and export OYB of good Y. Hence, at point A on (ToTA) there is excess demand for good X to the tune of XAXB and excess supply of good Y to the tune of YAYB. The excess demand for good X will bid up its price on the world market, and the excess supply of good Y will bid down its price on the world market. With these pressures on world prices on good X and good Y, the relative price ratio (PX/PY)A will rise towards the equilibrium terms of trade where demand will equal supply. That is to say the world price of good X will continue to rise and the world price of good Y will continue to fall until the equilibrium price E is achieved. LECTURE EIGHT

8.0 THE HECKSCHER – OHLIN (H-O) MODEL 8.1 Introduction We said earlier that, under increasing costs (or in the neo-classical model) a country has a comparative advantage in the production of a good if the good’s relative price is lower in that country than in the other country. In order to identify the sources of comparative advantage, it is necessary to examine the determinants of relative prices in the two countries. In Figure 6.7, it was illustrated that relative prices in each country are determined by the interaction of supply (resource availability and technology as summarized in the PPF) and demand (tastes as represented by community indifference curves CIC) Differences in relative prices can originate from:

Differences in resource availability Differences in technology Differences in tastes Or some combination of above three. For now, we shall restrict our attention to the possible effects of differences in resource endowment and tastes. 8.2The Role of Factor Endowment in Determining Comparative Advantage 8.2.1 The Heckscher - Ohlin (H-O) Model or Theorem

The role of theory in Economics is to help us interpret the real world in some orderly manner (some say in a scientific manner) The economics discipline has developed tools of analysis that help us to interpret the real world using certain accepted theories. For instance, the Ricardian model predicates that the production function is linearly homogeneous, such that if both factors of production are increased by say 10 percent under certain assumptions, then output will be increased by exactly 10 per cent. The Heckscher –Ohlin model is an improvement on the Ricardian model. The Heckscher –Ohlin model is a general equilibrium model. It can be used to examine how changes in demand or supply conditions in a country would affect the economy of a country involved in international trade. How differences in countries’ endowments of various factors of production determine patterns of trade was the first explored by Swedish economist Eli Heckscher and his student Bertil Ohlin at the beginning of the 20th century. To develop their model, (on the role of factor endowments), H-O adopted certain assumptions, which were in addition to the basic Ricardian model assumptions. These assumptions were:

I. Tastes do not differ in the two countries to be involved in trade. II. The two countries involved in trade differ in factor abundance III. The two goods to be traded differ in factor intensity.

8.2.2 Factor Abundance What did H-O mean by factor abundance? Factor abundance can be defined in two ways: (a) Using relative factor quantities: Country A is factor abundant if: KA/LA > KB/LB i.e. country A has more capital per unit of labour than country B. Note that country A could actually have less capital than country B, yet still be the capital abundant country. For example, if KA =50, LA = 50 and KB =100, LB = 150:

Such that KA/LA = 50/50 = 1, and KB/LB = 2/3 Then, country A is the capital abundant country. Therefore, what matters is not absolute quantities (as per Adam Smith’s theory) but a comparison of capital per unit of labour (as per David Ricardo’s). Given the two counties that are to trade and two factors they are endowed with: If country A is capital abundant, then by definition, country B must be labour abundant. The quantity-based definition of factor abundance described above depends on the supply of the factors of production in the two countries with the demand factors playing no role. (b) Using factor prices:

Country A is factor abundant if: rA/WA < rB/WB or WA/rA > WB/rB i.e. the relative price of capital (interest rate) in country A is lower than in country B or the relative price of labour (wages) is greater in country A than in country B. Thus the price-based definition considers the role of both demand and supply of the two factors The original H-O model was based on the quantity-based definitions, but many text books use the price-based definition. Thus, to avoid confusion when reading about this topic, be on the lookout to establish which definition has been used. The original H-O model was based on the quantity – based definition but in many books you will find the price-based definition being used. 8.2.3 What H-O theorem says

H-O combined the factor abundance with the idea that different goods involve different factor – intensities in their production to infer, conclude or predict that under unrestricted trade: I. A country will have a comparative advantage in the good whose production involves intensive use of the factor that the country possesses in abundance. II. A country will export the good in which it has a comparative advantage and will import the good whose production involves intensive use of the factor that the country possesses in relative scarcity. Note that because one of the assumptions is that technology is the same in both countries, if good X is capital –intensive in country A i.e. aKX/aLX > aKY/aLY, then

bKX/bLX > bKY/bLY Assume that country A is labour abundant (LA/KA, >LB/KB) and that good X is the labour-intensive good i.e. aKX/aLX < aKY/aLY and bKX/bLX > bKY/bLY If this is the case, then I. Country A has a resource endowment that is relatively well suited to the production of good X II. Country B has a resource endowment, which is well suited to produce good Y. For example, Kenya has a resource endowment of good agricultural land, which is well suited to produce tea; meaning that Kenya is farmland abundant and tea is a farmland-intensive good. China, on the other hand, has a resource endowment well suited to produce clothing; meaning that China is labour abundant and clothing production is the labour-intensive industry. The PPF of each of these countries reflects a bias toward the good of comparative advantage as shown in figure 8.1

Figure 8.1 Production Bias Due to Differences in Relative Factor Abundance: Kenya Versus China

Country A (Kenya)

Clothing Kenya Slope = -(Pt/Pt) Kenya

U0 Kenya

0 Tea Kenya

Country B (China) ClothingChinaSlope = - (Pt/Pc) China




If tastes were identical in Kenya and China as assumed by H-O, the autarky price of tea would be lower in Kenya and that of clothing would be lower in China. Under free trade, Kenya would specialize and export tea to China while China would specialize and export clothing to Kenya because both countries would use their abundant factor intensively. 8.2.4 The Role of Taste in Determining Comparative Advantage. Although the H-O model assumes that the production bias resulting from differences in factor endowment form the basis of trade, there are other possibilities. For example, two countries could have identical PPFs (i.e. identical factor endowments and technology) but very different tastes- e.g. Uganda and Kenya may have identical PPF in agricultural production, but when it comes to their nationals’ staple food the tastes are different. The differences in tastes would produce different autarky price ratios as shown in figure 8.2 Suppose in country A, Kenya, residents have a taste bias for maize (ugali) while in country B, Uganda, residents have a taste for cooking bananas (matoke). With identical PPFs, the strong demand for maize in Kenya and the strong demand for bananas in Uganda result in different relative prices in each country. Figure 8.2: Production Bias Due Taste Bias

Country A: (Kenya) YA

Slope = -(PX/PY)A


Good Y = Maize Good X = Bananas

0 XA Country B (Uganda)


Slope = - (Px/Py)B

Good X = Bananas Good Y = Maize


0 XB

This taste bias gives Kenya a comparative advantage in the production of maize, while Uganda gets the same for bananas. Under free trade, Kenya could specialize in maize production, while Uganda specializes in banana production even though the PPF are identical. When the identical taste assumption in the H-O model is relaxed, and both factor endowments and tastes are allowed to differ simultaneously, the taste bias can reinforce, partially offset or totally offset the production bias. Unlike in the constant-cost (Ricardian) model, tastes play a significant role in determining the direction of comparative advantage in the neo-classical model, and indeed in the real world.

8.3 Group Activity From what we have covered so far about the determinants of trade patterns, can you use these theories to answer the following? Why does Colombia export Arabica coffee? Why do Taiwan and Hong Kong export colour TV? Why does the USA export soybeans? Why does Japan export automobiles? Why does Brazil export steel? Why does Singapore export services? NB: All the above countries are world leaders in their respective export items.

LECTURE NINE 9.0 EMPIRICAL TESTING OF TRADE THEORIES 9.1 Introduction From the answers to the questions in the group activity in Lecture Eight, it should be apparent that there is no single theory or explanation that is sufficient to explain patterns of trade for all the countries listed. One fact that comes out clearly is that irrespective of what trade theory predicts, some trade will always take place between countries, viz: Governments’ imports or exports of military hardware are dictated by unique political and strategic goals which trade theory will not help much to explain. Trade in manufactured goods may respond to influences different from those affecting primary products like agricultural exports. The importance of relative factor endowment in determining trade patterns in oil or diamonds is much more obvious than the case of bicycles or shoes or radios. A large share of trade in many sophisticated manufactured goods is intra-industry trade: i.e. international trade in which each country imports and exports products from the same industry e.g. Japan exports cars to USA but imports aircrafts from the USA. Thus explaining different types of trade needs modifying our basic trade models: The Ricardian model

The neo-classical or H-O model. 9.2 Empirical Testing of Trade Theories One way of determining that a specific trade theory can explain particular patterns of trade is by empirically testing that theory. Adam Smith used historic observation that income levels tend to be higher in coastal cities, which engage in international trade, to advance his theory of absolute advantage. David Ricardo used his observation of differing opportunity costs in the production of wine and cloth in Portugal and England to argue that unrestricted trade between the two countries would increase output of both wine and cloth. But those early observations did not satisfy the rigorous standards of empirical testing of today. The fact that a theory appears to be overwhelmingly supported by available evidence cannot prove the theory as true or valid. No single empirical test can prove a theory as true but repeated tests, which give similar results can increase confidence in a theory. Similarly, results of empirical studies can contradict a theory but that does not prove the theory false. Test results that contradict a theory weaken confidence in the theory but there is always the possibility that the test itself was faulty in either design or executions. Often, the most useful outcome of an empirical study is not validation of the theory in question, but refinement of both the theory and the test. Let us now discuss attempts to test the Heckscher-Ohlin or factor endowment theory of trade. 9.2.1 Test of the Heckscher-Ohlin Theory

For several decades after the development of the H-O model, it was impossible to empirically test the theory using anything other than the simplest observations. For example, it was observed that England did not specialise in the growing of cotton, USA in bananas or France in mining diamonds. All these observations were consistent with H-O theory of relative factor endowment as a basis of comparative advantage. But this did not provide the H-O theory with a water-light case of proof. Several hurdles stood in the way of testing H-O theory empirically: One was lack of data on production inter-relationships among industries e.g. Suppose you were assigned the job of finding out factor intensities of the steel industry? It is not enough to pick a representative sample of steel mills and find out how much capital and labour are used in producing steel. Each input (coal, iron and machines e.t.c.) except labour is itself produced using capital and labour. So capital/labour ratios of all inputs used to produce steel must be known before one attempts to find the steel industry’s capital/labour ratio. In short, it is not only the direct capita/labour ratio, which is relevant, but also the indirect usage of capital and labour. In order to calculate these indirect inputs used to produce steel, you must know how many blast furnaces, heat protection suits, how much electricity and fuel (coal) e.t.c. go into making one tonne of steel. You must also know how much capital and labour go into making a blast furnace, a heat protection unit, kilowatts of electricity and fuel (coal) e.t.c. go into making one unit of each of them. Until the pioneering work of Wassily Leontief in 1941, the means of generating this enormous set of information did not exist. Leontief developed input-output tables for the USA economy that calculated how much output from each industry was used as input in each of the other industries. For this contribution, Leontief received a Nobel Prize in economics in 1973. It is these input-output tables that Leontief used to test the H-O model.

9.2.2 Leontief Test of H-O Model and the Leotief Paradox Leontief set out in 1952 to prove that a country will export those goods whose production involves intensive use of its abundant factor and import goods whose production involves intensive use of the scarce Factor. He tested this proposition first using 1947 data for USA.

Because there was no data on factor intensity of actual imports (since they were produced outside the USA), Leotief was forced to use data of import substitutes produced in USA as proxy. In 1947, no one seriously questioned the capital abundance of USA, relative to the rest of the world e.g. USA was labour scarce and therefore encouraged immigration,

The USA had a highly developed capital-intensive manufacturing sector prior to World War II. The war destruction of most capital stock in the rest of the developed world made USA even more relatively capital abundant. USA even provided capital for the reconstruction of Europe and Japan. All the above implied that according the H-O theory, all the goods exported by USA ought to be capital-intensive relative to the goods imported by the USA. Much to the surprise of everyone, Leontief’s study found out the opposite result, viz:

USA was exporting labour-intensive goods e.g. soybeans and wheat, and importing capital intensive goods (e.g. crude oil) In fact, USA exports were found to be 30 per cent more labour intensive than USA’s import substitutes (see table 8.1) Table 8.1 The Leontief Paradox.

Exports Imports

Capital (1947 dollars) 2,550,780 3,091,339 Labour (person-years) 182 170 Capital/labour Ratio (dollars/person-year) 14,015 18,184

Source: W.W.Leontief, “Domestic Production and Foreign Trade”, Proceedings of the American Philosophical Society, 1953. Reprinted in R.E Caves and H.G. Johnson, 1968, Readings in International Economics, Homewood, III: Irwin 9.3 Modification of H-O Model to Explain Patterns of Trade. 9.3.1 The Role of Tastes. H-O assumed that tastes were identical across countries. However, in the real world, large differences in tastes can introduce taste-bias that can dominate a production bias especially in food production. As pointed out earlier, if Kenyans by tradition prefer to eat maize/maize products, even if local soils and weather patterns are not well-suited for maize production, efforts will be made to grow maize, just like the Japanese and Koreans grow rice. If maize production in Kenya is relatively capital-intensive, and yet Kenya is labour-abundant (as the case is today) maize will be grown and surplus exported. This contradicts the H-O theory.

However, does this taste-bias explain the Leontief paradox? Evidence suggests that consumer tastes for manufactured goods are remarkably similar across countries. For example, consumer tastes for cars, clothes, TV, radios, cell phone are remarkably similar all over the world. Ironically, when it comes to luxury goods, rich consumers across countries tend to prefer labour-intensive goods, e.g. Rolls Royce, Shoes, Watches and even wine. It is therefore theoretically possible to explain the Leotief Paradox, by the presence of a strong taste bias. But one must provide strong evidence of that taste-bias to prove the Leotief Paradox. 9.3.2 The Role of Trade Barriers.

Comparative advantage determines patterns of trade in the absence of government-imposed barriers, e.g. tariffs, quotas and bans. Barriers can protect industries to the extent that over time they become efficient in factor productivity, management improvements e.t.c. This is what happened in Japan with regard to steel production, since Japan does not have resource endowment of iron and coal deposits used in making steel. Thus, if industries were originally protected to enable them to become competitive, in spite of relatively scarce resource endowment, then the H-O model cannot explain pattern of trade resulting from such protection: Japan exports cars and electronic equipment despite originally lacking the resource endowment for their production – protection in the 1960s and 1970s did it. South Korea exports ships, cars, electric and electronic goods – same as Japan largely due to protection provided to the infant industries in 1980s and 1990s. 9.3.3 Classification of Inputs

In the H-O model, inputs are classified in terms of capital and labour and yet this is unrealistic in the real world of today: The modern classification of inputs is as follows: Arable farmland. Raw materials or natural resources Human capital Man-made or non-human capital (technology) Unskilled labour Financial capital With the above classification of inputs, the USA’S factor abundance exists in farmland, human capital, financial capital and physical capital. This partly explains USA’s export success in I. Agricultural products (soybeans, wheat, corn e.t.c.) II. High technology goods e.g. computers, III. Research and Development (R&D) intensive industries e.g. pharmaceuticals. IV. Aeroplanes e.t.c. If one used the H-O model to analyse this is peculiar combination of exports from USA, one would get a labour–intensive outcome for many of the exports, but much of the labour is highly skill-trained and needs constant training and research input. On the other hand, a close analysis of the USA imports (crude oil, diamonds, copper bauxite, uranium) showed that many of them were produced using natural resources whose extraction involves capital-intensive technology. The same is true of processing of minerals e.g. processing crude oil and petrol-chemical industries are very capital intensive. It should be noted that the USA imports most of its mineral-based products mainly due to strategic reasons (e.g. desire to preserve their own natural resources as they exhaust those from the rest of the world), and not due to scarcity of natural resources or scarcity of capital. It will also be observed that labour is not a homogeneous factor as it varies in skills, education, training, and cultural exposure e.t.c. Some of the differences in human capital are responsible for the high productivity levels responsible for the competitiveness of USA’s exports in the world market. Therefore investment in human capital is as important or even more important as investment in physical capital in strengthening the country’s export base. A well-educated population is just as good as physical capital and a combination of the two does wonders for economic growth and development. As it happens, the USA is rich in both human and physical capital. 9.3.4 Intra-industry Trade.

The Ricardian and neo-classical models assume that goods are homogeneous. This implies (at least in the absence of transport costs) that a single good will not be both imported and exported by the same country. However, in most manufactured goods, homogeneity is a difficult assumption to sustain. The example most cited is automobile (motor vehicles) since all major industrialized countries export and import cars. The main explanation for this is product differentiation – this appeals to peoples’ tastes and is responsible for much of intra-industry trade. But if Japanese want M-Benz or BMW cars, why don’t their factories produce them at home? The answer to this question lies in two factors:

I. Patent protection or legal restriction factor. II. Increasing returns to scale – economies of scale factor.

9.3.5:Trade with Economies of Scale. If the average cost per unit of production of a good falls as the scale of production increases, production is said to exhibit decreasing costs, increasing returns to scale, or economies of scale. Economies of scale are important because they make it very difficult for small-scale producers to compete with the large-scale producers even if the former have the benefit of relative factor endowment (USA cotton Vs. Benin & Burkina Faso cotton farmers) As a result, there is a tendency towards large scale firms or plants (cement in Kenya) Economies of scale are a major incentive to specialisation e.g. in the car industry, there are firms which specialize in making engines only (Rolls Royce), head-lamps (Lucas), motors (Borsch).

9.3.6 Effects of Transport Costs on Trade Some goods are not traded internationally – these are known as non-traded goods. For most of them, their transport costs are so high that they can only be consumed locally e.g. sand, ballast. Thermal electricity generators are very heavy and involve high transport costs, but because their value is also high, they are traded. Therefore, value is critical to a good’s tradability.

Economists do not dwell too much on the effects of transport costs because, every now and then, new technology is produced to minimize transport (Telegraph versus telephone; telex versus internet; cell phone versus landline telephone.) Even for bulky traded goods, transport costs have been reduced drastically in recent times: Refrigeration of trucks, ships and planes has taken away the problem of attendant to transportation of perishables to distant markets. Containerized cargo shipping and faster ships have facilitated the quick and efficient low cost transportation of bulky items for very long distances (generators from Europe or USA to Kenya) If transport costs are important determinant of patterns of international trade, then the choice of location of industries or firms becomes significant. The field of urban and regional economics, which focuses on locational decisions, is a separate course. Here, we shall highlight a few basic industry characteristics that apply to location of firms and patterns of trade. 9.3.7 Effect of Location of an Industry on Trade

A decision to locate a firm depends among other things, the characteristics of the production process of the industry e.g. Mining operations must be carried on the site of the mineral deposits. However, once the minerals are out of the ground, a decision must be made as to the location of processing: On site if the raw material is heavy and bulky and processing will reduce weight and bulk. Market oriented location of production: It makes more sense to transport the bulky wheat to Kenya’s urban areas to make bread, where the bread market is dominant. Foot-loose or light industries: these are industries, which do not need to be located either near the source of raw materials or near the market. Foot-loose weight industries produce products, which do not lose weight. e.g. shoes, or electronic products. These industries move freely around the world in response to changes in prices of factors of production.

9.4: Factor Intensity Reversal and H-O Theory. One of the explanations given for failure of H-O theory to explain trade between countries is factor intensity reversal. A factor intensity reversal occurs when the same good is produced in two countries and is the capital-intensive good in one country and the labour-intensive good in the other (textiles made in USA versus textiles made in China). If this happens the H-O premises for trade collapses.

Suppose China is a labour-abundant country in which textiles (good X) is a labour-intensive good, while USA is a capital-abundant country, in which textiles (good X) is a capital –intensive good. The H-O theory predicts that China could export good X(textiles) and import good Y and USA could export good X (textiles) and import good Y, which is not a theoretically tenable proposition under these circumstances, since there will be no country to import good X, or to export good Y. As a result, both the H-O and the factor price equalization theory of Stolper- Samuelson collapse in the presence of factor intensity reversals. What is the source of factor intensity reversal?

The basic source of factor intensity reversals is the differing abilities of various industries to substitute capital and labour in the production process. The simple H-O model, assumes that the two industries (producing goods X and Y) have roughly equal abilities to substitute capital and labour in their respective production processes, implying that: I. Good X is the labour-intensive good in both countries.

II. Good X is the labour-intensive good regardless of relative factor prices. This assumption is crucial if one is to rule out factor intensity reversals. Thus, so long as the two goods (X, Y) maintain their same factor-intensity ranking regardless of the level of factor prices, factor intensity reversal will not occur. However, factor intensity reversals do occur in real life though not very frequently.

9.5 Paul Samuelson’s Factor Price Equalization Theory (1948) It is easy to see that free trade tends to equalize prices of traded goods across countries of the same level of development. What about factors of production among trading countries – can wages and interest rates be equalized between Kenya, Uganda and Tanzania? If factors of production moved freely across national borders, we would expect relative factor prices to be equalized across countries of same level of development. But you will recall that one of the assumptions of H-0 was that factors of production are mobile within one country but immobile between countries. When trade begins, a country increases its output of the good in which it possesses a comparative advantage and according to H-O, this will be the good whose production involves intensive use of the abundant factor. Thus the price of the abundant factor increases due to derived demand resulting from trade. Similarly, trade lowers the price of the scarce factor because imports reduce demand for domestic goods produced using the scarce factor. The same price adjustment process occurs in the second (trading) country, but the roles of the two factors are reversed. Samuelson’s price equalization theory states that:

“Trade raises the price of a factor in the country in which it is abundant, and lowers the price in the country where the factor is scarce” Thus, even though factors of production are assumed to be immobile between trading countries, free trade tends to equalize the relative price of each factor in the two countries. This is the idea behind the factor price equalisation theory first demonstrated by Paul Samuelson in 1948. However, why are factor prices between trading countries not equalised in the real world? Is the theory useless?

One of the reasons why there is inequality of income and wealth across countries is due to uneven distribution of natural resources. The other reason is uneven ownership of human and non-human capital. The Neo-classical model (H-O) assumes that all labour is homogeneous or equally productive, but this is not true in reality as: Differences in labour skills exist

Differences in training and education of labour. Differences in nutrition of labour. Differences in culture and environment.

The other reason is that the neo-classical model assumes that each good is produced using same productive technology in all countries, which is not the case in the real world. Finally, the effects of transport costs, policy barriers (protectionism) and the existence of non-traded goods go some way to explain why factor prices between trading countries are not equalized. In reality, factor prices are equalized in countries with same level of development e.g. wages and interest rates in Europe or even USA Vs. Europe.

9.6 The Stolper–Samuelson Theorem: The Relationship Between Output Prices and Factor Prices Changes in relative output prices that accompany the opening of trade are associated with changes in the levels of production of two goods in each country. According to the theory of comparative advantage, productive specialization is essential in order to capture the gains from trade. Because production of each good involves using different proportions of inputs (K, L), changing output combination alters relative demand for the two inputs. It is this change in relative input demand that causes changes in relative input prices and the distribution of income. For example, if due to trade opportunities offered by African Growth Opportunities Act (AGOA) Kenya investors shift from coffee to textile and garment production, the demand for inputs (such as machinery, sewing machines, skilled tailors, cloth, thread etc) will rise, while the demand for pesticides, fungicides, herbicides and unskilled labour for picking coffee will fall. Under the assumption of H-O theory, opening of trade increases the production of the good that uses the country’s abundant factor intensively. This will in turn increase the demand, and therefore the price of the factor(s) used in its production. Similarly, production of the good that uses the scarce factor(s) intensively falls with the opening of trade, reducing demand and therefore price of the factor (s) used in its production. Let us have a Kenyan example of coffee and textile production: Kenya is labour abundant and coffee is a labour intensive good. According to H-O theory, under free trade (say during the coffee boom on the world market) Kenyans have the incentive to specialise in coffee production. Because coffee production involves intensive use of labour, the demand for labour in coffee growing areas increases. During the coffee boom, Kenya according to H-O theory will decrease the production of textiles/garments because to produce them one uses the scarce factor (capital) intensively. The falling production of textiles/garments will release some of the labour used in that industry, but because production of textiles/garments is relatively capital intensive, the amount of labour released will be relatively small. Figure 9.1shows the effects of trade on the demand for labour and capital.

Figure 9.1 Effect of Trade on demand for labour and capital

Graph (a)











In Figure 9.1 Graph (a) shows the effect of trade in the labour market: In autarky, the demand for labour will be given by DAL0 price at WA0. Once trade begins, increased production of coffee increases demand for labour to DAL1, but because of the simultaneous decrease in the demand for labor in the textile industry, the released laobur reduces the effects of increased demand for labour to DAL2 at the price of WA2. The country’s fixed labour endowment is given by the vertical supply curve LA. Thus, the effect of trade raises the wage rate from WA0 to WA2. The effects of trade occurring simultaneously in the capital market in Kenya are shown in graph (b) of Figure 9.1. In autarky, the production pattern results in a demand for capital given by DAK0 at the price (interest rate) of rA0. When trade is opened, Kenya reduces its production of textiles (the capital-intensive good) causing the demand for capital to shift to DAK1. Production of coffee in Kenya increases but since coffee is laobur intensive, this involves only a relatively small increase in the demand for capital to DAK2 at the price of rA2. Because the wage rate has risen and the interest rate has fallen, the new equilibrium wage/rental (WA2/rA2) is greater than the ratio that prevailed in autarky. (WA0/rA0). Therefore, opening trade has redistributed income towards owners of labour (the abundant factor), away from owners of capital (the scarce factor). The above analysis has stumbled on one of the basic theories of international trade known as the Stolper –Samuelson theory. This theory was co-authored by Wolfgang Stolper and Paul Samuelson in 1941. In its more general form, the theory states:

“Under the assumptions of our model, a rise in the relative price of a good raises the relative price of the factor used intensively in its production” When the assumption of the H-O theory are added (that a country has a comparative advantage in the good that utilizes the abundant factor intensively), the Stolper –Samuelson theory implies that opening trade will increase the reward to the abundant factor and lower the reward of the scarce factor. Under the Stolper-Samuelson theory, trade raises the relative price of the good that uses the abundant factor intensively, thereby raising the relative prices of the inputs. The Stolper-Samuelson theory clarifies one reason for the controversy about free trade: Opening trade alters relative factor rewards, creating incentives for owners of the abundant factor input to support free trade while the owners of the scarce factor input resist attempts to free trade. The question that arises now is: For a country (Kenya) as a whole, are the rewards to the owners of the abundant factor large enough to compensate the losers (owners of the scarce factor) such that the country as a whole remains better off?

In the real world, such compensation, although theoretically possible through taxation/subsidies, is rarely made. Therefore, the Stolper-Samuelson theory clearly points out the existence of at least one constituency, which is for restricted trade or protectionist policies.

LECTURE TEN 10.0ALTERNATIVE THEORIES OF TRADE 10.1 Introduction Newer theories of international trade have emerged since empirical tests of the H-O theorem showed that, on its own, H-O theory fails to explain different patterns of trade between countries, especially trade in manufactured products. The H-O theory was primarily supply oriented because it focused on factor endowments and factor intensities. While H-O theory was sufficient to explain trade patterns involving primary products, it fell short when it came to manufactured goods. Unlike the Ricardian and H-O theories, the newer theories of trade introduce demand considerations in their analysis. They also drop some of the H-O assumptions and consider such factors as level of income, imperfect competition, role of technology and economies of scale. The dynamic feature of changes in comparative advantage overtime is also taken into consideration to explain the common feature of intra-industry trade which negates specialization based on factor abundance – a key pillar of the Smith, Ricardian and H-O trade theories. 10.2 The Imitation Lags Theory of Trade

The imitation lag hypothesis was formally introduced into trade theory by Michael V. Posner in 1961. This theory paved the way for the better-known product cycle theory of international trade. Posner’s theory relaxed H-O assumptions that same technology is always available in all countries Instead the imitation theory assumes that same technology is NOT always available in all countries, and there is a delay in transfer and diffusion/assimilation of technology from one country to another. Consider two trading countries A and B where country A, due to successful research and development, is ahead of country B in producing a tradable product. There will be a lag between the time country B acquires the technology to produce the same new product that country A has had the benefit of a head-start. This time lag is known as the imitation lag, defined as the length of time that country B takes before bringing a competing product, pioneered by country A, to the market. This time lag will include time taken by country B to transfer technology, install equipment, learn and acquire skills to use it, acquire inputs and produce quality products to compete with those of country A. Another lag involved in this process is the demand lag.

The demand lag is the length of time between when the product appeared in country A and when consumers in country B consider this new product a good substitute to some of the products they already have access to. The demand lag may exist due to:

Loyalty consumers in country B have to existing bundle of product Inertia or slowness of consumers to acquire taste for the new product Delay in information flow about the new product In Posner theory, the key feature is to compare the length of the imitation lag with that of the demand lag. Thus the central issue of importance in the imitation lag hypothesis is that trade focuses on new products resulting from new technology. Due to the head-start, country A will have a comparative advantage over country B in selling the new products until country B has gone through both the imitation and demand lags. In the real world, it is common for country B to overtake country A as the leading supplier of the new product as it happened with Japan in the production of radios, TVs and Video cassette recorders, (VCRs) all of which were pioneered by the USA in invention, production and marketing.

10.3 The Product Cycle Theory of Trade The product cycle theory (PCT) was developed by Raymond Vernon in 1966 and builds upon Posner’s imitation lag theory in its analysis of a situation, which arises when there is a delay in new technology diffusion. Vernon developed the theory due to the fact that, as per Leontief’s Paradox, the H-O theory failed to explain USA patterns of trade. Like the imitation lag theory, Vernon’s product cycle theory relaxes some of H-O assumptions. The PCT is concerned with the life cycle of a typical new product in the manufacturing sector in the USA and its effects on international trade. According to Vernon, a new manufactured product in USA will have two distinct characteristics: It will be a product catering for high income demand since USA is a high income country The product is produced using capital intensive technology since USA is perceived to be a labour-scarce country The PCT divides the life cycle of a new manufacture product in USA into three stages in the production cycle. The first stage in the production cycle is the new product stage, where the product is produced and consumed only in the USA, such that: Firms produced for the USA market only where the demand first emerged No international trade takes place since the product is unknown or unavailable outside the USA The second stage in the product cycle is the maturing product stage where: Some general standards for the product and its characteristics are beginning to emerge, allowing for mass production of the new product Economies of scale are achieved leading to reduction of price Foreign demand for the new product emerges, particularly so in other developed countries due to information flow. A trade pattern emerges where USA exports to other developed countries with relatively high incomes in Europe and Japan. USA producers of the new product explore possibilities of producing the new product in other developed countries to save on shipment and distribution costs. Production of the new product overseas will involve movement of capital and management from USA, which contradicts the Ricardian and H-O theories’ assumptions that factors of production (capital and labour) are mobile within the country but immobile between countries Production of the new p abroad will lead to a fall in USA exports of the new product According to Vernon, during the second stage of the production cycle, the new product might start to flow back from Europe and Japan to USA if the cost of production in these countries is lower that in USA as happened with electric appliances and electronic goods in 1970s and 1980s. It should be noted that relative factor endowment and factor prices, which played dominant role in the H-O theorem sill play a major role in the PCT. The final stage of Vernon’s product cycle theory is the standardized product stage, where the characteristics of the new product and the technology used in the production process are well known, such that: Production may shift to less developed countries where low labour costs play a major role in influencing relocation of the production process. USA and other developed countries become importers of the new product from the less developed countries where production is relocated. As a result of the PCT postulates, a dynamic comparative advantage shifts the production of the new product from the advanced country where it was developed and first produced to a less developed country. Vernon’s PCT can now explain a lot of today’s patterns of trade where export products from Tiger economies of South Korea, Hong-Kong/China, Taiwan and Malaysia were originally export products from USA.

10.4 The Linder Theory of Trade Swedish economist, Staffan B. Linder in 1961, set out specifically to address shortcomings in the H-O theory concerning trade in manufactured products, and ended up developing the Linder theory of trade. Linder’s theory departs dramatically from H-O theory because it is almost exclusively demand oriented. It postulates that income levels of individuals influence immensely their tastes for manufactured products, while a country’s per capita income level yields a particular pattern of tastes for manufactured products in that country. According to Linder, it is the tastes of the “representative consumers” in a country that create demand for manufactured products, and in the process this demand sends the necessary signals to firms in the country to produce the products. Once a country’s level of income has induced production of certain manufacture products, these form the base from which exports of a country will emerge. Linder’s theory assumed Engel’s law, which stipulates that the percentage of income spent on food (and basic necessities) declines as incomes rise. Thus, as income levels of a country rise, more manufactured goods of ascending order of sophistication will be produced and traded internationally. Suppose a low income country (Kenya) has a per capita income level that creates demand for goods A (maize flour), B (Kaluworks kerosene lamps), C (textiles and garments), D (paper and paper products) and E (ceramics), all arrayed in ascending order of product sophistication. Let us also suppose that a middle-income country (Turkey) creates demand for goods C, D, E, F (gas and electric cookers) and G (bath tubs and ceramic toilets), with goods F and G being of such sophistication that they are not in much demand in low-income country (Kenya). And suppose we add a high income country (Italy) which creates demand for goods E, F, G, H (refrigerators) and J (cars), then according to Linder’s theory: Low-income country (Kenya) and medium income country (Turkey) will trade with each other in goods C, D and E because of overlapping demand. Medium income Turkey and high-income Italy will trade with each other in goods E, F, G, again because of overlapping demand. However, high-income Italy will trade with Kenya in only good D, because it is the only good for which the two countries’ demand overlaps. This analysis makes it possible to arrive at Linder’s conclusion that: International trade in manufactured goods will be more intense between countries with similar per capita income levels than between countries with dissimilar per capita income levels. Linder made it clear that a good might be both an export and import good by the same country, which contradicts the Ricardian and H-O theories. The explanation for this is to be found in an earlier discussion in Lecture Nine, section 9.3.4, under intra-industry trade and product differentiation. Product differentiation enables countries to import goods which are substitutes to homemade ones because consumers’ taste preferences have been influenced to prefer imported substitutes to home-made goods. As a result, Japan exports vehicles (Toyotas, Nissans, Hondas) to Germany, while the latter exports vehicles (M-Benz, BMW, Volkswagen) to Japan. This intra-industry trade between countries could not be explained by the Ricardian and H-O theories.

10.5 Further Readings Students interested in other alternative theories of trade can look at the Murray model, based on economies of scale and the Paul Krugman model based on economies of scale and monopolistic competition in the following readings:

Kemp, M.C. (1964), The Pure Theory of International Trade. Englewood Cliffs N.J: Prentice-Hall, Ch.8 Krugman, P.R. (1979) “ Increasing Returns, Monopolistic Competition, and International Trade.” Journal of International Economics 9, No 4 (November 1979) pp 469-479 Appleyard, D.R and Field, A. J. (op cit) Ch. 10

LECTURE ELEVEN 11.0 PROTECTIONISM 11.1Introduction Up to this point, we have stressed the benefits of free trade. However, despite the wide spread acceptability of free trade as a concept and its practical benefits, international trade between countries has never been completely free. The policies that countries pursue or use to restrict trade are called protectionist policies or barriers to trade. 11.2 Barriers to Trade

There are many protectionist barriers to trade but the most commonly used one is a tariff. 11.2.1 Tariffs A tariff (origin: Arabic) is simply a tax or duty imposed on a good or service as it crosses the national border. In recent years, tariffs have been reduced due to international negotiations through first, the General Agreement on Tariffs and Trade (GATT) created after World War II and recently (since 1994), through the World Trade Organization (WTO) based in Geneva. The WTO, like its precursor (predecessor) GATT, is supposed to oversee world trade and work for barrier reduction in international trade. Main reasons for imposing a tariff are:

I. To discourage consumption of imports by raising the price of imported goods and services (mercantilist objective). II. To raise government revenue (mercantilist practice) III. To reduce balance of trade deficits by discouraging imports (mercantilist objective) IV. To protect domestic infant industry (mercantilist origin) V. To influence import price if the country has a monopsony power i.e. its consumption of the imported good is so large that it can influence world price e.g. USA with coffee and cocoa. (modern practice)

11.2.2 Types of Tariffs There are two main types of tariffs: i) Specific tariff: this is a tariff imposed on a unit of imported good e.g. Sh.20 per packet of cigarette or Sh.500 per radio, or Sh.1000 per TV set. ii) Ad valorem tariff: this is a tariff imposed as a percentage of the value (price) of a unit of good or service e.g. 25% of landed cost a car. The main advantage of a specific tariff is that it is easy to administer. The main disadvantages of a specific tariff are:

It is regressive in that it falls heavily on the poor consumer who purchases low quality and low price goods and services e.g. consumers of Sportsman vs. 555 cigarettes or black and white TV vs. colored TV sets. During periods of inflation, a specific tariff brings relatively less revenue tax unless the tariff rate is periodically adjusted to accommodate the rate of inflation. The primary advantage of ad valorem tariff is that revenue from its source increases with price especially so during inflation. It is also progressive in that the poor who consume low quality and therefore low priced goods and services pay proportionately less taxes than the rich consumers. The main disadvantage of ad valorem tariff is the difficulties encountered in its administration: How to determine the value of the good or what to use as cost price, e.g. whether to use cost plus transport; or whether to use cost, packaging, transport, storage and insurance; or whether to use free on board (FOB) or cost, insurance and freight (CIF) prices. It promotes corruption: in the process of determining value, individual custom officials collude with importers or exporters to defraud the country of revenue.

11.2.3 Effects of a Tariff Imposed by a Small Country In analyzing the effects of a tariff, the size of the country’s economy and not its geographical size is important. A country is described as small if it is a price taker in the world market. Its world consumption of goods and services is too small to influence the world price. Its terms of trade are exogenously determined

Let us analyse the partial-equilibrium effects of imposing a tariff by a small country as defined above. The analysis is partial equilibrium because it focuses of the tariff’s effects in the market for the tariffed good only and in the country imposing the tariff only, as figure 11.1 illustrates:

Figure 11.1: Partial Equilibrium Effects on Production, Consumption and Price



E P0y G P1y+ tSw+t

FSw P1y


0 Y2Y4Y0Y3Y1Y

In Figure 11.1, let Dd and Sd represent domestic demand and domestic supply respectively, of good Y(sugar) in a small country (say, Kenya) In autarky, the market for good Y is in equilibrium at point E with Y0 units being produced and sold at the price P0y . With free trade, the supply curve changes to a horizontal line Sw, such that the equilibrium price of good Y drops to P1y. The new relationship between the autarky and world price implies that good Y is a good in which the small country (Kenya) has comparative disadvantage (why?). This is also consistent with good Y being an imported good in Kenya (why?). This is because beyond Y2 the domestic supply curve Sd, which represents the domestic opportunity cost of domestic producers, is above the world supply curve Sw (representing the foreign suppliers’ opportunity cost of production or the domestic opportunity cost of importing). Because Kenya’s consumption of good Y is small by world standards, it purchases all its needs from the world market without affecting price P1y. Its smallness of consumption is graphically represented by a horizontal world supply curve Sw. Under unrestricted trade or free trade the economy would locate at point F, importing (Y1-Y2) units at price Y1y. However, for domestic producers of good Y in Kenya, due to free trade (sugar imports) they are able to sell less of good Y than in autarky and at a much lower price in order to compete with imported sugar. This is what triggers pressures from domestic producers (Mumias Sugar Corporation) and sugar cane out-growers for government protection from foreign competition. Note that in the short-run, free trade does not eliminate domestic production completely, because up to Y2, the domestic cost of production (as reflected by the Sd curve representing the domestic opportunity cost of producing good Y) is lower or below the world supply curve, Sw. For all units of good Y beyond Y2, foreign production cost is lower that domestic production cost (unless the foreign good Y is subsidized in the home country e.g. sugar from the EU is heavily subsidised) Thus, it is cheaper to import good Y beyond Y2.

Suppose due to the outcries or pressures from domestic producers and farmers, the government imposes a tariff t per unit of good Y imported. The new world supply curve shifts from Sw to Sw+t at price P1y+ t. Since the small country cannot affect its terms of trade, the tariff t is simply an addition to the domestic price of the imported good Y. The Kenyan consumer pays P1y to the foreign producer of good Y and tariff t to the Kenya government as revenue. The new equilibrium point is point G, at which consumers demand Y3 at the new price of P1y + t. Domestic supply increases from Y2 to Y4, thanks to the tariff, but imports are reduced from (Y1-Y2) to Y3-Y4), again thanks to the tariff. As a result, domestic producers are happy (because they can now sell more at a higher price) but the consumers are unhappy (because they have access to less of good Y and have to pay a higher price)

11.2.4 Partial Equilibrium Welfare Effects of a Tariff. The impact of a tariff on production of good Y, price of good Y and consumption of good Y has an effect on the welfare of the residents of a small country (Kenya) The welfare effects for producers are different from those of consumers. We use Figure 11.2 to show the welfare effects of a tariff as: Consumer Surplus

Producer Surplus Government revenue Consumer surplus is the satisfaction received from consumption of a good over and above the amount the consumer must pay to obtain it. In autarky, P0yHE in Figure 11.2 represents consumer surplus: this is the area bounded by the demand curve on top and the market price below. Producer surplus is the revenue received by producers over and above the minimum necessary for production: this is represented by P0YKE which is the area bounded on top by the market price and below by the supply curve.

Figure 11.2: Welfare Effects of a Tariff on Imports by a Small Country




E P0y G P1y + tSW + t jmn r F P1ySW

Z K Dd

0 y2 y4 y0 y3 y1Y

Under free trade, consumer surplus increases to P1y1HF When a tariff t is imposed, the consumer surplus falls to (P y 1+t) HG The imposition of a tariff causes the consumer surplus to fall by P1y (P1 y +t) GF This loss in consumer surplus can be divided into:

Redistribution effect of the tariff ( j ) Production effect of the tariff (m) Revenue to government effect of the tariff (n) Consumption effect of the tariff {r} The area of the trapezium j is the tariff redistribution effect, which is the loss of consumer surplus that is transferred to domestic producers from domestic consumers who pay the tariff. The triangle area m is the production effect i.e. units (Y4-Y2) are now produced domestically due to the tariff rather that imported. This area m is also the deadweight loss to the small country in that it is the net loss of consumer surplus, which neither goes to the government nor producers because it is a result of inefficient production: inefficient because world production is more efficient. The rectangle area n is the revenue effect that goes to the government as tax {t (Y3-Y4)} Government can use the tariff revenue to provide services to benefit all residents- this is a positive welfare effect. The revenues collected by government from the tariff also reduces chances of government increasing direct taxation However, if government misuses the tariff revenue, no positive welfare effects will accrue to residents. Triangle area r represents another deadweight loss by the small country that is a result of the consumers paying a higher piece due to the tariff, which in turn had reduced imports by (Y1-Y3) In summary, a small country lowers its overall level of welfare by imposing a tariff because there are no positive welfare effects to off-set the deadweights (m + r) in Figure 11.2.

LECTURE TWELVE 12.0 MEASUREMENT OF TARIFF EFFECTS 12.1 Effective Rate of Protection (ERP) The most common reason given to justify the imposition of tariff is protection of the infant industries. Proponents of the infant industry argument point out that the protected infant industry usually uses scarce factors (sometimes imported inputs) in its production process. This means that there is a need to measure the effects of tariff, which is levied for protection purposes. A tariff imposed by a country to protect its industries has the effect of raising the price of imported goods and thus making residents switch to domestically produced goods. Thus, the tariff protects local producers from foreign competition, particularly so from mature or established industries that had an early start. The issue then is: how do you measure the rate of protection, which in economic theory is known as effective rate of protection (ERP)? There are two methods of measuring ERP;

( i ) ERP = (V1-V0)/V0…………….where

V0 = domestic value added (DVA) i.e. the differences between the free trade price of the finished goods and the cost of imported inputs.

V1 = domestic value added plus the tariff.

Therefore, ERP is the percentage rate of increase in domestic value added that is possible due to the nominal tariff.

( ii) ERPj = (tj -åaij ti)/(1-åaij) Where ERPj = effective rate of protection of industry j aij = the free trade value of input i as a percentage of the free trade value of the final good j. tj = the tariff rate on the finished imported good j ti = is the tariff on imported inputs used by the domestic producers. Thus, whenever the nominal tariff rate on finished imported good (tj) exceeds the nominal rate of a tariff on imported inputs (ti) i.e. When tj > ti, then the ERP is greater than the nominal rate on the finished imported good i.e. (ERP > tj)

When the imported goods (finished imported goods and inputs) are tariffed at the same rate, i.e. tj = ti , then that rate accurately measures the degree of protection provided to the domestic good. But if the nominal tariff on the finished imported good tj is less than the nominal tariff on imported inputs ti i.e. when tj < ti, then the ERP is less than the nominal tariff on the finished imported good. In fact, it is possible for the ERP to be negative even if the nominal tariff on the finished imported good is positive: This happens when the nominal tariff on imported inputs is far greater than the nominal tariff on imported finished goods. Let us have some illustrations on how to calculate ERP using numerical examples. (i) Using the first method: ERP = (V1-V0) / V0

Let a domestically produced/assembled TV set in Kenya sell at Ksh. 40,000, under free trade. The set is produced using Ksh. 24,000 worth of imported inputs (e.g. picture tube, chassis, tuner and assorted electronic components). The Ksh. 16,000 (Sh 40,000 – Sh 24,000) difference between the free trade price of the finished TV set and the cost of imported inputs represents domestic value added (cost of labour, other local inputs and profit) Under free trade, DVA cannot exceed Ksh 16,000, since if it did, the domestically assemble TV will not compete internationally on price. If one levied ad valorem tariff of 10 percent on the imported finished TV set, its price will rise to Ksh 40,000 (1 + 0.10) = Ksh. 44,000/=, or (Ksh. 40,000 x 110)/100 = Ksh. 44,000. The 10 percent tariff has added Ksh 4000 to the price of the imported TV set. The price of the domestically assembled TV set could now (after a tariff is imposed on the imported TV set) rise up to Ksh. 44,000/= and still be competitive in the market on price. If the nominal tariff rate of a finished imported TV set is 10 percent, what is its effective rate of protection (ERP) enjoyed by the domestically assembled one? i.e. what percentage increase in DVA is possible due to the tariff? Let DVA under free trade be: V0 = Ksh16,000/=.

Add a 10 percent tariff (Ksh 4000/=) and DVA becomes V1 = Ksh (44,000 - 24,000) = Sh.20,000/=. Using the ERP formula to calculate the degree of protection one gets: ERP = (V1-V0)/V0 = Ksh (20,000-16,000) /16,000 = 25%

Thus the nominal 10 percent tariff allows the DVA to rise by 25 percent, which is equal to the degree of protection of domestic producers offered by a 10 percent nominal tariff. It can be observed that the lower the value of imported inputs the higher the degree of protection and vice versa. This will be true if there are no tariffs levied on imported inputs. Suppose a 5 percent tariff was imposed on imported inputs?

Then the DVA in the presence of a 5 percent tariff becomes: V1 = Sh. 40,000(1+0.10) – shs 24,000 (1+0.05) = Sh 44,000- Sh 25,200 = Sh 18,800. Therefore the ERP = (V1-V0)/V0 = Sh (18,800 - 16,000)/16,000 = 17.5% Thus the imposition of a tariff on imported inputs lowers the ERP from 25% to 17.5% Suppose two imported inputs A and B are used instead of one

If the price of the assembled TV is Sh 40,000, and the imported inputs A and B cost Sh 20,000 and Sh 8,000 respectively, Then under free trade, the domestic value added (DVA) is: Sh 40,000 - (Shs 20,000 + Sh 8,000) = Shs 12,000 Now if due to protection demands the Kenya government imposes a tariff of 10 percent on the imported TV set and, for revenue purposes, it imposes tariffs on imported inputs A and B at 5 percent and 8 percent respectively, such that the price P of the: Finished good PF = Sh 40,000+.10(40,000) = 40,000+4,000 = 44,000 Input A P’A = Sh 20,000 + .05(20,000) = 20,000 + 10,000 = 21,000 Input B P’B = Sh 8,000 + . 08(8,000) = 8,000 + 640 =8,640 Therefore the value added of the finished TV set = Sh 44,000 - (21,000 + 8,640) = Sh 44,000 - 29,640 = Sh 14,360

Using the first formula ERP = (V1-V0)/V0 , we get

ERP = Shs (14,360 - 12,000)/12,000 = .1966 = 19.7%

( ii) Using the second method to calculate ERP The general formula for calculating the effective rate of protection for industry j is: ERPj = {tj - åaij ti} /{1-åaij}

Using the general formula ERPj = (tj-åaijti)/(1-åaij) Where: tj represents the tariff rate on the final good j (TV set) ti represents the tariff rate on any input i (e.g A, B) aij represents the free trade value of the input i as a percentage of the free trade value of the final good. In our example above, the aij for inputs A and B would be: For input A, Sh 20000/40000 or .5 For input B, Shs 8000/40000 or .2 Calculating the ERP using the general formula will yield the same result as the first method i.e. ERPj = {.10 –[(0.50)(0.05) + (0.20)(0.08)]}/ {1 - (0.50) + 0.20)} = {.10-(0.025 + 0.016)}/ {1 - 0.70}

= {0.10 - 0.041}/{0.30} = 0.059/0.30 = 0.197 = 19.7%

The second method of calculating ERP has the advantage of illustrating the three general rules pertaining to the relationship between nominal tariff rates and effective rate of protection: 1) If the nominal tariff rate on the final good is higher than the weighted average nominal rates on the inputs, then ERP will be higher than the nominal rate on the final good. 2) If the nominal tariff rate on the final good is lower than the weighted average nominal tariff rate on inputs, then the ERP will be lower than the nominal tariff rate on the final good. 3) if the nominal tariff rate on the final good is equal to weighted average nominal tariff rates on inputs, then ERP will be equal to the nominal tariff rate on the final good. Rule 1 is called the escalated tariff structure that is used by most countries, which set out to protect local industries. Tariff rates on imported manufactured goods are higher than those imposed on inputs (international goods and raw materials) This situation causes problems between developed countries (DCs) and less developed countries (LDC) when it comes to leveling the field for competition in trade. Since DCs have escalated tariff structures with correspondingly heavier protection for manufactured goods industries, LDCs suffer more from this because their manufacturing industries are infants and therefore are hit harder by escalated tariff structures. As a result, LDCs are forced to export raw materials to DCs.

12.2 The “Height” of Tariffs An important consideration in the calculation of ERP is the height of a country’s average tariff- i.e. how much price restrictiveness or interference exists in the country’s tariff schedule The problem arises because countries have different tariff rates for different goods. One measure of tariff height is the unweighted average tariff rate, where tariff rates on different imported goods are averaged e.g. tariff rates of 10 percent, 15percent and 20percent on good A, B and C respectively would have unweighted average tariff rate of: {10% + 15% + 20%} / 3 = 15%

However, use of this technique does not take into account the relative importance of the imports e.g. if the country imports more of good A than B and C. The alternative technique of calculating the height of a tariff is a weighted average tariff rate (WATR), where each good’s tariff rate would be weighted by the importance of the good in the bundle of imports. If Kenya imports Shs 500 million worth of good A, shs 200 million worth of good B and Shs 100 million worth of good c, the weighted average tariff rate (WATR) is:

WATR = {(10% x Sh 500m) + (15% x Sh 200m) + (20% x Sh 100m)} / {(Sh500 + 200 + 100) million}

= {Sh 50m+ Sh 30m+Sh 20m}/Sh 800m = Sh (100m /Sh 800m) = 0.125 or 12.5%


13.0 NON-TARIFF BARRIERS AND NEW PROTECTION 13.1 Production Subsidies This is a situation where the government provides a subsidy to an infant industry to help it reduce the cost of production rather than raise price faced by domestic consumers Figure 13.1 shows the impact of a subsidy on an infant industry

Figure 13.1: The Effect of a Subsidy on an infant industry

Price Sd

Sd + Sub

Pw + Sub a b PwSW


0 ACB Quantity

In Figure 13.1, a shift from the domestic supply curve from Sd to (Sd + Sub), is a result of a subsidy Kenya’s domestic suppliers now supply OC instead of OA. But domestic consumers continue to pay (buy) at Pw because the subsidy takes care of the higher cost of production that domestic producers incur in order to increase production from OA to OC. Thus there is no loss in consumer surplus.

Area a (the trapezium) is the gain or increase in producer surplus Area b (triangle) is the deadweight production loss due to inefficiency, which is also the net loss to the economy, paid for by the subsidy. Therefore a subsidy encourages the growth of domestic infant industries without affecting the welfare of the consumers A subsidy does not also directly affect imports since the world price is retained That is why many economists allied to the IMF and World Bank recommend the use of subsidies rather than tariffs as a tool of protection. The problem with the subsidy is that for Kenya to be able to subsidise its domestic producers, it has to raise taxes, including from tariffs on imports.

13.2 Quotas Quotas are direct quantitative or dollar value limitations on imports, which when imposed and the quota attained, no more can be imported that year. Quotas are imposed by a country for the same reason that tariffs are imposed: Protection of infant industries

Reduction of trade deficit e.t.c. Quotas offer a more certain avenue of protection because quotas, unlike tariffs, are not dependent on the elasticity of demand for imports. Figure 13.2 below demonstrates the use of quotas to protect domestic industry.

Figure 13.2 Effect of Quota on International Trade



P1y E

cefg P0y C


0Y Y1Y3 Y2Y0 Quota

In Figure 13.2, total world supply is omitted for simplicity purposes. Unrestricted equilibrium is at C under free trade. The equilibrium after the quota is E because the quota reduces imports from Y0 –Y1, to Y2-Y3 Domestic production (supply) increases from 0Y1 to 0Y3. However, area c, e, f and g represent loss of consumer surplus due to the quota – similar to the tariff. Area c is the loss of consumer surplus by residents, which goes to domestic producers. Area e is the deadweight loss due to inefficiency in domestic production. Area g is the deadweight loss due to the quota limitations of imports that domestic consumers no longer have access to. Who takes f?

In tariff protection, it is the government, but in the case of a quota the area f will go to importers if they are privileged to buy at P0y e.g. licensed importers who enjoy the monopoly power to supply sugar (the over 200,000 tones short supply (2007) of domestic production) and maize importers during the drought periods. Or if government wishes to earn revenue from privileged importers, it charges them a fee, which constitutes part of the P1y-P0y that is supposed to accrue to monopoly importers. Or corruption – if government does not wish to charge a license fee, then to be given the privilege to import one has to grease the hands of those in power, with authority to issue the licenses. 13.3 Voluntary Export Restraint (VER)

In the case of voluntary export restraint, (VER) agreement is negotiated if the exporters’ bargaining power is weak (like Kenya’s textiles exports to USA). If the foreign exporters of the country’s imports are strong (like Japanese car exporters to Italy), then the restraint is not voluntary – the government imposes VER using the threat of a tariff or quota. For example:

Imports of steel to USA have been subject to VER on and off since 1968, with the USA negotiating agreements with Japan and Brazil. Before 1993 imports of cars from Japan to Europe were subject to VER to the extent that the VERs were really quotas, e.g. Italy was allowing importation of only 2200 Japanese cars per annum until the EC agreement of 1993 which forbade such restrictions. The effect of VERs are similar to quotas with the primary differences being the method of administration: Quotas are administered by the importing country

VERs are administered by the exporting country (here corruption is reversed – officials in the exporting country indulge in corruption by receiving bribes from competing exporters). One major effect of both quotas and VERs is to raise the quality of exports e.g. when in 1981 Japan agreed with USA to export 1.68 million vehicles, Japan dropped most low-price vehicles and exported high value ones. 13.4 Export Subsidies and Counter-veiling Duties

Export subsidies otherwise known as export promotion fee in Kenya is payment by government to a firm to export more commodities as an incentive - this is usually a major source of corruption evidenced by the 1990s Goldenberg/Pattni saga in Kenya. In this case exporters receive a payment in addition to the price of export so that with the subsidy, thy (exporters) can charge low international prices in order to compete with cheaper producers in the world market. Counter-veiling duties (CVD) in Kenya are suspended duties on imports. These are tariffs imposed by a country to offset export subsidies or the effects of a subsidy advanced by a competitor to her industries. A case in point is Egypt, which subsidizes its energy sector to make its manufactured goods competitive in the Common Market for East and Southern Africa (COMESA) market. 13.5 Administrative and Technical Standards

Countries establish a variety of regulatory standards some of which are protectionist as a consequence, if not by design: Domestic content requirement is one of them - this is a situation where a country requires that for a firm to sell its exports, the goods must contain domestic inputs – a common requirement in motor industry with outsourcing of inputs. USA demands that African countries that benefit from AGOA (Africa Growth Opportunity Act) use domestically grown cotton or cotton imported from USA to manufacture their textiles for export to USA. Other regulations could include health, safety and consumer product labeling requirements; control of entry into professions e.g. practicing medicine in USA or Law in Kenya. Technical barriers to trade have adversely affected Kenya’s export of horticultural products to the European Union (EU).

13.6 Government Procurement Policies If the government has unique goals to attain, then buying from abroad will not depend on utility maximization as the theory of international trade has assumes. “Buy Kenyan” requirement will keep a lot of imports out. A ban on goods from certain countries to fulfill a political goal, e.g. embargo on apartheid South African Products until 1993 kept South African imports out of Kenya.

13.7 National Security and Defense (Strategic Industries) Many countries protect their industries for strategic purposes: The ammunitions factory at Eldoret is protected against competition for strategic reasons. The USA has some of the most inefficient steel-producing firms and yet the government protects them from competition for strategic reasons. Other industries like staple food producing firms, crude oil firms are also protected by government against competition.

13.8 Dumping Dumping is a situation where a firm sells its products at a lower price in the export market than in the firm’s home country market – this is a price-based definition. Dumping also occurs when a firm sells a good or service in a foreign market at a price below the cost of production at home especially so when a subsidy is involved – this is a cost-based definition. Originally, it was the price-based definition, which was used to level dumping charges, but with many countries adopting subsidies as a trade strategy, the second definition is in vogue. For example, when the USA realized that electronic good from Japan were sold in USA at prices lower than the cost of production, the production cost price-based definition became more fashionable. The World Trade Organization (WTO) defines dumping as exporting at prices far below the cost of production. Thus, definition is important because dumping in one definition is not necessarily so in another. Dumping generates a lot of controversy in international trade and is usually the basis of protectionist pressures from domestic producers.

13.9 Types of Dumping. 13.9.1 Sporadic Dumping Sporadic dumping is done for short periods to clear old stocks and create room for new products. Kenya frequently does this with maize stocks in National Cereals and Produce Board (NCPB) depots during harvest time. Large retail stores like Wal Mart, Marks and Spencer, and Woolworth also engage in dumping to create room for new stocks. For example, during northern hemisphere winter, light or summer clothes are dumped in the less developed countries (LDCs) in the tropics to create room for winter clothes. Sporadic dumping can also be used to get a foothold into the market – Coke Cola did this when it launched its 500ml bottle of sodas at a price of Ksh 15/=, with its 300ml bottle retailing at Sh.12/=. Immediately the 500ml had established itself in the market, the price shot up to Ksh.30/= a bottle while the 300ml bottle increased to only Ksh.15/=.

13.9.2 Persistent Dumping Persistent dumping is persistent or continued international sale of goods below their price at home on either definition. This type of dumping undercuts domestic production and leads to persistent calls for protection e.g. cement, toilet papers and shoes imported from Egypt into the Kenya Market since Egypt joined COMESA. The main reason for persistent dumping is price discrimination, in order to: To earn a specific foreign currency for a country.

To get a permanent foothold on a market as consumer preference for the dumped goods entrenches. To discourage domestic production of a good in favor of the persistently dumped imports. In most cases, persistent dumping is state-assisted through subsidies by the government of the exporting firm. What determines price discrimination under persistent dumping is elasticity of demand, which also depends on availability of substitutes. A lower elasticity of demand for a good is most likely due to less availability of substitutes – the more and better the substitutes that exist for a good the higher will be the elasticity of demand. Thus, if affirm has a large size of domestic market, but faces stiff competition abroad, say due to availability of substitutes, a firm will engage itself in persistent dumping. 13.9.3 Predatory Dumping

Predatory dumping is a situation where foreign firms are intent on driving local producers out of the market by selling their products below the cost of production. Japan did exactly this against USA when it came to radios, TVs and video cassette recorders (VCRs). PYE a USA manufacturer of the above items collapsed due to Japanese imports. Predatory dumping is risky because:

To be selling below cost of production for purposes of driving others out, one must have an idea of the success of the operation because in the long run, the losses must be recouped with later higher prices. Suppose domestic producers where dumping is taking place hold out – say through a subsidy or if they think your resources cannot sustain a long-haul dumping operation, your mission will collapse. In reality predatory dumping is possible where the foreign producer’s technology is so superior (like was the case with Japan in electronics) or costs are so low (Uganda exports of maize to Kenya) that home producers realize they cannot compete and give up.

LECTURE FOURTEEN 14.0 IMPORT SUBSTITUTION: THE INFANT INDUSTRY ARGUMENT 14.1 Introduction The most common reasons given to justify the adoption of import substitution as an industrial strategy are usually similar to those advanced for imposition of tariff to protect infant industries. The precursor proponents of the infant industry were:

Alexander Hamilton in his famous Report on Manufactures (1791) in arguments for protection in defense of USA’s infant industries against Adam Smith’s Free Trade idea, which at that time favoured Britain, the most industrialized country in the world. Friedrich List in his arguments (1841) in favour of protection of German infant industries against Adam Smith, Ricardo and Say’s arguments for free trade, which at that time favoured Britain. John Stuart Mill (the dean of classical economists) in support of List’s infant industry arguments in his Principles of Political Economy (1848). Proponents of the infant industry argument point out that the protected infant industry usually uses scarce factors, many of which are imported inputs, in its production process. The same argument goes for import substitution industries.

According to H-O theory, the import substitution strategy of industrial development should involve: i. Intensive use of the abundant factor (labor for Kenya) ii. Produce to satisfy local demand but with surplus to export iii. For both i and ii above to be successful, there must be free trade iv. For iii to be useful to the import substitution strategy, whatever is produced must be competitive both on price and quality. How has the import substitution strategy been pursued in less developed countries (LDCs), including Kenya?

14.2 Import Substitution Strategy of Industrial Development in Developing countries There are four main impulses that trigger import substitution strategy in developing countries: The need to avoid dependence on foreign supply in case of war (self sufficiency and security argument) The need to reduce balance of payment difficulties (the mercantilist specie outflow argument). The need to create employment and promote development (the mercantilist argument of stemming skilled labor outflow). A deliberate effort by the leadership to adopt industrialization as a means to fast development (pursuing the mercantilist goal of a strong state). 14.2.1 The Infant Industry Argument

The basis of the infant industry argument is that the country might have a potential comparative advantage, in the development of a certain industry but due to the earlier start by others in different countries, it would be difficult for the young industry to compete. Thus, learning by doing and protection to facilitate expansion in order to reap the benefits of economies scale, should, in due course enable the newly established industry to overcome the initial quality and price disadvantage. The foreign exchange savings made due to local production can be diverted to more urgent requirements, including importation of technology for the import substitution strategy. Import substitution facilitates backward and forward linkages (external economies) in the economy. The above arguments for the infant industry justify protectionist measures, even when they go against the H-O theory.

Figure 14.1: The Effect of a Tariff on the Import Substitution Strategy.

GRAPH (a) Price Sd




0 Q2Q1Q3 Q




P1 dSw+t Pt cfetSw P2


0 Q1 Q4 Q5Q3Q

In the graph (a) the intersection of domestic demand and supply determines the domestic price in autarky where the equilibrium price P1 clears the market with the domestic output 0Q1. When trade opens, domestic consumers benefit by paying a lower world price P2 and have access to increased quantity of goods, thanks to imports i.e. 0Q3 instead of 0Q1. However, due to the lower price P2, domestic producers can only supply 0Q2 at that price – a drop from 0Q1. It is this drop in domestic production that triggers agitation for protection of domestic producers – invoking the infant industry argument. That a new or a small firm suffers from diseconomies of scale A new industry’s labor is inexperience and has yet to acquire the skills and repetitive hands-on practice to produce quality products – thus labour training is a major justification for protection of the infant industry. A new firm requires high revenues that can be ploughed back into training labour, expanding capacity and rewarding workers handsomely as an incentive to work hard and produce quality output. A new industry will provide external economies (positive externalities) to other economic activities e.g. create backward and forward linkages that eventually create positive social benefits. The new industry has potential comparative advantage (leading to exports) that can be trapped in the long run with the assistance of protection. Thus the need for the infant industry to be protected.

So, on what basis would protection of an infant industry be justified? If PR = Private Revenues PC = Private Costs SB = Social Benefits All the above being measured over some reasonable time period, then there exists: PR > PC and PR + SB > PC. ……………………(i) PR < PC and PR + SB < PC…………………….(ii) PR < PC and PR +SB > PC …………………….(iii) In equation (i) above, the protected industry is profitable on private revenue grounds and social benefits are a bonus, although one might argue that protection might lead the industry under-producing (due to complacency) if there is no competition. This industry can be established even without tariff protection, but with the structural rigidities found in developing countries, protection is a must. In equation (ii), it is not profitable on either private revenue or social benefits grounds to establish such industry since to do so will represent a misallocation of resources. In this case, protection is not justified, because it might never be competitive in the long run In equation (iii) there is need for infant industry protection from a social benefit point of view (e.g. to create employment) but not on profitability or private revenue grounds In this case the industry cannot be established unless assured of protection from the very beginning Thus, one of the main justifications of infant industry protection is that it must eventually become self-sustaining, because most of the social benefits that are generated in the early years of protection are sustained when protection is lifted. It is clear from the above analysis that:

To continue protecting an industry that is not competitive in the long run would be a misallocation of resources. Thus governments in developing countries should continue protecting infant industries only if:

(i) The social benefits outweigh the private costs (ii) Protection facilitates growth that enables the industries to achieve economies of scale and attain quality standards necessary for competition with established mature industries. In graph (b) we have a situation where domestic producers have convinced the government about the desirability of protection. The government responds by imposing a tariff t on top of the world price P2 The new domestic price rises to Pt

This causes consumers to reduce their consumption of imported goods from 0Q3 to 0Q5. Domestic industries are motivated by the new higher price Pt to increase their output from 0Q2 to 0Q4. Thus the difference between 0Q4 and 0Q2 constitutes the import substitution effect i.e. local production that was possible due to tariff protection. Thus import substitution strategy using tariffs will be beneficial to local producers but will hurt local consumers because: They now have to pay a higher price for the same good

Fewer goods are accessible to consumers, which could result in shortages, rationing and possibly lead to hoarding – all of which are undesirable effects. If the tariff revenues (c, d, e, f) are not used by the government to spread social benefits, the justifications for a tariff as a tool of protection is reduced or cancelled out altogether.

BIBILIOGRAPHY Appleyard, D.R. and Field, A. J. (1992), International Economics; Irwin, Boston. Atta, J. (1999), “Exchange Rate Policy and Price Determination in Botswana”, AERC Research Paper 93 Bernholz, P. (2003), Monetary Regimes and Inflation; Edward Elgar,

Cheltenham, UK. Bhagwati J. and Srinivasan, T.N. (1983 Lectures in International Trade, Cambridge, MA: the MIT Press, Ch 26 Bowen, H.P., Hollander, A. and Viaene, J. (2001), Applied International Trade Analysis; London: Macmillan LTD Einzig, Paul, (1966), Primitive Money, 2nd Edition; Pergarmon Press, Oxford. Fieleke, N. S. (1985) “ The Rise of the Foreign Currency Future Market”; Federal Federal Reserve Bank of Boston, New England Economic Review, March-April 1985 pp 38-47. Frenkel J. and Johnson, H.G. (1978), The Monetary Approach to the Balance of Payments; George Allen and Urwin, London. Gandolfo, G. (1987), International Economics II: International Monetary Theory And Open Economy Macroeconomics; Springer – Verlag, Berlin Gendreau, B. (1984), “ New Markets in Foreign Exchange”, Federal Reserve of Philadelphia, Business Review, July-August, 1984, Pp3-12. Hallwood, C.P. and MacDonald, R. (1994), International Money and Finance; Blackwell Publishers, Oxford. Hazelwood, A. (1975), Economic Integration: The East African Experience; Heinemann, Nairobi Helpman, E (1984) “ Increasing Returns, Imperfect Markets and Trade Theory.”

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Jevons, W.S. (1892), cited in Gary Smith, 1991, Money, Banking and Financial Intermediation; D.C. Heath and Company, Massachusetts Pp32. Johnson, H.G. (1958), “ The Gains From Free Trade with Europe; An Estimate”; Manchester School of Economics and Social Social Studies, September 1958. Kemp, M.C, (1964), Pure Theory of International Trade; Englewood Cliffs, NJ: Prentice-Hall, Ch.8 Krugman, P. R. (1979) “ Increasing Returns, Monopolistic Competition and International Trade” Journal of International Economics 9, No 4 (Nov 1979) pp 469-479 Krugman, P. R. (1979) “ A model of Innovations, Technology Transfer, and the World Distribution of Income.” Journal of Political Economy 87, No 2 (April 1979) pp 253-266 Lindert, P.H. (1991), International Economics, Richard D. Urwin, Inc. Delhi. Linder, S. B. (1961) An Essay on Trade and Transformation, New York: John Wiley and Sons. Lipsey, R. G. (1960), “The Theory of Customs Union: A General Survey”, Economic Journal 70, pp 496-513. Markusen, J. R., Melvin, J. R., Kaempfer, W. H and Markus (1995), International Trade: Theory and Evidence; New York: McGraw Hill. Meade, J.E. (1955) The Theory of Customs Union; Amsterdam: North Holland. Ogunkola, E. O. (1998) “ An Empirical Evaluation of Trade Potential in the Economic Community of West African States; AERC Research Paper 84. Pilbleam, K. (1992), International Finance; Macmillan Press LTD, London

Posner, M.V. (1961) “International Trade and Technical Change” Oxford Economic Papers, New Series, 13 No 3 (October, 1961) pp 323-324 Republic of Kenya (2011), Economic Survey, 2011; Nairobi: Government Printers Rivera-Batiz, F. L & Rivera-Batiz, L. (1994) International Finance and Open Economy Macroeconomics; Macmillan, New York. Robson, P. (1987), The Economics of International Integration; Allen and Urwin, London. Roll, E. (1992), A History of Economic Thought; Prentice-Hall, Inc. Englewood, Cliffs, N.J. Sailors. J.W. Qureshi U.A and Cross, E.M. (1973) “Empirical Verification of Linder’s Trade Thesis” Southern Economic Journal 40, No 2 (October 1973) pp 262-268 Salvatore, D. (1990), International Economics; Macmillan,London. Shapiro, A.C. (1983), “ What Does Purchasing Power Parity Mean?” Journal of International Monetary Finance 2, pp 295-318. Smith, A.1976, An Inquiry into the Nature and Causes of Wealth of Nations. (With an introduction and Commentary By Cathryn Sutherland) Oxford University Press, Oxford, First published in 1776. Smith, G. (1991), Money, Banking and financial Intermediation; D.C Heath and Company, Massachusetts. Sodersten, B. (1970), International Economics; Macmillan Press LTD. London Sodersten, B.(1992), International Economics; (2nd Edition) Macmillan, London. Sodersten, B. and Reed, G.V. (1994), International Economics; Macmillan,

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1 Define the following terms: volume of trade, primary products; globalization 2 Use Internet to establish the current (latest year of records) world volume of trade (exports plus imports) in goods and services. 3 “Trade between developed and developing countries is characterized by the former exporting manufactured products while the later exports primary products”. Discuss this statement to explain trade as an engine of growth. 4 Globalization in trade has implications on policy making powers of a country, sovereignty of countries, consumption patterns/tastes etc all of which have negative and positive effects on society. Discuss the pros and cons of globalization as advanced by the World Trade Organization.

LECCTURE TWO 1 Define the following terms: mercantilism; metropolis; manorial/feudal system; enclosure system; serf; laborer/worker; specie 2 Why do nations engage in trade when there are both gains and losses, with the later preponderant in many cases? 3 What did mercantilists believe in and practice?

4 What are the major contributions of mercantilists to the theory of international trade?

LECTURE FIVE 1 Define the following terms: political economy; specie-flow mechanism; protectionism; free trade; physiocracy; zero-sum game in trade; barter exchange; Adam smith’s “invisible hand” concept; division of labour; Smith’s theory of absolute advantage; opportunity cost. 2 What weakness in mercantilist doctrine did David Hume identify that laid the basis for free trade? 3 The success of mercantilist doctrines and practices planted the seeds of the system’s own destruction. Discuss this statement in relation to the emergence of free trade doctrine to counter mercantilists’ protectionist doctrines. 4 Free trade was good for England, the mother of the industrial Revolution. Was it also good for France, Portugal and Spain? Discuss. 5 How was Ricardo’s theory of comparative advantage an improvement on Adam Smith’s theory of absolute advantage?

LECTURE FOUR 1 Define the following terms: autarky; production possibilities frontier (PPF); marginal rate of transformation (MRT); opportunity cost; Ricardian/Constant costs model; utility; commodity indifference curve; marginal rate of substitution (MRS); absolute advantage; comparative advantage 2 What are the six assumptions of the Ricardian model and explain what each assumption implies. 3 Using graphs show how the production possibilities frontier (PPF) explains how resources (labour and technology) combine to produce goods and services required in a country. 4 Using graphs show how community indifference curves or marginal rate of substitution represent aggregate tastes or preferences of society, which in turn send signals to producers of goods and services in a country. 5 Use the concept of opportunity cost to explain in numeric terms the Ricardian model.

LECTURE FIVE 1 Define the following terms: relative price ratio; terms of trade; ceteris paribus; equilibrium price ratio/ market-clearing prices; consumption opportunity set; production opportunity set; trade triangles; gains from trade; gains from specialization. 2 Use graphs to show how, from a point of specialization, country A can transform its production of good Y into good X through domestic production and trade the surplus good X with supplies of good Y from country B 3 Use graphs to show how community indifference curves can be combined with production possibilities frontiers to produce trade triangles, which summarize each country’s imports and exports. 4 Use graphs to show gains from trade and gains from specialization.

LECTURE SIX 1 Define the following terms: classical economists; neo-classical economists; constant returns to scale; increasing cost PPF; perfect substitutes; production function; isocost; isoquant; capital/ labour ratio; capital intensive; labour intensive; neo-classical model versus Ricardian model; equilibrium price. 2 What reasons were given by neo-classical economists for their disagreements with postulates of the Ricardian model (use graph to explain your answer) 3 What is a production function? Use both algebraic terms and graphic presentation in your answer. 4 What are the two main sources of gains from trade that allow both country A and B to be better off with trade? 5 In a world with goods X and Y and two countries A and B write in algebraic terms the statement: “ good Y is capital intensive”

LECTURE SEVEN 1 Define the following terms: offer curve/ reciprocal demand curve; trade triangle approach; tabular approach; trading equilibrium 2 The two-prong nature of the offer curve is used as an analytical tool to show how international prices are determined: a) Use the “trade triangle approach” to derive offer curves b) Use the “tabular approach” to derive offer curves

LECTURE EIGHT 1 Define the following terms: factor endowment; factor intensity; quantity-based definition of factor abundance; price-based definition of factor abundance; H-O theory. 2 Which assumptions does Heckscher and Ohlin adopt in addition to the six Ricardian model assumptions to develop their H-O model? 3 Use algebraic terms and graphic examples to show that country A is capital abundant relative to country B 4 What is the role of taste in determining comparative advantage – use graphs to explain your answer.

LECTURE NINE 1 Define the following terms: intra-industry trade; empirical testing; input/output tables; taste-bias; human capital; product differentiation; economies of scale; non-traded goods; factor intensity reversal 2 While the H-O model can explain Brazil’s world leadership in producing steel and sugar, it does not explain Japan’s leadership in producing automobiles (vehicles). Discuss this statement in relation to H-O theory and current trade patterns. 3 What is the Leontief-Paradox? Explain your answer in detail. 4 Use consumer tastes as a major factor in influencing trade patterns to show deficiencies in H-O theory 5 How do trade barriers influence trade patterns against the H-O theory? 6 How did the trade Stopler Samuelson theory help to explain why some members of society in a country favour free trade while others favour protectionist policies?

LECTURE TEN 1 Define the following terms: imitation lag; demand lag; consumer inertia; product cycle hypothesis; dynamic comparative advantage; Linder’s hypothesis 2 What is the main distinguishing factor between the alternative theories of trade and H-O theory? 3 What is the main assumption of Posner’s imitation lag theory and how does this assumption help to provide a basis for Posner’s theory? 4 Explain the product cycle theory and show how Vernon arrived at his conclusion for his theory 5 State the Linder theory of trade and show how it explains trade in manufactured goods.

LECTURE ELEVEN 1 Define the following terms: specific tariff; ad valorem tariff; regressive tariff; progressive tariff; CIF and FOB prices 2 What are the main reasons for imposing a tariff by a small country? 3 What are the advantages and disadvantages of:

a) Specific tariff b) Ad valorem tariff 4 Using a graph, show the welfare effects of imposing a tariff by a small country 5 Explain why tariffs are still used by small countries despite the fact that economic theory does not show net positive effects for the imposing country.

LECTURE TWELVE 1 Define effective rate protection (ERP) 2 Use a numerical example to show that when a nominal tariff rate on a finished imported good tj is greater than a tariff on imported inputs ti, the effective ERP is greater than the nominal rate on the finished good. 3 Use a numerical example to show that when imported goods (finished imported good and inputs) are tariffed at the same rate i.e. tj = ti then the ERP is equal to the nominal tariff. 4 Use a numerical example to show that if the nominal tariff on the finished imported good ti , then the ERP is less than the nominal tariff on imported finished good. 5 What is the implication to government policy on protection of domestic industry resulting from the answer to the preceding question 4 above? LECTURE THIRTEEN

1 Define the following terms: export subsidy; quota; voluntary export restraint (VER); production subsidy; counter-veiling duties; outsourcing; dumping using cost based definition; dumping using price-based definition; sporadic dumping; persistent dumping; predatory dumping. 2 Using graph show how the effects of a production subsidy differ from those of a quota, in protecting an infant industry.

3 If the effect on trade of a quota are similar to those of VER, why are quotaS preferred? 4 Why are counter-veiling duties necessary, and under what circumstances would they be counter productive? 5 In what way is dumping a close cousin of subsidies?

LECTURE FOURTEEN 1 Define the following terms: import substitution; infant industry; backward and forward linkages; social benefits; private benefits; hoarding. 2 Are the arguments advanced by precursor proponents of the infant industry argument still relevant to developing countries today? 3 What are the pros and cons of globalization to Kenya in particular and world trade in general? 4 “Globalization is a euphemism for present day free trade crusade of neo-classical economists”. Discuss this statement in view of what you have learnt in international economics.

NB: To answer some of the questions above, especially those on definitions, students will have to seek help from the reading lists.

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