Chapter one

Introduction

1.1 THE SUBJECT MATTER OF INTERNATIONAL ECONOMICS

Today, no country inhabits an economic island. Its firms, industries, its commercial activities
in goods and services, its technology and available capital, its standard of living, and all other
features of its economy are related to the economies of other countries. The process of
globalization has left hardly any country isolated or unaffected by worldwide economic
conditions outside its own borders. Events outside the borders of a country can have a significant
impact on its economic performance and policy choices.

International economics is the study of causes and factors that necessitates goods and services
to flow from one country to the other.

International economics can broadly be categorized into:

1. International trade (pure theory of international trade):-primarily focuses on real

transaction in international economy i.e. on those transactions that involve physical
movement of goods and tangible commitment of economic resources.
2. International finance (the study of international money):-focuses on monetary side of
international economy i.e. financial transaction such as foreign purchase of U.S. dollar. E.g.
dispute over whether foreign exchange value of dollar should be allowed to float freely or
be stabilized by government action.

International economics deals with theory and practice of international trade and finance. It deals
with the economic relations among nations. In other words, it comprises of:

1. International trade theory – examines the basis for (or the forces that give rise to)
international trade and the benefits from such a trade.
2. International trade policy – studies the reasons for and the results of obstructions to the
free flow of trade.
3. The balance of payments – examines a nation’s total payments to and total receipts from
the rest of the world. These involve the exchange of one currency for the others.

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 4. Adjustment in the balance of payments – deals with the mechanism of adjustment to
balance of payments disequilibria under different international monetary systems.
International trade analysis focuses primarily on the real transactions in the international
economy, that is, on those transactions that involve a physical movement of goods or a tangible
commitment of economic resources. International finance (monetary analysis) focuses on the
monetary side of the international economy, that is, on financial transactions. In the real world
there is no simple dividing line between trade and monetary issues. Most international trade
involves monetary transactions, while many monetary events have important consequences for
trade.

1.2 WHY STUDY INTERNATIONAL ECONOMICS AS A SEPARATE FIELD

International economics uses the same fundamental methods of analysis as other branches of
economics, because the motives and behavior of individuals are the same in international trade as
they are in domestic transactions. Yet international economics involves new and different
concerns, because international trade and investment occur between independent nations. The
economic relations among nations differ from the economic relations among the various parts
of a nation. This gives rise to different problems, requiring somewhat different tools of analysis,
and justifies international economics as a distinct and separate branch of economics.

International trade theory and domestic microeconomics both rest on the same assumption
that economic agents maximize their own self-interest. Nevertheless, there are important
differences between domestic and foreign transactions. Similarly, international finance is closely
tied to domestic macroeconomics, but political borders do matter, and international finance is far
more than a modest extension of domestic macroeconomics. The differences between
international and domestic economic activities that make international economics a
separate body of theory are as follows:

1. Within a national economy labor and capital are generally free to move among
regions. This means that national markets for labor and for capital exist. Although wage
rates may differ modestly among regions, such differences are reduced by an arbitrage
process in which workers move from low- to high-wage locations. There are even smaller
differences in the return to financial capital across regions because investors have lower
costs of moving funds from one location to another. As a result, domestic microeconomic

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 analysis generally rests on the assumption that firms competing in a market pay
comparable wages and borrow funds at comparable interest rates. International trade is
quite different in this regard. Immigration laws greatly limit the arbitraging of wage rates
among nations, so that wage rates differ sharply across the world. Although capital flows
among nations more easily than labor does, exchange controls, costs of information, and
other factors are sufficient to maintain significant differences among interest rates in
different countries. Therefore, international trade theory centers on competition in
markets where firms face very different costs.
2. There are normally no government-imposed barriers to the shipment of goods
within a country. Accordingly, firms in one region compete against firms in another
region of the country without government protection in the form of tariffs or quotas.
Domestic microeconomics deals with such free trade within a country. In contrast, tariffs,
quotas, and other government-imposed barriers to trade are almost universal in
international trade. A large part of international trade theory deals with why such barriers
are imposed, how they operate, and what effects they have on flows of trade and other
aspects of economic performance.
3. Domestic macroeconomics normally deals with monetary and fiscal policy choices that
address cyclical economic fluctuations that affect the country as a whole. With one
currency used throughout the country, establishing a different monetary policy or
interest rate for different regions is not possible. While there are differences across
regions in the way central government spending is allocated, essentially fiscal and
monetary policies that exist in one part of the country also prevail in other parts.
International finance, or open economy macroeconomics, is about a very different
situation. Different countries have different business cycles; the significance of strikes,
droughts, or shifts in business confidence, for example, regularly differs across countries.
Because some countries may be in a recession while others enjoy periods of economic
expansion, they generally choose different monetary and fiscal policies to address these
circumstances. These differences in macroeconomic conditions and policies among
countries have major consequences for trade flows and other international
transactions.

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 4. A country normally has a single currency, the supply of which is managed by the central
bank operating through a commercial banking system. Consequently, there are no
internal exchange markets or exchange rates in a country. International finance involves a
very different set of circumstances. There are almost as many currencies as there are
countries, and the maintenance of a currency is typically viewed as a basic part of
national sovereignty. International finance is concerned with exchange rates and
exchange markets, and the influence of government intervention in those markets.
1.3. What is International Trade?

International trade is the exchange of goods and services between countries. This type of trade
gives rise to a world economy, in which prices, or supply and demand, affect and are affected by
global events. Political change in Asia, for example, could result in an increase in the cost of
labor, thereby increasing the manufacturing costs for an American sneaker company based in
Malaysia, which would then result in an increase in the price that you have to pay to buy the
tennis shoes at your local mall. A decrease in the cost of labor, on the other hand, would result in
you having to pay less for your new shoes. In most countries international trade represents a
significant share of gross domestic product (GDP).

1.4 Gains from trade

Probably the most important single insight in all of international economics is that there are
gains from trade-that is, when countries sell goods and services to each other, this exchange is
almost always to their mutual benefit. The range of circumstances under which international
trade is beneficial is much wider than most people thinks. It is a common misconception
that trade is harmful if there are large disparities in productivity and wages. On one side
business people in less technologically developed countries, such as India, often worries that
opening their economy to international trade will lead to disaster because their industries won’t
be able to compete. On the other side, people in technologically advanced nations where worker
earn high wages often fear that trading with less advanced , lower wage countries will drag their
standard of living down.

However, two countries can trade to their mutual benefit even when one of them is more
efficient than the other at producing everything, and when producers in less efficient country can

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compete only by paying lower wages. Trade provides benefits by allowing countries to export
goods whose production makes relatively heavy use of resources that are locally abundant while
importing goods whose production makes heavy use of resources that are locally scarce.
International trade also allows countries to specialize in producing narrower ranges of
goods, giving them greater efficiencies of large scale production. International migration
(trade of labor for goods and services) and international borrowing and lending (trade of current
goods for promise of future goods) are also forms of mutually beneficial trade. Finally,
international exchanges of risky assets such as stocks and bonds can benefit all countries by
allowing each country to diversify its wealth and reduce the variability of its income.

Although nations generally gains from international trade, it is quite possible that
international trade can hurt particular group within nations, in other words international
trade will have strong effects on the distribution of income. International trade can adversely
affect the owners of resources that are specific to industries that compete with imports, that is,
cannot find alternative employment in other industries. Example would include specialized
machinery, such as power looms made less valuable by textile imports and workers with
specialized skills, like fishermen who find the value of their catch reduced by imported seafood.

1.5 International and intra-regional trade

International trade and inter-regional trade are similar in some aspects. For example, the
southeast of U.S. sell cotton to the rest of the U.S. where conditions are not favorable to grow
cotton for the same reason the U.S. buys coffee from Brazil and/or Ethiopia. It makes little
economic sense to locally produce good that can be produced elsewhere in the world at a lower
cost and shipped at a lower price to consumers. The difference lie in the perception that trade
between two regions of the same country, such as the U.S. is buying from the U.S. and U.S. is
selling to U.S. whereas trade between one country and another country, is U.S. buying from and
U.S. selling to another country.

More on the difference between international trade and interregional trade

International trade (external trade or foreign trade) can be defined as the exchange of goods and
services between the residents of a given country with those of residents in the rest of the world.

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Domestic trade (internal trade) is the exchange of goods and services among the residents of the
same country. The difference between domestic and foreign trade can be explained in detail as
follows:

Factor mobility: The distinction made by classical economists between domestic and
international trade was grounded on the notion of geographic mobility of factors of production.
The assumption made was that within the nation, there is free mobility of factors of production.
If internal mobility were perfect, then all factors of production notably labor and capital –would
move into areas where they can receive highest rate of return for their services. Under idealized
perfect mobility there could not exist inter-regional differences in factor prices. The factors
would move away from the regions where their prices are relatively lower to regions where their
prices are relatively higher, until the factor price differences between the regions are completely
wiped off. In such a case, the price of any factor of production of a given type and quality must
be the same throughout the entire country. In international trade, however, the factor mobility is
neither free nor perfect.

First of all, there are restrictive immigration laws which prevent free mobility of labor from one
country to another. In respect of capital also, there are restrictions on the inflow and outflow of
capital and investment across national frontiers.

In addition to these legal barriers, there are other social, cultural and political barriers that restrict
the mobility of factors from one country to another. Differences in language, climate, social,
customs and practices, political and educational systems, etc. do create additional barriers to
factor mobility between nations. Within the nation, such differences may not exist, or may not
appear too formidable to be overcome by economic incentives. At any rate factor mobility is
relatively greater within country than between countries.

Product mobility: Within the nation, the movement of goods and services from one region to
another is free. The only internal barriers to free movement of goods and services are the
distance and cost of transportation –what may be termed as natural barriers. But in the case of
international trade, such a movement is not free, because in addition to the natural barriers, are
formidable man-made barriers. For instance, there are import and export duties and quotas,
exchange controls, non-tariff (hidden) barriers which put countless obstacles to the free

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movement of goods and services between nations. Growing protectionism and spirits of
nationalism have been making trade between countries more and more difficult. Agricultural
protectionism in the western industrialized countries and the policies of industrialization through
import-substitution in the developing countries are some of the examples of how international
trade in commodities is being deliberately reduced in today’s world.

Economic environment: Within the nation, the economic environment is more or less the same
in all the regions of the country. For example, the legal framework or the laws governing
consumption, production and exchange of goods and services are the same throughout the
country. The government polices with regard to interest rates, taxes, wages or prices are the same
within the country. Production techniques, factor proportions, factor prices, infrastructure
facilities and production functions or possibilities are nearly the same in the country. Similarly,
market structures-the degree of competition or monopoly in production-and consumer taste
patterns and preferences are more or less the same throughout the country. All of them would
add up to create a certain economic environment or investment climate within the nation. But
between nations, they could all differ very significantly. This would make the character of
international trade significantly different from that of domestic trade.

Monetary units: The difference between domestic and foreign trade is more obvious in
international monetary or currency differences. Within the nation, monetary laws and the
financial system and arrangements are the same for all regions in the country. Most significantly,
there is a single currency used as a medium of exchange or a measure of value which would
make exchange very smooth as far as domestic trade is concerned. This is not so between
countries. We have dollars, Euros, yens, pounds, franks, birr etc., and not all of them are freely
accepted in discharge of international monetary obligations. An Ethiopian importer must first
obtain US dollars before he can think of buying goods from the United States of America. But
with the domestic currency you can “import” and “export” goods from one region to another in
any quantity you wish. There are no currency complications or convertibility problems involved
in carrying out domestic trade. In respect of foreign trade, however, there are currency
complications, problems of non-convertibility of currencies, exchange rate controls and
restrictions and many other obstacles. International monetary differences, therefore, introduce

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complications and complexities in international transactions; and these are absent in domestic
trade and exchange.

The significance of international trade

 It increases productivity and efficiency.
 It brings economic growth.
 It strengthens the relationship among different countries.
 It benefits the poor by supplying goods at lower price.
 It encourages the opportunity of foreign direct investment