UNIT 12 FOREIGN TRADE

Objectives

After reading this unit you should be able to:

• define the concept of international trade and the need for it;

• state the advantages and disadvantages of international trade;

• identify the types of trade barriers and the initiatives taken to remove these barriers; and

• analyse recent trends in India’s foreign trade.

Structure

12.1 Introduction

12.2 Brief Historical Overview

12.3 Need for International Trade

12.4 Advantages and Disadvantages of International Trade

12.5 Theory of Absolute and Comparative Advantage

12.6 Intra- Industry Trade among Similar Economies

12.7 Types of Barriers to International Trade

12.8 Measures to Reduce Barriers to International Trade

12.9 India’s Foreign Trade: Recent Trends

12.10 Summary

12.11 Key Words

12.12 Self- Assessment Questions

12.13 References/ Further Readings

1
12.1 INTRODUCTION

We all exist in a global marketplace. The clothes up in your wardrobe might be designed and made in
Italy or China. The car that you own might be from Japan or Korea. The fancy and latest smart phone that
you possess might be made in Korea or China or Japan. The toy that you have gifted your child on her 5th
birthday, might be made in China. The laptop that you are working on, might be developed in UK. As an
employee, your job might be related to airplanes, cars, computers, farming, machinery or other
technology related industries, such that the major proportion of the sales of your company and your
salary, in turn, gets generated from the exports of such products. In short, we all are connected through
international trade, which has shown an immense growth in the last few decades.

International Trade refers to the exchange of goods and services between the countries. In other words,
international trade simply means imports and exports of goods and services. Export refers to the selling of
goods and services out of the country while import refers to flow of goods and services into the country.
From time immemorial trade has taken place through land and sea routes. Trade helps countries to boost
their productivity by concentrating on producing goods in which they are competitive. Trade also helps to
increase efficiency of world production under certain conditions. Given the advancement in transport and
communication the dimensions have changed over time. Costs have come down significantly and thus
countries trade more today than they used to even 50 years ago. The progress of trade however has been
bumpy with occasional protectionism halting its flow. Currently the world is going through such a crisis.
But history has shown that trade is one of the vehicles through which world GDP growth can be
influenced in the positive direction.

12.2 BRIEF HISTORICAL OVERVIEW

The exchange of goods and services among people (more commonly the Barter system of exchange) is an
age-old practice. Several political ideologies evolved since the late Renaissance period and has continued
up to World War II and have defined the world trading pattern according to their own beliefs.

According to the mercantilists, who dominated during the 16-18th century:

• Acquisition of wealth, in the form of gold, by a nation is of utmost importance.

• A nation can increase as well as benefit from trade only at the cost of other nations’ welfare. This
led to imposition of price and wage controls, promoting of domestic industries, exports of finalised

2
goods and imports of raw materials while limiting the exports of raw materials and imports of
finalised goods.

A strong opposition against the mercantilists came up towards the latter half of the eighteenth
century, in the form of Physiocrats (some French economic thinkers called themselves so as they
supported Liberalism) who demanded liberty in both production and trade. This led to strong
opposition against excessively high and often prohibitive custom duties and tariffs, and negotiations
of trade agreements with the more powerful foreign countries. A major success of this ideology
came in the form of the Anglo-French trade agreement of 1860, according to which the French
protective duties were lowered to a maximum of 25 per cent within 5 years along with free entry of
all French products except wine in Britain.

In the middle of the nineteenth century, there was an emergence of protectionist measures of
trade. The protective customs policies shielded many economies from the foreign competition. The
French Tariff of 1860, for example, charged extremely high rates on British products, more
precisely, 60 percent on pig iron, 40-50 percent on machinery and near about 600-800 percent on
woollen blankets. Transport costs between the two countries were an additional layer of protection
imposed.

The latter half of the nineteenth century witnessed Germany to follow systematically protectionist
policy followed by the US raising its duty rates sharply based on the McKinley Tariff Act of 1890.

The protectionism in the last quarter of the nineteenth century weren’t much stringent. Quantitative
restrictions were null and void, custom duties were low and stable, currencies were freely
convertible into gold, lesser issues with Balance of Payments and free factor mobility was allowed
across borders.

Post the World War I, in the first half of the twentieth century, trading conditions were dead.
World trade disrupted to such an extent from where recovery was almost impossible. It was further
followed by the Great Depression of 1930s, that witnessed mass unemployment levels, giving rise
to the mercantilists’ system of trade, through imposition of protective measures. Most of the
3
 countries attempted to improve their Balance of Payments by raising their custom duties,
introducing a wide range of import quotas and imposition of exchange controls (government
restrictions on the transactions related to foreign exchange, where purchases involving foreign
exchange transactions cannot exceed receipts in foreign exchange). The resurgence of this ideology
continued till the end of World War II, post which several trade agreements and newer trading
systems emerged to promote free flow of international trade.

12.3 NEED FOR INTERNATIONAL TRADE

Countries engage in trading internationally, when there are not sufficient resources or capacity to
satisfy all needs and wants of consumers domestically. By developing and utilising its own
domestic resources, a country can produce goods it is capable of, create surplus and then trade
internationally to buy goods and services from abroad which it is not capable of producing.

The concept of international trade goes back to almost 10,000 years ago, when there were not much
defined modern states and national border concepts. It goes back to the time when ships and pack
animals were the only mode of trading among people.

The countries today, globally, would not be able to survive without trading internationally. With
greater size and increasing population, there is an increase in needs and wants of nations
domestically, which a country may not be able to produce, given its resource base. Hence, import
and export relations worldwide are an integral part of survival for every economy.

Now, we know the reason behind exporting of goods by a country. But why does a country go for
importing of some goods and services? This question can be answered based on the reasons below:

• Price: A country may produce something at a relatively lower price than another country, which
may produce it at a higher cost.

• Quality: Every country has its own set of resource base which might differ from other countries,
and hence can produce goods it is capable of making by using its own resource base. So, if
country A can produce product 1 using its own resources and country B produces product 2 in a
similar line, they can import goods from each other which will be of much superior quality than
had they produced both domestically, without trading.

4
 • Availability: Nations are not well equipped to produce all goods and services domestically. Hence,
trading is a source of availability of all goods domestically.

• Demand: With increasing population, demand for goods and services increase. Hence, importing of
goods become necessary.

12.4 ADVANTAGES AND DISADVANTAGES OF INTERNATIONAL TRADE

Trading internationally has the following advantages:

1. Economies of Scale: When a country produces goods and services, it produces them in
surplus. This surplus is being traded internationally. Since, higher volumes of goods are being
produced, the cost of producing each good is reduced i.e., the country attains economies of
scale.

2. Comparative Advantage: Trading allows countries to specialize in production of goods and

services, it is capable of producing, using its resource base.

3. Competition: Selling goods and services internationally boosts both the foreign and domestic
markets. Domestic suppliers and consumers are aware about the foreign competition in terms
of prices and quality of goods and suppliers would ensure the quality and price of their goods
in order to meet the global competition.

4. Transfer of Technology: International trade enables transfer of technology among countries,

especially from a developed to a developing nation. Foreign companies are also approached
by the developing nations to set up local manufacturing units and help in infusion of such
technologies in the production of local goods.

5. More Job Creating Opportunities: Increasing in international trading also leads to creation
of more job opportunities in both domestic and foreign countries, thereby reducing
unemployment rates.

However, there are certain disadvantages associated with international trade such as:

5
1. Over-dependence adversely affects demand: One of the major cons of trading
internationally is exposed to both favourable and unfavourable events globally. Any
unfavourable event in the global front may affect the demand for domestic goods and can
even lead to higher risks of unemployment and reduced economies of scale.
2. Unfair for Start-ups: new start-ups or companies may not be able to flourish or may not be
able to expand both its resources and experience to compete against the bigger foreign firms.
3. National Security Threats: If a country is highly dependent on imports for strategic
industries (such as food, energy or military equipment), the exporters may be forced to take
up a decision which might be unfavourable to national interests.
4. Burden on Natural Resources: Every economy has a limited resource base, but if it
decides to welcome the entry of more foreign companies, the natural resource base may tend
to drain faster.

12.5 THEORY OF ABSOLUTE AND COMPARATIVE ADVANTAGE

International trade is now a global necessity. No country can better off without trading
internationally. David Ricardo, an economist and a member of the British Parliament, in the year
1817, argued in his paper “On the Principles of Political Economy and Taxation” stating that, free
trade and specialization can benefit all trading partners, including a country which happens to be
relatively inefficient. To understand this, we need to dive into the concepts of Absolute and
Comparative Advantages of trade.

Let us take for example, that there are two countries, Home and Foreign, producing two goods-
Cheese and wine. To keep things simple, we assume that each country has only one factor of
production- Labour. The unit labour requirements (labour hours required to produce a unit of a
good) to produce cheese and wine in Home country is given by aLC and aLW while that in Foreign is
denoted by a*LC and a*LW.

One might think that to determine which country will produce cheese and which country will
produce wine, all that is need to be done is to compare their unit labour requirements in production
of cheese and wine. If aLC<a*LC (case I), we can say that the Home labour is more efficient in
producing cheese than Foreign. Similarly, if aLC>a*LC (case II), we say that the Foreign labour is
more efficient in production of cheese than Home. The Theory of Absolute Advantage states that

6
when one country can produce a good with lesser units of a factor of production compared to
another country, then the former country is said to have an absolute advantage in the production of
that good. In case I, Home country is said to have an absolute advantage in the production of cheese
whereas in case II, the foreign country is said to have an absolute advantage in the production of
cheese. However, in a global scenario, where there are more than two countries engaging in trade,
absolute advantage alone is not sufficient in explaining the pattern of trade.

The Theory of Comparative Advantage, however, brings in the concept of opportunity cost, to
determine the gains from trade. A country has a comparative advantage in producing a good if the
opportunity cost of producing the good, in terms of other goods, is lower in that country compared
to other countries. The term opportunity cost refers to the amount of one good that is to be forgiven
to produce one extra unit of another good. From our example, if we want to derive that Home is
more productive in cheese and less productive in wine than Foreign, we can assume a relative
comparison of the unit labour requirements for both goods, in both the countries, in the form,

aLC/aLW< a*LC/a*LW……. (i)

or, to be precise, we can write it as,

aLC/a*LC < aLW/a*LW……. (ii)

This states that the ratio of the labour required to produce a pound of cheese to that of a gallon of
wine is lesser in the Home country than that in the Foreign. This ratio of labour requirements is
nothing but the opportunity costs of producing cheese in terms of wine and the comparative
advantage theory is defined in terms of opportunity costs. So, from (i) and (ii), we can say that
Home has a comparative advantage in the production of cheese than the Foreign. Foreign, on the
other hand, will have comparative advantage in the production of wine than Home and both the
countries will gain from trade by exporting the goods in which they are having comparative
advantage.

Does a country benefit from having Absolute Advantage in all goods?

One can only imagine that a country with higher-income levels, higher number of skilled workers,
technologically advanced equipment and the latest advanced production processes can have an
absolute advantage in all goods. US, for example, have the ability to produce both computers and

7
roses. As roses usually can be grown in the warm temperatures, how hard it might be, for US, to
supply roses in winter, especially in the month of February and on the eve of Valentines Day? The
flowers have to be grown in heated greenhouses which involve great expenses in terms of capital
investment and other scarce resources that are required to grow roses. Those resources could have
been put to produce computers.

Suppose, US grows 1 million roses for sale on Valentine’s Day. The resources required to grow
those roses could have produced 100,000 computers. Then the opportunity cost of 1 million roses is
100,000 computers. Now, if those 1 million roses could instead be grown in South America, it
would be extremely likely that the opportunity cost of those roses in terms of computers would be
lesser than that in United States. This is because, growing roses in South America is easier as it is
summer in February rather than winter. On the other hand, South American workers are less
productive than their US counterparts in the production of computers and thus computer production
in South America will yield lower computers (say 30,000 computers) than it would have been in
US. So, the opportunity cost of 30000 computers is 1 million roses.

These differences in opportunity costs raise the possibility of mutually beneficial trade agreements
between US and South America. Let US stop growing roses completely and produces only
computers while South America shifts its resource base completely in the production of roses than
computers. The resulting changes in production are given in the Table 12.1.

Table 12.1: Changes in Production pattern of Roses and Computers (Hypothetical)

Country Roses (in millions) Computers (in thousands)

United States -01 +100
South America +01 -30
Total 0 +70

From Table 12.1, it is clear that the world is producing just as many roses as before, but the global
production of computers saw a rise. So, with increase in production of computers by US and that of
roses by South America, there is an increase in the world’s economic pie, which in turn, also leads
to increase in standards of living.

8
Thus, it can be concluded that even if a country has the ability to produce all goods, it can still
benefit from trading with other countries, as a result of comparative advantage.

Activity 1

Look at India’s exports in 2019-20. Top 5 export commodities should be considered in terms of
value (say Rs. Crores). Now try to see whether the trade theories you have learnt can explain
why India exports these products. (You can look at Economic Survey 2019-20 where top 100
principal commodities exported are published).

________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

12.6 INTRA-INDUSTRY TRADE AMONG SIMILAR ECONOMIES

According to the theory of Comparative Advantage, a country can produce goods in which it
specialises to a certain degree and then trade them off globally. However, a significant proportion of
trade is intra-industry trade – trading of goods within the same industry, among fairly similar
economies like US, Japan, China, Mexico, and the European Union. But why do similar economies
engage in intra- industry trade? Well, this has three reasons:

• Gains from Specialization and Learning: Intra- industry trade between similar economies
produces economic gains as it allows both the firms and the workers to learn and innovate
on particular products and often on some very particular parts of the Value chain-
production of goods in different stages. For example- An Apple Macbook may be designed
and engineered in the US, parts might be supplied from Korea, assembled in China and
advertised and marketed by Japan. A large part of contribution in this splitting up of the
value chain goes to newer up-gradations in communication technology, information-sharing
services and transportation services. Instead of production of an entire product in a single
large factory, all the above steps can be done operating in different places and different

9
 economies, thereby involving greater involvement of learning, innovation and gathering of
skills.
• Economies of Scale, Competition and Variety: The concept of economies of scale means
that as the scale of production of an output increases, the average cost of production
declines. Intra-industry trade among fairly high-income economies involves a lot of
competition among products and consumer choices globally, if they go for trading
internationally. Had there been no trade, and only one or two large plants were supplying
products within a country, the consumers would have been left with little option to choose
their products from. Also, little or no level of competition would have existed among the
manufacturers globally.
• Dynamic Comparative Advantage: In an intra–industry trade, the comparative advantage
is dynamic – in the sense that the level of labour productivity does not only depend on
climate, geography, education or acquiring of new skill sets. It instead, depends on how a
firm engages its workers in specific and specialized learning about different products or
product parts, which has been made possible with the splitting up of the value chain. Newer
ways of acquiring unique set of skills are evolving with time which keeps on changing the
line of comparative advantage for the economies.

12.7 TYPES OF BARRIERS TO INTERNATIONAL TRADE

The most common barriers to international trade are tariffs, quotas and non-tariff barriers.

Tariffs are taxes imposed by governments on the imported goods. Quotas, on the other hand, are
trade restrictions imposed on the quantitative number of goods that can be imported or exported
during a particular period.

The effects of both tariffs and quotas are same i.e., both aim at lowering of imports and protecting
the domestic producers from the foreign competition. A tariff raises the price of the imported good
in the tariff imposing country, which in turn, reduces the demand for, and eventually the supply of
the good in the tariff imposing country. Quotas, on the other hand, put restrictions on the amount of
goods to be supplied to the quota imposing country, which in turn, raises the price of the product
within the quota imposing country, thereby reducing its demand among the consumers of that
country.
10
Non-tariff barriers include regulations imposed on product content or quality, product standards,
packaging and shipping regulations, harbour and airport permits, heavy customs procedures, etc.

Activity 2

Find out the principal barriers to India’s products exported to countries like USA, EU and Japan. Do
you see any similarity? (Look at WTO I-TIP portal)

________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

12.8 MEASURES TO REDUCE BARRIERS TO INTERNATIONAL TRADE?

Free trade refers to elimination of all barriers to international trade. Several numbers of
organizations and trade agreements are working out to ease the barriers to trade, thereby promoting
more of trade and mutual economic gains from it. Some of the important initiatives taken to remove
those barriers are discussed below:

1. General Agreement on Tariffs and Trade (GATT): Post the Great Depression and World
War II, international trade faced stringent cross-border restrictions. To eliminate those,
twenty-three nations came forward and united in 1947 to sign the General Agreement on
Tariffs and Trade (GATT). GATT encouraged free trade through proper regulation and
reduction in tariffs and also provided a forum for resolving trade related disputes among its
signatories.

2. World Trade Organization (WTO) and Regional Trading Agreements (RTAs):

Founded in 1995 by the members of GATT, located in Geneva, Switzerland and with
approximately 159 member countries at present, WTO encourages global trade through
lowering of trade barriers, introducing multilateral trading systems through Regional
Trading Agreements (RTAs), enforcement of international trade rules and providing a forum
11
 for resolving trade disputes. It is also empowered to monitor a country’s trade policy and
can guide the “guilty” members in eliminating all disputed trade restrictions imposed, if any.
Non-discrimination is the core principle of WTO, and its members have committed not to
favour any one trading partner over others. An exception to these is the Regional Trade
Agreements (RTAs), which are discriminatory by nature – in the sense that only its member
signatories can enjoy more favourable market-access conditions. The RTAs aim at
facilitating trade between its signatories but do not raise trade barriers with the other trading
countries.
WTO member countries can enter into the RTAs under specific conditions which will cover:
i) formation and operations of customs unions and free trade areas covering trade in goods,
ii) regional or global arrangements for trade in goods between developing member countries
and iii) agreements covering trade in services. In general, RTAs must cover all trade in
goods and services and help in promoting more of free trade among the countries under
RTA.

As of June 2016, all WTO member countries now have an RTA in force.

3. The World Bank and the IMF: The primary determinant in helping the poorer nations or
the less developing economies to involve as active members in the global trading system is
by providing financial assistance. This has been a major shared goal of two international
organizations – The International Monetary Fund (IMF) and the World Bank.

The IMF lends financial assistance to the needy economies, with conditions imposed, which
might include some of the tender financial or economic reforms.

The World Bank, on the other hand, provides economic assistance to the poor and the least
developing economies so as to ameliorate the lives of the people through community-
support programs which are mainly designed to ensure the provision of better health,
education, nutrition, infrastructure and other social services.

4. Trading Blocs: In some parts of the world, a group of countries have integrated to allow
free flow of commodities and services among their mutual boundaries. Such groups of
countries are known as Trading Blocs.
12
 The North American Free Trade Association (NAFTA) – (agreement signed for mutual
flow of trade among the US, Mexico and Canada) and the European Union ( EU) (signed
by 27 countries of Europe to open their borders for free trade) are the two most powerful
trading blocs at present.

Activity 3

Find out the major Regional Trading Blocs in the world and try to write a brief note on each
of them. (Go to commerce.gov.in)
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________

12.9 INDIA’S FOREIGN TRADE: RECENT TRENDS

India’s Gross Domestic Product (GDP) reached to US$ 2.88 trillion (Rs. 203.39 trillion) in 2019-20
through tremendous acceleration in the twin channels of trade and capital flows into the country
over the last two decades.

India generated a trade surplus of US$ 13.59 billion between April and November, 2020, with
exports (of both goods and services) amounting to US$ 304.25 billion and imports totalling to US$
290.66 billion (as per data from the Ministry of Commerce and Industry). The Government of India
is looking forward to grow exports, thereby creating a pool of more jobs for the educated and
talented youth, as well as, for the semi and un-skilled workers of India.

As per sources of RBI, its foreign exchange reserves now stand at US$ 583.13 billion (Rs. 42.75
trillion) as of December, 2020.

India’s external sector, during 2020-21, witnessed a series of MOUs (Memorandum of

Understanding) signed for:

13
(i) Strengthening the cross-border cooperation in the electricity sector with the United States
(ii) Strengthening the cross-border cooperation in the area of securities, with Luxembourg
(iii) Technology cooperation in the road infrastructure sector, with the Republic of Austria
(iv) Cooperation in the fields of Health and Medicine, with Cambodia (valid for a period of 5
years)
(v) Making education materials accessible to children with hearing disabilities, in cooperation
with NCERT, and
(vi) Strengthening the bilateral trade between India and Mexico through cooperation in the
sectors like pharmaceuticals, medical equipment, health care, agro-products, fisheries, food
processing and aerospace.

India’s foreign trade is sooner going to witness a new Foreign Trade Policy (2021-26) with major
focus on outlining policies and steps to accelerate domestic production and exports. It has emerged
as one of the most sought-after destination for foreign investments due to its trade policies,
government reforms and inherent economic strengths, alongside recent technological and
infrastructural developments across the country. It is expected to raise its exports (of both goods and
services) to Australia by US$ 15 billion in 2025 and US$ 35 billion by 2035.

Activity 4

1. Find out the largest and significant trading partners of India.

________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

2. Write a short note, using internet resources, on the Initiatives taken by the Indian government
to boost its exports under the Foreign Trade Policy, 2015-20.
________________________________________________________________________________
________________________________________________________________________________

14
________________________________________________________________________________
________________________________________________________________________________
_______________________________________________________________________________

12.10 SUMMARY

International trade allows countries to engage in buying and selling of goods across their
geographical boundaries, and can ensure productivity efficiency of the trading economies at the
same time. Despite bearing a few disadvantages like exposure to national security threats, depletion
of domestic natural resource base, creation of highly competitive forums for the newer start-ups to
flourish and adverse effects on the domestic demand on account of any unfavourable global
scenario, foreign trade ensures that a country attains economies of scale, can specialise in
production of goods and services given its natural resource base, regulates the prices and quality of
the commodities traded globally, facilitates the transfer of technologies among the trading countries
and helps in creation of employment opportunities globally. A country cannot benefit from trade if
it has absolute advantage in the production of all goods and services as it eliminates the scope of
specialising in the production of goods and services as well as trading with other countries. It can
benefit from trade only if it has comparative advantage in the production of goods and services,
which accelerates the productive efficiency of that country. However, trading globally also involves
some barriers in the form of tariff and non-tariff measures that are being imposed by the
government, and which may have an impact on the prices, quality and quantity of the goods traded.
To curb those barriers, several international organizations (such as the World Bank, the IMF,
GATT, WTO) and agreement bodies (such as the RTAs and the trading blocs) have come into
being, which work towards encouragement of free trade, reduction as well as regulation of the tariff
barriers, solving of trade disputes among the global trading partners and ensuring improvement in
living standards and employment rates worldwide.

12.11 KEY WORDS

Economies of Scale: Economies of scale refer to the cost advantages experienced by a firm when it
increases its production of output. These cost advantages arise because of the inverse relationship
that exists between the per-unit fixed costs and the quantity of the units produced. The greater the
15
production of output, the lower is the per-unit fixed cost. It also ensures a fall in the average
variable costs due to the operational efficiencies that arise with the increase in the scale of
production.

Intra-Industry Trade: International trade that occurs within similar industries rather than between
any two or more different industries. Intra-industry trade is highly beneficial as it stimulates the
innovation, ensures significant production efficacy and exploits economies of scale.

Non-tariff Barriers: Barriers other than tariff which restrict trade. Major ones are sanitary and
phyto-sanitary measures, labelling requirements, technical barriers to trade, inspection etc.
Developed countries are skilled in applying these measures to restrict trade in products of interest
from developing countries.

Quotas: These are quantitative restrictions on trade. Such barriers are more restrictive than tariffs
since it outright by prevents the flow of goods. In case of tariffs the change in flows also depends on
elasticity.

12.12 SELF-ASSESSMENT QUESTIONS

1. Define International Trade. Why is International Trade beneficial for a country? Discuss.

2. What has been the world trade pattern during historical times?

3. State two advantages and disadvantages each of international trade?

4. Briefly explain the concepts of Absolute Advantage and Comparative Advantage Theory of
International Trade? Give suitable examples to illustrate the concepts.

5. Do you think that a country can benefit from trade if it has Absolute Advantage in all
goods? Explain.

6. What types of barriers affect International Trade? How can they be managed?

7. What are Trading Blocs? State an example of one such trading bloc.

8. How does India’s external sector look like in the upcoming years? Will it be an engine of
growth? Discuss.
16
12.13 REFERENCES/ FURTHER READINGS

17