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Meaning of Trade

Trade refers to buying and selling of goods and services for

money or money's worth. It involves transfer or exchange of

goods and services to fulfill the requirement of human beings.The manufacturers or producer produces the goods, then moves

on to the wholesaler, then to retailer and finally to the ultimate

consumer.

Trade is essential for satisfaction of human wants,

Trade is conducted not only for the sake of earning profit; it also

provides service to the consumers. Trade is an important social

activity because the society needs uninterrupted supply of goodsforever increasing and ever changing but never ending human

wants. Trade has taken birth with the beginning of human life and

shall continue as long as human life exists on the earth. It

enhances the standard of living of consumers. Thus we can say

that trade is a very important social activity.

Trade can be divided into following two types:-

1. Internal or Home or Domestic trade.

2. External or Foreign or International trade

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1. Internal TradeInternal trade is also known as Home trade. It is conducted

within the political and geographical boundaries of a country. It

can be at local level, regional level or national level. Hence trade

carried on among traders of Delhi, Mumbai, etc. is called home

trade.

Internal trade can be further sub-divided into two groups:-

Wholesale Trade: It involves buying in large quantities from

producers or manufacturers and selling in lots to retailers for

resale to consumers. The wholesaler is a link between

manufacturer and retailer. A wholesaler occupies prominent

position since manufacturers as well as retailers both are

dependent upon him. Wholesaler act as a intermediary

between producers and retailers.

Retail Trade: It involves buying in smaller lots from the

wholesalers and selling in very small quantities to the

consumers for personal use. The retailer is the last link in the

chain of distribution. He establishes a link between wholesalers

and consumers. There are different types of retailers small as

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well as large. Small scale retailers include hawkers, pedlars,

general shops, etc.

2.International trade

International trade also called as foreign trade. Foreign trade

consists of export and import of goods and services across

international borders or territories from a country. The GDP of a

country is the domestic equivalent of foreign trade. In the case of

India, historically, textiles contributed a lot to the export and of

late that place is taken by IT/BPO in the form of services. Indian

imports mainly consist of manufactured goods.

The definition of foreign trade is the export of all goods and

services to foreign countries and the import of all goods and

services to the home country. For instance If Mr.X who is a

trader from Mumbai, sells his goods to Mr.Y another trader from

New York then this is an example of foreign trade.

In most countries, it represents a significant share of gross

domestic product (GDP). Industrialization, advanced

transportation, globalization, multinational corporations, and

outsourcing are all having a major impact on the international

trade system. Increasing international trade is crucial to the

continuance ofglobalization. Without international trade, nations

would be limited to the goods and services produced within their

own borders.

International trade can be further sub-divided into three

groups:-

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Export Trade: When a trader from home country sells his

goods to a trader located in another country, it is called export

trade. For e.g. a trader from India sells his goods to a trader

located in China.

Import Trade: When a trader in home country obtains or

purchase goods from a trader located in another country, it is

called import trade. For e.g. a trader from India purchase

goods from a trader located in China.

Entrepot Trade: When goods are imported from one country

and then re-exported after doing some processing, it is called

entrepot trade. In brief, it can be also called as re-export of

processed imported goods. For e.g. an Indian trader (from

India) purchase some raw material or spare parts from a

japanese trader (from Japan), then assembles it i.e. convert

into finished goods and then re-export to an american trader

(in U.S.A).

International trade is in principle not different from domestictrade as the motivation and the behavior of parties involved in a

trade do not change fundamentally regardless of whether trade is

across a border or not. The main difference is that international

trade is typically more costly than domestic trade. The reason is

that a border typically imposes additional costs such as tariffs,

transport Cost, Factor immobility and costs associated with

country differences such as different natural resources, markets,

language, the legal system or culture.

Steps For International Trade

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There are various steps involved in the exploitation of the

international market,

Survey of the Market: Market survey is a means of

obtaining maximum information which would help one identitythe markets where a particular product may be sold, or

identify the products that may be sold in a given market.

Decide on market products Configuration: Based on the

data available from the market survey, a decision has to be

taken by the management about the product it would like to

promote in a particular market, as also the market to which a

given product may be exported.

Draw up Marketing Strategy and Plan: A plan is a group ofdecisions taken by the management about the various aspects

of the marketing scenario product, price, promotion,

distribution etc. A marketing strategy is usually drawn up by

the management for a pre-determined level of sales volume

and profit in accidence with the data obtained by it from the

market survey.

Implement the Market Plan: The implementation of the

market plan would also involve the identification of various

sales promotion strategies, which would create a need for the

product in the market and consequently result in a sale. The

effectiveness of sales promotion strategies would determine

the volume of sale and the market share obtained by the

company for a particular product.

Reasons for Entering into International Trade:-

Although profit is the underlying motive, most of the firms are

directed into international market because of the following live

reasons as identified by Vern Terpstra:

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1. Product Life Cycle: A product may be at the end of the life

cycle in one market and not even introduced in another. The

unwillingness of the firm to write off its productive assets may

force it into international markets.

2. Competition: In the effort to avoid competition which may beintense in the domestic market. The firm may choose to

International market.

3. Excess Capacity: In an effort to minimize its fixed cost per

unit, the firm may undertake foreign orders.

4. Foreign Technology: In order to adopt new technology from

foreign market a firm may choose to go international

5. Geographical Diversification: This has to do with the

strategy that a firm may adopt. Instead of extending itsproduct line the firm may just choose to expend its market by

going International.

6. Increasing the market Size: In an effort to expand its

operation a firm may choose to go international.

Role of Foreign trade in the Indian Economy

To understand the role of foreign trade in the Indian

economy, need to understand the importance of foreign

trade for any country. I explain this with a simple

example:

Imagine that there are only two countries in the world, India and

Denmark. Both countries have 1 000 citizens. These citizens eat

only bananas and drink only milk (let's say they only eat banana-milkshakes). Each country needs 50 000 bananas and 50 000

liters of milk to feed its population.

In India, the weather is good; the sun shines a lot so bananas

grow easily. Therefore, one Indian can produce 100 bananas per

year. But India is also a dry country, so the cows in India don't

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produce much milk. Therefore one Indian can only produce 50

liters of milk per year.

In Denmark, the weather is not sunny, so bananas do not grow

easily. Therefore, one Dane can only produce 50 bananas peryear. On the other hand is Denmark a perfect place for cows,

because it is a very green country. Therefore, one Dane can

produce 100 liters of milk per year.

Let's suppose that there is no foreign trade in our two-country-

world. Denmark will produce 50 000 liters of milk and will use 500

inhabitants to do this. The other 500 Danes will be used to

produce bananas, resulting in a production of 25,000 bananas

(500 workers x 50 bananas per worker). So Denmark will come

25,000 bananas short to feed its population.

India will produce 50,000 bananas (using 500 workers) and

25,000 litres of milk (using the other 500 workers), and also India

will not be able to feed its population.So without foreign trade,

both countries will not be able to produce enough food for the

population.

Now suppose that there is foreign trade between India and

Denmark. Now both countries can produce the goods that they

are best in, bananas for India and milk for Denmark.

The 1000 workers in India will be able to produce 100 000

bananas. They only need 50,000, so the other 50,000 will be

exported to Denmark. The 1000 workers in Denmark will be able

to produce 100,000 liters of milk. They only need 50,000 litres, sothe other 50,000 litres will be exported to India. As a result of this

foreign trade, both countries will have enough food to feed their

population.

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This example makes two things clear.

Foreign trade is for the benefit of all countries.

When there is foreign trade, you will specialize in the

production of those goods in which you have an advantage toproduce them.

Now the role of foreign trade on the Indian economy is

easy to determine:

1. Foreign trade has made India richer. Products which are

difficult to produce for India (engines,) can be imported, which

is good for the Indian economy.

2. The rise of foreign trade has forced India to specialize in the

production of a few goods. These are mainly ores (the Indian

mines), food products and cheap products that are easily built

using cheap labour.

So India has been one of those countries which compete with

other economies by producing labour intensive products. This has

had a great influence on Indian economy, because it implies a

partial shift from agriculture to industrial production.

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Ricardo's Theory of Comparative cost Advantage

The most basic concept in the whole of international trade theoryis the principle of comparative cost advantage, first introduced by

David Ricardo in 1817 in his book 'Principles of PoliticalEconomy and Taxation'. This theory of comparative advantage,

also called comparative cost theory, is regarded as the classical

theory of international trade.

It remains a major influence on much international trade policy

and is therefore important in understanding the modern global

economy. The principle of comparative advantage states that a

country should specialise in producing and exporting those

products in which it has a comparative, or relative cost,

advantage compared with other countries and should import

those goods in which it has a comparative disadvantage. Out of

such specialisation, it is argued, will accrue greater benefit for all.

Types of Cost Difference in Production

Economists speak about three types of cost difference in

production, they are

1. Absolute cost difference,

2. Equal cost difference, and

3. Comparative cost difference.

1. Absolute Cost Differences:-

Adam Smith in his book 'Wealth of Nation' developed the

trade theory of absolute advantage in 1776. A country that has an

absolute advantage produces greater output of a good or service

than other countries using the same amount of resources. Smith

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trade; it should be allowed to flow according to market forces.

Contrary to mercantilism Smith argued that a country should

concentrate on production of goods in which it holds an absolute

advantage. No country would then need to produce all the goods

it consumed. The theory of absolute advantage destroys themercantilistic idea that international trade is a zero-sum game.

According to the absolute advantage theory, international trade is

a positive-sum game, because there are gains for both countries

to an exchange. Unlike mercantilism this theory measures the

nation's wealth by the living standards of its people and not by

gold and silver.

There is a potential problem with absolute advantage. If there isone country that does not have an absolute advantage in the

production of any product, will there still be benefit to trade, and

will trade even occur? The answer may be found in the extension

of absolute advantage, the theory of comparative advantage.

The principle of absolute difference in cost can be explained with

the help of table given below. Let us assume that we have 2

countries, I and II specialising in the production of X and Y.

In country I, one day's labour produces 20x or 10y. The internal

exchange rate is 2 : 1. In country II, one day's labour produce 10x

or 20y which gives us the domestic exchange rate of 1 : 2.

Country I has the absolute advantage in the production of X (as

20 > 10) and country II in Y ( as 10 < 20). If these countries enter

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into trade with the international exchange of 1 : 1, both countries

stand to benefit. Country I will have 1y for 1x as against 1/2y for 1x

within the country. Similarly country II will have 1x for 1y as

against 1/2x for 1y within the country.

Based on this example, according to Adam Smith, it can be

pointed out that international trade to be beneficial, each country

must enjoy absolute difference in cost of production.

2. Equal Difference in Cost:-

Adam Smith, in order to strengthen his argument in favour ofabsolute difference in cost pointed out that trade is not possible if

countries operate under equal difference in cost instead of

absolute difference.

The above table gives us the internal exchange rate 2x : 1y in

both countries. Since the exchange ratio between X and Y in both

countries is the same; none of them will benefit by entering into

international trade.

Based on this example, according to Adam Smith, for

international trade to be beneficial countries must enjoy absolute

difference in cost. Trade would not take place when the difference

in cost is equal.

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3. Comparative Difference in Cost:-

David Ricardo agreed that absolute difference in cost gives aclear reason for trade to take place. He, however, went further to

argue that even that the country has absolute advantage in the

production of both commodities it is beneficial for that country to

specialise in the production of that commodity in which it has

maximum comparative cost advantage or minimum comparative

disadvantage. Similarly the country's imports will be of goods

having relatively less comparative cost advantage or greater

disadvantage. The other country can be left to specialise in the

production of that commodity in which it has less comparative

advantage. According to Ricardo the essence for international

trade is not the absolute difference in cost but comparative

difference in cost.

Ricardo's Assumptions:-

Ricardo explains his theory with the help of following

assumptions:-

1.There are two countries and two commodities.

2.They produce the same two commodities.

3.There are similar test in both countries.

4. Labour is the only factor of production other than natural

resources.

5.The supply of Labour is unchanged.

6. All units of Labour are homogeneous.

7. Cost of production is expressed in terms of labour i.e. value of

a commodity is measured in terms of labour hours/days

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required to produce it. Commodities are also exchanged on the

basis of labour content of each good.

8.There is no technological change.

9.Trade between two countries takes place on barter system.

10. Labour is perfectly mobile within a country but perfectlyimmobile between countries.

11. There is free trade between the two commodities; there is no

trade barriers or restriction in the movement of commodities.

12. There are no transport costs involved in carrying trade

between the two countries.

13. Full employment exists in both countries.

Ricardo's Example:-

On the basis of above assumptions, Ricardo explained his

comparative cost difference theory, by taking an example of

England and Portugal as two countries & Wine and Cloth as

two commodities.

As pointed out in the assumptions, the cost is measured in terms

of labour hour. The principle of comparative advantage

expressed in labour hours by the following table.

The table shows that Portugal requires less hours of labour forboth wine and cloth. One unit of wine in Portugal is produced with

the help of 80 labour hours as above 120 labour hours required in

England. In the case of cloth too, Portugal requires less labour

hours than England. From this it could be argued that there is no

need for trade as Portugal produces both commodities at a lower

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cost. Ricardo however tried to prove that Portugal stands to gain

by specialising in the commodity in which it has a greater

comparative advantage. Comparative cost advantage of Portugal

can be expressed in terms of cost ratio.

Cost ratios of producing Wine and Cloth

Portugal has advantage of lower cost of production both in wine

and cloth. However the difference in cost, that is the comparative

advantage is greater in the production of wine (1.5 0.66 =

0.84) than in cloth (1.11 0.9 = 0.21).

Even in the terms of absolute number of days of labour Portugal

has a large comparative advantage in wine, that is, 40 labourersless than England as compared to cloth where the difference is

only 10, (40 > 10). Accordingly Portugal specialises in the

production of wine where its comparative advantage is larger.

England specialises in the production of cloth where its

comparative disadvantage is lesser than in wine.

Comparative Cost Benefits Both Participants

Let us explain Ricardian contention that comparative cost benefits

both the participants, though one of them had clear cost

advantage in both commodities. To prove it, let us work out the

internal exchange ratio.

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Wine Cloth Domestic

Exchange

Rate(England

)

Domestic Exchange

Rate (Portugal)

W :C

W : C

England

Portugal

120

80

100

90

0.83 :

1

1.11 :

1

1 : 1.2

1 : 0.89

Let us assume these 2 countries enter into trade at an

international exchange rate (Terms of Trade) 1: 1.

At this rate, England specialising in cloth and exporting one unit

of cloth gets only 0.83 unit of wine domestically, They can get

1.11 unit of wine by selling the same unit of cloth in

Portugal..England thus gains extra 0.11 unit of wine.

Similarly Portugal will find that while by exchanging one unit of

wine, they can get only 0.89 unit of cloth domestically, they can

get 1.20 unit of cloth if the same unit of wine is sold in the U.K.

thus gaining extra 0.2 unit of cloth.

In this example, Portugal specialises in wine where it has greater

comparative advantage leaving cloth for England in which it has

less comparative disadvantage.Thus comparative cost theory

states that each country produces & exports those goods in which

they enjoy cost advantage & imports those goods suffering cost

disadvantage.

Advantages of Ricardo's Theory of Comparative

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Efficient allocation of global resources.

Maximization of global production at the least possible cost.

Product prices become more or less equal among world

markets.

Demand for resources and products among world nations willbe optimized.

Thus, theory implies basis for international trade is the

comparative cost advantage of the nations to produce certain

products at lower cost than other countries.

Disadvantages of Ricardo's Theory of Comparative

cost Advantage:

Unrealistic assumption of labour cost

There is no similar test in both countries.

It is based on assumption of full employment

It neglects the role of technology.

It ignores element of transport costs, which is a series defect of

theory. It fails to consider different verities of a commodity in the

phenomenon of international trade. So it can not applied in

case of a country which import one variety of same commodity

It relates only to two commodities and two countries, scientific

and rational theory should not have such limitation.

Recardian principal of comparative costs is one sided theory of

international trade. It considers supply side of international

trade but takes no account of demand aspect.

Biblography

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P.K. Jain

P.K. Vasudeva

Class Notes

Internet

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