Balance and Kinds of Trade - Assignment Example

Introduction What is trade? Trade is when one entity purchases some good or service with the intention of selling it at a profit. Usually, trade involves selling goods or services which the entity or those associated with an entity do not need. However, this is not always the case. For instance, there have been many cases in which trade of certain good was banned due to it shortage in the place of origin still the good was traded illegally. In the absence of trade countries will have to specialize in the production of goods even if they have a lack of inputs and in extreme cases countries might have to live without certain goods and services since they cannot be produced. Other elements of commerce like transport, indemnification, storing, banking and promoting are related to trade. Trade can be categorized into foreign trade and home trade. Home trade can be further categorized into wholesale trade and retail trade.  Foreign trade, which is also called external trade or international trade, refers to purchasing and selling of products and services among two or more than two countries. Foreign trade offers a considerably broad market for the exchanging of products. It allows a country to focus on the manufacturing of goods at which it can specialize. Foreign trade has the following kinds: (a) Export Trade: It means selling products to foreign countries. For instance, Nigeria exports oil to the United States. (b) Import Trade: It means buying of goods from foreign countries. For in­stance, Unites States buys textile from Pakistan. (c) Entrepot Trade: It implies purchasing goods from one country with the objective of selling them to another country. For instance, United States imports oil from Saudi Arabia and exports it to Mexico. This kind of trade is also called re-exporting trade. Balance of trade The balance of trade also called net exports, is the difference among the monetary value of exports and imports of an economy during a certain time. A positive balance of trade is called trade surplus if it entails importing more than exporting; a negative balance of trade is the opposite and it is called trade deficit. The balance of trade is occasionally distinguished into a products and a services balance. 3 Sub topics for analysis Trade and foreign exchange Suppose the United States and Pakistan are the only two countries on this planet. United States has currency Dollar while Pakistan has currency Rupees. Importing products and services from the US by Pakistan creates a higher demand for Dollars which are needed to pay for the imported things. While exporting products and service by Pakistan to US causes supply of Dollars in Pakistan to increase since Americans will pay for the goods and services using their currency. Therefore if Pakistan has a positive balance of trade then this means its exports are higher than its imports. This implies that the demand for Dollars in Pakistan is lower than supply of Dollars. If it is assumed that there is no organization regulating the foreign exchange market one can safely conclude that when the demand for Dollars falls and the supply of Dollars falls the price of Dollar with respect to the Pakistan currency Rupees will decrease. On the contrary, if the supply of Dollars becomes lower than the demand as a result of negative Balance of Trade the price of Dollar with respect to the Pakistani currency will rise. The price of one currency in terms of another currency is called exchange rate. When exchange rate rises imports become more expensive hence forcing the country to import less while encouraging the other country to export more due to exports becoming cheaper. When a country imports less and exports more its balance of trade becomes less negative or more positive hence causing the exchange rate to fall automatically without the need for intervention by a foreign body. However, in the real world this does not always happen due to multiple reasons. One of the major reasons for this is that when the exchange rate depreciates the country which was exporting things increases trade barriers like Tariff and quotas. For instance, Pakistani currency depreciates against US Dollar then the exports of Pakistan become cheaper for the Americans however American government prevents exporting more than what is needed by increasing tariff on Pakistani exports. When the Pakistani government sees this it can impose trade barriers on imports of US in order to prevent the further depreciation of the Pakistani currency. As a result, trade gets restricted and “trade war” starts. To avoid such trade wars the World Trade Organization (WTO) came into existence. Today, the important questions are related to finding how effectively the WTO has prevented trade wars and has its existence helped in stabilizing exchange rates. Theory of comparative advantage According to this theory a country which has a lower opportunity cost for producing any good should produce more of that good rather than producing goods which have a higher opportunity cost compared to that of other countries. This should be accompanied with exporting the lower-opportunity good produced to a country which gives another good that has higher opportunity cost. As a result, scarce economic resources are utilized in the most efficient way and both countries involved in trade have more quantities of both the goods being produced and exported (Ruffin). Take the example of Brazil and the US. Brazil manufactures coffee which is widely appreciated throughout the world while the US is specialized at growing wheat. Suppose the following quantities of both products are produced before trade. Coffee Wheat USA 20 or 40 Brazil 10 or 5 Total output Suppose 1 unit of labor is needed for producing 20 units of coffee or 40 units of wheat in USA and 1 unit of labor is needed for producing 10 units of coffee or 5 units of wheat. Opportunity cost can be defined as the units of wheat forgone by selecting growing coffee instead of wheat. Opportunity cost of growing coffee for US= 40/20=2 Opportunity cost of growing coffee for Brazil= 5/10= 0.5 Since Brazil has lower opportunity cost for coffee it will grow coffee only while US will grow wheat only. US will then export the excess wheat in exchange for coffee. Before trade Coffee Wheat USA 10 20 Brazil 5 2.5 Total output 15 22.5 After specialization Coffee Wheat USA 0 40 Brazil 10 0 Total output 10 40 This theory fails to take into consideration two factors. Firstly, there is freight charges associated with trading which can increase the cost of importing a good from another country which has a lower opportunity cost for production to such an extent that in the long run it is profitable to manufacture that product in one’s own country. Secondly, there are goods which one cannot afford to rely on other countries for. Examples of such goods include military weapons like missiles and radars. Since these are used for the defense of a country from foreign forces any country for which sovereignty matters cannot afford to rely on another country for military weapons. Economists should further find how true is the theory of comparative advantage in the modern world for countries which are neighbors and for goods which are not of a secretive nature. Trade liberalization and income inequality in developing countries Before the discussion is taken any further it must be explained what is meant by trade liberalization. When export and import duties are minimized and quotas are removed a country can be stated to have liberalized trade. One often hears about trade liberalization to promote industrialization. The link among international trade liberalization in the third-world countries and income inequality remains as a debatable issue despite. The 2 x 2 x 2 Heckscher-Ohlin model states that trade liberalization will increase relative price of factor of production available in abundance (E.Leamer 39). This factor of production is usually unskilled workforce in the case of developing countries. As a result people in third world countries will earn more in general. However, in the real world trade liberalization has been correlated with an increase in income inequality. Whenever theory suggests things contradictory to reality empirical proof is needed. Various recent and old studies have found that Heckscher-Ohlin model. These studies discovered that income inequality increased during trade reforms in developing countries. Examples of such countries are Colombia, China, India, Mexico, Chile, Brazil and Argentina. Moreover, a further problem for the HO model has been evidence of within-industry increase in demand for skilled laborers (Lawrence and Slaughter 221). More research needs to be conducted to know if trade liberalization is what actually causes income inequality in third world countries. Bibliography E.Leamer, Edward. "Heckscher-Ohlin trade theory." 1 February 1995. Princeton University. 4 April 2012 pages 1-50 . Lawrence, R. Z. and M. J. Slaughter. "International trade and American wages in the 1980s : Giant sucking sound or small hiccup?" Brookings Papers on Economic Activity, 1993. Ruffin, Roy. "David Ricardos Discovery of Comparative Advantage." History of Political Economy 34.4 (2002): 727-748. Read More