Chapter 12: International Trade

12.1 Definition of International Trade

International Trade is trade between countries. It refers to trade carried out outside boundaries of a country hence it involves two or more may involve bilateral or multilateral trade and it is therefore categorized into exports and involves people in different countries who have different mostly involves countries with different monetary units

12.2 Importance/Benefits of International Trade

  • Countries can import those commodities they cannot produce e.g. cars, aero planes mobile phones televisions, clothes etc. are manufactured by few countries.
  • Enables a country to earn foreign income by exporting in surplus production and the income is used to import the goods that it can produce e.g. medicines, machinery and food
  • It expands market for the country’s products, hence consumers usually have a wide choice of goods (variety of products).
  • Enables countries to would make no sense for a country to specialize if there is no market, thus the resources are fully utilized and they also produce high quality goods
  • It improves social and cultural ties with different countries by doing business with them
  • It strengthens international peace-political links and world peace is promoted.
  • It stimulates economic growth and economic development-foreign income comes fostering trade and the income got can be used to develop infrastructure as well as markets due to the foreign investments that are made abroad to countries experiencing enabling environment.
  • Enables a country to import the necessities of life e.g. food, basic needs etc.
  • Low prices: since international trade promotes specialization and hence mass production unit cost of output is low and consumers benefit from consequent low economies of scale benefits.
  • Technology: international trade is an important channel for flow of technology from one nation to another. With international trade, countries producing consumer goods can exchange them for capital goods and therefore enhance their production capabilities. Ideas are also exchanged.
  • Competition-international trade increases competition thereby promoting efficiency in production. Inefficient firms which can only sell at high prices would be driven by efficient prices which can sell at low prices.
  • Sometimes it enables a country to obtain goods more cheaply than it can produce them i.e. where a country has comparative advantage in producing the commodities.
  • Enables countries specialize in production of goods and services for which they have comparative advantage in terms of resource endowment thus efficient utilization of resources.
  • Enables government to earn revenue through taxation.
  • Enables a country to dispose off its surplus.
  • Facilitates mobility of factors of production e.g. labour and capital from one county to another.
  • Promotes employment creation.

Arguments against International Trade

  • Military self-sufficiency: this argument is used to defend tariffs imposed to protect domestic industries producing goods and services essential for defence and war.
  • Increased domestic employment: to raise the Gross National Product, we would have to reduce imports. Increased G.N.P implies increased domestic employment, thus imports are highly discouraged. If demand for domestic goods are increased, production of domestic goods will go up and so will be employment.
  • Diversification of stability (self-sufficiency): countries don’t rely on imports for development. This promotes reduction reliance on few imported goods or services.
  • Infant industries argument: protective tariffs (government tax on imported goods)are needed to allow new domestic industries to establish themselves as cheap imports usually drives off young industries away from the market.
  • Cheap foreign labour argument: developed countries need to keep away products which are cheap mainly because they are made using cheap labour (it is a threat to us undeveloped i.e. low salary, cheap labour). If allowed, this cheap product will force domestic product out of market and producers will be forced to lower domestic wages thereby lowering standards of living in those developed countries.
  • Economic integration-countries intending to create common market/economic union may be forced to erect tariffs to keep products of non-member countries out of market.
  • Can lead to importation of harmful products.
  • Over depending on imported commodities e.g. the essential ones could lead to a country becoming a slave of other and could compromise sovereignty i.e. developing countries always owe developed countries some money leading to unfavourable balance of trade.
  • May lead to exhaustion of resources usually got in raw form.
  • A country that relies on imported products may face problems of supply during the times of emergency.
  • May lead to a country experiencing import inflation. This erodes importing power of people in importing country as they can afford to buy fewer commodities
  • High levels of specialization may lead to problems which occur when demand for commodity being produced falls as it may lead to massive unemployment at sectors of economy affected by fall in demand and lay off workers to cut down production costs.
  • It enhances interactions and through this people of a given country end up acquiring bad cultural values from their trading partners.

12.3 Theories of Comparative Advantage and Absolute Advantage

The Theory of Absolute Advantage (Specialization)

The earliest advocate of international trade was the so called father of economics Adam Smith. According to smith, labour costs determines efficiency in production and nations should concentrate their efforts in producing goods they could make more cheaply. Nowadays we know labour cost labour cost are not necessarily the dominant cost of production. However, this does not contradict Adams theory. Indeed, we still believe in advantages of specialization both at macro and micro suggesting that nations specialise in producing goods that they can produce more cheaply than anybody else. Smith was obviously advocating for international trade either at personal/national level. Specialization generates surplus output which has to be traded for what is scarce. If nations were to specialize in line with absolute advantage, then total output would increase thereby raising welfare of both consumers and producers. Increased output would generate more revenue to producers while consumers would be assured of adequate supply at reasonable prices. Assume the following output for a given resource of 100 workers or 100 man hours.

  Wheat Cars
Kenya 400 100
Japan 500 300
World Production 900 400

Assume specialization in line with degree of absolute advantage.

  Wheat Cars
Kenya 0 0
Japan 1000 600
World Production 1000 600

World’s production of wheat increases to 1000 and that of cars increases to 600. According to smith, it is unlikely that cost of production and would be uniform across countries. Some would produce more efficiently than others due to the reasons below:

  • Natural advantage i.e. Gods given resources e.g. oil.
  • Acquired advantages e.g. special skills acquired through training or high level of technology and investment in capital goods

Theory of Comparative Advantage by David Ricardo

The theory of absolute advantage failed to discuss fully the economic implications if a country had absolute advantage .if a country had  three products or six products, should that country be the only country in the world producing these goods?. Where would the other countries get commodities or money to exchange for goods produced by the advantaged country? To address this problem, David Ricardo developed the theory of comparative advantage. According to the theory of comparative advantage, the country which has absolute advantage in production of all goods should specialize in production of goods where its absolute advantage is greatest. A country with no absolute advantage should specialize in producing the goods where its absolute advantage is least (assume the following output for a given resource of 100 man power/workers.

Analysis of opportunity costs.

First scenario

  Wheat Cars
Kenya 400 100
Britain 500 300
World Production 900 400

Total Production 1300

Britain has absolute advantage in production of both wheat and cars. Nevertheless, Britain has te largest comparative advantage in production of cars. Suppose they specialize in accordance with Ricardo’s theory i.e. Kenya – produce wheat and Britain produce cars i.e. ratio of cars is 3 times i.e. 1:3 compared to wheat ratio 4:5 after specialization.

Second scenario.

  Wheat Cars
Kenya 800 0
Britain 0 600
World Production 800 600

If the opportunity cost of producing 400 wheat is 100 cars, it means if Kenya produced 0 cars,it could double production of wheat to 800 units. Likewise, Britain could double production of cars if she forfeited wheat production. We now have increased world production of cars by 200 units while production of wheat has gone down by 100 the worlds now better of? It all depends on world exchange rate between cars and wheat. Suppose two units of wheat, one would get 1 car. If Kenya wanted 200 cars then it would have to give 400 units of wheat.

Third Scenario

  Wheat Cars
Kenya 400 200
Britain 400 400
World Production 800 600

Total production 1400. Comparing first scenario with the last one, Kenya seems to have benefited more in trade than Britain. Using the first scenario, the opportunity costs can be realized. Britain should specialize in cars production while Kenya should specialize in wheat production because the opportunity costs are lower. Comparing the first scenario with the last one Kenya seems to have benefited more in trade than Britain but Britain is not badly off. Before trade, opportunity cost of 1 car was 5/3 wheat. Now through the market she can exchange 1 car for 2 units of wheat!

Before trade Kenya would have given 4 units of wheat to get one car with trade, she only needs to give 2 units of wheat! Due to the gains alluded to it, it is obvious that countries need not to be self-sufficient. There are other gains from international trade but what a country brings home from international trade depends on value of exports relative to value of imports or the international prices. Needless to say, the prices of imports and exports will be determined by forces of demand and supply: a situation which is complicated further by factors determining supply or demand.

Weaknesses/Assumptions of Comparative Advantage

  • It assumes that labour is the only factor of production.
  • Assumes perfect mobility of factors of production i.e. factors of production can be switched from one production to another. This is not easy.
  • Assumes no transport costs. If they are considered, what appeared to be a comparative advantage can translate to a loss.
  • Assumes that products are homogenous-in a modern economy, homogenous (similar in every respect) products are rare as firms strive to differentiate products in order to outbid each other in the market.
  • Free market economy: both Adam Smith and Ricardo advocated for free trade. Clearly their theories would have no substance in absence of free trade and free market economy.
  • Assumes constant cost: even when a country switches from one product to another and increases production of that other good in which it has comparative advantage, costs remain constant.

12.4 Terms of Trade

Terms of trade refer to the rate at which a country’s exports are exchanged for her imports. It is computed as export price index/import price index.

Reasons for differences in the Terms of Trade between Countries

  • Nature of commodity being exported: normally prices of primary products tend to be lower compared to those of manufactured goods. A country whose main export is raw materials such as unprocessed agricultural products is likely to experience unfavourable terms of trade. A country that exports finished products e.g. manufactured goods is likely to experience favorable terms of trade
  • Nature of commodity being imported-manufactured goods command higher prices compared to others in world market. A country that imports such expensive goods may experience adverse terms of trade while one that imports cheap raw materials may experience favourable terms of trade
  • Demand for a country’s exports-an increase in demand for a country’s export in the world market, such a country is likely to experience favourable terms of trade. If demand for a country’s export decline, she may experience unfavourable terms of trade.
  • Existing world economic order: due to their strong bargaining power, industrialised countries tend to dominate decision making in international market. International prices therefore tend to favour products from these a result, they may have favourable terms of trade while the less developed countries may have deteriorating terms of trade.
  • Total quantity supplied-this may depress price into the world market. A country relying on exportation of such a product may therefore experience unfavourable terms of trade. A country that relies on exportation of a commodity that is in short supply in world market may experience favourable terms of trade.

12.5 Balance of Trade

Balance of trade refers to the difference between the values of visible imports and visible exports of a country within a defined period of time; usually one financial year. Visible trade is trade in tangible goods e.g. Tea, oil, chemicals, fertilizers, machinery, vehicles, coffee, tools, etc. On the other hand invisible trade refers to trade in services e.g. Tourism services offered by expatriate’s, freight, insurance, banking charges, foreign loans and aids, expenses on foreign education, training and political delegates, expenses by foreign embassies and expenditure of a country in her foreign missions and repatriated profits and dividends.

If during a given period the value of imports is greater than that of exports, the balance of trade is said to be unfavorableable (deficit) and the vice versa favourable (surplus).  If the value is equal then it is at equilibrium or zero or (neutral).

Factor that may cause an adverse balance of trade.

  • Low exports
  • Increase in imports
  • Unfavorable terms of trade.
  • Shortage of capital
  • Climatic situation.
  • Devaluation policy by other countries.
  • The flow of capital goods.
  • Structural disequilibrium resulting from fundamental changes in growth of a country.

12.6 Balance of Payment

This refers to the differences between due receipts from other countries and due payments to other countries in the year i.e. it is the difference between inflows and outflows of foreign currency in a given economy for a given year. Bop will further be defined as the economic transactions of one country with the rest of the is the difference between visible and invisible exports versus visible and invisible imports. The bop will be surplus if total receipts are greater than total payments and therefore it is said to be favourable. On the other hand bop will be in deficit if total payments are greater than the total receipts. This deficit must be financed from overseas or by borrowing from overseas or the such a situation bop is said to be unfavourable and it will be at equilibrium position if total receipts and total payments are equal.

Balance of Payment Accounts

There are two types of balance of payment accounts:

  • Capital Account
  • Current Account

Capital Account

The capital account is maintained by the central bank. It involves long term payments either inward or outward. This includes foreign loans and shows the balance between receipts and payments regarding foreign loans, donations reserves, investments and aid. It is also known as financial account.

Current Account

It shows the balance between exports and imports of visible and invisible items during a particular year. It should be noted that on debit side we record payments(cash, foreign exchange outflows, shipping charges paid, bank charges paid, tourism overseas by Kenyans) and on the credit side we record receipts (cash, foreign exchange inflows, tourism income, remittances from diaspora, banking income received).

Unfavorable balance of payment is a macro economic problem because it:

  • Causes unemployment.
  • Leads to a fall in in exchange rate.
  • Leads to collapse of infant industries.
  • Causes capital flight
  • Results in low economic growth and development.

Causes of Disequilibrium in Balance of Payments

Surplus or deficit can denote disequilibrium of bop where the international receipt and payments are not equal. However, under normal circumstances, disequilibrium refers to deficit in bop where payments are greater than receipts. In such a situation, balance of payments is said to be unfavourable. Most of the less developed countries face unfavourable bop while developed countries face favourable BOP i.e. surplus in their BOP. The following are the main causes of the disequilibrium:

  • Reliance on few export commodities: the exports of most developing countries consist of mainly one or two primary products like copper, coffee, tea, cocoa, groundnuts, cotton etc. The demand for such products is not very high and their demand in international market is more elastic. This leads to low earnings of foreign exchange leading to deficits in BOP.
  • Increase in imports: the imports of most developing countries are too high and mostly constitute capital goods i.e. machinery. This is partly because less developed countries are technologically backward and can’t produce these goods locally. The prices of such import goods are quite high and this leads to unfavourable balance of payments.
  • Unfavourable terms of trade: they are unfavourable. Countries experiencing this get very low prices for their exports but pay exorbitant prices for the imports of manufactured and capital goods.
  • Shortage of capital: Most less developed countries are producers of primary commodities and cant process some of mineral and agricultural resources they produce into finished goods due to lack of capital and necessary technology.
  • Too much reliance on foreign borrowing: most developing countries face macro-economic problems such as unfavourable BOP because of relying too much on foreign borrowing either from World Bank and IMF or other friendly countries. Some of the loans they obtain are paid back with huge interest rates and this leads to unfavourable bop. This countries become so much indebted.
  • Natural calamities: this usually interferes with the production of some commodities. Agricultural production is very vulnerable to changes in climatic conditions and its production is affected adversely if these weather conditions are not favourable. This leads to unfavorable bop especially to countries which rely on one or two agricultural commodities as their main source of foreign exchange earning
  • Flow of capital: when outflow of capital is high/when inflow of capital is low, this will lead to unfavorable bop.
  • Taste and preference towards foreign goods-in some countries, citizens prefer consuming foreign goods as opposed to locally produced goods. This will increase imports resulting into unfavorable bop.
  • Foreign trade orientation-this refers to a situation whereby developed countries buy raw materials from developing countries at a cheaper price, process them into final goods (as they have the requisite technology) and then sell them to developing countries at a high price. This causes deficit in bop.
  • Devaluation policy by a trading partner-sometimes devaluation policy adopted by countries may result in bop deficit in other coffee is the main export of both Kenya and Uganda. If Uganda decides to devalue her currency, then her coffee will become cheaper in international market. This means Uganda will increase her coffee export and this may lower demand for Kenya’s coffee in the global a result, Kenya’s export of coffee will decline leading to unfavourable bop.
  • Changes in trade cycles i.e. boom, recession and depression.
  • Over valuation of a domestic currency: valuation refers to putting new values to local over valued domestic currency is likely to discourage exportation while encouraging imports because country’s exports become more expensive compared to imports. This results into a country earning less from exports while paying more for imports thereby causing disequilibrium in bop.

Measures to Correct Unfavourable Balance of Payments

  • Export promotion: this can be adopted by encouraging producers to produce goods for exports. If volume of export of goods and services is increased balance of payment deficits can be removed.
  • Import restriction
  • Devaluation: here, exports become cheaper to foreigners and imports expensive to residents. This helps to correct unfavourable balance of trade as volume of exports may increase.
  • Diversification of exports: it will increase developing countries volume of export correcting unfavourable bop
  • Increase in production: of goods and services. This will lead to increased volume of exports and it might also lower goods that are being imported from other countries and therefore correcting unfavourable bop.
  • External soft loans-the government can seek soft loans from World Bank, IMF and other friendly countries to correct her unfavourable bop.
  • Deflation-this is a situation whereby government can deliberately decide to reduce the price of domestic goods. This may be adopted with a view of encouraging consumption of domestic goods and discouraging consumption of foreign or imported goods and this help to correct unfavorable bop if domestic goods possess higher elasticity of demand.
  • Receiving gifts and donations from other rich friendly countries.
  • Selling foreign assets and investing money in domestic market.
  • Persuading/pleading with foreign countries to trade with us including marketing ourselves
  • Drawing upon our gold many countries central bank keep the gold, which belongs to a country. This gold can act as a security that will enable country to borrow loan from IMF and World Bank.

12.7 Exchange Rate Systems

An exchange rate regime or an exchange rate system refers to the price of a countrys currency expressed in terms of another country’s currency. Generally, the exchange rate is expressed as amount of the local currency per unit of the foreign currency. Exchange rate is usually of great importance because it determines the price of exports, determines price of imports and has a direct effect on exports and imports of a country.

Types of Exchange Rate Systems

Generally, there are two main types of exchange systems/regimes i.e.

  • Fixed Exchange Rate

This exchange rate regime is also known as pegged exchange rate. In this type of exchange rate system, the monetary authorities e.g. central bank fix their own currency value against some common standards e.g. 1 dollar = 112 KSH. Countries like China fix their exchange rates.

Advantages of Fixed Exchange Rates

  • Encourages long term capital flows because there is no uncertainty or risk.
  • There is no fear of fluctuations i.e. there is no rapid appreciation or depreciation.
  • It has no adverse effects on speculation
  • It is the best for small countries because small countries suffer when depreciation occurs.
  • It is less inflationary because of stability of currency.
  • There is certainty of foreign payment (exporters and importers knows what they will get)

Disadvantages of Fixed Exchange Rates

  • A country will be required to maintain a huge foreign exchange reserve in order to defend the chosen rate of exchange.
  • Tends to depend on international institutions e.g. IMF to help them solve problems of adverse depreciation.
  • It is usually complex and needs highly skilled administration.
  • There is a sustained balance of payment disequilibrium.
  • Defending a currency may involve raising interest rates, which can be both damaging and costly to domestic economy.
  • There is always reluctance to change the exchange rate and this could lead to a country persisting with an over-valued exchange rate in order to avoid devaluation.
  • It becomes appropriate at a time of high and differential rates of inflation between countries.
  • If a revaluation/devaluation is expected speculation may build up as great gains will be made or losses avoided.

2) Floating Exchange Rate System

Also known as free or flexible exchange rate, the floating exchange rate system refers to an exchange rate regime where the price/exchange rate is determined by forces of demand and supply, i.e. when we have more supply of dollars in Kenya, the usage of Kenya shillings will be minimal because the dollar will be easily affordable by many due to the law of demand and supply.

Advantages of Floating Exchange Rate Regime

  • It is simple to operate because it is determined through the market.
  • Enhances smoother adjustment of balance of payment as it leads to automatic stabilization.
  • It is the best when it comes to solving differences between supply and demand
  • Monetary policy is very effective in solving these problems.
  • Promotes international trade because forces of demand and supply have better market adjustments.
  • It leads to freeing of internal policy since where a country has a floating exchange rate, a BOP deficit can be rectified by a change in external price of currency. This leaves the government to pursue into the internal policy objectives such as growth and full employment without external constraints.
  • Provides an indication of a relative scarcity of a currency, which leads to better allocation and eliminates possibility of over valuation of the currencies that are common in many developing countries under a fixed exchange rate system.
  • Provides that there is a need to maintain a low reserve of foreign currency or a higher one to defend the local currency against either too much depreciation or too much appreciation.
  • Prevents rapid inflation since if a country is experiencing inflation its local currency will automatically depreciate against the hard foreign currencies

Disadvantages of Floating Exchange Rate System

  • Uncertainty: this arises since exchange rate can fluctuate in value from day to day and such can adversely affect trade, capital flows and forward planning.
  • Day to day change in exchange rate: this may encourage speculative movement of hot money from one country to another and thus worsening changes with exchange rate.
  • Lack of discipline: lack of discipline in economy since problems such as inflation may be ignored until they have reached a crisis level.
  • It impedes the movement of long term capital i.e. compromise on long term capital.
  • It is more inflationary i.e. if exchange rate increases, import prices increases also thus rapidly increasing inflation
  • Official intervention cannot always be ruled out i.e. in some cases the financial bodies are forced to intervene.

Factors Determining Exchange Rates

This are the factors affecting demand and supply of currency and includes;

  • Balance of payment: BOP deficit exerts downward pressure (depreciation) on a country’s currency whereas bop surpluses exert an upward pressure (appreciation) on a country’s local currency.
  • Relative level of interest rate: if domestic real interest rates increases relative to those of other countries, nationals of other countries will find the domestic economy an attractive place to invest. This will increase demand for domestic financial assets and would mean an increase in supply of foreign currencies. Thus an increase in interest rates tend to exert an upward pressure (appreciation on a country’s currency) while a decline in interest rate would lead to depreciation of local currency.
  • The level of inflation: if the general level of prices increases rapidly in one country this can cause depreciation of its domestic currency. During demand-pull inflation, there may be too much supply of local currency leading to its depreciation. Similarly if an economy is suffering from cost-push inflation, cost of production of goods meant for export will be high and this will affect the volume of export leading to deficit in bop and hence depreciation of domestic currency. Also if an economy is suffering from inflation, many countries avoid trading with it in order to avoid imported inflation.
  • Speculation: a belief by a speculator that a particular currency will appreciate will lead the holders of that currency to attempt to convert other currency in that currency because they will gain after depreciation. If they speculate that a certain currency will depreciate, they will set it at a current high price to avoid future losses.
  • Government policy: if a particular government is involved in persistent devaluation, there may be loss of confidence in its expectation of increased taxation of foreign income/confiscation of assets by government may also lead to loss of confidence with consequences in depreciation of local currency.
  • Political atmosphere: political upheavals may lead to loss of confidence on a country’s domestic currency.

12.8 Economic Integration/Regional Grouping

Economic integration refers to where two or more countries in same region join up and co-operate with each other for their mutual economic also refers to economic cooperation within a region. It means abolition of discrimination within an also means any type of arrangement in which countries agree to coordinate their trade, fiscal and or monetary policies.

In a region where complete economic integration is in practice implies that there is:

  • Free trade in all goods and services.
  • Free flow of capital.
  • Freedom of migration.
  • Freedom of establishment of business.
  • Free flow of information and ideas
  • No difference in taxation.
  • No national difference in rules governing competitors and monopoly.
  • No differences in environmental regulations
  • A single currency in use.

This type of integration is beneficial to member countries as they are able to develop faster than if they were to carry their economic activities individually.

Forms of Economic Integration

They are categorized depending on their degree of integration.

Preferential Trade Agreement (Preferred Treatment)

This is the weakest form of economic integration. Here, countries would offer tariff reductions and not eliminations, to a set of partner’s countries in some product categories.

Free Trade

This is a group of two or more custom authorities in which duties and other restrictive territories regulations of commerce are eliminated. Here, tariffs between the member countries are abolished but each country retains its own tariffs against non-members i.e. member countries apply uniform tariff rates to each other but separate individual tariffs to the remaining countries.

Customs Union

It allows no tariffs /other trade barriers between member countries as in free trade areas but the difference  is that it harmonizes trade policies of member countries with those of the rest of world e.g. member countries setting common tariffs according to the rest of world.

Common Market

It goes beyond the customs union and in addition to eliminating trade barriers among member countries and sharing trade policies, free movement of labour and capital among member nations is allowed e.g. EAC where one can work and establish business in any part in the region.

Economic Union

It will typically maintain free trade in goods and services, set common external tariffs among members, allow the free mobility of capital and labour and will also relegate some fiscal spending responsibilities to a supra-national agency. An example is of the European Union common agriculture policy (CAP)

Monetary Union

It establishes a common currency among a group of countries. This involves the formation of a central monetary authority which will determine monetary policy for the entire group as well as using common public services e.g. Railway and communication network e.g. European Union (E.U) which has adopted Euro as their common currency.

Multilateralism versus regionalism

The main objective here is on trade liberalization. The logic here is that the larger the regional trade area, relative to the size of the world market, the larger will be that regions market power in trade. The more market power, the higher would be the regions optimal tariffs and export taxes.

Duty free zones/free economic zones

This are set up to attract foreign investment by allowing raw materials and intermediate products to be imported duty free.

Importance/Case for Economic Integration to a Country

  • Enables countries to specialize in production of those commodities where they have comparative advantage thus trading surplus commodities.
  • Enables a country to exploit economies of scale as it provides wider market for goods and services and therefore promotes employment in the countries involved.
  • Encourages peace, free flow of information and better relations both economically and politically as the countries involved depends on each other.
  • Encourages foreign investment because the possibility of making large profits in a more enabling economic environment.
  • Trade stability is enhanced in cases where there is use of a common currency e.g. the Euro in the European Monetary Union.
  • Regional unemployment differences are reduced in where regional integration involves permitting free movement of factors between factors.
  • It fosters a great degree of competition thus promoting economic efficiency and consumer sovereignty through a wider variety of goods and services.
  • It leads to redistribution of income in favour of low income areas through low cost production in such areas and exporting to areas where prices are higher.
  • Availability of market/extension of locally produced goods-a wider market for a country’s products is created.
  • Creation of industries-this is so as to cater for the increased demand.
  • Extension of research-to cater for large markets, research institutions are established to enhance efficiency in production as well as production of quality products.
  • There is higher bargaining power in the world market and this helps the countries to get better prices for their goods
  • Flow of resources-member states which might be disadvantaged in terms of technical and human resource capabilities benefit from those which are more advanced. E.g. Kenya being more advanced than her neighbours will benefit from the big pool of human and technical resources in Kenya as there will be a free flow of resources among the countries.

Case Against/Problems Faced By Economic Integration

  • Political instability within the countries and political aggression between the various countries failing the integration efforts.
  • Production of similar products thus limiting scope of trade.
  • Unequal distribution of the benefits of regional integration where industrialized countries tend to grow more as they already enjoy certain economies of scale.
  • It leads to trade diversions where trade leads to of sources of commodities from low to high cost produce.
  • Since it involves reduction of tariff barriers between member countries, it leads to loss of revenue which implies that the government has less money to spend on developing projects.
  • In cases where there is sharing of common services such as railway and ports it may be difficult to allocate the benefits and costs of such sharing.
  • Inefficient industries may be killed off by imports from other member states, which is likely to result in increased unemployment in countries where industries have to close down.

Advantages of Free Trade

  • Promotes production.
  • Expands trade among member countries.
  • Establish uniform custom policy in member countries
  • Help members countries to raise their standard of living – Through specialization in particular countries, which it produces best and most efficiently, costs of production are reduced. This means that consumers pay less for quality goods and services.
  • Help to achieve full employment level because there is efficient allocation of resources i.e. residents of a country are free to migrate to any area where their services are needed.
  • Helps to develop for a greater variety of goods and services.
  • Creates economies of scale, more supply in member’s country
  • Market help to reduce prices.
  • Enhances of specialization: it allows international division of labour which leads to specialization. Countries engage in production of commodities which they can produce most economically resulting in lower production costs leading to favourable prices of goods and services.
  • Leads to quality and cheaper products
  • Leads to international peace an; d understanding.
  • Promotion of industrial growth: wide markets encourages new firms while the existing ones are forced to increase their production capacity to cater for the increased demand.
  • Helps to dispose-off the surplus

Negative effects of Free Trade

  • It reduces efficiency in production of different commodities.
  • Country involved remains less developed since more industries are not established.
  • The major disadvantage is that it gives way to inferior goods to enter the market and may pave way to monopolies.
  • Unfair competition-the less developed countries suffer due to stiff competition from the economically advanced countries which have better production techniques and adequate finances.
  • Slow economic development-a country may stagnate in other areas due to over-specialisation. There may also be no need to establish new industries as all needs are being met through trade.
  • Injurious and harmful products to social well-being of the citizens may get into the local market.
  • Dumping: sale of goods in an export market at a price below price charged in local economy.the motive may be to dispose off any surplus stock in the exporting country or an attempt to penetrate the local market unfairly.
  • Bad cultures are likely to find their way into the market.
  • Infant industries are usually killed.
  • Leads to exhaustion of natural resources.

Reasons why a country may find it necessary to control its international trade:

  • To protect infant and key industries against foreign competitions.
  • To avoid entry of harmful commodities in the country.
  • To avoid dependency in other countries.
  • To eliminate dumping of foreign goods, which may jeopardize the local market.
  • To create the employment opportunities through economic growth.
  • To correct the balance of payment deficit.
  • To determine the necessary and unnecessary goods and services.
  • To fight against possible monopoly by super firms.
  • To raise revenues for government projects in the country.

12.9 Trade Restrictions/Protectionism

The theory of comparative advantage advocates the gains from free trade and specialisation. In practice however, many governments impose barriers to trade. This now refers to the implementation of policies which restrict free flow of goods and services internationally. It also refers to imposition of measures aimed at restricting trade among countries.

Methods/Forms of Protectionism

  • By imposing tariffs: these are taxes charged on imports to make them expensive hence discouraging consumption in the local market.
    • The tariffs can be in form of custom duties (import duties). This is a source of revenue to the government although it is used to discourage imports.
    • A specific tariff is levied on commodities according to quantities purchased i.e. a fixed tax per unit of goods, compound tariff is fixed tax combining both the advolem and specific tariff, while Advalorem tariff is charged on goods according to their value.
  • Non-tariff barriers: these are more problematic. They are measures designed to restrict imports or artificially boost exports. These barriers may take the following forms;
    • Quotas: this are quantitative limits placed on importation of specified commodities. They may be set on value/volume of imports. Under quota system, any increase in domestic demand is expected to be satisfied by increasing production locally a good example is of embargo where we have zero quota.
    • Foreign exchange control: the government can make acquisition of foreign exchange more difficult to restrict
    • Voluntary export restrains (VERS): this are voluntary imposed limits by a government of an exporting country on the exports of a certain commodity aimed at forestalling official protective action on part of the importing japan has entered into a number of VERS with the USA and EU countries relating to the export of its cars
    • Bureaucratic export procedures: this involves imposition of complex and time consuming bureaucratic procedures for goods entering a country which may increase the difficulty and cost of exporting.
    • Product standard specifications: imports can be restricted on basis that they have not met quality standards. Health and safety regulations can be used to limit imports on standard goods.
    • Subsidies: this is an indirect measure providing protection from overseas producers by making domestic products more attractive relative to imports.
    • Moral persuasion: the government appeals to importers and exporters to willfully restrict importation/exportation of a certain commodity.
    • Embargoes: this is an official order that forbids buying/selling of a is usually established for political rather than for economic reasons.

Arguments/Reasons for Protection

  • Revenue argument: it is a source of revenue for state mainly through tariffs.
  • Infant industry argument: they are protected in the short run
  • Declining industry argument: without dealing with this, industries might collapse leading to sudden mass unemployment.
  • The dumping argument/discourage dumping: this is the practice of selling abroad at a price lower than charged for same product in domestic market. It has a short term benefits for countries receiving the cheaper commodities, the longer term consequences may be a reduction in domestic output and employment. This is because it kills small industries in the less developed countries where the cheap goods have been dumped by the developed nations because the consumers will automatically buy this cheap products. Most developing countries therefore impose high tariffs meant to discourage dumping.
  • Balance of payment argument-tariffs and quotas may therefore be used in an attempt to restrict imports and improve balance of payment position
  • The strategic industry argument-this is a non –economic argument stating that industries produce goods and services which are of strategic importance in times of crises or armed conflict. This industries need to be protected since they are very strategic to a country e.g. food production is very important to a country. In case of a war, a country has to be in a position to ensure there is enough food in country and this explains why some countries protect their agricultural sectors.
  • To avoid the dangers of specialization: specialisation may lead to diseconomies of scale e.g. agricultural specialization may contribute to monoculture, which can in turn lead to soil erosion, vulnerability to pests and falling agricultural yields in future. Over specialization can cause a country to be completely vulnerable to certain changes in demand or to costs and availability of imported raw materials or energy or new inventions, which eliminate its comparative advantage.
  • Economic sanctions: a measure taken in respect of some economic activity which has the effect of damaging another country’s economy i.e. weaken a political economy.
  • Creation and protection of employment: by imposing trade restrictions, imports are discouraged encouraging establishment of local industries to provide commodities that would otherwise have been imported. Existing industries continue to thrive thereby ensuring that employed remain in employment
  • To preserve morals and culture: people of different nations interact to carry out trade and people may end up borrowing cultural values of other country. The government ban foreign goods which are likely to interfere with culture, moral and health standards of its people e.g. films and literature may erode cultural practices of society
  • To expand domestic market-buying imported goods expand s market for foreign goods. Government may reverse this by introducing protective measures with the aim of encouraging citizens to consume locally produced goods and this will expand market for domestic products due to an increase in demand. Demand may further stimulate investment.
  • To facilitate economic recovery: where an economy is facing a recession/depression, the government may adopt protective measures which will stimulate investment. This is aimed at achieving economic recovery.

Disadvantages of Trade Restrictions

  • Production of low quality products: the protected local industries may end up producing low quality commodities due to lack of competition. The local consumer is therefore denied the chance of enjoying high quality goods which might have otherwise come from the other country.
  • Overprotection of infant industries-they should be protected to a given period of time and then exposed to competition. Overprotection reduces their competitiveness and the international market is also limited.
  • Raising the prices of goods-the protected local industries may not enjoy economies of large scale due to their small sizes and they therefore incur high production costs for their products leading to increase in prices of commodities.
  • Reduction in volume of international trade-free trade facilitates specialization and thus one country will engage in production of the commodities it can produce economically. Protectionism reduces volume of international trade since countries tend to produce everything they need
  • Possible emergence of monopolies-protection gives domestic firms monopoly power. Monopolies are notorious for exploiting consumers by charging high prices.
  • Possible retaliation by other countries: when a country imposes restrictions on imports from another country, the other country can react by similarly imposing restrictions on imports from former country. This would be detrimental to both countries.
  • Less consumer choice-trade restrictions implies that there would be few goods and services that consumers can chose from. This in turn leads to low standards of living for such consumers.

12.10 International Financial Institutions

The International Monetary Funds (I.M.F.)

It was established in 1944 aimed at restructuring international trade transactions. The major objectives were:

  • To case debt payment among member countries.
  • To settle trade imbalances and advances.
  • To provide short term loans to member countries.
  • M.F. uses special drawing rights (SDR) to assist member countries to settle their deficits, and short terms loans. It’s done out of the members pooled funds. Each member country is required to subscribe a define amount and is expected to maintain the sum in order to qualify for short term loans in need be.
  • Maintenance of stable exchange rates.
  • Promotion of consultation and cooperation among member countries.
  • Promote economic stability and prevent crisis
  • To help resolve crises when they occur.
  • Promote growth and alleviate poverty.
  • Provision of sufficient international liquidity.
  • It uses concessional lending and non-concessional lending.
    • Concessional IMF facilities: uses the poverty reduction and growth facility (PRGF) where interest on loans is 0.5%; loan repayment being 5.5-10 years.
    • Non-concessional IMF facilities: they are subject to IMF market related interest rate based on SDR interest rate. They include:
      • Stand-by arrangements (SBA): they are designed to deal with short term bop problems and is the most widely used IMF facility.
      • Extended fund facility (EFF): it aims on helping countries to address protracted bop problems that were rooted in structure of economy.
      • Supplementary reserve facility (SRF): The aim is to meet a need for very short term financing on a large scale.
      • Contingent credit lines (C.C.L): it aims to helping members countries to prevent crises.
      • Compensatory financing facility (CFF): it was established with the aim of helping countries that were experiencing a sudden shortfall in export earnings or an increase in cost of imports caused by fluctuating world commodity prices
      • Emergency assistance: this is mainly to countries that have experienced a natural disaster or are emerging from a conflict situation.

World Bank

All members of World Bank must be members of I.M.F. The World Bank encompasses all the five institutions namely:

  • International Bank of reconstruction and development (I.B.R.D): it aims to reduce poverty by promoting sustainable development in middle income and creditworthy poorer countries by means of loans, guarantees and non-lending which includes analytical and advisory services.
  • The International Development Association (IDA): helps poorest countries to reduce their levels of poverty by providing interest-free credits with a 10 year grace period and maturities of 35-40 years.
  • International Finance Corporation (IFC): the mandate is to further economic development through private sector.
  • The Multilateral Investment Guarantee Agency (MIGA): it aims at promoting foreign direct investment into emerging economies in order to improve people’s lives and to reduce poverty.
  • The International Centre for Settlement of Investment Dispute (ICSID): Aims at encouraging foreign investment by the provision of international facilities for reconciliation and arbitration of investment disputes.

Principle Functions of the World Bank

  • Provide funds for capital development
  • Give loans to be paid back within a period of 5 to 25 years.
  • Encourage free trade and international cooperative through investment.
  • Assist in reconstruction and development by facilitating investment of capital for productive purposes.
  • To promote foreign private investment by guarantee of or through participation in loans.
  • To provide loans for productive purposes out of its resources or out of funds borrowed by it facilitating economic development of member countries.
  • To promote the long-range growth of international trade