Question 1.

Describe the concepts, nature & scope and considerations of

international economics.
Answer 1. International economics, which emerged as a 'specialist' field of
economics long ago, has developed in depth and width over time due to a
lot of theoretical, empirical and descriptive contributions. International
economics has enjoyed a long, continuous and rich development over the
past two centuries, with contributions from some of the world's most
distinguished economists, from Adam Smith to David Ricardo, John Stuart
Mill, Alfred Marshall, John Maynard Keynes and Paul Samuelson.
International Economics as a matter of fact encloses the basic principles
pertaining to International Trade and Finance.
Concepts and Scope:International economics deals with the economic interdependence among
countries and includes the effects of such interdependence and the
factors which affect it. In other words, international economics deals with
those international forces which influence the domestic economic
conditions as well as those which shape the economic relationship
between countries, world economic integration and transition.
In the words of Sodersten and Geoffrey Reed, Even if most people are
agreed that international economic relations are of great importance for
most countries, it does not necessarily follow that international economics
should be studied as a subject independent of other branches of
economics.
Further elaborating and interpreting the views of Sodersten and Reed,
international economics may be defined specifically in the following words
International Economics is that branch of Economics which deals with
International Trade and International Finance. International Economics
may also be defined as a sub-branch of economic theory that deals with
the discussion of the principles related to international trade and finance.
According to Dominick Salvatore, International Economics deals with the
economic and financial interdependence among nations. It analyzes the
flow of goods, services payments and monies between a nation and the
rest of the world, the policies directed at regulating these flows and their
effect on the nation's welfare.

Nature and Scope of International Economics:The scope of the subject is broad. The need for development of this
distinct branch of economics was justified by a number of important
factors. Economic activities between countries are made different from
those within the countries by the fact that factors of production are
generally less mobile between countries than within the country. In fact,

international trade theories have been based on the traditional

assumption that factors of production are perfectly mobile within the
country and completely immobile between countries. Simultaneously, it is
assumed that goods are perfectly mobile both within and between
countries but for government restrictions in some cases. Indeed, the
impact of different types of government restrictions on trade, production,
consumption and income distribution is an important area of study in
international economics.
Considerations:1. Theoretical ConsiderationsThe theoretical part tries to go beyond the phenomenon to seek
general principles and logical frameworks which can serve as a
guide to the understanding of actual events (so as, possibly, to
influence them through policy interventions). Like any economic
theory, it uses for this purpose of abstractions and models, often
expressed in mathematical form. The theoretical part can be further
divided into pure and monetary theory, each containing aspects of
both positive and normative economics, although these aspects are
strictly intertwined in our discipline.
The theoretical part of international economics may be divided into
pure theory of international trade and international monetary
economics.
The pure theory of international trade, which has a micro-economic
nature, covers a very wide area.
The pure theory encompasses mainly the following:
The bases or causes of trade and the pattern of trade.
Effect of trade on production, consumption and distribution of
income.
Effect of trade on relative factor prices and product prices.
Gains from trade and distribution of the gains.
Effect of trade barriers on trade, factor and product prices and
income distribution.
Effect of trade on economic growth and vice versa.
The international monetary theory, which is of a macroeconomic
nature; deals with matters pertaining to balance of payments and
international monetary system. It covers areas such as causes and
methods of correcting balance of payments disequilibria, exchange
rate determination, international liquidity, relationship between
balance of payments position and other macroeconomic variables
etc.
2. Descriptive Considerations
The descriptive part is concerned with the description or
international economic transactions just as they happen and of the

institutional environment in which they take place. This covers

international trade flow of goods and services, flow of international
financial and other resources, international organizations like IMF,
World Bank, Regional Development Banks, WTO, UNCTAD, etc.
International Economic Agreements (including trade blocs) and so
on. International trade is only one, though an important part of
international economics.
Business strategies, particularly of the large corporations, such as
multinational investments, production sharing and global sourcing,
joint venturing and other alliances etc. have been increasingly
fostering world economic integration and transnationalisation. These
forces will gather more momentum in the future. However, the
literature on international economics does not appear to be giving
due importance to the role of business strategies in shaping the
world economic transition.
Subject Matter of International Economics
The subject matter of International Economics comprises of the
study of the following:
International Trade: This deals with the basis of international
trade and the gains from trade.
International Trade Policy: International Trade Policy examines the
reasons for and the effects of trade restrictions and the concept
of new protectionism.
The Balance of Payments: The balance of payments measures a
nation's total receipts from and the total payments to the rest of
the world.
Foreign Exchange markets: Foreign Exchange markets are the
institutional framework for the exchange of one national currency
for others.
Open Economy Macroeconomics: Open Economy
Macroeconomics deals with the mechanisms of adjustment in
balance of payments disequilibria (deficits and surpluses).
More importantly, it analyzes the relationship between the internal
and external sectors of the economy of a nation and how they are
interrelated or interdependent with the rest of the world economy
under different international monetary systems.
International trade theory and policies are the micro-economic
aspects of international economics because they deal with individual
nations treated as single units and with the (relative) price of
individual commodities. On the other hand, since the balance of
payments deals with total receipts and payments, as well as with
adjustment and other economic policies that affect the level of
national income and the general price of the nation as a whole, they
represent the macroeconomic aspects of international economics.

These are often referred to as Open Economy Macroeconomics or

International Finance.
International economic relations differ from inter-regional economic
relations (i.e., the economic relations among different parts of the
same nation), thus requiring somewhat different tools of analysis
and justifying international economics as a distinct branch of
economics. That is, nations usually impose some restrictions on the
flow of goods, services and factors across their borders, but not
internally. In addition, international flows are to some extent
hampered by differences in language, customs and laws.
Furthermore, international flows of goods and services and
resources give rise to payments and receipts in foreign currencies,
which change in value over time.

Question 2. Explain the theories of international trade in detail.

Answer 2.
Theories of International Trade:1. Classical Theories
Theory of Mercantilism (1500-1700) - Mercantilism became
popular in the late seventeenth and early eighteenth centuries in
Western Europe and was based on the notion that governments
(not individuals who were deemed untrustworthy) should become
involved in the transfer of goods between nations in order to
increase the wealth of each national entity. Wealth was defined,
however, as an accumulation of precious metals, especially gold.
Consequently, the aim of the government was to facilitate and
support all exports while limiting imports, which was
accomplished through the conduct of trade by government
monopolies and intervention in the market through the
subsidisation of domestic exporting industries and the allocation
of trading rights.
The concept of mercantilism incorporates two fallacies. The first
is the incorrect belief that old or precious metals have intrinsic
value, when actually they cannot be used for either production or
consumption. The second fallacy is that the theory of
mercantilism ignores the concept of production efficiency through
specialisation.
Neomercantilism corrected the first fallacy by looking at the
overall favourable or unfavourable balance of trade in all
commodities, that is, nations attempted to have a positive
balance of trade in all goods produced so that all exports
exceeded imports. The second fallacy, a disregard for the
concept of efficient production, was addressed in subsequent

theories, notably the classical theory of trade, which rests on the

doctrine of comparative advantage.
Adam Smith Theory (1800) - Being influenced by individualism
around the beginning of the nineteenth century and by the
industrial revolution, Adam Smith emphasised the importance of
individual freedom. He believed that if the individual was
permitted to pursue his or her own interest without interference
from the state, he or she would promote the well-being of all by
the invisible hand. In his famous book The Wealth of Nations
(published in 1776), Adam Smith put forward the theory that
international trade would occur in situations where nations had
absolute advantages over rival states, i.e. they could produce,
with a given amount of labour and capital, larger outputs of
certain items than any other country. The flaw in this argument is
that it fails to explain why countries with an absolute
disadvantage in all their products (i.e. countries which produce
less of everything made within the country, using a given amount
of labour and capital, than other nations) still engage in
international trade. A possible resolution of this question was
suggested by the eminent economist, David Ricardo, who, in
1817, alleged that trade among nations resulted from differences
in the comparative advantages of countries in the production of
various items, not differences in absolute advantage. Ricardo
assumed that the cost of producing any good depended only on
the amount of labour used in its production, and that firms and
workers could not move freely between nations (a reasonable
assumption for the early 1800s).
Classical Economic Theory:- This theory was based on the
economic theory of free trade and enterprise that was evolving at
the time. In 1776, in The Wealth of Nations, Adam Smith rejected
as foolish the concept of gold being synonymous with wealth.
Instead, Smith insisted that nations benefited the most when
they acquired, through trade, those goods they could not
produce efficiently and produced only those goods that they
could manufacture with maximum efficiency. The crux of the
argument was that costs of production should dictate what
should be produced by each nation or trading partner.
Under this concept of absolute advantage, a nation would only
produce those goods that made the best use of its available
natural and acquired resources and its climatic advantages.
Some examples of acquired resources are available pools of
appropriately trained and skilled labour, capital resources,
technological advances, or even a tradition of entrepreneurship.
Classical theory holds that expanding the labour pool leads to
decline in the accumulation of capital per worker, lower worker

productivity and lower incomes per person, eventually, causing

stagnation or economic decline. Naturally, this theory was proven
incorrect by numerous scientific and technological discoveries,
which provided for greater efficiencies in production and greater
returns on inputs of land, capital and labour. It was also knocked
awry by the growing acceptance of birth control as a means of
limiting population size.

Factor Endowment Theory:- The Eli Heckscher and Bertil Ohlin

theory of factor endowment addressed the question of the basis
of cost differentials in the production of trading nations. They
posited that each country allocates its production according to
the relative proportions of all its production factor endowments
land, labour and capital on a basic level, and, on a more
complex level, such factors as management and technological
skills, specialised production facilities, and established
distribution networks.
Thus, the range of products made or grown for export would
depend on the relative availability of different factors in each
country. For example, agricultural production or cattle grazing
would be emphasised in such countries as Canada and Australia,
which are generously endowed with land. Conversely, in small
land mass countries with high populations, export products would
centre on labour-intensive articles. Similarly, rich nations might
centre their export base on capital-intensive production.
Economist Paul Samuelson extended the factor endowment
theory to look at the effect of trade upon national welfare and the
prices of production factors. Samuelson posited that the effect of
free trade among nations would be to increase overall welfare by
equalising not only the prices of the goods exchanged in trade,
but also of all involved factors. Thus, according to his theory, the
returns generated by use of the factors would be the same in all
countries.

2. Modern Trade Theories: Strategic Trade Theory - In the last two decades, a new set of
models has come into being, using he perspectives of game
theory and theories of industrial organisation. While there is no
one overarching model, this broad collection of theories and
ideas has come to be known as strategic trade theories. Most
of the models of strategic trade are motivated by the attempt to
relax (and explore systematically the implications of) the
seemingly restrictive assumptions of the Ricardian and H-O
models, such as those relating to perfectly competitive markets,

constant or decreasing returns to scale, product homogeneity,

per factor mobility, no externalities or spillover effects, and so
forth. In the process of doing so, a fresh new set of insights
relating to international trade and trade policy has emerged.
Modern Investment Theory:- Other theories explain investing
overseas by firms as a response to the availability of
opportunities not shared by their competitors, that is, they take
advantage of imperfections in markets and only enter foreign
spheres of production when their comparative advantages
outweigh the costs of going overseas. These advantages may be
production, brand awareness, product identification, economies
of scale, or access to favourable capital markets. These firms
may make horizontal investments, producing the same goods
abroad as they do at home, or they may make vertical
investments, in order to take advantage of sources of supplies or
inputs.
Going a step further, some believe that firms within an oligopoly
enter foreign markets merely as a competitive response to the
actions of an industry leader and to equalise relative advantages.
Oligopolies are those market situations in which there are few
sellers of a product that is usually mass merchandised. Two
examples are the automobile and steel industries. In these
situations no firm can profit by cutting prices because
competitors quickly respond in kind. Consequently, prices for
oligopolistic products are practically identical, and are set
through industry agreement (either openly or tacitly).
Thus, firms within an oligopoly must be keenly aware of the
actions, market reach, and activities of their competitors. Unless
their response to the actions of competitors is following the
leader, they will yield precious competitive edges to their
competitors. Therefore, it follows that when a market leader in an
oligopoly establishes a foreign production facility abroad, its
competitors rush to follow suit.
Thus, the impetus for a firm to go abroad may come from a wish
to expand for internal reasons to use existing competitive
advantages in additional spheres of operations, to take
advantage of technology, or to use raw materials available in
other locations. Alternatively, the motive might arise from
external forces such as competitive actions, customer requests or
government incentives. The final determinant, however, is based
in a cost benefit analysis. The firm will move abroad if it can use
its own particular advantages to provide benefits that outweigh
the costs of exporting or production abroad and provide a profit.

 International Product Life Cycle Theory:- The international

product life cycle theory puts forth a different explanation for the
fundamental motivations for trade between and among nations.
It relies primarily on the traditional marketing theory regarding
the development progress and life span of products in markets.
This theory looks at the potential export possibilities of a product
in four discrete stages in its life cycle. In the first stage,
innovation, a new product is manufactured in the domestic arena
of the innovating country and sold primarily in that domestic
market. Any overseas sales are generally achieved through
exports to other markets, often those of industrial countries. In
this stage, the company generally has little competition in its
markets abroad.
In the second stage the growth of the product sales tend to
increase. Unfortunately, so does competition as other firms enter
the arena and the product becomes increasingly standardised. At
this point, the firm begins some production abroad to maximise
the service of foreign markets and to meet the activity of the
competition.
As the product enters the third stage, maturity, exports from the
home country decrease because of increased production in
overseas locations. Foreign manufacturing facilities are put in
place to counter increasing competition and to maximise profits
from higher sales levels in foreign markets. At this point, price
becomes a crucial determinant of competitiveness.
Consequently, minimising costs becomes an important objective
of the manufacturing firm. Production also frequently shifts from
being within foreign industrial markets to less costly lesserdeveloped countries to take advantage of cheaper production
factors, especially low labour costs. At this point, the innovator
country may even decide to discontinue all domestic production,
produce only in third world countries, and re-export the product
back to the home country and to other markets.
In the final stage of the product life cycle, the product enters a
period of decline. This decline is often because new competitors
have achieved levels of production high enough to affect scale
economies in the production that are equivalent to those of the
original manufacturing country.
The international product life cycle theory has been found to hold
primarily for such products as consumer durables, synthetic
fabrics and electronic equipment, that is, those products that
have long lives in terms of the time span from innovation to
eventual high consumer demand. The theory does not hold for
products with a rapid time span of innovation, development and
obsolescence.
The theory holds less often these days because of the growth of
multinational global enterprises that often introduce products

simultaneously in several markets of the world. Similarly,

multinational firms no longer necessarily first introduce a product
at home. Instead, they might launch an innovation from a foreign
source in the domestic markets to test production methods and
the market itself, without incurring the high initial production
costs of the domestic environment.

Question 3. Define the Heckscher-Ohlin model and Samuelson models of

international trade.
Answer 3.
Heckscher-Ohlin Model:According to this theory, there is difference in factor endowments among
different countries of the world. For instance, certain countries have
comparatively large supply of labour while in others the supply of capital
is relatively large. Because of difference in factor endowments, there is
difference in the prices of the factors. Difference in the prices of the
factors depends on their relative scarcity or abundance. Owing to
difference in the prices of the factors, there is difference in the costs of
the goods. Hence this theory states that the main cause of difference in
comparative costs is the difference in factor endowment. Thus,
international trade takes place because of diversity in factor endowments
and hence difference in prices. Each country will export that commodity in
the production of which such factor is used whose supply is relatively
abundant and price is relatively cheaper. On the other hand, it will import
that commodity in the production of which that factor is used whose
supply is relatively scarce and price is relatively dearer. According to this
theory, conditions of supply alone determine the pattern of international
trade. BO Sodersten, writes that some countries have much capital,
others have much labour. The theory now says that countries that are rich
in capital will export capital intensive goods and countries that have much
labour will export labour intensive goods!

Samuelson Models:Paul Samuelson is considered by many to be the founder of neoclassical

economics. In welfare economics he helped to establish the criteria for
deciding whether an action will improve welfare; these criteria came to be
known as the LindahlBowen-Samuelson condition. Samuelson is
predominantly acknowledged for his public finance theory on determining
the optimal allocation of resources in the presence of both public goods
and private goods. Finally, Samuelson has influenced international
economics through two important theories of international trade: the
Balassa-Samuelson effect (consumer price levels are systematically higher
in wealthier countries than in poor countries) and the Hecksher-Ohlin
model (a General equilibrium mathematical model of the macro economy
in international trade), in which the Stolper-Samuelson theorem (a basic
theorem in trade theory which describes a relation between the relative
prices of output goods and relative factor rewards) is utilized.