Economic Chapter 13: International trade (foreign trade) 

International trade

International trade refers to the exchange   of commodities    across the national   boarders   of the country.

OR

 International trade refers to the exchange of commodities   between residents of one country and those of other countries.

International trade can be visible or invisible trade.

Visible international trade refers to the exchange of goods between countries.

Invisible international trade refers to the exchange   of services   between   countries   for example   tourism, electricity.

Foreign trade is divided into two forms

Bi-lateral trade is trade between two countries

Multi -lateral trade is trade among many countries,

Note.

If a country sells commodities   to other countries,   they are called exports. The activity   is called export trade.

If a country  buys  commodities   from  another  country,   they  are  called  imports and  the  activity  is called import trade.

Why do countries carry out international trade?

1. Differences in natural resource endowments. Different countries   have different   natural resource endowments in form of minerals, forests etc. Therefore   there is need for counties to specialize   and exchange in order to get what they do not have through international
2. Lack of self-sufficiency in terms of goods and services. No  country   can  satisfy   all  her  needs therefore  countries  trade  together  in order to get what  they  cannot  produce  locally.
3. Need for foreign exchange. There is need for international trade for countries   to acquire   foreign exchange which can be used for import purposes.
4. Need to dispose of the surplus output. Some countries    produce   more   than   what   they  .can consume,  therefore  there  is need  to sell off the  excess  output   to other  countries   in order  to avoid resource  wastage.
5. Need for specialization. There is need for specialization among countries   in the production    and exportation   of commodities that they can produce   at lower costs than other countries   and import commodities   that they can produce at high cost hence international   trade.
6. Need to promote international relations among countries through international trade.  In addition, some countries need international   trade in order to further their political economic ideologies.
7. Differences in tastes and preferences among citizens of different countries. Some citizens prefer imported better quality products to the poor domestically   produced   goods.  Therefore   there is need for international   trade in order to acquire such products.
8. Need to import modern technology and capital. Some countries have natural resources but lack enough capital and technology   to exploit them.  Therefore   there’s   need for international    trade for such countries to acquire capital and technology   to full utilize their resources.
9. The vent for surplus theory of international trade. This theory states  that  opening   up  of world markets   through   international    trade  encourages   the  use  of  formerly   idle  resources   in  countries. This  theory   explains   how  international    trade  creates   an  out  let  for  the  use  of  some   resource possessed  by some  countries   for export  purposes.

Principles (theories) of international trade

(a)  The Principle of absolute advantage.

(b) The principle of comparative   advantage

 

(a)   The Principle (Theory) of Absolute advantage

This   theory   was   advanced    by Adam Smith.   It states   that   given   two   countries    producing    two commodities   using  similar  resources,  a country  should  specialize   in the production   of the commodity where  it can produce  more  units  at less costs  than the other  country.

Example

Country	Tons of cotton	Tons  of coffee
Kenya	10, 000	90,000
Uganda	50,000	100,000

 

From the table above, Uganda has absolute advantages   in the production   of both commodities.    This is because  given  the  same  amount  of resources,   Uganda   is able  to produce  more  units  of cotton  and coffee  than Kenya.

 

(b)  The Principle (Theory) of Comparative advantage

• This principal    states   that   given   two   countries    producing    two   commodities     using    similar resources,   a country should specialize in the production   of a commodity   where it incurs the least opportunity   cost than the other.
• According to  this  theory,   a country   is  said  to  have   comparative    advantage   if  it can  produce commodity at  a  lower   opportunity    cost   than   the   other   country   irrespective    of  the   absolute advantage.

Example

Country	tons  of Cotton	Tons   of Cofiee
Kenya	4000	16,000
Uganda	10,000	20,000

Opportunity cost of producing cotton

This means   that to produce one unit of cotton,   Uganda foregoes 2 units of coffee.

This means   that to produce one unit of cotton,   Kenya foregoes 4 units of coffee.

Therefore  Ugandan   should  specialize  in the production   of cotton  since it has a lower  opportunity   cost (2  tons   of  coffee)   than   Kenya   (4  tons   of  coffee). This    means   that  Uganda   has  comparative advantages   in the production   of cotton.

Opportunity cost of producing coffee

This means   that to produce one unit of coffee,   Uganda foregoes ½ units of cotton.

This means   that to produce one unit of coffee,   Kenya foregoes ¼ units of cotton.

Therefore  Kenya   should  specialize  in the production   of coffee  since it has a lower  opportunity   cost (¼   tons )   than   Kenya   (4  tons   of  coffee). This    means   that  Uganda   has  comparative advantages   in the production  of cotton.

Assumptions   of the theory of Comparative advantage

1. It assumes only two countries participating in trade in the world.
2. It assumes that each country produces only two commodities
3. It assumes free trade that is international trade is free from trade barriers
4. It assumes constant technology in the two countries.
5. Is assumes absence of the law of diminishing returns such that there are no economies and diseconomies of scale.
6. It assumes perfect mobility of factors of production within the country but perfect immobility of factors of production between the two countries.
7. It assumes full employment of factors of production in the two countries that is there is no excess capacity.
8. It assumes similar tastes and preferences in the two countries.
9. It assumes existence of perfect competition in the international markets.
10. It assumes barter system of exchange
11. It assumes that labour is the only factor of production and all labour units are homogeneous in the two countries that is labour has the same efficiency and skills in the two countries.
12. It assumes the same exchange rate for the two countries,

Weaknesses (Criticisms/Limitations) of the theory of comparative advantage     

1. The assumption that the world is composed of two countries is unrealistic. In the real world there are many countries producing a variety of commodities.
2. Factors of production are not perfectly mobile as assumed by the theory. Some factors like land are highly immobile.
3. It assumes free trade, yet in the real world, international trade is dominated by restrictions and other trade barriers in form of tariffs, quotas etc.
4. The assumption that factors of production are equally efficient in two countries is unrealistic. This is because different factors of production have different efficiency and productivity between countries.
5. It assumes constant technology, yet technology is constantly changing and this leads to changes in efficiency and comparative advantage.
6. It assumes absence of diminishing returns, yet production in countries is characterized by the law of diminishing returns due to poor farming methods especially in the agricultural sector.
7. The assumption that there are no transport costs in international trade is unrealistic. Transport costs do exist and they determine the nature and pattern of international trade.
8. It is possible for two countries to have the same opportunity cost and in this case it is hard to determine which country should specialize in the production of a given commodity.
9. The   theory    does   not   take   account   the need for   diversification.   Instead    it   encourages specialization   which under mines the countries need for self-reliance   and independent.
10. The theory assumes perfect competition which does not exist in the real world.
11. The theory assumes full employment or resources yet there are high rates of unemployment and under employment  of resources in all countries.

Relevance (Applications)   of the theory of comparative advantage

1. The theory emphasizes specialization which  forms   the basis   of international    trade.   This   is because   countries   should specialize   in the production   of commodities   where they have greatest comparative   advantage over others.
2. The theory is relevant in the process of bi-lateral trade. This is because it assumes countries which apply under this form of trade.
3. The  theory  is applicable under economic  (regional) integration where  certain  countries   remove or eliminate  certain  trade  barriers  in order  to encourage   free trade in the integrated   region.
4. Due   to differences   in resource   endowments,   some   countries    have   managed    to   produce commodities    at lower   costs than others   and have become   major   suppliers   to other   countries basing on the theory of comparative   advantage.
5. The   theory   is   relevant   under   barter trade between    two   countries    where    they   exchange commodities   for commodities   basing on the law of comparative   advantage.   For example   Uganda used to exchange beans for oil in the late 1870’s with Libya
6. According   to  this  theory  countries  have been  able to acquire more goods  and services  from other  countries  which  have  ability  to produce  them more  cheaply.
7. The   theory   is relevant because it encourages market expansion which   forms   the basis   of international   trade.

 

The role of international trade in the development   process

Advantages/Positive role/Arguments   for international   trade

1. It encourages the exploitation and utilization of idle resources like land labour in the country through the vent for surplus theory. This is because the opening up of external market   opens up the opportunity   for the country to produce for export.
2. It enables the country to earn foreign exchange from her exports. This foreign  exchange   is used  for  importation   of  capital   and  other  manufactured    goods  from  other  countries   which   the country  cannot  produce.
3. It promotes competition which leads to efficiency in production hence high quality  products. This leads to more output and consumption   at low prices hence improved standards   of living.
4. Market expansion. International  trade widens the market   for the countries product which leads to increased production   hence economies   of scale.
5. Government revenue.  It helps the government   to earn revenue   in form of export   and import tariffs. Such revenue   is used to construct   social and economic   infrastructure    which   is vital for economic development.
6. It enables the countries to acquire a variety of commodities which they cannot produce  locally. This improves and increases the choice of the people hence improved welfare.
7. It helps the country to overcome shortages which can be caused by unforeseen  circumstances for example drought, famine etc.
8. It promotes specialization. Countries specialize in the production  of commodities   for which they have the resources   and they can produce efficiently.   This increases output of high quality hence economic growth and development.
9. Creation of employment opportunities. This is as a result   of increased   resource   exploitation, export and import activities, investments   and market expansion resulting from international   trade.
10. Technology transfer. International  trade promotes   the movement   of modem   techniques,   ideas, knowledge   and skills especially to developing   countries   from developed   countries.  This promotes rapid economic growth and development.
11. It encourages capital inflow from rich developed countries   to poor countries   in form of loans, grants, foreign   capital   investment.    This leads   to transformation     of economies    of developing countries.
12. It promotes mutual understandings and diplomatic relations among countries. This enhances peace  and economic  stability  among  trading  partners.

Demerits (Disadvantages/Arguments against/Negative role) of international   trade

1. Dumping problem. International    trade encourages   dumping   which   retards   the development    of local infant industries in the countries where the commodities   are dumped.

Note. Dumping refers   to the selling commodities   in foreign markets   at lower prices than the price charged in the domestic market.

2. Increase in economic dependence and reduction in self-reliance. It encourages   the dependence syndrome  in countries  most  especially  for developing   countries   which  have  to depend  on imports from developed  countries  in form of consumer  and capital  goods.
3. Imported inflation. It leads to imported   inflation   especially   when imports   are bought at higher prices from countries experiencing   inflation.
4. Balance of payment problems. It results  into unfavorable   balance  of payments  That  is when  the country  spends  more  on imports  than  what  it receives  from  exports.  This is true for Uganda as it imports expensive manufactured   goods and exports primary or agricultural   products.                        .
5. It worsens the terms of trade for the  country  when  the  import  prices  are  higher  than  exported prices.
6. It encourages  the importation  of dangerous  and harmful  products  to  the  country   in  form  of drugs,  pornographic   materials  etc.  Such products may adversely   affect the country economically, culturally and socially
7. Demonstration effect. International  trade encourages   demonstration    effect where by local people tend   to consume   luxurious    expensive    commodities    from   foreign   countries    and   neglect    the domestically   produced goods.  This undermines   the growth of local infant industries.
8. It encourages brain drain. Brain drain refers to the massive  movement   of skilled labour from one country to another especially   from developing,   to developed   countries.   This leads to lack of skilled manpower   in the developing   countries.
9. It leads to political instabilities especially  in developing   countries.   This is because   they import fire-arms   and military    hard ware   from developed   countries.   This   contributes   to under development   of developing countries.
10. It perpetuates political ties and economic dominance by developed on to developing   countries. In this  case  developing   countries  have  to accept  political   and  economic   policies   from  developed countries  which  may not be in their  line of development.
11. It leads to under development and collapse of local infant industries as they are exposed to foreign  competition   in  form  of  high  quality  imported commodities    as  compared   to  the  locally produced  domestic  products.  This undermines   the countries need to industrialize.
12. It acts as disincentive to work  for  the  local  people   since  they  are  assured   of  the  supply   of commodities   from  foreign  countries  in form of imports.  This discourages   production   activities   in the country.
13. It promotes international inequalities where by developed countries   benefit   more as compared to developing    countries.   This   is because   developed    countries   produce    and export   expensive manufactured   products   while developed   countries produce and export cheap primary products   to developed   countries.

 

Commercial policy

This  refers  to the  set of rules  and measures   adopted  by the country  for the conduct  and regulation   of its foreign  and domestic  trade  in order  to achieve  the desired  economic   objectives.

 

Objectives of the commercial policy

1. To encourage   exports and discourage   imports in order to achieve   favourable   balance of payment position.
2. To increase foreign exchange earnings in form of increased revenue from exports
3. To increase government   revenue through import and export duties.
4. To increase employment   opportunities.
5. To encourage industrialization by protecting  domestic infant industries.
6. To encourage   foreign investments   and capital inflow inform of loans and grants
7. To encourage and promote cooperation   with other trading partners.

Tools (Instruments)   of the Commercial policy

1. Tariffs
2. Quotas
3. Exchange   rate policy
4. Trade agreements
5. Economic   integration
6. Dumping
7. State trading
8. Export credit

 

Note.  Beggar -my-neighbor  policy refers  to the measure  adopted  by the country  to improve  on its economic   conditions   but  with  adverse   effects   on  economies    of  its  trading   partners,   for  example dumping.

 

Protectionism (trade barriers/restrictions)

• Protectionism refers   to   the measures    employed    by   the   government     (country)    to   regulate international   trade.
• Free trade occurs when there are no trade barriers in international  trade.

Tools (Instruments) of Protectionism   (Trade barriers)

1. Tariffs. A tariff refers to the tax imposed on imports  (import tariff) or exports  (exports tariff) of the  country.   If the country  wants  to reduce  imports,   it increases   import  tariff  (duties) and  if the country  wants  to encourage  exports,  it reduces  the export  duties.

 

Tariffs can either be Advalorem   or specific.

 Advalorem  tax. This refers to the tax imposed on commodities   basing on their monetary   value. For example 30%   of the value of the imported commodity   as a tax

Specific tax. This is the tax imposed on commodities   basing on their quantities   or units imported for example a tax of 500/= imposed on each unit of the commodity   imported.

2. Quotas. These are physical or quantitative   restrictions   on the amount   of a commodity   imported into or exported from the country in a given time.  Import quotas restrict the amount of imports to the country and export quotas are restricts the amount of exports.
3. Foreign exchange control.  This   is where   the   government    restricts    the   supply   of   foreign exchange   for import purposes.   For  example   it  can  allocate   foreign   exchange   at  lower  rates  to importers   of essential  commodities   and  at high  rates  to importers   of non-essential   and  luxurious commodities   so as to reduce  on their  importation.
4. Trade embargoes (sanctions). This   is where   the   government    prohibits   the   importation     of commodities   from certain countries and exportation   of commodities   to certain   countries   in form of economic sanctions.  Such sanctions are aimed at promoting peace, harmony   and human rights. For example the economic sanctions imposed on Iraq and Zimbabwe by U.S.A.
5. Deflationary policy. This is where  the  government   through  the central  bank: uses  the  restrictive fiscal  and  monetary   policies   in  order   to  reduce   on  the  amount,  of  money   circulating    in  the economy   so  as  to check  on the  aggregate   demand   for  imports.   This   can help to reduce   on the quantity of imports to the country.
6. Total ban (Complete ban). This is where the government  completely prohibits   the importation   of a certain commodity   from a given country.  This  is done when  the commodity   is either  harmful, when  there  is political  crisis  between  the two countries  or when  the commodity   is security  risk  to the country.
7. Administrative controls (restrictions). This is where the government  sets bureaucratic   formalities or  procedures   which  the  importers   or  exporters   have  to  follow  in  the  process   of  international trade.  These   procedures   tend  to  be  lengthy   and  costly   such  that  it  becomes   uneconomical    to import  or export  certain  products  hence  controlling   international   trade.
8. Subsidization. This   is where   the   government     gives   assistance    to the   producers    of   certain products.    Such   economic    assistance    can   be   in form   of   soft   loans   and   subsidized     inputs particularly   to the domestic producers   of essential products.  This lowers the production   costs and enables the home producers   to sell their commodities   at fair prices in order to compete   favorably with the imported products.
9. Import licenses. The government  can restrict licenses given to importers   and exporters   of certain commodities   hence controlling   international   trade.
10. Devaluation. This refers to the deliberate  government   policy of reducing   the value of domestic currency in terms of other currencies.   Devaluation   discourages   imports and encourages   exports. This  is  because   it makes  exports  cheap  to  the  foreigners   and  imports   expensive   to  the  locals. However, this policy can be effective if imports and exports have elastic demand.
11. Transport discrimination. This is where the government discriminates   against imports in form of high transport   charges   while the locally produced   goods are transported   at low changes.   This discourages   the imports into the country.
12. State trading. This is where the government takes over the importation   of certain   commodities from private individuals.   In this case the government   restricts   the amount   to be imported   hence controlling   international   trade.
13. Special import deposits. This  is where   the   government    requires    the   importers    of   certain commodities    to first deposit   a given   amount   of money   with the central   bank   before   being licensed to import.  This reduces on the number   of importers   hence discouraging    imports   in the country.
14. Quality control standard agencies such as UNBS and National drug authority are used to prevent inferior products from entering the country.

Merits (Advantages /Arguments)   for Protectionism

1. It encourages the exploitation and utilization of domestic idle resources. This   is because protectionism against     imports     increases     aggregate     demand     for    the    locally     produced commodities.    This increases the productive   capacities   in the economy   hence economic   growth and development.
2. 2. It helps to control dumping. Dumping   refers to selling of commodities   in foreign   market   at a high price  as compared  to the price  charged  in the domestic  market   This  discourages   production in the country  where  commodities   are dumped  hence  the need  for protectionism.
3. It helps to raise government revenue. This is realized   from the tariffs   imposed   and trade licenses issued in the process of protectionism.    The revenue is used to finance   government   re- current and development   expenditures
4. It facilitates the development of domestic infant industries. Infant industries   produce   at high costs and their products   are of poor quality.  Therefore,   there  is need  to protect-such    industries from competing  with  the cheap  high  quality  imports  in order  to enable  them  to develop.
5. For Health reasons. Protectionism    discourages   the importation   and consumption    of harmful and dangerous imports by the local population.   Such commodities   are in form of expired drugs, food stuffs and other substandard   commodities.
6. 6. It helps to control imported inflation. Trade restrictions   are used to reduce   on the importation of commodities   from countries affected by inflation hence controlling   imported inflation.
7. It improves the balance of payment position of the country. Protectionism    encourages    the production of formally    imported    commodities    locally   through   the   establishment     of import substituting   industries.  This reduces expenditure   on imports hence improved balance of payment position.
8. It saves the scarce foreign exchange earnings of the country.  Protectionism    encourages   the production   of formerly   imported   commodities   locally. This reduces   foreign   exchange   outflow hence accumulating   foreign exchange reserves.
9. It increases employment opportunities. Through   protectionism,    the money   which   would   be spent on imports is diverted   to the consumption   of domestically   produced   commodities.    This increases   domestic production   and other economic   activities   hence creating more employment opportunities.
10. It leads to the development of social and economic infrastructure. Protectionism    promotes   the development of  the  social  and  economic   infrastructures    in  form  of  roads,   schools,   hospitals, financial  institutions   etc. required  for import  substituting   industries.
11. It promotes self-sufficiency   and reliance of the economy.   Protectionism     encourages    the production   of a number of formally imported goods and services locally.  This leads to increased self-reliance   and sustenance   of the economy hence reducing the problem of foreign dependence.
12. It facilitates the development of skills for local entrepreneurs.   This   promotes    managerial capacity   building   through   on job   training   and helps   to reduce   government    expenditure    on training costs.
13. For retaliation purposes. Some countries   impose   restrictions    to retaliate   against   restrictions made by other countries on their exports.
14. National security argument. A country  may  impose  restrictions   on the  importation    of  certain commodities       for  security   reasons   .For  example   restricting    the  importation    of  fire   arms   for security  purposes.
15. For political purposes. Trade restrictions    can   be   used   to promote    and   achieve    political objectives.   For example  African  countries  managed  to reduce  apartheid  rule  in South  Africa  by imposing  trade embargoes   on the South African  government   of that time.

Demerits (Disadvantages/ Arguments   against) Protectionism

1. It leads to technological unemployment.   This   is true  if  the  protected   industries    use  capital intensive   techniques   of  production    which  in  the  long  run  replaces   labour   hence   technological unemployment. This is true especially   with foreign   investors   who prefer to use capital intensive techniques   of production.
2. It increases economic dependence of the country. This is true if protected   industries   continue to import raw materials   and spare parts from foreign countries.   This increases   the production   costs hence high prices for goods and services.
3. It promotes profit repatriation.  This is  true  if  the  protected    industries   are  owned   by  foreign investors  and this promotes  capital  flight  hence  limited  capital  accumulation   in the economy.
4. 4. Protectionism in form of regional integration leads to trade diversion.  Countries   within   the integrated region may end up buying raw materials   from within the region at high costs instead of importing    them   from   nonmember   countries   at cheaper       This   increases    the   costs of production.
5. It reduces the welfare of the local consumers. This   is  protectionism     reduces   the  choice   of consumers   and  it leads  to  the production   of poor  quality   and  expensive   goods  and  services   as compared  to the imported  commodities.   This leads to poor standards of living.
6. It leads to balance of payment problems in the country.  This is due to increased   importation   of expensive factor inputs in form of raw materials, intermediate   goods and expatriates.
7. It increases government   expenditure.     This   is because    it is costly   for the   government    to implement   and enforce   the protectionism   policy.  This makes   it difficult   for the government    to meet her recurrent   and development-expenditures.
8. It leads to the emergency of local monopolies. The   protected    domestic    industries    end   up becoming    monopolies.     They   restrict    output   and   charge    high   prices    hence    exploiting     the consumers.
9. It encourages retaliation and tariff wars among trading partners.  This is because protectionism is used as a beggar-my-neighbor     policy whereby a country uses it to improve   on its economic conditions at the expense of its trading partners.
10. It promotes inefficiency in production. Local producers  are sheltered   from foreign competition and this leads to the production   of poor quality  products

 

Revision questions

Section A questions

1 (a) Define the term “Dumping”   as used in economics

(b)   Give three demerits of dumping policy in the importing   countries.

2  (a)  State the vent  for surplus  theory  of international   trade

(b)  Give    three    circumstances     under    which    protectionism      may    fail    to   achieve    economic development   in an economy.

3  (a)    State the “vent-for  surplus”  theory  of international     trade.

(b)  State three assumptions   underlying the principle of comparative   advantage

4   (a) Define the term commercial   policy.

(b) Outline three instruments   (tools) of commercial policy used in your country.

5   (a) What are non-tariff   barriers?

(b) Mention any three non-tariff barriers to trade.

6   (a) What is meant by the term beggar-my-neighbor    policy?

(b)  State three objectives   of commercial policy in your country.

7. (a) Differentiate between tariffs and quotas

(b) Mention two objectives   of imposing import duties in your country

 

Section B questions

 

1  (a) Differentiate   between  multilateral   trade and bilateral  trade

(b)  “Developing   countries   should pull out from participating   in International   trade.   Discuss.

2  (a)    Explain  why your  country  has gained  less from  foreign  trade

(b)   What policy measures   are being adopted to improve on your country’s    low position   in foreign trade?

3    Study the table below showing output levels of two countries   in two commodities   given the same units of labour, answer the questions which follow

 

Country	Commodities
	Generators	Coffee
X	400	600
Y	100	300

 

 

(a) State the country with   absolute advantage in the production   of both commodities.

(b) Calculate the opportunity   cost of producing each commodity   in each country

(c) In which commodity   should each country specialize?

(d) What are the limitations   of the comparative   cost advantage   theory in international   trade?

4  (a)  Explain  the law of comparative   cost advantage?

(b) Why  may  the use  of the  law  of comparative   cost  advantage   fail  to bring  about  closer  regional cooperation   in East Africa?

5  (a) Distinguish   between  the principles  of absolute  advantage   and comparative   advantage

(b)   To what extent is the theory of comparative   advantage   applicable   in international    trade in developing   countries?

6   (a) Explain the various forms of protectionism   employed in international   trade

(b) What are the positive implications   of protectionism   in an economy?

7   (a)  Why may  government   adopt protectionism   policies  in an economy?

(b)  What problems  are associated  with  adopting  protectionism   policies  in an economy?

 

 

Terms of trade (T.O. T)

Terms of trade refer  to the  rate  at which  the goods  of one  country   are  exchanged   for the  goods  of another  country.   OR. Terms of trade refer to the purchasing   power of the country’s   exports   in terms of its imports.

Types of Terms of trade

(a) Barter (Commodity) T.O.T. This refers to the ratio of export prices to the import prices.   OR. It refers to the ratio of price index of exports to the price index of imports.

• If the barter T.O.T is greater than 1; the country is said to experience favorable terms of trade
• If the barter T.O.T is less than 1; the country is said to experience unfavorable terms of trade

Barter T.O.T can also be expressed as percentage using the following formula

Barter T.O.T are favorable if it  is greater than 100% and unfavorable if it  is less than 100%

(b) Income (Monetary) T.O.T. This refers to the ratio of value of exports to the price index of imports. It shows how much a country can import using the revenue from exports

where Q_x = quantity of export, P_x = price of export and P_m = price index of imports

(c) Gross barter T.O.T. this refers to the ratio of the quantity of export to quantity of imports

where Q_x = quantity of export, Q_m = quantity of imports

Example

Given that the price index of exports is 120and imports is 130 and quantity of export is 200kg. Calculate

• The barter T.O.T

• State whether the country is facing or experiencing favorable and unfavorable T.O.T

The country is experiencing unfavorable terms of trade  because the barter terms of trade is less than 100%

 

Causes of unfavorable terms of trade in developing countries

1. Production and exportation of similar products by developing countries. This leads to excess supply on the world market hence low export prices as compared   to import prices.
2. Discovery of synthetic substitutes by developed countries   for exports from developing   countries. This has greatly reduced   the demand   for exports   from developing   countries   hence   low export prices.
3. Development of raw material saving technology by developed countries.   This has reduced   the demand for raw materials   from developing   countries hence low export prices.
4. 4. Production and exportation   of   cheap primary   products   (raw, materials)   by   developing countries. Such products fetch low prices on the world market hence unfavorable     terms of trade.
5. International commodity agreements favour   developed countries by   fixing   low   prices   for exports from developing   countries   and higher prices for exports from developed   countries   hence deteriorating   terms of trade
6. Weak bargaining power among developing countries due to limited economic integration   leads to low prices for their exports.
7. Some developing countries (like Uganda) are land locked. This leads to high costs of transport for their exports and imports. The  high  transport   costs  reduce   the  prices   for  their  exports   and increase  the prices  for their  imports  hence  unfavorable   terms  of trade.
8. Protectionism by developed countries against  exports from   developing  countries  in  form of tariff  and  non-tariff  barriers.   This is aimed at protecting   their economies   as a way of achieving self-sufficiency   and reliance.   This has greatly reduced the demand   for exports   from developing countries hence unfavorable   terms of trade.
9. Developing countries have a high marginal propensity to import.  This   enables   developed countries  to fix high prices  on their  products  hence  unfavorable   terms of trade.

Measures (solutions)   to improve the Terms of trade in developing countries

1. Promote export diversification including the production of industrial products   so as to avoid over flooding of the world markets by similar products produced by developing   countries.  This helps to increase the export prices hence favourable   terms of trade.
2. Embrace regional integration and   economic    co-operation     so   as   to promote    trade    among developing countries.  This can help them   to avoid being exploited by developed countries.
3. Establish export promotion  industries  to  add  value  to  the  exports   as  a way  of  increasing    the export  prices.
4. Adopt technological development in order to improve on quality and quantity of exports. This can help to increase on the export prices.
5. Encourage manufacturing and processing plants or industries so as to add value to their exports. This can help to improve on the quality of their exports hence high export prices.
6. Formation of strong  commodity  associations  so as 1:0  jointly   bargain  for fair prices  for their exports  on the world  market.  For example coffee producers Association   (CPA).
7. Adopt favorable policies like subsidization of local producers and privatization of the inefficient parastatals.        This can help to improve   on quality   and quantity   of their exports   hence   favourable terms of trade
8. Carry out market research and advertisement as a way of improving on the marketability and prices  of their  exports.

Balance of payments (B.O.P)

This  refers  to the  difference   between  the  country’s   total  receipts  from  exports   and  total  expenditure on imports  in a given time.

If the country’s   receipts (revenue) from exports exceed her expenditure   on imports, the country is said to have a balance of payment surplus and therefore   it experiences   favourable   balance   of payment.

If the country’s   expenditure   on imports exceeds  her receipts  from  exports,  the  country   is said to have  balance of payment  deficit and therefore  it experiences  unfavorable   balance  of payment.

 

Balance of Payment Account

Balance of payment account is a systematic   record of all a country’s   economic   transactions   with the rest of the world in a given time.

The  balance  of payment   account  takes  the  form  of double  entry  accounting   system  like  balance sheets   of  business   enterprises.   Exports   and  other   transactions    that  lead   to  inflow   of  foreign exchange  are recorded  on the credit side  while  imports  and other  transactions   that lead  to outflow of  foreign  exchange   are recorded   on the  debit  side  of the  balance  of payment   account.   Like all balance  sheets,  the balance  of payment  account  must  balance.

Components   of the B.O.P Account

The B.O.P account has four major components;

(a) The current account

(b) The capital account.

(c) The monetary   (cash) account.

(d) Errors and the omission’s   account.

 

(a) The current account

This is summary record of international   transactions   in goods, services and transfers. The current account is divided into;

• Visible trade account. This records receipts from exports and  expenditure   on  imports   resulting from  the  exchange   of  goods  only  (Visible   trade}.The  difference   between   receipts   from  visible exports  and expenditure   on visible  imports  is called Balance of trade  (visible balance of trade)
• Invisible trade account. This records receipts from exports and expenditures on imports resulting from   exchange    of   services   only   (invisible    trade).   For example   tourism,    transport,    medical, education   etc.
• The difference between the receipts from services exported and expenditure   on services imported is called  invisible balance of trade.
• Transfer payments (Unilateral transfer) account. This records   donations   by the country   and donations to the country. For example  gifts and grants
• Current account balance = visible balance (trade balance) + invisible balance + net transfer payments.

(b) The capital account

This  is a record  of  capital  movements   which  are  either  be capital  inflows  or capital  outflows   of the country.  Capital movements   (flows) are in form of private or public foreign investments,   loans,  debt payments  and repayments   etc.

Balance of payments = Balance on Capital account + Balance on current account

(c) Monetary (cash) account

• This is also called the official settlement or financing account.  It is a record   of how foreign exchange reserves   change in response to current and capital transactions.   This account indicates a surplus or deficit on the B.O.P account and it shows how the dis equilibrium   can be corrected
• When there  is a surplus  on the combined  current  and  capital  account,  it implies  an increase  in the foreign  exchange,  reserves   (Net  inflow  in the  foreign  exchange   reserves).   A deficit implies a net out flow (a decrease in foreign exchange reserves).

A balance of payment   deficit can be offset (financed)   by using accommodating items on monetary account.  Accommodating items methods used by the central bank to establish a balance by offsetting a deficit in the balance of payment account.  The process of financing  a deficit  using  accommodating items  is called accommodating  the balance.

Examples of accommodating items include;

1. Selling the country’s investments abroad.
2. Using foreign exchange reserves available in the central bank.
3. Selling gold stock held in the central bank.
4. Borrowing from international lending institutions   like IMF and World Bank.
5. Borrowing from friendly countries.
6. Selling government securities abroad i.e. Treasury bills and bonds.

A balance of payment   surplus can be offset (financed)   by using autonomous items on the monetary account.   Autonomous   items  are  methods   used  by  the  central   bank  to  bring   about   a  balance   by disposing   off the  surplus  in the balance  of payment   account.   The expenditure   incurred   in disposing off the surplus is called autonomous expenditure.                                                                .

Examples of autonomous items include;

1. Making investments abroad
2. Buying gold so as to increase on its stock in the central bank.
3. Offering loans to other countries.
4. Giving donations to other countries.
5. Offering loans to international institutions like I.M.F.
6. Increasing on the stock of foreign exchange reserves in the central bank.

(d) Errors and Omissions   account

This is also called a balancing item account. This  part  of the  balance   of payment   account   records errors  and  omission   which  may  have  been  made  in the  process   of making   the  balance   of payment account   In this case  the figure  representing   the errors  and omissions   made  (Balancing  item) is added or subtracted  on any side of the balance  of payment  account  for purposes  of balancing.

Format of the balance of payment account

Debt side	Credit side
Imports Current account Goods  imported ……………………………xx Services imported ………………………….xx Transfer payment ………………………….xx   Capital account Loans to foreigners ……………………….xx Investment in other countries ………..xx   Cash account Accommodating items ……………………xx   Errors and omissions account Balancing items …………………………….xx	Exports   Goods  imported ……………………………xx Services imported ………………………….xx Transfer payment ………………………….xx   Loans from foreigners ………………….xx Investment by foreigners……. ………..xx       Autonomous items ………………………xx     Balancing items …………………………….xx

Causes of persistent   balance of payment problems   (Deficits)  in Developing   countries

Persistent   balance   of  payment   deficits   are  experienced   by  the  country   when  its  foreign   exchange expenditure   exceeds   its  foreign  exchange   earnings   year  after  year.  Balance   of payment   deficits   are caused by factors which;

(a)  Reduce foreign exchange   earnings and increase foreign exchange expenditure.

(b)  Increase capital outflow and reduce capital inflow. These factors include:

1. High levels of inflation in developing countries. Inflation increases production costs and discourages   exports by making   them expensive. This leads to low demand for exports hence low foreign exchange earnings.
2. Low export prices. Since developing   countries   mainly export primary   products   where prices are low on the world market,   they get less foreign   exchange   earnings   hence   balance   of payment.
3. Excessive reliance on imports in form of consumer and capital goods. Developing    countries import   expensive   manufactured    products   leading   to high foreign   exchange   expenditure    hence balance of payment deficits.
4. Low productive capacities in developing countries. This is due to limited co-operant factors used in the production   process   like limited capital, use of poor technology,   unskilled   man power etc. This leads to low output for export purposes hence balance of payment   deficits.
5. Excessive capital out flow in forms of profit repatriation, public debt servicing   and capital flight by the nationals.
6. Wide spread political instabilities in developing countries. Political   instabilities    discourage investments   and production   which leads to a decline in exports.  In addition   political   instabilities increase expenditure on military equipments   which leads to borrowing   hence balance   of payment deficits.
7. Poor and inadequate social and economic infrastructures .The existing infrastructure is in a bad state.   For   example,   there   exists   poor   transport,   storage   and   communication     facilities    which greatly   discourage   the production    and distribution   of commodities    for export   purposes    hence balance of payment deficits.
8. Use of poor technology. This results into inefficiency in resource use and the production   of low quantity and poor quality exports which fetch low prices on the world market.
9. Protectionism by developed countries.   The  high   tariff   and   non-tariff   barriers    imposed    by developed   countries  against  exports  from  developing  countries   lead to a reduction   in exports  and foreign  exchange  earnings  hence  balance  of payment  deficits.
10. Discovery of synthetic fibers by developed countries. Synthetic fibers like Nylon,   Rayon,   silk and  the  use  of raw  material   saving   technology   by  developed   countries   have  led  to  a decline   in demand   for  agricultural   raw  materials    from  developing    countries   hence   a  decline   in  foreign exchange  earnings.
11. 11. High population growth rates and dependence burdens. These force developing    countries   to import more foodstuffs and medical   services in order to support the rapidly growing   In addition,   a rapidly  growing  population   has led to an increase  in consumption    of commodities which  would  otherwise  be exported  hence  balance  of payment  deficits.
12. Existence of natural disasters. These   include   floods.,  drought,    pests    and   diseases    which adversely  affect  the agricultural   sector  hence  a decline  in agriculture   export  and export  earnings.
13. High levels of corruption and embezzlement of scarce economic resources. Resources meant for domestic and export production   and embezzled for personal gain.  This  increases   government expenditure   on  un  productive   public   enterprises   forcing  the  government    to  keep  on  importing hence  balance  of payment  deficits.
14. Limited economic diversification   by developing countries.   Developing     countries    tend   to concentrate    on   the   production     and   exportation    a   few   traditional    cash   crops    which    face unfavorable   terms of trade on the world market hence balance of payment deficits.

Measures (Policies) of solving balance of payment problems in developing   countries

The measures taken should be aimed at;

(a)  Increasing   exports and export earnings.

(b) Decreasing   imports and import expenditure.

1. port promotion policy. This  policy  is aimed  at  increasing   the  export  base  and  reducing   the obstacles   in the export  process  through   subsidization   of producers   and  trade  liberalization.    This leads to increased exports and export earnings.
2. Devaluation policy. This is the deliberate government   policy of reducing the value the country’s currency in terms of other currencies.   Devaluation   helps to discourage   imports by making   them expensive   for the locals and encourages   exports as they become cheaper to the foreigners.   This can be successful   if both imports and exports have elastic demand.
3. Import substitution   policy.   This    policy    is   aimed    at   establishing     industries     to   produce commodities    formally   imported    by   the country   as a way   of reducing    imports   and   import expenditure.
4. Economic diversification.  Developing    countries   need   to diversity   their   economies    so as  to reduce  their  over  dependency   on  a  few  traditional   cash  crops .like  cotton   and     Instead, they  should carry  out a number  of economic  activities  in order  to diversity   their  export  base  and increase  on their  foreign  exchange  earnings.
5. Economic integration.  Developing    countries   should   encourage    economic   integration    within themselves   in order to promote   market expansion.   This will not only encourage   production   for export   purposes   but also widen   the source   of foreign   exchange    earnings   for the   integrated    countries.
6. Foreign exchange control. The government should control the  issuing  of foreign  exchange   for import   purposes.   It  should   give   foreign   exchange    at  lower   rates   to  importers    of   essential commodities   which  are  scarce  in  the  economy   and  at high  rates  to  importers   of non-essential commodities.   This helps to regulate foreign exchange expenditure.
7. Political stability and security. Governments   of developing   countries   should promote   political stability   through   democratic    means   and peace      This   will not only create   a  conducive investment   climate  but also a reduction  in expenditure   on defense.
8. Infrastructural development. The government should encourage   the development   of social and economic   infrastructures    in form of transport   network,   communication    facilities,   banking   and insurance    services.   This   can   help   to   facilitate    production,     distribution     and   exchange    of commodities   among countries.
9. Divesture. The government should completely   privatize   all its inefficient   parastatals   in order to minimize            corruption    and   embezzlement     of government     funds.   This   will   not   only   reduce government   expenditure but also promote efficiency in production   hence better quality exports.
10. Encourage foreign investors. Foreign   investors   bring   in foreign   exchange   and increase   on capital inflow through their   private   foreign investment   within   the country.   This also increases production   of better quality products   for export purposes.
11. Use of restrictive fiscal and monetary policies. Such policies   can be used to encourage   export production   and to discourage   demand   for imports.  For  example  use  of restrictive   fiscal  policies like   increased   taxation,    reduced    government    expenditure    and   restrictive    monetary    policies should  be  applied  to  reduce   on  aggregate   demand   for  imports   and  to  control   inflation   in  the economy.
12. Import restrictions. Developing countries   should use appropriate   import restrictions   like import quotas and increasing import duties as a way of reducing imports and import expenditure.
13. Seeking foreign aid. Developing countries   should seek for foreign aid in form of donations   and grants   from developed   countries   with surplus resources.   This can help them to finance   their productive   activities hence increasing production   for experts.
14. Promoting tourism. Developing countries   should promote   tourism as a way of earning   foreign exchange.  This is possible if they maintain political stability and security.

Exchange rates

• Exchange rate refers to the value   of the country’s   currency   in terms of other currencies.   For example $1 = UG shs. 3670.
• Hard currency. This refers to the currency which can easily be converted   into other currencies and it is internationally   recognized   and accepted. For example pound, dollar, euro etc.

Types of exchange rates

(a) Fixed (Pegged) exchange rate. This is where the value of the county’s   currency in terms of other currencies   is fixed by the monetary   authority (government)

Merits of (Arguments for) a fixed exchange rate

1. It facilitates international   trade by ensuring certainty of prices of exports and imports.
2. It ensures stability in foreign exchange market.  This creates   confidence    in the value   of the domestic currency.
3. It encourages long-term capital inflows thereby promoting investments   in the economy.
4. It discourages currency speculation in the foreign exchange market. Currency speculation refers to the act of buying and selling foreign currency with    the aim of marking profits.
5. It is possible under the fixed exchange rate to use government policies like devaluation to achieve certain economic objectives. .
6. It is easy to control and regulate by the government (monetary   authority)   unlike other types of exchange rate.
7. It reduces exploitation and cheating of foreign exchange buyers by foreign exchange   dealers (sellers).
8. It facilitates planning since the foreign exchange earnings   can easily be predicted   according   to the fixed exchange rate.
9. It helps to impose discipline on monetary authority to follow responsible financial policies   with in the country.  For example it may stop the government   from perusing   inflationary   policies which may discourage investments   in the country.

Demerits of a fixed exchange rate

1. It is too rigid and therefore, it may not respond to the changes in the economy.
2. It is expensive to maintain since it requires   complicated exchange   rate control   measures    and monitoring   which may lead to resource misallocation.
3. It discourages competition in the foreign exchange market and this leads to inefficiency in the foreign exchange trade.
4. It makes the importation of essential commodities expensive .This results in imported inflation in the economy.  This  is true  if the  exchange  rate  is fixed  above  the  equilibrium   exchange   rate  (over valuation  of the exchange  rate),
5. It leads to the decline in foreign exchange earnings as it discourages exports.  This  is true  in case the  exchange  rate  is fixed  below  the  equilibrium   exchange   rate  (under  valuation   of the  exchange rate).

(b) Flexible (Free/Floating) Exchange rate. This  is where  the  value  of  the  country’s    currency   in terms of other currencies   is determined  by forces  of demand  and supply  of the foreign  currency.

Merits of a free exchange rate (Exchange rate liberalization)

1. The system is automatic. It does not require government involvement   and expenditure   on foreign exchange rate monitoring.
2. It does not require a lot of foreign exchange  reserves  since  it is  determined   by  the  forces  of demand  and supply.
3. It encourages competition in the foreign exchange market thereby promoting   efficiency   in the foreign exchange trade.
4. It helps the country to pursue an independent monetary policy aimed at promoting economic stability.
5. It helps to eliminate the problem of bureaucracy involved in acquiring   foreign   exchange   and this promotes international   trade.
6. It encourages free capital movements among countries and this promotes   foreign   investments within the country.
7. It indicates  the  strength  of  the  domestic  currency  in  terms   of  other   currencies    since   it  is determined   by the forces  of demand  and supply.
8. It reduces the problem associated with over valuing   and under valuing of the   domestic currency.

Demerits of a Flexible exchange rate (Exchange rate liberalization)

1. It creates uncertainties in the foreign exchange market. This discourages trade and investment.
2. It leads fluctuations   in the foreign exchange earnings of the country.  This makes it difficult   for planning and budgeting   by the government.
3. It may lead to inflation since it is not controlled by the government.   This occurs when importers acquire foreign exchange at high rates.
4. It leads to balance of payment deficits in case of increased foreign exchange outflow   for import purposes.
5. It discourages long term contracts between borrowers and lenders which hinders investments and economic development. .
6. It leads to resource misallocation In case the Importers of non-essential    commodities    acquire foreign exchange at lower rates.
7. It encourages heavy speculation in the foreign exchange market.  This leads  to  exploitation   of the foreign  exchange  buyers  as they  acquire  foreign  exchange  at high  rates.

(c) Mixed (Managed float /Dirty float/Adjustable peg) Exchange rate. This is where the exchange rate is controlled   by the government   but it is allowed to fluctuate   between   certain limits.  There exists   the upper   and lower   exchange   rate limits   within   which   buying   and selling   of foreign exchange takes place.

(d) Dual exchange rate system.  This is where   there is co-existence    two parallel   exchange   rates within the country.

(e) Multiple exchange rates. This is where there is existence of more than two exchange rates within the country.  It is common where there is liberalization   in selling and buying of foreign currency.

 

Devaluation

Devaluation refers to the deliberate   government   policy of reducing   the value of its currency   in terms of other currencies.   OR. It refers to the reduction in the value the country’s   currency in terms of other currencies under the fixed exchange rate system.

Example

Before devaluation        $1 = UOX  3600

After devaluation          $1 = UGX  4000

Currency depreciation.  This  refers  to  the  reduction  in the  value  of the  country’s   currency   in terms  of other  currencies   due  to the  forces  of demand  and  supply  of the foreign  currency.   OR. It is the reduction in the value the country’s   currency in terms of other currencies   under the floating exchange rate system.

Currency revaluation.  This refers to the legal increase   in the value of country’s    currency   in terms of other currencies.

Currency appreciation.  This  refers  to increase  in the value  of the  country’s   currency   in terms  of other currencies  due to the forces  of demand  supply  of the foreign  currency.

Reasons for devaluation

1. To increase exports by making them cheaper to the foreigners.
2. To reduce imports by making them expensive to the local people
3. To reduce balance of payment deficits by increasing exports and decreasing   imports.
4. To control inflation by making domestically   produced   goods cheaper   as compared   to imported goods.
5. To encourage domestic investments by encouraging production   for exports.
6. To encourage foreign exchange inflow as a result of increased export earnings.

  Conditions   necessary for devaluation to be successful

2. The demand for exports should be price elastic such that a slight reduction in the export prices leads to a big increase in the quantity of exports.

2. The demand for imports should be price elastic such that after devaluation a small increase in the import prices results into a big reduction in the quantity.

2. The supply of exports should be price elastic. There should not be supply rigidities in the production of exports.
3. The supply of imports must be price inelastic such that an increase in import prices should discourage their importation and the volume of imports must decrease as their demand decreases.
4. The trading partners (competing countries) should not devalue at the same time. That is there should not be retaliation between trading partners if devaluation is to be successful.
5. There should not be trade restrictions on the exports of the country devaluing her currency by other countries.
6. High levels of Inflation should not exist in the country devaluing her currency. This is because inflation discourages exports by making them expensive to the foreigners.
7. There should be a fixed (pegged) exchange rate if devaluation is to be successful, that is the exchange rate should be controlled by the government.

Factors as to why devaluation has not been successful   in developing countries

1. Inelastic demand for their exports.  The elasticity of demand for exports from developing countries is low due to their poor quality and competition with the synthetic substitutes from developed countries
2. Inelastic demand for imports. Most of the imports from developed   countries   are essentials   for example   capital   goods, drugs, petroleum   products   etc.  and this  makes  developing    countries   to continue  importing   despite  the expensive  imports  after devaluation.
3. Inelastic supply of exports from developing countries. This is caused by supply rigidities   like pests and diseases, bad weather and lack of co-operant factors such as inadequate capital. Therefore   the demand for exports has not been fulfilled in the foreign market.
4. Protectionism by developed countries for exports from developing countries. This has limited the market for their exports despite their devaluation   policies.
5. Competitive retaliation by other trading partners in form of counter devaluation. This has made imports from those trading partners cheaper than before hence making devaluation   ineffective.
6. High levels of inflation in developing countries. This makes production cost high and make exports expensive while imports cheaper.
7. High levels of black marketing (smuggling) in developing countries. This has led to continued flooding of the domestic markets by imports hence violating the devaluation  policy.
8. Political instabilities ill developing countries. These have discouraged   production    for exports and for domestic   consumption    leading   to continued   importation   of consumer    commodities    to developing   countries.
9. Existence of multiple exchange rates in developing countries. This has made   it difficult   for governments  of   developing    countries    to control    exchange    rate   for   import   purposes    under devaluation.   This  is because  some  importers   get  foreign  currency  at cheaper  rates  from  different sources  hence  failing  the devaluation  policy.
10. Use of conflicting fiscal policies for example heavy taxation on producers in an attempt to obtain government    revenue   has greatly   discouraged    production    for exports   hence   undermining     the devaluation   policy.

Economic integration (regional integration/co-operation)

Economic  integration  refers  to the corning  together   of different  countries  in carrying   out  economic activities   so as to benefit  from  the  economies   of  scale.  OR. This  is where  a group  of countries  join together  in carrying   out  economic  activities  with  a view  of increasing   social  and  economic   benefits from trade.

 

Examples of Economic integration

1. East African community (EAC)
2. Economic  community   of West African states (ECOWAS)
3. European Economic Union (EEU)

 Conditions   necessary for successful   economic integration

1. Geographical proximity (nearness). Member  countries   should  be geographically    close  to  each other  so  as  to  effect  preferential   treatment   and  to  construct   the  necessary   infrastructure    jointly which  link  all the member  countries.
2. Relatively same level of development. Countries  in the integrated   region should be at the same level of development   to ensure equal distribution   of economic benefits.
3. Common ideology. Member countries should possess the same ideology  which may be political, economic   or social.  That is, they should either be capitalists   or socialists if they are to harmonize their policies.
4. Relatively equal size. Member  countries    should   preferably    be relatively    of   equal   size   and resources   so as to contribute equally to the economic   development   of each member country.
5. Political will and stability. All member  countries   should   have  political   will,  commitment    and peace  so as to implement  what  they have  discussed   and agreed  upon.

Forms (Stages) of economic integration

The stages of economic   integration are classified   according to the level of development   as follows.

1. Preferential Trade Area (PTA). This is the stage where countries reveal the need for integration. They reduce tariffs among themselves on selected commodities.
2. Free Trade Area (FTA). This is the stage  where  member countries   eliminate   all  tariffs  and  other non-tariff barriers among  themselves  but each member  country  maintain   its own tariff  structure   on commodities   from nonmember  countries.
3. Customs Union. This is the stage where member   countries   eliminate   all trade   and non-trade barriers amongst   themselves.   In addition,   they adopt a common   tariff structure   on commodities from nonmember countries.
4. Common Market. This is the stage where member  countries   eliminate   all trade barriers   amongst themselves   and charge a common tariff structure   on commodities   from non-member    countries.   In addition,   they allow free mobility   of factors of production   within   the integrated   region   such as capital and labor.
5. Economic union (Economic community/federation). This is the stage where member  countries eliminate   all  trade  barriers  among  themselves,   charge  a common   tariff  structure   on  commodities from  non-member    countries   and  they  allow’  free  mobility   of  factors   of  production    within   the region.  In addition,   member countries jointly   own  certain  enterprises   like  Banks,  Railways,   roads, Dams  etc.  They   also  adopt  common   economic   policies   and  strategies   and  they  use  a  common currency  for example  the European  economic  community.

Merits (Benefits) of economic integration

1. Market expansion. Economic  integration  provides  a wider  export  market  since  member   countries have  to  import   from  within  the  region.   This encourages   production    and use of idle resources within the member countries.
2. Trade creation effect. Trade creation refers to the movement   of production    activities   and trade from high   cost   nonmember   countries    to  low   cost   member    countries    within  the   economic integration.   This promotes trade within the region.
3. Increase in bargaining power. Economic integration increases  the bargaining   power of member countries   within   the integrated   region.   This is because   they can collectively    bargain   for higher prices for their exports.  This improves on the terms of trade for their exports.
4. It promotes healthy competition among member countries. This form of competition    not only encourages efficiency in resource   use but  also leads to  the  production    of better   quality  products for the regional  market.
5. If promotes economic interdependence   among   member    countries    through   the   exchange    of commodities and factors   inputs.   This promotes    balanced   economic   growth   and development within the region.
6. It facilitates technological transfer. Technology  transfer refers to the movement   of modem   and better   techniques    of production    from   one   country   to another   especially    from   developed    to developing   countries.   Such technology   transfer can be in form of technical   knowledge,   advanced equipment   etc. This promotes production   hence economic   growth.
7. It encourages   industrialization   through   the   establishment    of   common    processing     and manufacturing industries   within the region.  This increases   the production   better quality products for domestic consumption   and export.
8. Joint establishment of expensive and complex projects is possible   under economic   integration by member countries   for example power generation   oil drilling etc.
9. Employment opportunities.   It promotes    the   creation    of   employment     opportunities     due   to increased number   of economic activities and through the process of trade.  This helps to increase on the incomes of individuals hence better standards of living.
10. It promotes political co-operation and stability with in the region. This can  be  in  form   of member  countries  interacting   in trade  and jointly  owning  some  enterprises   which  facilitates   good relationship   among  themselves
11. It reduces the costs of duplicating commodities within the countries. If an industry is established in one country,   there is no need to establish   a similar   industry   in another   country   within   the integrated region.
12. It increases the choice of consumers. This is because a variety of commodities  are produced   and consumed   within the region and this improves the standards of living   of the people in the region.
13. It facilitates trade especially where   countries    adopt   a common    currency.    This   promotes economic   stability in the region.

Demerits of economic integration

1. It encourages trade diversion. Trade diversion refers to the movement  of production    activities and   trade   from   low   cost   nonmember    countries    to high   cost member    countries    within    the integrated region.  This discourages   production   and consumption   within the region.
2. Loss of government revenue. Under   economic   integration,    tariffs   are eliminated   which   would otherwise   contribute   to government   tax revenue in form of import and export duties.
3. Uneven distribution of economic benefits. Within the integrated  region,  some  countries   which  are well  endowed  with  resources  benefit  more  than others  as a result  of the wide  market  created.   This brings about regional imbalances.
4. It undermines the natural sovereignty of member countries. This is because it interferes   with  the political,   social  and  economic   policies   of countries   where  by  individual   countries   may  not  be  ill position  to pursue  independent   policies.
5. It encourages dependency syndrome as member countries  greatly   depend   on other   countries within the region for economic purposes.   This undermines   the countries need to be self-reliant   and independent.
6. It leads to colonial hang over Colonial hangover is a situation where   individuals    within   the integrated   region prefer to consume   commodities   from colonial   masters   (developed   countries)   to those produced   within the region.  This limits the market for the commodities   produced   within the region.
7. It leads to problems in implementing and harmonizing the social economic policies discussed upon by member countries.  This is true especially if countries have different political ideologies.
8. It leads to quick resource exhaustion  as resources   are  over  utilized   to  serve  the  wider   market created  as a result  of economic   integration.
9. Most developing countries   produce   similar commodities   which are agricultural   in nature. Therefore   countries   may  not  benefit   as  they  need  to  trade  with  developed   countries    so  as  to acquire  capital  goods  and other  raw materials  which  are essential  for production.

 

Revision questions

Section A questions

1    (a) Distinguish   between Barter terms of trade and income terms of trade.

(b) Calculate   the barter T.O.T   for the country   if her import   index   is 125 and her export   index   is 85. Comment   on your results.

2    (a) Distinguish   between a trade balance and accommodating item.

(b) Mention two ways of accommodating   the balance under balance of payment.

3    (a) Define the term foreign exchange reserves?

(b)  Give any three uses of foreign exchange reserves in your country.

(c) Mention three ways of increasing   the foreign exchange reserves of the country.

4    (a)  What  is meant  by currency  devaluation?

(b)  Give three circumstances   under which devaluation   may fail to succeed.

5    (a) Distinguish between currency   appreciation   and currency depreciation.

(b)  Given  that the  exchange   rate  of Ugandan   shillings  for  Us dollar  is shs  1800/  =  1 Us  dollar. Calculate the new, exchange   rate when Ugandan shilling depreciated   by 10%.

6    (a) what is the difference between a floating exchange rate and a fixed exchange rate? (b) Give any two merits  of a floating  exchange  rate system

7    (a) Distinguish between a Managed   float exchange rate and dual exchange rate.

(b)  Mention any two objectives   of devaluation.

8    (a) Distinguish between currency   over valuation and currency undervaluation.

(b) State any two effects of currency   depreciation   in your country

9    (a) Distinguish between a Customs   Union and a common market

(b) Give two factors limiting   the establishment    of a customs   Union   among the East African countries

10  (a) Differentiate  between  trade  creation  and Trade  diversion

(b) Mention two demerits of trade diversion in an economy

11  (a) Differentiate   between  preferential   trade area union  and Free Trade  Area

(b)  Mention two conditions   necessary   for the success of economic integration

12  (a)   Distinguish  between  transfer  payments  and transfer  earnings

(b)   Mention any three sources of transfer payments   to your country.

13   Mention four factors that determine   the exchange rate in an economy

14. Distinguish between the following terms.

(a)  Dumping and state trading

(b)  Advolorem   tax and specific tax.

(c)  Import  duty and export  duty.

(d)  Balance of trade and invisible balance  of trade

(e) Visible trade and invisible trade.

(f) Accommodating   items and autonomous   items.

 

Section B questions

1  (a)  Distinguish   between  Barter  terms  of trade and income  terms  of trade

(b) Account for the unfavorable   terms of trade in your country

2  (a) Account  for the persistent   balance  of payment  deficits  in your country

(b) What policy measures are being taken to improve on your country’s   balance of payment   position?

3  (a) Explain  the components   of the balance  of payment  account.

(b) Explain the methods of offsetting   a deficit and a surplus in the balance of payment   account.

4  (a) Explain  the conditions  necessary   for devaluation   to succeed

(b) Explain   why devaluation   may  fail  to achieve  an  improvement    in  balance  of payments    in an economy

5  (a) Define  the term exchange  rate  liberalization.

(b) Explain the merits and demerits   for liberalizing exchange rate.

6  (a) Explain  the stages  of economic   integration.

(b) Examine the factors limiting of economic integration   in developing   countries.

7  (a) Distinguish  between  customs  union  and common  market.

(b) What are the implications   of creating the East African Community   to your country?

8    “Protectionism    rather   than   free   trade   should   be adopted    if the   country   is to benefit    from international   trade”.  Discuss.

9  (a)   To what  extent  is inflation  the cause  of balance  of payment  problems   in your country.

(b)   Explain why your country has failed to reduce balance of payment problems.

 

 

Dr. Bbosa Science            +256 778 633682