Balance of Trade and Payment and Cost Theory of International Trade

Concept of Balance of Trade (BOT)

The difference between a value of export and imports of a country in a fiscal year is known as Balance of Trade. It is also known as “trade balance” or “international trade balance.” It is the largest component of the country’s Balance of Payment. The balance of trade includes only visible trade which is known as the value of exports and imports registered during the specific time period at the customs office. If the money value of export is greater than the money value of import, then it is said to be a favorable balance of trade. And if the money value of import is greater than the money value of export, then it is said to be an unfavorable balance of trade.

Symbolically it can be expressed as:

M = X → Balanced balance of trade

M > X → Deficit or unfavorable balance of trade

M < X → Surplus or favorable balance of trade

Where,

M = value of imported visible goods

X = value of exported visible goods

Concept of Balance of Payment (BoP)

A systematic accounting system of a country which records all its economic transactions along with other countries of the rest of the world in a given time period is known as Balance of payments. Generally, a time period is one year. The balance of payment records monetary value of the transactions like country’s exports and imports of goods, service, financial capital and financial transfers. It refers to total inflow and outflow of financial transaction made by a country with foreign sectors. Besides, import and export, a country is making various transactions with the foreign sectors on a daily basis. The balance of payment is double entry accounting system that includes debit and credit. All the expenses (outflow) made by the country in one year are considered under debit while all the income (inflow) received by country is kept under the credit. If the total outflow is more than total inflow then it is called BOP deficits or unfavorable (negative) balance of payment. Similarly, if the inflow is more than outflow it is called BOP surplus or favorable (positive) balance of payment.

It includes the following headings:

1. Current Account: It includes visible trade (export and import), trade in service, income and transfer and remittance. If export is greater than import then it is a surplus in a current account. Similarly, if an import is greater than export then it is a deficit in current account. The visible trade involves selling & buying of goods with foreign parties. Trade in service involves cargo, business, airline services, education fees etc. Income involves all the divided receipt from investment by the domestic people in production plants of foreign countries. The transfer involves aid and grants, gifts, awards etc.
   
   
2. Capital Account: It involves the inflow and outflow of investment in purchasing real assets or production plants. It is made up of capital transactions like borrowing and lending of the capital, repayment of the capital, sale and purchase of the securities etc. If the capital account is positive, assets of the country decrease similarly if capital account is negative, assets of the country increases.
   
   
3. Financial Account: It includes the investment made in purchasing bonds of a foreign government or foreign companies. It also involves the government’s reserve with International Monetary Fund. It also involves the total amount of foreign currencies held by the government.(Khanal, Khatiwada, and Thapa)

Comparative Cost Theory of International Trade

The comparative cost theory of international trade was developed by a classical economist David Ricardo in 1817. Comparative cost theory of international trade is based on the cost of different production of similar commodities in the different nation due to the geographical division of labor and specialization in production. Due to the different climate and geographical conditions country can produce particular commodity at a lower cost than the other countries.

(Comparative cost theory of international trade)

According to this theory, the international trade between two countries is possible only if each of them has absolute or comparative cost advantage in the production of at least one commodity.

Assumption of the Theory

• There are only two countries and two commodities
• There is no governmental intervention in export and import
• Labors are the factor of production.
• There is perfect mobility of labor within the country but not between the countries
• There is free trade that means no cost of transportation between the countries
• The law of constant returns to scale operates in production.
• The units of labor are homogeneous
• The units of each commodity in both countries are homogeneous

Criticism of the Theory

• This theory is not applicable if there are more than two countries or more than two commodities
• In every country, there is more or less government intervention in international trade
• There is cost of transportation from one country to another country
• The units of labor are not homogeneous and the workers are paid more or less in different countries
• There may be increasing or decreasing returns to scale
• Labor is not perfectly mobile within the country too. In the modern era, there is mobility of labor from one country to another
• The commodities produced in the different countries differ in quality, taste, size, quantity etc.

(Comparative cost theory: assumption and criticism)

Bibliography

Khanal, Dr. Rajesh Keshar, et al. Economics II. Kathmandu: Januka Publication Pvt. Ltd., 2013.

Comparative cost theory of international trade. 08 July 2016 <http://notes.tyrocity.com/comparative-cost-theory-of-international-trade/>.

Comparative cost theory: assumption and criticism. 08 July 2016 <http://www.yourarticlelibrary.com/economics/comparative-costs-theory-assumptions-and-criticisms-economics/11069/>.