Adam Smith's theory of absolute advantage states that countries should specialize in producing goods they are relatively efficient at, and trade for goods they are less efficient at. India has an absolute advantage in rice production, while Bangladesh has an absolute advantage in jute production. Both countries would benefit from specializing - India in rice and Bangladesh in jute, and trading the surplus. Even if one country has an absolute advantage in all goods, as long as countries have comparative advantage in different goods, trade is mutually beneficial. The balance of payments accounts for a country's total economic transactions with the rest of the world and must always balance, with credits equaling debits. It provides important information for analyzing a country's international trade and identifying strengths

1. Gains from Trade

2. Adam Smiths
Theory of Absolute Advantage

Country should specialize in the production of commodities
which it can produce most efficiently – Lower Cost of Production.

A country tends to specialize in production of commodities in which
it has Absolute Advantage
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
20

3. Adam Smiths
Theory of Absolute Advantage

Would should country’s be doing?

India



India should specialise in Rice production.
As India has to sacrifice 2 Qtl of Rice for 1 Qtl of Jute.
It can import jute from Bangladesh
1Qtl of Rice = 1.5 Qtl of Jute (30/20)
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
20

4. Adam Smiths
Theory of Absolute Advantage

Would should country’s be doing?
Bangladesh
 Should specialise in Jute
 Import Rice from India
 As in domestic trade they get 0.4 Qtl of Rice (20/50) for Jute
 If they trade they get 0.67 Qtl of Rice (20/30) for 1 Qtl of jute
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
20

5. Ricardo's Insight

What if one country has absolute advantage in both the
commodities?

Is trade possible?

As long as countries have comparative advantage in the production
of both the commodities specialisation and trade would always be
possible.
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
80

6. 
India
It can produce both the goods efficiently.
It has comparative advantage in rice production.
It can produce Rice at 60% (30/50) cost then Bangladesh.
It has comparative disadvantage in jute because cost of jute
production is twice the cost of rice production.

Bangladesh
It has comparative advantage in jute production
Relative cost of jute production ( 80/50 = 1.6 Qtl of rice) is
less than India’s(60/30= 2Qtl of rice).
Country
Rice
Jute
India
30
60
Bangladesh
50
80

7. Gains from Foreign Trade
Internal Exchange Rate (Quintal)
Bangladesh
India
Rice
Jute
Rice
Jute
1
0.5
1
0.625
50/80
30/60
2
1
1.6
1

8. Who Gains from Trade?
Who Gains India or Bangladesh?




It depends upon the determination of commodity exchange rate
between two countries.
India’s exchange rate ranges between 500Kg to 625 kg of Jute
for 1 Qtl of Rice.
Bangladesh it ranges between 1.6 to 2 Qtl of Rice for 1 Qtl of
Jute.
If Exchange rate in foreign trade are same as internal rates then
both the country gain.

9. Heckscher-Ohlin Theory of Trade

The comparative advantage in the cost of production is due to the
difference s in the factor endowment of the nations.

It refers to the overall availability of usable resources in the country.
A country tends to specialise in the export of a commodity whose
production requires intensive use of its abundant resources and
imports a commodity whose production requires intensive use of its
scarce resources.

10. Balance Of Payments

11. Definition
“It is a systematic record of a country’s economic and financial
transactions with the rest of the world, over a period of time”.

Transaction of goods and services and income between an
economy and the rest of the world.

It standard double- entry book – keeping.
Credit = Debit

The BOP must always balance.

The time period is one year – financial or calendar.

12. Purpose

It provide data for the Economic analysis of the country’s as the
partner in International trade.

It reveals the changes in composition and magnitude of
foreign trade.

It predicts future performances on past trade performances.

It also revels the weak and strong points in the country’s foreign
trade and thereby Govt intervention for corrective measures.

13. Balance of Trade vs BOP

Balance of Trade :
It refers to the difference in value of Imports and Exports
i.e “ Visible Items”



Favourable Balance of Trade :
Unfavourable Balance of Trade:
X>M
X< M
Balance of Payments:
Includes both Visible and Invisibles items
( Such as Services by shipping, banking and insurance,
interest payment, dividend, expenditure of tourist, foreign
investment, external lending and borrowing, NRI deposits etc)

14. Components of BOP
BOP
Current A/C
Capital A/C
Merchandise /
Visible
Short Term
Capital Movement
Invisible
Export / Import
Long Term
Capital Movement
Unilateral Transfers
Changes in Gold and
Exchange Reserves

15. Current Account
It includes all transactions which give rise to or use up National Income.
Credit : Value which are receivable
Debit: Value which are payable.
a) Merchandise / Visible Exports and Imports
 Merchandise Exports : Sales of Good abroad
 Merchandise Imports: Purchase of Goods from aboard
b) Invisible Items
 Invisible Exports: Sales of Services
 Invisible Imports: Purchase of Services
c) Unilateral Payments

Gifts, Private remittances, grants , disaster relief

16. Capital Account
Which increase or decrease country’s total stock of capital.
a) Short Term Capital Movement

Purchase of short term securities

Speculative Purchase of Foreign Currency

Cash balances held by foreigners

Net balance ( + /- ) of current account
b) Long Term Capital Movement

Direct Investments in Shares, bonds and in real estate and physically
assets which investors hold a controlling power.

Portfolio investments in stocks and bonds

Repurchase and resale of securities

Direct export and import of capital goods
c) Gold and Foreign Exchange reserves
They are maintained to stabilize the exchange rate of the home
currency and to make payments to the creditors in case of deficit.

17. Components of BOP
Current Account Balance
Credit (Receipts)
Debit (Payments)
Export of Goods
Import of Goods
Export of Services
Import of Services
Interest profits and Dividend Received
Interest profits and Dividend paid
Unilateral Receipt
(Gifts, grants, disaster relief)
Unilateral Payments

18. Components of BOP
Capital Account Balance
Credit (Receipts)
Debit (Payments)
Foreign Investment – Direct, Portfolio
Investment Aboard – Direct, Portfolio
Short Term Borrowings
Short Term Lending
Long Term Borrowings
Long Term Lending
Foreign Exchange Reserves (+)
Foreign Exchange Reserves (-)

19. BOP are always Balance

BOP is based on double – entry book keeping in which both sides of a
transactions, receipt and payment are recorded.

Export:
Outflow of goods / Inflow of foreign currency

Import:
Inflow of Goods / Outflow of foreign currency
Both outflow and inflow are recorded in BOP A/C

20. Indias BOP

21. Capital A/C

22. India’s BOP

23. Bop Disequilibrium
BOP Equilibrium :
Total Receipt = Total Payment
Demand for foreign Exchange = Supply
BOP Disequilibrium :
Demand > Supply :
Demand < Supply :
Deficit
Surplus
Deficit in Current A/C is offset by Surplus in Capital A/C
Surplus in Current A/C is offset by a deficit in capital A/C
( By loans / borrowings or depleting its gold /foreign exchange reserves)

24. Causes and Kinds BOP Disequilibrium
1)Economic Factors
a) Price Change

Change in Price level causes BOP disequilibrium.

The change in price level may be inflationary or deflationary.

Inflation makes import cheaper and export costlier.

Increase in imports as domestic prices become higher than import
prices

Decrease in exports as domestic price rises.

Deficit in BOP
b) Development Disequilibrium

Large scale development expenditure increase the purchasing
power

Increases demand and prices

Increases in large imports.
Its common in developing countries as large scale import of
capital goods.

25. Causes and Kinds BOP
Disequilibrium
c) Cyclical Disequilibrium
Business cycle fluctuations causes disequilibrium.
The country’s which are dependent upon Imports faces
large deficit during inflation
Moderate deficit or surplus during depression.



d) Structural Disequilibrium




Depletion of Natural Resources
Changes in Technology
Alternative source of Supply
Development of better substitute

26. Causes and Kinds BOP
Disequilibrium
2)
Political Factors


3)
Political Instability may experience large capital outflow and
inadequacy of domestic investment and production.
War and changes in trade route can also cause disequilibrium.
Other Factors

Disturbances or crop failure

Rapid growth in population leads to large scale imports of
foodgrains.

Changes in taste preferences and fashion causes change in
export and import.

27. Correction of Disequilibrium
Correction
Of BOP
Automatic Measures
Deliberate Measures
Monetary
Measure
Trade Measure
Miscellaneous

28. Correction of Disequilibrium
A) Automatic Measures



BOP disequilibrium may be automatically corrected
If the market forces of demand and supply are allowed to have a free
play, in course of time equilibrium would be restored.
For ex
 If there is deficit in BOP
 Demand for Foreign exchange exceeds its supply
 This result in increase in exchange rate
 Fall in value of domestic currency
 Exports cheaper and import costlier
 Increase in Exports and fall in imports
 Equilibrium in BOP

29. Correction of Disequilibrium
1) Monetary measures
a) Monetary Contraction / Deflation

Contraction or Expansion of money supply
For Example:
 Deficit in BOP
 Contract the Money Supply
 Reduces purchasing power
 Decrease the demand
 Reduces domestic prices
 Decrease in imports and increase in exports

30. Correction of Disequilibrium
b) Devaluation
Reduction of the official rate at which the currency is exchanged for
another currency
 Devaluation is done to improve its BOP
 Export prices fall, Export increases
 Import prices goes up, import reduces
 Deficit of BOP reduces

Condition for the successful working of Devaluation





Elastic demand for imports and exports
Structure of Imports and Exports
Domestic Price stability ( Should not lead to Price rise)
International co-operation
Hike in import duties, reduction in export duties, export license, export
promotion programme

31. Correction of Disequilibrium
c) Exchange Control



Central Govt has complete control over foreign exchange
reserves.
Exporters surrender foreign exchange in exchange of
domestic currency.
Govt release foreign exchange only for essential imports.
Its not a permanent solution to long – run disequilibrium because it
suppresses demand for Imports and not cure Deficit.

32. Correction of Disequilibrium
2) Trade Measures
Export promotion measures and import substitutions
a) Export Promotion:
Reducing Export duties
Export subsidy
Export incentives and facilities.
b) Import Control:
Increasing Import duties
Import quotas
Import license and prohibition.

33. Correction of Disequilibrium
3) Miscellaneous Measures
Obtaining foreign loans
Development of tourism
Incentives to enhance inward remittances
Encouraging foreign investment.

35. 20
20
20
20
20
05
04
03
02
01
-0
6
-0
5
-0
4
-0
3
-0
2
-0
1
00
-9
9
-2
0
00
99
98
-9
8
-9
7
-9
6
Imports
20
19
19
97
96
95
-9
5
-9
4
-9
3
-9
2
Exports
19
19
19
94
93
92
91
600000
19
19
19
19
Post 1991 Trade Trends
700000
F Invest
500000
400000
300000
200000
100000
0

36. Movement in Foreign Exchange
Reserve