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Topics in International
UNIT 20 TOPICS IN INTERNATIONAL Economics

ECONOMICS
Structure
20.0 Objectives
20.1 Introduction
20.2 Comparative Advantage as a Basis for Trade
20.2.1 Comparative Cost Advantages– Why Trade Takes Place?
20.2.2 Ricardo’s Comparative Cost Theory
20.3 Terms of Trade
20.3.1 Theory of Reciprocal Demand and Terms of Trade
20.3.2 Types of Terms of Trade
20.4 The Gains from Trade
20.4.1 Factors Determining Gains from Trade
20.5 The Balance of Payments
20.5.1 Structure of Balance of Payments
20.6 Let Us Sum UP
20.7 Key Words
20.8 Some Useful Books
20.9 Hints/Answers to Check Your Progress Exercises
20.1 OBJECTIVES
After going through this unit, you will be able to:
l differentiate between absolute advantage and comparative advantage;

l explain how international trade takes place on the basis of comparative advantage;
l discuss the Ricardian model of international trade;
l describe the gains from trade;
l define the various measures of terms-of-trade; and
l explain and analyse the balance of payments.
20.1 INTRODUCTION
In this unit we will discuss the nature of international trade and the reasons why
countries trade with each other. To begin with, we will examine whether there is
any difference between internal and international trade. This will be followed by
two questions: why trade takes place and how it does so.
Two theories will help us explain the gains from trade. This will be followed by
the concept and structure of balance of payments along with the meaning of
deficit/surplus in a country’s balance of payments.
In this unit our attempt is to make a very simple presentation of issues related to
international trade. We have steered clear of tedious and ‘difficult’ derivatives
while bringing the essence of concepts to you.
20.2 COMPARATIVE ADVANTAGE AS BASIS FOR

TRADE
Our wants are unlimited and resources are limited. We cannot satisfy all our
wants. As the resources are also limited, we try to make the best use of them both 5
Introduction to International in consumption and production. One may be capable of undertaking many economic
Trade and Public Economics activities or able to produce a number of goods. But his efficiency or productivity
will not be the same to produce all the goods. He may be relatively efficient for
some goods less efficient or inefficient for some other goods. The same is true for
all individuals. In view of this, persons choose their own lines of economic activities
in which they are more efficient than others. This division of economic activities
is also called division of labour. What is true for individuals is true for regions or
nation.
Trade, whether within a country or between countries is an act of exchange. We

exchange one thing for another. Like individuals, countries also normally do not
produce each and everything. Only under restrictive assumption of a closed economy,
where we do not have external trade and economic relations, almost all the
commodities are produced within a country and exchange or barter takes place
within the country.
Needless to say that in the closed economic scenario, we presume above, it will
result neither in maximization of production nor optimum use of factors of production.
In fact closed or isolated economies are unthinkable these days. Rapid changes in
transport and communication have changed the meaning of place and time.
Transportation has become so quick that one can take his breakfast in India and
lunch in France/Germany and evening tea somewhere else. Earlier it took many
days to cover few hundred miles.
In international trade we have two important questions: Why does trade take
place? And how does trade take place? We will answer these one by one.
20.2.1 Comparative Cost Advantages - Why Trade Takes Place ?
An important question is why people trade? The answer is very simple. It is

human nature to exchange one thing for another. People exchange things not for
the sake of exchange but for the simple reason that they cannot produce everything
efficiently and at a lower cost. Similarly, a country, which has, for example, mineral
resources only and limited cultivable land, is bound to import agricultural commodities.
Thus, we find that like individuals, countries also differ in factor endowments. As
a result, some countries can produce other commodities more efficiently at a lower
cost. There is a possibility that a country can produce most of the commodities at
a lower cost as compared to many others. But the level of efficiency will not be
the same for all goods. In some commodities, that country may be the best, in some
it may be better and still in some others it may be just good. The efficiency is not
equal in all lines of production. It is of different degrees. As it will not be possible
for that country to produce all commodities because of the limitations of resources
and also of time factor, production of these commodities where its superiority is
most marked will be undertaken. We can, therefore, conclude that trade takes
place because of relative differences in costs, which result from differences in
factor endowments.
Let us take an example. We take two countries and assume that they produce only
two commodities. [ The number of countries and commodities can be more, but
specialization in production will be on the basis of efficiency, that is, relative costs
of production]. Let A and B be two countries and both of them produce commodities
X and Y. We also assume that with certain amount of labour and capital different
units of X and Y are produced. Let the following table show quantities of X and
Y that can be produced in their countries with given amounts of capital and labour.
6
Country Commodity Economics
X Y
A 20 10
B 10 20
Country A can produce 20 units of X and 10 units of Y. Country B, on the other

hand, with the same amount of labour and capital can produce 10 units of X and
20 units of Y. In this example A is most efficient in the production of X and B
is most efficient in the production of Y. The cost ratio of X and Y in A is 1:2
and B country it is 2:1. Obviously, under these circumstances, country A will gain
by producing X only and country B will gain by producing Y commodity only.
Country A has absolute advantage in X and country B has absolute advantage in
Y. It is called the theory of absolute advantage and was propounded by Adam
Smith who assumed labour to be the only factor of production. He thought that
these absolute differences in advantage are the basis of international trade.
The basis of absolute cost advantage theory is that cost ratios of commodities differ
in different countries, but, it has assumed that each country is absolutely superior
in one line of economic activity. This appears unrealistic. Because in a group of
countries, a country can be relatively more or less efficient. It is not normal to find
a country absolutely superior. Superiority is always relative. Therefore, it is more
practical to consider relative or comparative differences in cost. David Ricardo
gave his explanation on the basis of comparative differences in the cost of production.
It is, therefore, known as comparative cost theory of international trade. Before
considering comparative differences in cost, let us take one example where costs
are different. Again we assume, A and B, two countries producing X and Y
commodities such that
Country Commodity
X Y
A 20 10
B 10 20
In this example country A has advantage in both the commodities as 20 unit of X

and 10 unit of Y can be produced with a certain amount of labour and capital.
While country B, with the same amount of factors, can produce 10 units of X and
5 units of Y. Obviously country A is superior and more efficient in both X and Y
commodities and country B is less efficient in both commodities. Let us now
consider the ratios of commodities in both the countries. In country A, the ratio
of X and Y is 2:1 and in country B also the ratio of X and Y is 2:1. Under such
circumstances trade may not take place as both the countries have an equal cost
ratio. In country A two units of X will exchange for one unit of Y and in country
B also two units of X will exchange for one unit of Y. Although country A is
absolutely superior in both the commodities and country B is absolutely inferior in
both X and Y trade will not take place as no country will gain because the cost
-ratios are similar or identical in both the countries. Here, we find that despite
‘advantage’ there will be no trade. However, specialization and trade can be mutually
beneficial even for such economies if there exists substantial economies of scale
in both the industries. Yet, it is not possible to pinpoint which commodity a country
must specialize in. 7
Introduction to International
Trade and Public Economics 20.2.2 Ricardo’s Comparative Cost Theory
Let us take an example to explain Ricardo’s comparative cost theory. As usual we
have two countries and two commodities and the amount of labour needed (in
hours) to produce one unit each of X and Y as given below:
Country Hours required for Commodity

X Y
A 120 100
B 80 90
From the above example, it is clear that country A is able to produce 1 unit of X
with 120 hours of labour while it can produce 1 unit of Y with 100 hours of labour.
Thus, X is more expensive than Y. One unit of X will cost 120/100 units of Y. In
country B, it takes 80 hours of labour to produce 1 unit of X and 90 hours of labour
to produce 1 units of Y. Notice that country B has absolute advantage in both lines
of production because it takes less labour in B than A to produce both X and Y.
However, within B, Y is more expensive per unit than X. One unit of X costs 80/
90 or 0.89 units of Y. Although country B has absolute advantage in both lines
of production, each country has a comparative advantage in different goods. A
has a comparative advantage in producing that good whose opportunity cost is
lower in this country than in the other country. The opportunity cost of 1 unit of
X for Y in country A is 120/100 = 12/10 while in country B it is 80/90 or 8/9.
Thus, the opportunity cost of X for Y is lower in B than A. On the other hand,
the opportunity cost of 1 unit of Y for X in country A is 100/120 = 10/12, while
in country B it is 90/80 or 9/8. So opportunity of Y for X is lower in A than in
B. Thus, B has a comparative advantage in producing X while A has a comparative
advantage in producing Y.
We saw above that in country A, one unit of X traded for 120/100 or 1.2 units of
Y, while in B, one unit of X traded for 80/90, or 0.89 units of Y. If country A could
import one unit of X for less than 1.2 units of Y, and if country B could import more
than 0.89 units of Y for 1 unit of X, both countries would gain from international
trade.
Ricardo did not discuss about the point where the actual rate will be determined.
He only explained why trade takes place. The actual rate will be determined by
the mutual demand of A and B countries. This was explained by J.S. Mill who
propounded the theory of Reciprocal Demand. In fact, the other question, how
trade takes place was explained by J.S. Mill. Both the theories together constitute
the Classical Theory of International Trade.
Before we proceed further, it will be necessary to discuss Ricardo’s assumptions

regarding comparative cost theory. You may note that assumptions are a necessary
part of theory. They simply facilitate our analysis and formulation of the theory.
But if assumptions interfere with the conclusions then we have to critically examine
the nature of the assumptions. Ricardo’s assumptions, for the sake of convenience,
can be put into two categories. The first category will consist of facilitating
assumptions. In this category we put the following: (1) Two countries, (2) Two
8 commodities, (3) Labour cost and not money cost, (4) No transport costs, (5) Free
trade, (6) Gold standard, (7) Perfect Competition in the production of the goods. Economics
The assumption of two countries and two commodities is just to facilitate the
analysis. We can increase the number of countries and commodities. Trade will
take place only on the basis of comparative cost. We are giving below three
countries and three commodities case :
Countries Commodities
X Y Z
A 10 11 12
B 9 11 10
C 11 10 9
Figures in table show number of units of respective commodities that a given

amount of labour can produce. Now in this case also the trade will place only on
the basis of comparative advantage or disadvantage. Country A is most efficient
in Z commodity, country C is most efficient in X commodity and country A and B
are equally efficient in the production of Y commodity. The basis of trade will
remain the same irrespective of the number of countries and commodities.
Next, the labour cost can be converted into money costs. We can express the
costs of products in terms of the currency of the participating countries. Instead
of giving cost in terms of units of commodities with fixed amount of labour, we can
give unit cost in terms of money. The country which can produce larger units of
a commodity with the given amount of labour will have lower prices (the lower cost
in money terms) as compared to a country which is producing lesser number of
units with the same amount of labour. The fact is that it will not invalidate the
theory. Even if we consider money cost the terms of trade will remain the same.
The same logic applies to transport cost. Transport costs will change the cost ratios
(as we will have to add the cost of transport to money cost). Trade according to
Ricardo’s theory of comparative cost will take place on the basis of comparative
or relative difference in cost.
If we drop the assumption of gold standard, it will not change the basis of trade.
Even under paper currency, the trade will take place on the basis of cost differences.
Assumption of free trade is necessary. If countries adopt restrictive trade practices

like tariff and quotas, then the normal pattern of trade is disrupted. There will
be distortion. It will not be a normal situation.
Ricardo’s labour cost approach has been severely criticised by many economists,
particularly, Ohlin. Ohlin in his ‘Interregional and International Trade’ in Appendix
has given his criticism of the comparative cost theory. His argument is that labour
cost approach is not the correct tool to find the cost of a commodity. Nobody can
dispute this. Because these days labour cost can vary roughly from 30% to 60%
depending upon the nature of the commodity. Capital is equally important. Once
we accept the importance of capital, rate of interest assumes importance.
If capital accounts for a larger share in the cost, then even rate of interest can also
bring about a change in the cost of production, the comparative advantage will be
affected. These days technology has also assumed much importance. The fact
is that labour cost is not the correct index of measuring cost of production. Labour
cost alone cannot determine cost. Further, labour is not homogeneous. There are
different types of labour like unskilled, skilled, trained and technical. All these
have different wages or rates of remuneration. It will be difficult to find comparative 9
Introduction to International costs even if we accept labour costs.
Trade and Public Economics
The second category of Ricardo’s assumption include,
1) both the countries are almost of same size,

2) their patterns of consumption are also similar,
3) that there will be complete specialization’s.
These assumptions are really very restrictive in nature. Perhaps his overriding
concern with complete specialization must have been responsible for incorporation
of the other two. But overall implications of these three will be that trade may
not be possible if two trading partners were vastly different in geographical sizes
and had different pattern of consumption.
Heckscher-Ohlin Approach : Heckscher and Ohlin tried to analyses the question

of why do different nations trade in a different manner. They tried to bring in
factors other than labour explicitly into the trade model. They further tried to relate
specialization to the factor endowments of the countries explicitly. These models
also admit possibility of less than complete specialization. Thus, several of the
shortcomings of Ricardo’s formulations can be addressed under Heckscher-Ohlin
framework. Take, for example, considerations such as: (1) trade is not determined
by labour cost differentials alone, (2) the endowments of different resources
processed by the trading countries determine the direction of spcecialisation, (3) the
countries need not be of the same size, (4) they need not have similar patterns
consumption either and finally, (5) trade need not lead to full specialization.
The assumtions of their model is that different countries have different endowments.
Each country, even when faced with same kind technology as opened to other,
picks up those technique of production which uses the factors available to it in
relative abundance more intensively. The factor abundence must be reflected in
relative factor prices in the society. Thus, a labour abundant society uses relatively
labour-intensive technology and a capital abundant economy uses capital intensive
technology. Not only that, the ones with more labour will have a relative advantage
in expansions of labour intensive industry. Similarly the capital rich country finds
it easier to expand its capital intensive industry. This way, factor abundence as
reflected in relative factor prices, determines the direction of specialisation.
These things, we must admit, were not considered by Ricardo. Does it mean that
Ricardo’s comparative cost theory is wrong? No. It only means that Ricardo’s
theory was not comprehensive and also sophisticated. But ‘why trade takes place’
can only be explained by relative abundance or scarcity, resulting in comparative
costs differences. Ricardo’s measuring unit of cost was not correct. In fact, at
the time, when Ricardo propounded his theory, labour cost approach was generally
rather universally accepted. In fact it was the only measuring unit. Ricardo was
justified in using the existing tool. Tools of analysis have changed and therefore
refined version or a super structure can be created on the foundations laid down
by Ricardo using new tools of analysis.
Check Your Progress 1
1) Is internal trade basically different from international trade? (Explain in one

sentence)
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10
2) What is absolute difference in cost ? (Give example and explain) Topics in International
Economics
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3) Will there be trade with equal differences in cost ?
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4) Explain the advantages of comparative cost principle.
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5) Discuss one important shortcoming of comparative cost principle.
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6) Analyse the effects of differences in endowments and specialization.
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20.3 TERMS OF TRADE

We have so far answered only one question, why trade takes place. The other
aspect of the problem of trade is, how trade takes place, which is unanswered.
It will depend upon how much of one country’s commodity the other participating
country is willing to accept against a certain amount of his own commodity. The
fact is that we must know the terms of both the participating countries at which
they are willing to exchange their commodities.
The determination of terms of trade is also an important problem. The comparative

cost differences provide the limits within which terms of trade can be determined.
The actual point is the outcome of the effectiveness of the demand of both the
countries. J.S. Mill’s theory of reciprocal demand explains the determination of
terms of trade between two countries.
20.3.1 Theory of Reciprocal Demand and Terms of Trade

J.S.Mill’s theory of reciprocal demand explains how trade takes place. The problem
is very simple. A comparative difference in cost-ratios sets the limits within which
participating countries can import and export goods and commodities. How the
terms of trade are determined between two countries? One may like to know how
much, say, one country will export and how much it will import. The Ricardian
theory does not answer this.
Determination of terms of trade was discussed by J.S. Mill. Because unless we

determine terms we cannot explain how many units of goods and commodities will
be imported/exported. This important aspect of trade was discusses by J.S. Mill
on the foundations laid down by David Ricardo. Given the difference in cost, the
demand in both the countries will determine terms of trade i.e., how much of a
commodity one country is willing to purchase in exchange for a certain amount of
other country’s commodity. It is, therefore, the demand for each other’s goods or
the reciprocal demand, which will determine the terms of trade between the
participating countries. J.S. Mill, on the basis of the cost ratios (that is, accepting 11
Introduction to International the differences in comparative cost as the cause for trade as suggested by Ricado)
Trade and Public Economics explained the determination of terms of trade.
Let us again take two countries, A and B, producing two commodities X and Y.
Country Commodity
X Y
A 120 100
B 90 80
Again to repeat, with the given amount of factors, a country can produce, 120 units
of X or 100 units of Y. Similarly country B can produce 90 units of X or 80 units
of Y. It may be pointed out that although country B in isolation is better equipped
in the production of X as compared to Y but as compared to country A, it is
inferior in the production of both commodities. According to the comparative cost
theory, country A will specialize in the production of X and country B in the
production of Y commodity.
Let us consider the cost ratios of both the countries as given above. In country
A the ratio of X and Y is 12/10. It means 12 units of X will exchange 10 units
of Y, or vice versa. In country B it is 9:8, that is, 9 units of X can be exchanged
for 8 units of Y, or vice-versa. As indicated above, country A will be happy to get
10 units of Y by exporting anything less than 12 units of X. Similarly country B
will be happy to get more than 9 units of X by exporting 8 units of Y. In between
these extremes the terms of trade will be determined as there is gain to both the
countries.
A is willing to give 120 units of X for 100 units of Y. B is willing to accept 90 units
of X for 80 units of Y or 112.5 units of X for 100 units of Y. Thus, if they agree to
a rate between 112.5 to 120 units of X for 100 units of Y, both will be better off.
If the rate of exchange so determined is equal to A country’s internal ratio, it will

not be willing to trade. So there will be no trade. If the rate is closer to rate of
transformation in country A, most of benefits from trade accrues to B.
The concept of reciprocal demand is also criticized by a number of economists.

Reciprocal demand considers only the demand of both the countries. But demand
alone cannot help us in determining the terms of trade. The supply side, that is,
the cost aspect is also important. In fact, there are two sets of demand and two
sets of supply. Marshalls analysis overcomes this limitation. Marshall uses the
concept of offer curves for analyzing the reciprocal demand. The offer curves of
a country tells us, how much of a commodity one country is willing to exchange
for another commodity. The point at which offer curves of respective countries
cut each other will be the equilibrium point and terms of trade will be determined
at that point.
20.3.2 Types of Terms of Trade

Before we discuss gains from trade, it will be better to have some idea about
different types of terms of trade. In general, the terms of trade refers to a rate
at which goods or commodities are exchanged between two countries. If for
example, 5 units of X of country A can be exchanged by 10 units of Y of country
B then the terms of trade will be 5X: 10Y or X:2Y. It means that terms of trade
12 can also determine gains from trade. For example, if the price of export commodities
increases and the price of import commodities decreases or even remains constant, Topics in International
then this country will relatively gain more form the other participating country. It Economics
can buy more goods by exporting less goods. The opposite will happen if import
price rises and export price either remains constant or declines. In view of this,
it is desirable to discuss types of terms of trade.
1) Commodity Terms of Trade
It is also called net barter terms of trade. As the term indicates, terms of trade
are determined on the basis of exchange of commodities. When commodities
exchange between two countries, it is actually barter. It is a ratio between the
export and import prices of a country. In simple terms commodity of trade at a
point of time is equal to
Px
Tc =
Pm
(where Tc is commodity terms of trade, P is price and X and M refer to exports

and imports, respectively). When we consider a period of time, then the changes
in commodity terms of trade can be explained. We can write O for the base year
and I for next period. If we want to find out the change in period I as compared
to the base year, then it can be put as follows:
TC1 = (PX1 PXO)/PMO.
2) Gross Barter Terms of Trade
Gross barter terms of trade as the term indicates is a modifies version of commodity
terms of trade. It takes into account total exports and imports of a country instead
of a particular commodity export and import. The gross barter terns of trade at
a point of time will indicate the relation of ratio between total quantity of imports
and total quantity of exports. In the form of a formula we can put it as follows :
Tg = QM/QX
Where, Qm = total quantity of imports, Qx = total quantity of exports.
If this ratios is higher then it is favorable to the country concerned and if the ratio
is lower then it is unfavorable to the country. Like commodity terms of trade, we
can consider gross barter terms of trade over a period of time. We can compare
between two points of time. As above, the base period will be indicated by O and
the next following period by 1. The formula can be modified a little :
Base Year : TG0 = QMO/QMO
Current Year : TG1 = QM1/QX1
3) Income Terms of Trade
G.S. Dorrance has formulated the concept of income terms of trade. It is an

improvement over commodity or gross barter terms of trade. In this concept of
terms of trade, we take into account index of export prices along with export
quantity and in case of import we consider only index of import prices. As the
import and export prices are determined by total imports and exports, it can rightly
be considered as a modified or improved version of gross barter terms of trade.
13
Introduction to International Income terms of trade establish a ratio between index of export prices and export
Trade and Public Economics quantity on the one hand and index of import prices on the other hand. To put it
into a formula
⎛P ⎞
Ty = ⎜ x ⎟ Q m
⎝ Pm ⎠
Here Ty is the income terms of trade (it may be pointed out that in economic
analysis normally Y and not I is written for income. Therefore Y has been
written). Ty measures country’s export based capacity to import.
A change in income terms of trade indicates the nature of changes in trade (import
and export). If there is an increase in terms of trade, then it shows that a country
can further increase its imports. If there is decrease then the reverse will be true,
that is, the capacity to import will reduced. Incidentally, it can be added that if
income terms of trade are favorable, it does not necessarily follow that barter terms
of trade are also favorable. This is because of the concept of prices are more
important and price-variation can make a change without causing a change in barter
terms of trade.
4) Single Factoral Terms of Trade
Trade is a continuos process spreading over a period of time. It is possible that

during the time period some changes can take place in the utilization of factors,
which will result in an increase in productivity. Single factoral terms of trade takes
into account of these changes in productivity in export sector. The index of the
productivity in export industries has to be multiplied by the commodity term of trade
giving,
⎛P ⎞
Ty = ⎜ x ⎟ Fm ,
⎝ Pm ⎠
Where Ts = Single Factoral Terms of Trade, Px = Price index of exports,

Fx = productivity.
Any improvement in productivity will be reflected in an improvement in terms of

trade. At the same time there is disadvantages also. International trade implies
open economy, that is, participating countries are maintaining economic relations
with other trading countries. If we want to have the real and correct picture, then
we must consider the changes in the productivity of the other country’s export side
also. When we consider changes in the productivity in both import and sectors and
make necessary adjustment in the formula, then it is called Double Facotoral
Terms of Trade. In this we take account of changes in productivity of both
importing and exporting countries. In view of this, we can modify the equation of
single factoral terms of trade to take account of changes in the other country. It
will be
⎛P ⎞ ⎛ Fx ⎞ P x Fx
Td = ⎜⎜ x ⎟⎟ ⎜⎜ ⎟⎟ = , where
⎝ Pm ⎠ ⎝ Fm ⎠ Pm Fm
PxFx = price index of exports multiplied by productivity index of exports, PmFm =

price index of imports multiplied by the productivity index of imports.
In both cases it will indicate relative changes in productivity.

14
These are some of the main types of terms of trade. Besides Prof. Viner and Topics in International
Professor Kindleberger have also talked about ‘Real Cost Terms of Trade’ and Economics
‘Utility Terms of Trade.’
Terms of trade occupy an important place in international trade. It indicates the

purchasing capacity of a country to purchase goods from other country. Every
country wants to have favorable terms of trade because it shows its capacity to
make purchases in the international market. On the other hand, unfavorable terms
of trade indicates the limitations in making purchases in the international market. In
fact, terms of trade can be considered as means of gain from trade.
1) What are terms of trade?
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2) What is the meaning of reciprocal demand?
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3) Will a country gain much if her cost ratios and terms of trade are identical?
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4) Discuss the main limitation of J.S. Mill’s theory of reciprocal demand.
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5) Explain the concept of offer curves.
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6) Explain the meaning of commodity terms of trade.
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7) Fill in the Blanks:
a) TC = is ………. terms of trade
b) Ty = is ………. terms of trade
c) Tg = is ………. terms of trade.
20.4 GAINS FROM TRADE

The discussion of why and how trade takes place clearly indicate the gains from
trade. International trade is international division of labour. Just as individuals gain
by division of labour, similarly countries also gain by international division of labour.
Trade is an extension of division of labour between countries. Some of the important
gains are as follows.
15
Introduction to International i) Optimum use of Resources
With division of labour there will be optimum allocation of resources and maximum
production within a country and also between countries. Like individuals, when all
the countries specialize in those lines of economic activities where they have
comparative advantage, then naturally best use of economic resources will be
made. And when best use of economic resources is there, production will be
maximum.
Further, resources relatively speaking, are not abundant; continuous, prolonged and
indiscriminate use will exhaust them soon. Besides, the maximum outcome will not
be there. Therefore, a proper and careful use will be essential. International Trade
makes it possible because of the comparative advantage in costs. A country which
can produce a commodity at a lower cost than other countries will make a better
use of existing resources. In an isolated country when resources are used to
produce most of the required commodities, then naturally the optimum allocation of
resources will not be feasible. Thus, we can say that if the countries trade then
not only within a country but even at the international level, there will be desirable
use of resources.
ii) Advantage of Large Scale Production
Division of labour is limited by the size of the market. If a country has limited
demand then production will be less. International trade removes this limitation of
the market. Now, a country will produce not only for his consumers but for the
consumers of different countries. The size of the market has increased. As a
result economies of large scale production will be operating. These economics can
be listed below:
a) Economy in Large Scale Buying and Selling
A country now producing for a bigger market, will purchase inputs in large quanties.
It is a common experience that when we make bulk purchases, there is economy
in expenses. Similarly, the cost of selling per unit will decrease. Thus, there will
be economy in large scale buying and selling.
b) Gains accruing due to Indivisibility of a Factor of Production
Every machine has an optimum capacity. If the market is limited then production
from that machine will be less and the unit cost will be higher. The cost of
commodity can be divided into fixed and variable cost. Total variable cost will
increase with an increase in output. Fixed cost per unit will decline till the optimum
point is reached. In view of this as the production will increase, the unit cost will
decrease till the optimum point is reached. Thus, we can say that due to trade,
production will increase and machines or productive units will be producing to the
optimum level and as a result the cost will decrease.
c) Improvement in the Quality
Because of large scale production and competition in the market, the quality of
commodities will increase. In fact, consumers will buy goods of better quality with
a lower price. Therefore in order to secure the market, entrepreneurs (producers)
will like to improve the quality of commodities. Continuous research and development
will become a part of the business unit. The cold wind of competition in the
international market will force producers to renovate or innovate. There may be
limitation of the best technique available in the world. Besides, the competition will
force producers not only to improve the quality but related development in the
sources of raw material, banking facilities etc., Thus, there will be many gains
16 from trade.
The gains from trade are not limited to optimum allocation of resources and advantages Topics in International
of large scale production only. Trade directly influences developmental effort of Economics
a country. It assumes the role of a leading sector in the process of economic
development. It has also been called the engine of economic growth. The fact is
that rapid development of an important sector can promote development of all other
sectors in the economy.
20.4.1 Factors Determining Gains from Trade

The extent of gain from trade is determined by many factors. We can discuss
them under the following heads:
Relative Differences in Cost Ratio
The extent of gain from trade is determined by the relative differences in cost
ratios. If a country has greater differences in cost ratios it will gain more because
if the differences are marginal then gains will also be marginal. Thus, gains are
directly related to productivity and efficiency conditions prevailing in a country.
Higher the productivity and efficiency greater will be the gains from trade.
Reciprocal Demand
Reciprocal demand also determines the extent of gain. If, for example, country A’s
demand is more and country B is not willing to supply at the existing rate, then rate
will change in favour of B. Or, if country A’s demand is less and country B is
willing to supply more then the terms of trade will favour country A. The relative
strength and elasticity of demand of both the countries will determine the gains from
trade. In other words, the extent of gain from trade is determined by reciprocal
demand.
Ultimately two factors figure out importantly in determining the gains from trade:
Higher the efficiency in production, greater will be gains. Further, income and
nature of the commodity, which will influence the demand, will influence the gain.
As more than one country is involved in trade, we have to consider the relative
capability and demand of both the countries.
Sometimes, size of a country also influences the gains. It can be said that the gains
to a small country will be relatively larger, because, a small country faces many
obstacles and limitations in large scale production. In this way size of a country
also influences the gain. On the other hand, in a very small country, availability
of domestic reasons will be limited in size and variety. This may have adverse
effects on efficiency. Therefore, we cannot make any generalization and relate
the gains to the size of an economy.
1) Will there be gain from International Trade if the cost ratios are the same in both
the countries? (Answer in two sentences)
....................................................................................................................
....................................................................................................................
2) Name two important gains from trade.
....................................................................................................................
....................................................................................................................
3) How cost ratios affect gains from trade.
17
Introduction to International ....................................................................................................................
....................................................................................................................
4) Is demand also important in determining gains from trade?
....................................................................................................................
....................................................................................................................
5) Will the size of the market influences the gains from trade?
....................................................................................................................
....................................................................................................................
20.5 BALANCE OF PAYMENTS

In this section, we will introduce you to the monetary aspect of international trade.
When countries trade with each other, they pay in foreign exchange or foreign
currencies. So, we will be talking here of trade among countries which is not
barter (that is, not in terms of physical commodities). Each country has its own
currency, it own monetary system. This complicates matters. We are paying
attention to some of them here.
The fundamental tool for depicting international economic transaction is the balance
of payments accounts. The balance of payments accounts are a summary accounting
statement of the dealings of a country with the outside world. The balance of
payments accounts constitute a record of the transactions between a country and
the rest of the word in a specific time interval, usually a year. Hence the balance
of payments are a flow, not a stock. This is important to remember. The balance
sheet of a firm, or even the national balance sheet are stocks.
There are two fundamental things to keep in mind while talking of the balance of
payments. The first is that a distinction be made between debits and credits.
Secondly, debit and credit items are put in proper sub accounts.
Let us begin with the second point. The balance of payments account (presented
as a table) is usually divided into two main parts and each part has several
subdivisions. The two main parts are:
1) The current account: This account shows all flows that directly affect the
national income accounts of the country. It includes:
i) exports and imports of merchandise

ii) exports and imports of services
iii) inflows and outflows of income
iv) income from investments
v) grants, remittances and other transfers.
2) The capital Account: This account shows all flows that directly affect the
national balance sheet. It includes:
i) direct investment
ii) portfolio investment
iii) other private capital
18 iv) changes in cash balances, which include:
a) changes in official reserves assets, that is, changes in the reserves held by Topics in International
official monetary authorities, resulting from intervention in foreign exchange Economics
markets.
b) changes in cash balances held by banks and other foreign exchange
dealers.
Item (a) above is actually a balancing item. Particularly it is treated separately

from government capital. The main reason is that official reserve transactions are
undertaken by the authorities in order to manage the country’s balance of payments
(BoP).
Let us now come to the other main point about the balance of payments. This
principle is the distinction between debits and credits. Here, remember two things:
First, since the balance of payments table is an accounting statement, the items
balance in the aggregate. The total debits always equal total credits (any difference
is shown as statistical discrepancy). Every individual transaction in the balance of
payments table appears twice because the BoP accounts are built on the principles
of double entry book-keeping. Each individual transaction appears for the first
time in the current or capital account and then for the second time in the cash
component of the capital account.
The second thing to remember is, that is, a general sense, any action that creates
an obligation for a foreign economic agent to pay a domestic economic resident is
a credit, whereas any action that creates an obligation for a domestic resident to
pay a foreign agent is a debit.
Let us have a closer look into structures of balance of payments account of

countries.
20.5.1 Structure of Balance of Payments

The terms balance of trade and balance of payments are often used in international
trade. These two terms have different meanings. Balance of trade as compared
to balance of payments has a limited and narrower meaning. Balance of trade
refers only to goods, commodities and services’ trade. It is also called visible and
invisible import and exports. Goods and commodities can be seen and therefore
they are called visible items. Services like shipping, freight and insurance are called
invisible items. Balance of trade has, thus, restricted meaning. Balance of payments
on the other hand is more comprehensive. It is an account of total transactions of
a country with the outside world for the period of time under consideration. When
we call it an account of total transactions it takes account of not only visible and
invisible items of trade but other transactions as well like capital transactions.
The principle of double entry book-keeping is followed in making an account of

balance of payments. But there is one difference. In business debits are shown
on the left side and credit on the right side. In balance of payments, credit is shown
on the left side and debit on the right side. But a question naturally arises. What
do we mean by credit and debit in international trade? All transactions of a country
involving receipts are credit. It includes exports of goods, commodities and
services and also the capital and other things which a country is receiving. All
these things are kept on the credit side as they are receipts. On the other hand,
when we purchase some items, we have to make payments for them. It is the
debit side. All imports of goods commodities and services require payments to the
other country. These import items are kept on the debit side. Besides these, a
country can give capital assistance to another country or payments of loans and
interest to international institutions like World Bank and International Monetary
Fund or from some other countries. They are all payments and therefore included
on the debit side. 19
Introduction to International Thus, we can group all transactions of a country either as receipts or payments.
Receipts are kept on the left side and payments on the right side.
Now the next question that follows is about the items of balance of payments and
their classification. Important items of balance of payments are imports and exports
of goods and commodities. Normally a country imports a number of commodities
which cannot be produced cheaply or otherwise. Similarly, a country exports those
goods and commodities which can easily be produced efficiently and economically.
These commodities can be perishable goods, durable goods and also machines etc.
A country will import goods only according to its requirements and needs. As
suggested earlier all these items are included in visible items. These items can be
either exports and imports.
The other items are services like shipping and insurance etc. These are different
than visible items because services cannot be seen. For example when we export
some goods through either air or water, services involved in such processes cannot
be noticed. Therefore, invisible items include exports or imports of services. Normally
a less developed country has to pay more for invisible items as services are not well
developed in these countries.
These two items, visible and invisible, are included in trade items. Besides trade
items, balance of payments also includes items which are called transfer items.
These transfer items deal with financial transactions i.e., the transactions of money.
The financial transactions can also be divided into two parts unrequited transfers
and capital transfers. Unrequited transfers are basically different from capital
transfers. The difference is of nature and type. To-day many people of different
countries are working in other countries. Why they are working is not our concern
in the context of balance of payments. These people remit a part of their earnings
to their home country. Our concern is with their transaction. Sometimes people
send gifts etc., to persons in other countries. It can be a gift check. Besides these,
we have indemnities which countries may individually pay to other countries. For
all these items in the case of which nothing is given in exchange, nor is there any
commitment to return such items at a future date, are included in category of
unrequited transactions. In fact these are the items where we do not bother about
the cause but we consider only its effects. These transactions take place and are
in the form of payments or receipts. Our only concern is to keep these under
unrequited receipts or payments. It can be added here that generally a large
number of people from less developed or developing countries go to other countries
where they can earn more. Their remittances are normal as they send the money
to their family members. We have to take account of these transactions also as
they are included in balance of payments. Another important component of transfer
item is capital transaction. These transactions include borrowings from foreign
countries and international institutions, payments of loans and interest etc. In fact,
international borrowing has come to stay. Countries take loans for development and
other purchases. These can also be divided into receipts and payments. The
amount which a country is receiving from other will be included in capital receipts
and similarly capital payments will be those which a country is paying to other
countries These are the main items of balance of payments. We can make a
hypothetical account of developing countries’ balance of payments.
This balance of payments account has been divided into parts A and B for the sake
of convenience. Part A included trade items only which has visible and invisible
exports and imports of goods, commodities and services. Part B deals with transfer
items. In transfer items money transactions take place between countries. These
20 money transactions have also have been divided into sub-groups -unrequited
transactions and capital transfers. These are the four main groups under which we Topics in International
Economics
can include all transactions of country. This account is presented in Table 20.1.
If we carefully go throughout the table, we can make some important observations

about the balance of payments.
Table 20.1 : Balance of Payments
(In. Rs. crore)

Credit Side Debit Side Balance Surplus or deficit
Part A
TRADE TRANSACTIONS
(i) Visible Exports 750 Visible Imports 950 –200
(ii) Invisible Exports 200 Invisible Imports 150 +50
Total of Trade items 950 1100 –150
Part B
TRANSFER TRANSACTIONS
(iii) Unrequited 150 Unrequited 100 +50
(iv) Capital Receipts 200 Capital Payment 100 +100
Total of Transfer Receipts 350 200 +150
First of all, it is important to note that the total receipts are equal to total payments.
On the credit side we have Rs.1300 crore and on the debit side, we have Rs.1300
crore. There is balance between credit and debit sides. Total payments of this
country are equal to total receipts. It means there is equilibrium in balance of
payments. We can say that balance of payment always balances (in the account
sense).
Secondly, if we consider different groups or heads, there is difference between

receipts and payments. Let us first consider trade items. Under trade items,visible
exports are of Rs.750. While imports are of Rs. 950 crore. The value of imports
is Rs.200 crore more than the value of exports. In visible items, there is deficit as
imports exceed exports by Rs.200 crore.
It means that the country under consideration is importing more than what it is
exporting. This can also mean that the country is unable to meet its requirements
or there are certain goods/commodities which cannot be produced are being imported.
As exports are less than imports there is deficit. There can be many factors for
lower level of exports. For example, the goods which are produced by this country
are less in demand or its quality is inferior and price higher. We can say that it
has limited export capacity and therefore, there is a deficit in visible items.
Invisible items give a different picture. Invisible exports are greater than invisible
imports. The table shows that exports are of Rs.200 crore while imports are of
Rs.150 crore under this heading. There is export surplus. Exports are greater by
Rs. 50 crore as compared to imports.
21
Introduction to International We can say, now, that in trade items visible imports are higher by Rs. 200 crore
and invisible exports are greater by Rs.50 crore only. If we consider the total
receipts and payments under trade items only, we find that total receipts are equal
to Rs.950 crore and total payments are equal to Rs. 1100 crore. The net gap
between payments and receipts is of Rs.150 croroes. Total payments are greater
than total receipts. There is overall deficit in trade items. It can also be said that
there is disequilibrium in balance of trade and the deficit is of Rs.150 crore.
Let us now consider transfer items. Transfer items are further sub-divided as
unrequited items and capital items. We will consider receipts and payments under
these two groups. It is clear from the balance of payments table that receipts under
unrequited items are greater than payments. Receipts are of Rs. 150 crore and
payments (debit side) are of Rs. 100 crore only. In this group receipts are greater
than payments. We can say there is surplus in unrequited items. This surplus is
of Rs.50 crore. The capital items also show that country is getting more than what
it is giving. May be as a loan/grant from international institutions like IMF, World
Bank or from some developed countries. This country is getting more assistance
and its payments are limited to repayment of loans and interest thereon. Capital
transactions like the unrequited transactions show greater receipts than payments.
Under capital transactions, receipts amount to Rs.200 crore while payments are
only of Rs. 100 crore. It means receipts are greater by Rs.100 crore than payments.
Let us now consider total surplus and total deficit in balance of payment. It will
be easier to explain if we rearrange of balance of payment according to deficit/
surplus.
It can be observed that in trade items, total receipts amount of Rs.950 crore while
payments are of Rs.1100 crore, thus, leaving a gap of Rs.150 crore. We can say
that there is deficit in balance of trade items, which is equal to Rs.150 crore. But
this does not mean that there is deficit in balance of payments of this amount. We
have to take account of transfer items also. Both the groups under transfer
transaction, namely, unrequited transactions and capital transactions show greater
receipts than payments. The table shows that unrequited receipts are greater than
unrequited payments. There is surplus of Rs.50 crore. Similarly capital receipts
are higher by Rs.100 crore than capital payments. Thus, total transfer items
indicate a surplus of Rs.150 crore. Thus, we find that the deficit of trade items
is wiped out by the surplus of the transfer items. The total receipts are equal to
that payment. It is clear from the balance of payments schedule that the total
receipts of this country are equal to Rs.1300 crore and total payments are also
Rs.1300 crore. There is neither deficit nor surplus. We can say, therefore, in an
accounting sense, balance of payments always balances.
Now, there is another important question. Very often we say that a country’s
(particularly less developed or developing country) balance of payment is unfavorable.
It means there is deficit in total transactions. But in our example, we find that there
is equilibrium in balance of payments i.e., there is neither surplus nor deficit.
Apparently these are contradictory statements. At a time only one statement can
be true. If there is deficit in balance of payments, it cannot be in equilibrium. And
if it is in equilibrium there cannot be deficit (or even surplus) in a balance of
payments.
We can easily resolve the contradiction. First of all, when we say that balance of
payments is in equilibrium balance of payments always balances. It is in the accounting
sense. Because, whenever our total payments are greater and total receipts are
22
lesser, we have to make payment somehow. We can borrow from other countries/ Topics in International
Economics
international institutions to make the payment. When we borrow, it is kept on the
credit side because it shows receipts and therefore total receipts are equal to total
payments. It is clear that with the classification and items of a balance of payments
given above we cannot give a meaningful idea of surplus or deficit in a balance
of payment. It will not indicate the pressure on balance of payment. It will not
indicate the pressure on balance of a payment unless we specifically know the
amount borrowed for making payment or a similar action adopted by this country.
Professor J.E Meade, in trying to explain this, has rearranged the balance of
payments in terms of autonomous transactions and accommodating transactions.
All the terms of a balance of payment may be autonomous or accommodating or
partly autonomous and partly accommodating. And on this basis we can explain
deficit or surplus on a country’s balance of payments. What are autonomous and
accommodating transactions? Autonomous transactions arise out of normal trade
consideration i.e., a country is in a position to export in the international market. All
these transactions are autonomous. Or for example, if we import some commodities
from a country and that country is the cheapest and best source. It means we are
purchasing purely on market/trade considerations. This is autonomous transaction.
There can be some other consideration also. For example, suppose we want to
help a friendly country. We can purchase some items from that country or give
financial assistance. These transactions are different from autonomous transactions.
They are called accommodating transactions. Here the main objective is to
accommodate a country. Reasons may be political, economic, social or even
religious. The demarcating line is that these transactions involve a deliberate
intention to ‘accommodate’, ‘assist’, ‘help’ the other friendly country. Thus, all
transactions can be either autonomous or accommodating. Accommodating
transactions of a country will indicate the extent of imbalance in a country’s balance
of payments. So, Professor Mead has defined deficit in a country’s balance of
payments as follows: ‘An actual balance of payments deficit as the actual amount
of accommodating finance used in any period of time’, and a potential balance of
payments deficit as the amount of accommodating finance which it would have
been necessary to provide in any period in order to avoid any depreciation in the
exchange rate without the employment of exchange control, etc.
It is of course this potential deficit (or the corresponding potential surplus) that is
the proper measurement of balance of payments disequilibrium.
1) What is balance of payments? (Write in one sentence)
....................................................................................................................
....................................................................................................................
2) What is the difference between balance of trade and balance of payments.
....................................................................................................................
....................................................................................................................
3) In which sense, if any, balance of payments always balances.
....................................................................................................................
....................................................................................................................
23
Introduction to International 4) What are invisible transactions?
....................................................................................................................
....................................................................................................................
5) Name any two important items of balance of payments.
....................................................................................................................
....................................................................................................................
6) Explain the meaning of deficit in balance of payments.
....................................................................................................................
....................................................................................................................
7) Is the deficit in balance of trade the same as deficit in balance of payments.
....................................................................................................................
....................................................................................................................
20.6 LET US SUM UP

This unit dealt with various aspects of international economics. It started by
discussing the reasons for countries to trade with each other. Among other theories,
the unit discussed extensively the theory of absolute advantage propounded by
Adam Smith, and the theory of comparative advantage most commonly associated
with David Ricardo. It also discussed the modern variant of comparative advantage
put forward by Heckscher and Ohlin. The unit then went on to discuss the potential
gains from international trade. Some of these are: optimum use of resources and
advantages of scale economies. Concepts pertaining to various types of terms of
trade such as the commodity terms of trade, gross barter terms of trade, income
terms of trade, single factoral terms of trade were then explained and discussed,.
This was also related to the theory of reciprocal demand. Finally the unit looked at
monetary aspects of international trade and discussed the meaning of balance of
trade and balance of payments. It also described the components of and the items
that constitute a country’s balance of trade and balance of payments
20.7 KEY WORDS

Balance of Payments : An account of total transactions of a country in a
given period of time with the outside world.
Balance of Trade : An account of total merchandise trade including visible

and invisible items of a country.
Capital Transaction : This is transfer of capital from one country to another.

It may be from a country , international institutions
like IMF or IBRD.
Comparative Cost : Difference in the cost ratio of different countries in

Advantage different commodities gives comparative advantage in
costs. One country may enjoys advantage in relative
cost ratios. As a result one country can be more
efficient in some commodities and another country
can be less inefficient in some other commodities.
24
Division of Labour : One man cannot be equally competent in all the lines Topics in International
Economics
of economic activities. One person may be more
efficient in some lines of economic activities, another
person may be more efficient in other lines of activities.
In view of this every person chooses that line of
economic activity in which he is relatively more
efficient.
Equilibrium : A point where two opposite forces meet. Where

receipts are equal to payment.
Invisible Items : It means items of services etc., which are traded

of Trade between countries and includes shipping, insurance
etc.
Leading Sector : In the process of growth, during its third stage which
Professor Rostow terms as ‘the take off stage’, one
sector develops rapidly. It has linkage effect that
favorably affects other activities also. It leads to the
development of other sectors. Hence the name,
‘Leading Sector’.
Offer Curve : It means the amount of a country’s commodity which

that country is willing to offer for a certain amount
of other commodity of the other country.
Reciprocal Demand : The demand for each others’ goods in exchange for
ones’ own output by two countries.
Terms of Trade : The terms (or the rate) at which two commodities are
exchange between countries.
Unrequited Transactions : There is no quid pro quo, immediate or otherwise for

these item.
Visible Items of Trade : It means goods and commodities which are traded
between countries. As goods and commodities can
be seen they are called visible items of trade.
20.8 SOME USEFUL BOOKS

Sodersten, B. (1980), International Economics, Mcmillan, London
Kenen, Peter (1994), The International Economy, Cambridge University Press,

Cambridge, UK.
Krugman, Paul R. and Maurice Obstfeld (1997), International Economics: Theory

and Policy (Fourth Edition), Addison-Wesley, Massachusetts, USA
20.9 HINTS/ANSWERS FOR THE CHECK YOUR

PROGRESS EXERCISES
For all, Read Section 20.2 25

Introduction to International Check Your Progress 2
1) Read Section 20.3 and answer.
2) Read Sub-section 20.3.1 and answer.
2) Read Section 20.5 & Sub-section 20.5.1 and answer.
26
to inflationary pressures, specially if the deficit is small in relation to national income Public Economics
and is not persistent. Also, deficits can sometimes help the economy to recover
from a recession.
21.8 MARKET BORROWING

In the previous section, you got some idea of the various measures of deficit. We
saw that a deficit, howsoever defined, is an excess of spending over government
revenue. In this section, we look at a related concept: market borrowing.
Public Debt
The overall debt and obligation of the government, measured at a point of time,
is the public debt. The public debt has been defined in various ways depending on
the items that are thought appropriate to be included in the definition. To get an idea
of the public debt, let us look at the various obligations of the government. First, the
government creates currency. Often, a part of the currency may be issued by the
central bank, but usually the central bank in most countries is part of the government
so that the total currency issued and obligation may be considered a government
liability to the rest of the economy.
The second set of obligations is the short-term debt, normally with a maturity of less
than a year at the time of issue and consists of items such as Treasury Bills and
short-term loans from the central bank. There are some debts that do not have any
specific date of maturity and are called floating, and part of these may be paid of
at various times and are subject to various terms and conditions. These include
provident funds, small savings, reserve funds etc. In India, the government has
issued certain special securities to meet its obligations towards international institutions
like the World Bank and the International Monetary Fund (IMF). These special
securities are sometimes called special floating debt.
The importance of market borrowings lies in the fact that in some cases, such as
Indian public finance, market borrowings are excluded in the estimation of budgetary
deficits. Market borrowings are long term borrowings, where the maturity period is
over a year. The reason given for excluding market borrowings from budgetary
deficits is that it is felt that since these are long term obligations, they merely divert
investible funds from the private sector to the government and hence do not raise
the purchasing power and the quantum of currency. Consequently, inflationary
pressures in the economy do not build up by the market borrowings. This view need
not be correct, as the RBI itself takes up a large portion of market borrowings. The
effect of both short term and long term loans taken up by the RBI is the same, in
increasing the amount of currency.
1) Distinguish between public deficit and public debt.

....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Explain the effect of deficit financing on the capital market

....................................................................................................................
....................................................................................................................
....................................................................................................................
27
Trade and Public Economics 21.9 LET US SUM UP
This unit has acquainted you with the basic elements of public economics including
several basic concepts from traditional public finance. Our point of departure was
a description of market failure. We discussed the various types of market failure.
Next we explained the concept of Pareto improvement and Pareto optimality. In
this connection we mentioned the link between perfect competition and Pareto
optimality. Here we also talked about the two fundamental theorems of welfare
economics.
We then took up the explanation of the concept of a public good. We saw that non-
rivalry and exclusivity characterize a public good. A good like this is actually a pure
public good. We took up a brief discussion of impure public goods, two types of
which are club goods and goods in the presence of congestion. We also considered
some issues in the provision of public goods and saw the central difference in
obtaining a social benefit function from individual functions. It was pointed out that
the individual curves are added vertically instead of horizontally, as happens in the
case of a private good. We saw, too, what Lindahl equilibrium means.
We next went on to a discussion of externalities. We saw that an externality is an

example of a market failure. After considering the four basic types of externalities,
we discussed ways of coping with externalities. Here we discussed Pigou’s
suggestion of correction using suitable taxes and subsidies. The other way, as we
saw, is granting property rights and letting private parties arrive at mutually beneficial
deals. We explained very important Coase as well.
These broad topics of market failure, public goods and externalities constitute elements
of what may be called an extension of some the previous units that you studied in
this course. The next three broad topics- public revenue, deficits and market
borrowing are central themes in traditional public finance. We began our discussion
of public revenue by pointing out a distinction that some have made, between
revenue and receipts after broadly classifying revenue into tax and non-tax. We
then turned to a discussion of the engaging an important topic of deficits and their
financing, briefly touching upon the distinction between debt and deficit. We discussed
and compared various measures of the government deficit.
21.10 KEY WORDS

Balanced Budget : A government budget in which the total revenues
exactly match the total expenditure.
Capital Expenditure : Expenditure incurred on items that have a long term

basis.
Capital Receipts : Receipts accruing from items of a long term character.
GNP Elasticity of : The ratio of the percentage rise in government

Public Expenditure expenditure to a percentage change in GNP.
Perfectly Competitive : A Market situation where no buyer or seller is able

Market to influence prices, where the goods sold by all sellers
are homogeneous, and where there is full and perfect
information and free entry and exit to and from the
market.
Pure Public Good : A good characterised by both non-rivalry and non-

exclusion in consumption.
28
Revenue Expenditure : Expenditure incurred on short-term activities Public Economics
Revenue Receipts : Receipts incurred on activities, usually for a period

more than a year.
Short-term Debt : Those instruments with maturity of less than one year.
Instrument

Bhatia, H.L, Public Finance (Latest edition) Vikas: New Delhi
Browning, Edgar K. and Jacquelene Browning (1994), Public Finance and the
Price System (Fourth Edition) Prentice Hall: Englewood Cliffs New Jersey
Musgrave, Richard A. and Peggy B. Musgrave (1989), Public Finance in Theory

And Practice (Fifth Edition) McGraw-Hill International Edition: New York
Stiglitz, Joseph E. (1994), Public Sector Economics, Third Edition, W.W. Norton
& Co.: New York
21.12 HINTS/ANSWERS TO CHECK YOUR

PROGRESS EXCERSISES
3) Read Section 21.3and answer.
29
Public Economics
UNIT 21 PUBLIC ECONOMICS
Structure
21.0 Objectives
21.1 Introduction
21.2 Market Failure
21.3 Public Goods
21.4 Externalities
21.5 Public Expenditure
21.5.1 Theories About the Rise in Public Expenditure
21.5.2 Kinds of Public Expenditure
21.6 Public Revenue
21.7 Measures of Budget Deficit
21.8 Market Borrowing
21.9 Let Us Sum Up
21.10 Key Words
21.11 Some Useful Books
21.12 Hints/Answers to Check Your Progress Exercises
21.0 OBJECTIVES
In this unit of the course on the fundamentals of economics, we consider some
situations where the market process may not allocate scarce resources in an optimal
manner. You will also be introduced to some concepts and processes of the
government’s economic functioning. After going through the unit you will be able
to:
l list the situations of market failure;

l state the two basic laws of welfare;
l identify and describe situations of externalities;
l define a public good, and discuss its properties;
l explain the concepts and components of government revenue and expenditure;
l describe the various measures of deficit and discuss their impact; and
l explain what is market borrowing and list the other methods of deficit financing.
21.1 INTRODUCTION
As we discuss through this unit, we shall be concerned with two broad themes. The
first, which we discuss in the latter half of the unit, comprises concepts from what
is called Public Finance. These concepts include government revenue, government
expenditure, budget deficit and the ways of financing these. In other words, these
are about how governments raise funds, how they spend these and on what, and
how the deficit or shortfall is met. The earlier portions of the unit are an extension
of standard microeconomics— the concepts that you studied in the first few blocks
of this course.
21.2 MARKET FAILURE

For much of the initial section of this course, you were told about the functioning
of the various market forms— perfect competition, monopoly and so on. In this
section of this unit, we will look at some situation where the market is not necessarily
the best allocator of resources. The idea is that under certain conditions (which we
27
Introduction to International shall come to in a moment, and which some consider being too stringent), the
Trade and Public Economics market mechanism happens to be the most efficient way to allocate resources, to
carry out production, consumption and investment. When these conditions are fulfilled,
the market should be left alone.
What are these conditions? The basic requirement is that perfect competition should
prevail. In other words, no buyer or seller should be in a position to influence prices
and there should be perfect and complete information, which is virtually costless to
acquire. Another requirement is that there are no externalities. In a later section we
will discuss externalities in detail but for now it is enough to know that it means the
action of an economic agent confers unintended costs or benefits on some other
economic agent(s). Thirdly, there should not be increasing returns to scale in
production. Although an earlier unit on production functions has explained this
concept, it is worth repeating here. Returns to scale deals with a situation where
all inputs are increased by the same amount and we look at what happens to output.
If output increases by more than the proportion in which the inputs are increased,
we have increasing returns to scale. Suppose we double the amount of all inputs.
If output more than doubles, we have increasing returns to scale. What happens if
there are increasing returns to scale? The basic answer is that in such a case, even
after all inputs have been paid their remuneration equal to their marginal product,
the total product is not exhausted, and this means the presence of extra-normal or
super-normal profits. This goes against the basic idea of perfect competition.
The important thing to understand here is that perfect competition satisfies an

important criterion of welfare that is put forward in the literature. This is known
as Pareto-optimality. Let us see what this means. Any change that makes someone
better off while not making someone else worse off is known as Pareto superior
or is called a Pareto improvement. When we get to a situation where it is impossible
to make someone better off without making someone else worse off it is called a
Pareto optimal condition. There are two statements made in welfare economics,
which are known as the two theorems of welfare economics. The first theorem
states that any perfectly competitive situation is a Pareto-optimal situation. The
second theorem states that any situation which is Pareto-optimal can be seen to be
equivalent to a perfectly competitive situation. There is, thus, a close relationship
between Pareto-optimality and equilibrium in a (perfectly competitive) market.
Pareto-optimality also automatically ensures that resource allocation is most efficient
and wastes are avoided.
1) What are the conditions under which the market economy performs as the
best allocator of resources?
....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Explain the concept of Pareto optimality. When do we say that a situation

is Pareto-superior as compared to another situation?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) State the two laws of welfare economics.

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28
Public Economics
21.3 PUBLIC GOODS
When we hear the words ‘public’ and ‘goods’ together, we may be led to think that
these goods are provided by the public sector. This is not necessarily the case.
While it is true that the government largely provides public goods-and later we will
discuss the reasons-this type of goods may also be provided by the private sector.
There are two characteristics that a public good possesses, regardless of whether
it is provided by the government, or not. These two characteristics are non-rival
consumption and non-exclusion. Let us see what these concepts mean
Non-rival Consumption
This concept means that for a given level of production, consumption by one person
does not diminish the quantity left for someone else to consume. In other words,
a good is said to be characterised by non-rivalry in consumption if, once it is
produced, several people can simultaneously consume it. We can give some examples.
Suppose it is a chilly winter evening and you are keeping yourself warm by sitting
by a fire. If I come along and sit beside you to get some warmth by the fire, the
warmth that you get from the fire does not diminish. Another classic example is
national defence. National defence ‘consumed’ by one citizen of country does not
reduce the amount left over for others. Yes, it is true that people living in border
areas may feel threatened more by an external attack; nevertheless, military defence
per se as a good is characterised by non-rivalry in consumption. Other examples
are pollution control measures, and many public health programmes.
In much of economics, we deal with goods, which are rival consumption goods. For
a given level of production of shirts in an economy, the amount consumed by one
person reduces the amount left over for others to consume. The basic implication
for rival consumption is that a way has to be found to allocate or ration the good
among the consumers. With non-rival goods, there is no such problem because
consumption by one person does not reduce the consumption by another person.
But this is not the case with rival goods and the usual mechanism applied or
suggested by economic theory to allocate the goods is the price system or, in other
words, through demand and supply.
Non-exclusion
This is the second characteristic of a public good. To understand non-exclusion we

can look at private goods which are characterised by the exclusion principle, and
see what this means. Then we can grasp the meaning of non-exclusion. Take a
private good like an apple. If you eat an apple you can exclude me from eating
the apple. So for a private good, it is possible to confine the consumption. On the
other hand, for public goods, it may be impossible or extremely expensive to
confine the benefits of the good to a few persons. A person will derive benefit
from the production of the good, regardless of whether or not he or she pays for
the good. A classic example of a public good, much cited in the literature, is a
lighthouse. When the light of the lighthouse is on, it is difficult to prevent any nearby
ship from seeing it and being guided by it (non-excludability). Moreover, one ship’s
use does not reduce the light left for other ships, or, in other words, one ship’s use
does not affect the ability of other ships to use the light (non-rivalry).
It is important to carefully distinguish between non-rivalry in consumption and non-

exclusion. The former concept captures the idea that the amount consumed by one
person does not reduce the amount left over for consumption by others. A good
may be non-rival and yet it may be possible to exclude some people from using that
good. A classic example is cable television broadcast. If a programme is being
broadcast, then its viewing by one person does not diminish the amount left for
others. However, it is possible to exclude some people from viewing the programmes. 29
Introduction to International Those who do not have access to a TV set, or those who do not subscribe to some
Trade and Public Economics channels may not be able to view certain programmes. Remember, there is no
diminishing of the quantity available for consumption. Another example is cinema
in a theatre. For the people inside the hall, no one gets to watch more of the movie
than anyone else does. It is, however, possible to exclude people who do not pay
for the ticket from watching the movie. So the movie is a good which is non-rival
but excludable. Goods that are both non-rivals in consumption and having the non-
exclusion property are called pure public goods. To qualify as a public good, a good
has to have at least non-rival consumption. In the examples given above, although
there is non-rival consumption, the goods are excludable.
Club Goods, Congestion and Impure Public Goods
We mentioned above that pure public goods are characterised by both non-rival
consumption as well as exclusion. There are, however, some goods for which
consumption is non-rival but where exclusion can be applied as in the cable television
or movie theatre examples above. These goods are sometimes called club goods.
This is actually what happens in the case of members of a club, who have joint and
hence non-rival consumption, but where nonmembers are excluded. Because of this
kind of nature of an actual club, goods which possess the characteristic of non-rival
consumption coupled with exclusion possibilities are sometimes called club goods.
There is another class of impure public goods. This class of goods have rival
consumption but in their case it is very difficult or extremely costly to carry out
exclusion in consumption. A congested road is a prominent example. One person
driving a vehicle does not mean others can be excluded from driving their vehicles
but clearly, the space taken up by one person on the road reduces the space
available for others - hence use of road space is a rival good. A similar example
is that of a beach. People cannot exclude others from enjoying a beach, but it is
possible that the beach gets crowded and hence the space available for each person
on the beach gets reduced. Thus a beach has rival consumption. From these
examples we see that cases of congestion are yet another type of impure public
good in a sense opposite of club goods - which exhibit rival consumption but no or
negligible exclusion.
Before we discuss more about public goods, especially regarding their provision, let
us pause to look at the various types of goods. At one extreme are private goods
that have both rival consumption and exclusion. At the other extreme are pure
public goods that have non-rival consumption as well as non-exclusion. In between
the two extremes are impure types of public goods: the first type characterised by
non-rival consumption and exclusion (club goods) and the other type which has rival
consumption but non exclusion (goods in situations of congestion).
The various possibilities regarding the presence or absence of exclusivity and rivalries
are shown, with examples, in the following table.
Rivalry and Exclusion Non-rivalry and Exclusion

Rivalry and Non-Exclusion Non-rivalry and Non-Exclusion
Provision of Public Goods
The private sector often does not do a good job at providing public goods. The main
reason is that since it is difficult to exclude people from consuming the good, it
becomes difficult to price the good. This in turn robs private entrepreneurs of the
incentive to produce the good.
Even if some people could be excluded from consuming the good, the non-rivalry
in consumption would mean that it is costly and inefficient to exclude anyone. Once
30 the good is produced, the marginal cost of providing the good to an additional person
is zero. The basic issue is that due to the presence of non-exclusion in the case of Public Economics
public or social goods, the market mechanism, that is, the principle of demand and
supply regulated by the price system may not be an efficient method for the provision
of public goods. This is quite unlike the case of private goods, which are characterised
by exclusion, so that only the person who pays for a good gets to enjoy it. A related
and equally serious problem arises in the case of public goods, specially when that good
is to be financed by the consumers or users themselves, like security in a residential
colony in an entry. This is the so-called free rider problem. In essence this means
that since for a public good it is difficult to carry out exclusion, even those who do not
pay for the good, or do not put forward their share of finance can avail themselves of
or enjoy the good. This provides an incentive for an individual consumer to get a ‘free
ride’ or be ‘ free-rider’ at the expense of others, anticipating, often correctly in the case
of public goods, that others will in any case pay for the good. The problem arises when
a large number of customers begin to think on these lines. As is evident, in those
situations, where projects (public goods) are to be financed by the consumers themselves,
there is every possibility that such projects will not get financed. For public goods in
general, the free rider problem leads to situations where individuals have incentives as
well as the opportunity to enjoy the goods without paying for them. Hence the good
may be under-supplied.
We know that a perfectly competitive market will provide the optimal quantity of
a private good because production will be expanded to the point where demand
equals supply. In perfectly competitive markets, the demand curve represents the
marginal social benefit, that is, the full social benefits of additional units (let us
denote it by MSB) whereas the supply curve reflects the marginal social cost of
production (denote it by MSC).
In the above paragraph we assumed that there were no externalities. Let us now
suppose the good is a public good. Even now, output should be expanded to the
point where MSB = MSC. But the important point is that with public goods the
market demand curve is no longer obtained from individual demand curves by
horizontal summing of the individual curves. The reason is that all individuals
simultaneously consume each unit of the public good (non-rival consumption).
The following Fig.21.1 depicts the derivation of MSB curve for a public good from
individual curves.
Fig. 21.1
Ps
MSC
F
PB
MIBB MSB
PA MIBA E
D
O
Q Quantity
31
Introduction to International We have considered only two individuals for simplicity. Let the two persons be A and
Trade and Public Economics B. MIBA represents the marginal individual benefit curve for A and likewise MIBB for
B. We also assume a horizontal marginal cost curve for simplicity. At any given quantity
the demand price reflects the marginal benefit for the consumer. To get marginal social
benefit, we have to add the marginal benefits to all the individual consumers. Thus in
this case we add the price for consumer (PA) with the price for consumer B (PB) to
arrive at social benefit (Ps). For the Qth unit of the good A receives MIB equal to QD
and B receives MIB equal to QE. But, since it is a pure public good and hence non-
divisible, both A and B consume Q units of the good and both receive the benefits. Thus
the MSB curve, shown by the thick line is derived by vertically summing the MIBs of
A and B because of non-rivalry. At the point Q, MSB equals QD + QE = QF. The
optimal output now turns out to be OQ units of the public good because at the
corresponding point on the MSB curve MSB intersects the MSC curve. To the left of
Q society gets social benefit is more than costs, that is, MSB is greater than MSC and
hence it is beneficial to increase production. Thus Q is the most efficient point because
only at this point is the sum of A’s marginal benefit and B’s marginal benefit equal to
the marginal social cost.
Of course, our analysis is quite simplified and we could make it more complex. For
instance, in many situations, the MSC curve need not be horizontal but may be
upward sloping. Also, the good need not be a pure public good so that the consumers
need not all consume the same amount of the good. An example of this is education.
In actual practice, obtaining marginal individual benefit curves of individuals is very

difficult, especially if the number of individuals is large. Frequently, in many societies,
bureaucrats and government officials decide on behalf of society the quantity of
public goods to be produced and distributed. The danger is that an underestimation
of social costs and/or an overestimation of social benefits can result in overproduction
the public good. Consequently, there can be a net social loss.
There is another problem with regard to the supply of public goods that we
consider now. This arises out of a uniform pricing of public goods. Suppose there
is a non-rival but excludable public good. Suppose the government follows an
optimal social policy and provides an amount for which MSB = MSC. Suppose
that all users of the public good are to be charged a uniform price and let the price
be one at which the users are willing to buy the full amount provided. In such a
case, most users will be willing to buy more units than they can, while no one
wishes to buy fewer units. This is shown in the following diagram (see Fig. 21. 2).
Fig. 21.2
Price, Cost, Benefit
X+Y
PY
MC
A Y
X
PX
O Q0 Q1
32
We have, for simplicity, taken only two individuals, X and Y. Curves X and Y show Public Economics
the marginal value for the two individuals. Since each unit of the good can be
consumed by both X and Y, the total social value of a unit of the good is given by
the curve X+Y, which is obtained by vertically summing X and Y. Suppose OA is
the (constant) marginal cost. Then the MSB should be equated to the MSC (which
in this case is equal to the marginal cost). To induce X to consume the quantity
OQ0, the price must be OPX. But with price PX, individual Y would want to consume
the quantity OQ1, which is larger than OQ0. Thus with the same price being
charged for all consumers, some individuals will want to consume more than is
provided. The solution lies in being somehow able to charge OPX for individual X
and charge price OPY for individual Y. In such a case, both individuals consume
quantity OQo which is the quantity at which MSB = MSC. Also, for this quantity,
production costs are totally covered as MC = OA = Average costs ( because the
MC curve is horizontal) and this is equal to OPX + OPY which is the entire average
revenue. Such an equilibrium or situation where MSB =MSC, where each individual
is charged a price equal to his marginal individual benefit (MIB) curve and where
prices cover production costs is called a Lindahl equilibrium. A basic problem
relates to the elicitation of actual responses and preference of all individuals. This
is the problem of designing a so-called demand revelation mechanism. Some
economists have suggested ways of designing incentive-compatible mechanism
whereby even self-interested individuals are induced to reveal their true preferences.
Merit Goods
In all the types of goods— private goods, impure public goods and pure public goods
we have encountered till now there has been a common feature that can be found:
It is the consumer who decides whether she wants to consume the good or not.
Even for a free rider the decisions is hers alone. However, remember few exceptions
like military defence- a public good where the decision to ‘consume’ does not rest
with the consumer.
So we see there are goods which seem worthy of consumption and it is decided
by an external agency, frequently the government. This type of goods is called
merit goods. An example is the case of the government deciding that rider of
motorised two-wheeler vehicles must wear helmets, for their own good and safety.
Helmets would be private goods, but since it is an external agency, the government
which decided that people have to wear helmets, helmets become a merit good as
well.
Merit goods are goods, which are consumed on the social interest. These are
reflected in community wants, and individual wants are made subservient to the
common good in such cases. The assumption made tacitly here is that long association
among members of a society leads to the development of some common goals,
interests and values of that society. In modern democratic societies, the State is
supposed to represent social preferences. There is also a sense of paternalism
inherent in the concept of merit goods. Merit goods are not only those which are
provided by the State. If certain individuals or groups in society act as donors or
display altruism but at the same time determine the form that the charitable item
is to be provided, say, in kind rather than cash, it becomes an example of merit
good.
21.4 EXTERNALITIES
‘Externalities’ means ‘of or from outside’. An externality is a situation where a
consumer or producer is affected, either positively or negatively, by the consumption
or production by another agent. Simply put, externalities are situations where the
behaviour of some economic agent(s) affects the welfare of others.
33
Introduction to International Externalities are side effects. Examples of externalities are abound. Immunisation
Trade and Public Economics against a contagious infection confers the benefits directly to the person getting
inoculated. But it also indirectly benefits others because the chances of their
contracting the disease from the affected person are reduced when he gets inoculated.
This indirect benefit is an externality.
There are externalities in the production side also. Suppose firm A spends a lot
of money in imparting skills and high level techniques to its workers. If subsequently
many of these workers join firm B, then firm B (which is a consumer of the
services of these workers) reaps the benefits of the services of trained and skilled
workers. Another example, which is frequently cited, goes as follows: There is
a beekeeper, and next to his plot is the plot of an owner of an orchard. But the
nectar from the flowers helps the bees to produce honey. This is an external
benefit for the beekeeper.
There are external costs as well. Pollution is an example. If a firm’s smoke

increases the risk to the people living around the factory of catching respiratory
diseases, or if its effluents ejected in a river flowing nearby poison a lot of fish and
again increases the danger to the people eating the fish, it is an external cost
imposed on the people. Sometimes psychic effects are put in the category of
externalities. Suppose you maintain a beautiful garden and I as your neighbour
derive pleasure from looking at the flowers, I get external benefits. If I play music
very loudly at night, and it disturbs you, then it is an external cost for you.
What is the relation between public goods and externalities? At one level, the two
are very similar, specially with regard to the characteristic of non-rival consumption.
The inoculation example given above for an externality, can also be seen as non-
rival consumption in the sense that the inoculation of a person does not decrease
the amount of ‘reduction of risk of disease’ that is ‘consumed’ by other people.
Thus, public goods and external benefits seem to be related. The basic relation is
that all public goods are characterised by externalities but all examples of externalities
are not at the same time examples of public goods. Public goods, as we saw above,
mean that there are externalities of consumption. Hence externalities are a necessary
condition for a good being a public good. Being a public good is not a necessary
condition for a situation of externalities.
Ways of Coping with Externalities
There are two broad ways of dealing with the problems posed by externalities. One
way consists of methods which do not require abandoning the working of the
market and can be accommodated by the normal functioning of the market. The
other way is using “traditional” solutions and consists of taxation and internalisation
of costs. Let us take up the traditional methods first. These include taxes and
subsidies. The British economist A.C. Pigou was a great proponent of this view.
To understand Pigou’s solutions for externalities, let us study how he understood the
phenomenon. First, let us talk of the various kinds of externalities: (1) positive
externalities in consumption. An example is vaccination; (2) negative externalities
in consumption. A noisy motorcycle disturbing neighbours is an example; (3)
negative externalities in production. An example of this is a paper mill that
dumps its waste into a river. The waste adversely affects the riverside residents
and fishers; (4) positive externalities in production. The case of the beekeeper
and the farmer cited above is an example.
Now let us come to Pigou’s argument. His basic point is that in the presence of
externalities, even if perfect competition prevails, a Pareto optimum is not attained.
To see why, we must distinguish between private and social costs on the one hand
34 and private and social benefits on the other. In the presence of externalities, there
is a divergence between social and private costs on the one hand and private and Public Economics
social benefits on the other. With externalities present, social benefit or cost is a
combination of private and external benefit or cost.
We denote the relationships in the following way:
Let
MPC = marginal private cost
MEC = marginal external cost
MSC = marginal social cost
Then MSC = MPC + MEC
Also let
MPB = marginal private benefit
MEB = marginal external benefit
MSB = marginal social benefit
Then MSB = MPB + MEB
For overall efficiency, MSC should be equal to MSB for each product. As long as
MSB>MSC production should be expanded and vice versa.
Now let us consider a method of dealing with externalities, which does not require
abandoning the working of the market. This method was suggested by Ronald
Coase. The essence of Coase’s method is that private individuals can solve the
problem of externalities through voluntary bargaining and the government is not
needed to deal with externalities. However, for this the required conditions are
perfect competition and absence of transaction costs. The Pigovian approach is to
tax the agent who is creating the external costs. The person who has the cost
imposed on him or her would be provided a subsidy.
By contrast, Coase suggests that the person who is imposing the costs can
compensate (monetarily) the person who is adversely affected. Coase even suggests
that in some cases the person who is likely to be adversely affected could pay the
person who is about to create negative externalities for him by way of incentive
to not to undertake the activity that would create such externalities. Thus the basic
point Coase makes is that voluntary bargaining can lead to efficient allocation even
in the presence of externalities. Coase suggests not only that voluntary bargaining
leads to efficient outcomes but that there is a close relationship between external
effects and property rights. Coase’s proposition that with perfect competition and
absence of trasnsction costs, voluntary bargaining can solve the problem of
externalities is sometimes called the Coase Theorem For his ingenious theory,
Coase got a Nobel Prize in Economics.
1) Distinguish between non-rivalry and non-exclusion in the consumption of

goods.
....................................................................................................................
....................................................................................................................
.................................................................................................................... 35
Introduction to International 2) What is an impure public good?
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) What is a merit good? Is every merit good a public good?

....................................................................................................................
....................................................................................................................
....................................................................................................................
4) What are externalities? Briefly compare the Pigovian method with the Coase
method for dealing with externalities.
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21.5 PUBLIC EXPENDITURE

The Government has to undertake certain expenditures both for its own maintenance
and the maintenance of society. All these expenditures are together called public
expenditure. In almost all societies, public expenditure has shown a tendency to rise
over time. While many economists have advocated a policy of laissez faire, in
reality governments have had to incur certain necessary expenditures. In addition,
over time ideas of social welfare have gained currency and almost all governments
undertake social welfare measures. There are also necessary administrative costs
and expenditure on defence.
21.5.1 Theories about the Rise in Public Expenditure

There are two broad theories about public expenditure. The first is by the German
economist Adolph Wagner (1875-1917). He did a study of historical facts about the
German economy and propounded what is called, The Law of Increasing State
Activities. He suggested that activities of various levels of government have an
inherent tendency to increase over time. The government sector in the economy
rises faster than the economy as a whole. There is consequently a rise in government
expenditure. Now, this rise in government expenditure can be expressed in many
ways: (a) a rise in absolute levels of government expenditure, (b) a rise in the ratio
of government expenditure to GNP, (c) a rise in the proportion of the public sector
in the economy. Even in the case of (a), the absolute rise may be in nominal or real
terms. One should also adjust for a secular increase in population and see the rise
in per capita terms. It is not clear in which of the above senses Wagner was talking
about the rise in government expenditure, though Musgrave suggests that the correct
measure should be (c). Also, for (b) above one should as well look at the GNP
elasticity of government expenditure.
Wagner’s law is mainly applicable to modern progressive governments. According

to Wagner, it is applicable mainly in the initial stages of modern government activities.
He felt that as modern industrial society develops, there would be increasing pressure
for social progress and there would be attempts to make business and industry more
socially conscious. The public sector and government activities would therefore rise.
The second main theory about rise in government expenditure is by Jack Wiseman
and Alan Peacock and is called the Wiseman-Peacock hypothesis. They studied
36
public expenditure in Britain for the period 1890-1955 and on this basis suggested Public Economics
that public expenditure does not increase in a smooth and continuous manner but
in discrete jumps or in a step like manner. This is mainly because unexpected social
disturbances and events take place and government expenditure has to rise to meet
the requirements. Of course, they suggested that the existing revenue is in most
cases not adequate to meet the expenditure requirements, and revenues, particularly
taxes, rise to a new level. This hypothesis is about occurrence of unusual and
abnormal events, but it is largely true that government expenditures rise over time
in almost all modern societies. Buchanan and Tullock based on U.S. experience,
have argued that there is an increasing discrepancy between government expenditure
and government output, with the former tending to run ahead of the latter. They
give two reasons for this. First, unlike the private sector, the expenditure on
government officials increases faster than the corresponding rise in their output.
Secondly, with the growth of welfare activities and social security, the proportion
of people receiving transfer payments from the government increases.
What are the main reasons for the secular rise in government activities and
expenditures over time? First, the traditional functions of the State were expanding.
Defence was receiving greater emphasis and expenditure on it was increasing.
Wages of government officials was going up. Second, state activities around welfare
measures were increasing in their coverage. Third, investment activities of the
State have been expanding. Fourth, population itself has been going up necessitating
a hire level of committed expenditure on the part of the State. Fifth, related to the
previous point on population is increasing urbanisation, which requires a much larger
per capita expenditure on civic amenities. Sixth, modern governments need to
borrow and thus public expenditure in the form of repayment of loans and increasing
costs of debt servicing go up. Finally, increasing use of planning and consequently
capital accumulation by the government tends to increase public expenditure.
21.5.2 Kinds of Public Expenditure

Not only are there several types of government expenditure but there are also a
number of ways in which public expenditure can be classified. But before discussing
the different types of public expenditure, let us bring out the essential difference
between private and public expenditure. Are there any similarity between the two?
The basic similarity is that given the objectives both would like to see a good
return on the expenditure. This is particularly true for investment expenditure. Both
private units as well as government would like to maximise some objective function.
The primary difference stems from the different objective functions that private and
public units have. Private units and the government raise resources for expenditure.
Following contrasting methods. While the government decides the amount of
expenditure to be made and proceeds to raise the resources thereafter, private
individuals keep the income at their disposal as a constraint before deciding the
amount of expenditure. Public expenditure also has a greater degree of flexibility.
Moreover, the state has a much longer time horizon to plan the expenditure.
Let us now discuss the various types of public expenditure. There have even been
different ways of classifying public expenditure. The traditional way, existing for
several centuries, is to use an accounting classification. This has been useful for the
state in keeping track of expenditure and it affords some control and checks over
public expenditure. It provided information about leakage, misappropriation and
wastage of resources. This way of classifying public expenditure way was useful
for auditing purposes and to control misappropriation but it was not useful in providing
information about the effects of expenditure. Therefore, for policy making, a better
way to classify expenditure was sought. An economic basis of classification was
brought in, which could provide better information about the economic effects of
expenditure. 37
Introduction to International There are many ways to classify expenditure on an economic basis. Two of the
Trade and Public Economics most useful are the classification into productive and unproductive expenditure and
transfer and non-transfer expenditure. Let us first deal with the former. The basic
sense of ‘productive’ here is investment. Broadly, investment expenditure is, according
to this classification scheme, considered productive because it is seen to raise the
economy’s productive capacity, while consumption is considered unproductive. This
view is expressed strongly under the laissez-faire philosophy. In fact, this distinction
used to be strictly made during Adam Smith’s time. In this view, expenditure on
defence, administration, law and order were considered unproductive. The government
sector was considered alien to the rest of the economy. Today we need not strictly
adhere to this kind of view and hence, classification of government expenditure, for
several reasons. First, the government is an integral part of the economy and has
to undertake many kinds of expenditure that would have the effects on the rest of
the economy. Second, there are many assets, which are not directly productive in
the sense of yielding returns but are necessary for economic development.
Expenditure on social items is of this kind. Some of these expenditures, such as
public works, can yield future returns. Moreover, they increase the national product.
Third, assets need not only be in tangible form to be called productive. Investment
in human capital, for instance, can significantly raise the productive capacity of the
economy. These expenditures also yield utility directly. Fourth, the economy and
society cannot sustain themselves without certain necessary expenditures. National
defence is one such item. There are also certain expenditures, which indirectly raise
the productivity of the economy such as expenditure on research and development.
Another way of classifying government expenditures is as transfer and non-transfer

expenditure. Pigou favoured this approach to classifying expenditure. Any expenditure
without a corresponding transfer of real resources is called a transfer payment.
Examples include gifts, pension payments etc.
21.6 PUBLIC REVENUE

Any government, to carry out activities for economic development, to run the
administration, and to perform other general tasks, needs to raise funds for financing
these various activities. All the funds that the government raises are together called
public revenue. There are several types of revenue, important among which are
taxes, market borrowings, income from currency, income from public undertakings,
sale of assets, fees, fines, gifts and donations and so on. Some economists, like
Hugh Dalton, have sought to make a distinction between public receipts and public
revenue-with the latter being a part of and narrower concept than the former. It
also does not include market borrowings, income from sale of public assets and
income from printing money. There is no harm, however, in simply considering
public revenue as a single concept here.
Classification of Public Revenue Sources
Now let us discuss the revenue side of the government budget and look at the
various receipts of the government. Just as there are revenue expenditure and
capital expenditure, there are revenue and capital receipts as well.
Let us first discuss receipts which are revenue receipts. In Indian budgets, they are
placed under the revenue account. Revenue receipts are classified into tax and non-
tax revenue. We will presently discuss the difference between tax and non-tax
revenue. For the moment, let us just say that non-tax receipts include currency,
coinage and mint; interest receipts, dividends and profits; and other non-tax revenue
from various government services like administrative services, public service
commissions, and jails and prisons.
38
Now we move on to capital receipts. The basic difference between revenue receipts Public Economics
and capital receipts is that the former is of a short-term duration (less than a year,
usually) while the latter are receipts from activities of a long-term nature. The
principal type of capital receipts are market borrowings - loans that have a maturity
of 12 months or longer at the time of issue. The second category of capital receipts
is external loans. The next category of capital receipts is recoveries of loans made
by the government. In India, for the budget of the central government, it consists
of loans made by the central government to state governments, union territories, and
non-government parties. Provident Funds are another important component of capital
receipts. Other capital receipts include the net effect of transactions occurring
under a variety of accounts and deposits.
Now we go back to revenue receipts and the difference between tax and non-
tax revenue. The main characteristic feature of a tax is that it is a compulsory
levy on those who are to pay it irrespective of whether they receive any corresponding
return of goods and services from the government. In other words, those who pay
taxes do not receive definite and direct quid pro quo from the government. Thus
a tax is not a price paid by the tax-payer and no tax-payer can claim any direct
benefit from the government on the ground that he or she is paying a tax. The
benefit may go to anyone irrespective of who pays the tax. A tax is a liability
imposed upon the tax assessees who may be individuals, groups, or other legal
entities.
Now let is discuss some concepts relating to a tax. First, the base of a tax is the
legal description of the object with references to which the tax is levied. For
example, the base of an income tax is the income of the assessee as defined and
estimated. The base of an excise duty is the production or processing of a specific
good.
The incidence of a tax related to the entity (person or group or other legal entity)
that has to bear the final burden of a tax. The assessee on whom the tax is levied,
and who is to pay the tax can sometimes shift it further to someone else. For
example, sales tax is levied on the seller of a commodity and he pays it, but the
burden of payment is passed on to the consumers by the seller in terms of a higher
price. So when you buy a good on which there is a 7 per cent sales tax, you pay
a price that includes this tax that had actually been levied by the government on
the seller (all sellers of this commodity). On the other hand, income tax is a tax,
the burden of which cannot be shifted. If you are to pay income tax, you cannot
shift it someone else. The initial entity on which the tax is levied is called the
impact of a tax while the final burden of a tax is called the incidence of a tax.
Those taxes for which the burden of tax cannot be shifted by the assessee are
called direct taxes, while those whose burden can be shifted are called indirect
taxes. Thus income tax is a direct tax while sales tax and excise duties are indirect
taxes. Thus for direct taxes, the impact and incidence of the tax is the same, while
for indirect taxes, the two are different.
1) Discuss the Wiseman-Peacock hypothesis about the rise in government

expenditure over time.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
39
Introduction to International 2) Distinguish between (a) public and private expenditure, (b) productive and
Trade and Public Economics unproductive public expenditure, (c) transfer and non-transfer public expenditure.
....................................................................................................................
....................................................................................................................
....................................................................................................................
3) Distinguish between revenue and capital receipts and give two examples of
each.
....................................................................................................................
....................................................................................................................
....................................................................................................................
21.7 MEASURES OF BUDGET DEFICIT

Very generally speaking, a budgetary deficit is simply the excess of public expenditure
over public revenue. In practice, however, there are a variety of measures of the
budget deficit. There is the added problem that a single measure or a concept may
be called by different names by different experts, or a particular name may signify
different concepts to different experts. In this section we discuss both the measures
used in the theoretical public finance literature as well as the various measures used
by the Government of India (GOI) in its annual budget documents.
We must, at the outset, distinguish between the concepts of deficit and debt. The
deficit is the excess of government spending over government revenues in a particular
year. The government debt, on the other hand, is the sum of all previous outstanding
government debt obligations held by the public. So the government deficit is a flow
concept which is measured over a period of time. In contrast, the government debt
is a stock concept, which is measured at a point of time. Another general point that
needs to be mentioned in this connection is the distinction between real deficit and
nominal deficit. The former measures the deficit adjusting for inflation and is measured
in terms of some base level prices whereas the latter is ascertained in terms of the
current price level.
We now discuss the various measures and concepts of budget deficit as used in the
literature and also by the GOI. To proceed, let us write down the items of receipts
and expenditures as they appear in the annual budgets of the GOI.
We can begin by looking at the expenditures. Typically, expenditures are classified

into those in revenue account and those in capital account. Basically the difference
between the two accounts is that the former relates to expenditure incurred in the
current financial year while the latter deals with expenditure incurred over longer
time periods. There are two items in expenditure on revenue account: interest
payments by the government and non-interest expenditure. Expenditure on capital
account similarly has two items: loans and advances, and capital outlay.
Now let us discuss the revenue side of the government budget and look at the
various receipts of the government. Just as there are revenue expenditure and
capital expenditure, there are revenue and capital receipts as well. Revenue receipts
consist of two items: tax revenue and non-tax revenue. Non-tax revenue, in turn,
has three items-interest, non-interest revenue and grants. Capital receipts are of
four kinds: recoveries, borrowings, other than through Treasury Bills, other capital
receipts and sale of public assets.
The balance of total expenditure and total revenue is budgetary deficits, which is
40 met by borrowings through Treasury Bills and drawing down cash balances.
Now let us consider revenue and expenditure items in detail. Public Economics
We can first depict the above mentioned items succinctly as follows:
I) Revenue Receipts
a) Tax Revenue (net)
b) Non-tax Revenue
i) Interest
ii) Non-Interest
iii) Grants
II) Capital Receipts
a) Recoveries
b) Borrowings, other than through Treasury Bills
c) Other Capital Receipts
d) Sale of Public Assets
III) Total Receipts (I + II)
IV) Expenditure on Revenue Accounts
a) Interest Payments
b) Non-interest Payments
V) Expenditure on Capital Account
a) Loans and Advances
b) Capital Outlay
VI) Total Expenditure
VII)Borrowings through Treasury Bills and Drawing Down of Cash Balances
Several measures of deficits can be constructed from the above items of revenue
and expenditure. Let us now consider these.
1) Deficit on Revenue Account or Revenue Deficit: The excess of expenditure

on revenue account over receipts on revenue account, or item IV - item I.
2) Deficit on Capital Account: The excess of capital disbursements over capital

receipts, or item V - item II.
3) Budgetary deficit : 1 + 2
We now discuss an important aspect related to budget deficit or budgets in general.

This is to do with the questions: should the government aim for a balanced budget
and avoid deficits altogether? Is it deleterious to the state of the economy? Why
is a reduction or even removal of deficits advocated by many agencies and experts?
Classical writers till about the first three decades of the twentieth century were
traditionally advocating the balancing of government budget over the relevant period
under consideration. In other words, the total revenue of the budget was sought to 41
Introduction to International be balanced with the total expenditure of the government. Of course, the important
Trade and Public Economics question is what should be the relevant considered period? The relevant period was
usually taken to be a year. Hence, on the revenue side of the budget, borrowings
(short term as well as long term) were not included. Moreover, the budget was
considered in an accounting sense. But even in this practice, some modifications
have sometimes been suggested. Some have suggested that repayment of loans
should not be counted towards the current year’s deficit, although interest payments
should be considered.
What were and are the main arguments put forward by the advocates of balanced
budgets? First, traditionally, the government budget was considered just like the
budget of a private unit. Just as it is thought undesirable for a private unit, particularly
a household to incur deficits, it was considered unwise on the part of the government
to run deficits in its budget. These days, of course, with consumer credit and credit
cards, it is not always insisted upon that private individual budgets balance. The
argument that government budgets are just like private budgets stems from viewing
government as external to the productive economy. The governments, too, had
sometimes a tendency to be profligate.
The second argument put forward against budget deficits are that financing of the
deficits means that currency and money supply in the economy increases and this
puts pressure on prices and leads to inflation.
The third argument is ingenious. It is argued that people do not like increased taxes
imposed on them. On the other hand, government expenditures have a tendency to
increase, as we have seen in the section on expenditure. So, the government finds
it easier to finance the budgets through public borrowing, because the people are
happy to lend to the government, especially if the rate of interest on the loans is
high. The very fact that the government finds it easy to finance deficits through
public borrowing or increasing the money supply, makes the government reckless
about expenditures, and spending increases even more. This increases deficits.
Inflation resulting from deficit financing also has a tendency to further deficits.
Thus, deficits have a tendency to feed on themselves and spiral. Therefore, proponents
of this view feel that deficits should be firmly curbed as soon as they arise.
We must keep in mind that those who propose that deficits should be kept at very
low levels also argue that government should keep tax rates low. Their argument
is not only that lower rates of taxation would lead to higher tax compliance but is
also that high rates of taxation would diminish the incentive of economic agents in
the private sector to undertake profitable ventures. Consequently, output and
productivity would suffer. So, if lower rates of taxation are to go hand in hand with
low deficits it only means that governments should keep expenditure levels very
low. Moreover, the proponents of this view also suggest that governments should
not enter into areas where, there may be potential profits for government, such as
hotels and tourism. Hence in summary we can say, the proponents of the view that
deficits should be low tend to be conservative and believers in laissez faire philosophy.
What can be the arguments in favour of budget deficits? Remember that Keynes
was an advocate of deficit financing for curing economic depressions. Moreover,
during the post World War II period of growth in the American economy, that
economy had, in several years in the 1950s and 1960s, deficits in government
budgets. Some of the other arguments in favour of budget deficits, or rather, for
tolerating deficits and not developing a phobia of them, are the following:
First, balancing of budgets should not be an end in itself. Both in aims and structure
public budgets are different from private ones. Budgets should be used to help the
economy. Budgets should not be neutral in their effect on the economy, unlike what
42 the proponents of balanced budgets suggest. Secondly deficits do not always lead
to inflationary pressures, specially if the deficit is small in relation to national income Public Economics
and is not persistent. Also, deficits can sometimes help the economy to recover
from a recession.
21.8 MARKET BORROWING

In the previous section, you got some idea of the various measures of deficit. We
saw that a deficit, howsoever defined, is an excess of spending over government
revenue. In this section, we look at a related concept: market borrowing.
Public Debt
The overall debt and obligation of the government, measured at a point of time,
is the public debt. The public debt has been defined in various ways depending on
the items that are thought appropriate to be included in the definition. To get an idea
of the public debt, let us look at the various obligations of the government. First, the
government creates currency. Often, a part of the currency may be issued by the
central bank, but usually the central bank in most countries is part of the government
so that the total currency issued and obligation may be considered a government
liability to the rest of the economy.
The second set of obligations is the short-term debt, normally with a maturity of less
than a year at the time of issue and consists of items such as Treasury Bills and
short-term loans from the central bank. There are some debts that do not have any
specific date of maturity and are called floating, and part of these may be paid of
at various times and are subject to various terms and conditions. These include
provident funds, small savings, reserve funds etc. In India, the government has
issued certain special securities to meet its obligations towards international institutions
like the World Bank and the International Monetary Fund (IMF). These special
securities are sometimes called special floating debt.
The importance of market borrowings lies in the fact that in some cases, such as
Indian public finance, market borrowings are excluded in the estimation of budgetary
deficits. Market borrowings are long term borrowings, where the maturity period is
over a year. The reason given for excluding market borrowings from budgetary
deficits is that it is felt that since these are long term obligations, they merely divert
investible funds from the private sector to the government and hence do not raise
the purchasing power and the quantum of currency. Consequently, inflationary
pressures in the economy do not build up by the market borrowings. This view need
not be correct, as the RBI itself takes up a large portion of market borrowings. The
effect of both short term and long term loans taken up by the RBI is the same, in
increasing the amount of currency.
1) Distinguish between public deficit and public debt.

....................................................................................................................
....................................................................................................................
....................................................................................................................
2) Explain the effect of deficit financing on the capital market

....................................................................................................................
....................................................................................................................
....................................................................................................................
43
Trade and Public Economics 21.9 LET US SUM UP
This unit has acquainted you with the basic elements of public economics including
several basic concepts from traditional public finance. Our point of departure was
a description of market failure. We discussed the various types of market failure.
Next we explained the concept of Pareto improvement and Pareto optimality. In
this connection we mentioned the link between perfect competition and Pareto
optimality. Here we also talked about the two fundamental theorems of welfare
economics.
We then took up the explanation of the concept of a public good. We saw that non-
rivalry and exclusivity characterize a public good. A good like this is actually a pure
public good. We took up a brief discussion of impure public goods, two types of
which are club goods and goods in the presence of congestion. We also considered
some issues in the provision of public goods and saw the central difference in
obtaining a social benefit function from individual functions. It was pointed out that
the individual curves are added vertically instead of horizontally, as happens in the
case of a private good. We saw, too, what Lindahl equilibrium means.
We next went on to a discussion of externalities. We saw that an externality is an

example of a market failure. After considering the four basic types of externalities,
we discussed ways of coping with externalities. Here we discussed Pigou’s
suggestion of correction using suitable taxes and subsidies. The other way, as we
saw, is granting property rights and letting private parties arrive at mutually beneficial
deals. We explained very important Coase as well.
These broad topics of market failure, public goods and externalities constitute elements
of what may be called an extension of some the previous units that you studied in
this course. The next three broad topics- public revenue, deficits and market
borrowing are central themes in traditional public finance. We began our discussion
of public revenue by pointing out a distinction that some have made, between
revenue and receipts after broadly classifying revenue into tax and non-tax. We
then turned to a discussion of the engaging an important topic of deficits and their
financing, briefly touching upon the distinction between debt and deficit. We discussed
and compared various measures of the government deficit.
21.10 KEY WORDS

Balanced Budget : A government budget in which the total revenues
exactly match the total expenditure.
Capital Expenditure : Expenditure incurred on items that have a long term

basis.
Capital Receipts : Receipts accruing from items of a long term character.
GNP Elasticity of : The ratio of the percentage rise in government

Public Expenditure expenditure to a percentage change in GNP.
Perfectly Competitive : A Market situation where no buyer or seller is able

Market to influence prices, where the goods sold by all sellers
are homogeneous, and where there is full and perfect
information and free entry and exit to and from the
market.
Pure Public Good : A good characterised by both non-rivalry and non-

exclusion in consumption.
44
Revenue Expenditure : Expenditure incurred on short-term activities Public Economics
Revenue Receipts : Receipts incurred on activities, usually for a period

more than a year.
Short-term Debt : Those instruments with maturity of less than one year.
Instrument

Bhatia, H.L, Public Finance (Latest edition) Vikas: New Delhi
Browning, Edgar K. and Jacquelene Browning (1994), Public Finance and the
Price System (Fourth Edition) Prentice Hall: Englewood Cliffs New Jersey
Musgrave, Richard A. and Peggy B. Musgrave (1989), Public Finance in Theory

And Practice (Fifth Edition) McGraw-Hill International Edition: New York
Stiglitz, Joseph E. (1994), Public Sector Economics, Third Edition, W.W. Norton
& Co.: New York
21.12 HINTS/ANSWERS TO CHECK YOUR

PROGRESS EXCERSISES
45

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Topics in International

UNIT 20 TOPICS IN INTERNATIONAL Economics

l differentiate between absolute advantage and comparative advantage;

20.2 COMPARATIVE ADVANTAGE AS BASIS FOR

Trade, whether within a country or between countries is an act of exchange. We

20.2.1 Comparative Cost Advantages - Why Trade Takes Place ?

An important question is why people trade? The answer is very simple. It is

Country A can produce 20 units of X and 10 units of Y. Country B, on the other

In this example country A has advantage in both the commodities as 20 unit of X

Country Hours required for Commodity

Before we proceed further, it will be necessary to discuss Ricardo’s assumptions

Figures in table show number of units of respective commodities that a given

Assumption of free trade is necessary. If countries adopt restrictive trade practices

1) both the countries are almost of same size,

Heckscher-Ohlin Approach : Heckscher and Ohlin tried to analyses the question

Check Your Progress 1

1) Is internal trade basically different from international trade? (Explain in one

20.3 TERMS OF TRADE

The determination of terms of trade is also an important problem. The comparative

20.3.1 Theory of Reciprocal Demand and Terms of Trade

Determination of terms of trade was discussed by J.S. Mill. Because unless we

If the rate of exchange so determined is equal to A country’s internal ratio, it will

The concept of reciprocal demand is also criticized by a number of economists.

20.3.2 Types of Terms of Trade

1) Commodity Terms of Trade

(where Tc is commodity terms of trade, P is price and X and M refer to exports

TC1 = (PX1 PXO)/PMO.

2) Gross Barter Terms of Trade

Where, Qm = total quantity of imports, Qx = total quantity of exports.

Base Year : TG0 = QMO/QMO

Current Year : TG1 = QM1/QX1

3) Income Terms of Trade

G.S. Dorrance has formulated the concept of income terms of trade. It is an

4) Single Factoral Terms of Trade

Trade is a continuos process spreading over a period of time. It is possible that

Where Ts = Single Factoral Terms of Trade, Px = Price index of exports,

Any improvement in productivity will be reflected in an improvement in terms of

PxFx = price index of exports multiplied by productivity index of exports, PmFm =

In both cases it will indicate relative changes in productivity.

Terms of trade occupy an important place in international trade. It indicates the

Check Your Progress 2

1) What are terms of trade?

20.4 GAINS FROM TRADE

ii) Advantage of Large Scale Production

a) Economy in Large Scale Buying and Selling

b) Gains accruing due to Indivisibility of a Factor of Production

c) Improvement in the Quality

20.4.1 Factors Determining Gains from Trade

Relative Differences in Cost Ratio

Check Your Progress 3

20.5 BALANCE OF PAYMENTS

i) exports and imports of merchandise

Item (a) above is actually a balancing item. Particularly it is treated separately

Let us have a closer look into structures of balance of payments account of

20.5.1 Structure of Balance of Payments

The principle of double entry book-keeping is followed in making an account of

If we carefully go throughout the table, we can make some important observations

Table 20.1 : Balance of Payments

(In. Rs. crore)

(i) Visible Exports 750 Visible Imports 950 –200