EEC-11

Book-9

Q:        Differentiate between interregional and international trade. What factors determine gains from international trade? (June, 07)                                                                               10

Ans:     Inter-regional trade is trade between different regions within the same country, whereas interna­tional trade is between different countries. The difference between inter-regional trade and international trade, is only one of degree, not of kind. The fundamental principles in both cases are the same. International trade, like inter­regional trade, is the result of division of labour. In internal or inter-regional trade, people specialised producing goods in which they have a greater comparative advantage; the same thing happens in international trade. There are, however, several differences between domestic trade and foreign trade which necessitate the formulation of a separate theory of international trade.

            The capital and labour between two countries are not so mobile as between two different parts of the same country. It is on account of the greater mobility of labour and capital within the country that there is a tendency for the equalization of interest and wage rates. Sometimes, the production conditions differ from country to country. For example, one country can be more advanced than another country in science and technology. Thus, the production costs will be lower in the former country. One country can be endowed with greater and more abundant natural resources than another country. Thus, on account of these differences, the production costs, of the same commodity can be different in the two countries. Generally speaking, there are no restrictions on the flow of trade between two parts of the same country. As against this, there is a multiplicity of restrictions on trade between two countries. Since a country has one common currency, there are no difficulties 'in making payments in internal trade. But there sue different currencies in different countries. As such, a number of foreign exchange difficulties arise in international trade. Sometimes, the scarcity of foreign exchange limits the size of Imports from other Countries.

            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 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.

            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. ,Jhis may have adverse effects oil efficiency. Therefore, we cannot make any generalization and relate the gains to the size of an economy.(623 Word)   …..Too long

Q:        Why do countries trade with each other? Critically examine the Ricardian theory of comparative advantage in this regard. (June, 08)                                                            5+15=20

Ans:     Countries trade with each other due to the following reasons

·         No country can be completely self sufficient, and trade between countries is therefore essential to ensure a supply of a country’s needs.

·         It enables the people to enjoy those goods and services which they cannot produce themselves or which they can produce at a relatively high cost.

·         There is unequal distribution of productive resources by the nature on the surface of the earth. Countries differ in respect of climatic conditions, availability of cultivable land, forests, mines, mineral products, labour, capital technology and entrepreneurial skills etc. Given their diversities, no country has the potential to produce all the commodities at the least cost.

·         Just as there is division of labour in the case of individuals, the countries also adopt this principle at the international level. Each one of them specializes in the production of only such commodities, which they can produce at comparatively lower cost than the others. They export such products toothers and in return import those products in the production, of which they have comparative cost disadvantage.

            In recent years, the theory of comparative cost has come in for scathing criticism at the hands of eminent economists like Bertil Ohlin and Frank Graham. The main criticisms levelled against the theory are as follows :

(i) Assumption of Labour Costs. The most fundamental criticism against the theory is that it had its roots in the labour-cost theory of value. But this is not valid assumption, since beyond a point the law of increasing or decreasing cost operates. The cost ratios are bound to change when specialisation between the two countries has gone apace.

(ii) Assumption of Fixed Proportions. It is assumed that the various factors of production are always combined in the same fixed proportion. If costs other than the labour costs are admitted into the analysis of relative values, then they must always constitute a constant percentage of total costs, otherwise value would be determined by something other than labour costs. This assumption is totally wrong and unrealistic. In the real world, there is a wide variation in the proportion in which the factors of proportion are combined with each other.

(iii) Assumption of Constant Costs. Another criticism of this theory relates to its assumption of constant costs. According to the classical economists, the Law of Constant Costs prevails in every industry so that additional units of the same commodity.can be produced at a constant labour cost per unit. But this assumption of constant costs is totally wrong and unrealistic.

(iv) Assumption of Internal Mobility and External Immobility. Another drawback of the classical theory of comparative costs is to be found in its basic assumption that, internally, factors of production are completely mobile, but internationally they are wholly immobile. The assumption is totally wrong, unrealistic and contrary to facts. Internally, the factors of production are never perfectly mobile. Internationally, too, the factors of production are not perfectly immobile as assumed by the theory.

(v) Absence of Transport Costs. Still another criticism of the theory relates to its assumption that transport costs do not exist. This is manifestly a wrong and unrealistic assumption. There are several branches of production in which transport costs are even higher than production costs. A particular commodity cannot enter into international trade unless the difference in production costs between the two countries is higher than the cost of transporting it from one country to another. Transport costs are, thus, too important to be ignored.

(vi) Unrealistic Theory. The theory of comparative cost is unrealistic in the sense that actual production in a country may not accord with the principle of comparative advantage. In other words, a country may produce even those goods in which it does not possess any comparative advantage. In these days of  national self-sufficiency, every country tries as best as it can to be self-sufficient in the production of important commodities on military and strategic grounds.

(vii) Complete Specialization Impossible. This theory has been criticized on the ground that complete division of labour and specialization would not be possible. It may be possible for a small country to specialize in the production of one commodity or a few commodities. But it is simply out of question for a big country like, USA, China or India to specialise. Thus, again the theory though looks plausible, is not realistic.

            Other than the above mentioned criticism, there are many other criticism of comparative cost theory. (745 Words)

Q:        In what way is domestic trade different from foreign trade? Discuss the           comparative costs theory of trade.          (June, 03)                                                   5+15

Ans:     There are certain basic differences between domestic trade and international trade. The main differences between internal trade and international trade are-

• The capital and labour between two countries are not so mobile as between two different parts of the same country. It is on account of the greater mobility of labour and capital within the country that there is a tendency for the equalization of interest and wage rates.
• one country can be more advanced than another country in science and technology. Thus, the production costs will be lower in the former country.
• One country can be endowed with greater and more abundant natural resources than another country. Thus, on account of these differences, the production costs, of the same commodity can be different in the two countries.
• Generally speaking, there are no restrictions on the flow of trade between two parts of the same country. As against this, there is a multiplicity of restrictions on trade between two countries.
• Since a country has one common currency, there are no difficulties in making payments in domestic trade. But there are different currencies in different countries. As such, a number of foreign exchange difficulties arise in international trade.

            The theory was first propounded by economist, David Ricardo. According to this theory, a country tends to specialize in the production of those commodities in which it possesses a comparative advantage by virtue of its climate, natural resources, skill of its people and capital equipment. The term comparative advantage means the special abiliity of the country to provide a particular commodity or service relatively more cheaply than other commodities or services. The various assumptions of the theory are-  Two countries, two commodities, Only labour costs and no money cost, No transportation charges, Production to take place under conditions of constant cost, free trade and perfect compitition in the production of the goods.

            The movement of trade between the two countries, according to this theory, is determined by cost differences. We can explain Ricardo's comparative cost theory by taking an example. we have taken 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 reqd. for
	Commodity X	Commodity Y
A	120	100
B	80	90

From the above table, 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 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 i 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 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. Thus, permanent international trade between the two countries can take place only if there are comparative differences in production costs between the two countries. (750 Words)

******Internal=Interregional=domestic

Q:        Examine the theory of comparative cost advantage of international trade. (Dec.,07)    20

Ans:     In recent years, the theory of comparative cost has come in for scathing criticism at the hands of eminent economists like Bertil Ohlin and Frank Graham. The main criticisms levelled against the theory are as follows :

Assumption of Labour Costs. The most fundamental criticism against the theory is that it had its roots in the labour-cost theory of value. The most fundamental criticism against the theory is that it had its roots in the labour-cost theory of value. But this is not valid assumption, since beyond a point the law of increasing or decreasing cost operates. The cost ratios are bound to change when specialisation between the two countries has gone apace.

Assumption of Fixed Proportions. Based on the labour cost theory of value, this theory requires the further assumption that the various factors of production are always combined in the same fixed proportion. If costs other than the labour costs are admitted into the analysis of relative values, then they must always constitute a constant percentage of total costs, otherwise value would be determined by something other than labour costs. Now this assumption of fixed factoral proportion is totally wrong and unrealistic. In the real world, there is a wide variation in the proportion in which the factors of proportion are combined with each other.

Assumption of Constant Costs. Another criticism of this theory relates to its assumption of constant costs. According to the classical economists, the Law of Constant Costs prevails in every industry so that additional units of the same commodity.can be produced at a constant labour cost per unit. But this assumption of constant costs is totally wrong and unrealistic.

Assumption of lnternal Mobility and External Immobility. Another drawback of the classical theory of comparative costs is to be found in its basic assumption that, internally, factors of production are completely mobile, but internationally they are wholly immobile. The assumption is totally wrong, unrealistic and contrary to facts. Internally, the factors of production are never perfectly mobile. Internationally, too, the factors of production are not perfectly immobile as assumed by the theory.

Absence of Transport Costs. Still another criticism of the theory relates to its assumption that transport costs do not exist. This is manifestly a wrong and unrealistic assumption. There are several branches of production in which transport costs are even higher than production costs. A particular commodity cannot enter into international trade unless the difference in production costs between the two countries is higher than the cost of transporting it from one country to another. Transport costs are, thus, too important to be ignored.

Unrealistic Theory. The theory of comparative cost is unrealistic in the sense that actual production in a country may not accord with the principle of comparative advantage. In other words, a country may produce even those goods in which it does not possess any comparative advantage. In these days of  national self-sufficiency, every country tries as best as it can to be self-sufficient in the production of important commodities on military and strategic grounds.

Complete Specialization Impossible. This theory has been criticized on the ground that complete division of labour and specialization would not be possible. For e.g a small size country will possess limited natural resources, therefore, it could specialize in the production of one commodity. It would devote all its resources to the production of that particular commodity. Despite this, its production of commodity would not be adequate to meet the requirements of both the countries. The large-sized country, on the contrary, would have to produce both the commodities. In other words, it would produce even that commodity in the production of which it possesses no comparative advantage merely because the small-sized country cannot, in view of its limited resources, produce that commodity in abundance to meet the full requirements of both the countries.

Clumsiness of the Theory. This theory has been castigated by Bertil Ohlin as unduly cumbersome and unreal. The major drawback of this theory is that it does not take into account cost differences in the two countries in their entirety. The theory leaves out interest on capital, transportation charges and other items from the production costs. This is obviously a wrong and unrealistic treatment of the subject. (704 Words)

Q:        Explain the Heckscher-Ohlin theory of international trade. How does it differ from    Ricardian comparative-advantage theory?      (Dec., 06)                                            20

Ans:     The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic comparative advantage. The theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce. Core assumptions of the H-O model: (1) Labor and capital flow freely between sectors (2) The production of shoes is labor intensive and computers is capital intensive (3) The amount of labor and capital in two countries differ (difference in endowments) (4) free trade (5) technology is the same across countries (long-term) (6) Tastes are the same.

            Each region specializes in the production of those commodities for which it was best suited in terms or natural resources and factor equipment. It then exchanges these commodities for other goods for which other regions were better suited. Bertil Ohlin, thus, points out that variations in productive factors is a cause of interregional trade and specialization. The variations in productive factors or, factor-endowments cause differences in prices in different countries and the price-differences are the cause of international trade. In the words of Ellsworth, "The immediate cause of interregional trade in goods is to be found in price-differences. In other words, interregional (or, international) trade is a price phenomenon."

            Now question is- Under what circumstances do relative commodity prices differ in different countries? Differences in relative commodity prices depend upon the demand for and the supply of a commodity in the two regions. The demand for a commodity depends upon consumers' wants, and consumers' income. The supply of a commodity depends upon supply of productive factors, and technical conditions of production. According to Ohlin, the technical conditions of production are virtually the same everywhere; hence this factor can be safely kept out of the discussion. Consequently, differences in relative commodity prices depend upon the two conditions, namely, consumers' wants, and consumers' income, the demand and the supply of the productive factors. Bertil Ohlin's main conclusion can, thus, be summarized as follows:

(i)  The immediate cause of interregional or international trade is the differences in relative commodity prices in the two geographical regions or countries.

(ii) Differences in the relative commodity prices are due to the relative scarcities of productive factors in the two regions or countries. In the words of Ohlin, "International trade, thus, implies an exchange of abundant factors for the scantily supplied factors." Ellsworth has summed up Ohlin's theory thus : "Regional differences in factor-equipment occupy the fundamental position in the explanation of interregional specialization and trade. Given such differences, factor-prices will vary from region to region which, in turn, means that commodity prices will differ."

Ohlin's theory departs from the classical (Comparative Cost Theory) in the following respects:

(i) It seeks to explain the phenomenon of international trade in terms of general theory of value rather than the Labour theory of value.

(ii) Unlike the classical theory, Ohlin's theory asserts that there is no need for a separate theory of international trade.  

(iii) Ohlin's theory is a type of location theory and stresses the space element. It is simply the multiple market theory of pricing. Hence it is more realistic than the highly abstract classical theory of comparative costs,

(iv) Since Ohlin's theory takes two or more factors of production into account, factor supplies become crucial determinant of comparative advantage. In the classical theory, only one factor-labour is considered, hence factor supply aspect is rendered irrelevant.

Thus Ohlin's theory integrates factor markets into international trade theory.

(v) The classical theory seeks to establish the welfare propositions of the international trade theory. On the other hand, Ohlin's theory represents a contribution to positive economics. It attempts a scientific explanation of the structure of international trade.

(vi) The classical theory laid emphasis on the quality of a single factor labour. On the other hand, in Ohlin's theory it is the quantity of all factors and not their quality in different regions which account for the emergence of international trade.

(vii) In the classical theory, comparative advantage arises from superior skills or techniques. But this superiority may vanish when others have learnt the technique. Hence, international trade will come to an end. But Ohlin's theory asserts that international trade will always continue, because international trade arises from differences in relative commodity costs which are due to relative differences in factor prices and relative differences in factor requirements.

(viii) The classical theory does not explain why there are differences in comparative costs, but Ohlin's factor-proportions analysis is able to do so.

            Thus, Ohlin's theory represents a real departure from the classical doctrine and is a great improvement thereon. (787 Words)

********Heckscher-Ohlin theory of international trade is also know as Modern theory of  international trade and Richardian Theory of Comparative Cost is also known as Classical theory of international trade

Q:        What do you mean by balance of payments? What are the components of a balance-of-         payments account?                     (Dec., 06) (Dec., 01)                                                               10

Ans:     The balance of payments of a country is an annual record of its monetary transactions with other countries of the world. It is an impor­tant index which reflects the true economic position of . country, whether the country is a creditor or a debtor country. There are various types of monetary transactions taking place amongst the countries of the world. Broadly speaking, we can classify them under three heads : (i) The exports and imports of a country give rise to monetary transactions with other countries. The exports give rise to receipts from foreign countries while imports result in payments which are to be made to foreign coun­tries for imported goods, (ii) The international lending and borrowing also give rise to monetary transactions amongst the countries of the world, (iii) The servicing of foreign debts and their final repayments also result in international payments and receipts. Thus, the balance of pay­ments is an annual record of the international receipts and payments of a country.

            The BOP is divided into two main categories: the current account and the capital account Within these categories are sub-divisions, each of which accounts for a different type of international monetary transaction.

The Current Account:            The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account. Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods. Services refer to receipts from tourism, transportation, engineering, business service fees etc. When combined, goods and services together make up a country's balance of trade (BOT). Receipts from income-generating assets such as stocks are also recorded in the current account. The last component of the current account is unilateral transfers like grants, remittances and other transfers.

The Capital Account: The capital account is where all international capital transfers are recorded. It includes both long term and short term borrowing and lending, repayment of capital, sale and purchase of securities and other assets to and from foriegners- indiviadual and governments. International monetary flows related to investment in business, real estate, bonds and stocks are also documented. Also included are government-owned assets such as foreign reserves, gold, held with the IMF, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account. (405 Words)

Q:        Distinguish between free trade and protection. Also discuss their relative merits and   demerits.            (Dec., 99)                                                                                                        20

Ans:     Free Trade refers to that state in which there is unrestricted ex­change of goods and services amongst the various countries of the world. It is a type of trade policy that allows traders to act and transact without interference from government. Thus, the policy permits trading partners mutual gains from trade, with goods and services produced according to the theory of comparative advantage, while Protection refers to that policy of the government under which a number of restrictions are imposed on import trade with a view to giving protection to home industries. This policy is closely aligned with anti-globalization, and contrasts with free trade, where government barriers to trade are kept to a minimum.

Both Free trade and Protection have relative merits and demerits-

(i)           Harmful to Economically Underdeveloped Countries. Due to free trade the underdeveloped and weak industries of backward countries cannot face the unequal competition of well-established industries in the developed countries. Poorer countries have argued that they needed to protect “infant industries” so they can get them off the ground in the first place.

(ii)         Basic Industries and employment: The basic industries are need for the speedy economic development of a country, because without these industries, the economic growth of a country cannot be automatic and self-sustained. The new industries come into existence as a result of the policy of protection and the people get increasing opportu­nities of employment within the country.The basic industries and vol­ume of employment in a country can be increased by following the policy of protection. Free trade will stagnet the growth of new industries and hence employment.

(iii)       Improvement in Balance of Trade. The policy of protection is sometimes supported on the ground that it leads to a per­ceptible improvement in the balance of trade of a country. If the imports are cut down through the imposition of high import duties, there shall be improvement in the balance of trade of the country.

(iv)       Home Market: When the government cuts down its imports by following the policy of protection this encourages the sale of home-made goods within the country. Consequently, the volume of employment increases within the country. With increased employment, the demand for home-made goods increases still further, resulting in a further development of the home market.

(v)         Proper Utilization of the Factors of Production. Under free trade every country specializes in the production of those commodities in which it enjoys the maximum advantage. Since produc­tion is based on the principle of comparative costs, the country is able to utilize its productive resources in a proper manner under a policy of free trade.  

(vi)       Benefits to the Consumers. The indigenous industrialists have to compete with the foreign industrialists under the policy of free trade. Hence, they try to sell their products at cheap prices by cutting down their production costs. Moreover the policy of protec­tion often feeds those industries which are not efficient or economical for the country. Such industries automatically come to end or improve their standards in course of time. Also, the home industries have to face the competition of foreign industries, they cannot set up monopolistic combines to maximize their profits.

(vii)     Reduction in Foreign Trade. When a country reduces its im­ports through a policy of protection, its exports also decline because the Other countries retaliate by imposing import duties on its exports. Thus, the policy of protection often results in a serious decline in foreign trade,

(viii)   Proper Utilization of Natural Resources: There is always wasteful utilization of a country's natural resources under the policy of free trade. The reason is that when a country acquires specialization in the production of a particular commodity, then this results in a speedy exhaustion of material resources in the country. But there is no such fear under a policy of protection.

            There are many more pros and cons of free trade and protection policy which are addressed time to time but from the above discussion, it appears that the advantages of the policy of protection are several times its disadvantages. In fact this is the reason why almost all countries of the world including the developed countries have abandoned the policy of free trade today in favour of the policy of protection. (702 Words)

Q:        Explain the difference between Balance of trade and Balance of payments. How does            balance of payments always balance?   (June, 01)                                                       10

Ans:     The balance of payments of a country is an annual record of its monetary transactions with other countries of the world. It is an impor­tant index which reflects the true economic position of country, whether the country is a creditor or a debtor country. There are various types of monetary transactions taking place amongst the countries of the world. On the other hand, the balance of trade of a country shows its trade transactions with the rest of the world during the course of a year. It indicates the relation­ship between the value of exports and the value of imports of the country in question. But the balance of trade takes into account only visible exports and imports. The visible exports and imports are those which are actually recorded at the ports. If the money value of exports is greater than the money value of imports, then the balance of trade is said to be favourable to the country. If imports are more than exports then, the balance of trade is said to be unfavourable for the country.

            But it is not only the visible imports and exports which give rise to international payments and receipts. There can be several other items known as invisible items which can give rise to international receipts and payments such as the services rendered by shipping, insurance and bank­ing companies, debt repayments and payments of interest, expenditure by tourists, payments of dividends on capital invested by foreigners, etc. So, to know the real international monetary position of a country, it shall be more appropriate to refer to the balance of payments of the country concerned. The balance of payments is a wider and a more comprehensive concept than the balance of trade. In addition to the values of visible exports and imports, the balance of payments also in­cludes various types of invisible imports and exports or non-commodity items which give rise to international receipts and payments.

            The balance of payments on current account is said to be balance when the total of the credit items is exactly equal to the total of the debit items. However, as mentioned above, this rarely happens. Hence there is either a deficit or a surplus in the current accounts of balance of payment. This deficit or surplus is met by transfers in the capital account. In other words, the balance of payment is made to balance through the capital account. This deficit can be covered by- drawing upon the country’s foreign exchange reserve, by borrrowing from abroad and by exporting gold. Now the IMF grants temporary accomodation to bridge the gap. (433 Words)

Q:        Explain the concept of (a) terms of trade, (b) offer curve, and (c) reciprocal demand.             Explain with the help of a diagram.  (June, 99)                                                       20

Ans:     The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other.  There are several measures of terms of trade, each representing a different concept The important measures among them are: (i) Net barter terms of trade; (ii) Gross baiter terms of trade; and (iii) Income terms of trade. The following are the main factors on which the terms of trade of a country may depend:  (i) Elasticity of demand and supply; (ii) Availability of substitutes; (iii) Size of demand; (iv) Rate of Exchange; (v) Production pattern of a country. We calculate the terms of trade as an index number using the following formula:

            ToT = 100 x Average export price index / Average import price index

If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports. If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

Offer curve: In international trade, an offer curve shows the quantity of one type of product that an agent will export ("offer") for each quantity of another type of product that it imports. The offer curve is simply another useful way to describe an individual's demand behavior. We can also use the offer curve to describe the market's demand behavior, by summing up the behavior of individuals. While the offer curve can be constructed when there are more than two goods, it is most useful in the two-good case. The offer curve was first derived by English economists Edgeworth and Marshall.

            The Offer Curve is derived from the country's PPF. We describe a Country named K which enjoys both goods Y and X. It is slightly better at producing good X, but wants to consume both goods. It wants to consume at point C or higher (above the PPF). Country K starts in Autarky at point C. At point C, country K can produce (and consume) 3 Y for 5 X. As trade begins with another country, and country K begins to specialize in producing good X. When it produces at point B, it can trade with the other country and consume at point S. We now look at our Offer curve and draw a ray at the level 5 Y for 7 X. When full specialization occurs, K then produces at point A, trades and then consumes at point T. The price has reduced to 1 Y for 1 X, and the economy is now at equilibrium

Reciprocal demand: The concept that, in international trade, it is not just supply and demand that interact, but demand and demand. That is, a trading equilibrium is a reciprocal equilibrium in which one country's demand for another country's products (and willingness to pay for them with its own) matches with the other country's demands for the products of the first. Normally when we think of trade in general, we think about the ideas of supply and demand and how they relate to each other. When it comes to international trade, the notion of "reciprocial demand" makes us think about how demand and demand relate to each other as well. Basically the concept of reciprocal demand is about how there is a trading equilibrium when Country X's demand for Country Y's products is linked up with Country Y's demand for Country X's products. For example, consider a situation (totally oversimplified, but it might help) where Country X produced oranges but no apples. Maybe Country X would like to produce apples, but for whatever reason (climate, lack of infrastructure, or other barriers to entry) they can't. Country Y produces apples, but not oranges, and doesn't produce oranges for the similar reasons why Country X doesn't produce apples. The people in both countries want both kinds of fruit, hence the idea of "reciprocal demand," which just means that there is demand for what the first country produces in the second country, and there is demand for what the second country produces in the first. The two countries can engage in trade that satisfies the demand in each nation for the other's product. (758 Words)

****Diagrams not available for Terms of Trade and Reciprocal Demand

Q:        Discuss in brief the conditions under which market fails.      (June, 08)                          12

Ans:     Market failure is said to be exists when the production or use of goods and services by the market is not efficient. That is, there exists another outcome where all involved can be made better off. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient - that can be improved upon from the societal point-of-view.  According to mainstream economic analysis, a market failure (relative to Pareto efficiency) can occur for three main reasons.

            First, an agent in a market can gain market power, allowing them to block other mutually beneficial gains from trade from occurring. This can lead to inefficiency due to imperfect competition, which can take many different forms, such as monopolies, monopsonies, cartels, or monopolistic competition, if the agent does not implement perfect price discrimination. In a monopoly the market equilibrium will no longer be Pareto optimal. The monopoly will use its market power to restrict output below the quantity at which the MSB is equal to the MSC of the last unit produced, so as to keep prices and profits high.

            Second, the actions of an agent can have externalities, which are natural to the methods of production, or other conditions important to the market.   For example, when a firm is producing steel it absorbs labor, capital and other inputs, it must pay for these in the appropriate markets, and these costs will be reflected in the market price for steel.   If the firm also pollutes the atmosphere when it makes steel, however, and if it is not forced to pay for the use of this resource, then this cost will be borne not by the firm but by society. Hence, the market price for steel will fail to incorporate the full opportunity cost to society of producing. In this case, the market equilibrium in the steel industry will not be optimal. More steel will be produced than would occur were the firm to have to pay for all of Its costs of Abduction. Consequently, the MSC of the last unit produced will exceed its MSB.

            Finally, some markets can fail due to the nature of certain goods, or the nature of their exchange. For instance, goods can display the attributes of public goods or common-pool resources, while markets may have significant transaction costs, agency problems, or informational asymmetry. In general, all of these situations can produce inefficiency, and a resulting market failure. (408 Words)

Balance of Trade and Balance of Payments                                               (Dec., 99)        5

The balance of payments of a country is an annual record of its monetary transactions with other countries of the world. It is an impor­tant index which reflects the true economic position of country, whether the country is a creditor or a debtor country. There are various types of monetary transactions taking place amongst the countries of the world. On the other hand, the balance of trade of a country shows its trade transactions with the rest of the world during the course of a year. It indicates the relation­ship between the value of exports and the value of imports of the country in question. But the balance of trade takes into account only visible exports and imports. The visible exports and imports are those which are actually recorded at the ports. Balance of Payment also reflects invisible items which can give rise to international receipts and payments such as shipping, insurance and bank­ing companies, expenditure by tourists, etc. The balance of payments is a wider and a more comprehensive concept than the balance of trade. (176 Words)

Balance   of   payments,   for   any   country,   always balances               (Dec., 00)        5

The balance of payments on current account is said to be balance when the total of the credit items is exactly equal to the total of the debit items. However, as mentioned above, this rarely happens. Hence there is either a deficit or a surplus in the current accounts of balance of payment. This deficit or surplus is met by transfers in the capital account. In other words, the balance of payment is made to balance through the capital account. This deficit can be covered by- drawing upon the country’s foreign exchange reserve, by borrrowing from abroad and by exporting gold. Now the IMF grants temporary accomodation to bridge the gap.(111 Words)

Balance of Payments                                                                   (Dec., 02), (June, 02)       5

The balance of payments of a country is an annual record of its monetary transactions with other countries of the world. It is an impor­tant index which reflects the true economic position of . country, whether the country is a creditor or a debtor country. There are various types of monetary transactions taking place amongst the countries of the world. Broadly speaking, we can classify them under three heads : (i) The exports and imports of a country give rise to monetary transactions with other countries. The exports give rise to receipts from foreign countries while imports result in payments which are to be made to foreign coun­tries for imported goods, (ii) The international lending and borrowing also give rise to monetary transactions amongst the countries of the world, (iii) The servicing of foreign debts and their final repayments also result in international payments and receipts. Thus, the balance of pay­ments is an annual record of the international receipts and payments of a country. The BOP is divided into two main categories: the current account and the capital account Within these categories are sub-divisions, each of which accounts for a different type of international monetary transaction. (196 Words)

Terms of Trade                                                                     (Dec., 02)- 2    (Dec.,07)- 3

The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other.  There are several measures of terms of trade, viz. Net barter terms of trade; Gross baiter terms of trade; and Income terms of trade. The following are the main factors on which the terms of trade of a country may depend:  (i) Elasticity of demand and supply; (ii) Availability of substitutes; (iii) Size of demand; (iv) Rate of Exchange; (v) Production pattern of a country. We calculate the terms of trade as an index number using the following formula:

            ToT = 100 x Average export price index / Average import price index. (115 Words)

Free Trade verses Protection                                                                       (June, 00)       5

Or

Free trade vs. Restricted trade                                                                     (Dec., 02)        5

Free trade is a type of trade policy that allows traders to act and transact without interference from government. Thus, the policy permits trading partners mutual gains from trade with goods and services produced according to the theory of comparative advantage.Under a free trade policy, prices are a reflection of true supply and demand, and are the sole determinant of resource allocation. Free trade differs from other forms of trade policy where the allocation of goods and services amongst trading countries are determined by artificial prices that do not reflect the true nature of supply and demand. On the other hand Protection in economics is the economic policy of restraining trade between states, through methods such as tariffs on imported goods, restrictive quotas, and a variety of other restrictive government regulations designed to discourage imports, and prevent foreign take-over of local markets and companies. This policy is closely aligned with anti-globalization, and contrasts with free trade, where government barriers to trade are kept to a minimum. In other words it refers to policies or doctrines which "protect" businesses and workers within a country by restricting or regulating trade with foreign nations. (191 Words)

*****Protection= Restricted Trade

Offer curve                                                                                 (June, 06), (June, 03)        2

In international trade, an offer curve shows the quantity of one type of product that an agent will export ("offer") for each quantity of another type of product that it imports. The offer curve is simply another useful way to describe an individual's demand behavior. We can also use the offer curve to describe the market's demand behavior, by summing up the behavior of individuals. While the offer curve can be constructed when there are more than two goods, it is most useful in the two-good case. (87 Words)

Assumptions of Ricardo's comparative cost theory of trade                     (Dec., 03)        5

According to Ricardo's comparative cost theory of trade theory, a country tends to specialize in the production of those commodities in which it possesses a comparative advantage by virtue of its climate, natural resources, skill of its people and capital equipment. The term comparative advantage means the special abiliity of the country to provide a particular commodity or service relatively more cheaply than other commodities or services. The various assumptions of  the theory  are as follows: Production costs means only labour costs to be expressed terms of so many units of labour. All labour was assumed to be homogeneous.Production was assumed to take place under conditions of constant cost. The factors of production were perfectly mobile within the country, but totally immobile between countries. It is assumed that there are no transportation charges and that there are no restrictions on the movement of international trade from one country to ariother. Only two countries and two commodities are to be considered at a time. (163 Words)

Heckscher-Ohlin theory of international trade                                           (June, 03)       5

The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic comparative advantage. The theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce. Core assumptions of the H-O model: (1) Labor and capital flow freely between sectors (2) The production of shoes is labor intensive and computers is capital intensive (3) The amount of labor and capital in two countries differ (difference in endowments) (4) free trade (5) technology is the same across countries (long-term) (6) Tastes are the same. Main conclusion of Modern theory of international trade can, be summarized as- (i)  The immediate cause of interregional or international trade is the differences in relative commodity prices in the two geographical regions or countries. (ii) Differences in the relative commodity prices are due to the relative scarcities of productive factors in the two regions or countries. (176 Words)

Public Debt                                                                                                    (June, 02)       2

Public debt represents State borrowings from the public. It has been classified under two heads—internal debt and external debt. Internal debt is contracted by the government from the citizens of the country. On the contrary, external debt is taken by the government from foreign individuals, institutions  and governments. (49 Words)

Foreign Trade Multiplier                                                                             (Dec., 00)        2

Foreign trade multiplier is the extension of Keynesian multiplier theory to the open economy where there are flows of goods and capital between a country and others. In the open economy foreign trade, imports and exports of an economy are also to be taken into account as these have multiplier effect on changes in the national income of a country.  (60 Words)

Externalities                                       (June, 06),(Dec., 99), (June, 99)2      (June, 08)       3

Measures of Budget                                                                                      (Dec., 06)        5

Deficit Quantity                                                                                             (Dec., 06)        5

Characteristics of public good                                                                     (Dec., 03)        5

A public goods is defined as a goods that one person's consumption of the goods does not reduce the amount available to others. The same benefits are available to all and without mutual interference. Such good can be provided by both Public and Private sectors. For e.g. public good provided by Government is national defence and public good provided by private sector is television or radio signal. Public goods are characterised by two factors non-rivals and exclusion. Non rival concept of Public goods is something where good provided is available to each person in the community. For example, a television signal that is available to one person can be made available to all persons in the area within the range of the signal. One viewer's use of the television signal does not reduce its quality or the amount for others. Exclusion principle applies when the good is provided to all community i.e it is non rival but its consumption is made available on paying the price; who does not pay, is excluded. For e.g Cable connection is available to all person in the community. Its quality or amount also doesnot diminishes, i.e it is non-rival ; but who donot pay for it are devoid of it or rather excluded. (209 Words)

***Club Goods: Incudes

Non-rival and Non Exclusion          : Also known as Pure Public Goods, eg. Television signal

Non-rival and Exclusion               : e.g. Cable TV Connection or elctricity by Govt.

Impure Public Goods includes

Rival and Non Exclusion               : e.g Using of Beach. No body can be excluded for using                                          beach as it is a public place but if it is already filled or                                           congested it is difficult to use.

Rival and Exclusion                    : This is provided by private sector. E.g. any personal product                                    like TV or Refrigirator

(Go through  Book9 Unit 21 Page 29 and 30) Important

Merit Goods

In all the types of goods— private goods, impure public goods and pure public goods it is the consumer who decides whether they want to consume the good or not. However, there are few exceptions. For e.g. a 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. Thus, 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. Merit goods are goods, which are consumed on the social interest or in other words, goods for which it is thought that consumption should be encouraged are called merit goods.(139 Words)

Comparative Cost Theory  for 5 marks

The theory was first propounded by economist, David Ricardo. It was further developed and refined by J. S. Mill, Cairnes and Bastable. According to this theory, a country tends to specialize in the production of those commodities in which it possesses a comparative advantage by virtue of its climate, natural resources, skill of its people and capital equipment. The term comparative advantage means the special abiliity of the country to provide a particular commodity or service relatively more cheaply than other commodities or services. According to the theory a country will concentrate on the production of those goods and services in which it has cost advantages and exchange them for goods and services produced by other countries for the production of which it was either less suited or had positive cost disadvantages. The concept of comparative advantage also explains why a country capable of producing a wide variety of goods and services at a lower cost than any other country should concentrate on producing that good or Service for which its cost advantage is the greatest and leave the production of other goods in which it has a positive but less cost advantage, to other countries. (196 Words)

Q:     Discuss the theory of comparative cost advantage of international trade. (Dec.,07)       20

Ans:     The theory was first propounded by economist, David Ricardo. It was further developed and refined by J. S. Mill, Cairnes and Bastable. According to this theory, a country tends to specialize in the production of those commodities in which it possesses a comparative advantage by virtue of its climate, natural resources, skill of its people and capital equipment. The term comparative advantage means the special abiliity of the country to provide a particular commodity or service relatively more cheaply than other commodities or services. According to the theory a country will concentrate on the production of those goods and services in which it has cost advantages and exchange them for goods and services produced by other countries for the production of which it was either less suited or had positive cost disadvantages. The various assumptions of the theory are as follows :

(i)    Production costs means only labour costs to be expressed in terms of so many units of labour.

(ii)   All labour was assumed to be homogeneous.

(iii)  Production was assumed to take place under conditions of constant cost.

(iv) The factors of production were perfectly mobile within the country, but totally immobile between countries.

(v) It is assumed that there are no transportation charges and that there are no restrictions on the movement of international trade from one country to another.

(vi) Only two countries and two commodities are to bo considered at a time.

            The movement of trade between the two countries, according to this theory, is determined by cost differences. We can explain Ricardo's comparative cost theory by taking an example. we have taken 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 reqd. for
	Commodity X	Commodity Y
A	120	100
B	80	90

From the table, 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 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 g 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 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 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. Thus, permanent international trade between the two countries can take place only if there are comparative differences in production costs between the two countries. This is known as the Theory of Comparative Costs. (682 Words)

Net Barter Terms of Trade

It is obtained by dividing the index of export prices by the index of import prices bom indices expressed in percentages and the quotient thus obtained also expressed in percentage. In symbols it is P_X / P_M X 100, where P_X stands for the index number of export prices and P_M stands for the index number of import prices.                                                     

Let us take an example. If the index number of export prices of country A is 200 and index number of import prices is 100, then the net barter terms of trade will be equal to 200/100 x 100=200. This means that the Net barter terms of trade of a country A have shown an increase of 100 per cent over the base period. If the value of the Net barter terms of trade comes to lower than 100, that means that the terms of trade have fallen to that extent. From the point of view of a country, a rise in the net barter terms of trade is favourable because as a result of the rise, the country has now to pay a smaller quantum of exports in return for the same volume of imports or alternatively the same volume of exports for a larger quantum of imports. (208 Words)

Gross Barter Terms of Trade

It is obtained by dividing the index of the physical quantity of exports by the index of the hysical quantity  of imports,   all  expressed  in  terms  of percentages.

In symbols, Q_X/ Q_M X100 where Q_X stands for the index number of quantity of exports, and Q_M stands for the index number of quantity of imports. If Q_X =100 and Q_M =80 then the gross

barter terms of trade will be equal to 100/80 x 100= 125 which means that the gross barter terms of trade have shown an improvement of 25 per cent. (93 Words)

Income Terms of Trade

This is obtained by dividing the value of exports (Value index=Quantity index X Price index), divid­ed  by the index of import prices. In symbols, Q_X X P_X/ P_M X 100. A rise in this index means that a country can obtain a larger volume of imports from its sale of exports in a given year relative to the base year. (60 Words)

Q. Distinguish between Private and Public Debt.

Ans:    Following are the main differences between private debt and public debt :

(i) The government can force the people to lend to it, but no private individual can compel another individual to give loans to him.

(ii) The government can repudiate loans taken from the public whereas the private individual can, under no circumstances, refuse repay­ment of loans to another private individual. The government can effect unilateral reduction in the rate of interest on public loans. But a private individual is not in a position to do so.

(iii) The government can contract loans from the public for a very long time. A private individual, on the contrary, can secure loans, at best, for a short period only.

(iv) The government can borrow both from internal as well as from external sources. In other words, it not only borrows from others, it can borrow from itself. When the government covers the deficit through printing paper notes, that amounts to taking loans from itself. But a private individual can borrow from external sources only.

(v) The loans taken by the government are generally spent to promote the welfare of the people, including the creditors. For example, when the government spends the loan-money on developmental projects, it benefits almost all sections of the community including the creditors. On the contrary, private loans are not spent in the interests of the credi­tors.

(vi) Under public debt, the creditor can realize his capital by sell­ing the government securities in the market. But this is not possible in the case of private debt.

(vii) Public debt produces a deep impact on production of wealth in the country. As against this, private debt produces no such impact.

(viii) Since government's credit is high, it is able to secure loans at Cheaper interest rates than the private borrowers.

(ix)   The government repays the public debt by taxing the people. The creditors also make their contribution in this task. As against this, the burden of private debt is never born by the creditors.

(x) Public debt is always spent for productive purposes, whereas private debt may be spent both for productive as well as unproductive purposes.    (358 Words)

Internal Debt and External Debt

Public debt represents State borrowings from the public. It has been classified under two heads—internal debt and external debt. Internal debt is contracted by the government from the citizens of the country. On the contrary, external debt is taken by the government from foreign individuals, institutions  and governments. The internal debt is better than the external debt. Firstly, when loans are taken from the foreigners, the country has to pay a heavy sum of money by way of interest. This results in the remittance of huge funds to foreign countries. Secondly, external debt can also pose a danger to the economic and political independence of the country. An internal debt does not increase the total availability of resources within the country. It simply involves transfer of resources from the bond-holders to the government. An external debt, on the contrary leads to an increase in the total availability of resources for the debtor-countries, because it represents a transfer of wealth from the creditor-nation to the debtor-nation.  (166 Words)

Q. 1.   Account for the large increase in the public debt of modern governments.                           

Ans:     The size of public debt has increased tremendously in modern times: There is hardly any government today which has not contracted loans from its people. Following are the main causes of the extraordinary increase in public debt in modern times :

(i) Developmental Planning. Modern governments have abandoned the policy of laissez-faire. They now actively intervene in economic affairs according to the requirements of the economy. For example, modern governments resort to planning with a view to accelerating the rate of economic growth. For this purpose, the government has to borrow funds on a large scale from the public.

(ii) Unpopularity of Taxation. Taxation, whether old or new, is always unpopular with the public which generally opposes the imposition of new taxes. To get over this opposition, the government adopts the easy path of public borrowing.

(iii) Facing Natural Calamities, The government sometimes bor­rows money from the public to cope with natural calamities, such as, fainines, floods, earthquakes, etc. though the size of such loans is not
substantial.                                                                                     

(iv) Waging Wars. During the wars, the governments have to bor­row heavily from the public. In fact, this has turned out to be the most important reason for the phenomenal increase in public debt.

(v) Covering Temporary Deficit in the Budget. Sometimes, the government does not think it appropriate to meet the deficit in the budgef by resorting to additional taxation. In such a situation, the gov­ernment may resort to borrowings from the public.

(vi) Dealing with Depression. Public borrowing is also looked upon as an effective measure to deal with depression and unemployment in the economy. The reason is that if the government resorts to additional taxation at such a time, it is bound to have an adverse effect on the capacity to work and to invest, of the people.

(vii) Controlling Inflation. Through public borrowings on a large scale, the government can neutralize the excessive purchasing power in the hands of the public. This will have the effect of reducing inflationary pressures in the economy. Public borrowing has become quite popular with the governments both in the developing as well as the developed countries in view of its importance as an anti-inflationary measure. (363 Words)

Q: How will you justify the increase in public expenditure ? What causes are responsible for the recent increase in public expenditure ?

Ans:     The modern governments not only perform such primary functions as the civil administration as well as the defence of the country, but also take considerable interest in promoting the economic development of their respective countries. The public expenditure has increased in recent years due mostly to the developmental activities of the government. Hence, the increase in expenditure is quite justifiable.

            The main reasons for the increase  in public expenditure are as follows :

(i) Developmental Work. Modern governments have also taken up developmental work in addition to their primary functions of administration and defence. For example, the Central and the State Governments in India perform a large variety of developmental functions. In fact, sustained efforts are being made to bring about the all-round development of the economy under the Five Year Plans.

(ii) Increase of Population. As a result, the governments have to incur greater expenditure to meet the requirements of their increasing population. In fact, the public expenditure increases in the same propor tion in which the population increases.                     

(iii) Rise in the Price-level. As a result of the rise in the price-level, the public expenditure has gone up everywhere. The reason is that like the private individuals, the government has also to buy goods and serv ices from the market at higher prices.

(iv) Rise of Democracy. The public expenditure in various coun tries has gone up recently on account of the establishment of democratic governments in several countries. To achieve the goodwill of the public, the ruling party offers a large variety of services and facilities to the public. As a result of this, public expenditure in these countries has gone up.

(v) Expenditure on War. The world has witnessed two World Wars during the first eight decades of the present century. The governments of various countries had to spend astronomical amounts on the prosecution of war. The public expenditure has naturally gone up as a consequence of these wars.

(vi) Greater Expenditure on Internal and External Security. Every government has to spend today more on the maintenance of internal and external security. The world today is divided into two. hostile military camps. Each camp is spending increasing amounts to add to its military strength.

(vii) Welfare State. The State is no longer the old law and order State. The modern State is a welfare State. It has to spend increasing amounts on such items as social insurance, unemployment relief, free medical aid, free education, etc. to improve the economic and social welfare of the country. (419 Words)

Q: Explain the theories about the Rise in Public Expenditure              

Ans:     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 public expenditure in Britain for the period 1890-1955 and on this basis suggested 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. (476 Words)

Q. 1.  Discuss the various sources of public revenue.

Ans:     Following are the main sources of public revenue available to modern governments :

(i)Taxation. It constitutes the most important source of revenue v the modern governments. A tax possesses essential characteristics : (a) It is a compulsory payment and every citizen is legally bound to pay the tax imposed upon him. (b) The tax is paid by the taxpayer to enable the government to incur certain expenses in the common interest of society, (c) The payment of a tax by a person does not entitle tern to receive any direct benefits from the government in return for the tax. (d) There is no relationship between the tax paid by the person and the benefits that he may receive as a result of government expenditure.

(ii)   Fee. The term ‘fee' refers to that compulsory payment which is made by those citizens who receive special benefit from the services rendered by the government. For example, the licence fee is charged

from those citizens who are given licences by the government. Generally leaking, the fee is charged according to the magnitude of the benefits received by the citizens.

(iii) Price. The price is a payment made by the citizens to the vernment for the goods and services sold to them. For example, the government provides transport services to the citizens and in exchange targes fares and freights from them. There is a definite relationship between the price paid and the benefit received by the citizen. As a matter of fact, the fee and the price are both paid in exchange for services rendered by the government. But the fee is the payment made for non-economic services, while price is the payment made by the citizens exchange for non-economic services, while price is the payment made by the citizens in exchange for economic services rendered by the government.

(iv) Special Assessment. The payment made by the citizens of a particular locality in exchange for certain special facilities given to them by the authorities is known as special assessment. For example, if a municipal corporation in a city builds roads in a particular locality or makes arrangement for the supply of electricity and water, the value of property in that locality will inevitably go up. To that extent, the residents will be directly benefited. In such a  case, the municipal corporation can levy a special tax on the residents, because the value of the property has gone up on account of services rendered by it. Such a tax is known as  'special assessment’.              

(v) Fines  The government also imposes fines from time to time on those persons who violate the laws of the country. Of course, the income from this source is exceedingly small.

(vi) Gifts and Grants. Sometimes, the government may also earn some income in the form of gifts offered to it by the citizens. But the amount of this income is limited. Further, the government of a country may receive grants from foreign governments for general or specific purposes.

(vii) Duties. The excise duties are generally levied on those com­modities, the consumption of which does harm to the health and well-being of the citizens. For example, the duties levied on wine, opium and other intoxicants belong to this category. The object is not to earn in­come but to discourage the consumption of harmful commodities by the citizens. 

(viii) Government Properties. Modern governments also earn some income from properties owned by them. For example, the royalty from mines and oil-fields, the revenue from forests and the income from landed property can be included in this category. (593 Words)

Incidence of tax:

Incidence of a tax refers to the money burden of a tax on the person who ultimately bears it. In other words, when the money burden of a tax finally settles or comes to rest on the ultimate tax-payer, is called the incidence of a tax. The incidence of tax remains upon that person who cannot shift its burden to any other person, i.e, who ultimately bears it Thus, there are three distinct conceptions- the impact, the shifting and the incidence of a tax, which correspond respectively to the imposition, the transfer, and the settling or coming to rest of the tax. The impact is the initial phenomena, the shifting is the intermediate process, the incidence is the result.

Impact of tax:

The impact of a tax is on the person who pays the money in the first instance. In other words, the man who pays the tax to the government in first instance bears its impact The impact of a tax is, therefore, the immediate result of the imposition of a tax on the person who pays in the first instance. It corresponds to what is often but erroneously called the 'original incidence’ or the 'primary incidence’ of a tax. The impact of tax as such, denotes the act of impinging. Impact of a tax, therefore refers to the immediate burden of the tax and not to the ultimate burden of the tax.

Shifting of Tax

Shifting of a tax refers to the process by which the money burden of a tax transferred from one person to another. Whenever there is shifting of taxation the tax may be shifted forward or backward.