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Midterms IBT

Advantages of Free Trade:

a. International Specialization - Free trade causes international special-isation as it enables the different countries to produce those goods
in which they have comparative advantage. International trade enables countries to obtain the advantages of specialisation. First, a great
variety of products may be obtained.

b. Increase in World Production and World Consumption - International trade permits an industry to take full advantages of the economies
of scale (large-scale production). If certain goods were produced only for the home market, it would not be possible to achieve the full
advantage of large-scale production. So, free trade increases the world production and the world consumption of internationally traded
goods as every trading country produces only the selected goods at lower costs.

c. Safeguard against the Advent of Monopolies - Thirdly, if there were no international competition, the home market would be so narrow
that it would be comparatively easy for the combinations of firms in many indus-tries, e.g., motor cars, paper and electrical goods, to
exercise some control over it. Free trade is often an efficient way of breaking up domestic monopolies.

d. Links with Other Countries - International trade and commercial relations often lead to an interchange of knowledge, ideas and culture
between nations. This often produces a better understanding among those countries and leads to amity and theory reduces the
possibility of commer-cial rivalry and war.

e. Higher Earnings of the Factors of Production - Furthermore, free trade increases the earnings of all the factors as they are engaged in the
production of those goods in which the country has comparative advantage. It would increase the productivity of each factor.

f. Benefits to Consumers - On account of free trade the consumers of the different countries get the best quality foreign goods, often of a
wider range of choice, at low prices.

g. Higher Efficiency and Optimum Utilisation of Resources - Free trade stimulates home producers, who face to foreign competition, to put
forth their best effort and thus increase managerial efficiency. Again, as under free trade each country produces those goods in which it
has the best advantages, the resources (both human and material) of each country are utilised in the best possible manner.

h. Evil Effects of Protection - Free trade is also advocated because it can remove the evil effects of protection, such as high prices, growth of
monop­olies, etc. It is also immune from such abuses as ‘corruption and bribery’ and the creation of vested interests which often arise
under a protectionist system.

Disadvantages of Free Trade:

a. Excessive Dependence - As a country depends too much on foreign countries, an outbreak of war may upset its economy. During the
1991 Gulf War America refused to sell its products to its enemies (i.e., Gulf countries)

b. Obstacles to the Development of Home Industries - If foreign goods are imported freely, the domestic industries of the developing
countries would not be able to develop rapidly due to the superior strength of foreign industries.

c. Empire-Builder - Under free trade, the foreign traders particularly the dominant ones may try to become empire-builders in future. In the
past free trade gave rise to colonialism and imperialism.

d. Import of Expensive Harmful Goods - A country may also import expensive and harmful foreign goods.

e. Rivalry and Friction - Finally, free trade sometimes creates rivalry and frictions among the trading nations. In other words, commercial
rivalries resulting from trade often lead to war. This is an important point.

Types of Trade Barriers

- policies and design to conduct international trade.

Tariff – tax
Import Quota – limit impose by a nation quantity or total value of good that may be imported during a given period of time. Reduces the potential
damage to threaten in certain industry

Export Subsidy – govt. payment to a domestic producer that reduces production cost which enables the domestic producers to lower price in world

Voluntary Export Restriction – self impose limitation.


Classical Theory –

Mercantilism – Promote export, and disregard import. Country encourages to have trade surplus.

Trade Surplus – Value of Export > Value of Import

Neo Mercantilism – Protectionist policy

Absolute Advantage – Focus on the ability of a country to produce a good more efficiently done other nation. Trade should flow naturally
according to market forces and limit intervention coming from government.

Comparative Advantage – A person has a comparative advantage at producing something if he can produce it at lower cost than anyone else


Free trade and globalization have provided benefits to countries that engage in trade. New industries realized and have thrived in some
countries because of trading. This case was clear in Bangladesh for its garments. The United States was known as the supplier of aircraft. Taiwan
and Korea have specialized and both known for semiconductors. These industries are also the primary exporters of commodities to other countries
either as a finished product or as an intermediate product. Despite the benefits brought by trading, there are still winners and losers in trading.
Economists, however, made it clear that the benefits outweigh the cost.

Countries that engage in trade were guided with trade theories in crafting policies for their respective countries. These trade theories have already
existed for a long time and known as classical theories of trade. These theories will be examined in this lesson including the arguments on the
manner of the conduct of trade and why it is favorable. There are three notable theories of trade that will be subjected to this analysis. These are
mercantilism, absolute advantage, comparative advantage.


The classical trade theories are static. The models failed to consider the role of trade to the change in the stock of resources of countries.
The efficiency of countries in utilizing resources was not considered in the model. The productivity of countries in producing goods will change over
time because of the availability of factor inputs from abroad. Likewise, it was believed that trade will lead countries to be efficient in the use of its
stock resources. The source of this efficiency could come from the expansion of the market and the demand for goods and services because of

Product Life Cycle - This was based on the observation of the emergence of new products coming from the United States. The large size of the
United States' wealth and markets gave incentives to firms to produce new products. Eventually, production in other countries will occur as
products and markets grow mature. The maturity of products and the market will standardize the process of production and pricing will be the
basis of competition. Firms have to consider the cost of production and need to locate production to where labor cost is lower. Products will re-
enter the US markets as an export to the United States.

Economies of scale and first-mover advantage. Economies of scale are achieved because of the reduction in the per-unit cost of production due to
large scale production. The possible sources of the occurrence of economies of scale are the ability of firms to utilize more productive inputs and
the equal spread of fixed cost due to large scale production. The first-mover advantage is described as the strategic advantage secured by firms
who enter the market ahead of others. The pattern of trade that can be observed on products where economies of scale are significant and with a
large proportion of world demand may reflect first-mover advantage. Countries were able to dominate exports of these products because these
countries were able to achieve economies of scale and first-mover advantage (Hill,2011).

strategic trade theory - involving government intervention. This theory suggests that government intervention in certain industries can enhance
the chances of favored firms of international success (Peng,2012). However, this theory advocating government intervention was criticized by
those who favor free trade.
national competitive advantage - by analyzing Porter's Diamond. Porter's Diamond focused on the four broad attributes of a country. These
attributes are said to shape the business environment where domestic firms compete and can promote or hinder the creation of competitive

- Popular from 1500 – 1800
- A country’s wealth is measured by its holdings of treasure (usually gold)
- Gold used to solidify national power (pay armies in order to amass treasure)
- Restrict imports and provide subsidies to promote exports to create “favorable balance of trade”.
-Import raw materials from colonies, export more highly valued finished products.

Absolute Advantage
-A country’s wealth is based on its available goods and services rather than on gold.
- Trade should be unrestricted so that each country may specialize in products for which it has an
- Specialization will increase efficiency and benefit all

Sources of advantage
Natural Advantage
Natural Resources
Transportation Costs
Acquired advantage
Design skill
Process technology

Comparative Advantage - Gains from trade will occur even when a country has no absolute advantage with its trading partners.


- The classical theories of trade assumes that trades are static

Product Life Theory:

 the first theory to account for the change of trade patterns overtime

 A theory suggesting that patterns of trade change overtime as production shifts and as the product moves from new to maturing then to
standardized stages (Peng,2012,p.68)

Strategic Trade

 Strategic intervention by governments may help domestic firms reap first mover advantages in certain industries.

 First mover firms, aided by governments, may have better odds at winning internationally.

 Heavily resisted by scholars who advocate “free trade”

National Competitive Advantage of Industries

The competitive advantage of different industries in a country was based on this four interacting forces (Peng,2012,p.71).
 Factor endowments- a nation’s position in factors of production such as skilled labor or the infrastructure necessary to compete in a
given industry

 Demand conditions-the nature of home demand for the industry’s product or service.

 Relating and supporting industries-the presence or absence of supplier industries and related industries that are internationally

 Firm strategy, structure, and rivalry- the conditions governing how companies are created, organized, and managed and the nature of
domestic rivalry

Theories of International Trade: A Summary

Classical Theories Main Points Strengths and Influences Weaknesses and Debates
Mercantilism  International Trade is a zero-  Forerunner of modern-day  Inefficient allocation of
sum game; trade deficits are protectionism resources
dangerous  Reduces the wealth of the
 Governments should protect nation in the long run
domestic industries and
promote exports
Absolute Advantage  Nation should specialize in  Birth of modern economics  When one nation is
economic activities in which  Forerunner of the free trade absolutely inferior than
they have an absolute movement other, the theory is unable
advantage and trade with each  Defeats mercantilism, at least to provide any advice.
other intellectually  When there are many
 By specializing and trading, nations, it may be difficult
each nation produces more and to find an absolute
consumes more. advantage
 The wealth of all trading
nations and the world
Comparative Advantage  Nation should specialize in  More realistic guidance to  Relatively static, assuming
economic activities in which nations (and their firms) that comparative
they have comparative interested in trade but having advantage and factor
advantage and trade with each no absolute advantage endowments do not
other  Explains patterns of trade change over time.
 Even if one nation is absolutely based on factor endowments.
inferior than another, the two
nations can still gainfully trade.
 Factor endowments underpin
comparative advantage
Modern Theories
Product Life Cycle  Comparative advantage first  First theory to incorporate  The United States may not
resides in the lead innovation dynamic changes in patterns always be the lead
nation, which exports to other of trade. innovation nation.
nations.  More realistic with trade in  Many new products are
 Production migrates to other industrial products in the 20th now launched
advanced nations and then century simultaneously around the
developing nations in different world
product life cycle stages
Strategic Trade  Strategic intervention by  More realistic and positively  Ideological resistance
governments may help incorporates the role of from many “free trade”
domestic firms reap first-mover government in trade scholars and policy
advantages in certain  Provides direct policy advice makers.
industries.  Invites all kinds of
 First-mover firms, aided by industries to claim they
governments, may have better are strategic.
odds at winning internationally
National Competitive  Competitive advantage of  Most recent, most complex,  Has not been
Advantage of Industries different industries in a nation and most realistic among comprehensively tested.
depends on the four interacting various theories  Overseas (not only
aspects of a diamond.
 The four aspects are  As a multilevel theory, it domestic) demand may
1.factor endowments directly connects firms, stimulate the
2. domestic demand industries, and nations. competitiveness of certain
3.firm strategy industries.
4. related and supporting
Adapted from Peng, M. (2012). Global Business. Cengage Learning Asia.(p.71)

Whenever a country has an absolute advantage in the production of a good or service, it should always
produce that good or service.
Use a ratio we will call Give up over Gain. We will divide the total amount of goods the country will give
up at one end, by the total amount of goods it will gain at the other end.
When countries specialize and trade they will be better off than if they try to produce both products


1. The theory of absolute advantage contends that the source of wealth of a country is through the possession of
precious metals like gold.
2. Mercantilism asserts that the favorable balance of trade of a country is through promoting more export than
3. The theory of absolute advantage maintains that the wealth of the nations depends on the total value of goods
and services and the ability of people to consume
4. The theory of mercantilism concludes that the gains of one country that engages in trade are the loss of the
other party.
5. The theory of absolute advantage believes that trades are both beneficial to the countries that engage in trade.
6. The theory of mercantilism argues that countries must import more and export less.
7. The theory of absolute advantage favors that trade must be restricted and discourage specialization.
8. The theory of absolute advantage concludes that if the source of advantage are absent trade is impossible.
9. The theory of mercantilism’s prescription is to export raw materials from colonies and import high valued
finished products to these colonies.
10. The theory of absolute advantage asserts that countries will benefit from trade if it will export goods that it can
produce at lower cost.
11. One of the assumptions in the theory of comparative advantage is that one of the countries has an absolute
advantage in producing both goods.
12. The theory of comparative advantage prescribes that countries should specialize in one product and trade with
another country.
Countries Computer Milk
INDIA 8 40
KOREA 5 30

Based on this data 1 computer costs 5 milk for KOREA while 1 computer costs 6 milk for INDIA

Countries Robots Milk
INDIA 7 21
KOREA 2 10

Based on data above KOREA should specialize in producing robots because it has a lower opportunity cost
compared to INDIA



Countries Robots Milk
US 7 21
INDIA 2 10

Based on the data above US should specialize in producing robots while India must specialize in producing milk.

16. Product life cycle theory argues that government intervention in selected industries enhances the international
success of the favored industries.
17. Strategic trade theory asserts that the changes in the patterns of trade are due to the maturity of the product
and production is migrated to other nations to minimize cost.
18. Firms gain the first mover advantage when it enters the market ahead if others and reaps the benefits of being
the first to operate in the market.
19. The national competitive advantage of industries depends of four attributes of the business environment of the
20. The way how a firm is managed, governed, and organized is an example of factor endowments.


Market – Group of buyers and sellers of a particular product

Competitive Market – there are many buyers and sellers so that each has a negligible on the market price
1. Goods offered for sale are all exactly the same
2. Buyers and sellers so numerous that no single buyer or seller has no influence over the market price

FOREX Market - market where the buyers and sellers are involved in the sale and purchase of foreign currencies. In other words, a market where
the currencies of different countries are bought and sold is called a foreign exchange market
Components of ForEx Market:
1. Central Bank
2. Brokers
3. Commercial Banks – 2 most important in ForEx (Purchases from Broker then sells it to buyer
4. Exporters and Importers
5. Immigrants
6. Investor
7. Tourists

The structure of the foreign exchange market constitutes central banks, commercial banks, brokers, exporters and importers, immigrants,
investors, tourists. These are the main players of the foreign market, their position and place are shown in the figure below.

At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies- exporters, importers, tourist, investors, and immigrants.
They are actual users of the currencies and approach commercial banks to buy it.

The commercial banks are the second most important organ of the foreign exchange market. The banks dealing in foreign exchange play a role of
“market makers”, in the sense that they quote on a daily basis the foreign exchange rates for buying and selling of the foreign currencies. Also, they
function as clearing houses, thereby helping in wiping out the difference between the demand for and the supply of currencies. These banks buy
the currencies from the brokers and sell it to the buyers.

The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function as a link between the central bank and the
commercial banks and also between the actual buyers and commercial banks. They are the major source of market information. These are the
persons who do not themselves buy the foreign currency, but rather strike a deal between the buyer and the seller on a commission basis.
The central bank of any country is the apex body in the organization of the exchange market. They work as the lender of the last resort and the
custodian of foreign exchange of the country. The central bank has the power to regulate and control the foreign exchange market so as to assure
that it works in the orderly fashion. One of the major functions of the central bank is to prevent the aggressive fluctuations in the foreign exchange
market, if necessary, by direct intervention. Intervention in the form of selling the currency when it is overvalued and buying it when it tends to be

Functions of Foreign Exchange Market

Foreign Exchange Market is the market where the buyers and sellers are involved in the buying and selling of foreign currencies. Simply, the
market in which the currencies of different countries are bought and sold is called as a foreign exchange market.

The foreign exchange market is commonly known as FOREX, a worldwide network, that enables the exchanges around the globe. The following are
the main functions of foreign exchange market, which are actually the outcome of its working:

1. Transfer Function: The basic and the most visible function of foreign exchange market is the transfer of funds (foreign currency) from one country
to another for the settlement of payments. It basically includes the conversion of one currency to another, wherein the role of FOREX is to transfer
the purchasing power from one country to another.

For example, If the exporter of India import goods from the USA and the payment is to be made in dollars, then the conversion of the rupee to the
dollar will be facilitated by FOREX. The transfer function is performed through a use of credit instruments, such as bank drafts, bills of foreign
exchange, and telephone transfers.

2. Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth flow of goods and services from country to
country. An importer can use credit to finance the foreign purchases. Such as an Indian company wants to purchase the machinery from the USA,
can pay for the purchase by issuing a bill of exchange in the foreign exchange market, essentially with a three-month maturity.
3. Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange risks. The parties to the foreign exchange are
often afraid of the fluctuations in the exchange rates, i.e., the price of one currency in terms of another. The change in the exchange rate may
result in a gain or loss to the party concerned.

Thus, due to this reason the FOREX provides the services for hedging the anticipated or actual claims/liabilities in exchange for the forward
contracts. A forward contract is usually a three month contract to buy or sell the foreign exchange for another currency at a fixed date in the future
at a price agreed upon today. Thus, no money is exchanged at the time of the contract.

There are several dealers in the foreign exchange markets, the most important amongst them are the banks. The banks have their branches in
different countries through which the foreign exchange is facilitated, such service of a bank are called as Exchange Banks.

Types of Foreign Exchange Transactions

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement
of exchange of currencies of one country for another at an agreed exchange rate on a definite date.

1. Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It
is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contractis signed
between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing
exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.
2. Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of
currency after 90 days of the dealat a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called
a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward
3. Future Transaction: The future transactions are also the forward transactionsand deals with the contracts in the same manner as that of normal
forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the
following grounds:

 The forward contracts can be customizedon the client’s request, while the future contracts are standardized such as the features, date, and the
size of the contracts is standardized.
 The future contracts can only be traded on the organized exchanges,while the forward contracts can be traded anywhere depending on
the client’s convenience.
 No marginis required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept
as collateral so as to establish the future position.
4. Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here
one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral,
and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off
the obligations denominated in a different currency without suffering a foreign exchange risk.
5. Option Transactions: The foreign exchange option gives an investor theright, but not the obligation to exchange the currency in one denomination
to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the
currency is called as a Put Option.

Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency of another country for the
settlement of payments.

The foreign exchange market is governed by the law of supply and demand. The interaction between the supply of currency and the demand for
currency in the market results in an equilibrium exchange rate and equilibrium quantity. The graph below illustrates the model of exchange rate

According to Peng (2012), there are five determinants of foreign exchange rates. These are the differences in the relative prices of goods
between countries as explained by the law of one price and measured using the purchasing power parity (PPP). The other determinants are
interest rate and inflation, productivity and balance of payments, exchange rate policies of governments, and investor psychology.

Managers who engage in international business need to know that the exchange rate exerts influence on the profitability of trade and investment
deals of the firm. Unexpected changes and most importantly counterintuitive changes in the exchange rate can make profitable ventures
unproductive. The foreign exchange risk poses transaction, translation, and economic exposure to firms. Tactics and strategies must be employed
by the firm to protect short term cash flows from the adverse changes in the exchange rate.

Foreign Exchange Market: Functions Theories & Implications (PPT)

Functions: 2 main functions

- Currency conversion
- Insurance against foreign exchange risk

1. What is a foreign exchange market?

Answer: A foreign exchange market is a market for converting the currency of one country into that of another country.

2.What is an exchange rate?

Answer: The exchange rate is the rate at which one currency is converted into another currency.

3.What is the law of one price?

Answer: "The law of one price states that in a competitive market free of transportation costs and barriers to trade, identical products sold in
different countries must sell for the same price when their price is expressed in terms of the same currency" Krugman and Obstfeld as cited by
Hill (2011).

4.What is Purchasing Power Parity (PPP)?

Answer: "PPP is a conversion that determines the equivalent amount of goods and services different currencies can purchase. This conversion is
usually used to capture the differences in cost of living between countries.

5.What is a Fisher Effect?

Answer: The Fisher Effect is an economic theory articulated by Irvin Fisher. This theory asserts that interest rates reflect expectations about the
likely inflation rate. Fisher Effect states that a country's "nominal" interest rate is the sum of the required "real" rate of interest and the
expected rate of inflation over the period for which the funds are to be lent.

6.What are the three main categories of foreign exchange risk?

Answer: The three main categories of foreign exchange risk are transaction exposure, translation exposure, and economic exposure.

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such
exposure includes obligations for the purchase or sale of goods or services at previously agreed prices and the borrowing or lending of funds in
foreign currencies.
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is
concerned with the present measurement of past events.

Economic exposure is the extent to which changes in the exchange rates affect a firm's future international earning power. Economic exposure is
concerned with the long-run effect of changes in exchange rates on future prices, sales and costs.

7.What is a floating exchange rate policy?

Answer: The floating exchange rate policy or flexible exchange rate policy is the willingness of a government to let demand and supply
conditions determine exchange rate via the foreign exchange market.

8.What is a dirty float policy?

Answer: A dirty float policy or (managed float) uses selective government intervention to determine exchange rate.

9.What is a fixed rate policy?

Answer: A fixed rate policy is conducted by setting the exchange rate of a currency relative to other currencies.

Use of Foreign Exchange Market in International Business

4 uses of Currency conversion

1.Convert payments received from export and income received from foreign investment
2. IB use foreign exchange (FX) market to pay foreign companies for products in its domestic currency
3. FX market facilitates short term investments in money market securities in cases spare cash are available
4. FX market is also used for currency speculation

Insurance against foreign exchange risk

Firms engage in hedging to minimize adverse consequences for the firm
- Spot exchange rate
- Forward exchange rate
- Currency swaps

Implications for Managers

- Transaction exposure
- Translation Exposure
- Economic Exposure

5 key determinants of demand for products and services

Economic demand depends on a number of different variables. For instance, price is a key drive r of demand, as there are very few
consumers that don’t care about money. Equally, a consumer’s purchasing habits may change if they get a pay rise. In order to measure
these fluctuations, economists have identified five key determinants of demand that influence purchase patterns associated with a
product or service. In turn, manufacturers and suppliers can study these metrics to manage inventory. Below, we look at these factors in
more detail.

1. Income
When an individual's income rises, they can buy more expensive products or purchase the products they usually buy in a greate r
volume. As a result, this causes an increase in demand. Conversely, if incomes drop, then demand is likely to decrease. Usually, this
trend will acutely affect ‘luxury’ markets, such as vacations, cars, or restaurants. Furthermore, products that suffer a fall in demand
while incomes rise are referred to as ‘inferior goods’. Although this does not necessarily indicate lower quality, the product’s
performance on the market generates a negative demand curve.

2. Price
The laws of supply and demand dictate that if the cost of a particular product rises, demand will decrease. For example, if the price of
crude oil goes up, the cost of petrol will rise in gas stations. Therefore, depending on the income of the consumer, they will drive less to
conserve gas. This tendency is demonstrated during public holidays, when people will drive shorter distances to visit family or for

Equally, a change in price can cause demand for a related product to fluctuate. For instance, if we reflect again on the price of crude oil,
other products associated with gasoline might rise in price. For example, the cost of train travel may rise as a result of mo re consumers
opting to travel by rail. However, when the price of petrol falls, more people will return to the roads, thus, triggering a d rop in the price of
train tickets.

3. Expectations, tastes, and preferences

If consumers suspect that the price of a product will rise in future, the demand for said product will increase in the present. For
example, if there is a rise in petrol prices forecast for the coming week, motorists will fill up today. Equally, customers’ attitudes, tastes,
and preferences can impact demand in ways less directly associated with cost. For instance, if a popular celebrity is involved in marketing
a product, demand may increase. Conversely, if a scientific study reports a product is detrimental to your health, demand will drop.

4. Customer base
One of the most important determinants of demand is the size of the market. The more consumers want to purchase a product, the
faster demand will rise. Although a rise in population is an obvious way this can happen, there are other factors that influence the size of
a customer base. For example, a company may produce a highly effective marketing campaign that introduced their product or service to
a new segment.

5. Economic conditions
Consumers’ perceptions of the economy affect their propensity to consume. To illustrate, if consumers are confident their jobs are
secure, they are more likely to spend. This tendency is known as consumer confidence. Defined as consumers' feelings about economic
conditions, consumer confidence indicates the overall state of the economy. However, if consumer confidence is low, individuals are
more likely to put their money into savings accounts – especially if interest rates are high.

The determinants of demand vs determinants of consumption

Economists’ analysis has defined various key determinants of demand and consumption. However, in practice, they often overlook the
relationship between demand and price. The development of these ‘gap’ models illustrates the prevalence of an approach that s ees
demand operating independently of price. In reality, demand is a complex relationship between price and quantity, as opposed to a
static notion that only depends on geopolitical factors. As such, manufacturers and suppliers need to study pricing strategy alongside
traditional demand dynamics.

5 Determinants of Demand With Examples and Formula

Demand drives economic growth. Businesses want to increase demand so they can improve profits. Governments and central
banks boost demand to end recessions. They slow it during the expansion phase of the business cycle to combat inflation. If you offer
any paid services, then you are trying to raise demand for them.
So what drives demand? In the real world, a potentially infinite number of factors impact each consumer's decision to buy something. In
economics, however, the equation is simplified to highlight the five primary determinants of individual demand and a sixth for aggregate

The Five Determinants of Demand

The five determinants of demand are:

1. The price of the good or service.

2. The income of buyers.
3. The prices of related goods or services—either complementary and purchased along with a particular item, or substitutes and
bought instead of a product.
4. The tastes or preferences of consumers will drive demand.
5. Consumer expectations. Most often, this refers to whether a consumer believes prices for the product will rise or fall in the

For aggregate demand, the number of buyers in the market is the sixth determinant.

Demand Equation or Function

This equation expresses the relationship between demand and its five determinants:

qD = f (price, income, prices of related goods, tastes, expectations)

As you can see, this isn't a straightforward equation like 2 + 2 = 4. It isn't that simple to create an equation that accurately predicts the
exact quantity that consumers will demand.

Instead, this equation highlights the relationship between demand and its key factors. The quantity demanded (qD) is a function of five
factors—price, buyer income, the price of related goods, consumer tastes, and any consumer expectations of future supply and price.
As these factors change, so too does the quantity demanded.

How Each Determinant Affects Demand

Each factor's impact on demand is unique. When the income of the buyer increases, for example, that could also increase demand.
The buyer has more money and is more likely to spend it. But when other factors increase—like the price of related goods, for
example—demand could decrease.

Before breaking down the effect of each determinant, it's important to note that these factors don't change in a vacuum. All the factors
are in flux all the time. To understand how one determinant affects demand, you must first hypothetically assume that all the other
determinants don't change.

That principle is called ceteris paribus or “all other things being equal.”

So, "ceteris paribus," here's how each element affects demand.

The law of demand states that when prices rise, the quantity of demand falls. That also means that when prices drop, demand will
grow. People base their purchasing decisions on price if all other things are equal. The exact quantity bought for each price level is
described in the demand schedule. It's then plotted on a graph to show the demand curve.

The demand curve shows just the relationship between price and quantity. If one of the other determinants changes, the entire demand
curve shifts.

If the quantity demanded responds a lot to price, then it's known as elastic demand. If demand doesn't change much, regardless of
price, that's inelastic demand.

When income rises, so will the quantity demanded. When income falls, so will demand. But if your income doubles, you won't always
buy twice as much of a particular good or service. There's only so many pints of ice cream you'd want to eat, no matter how wealthy
you are, and this is an example of "marginal utility."
Marginal utility is the concept that each unit of a good or service is a little less useful to you than the first. At some point, you won’t want
it anymore, and the marginal utility drops to zero.

The first pint of ice cream tastes delicious. You might have another. But after that, the marginal utility starts to decrease to the point
where you don't want any more.

Prices of related goods or services

The price of complementary goods or services raises the cost of using the product you demand, so you'll want less. For example, when
gas prices rose to $4 a gallon in 2008, the demand for gas-guzzling trucks and SUVs fell. Gas is a complementary good to these
vehicles. The cost of driving a truck rose along with gas prices.

The opposite reaction occurs when the price of a substitute rises. When that happens, people will want more of the good or service and
less of its substitute. That's why Apple continually innovates with its iPhones and iPods. As soon as a substitute, such as a new Android
phone, appears at a lower price, Apple comes out with a better product. Then the Android is no longer a substitute.

When the public’s desires, emotions, or preferences change in favor of a product, so does the quantity demanded. Likewise, when
tastes go against it, that depresses the amount demanded. Brand advertising tries to increase the desire for consumer goods.

When people expect that the value of something will rise, they demand more of it. That helps explains the housing asset bubble of
2005. Housing prices rose, but people kept buying houses because they expected the price to continue to increase. Prices continued
increasing until the bubble burst in 2007. New home prices fell 22% from their peak of $262,200 in March 2007 to $204,200 in October
2010. However, the quantity demanded didn't increase—even as the price decreased—and sales fell from a peak of 1.2 million in
2005 to a low of 306,000 in 2011.

So why didn't the quantity demanded increase as the price fell? It's in part because the broader economy was experiencing a
recession. People expected prices to continue falling, so they didn't feel an urgency to buy a home. Record levels
of foreclosures entered the market due to the subprime mortgage crisis. Demand for homes didn't increase until people expected future
home prices would, too.

Number of buyers in the market

The number of consumers affects overall, or “aggregate,” demand. As more buyers enter the market, demand rises. That's true even if
prices don't change, and the U.S. saw this during the housing bubble of 2005. Low-cost and sub-prime mortgages increased the
number of people who could afford a house.

The total number of buyers in the market expanded. This increased demand for housing. When housing prices started to fall, many realized they
couldn't afford their mortgages. At that point, they foreclosed. That reduced the number of buyers and drove down demand.

The law of demand states that, other things being equal,

 More of a good will be bought the lower its price

 Less of a good will be bought the higher its price

Ceteris paribus means “other things being equal.”

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price.
Demand is based on needs and wants—a consumer may be able to differentiate between a need and a want, but from an economist’s perspective,
they are the same thing. Demand is also based on ability to pay. If you can’t pay for it, you have no effective demand.

What a buyer pays for a unit of the specific good or service is called the price. The total number of units purchased at that price is called the
quantity demanded. A rise in the price of a good or service almost always decreases the quantity of that good or service demanded. Conversely, a
fall in price will increase the quantity demanded. When the price of a gallon of gasoline goes up, for example, people look for ways to reduce their
consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists
call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that
affect demand are held constant.
An example from the market for gasoline can be shown in the form of a table or a graph. (Refer back to “Reading: Creating and Interpreting
Graphs” in chapter 0 if you need a refresher on graphs.) A table that shows the quantity demanded at each price, such as Table 1, is called a
demand schedule. Price in this case is measured in dollars per gallon of gasoline. The quantity demanded is measured in millions of gallons over
some time period (for example, per day or per year) and over some geographic area (like a state or a country).


In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship
between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists
talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand
refers to the curve and quantity demanded refers to the (specific) point on the curve.

Change in Demand vs. Change in Quantity Demanded

It’s hard to overstate the importance of understanding the difference between shifts in curves and movements along curves. Remember, when we
talk about changes in demand or supply, we do not mean the same thing as changes in quantity demanded or quantity supplied.

A change in demand refers to a shift in the entire demand curve, which is caused by a variety of factors (preferences, income, prices of substitutes
and complements, expectations, population, etc.). In this case, the entire demand curve moves left or right .

Figure 1. Change in Demand. A change in demand means that the entire demand curve shifts either left or right. The initial demand curve D 0 shifts
to become either D1 or D2. This could be caused by a shift in tastes, changes in population, changes in income, prices of substitute or complement
goods, or changes future expectations.

A change in quantity demanded refers to a movement along the demand curve, which is caused only by a chance in price. In this case, the demand
curve doesn’t move; rather, we move along the existing demand curve.

Figure 2. Change in Quantity Demanded. A change in the quantity demanded refers to movement along the existing demand curve, D0. This is a
change in price, which is caused by a shift in the supply curve.

1. Which of these describes PPP?

- A law of one price
2. Which economic variables have a relationship with the inflation rate based on the Fisher Effect?
- Interest Rate
3. If one country’s interest rates are high relative to other countries, that country will attract foreign funds. A high – interest rate will
increase the demand for the home currency. What will happen to the exchange rate of the home currency?
- Exchange rate of home currency will APPRECIATE
4. A country’s productivity when improved will attract more FDI. In turn, more FDI will be attracted to the country and will result in high
demand for its currency. What is the effect of this situation to the home country’s exchange rate?
- Exchange rate of the home country will APPRECIATE
5. It is defined as the price of one currency in terms of another. This is called what?
- Foreign Exchange Rate
6. It is the rick faced by the firm on the possible unpredicted changes of the future exchange rates and its possible adverse consequences
for the firm.
- Foreign Exchange Risk
7. The market for buying and selling currencies of different countries is called what?
- Foreign Exchange Market
8. An exchange rate policy wherein the exchange rate of the currency is set a fixed value relative to the currency of other countries.
- Fixed Rate Policy
9. A kind of exposure to exchange rate wherein the income of individual transactions is affected by fluctuations in foreign exchange values
-Transaction Exposure
10. A foreign exchange risk associate with the long – run effect of changes in exchange rates oon future prices and costs.
- Economic Exposure
11. A group of buyers and sellers of a particular good or service.
- Market
12. The amount of good that buyers are willing and able to purchase.
- Quantity Demanded
13. The claim that other things being equal, the quantity demanded of a good falls when the price of the good rises.
- Law of Demand
14. A table that shows the relationship between the price of a good and the quantity demanded
- Demand Scedule
15. A graph of relationship between the price of a good and the quantity demanded.
- Demand Curve
16. Price of the good itself will shift the demand curve
- False
17. Income will shift the demand curve
- True
18. Prices related goods will shift the demand curve
- True
19. Taste will not shift the demand curve
- False
20. Number of buyers will represent a movement along the demand curve.
- False