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TRADE THEORIES

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What is Trade?- Exchange ofgoods and services

Why do we need to do trade?

Differences in cost are the basic cause of

trade. Every country will have goods that can

be produced cheaper than others. This

promotes them to export that product for

another. Eg. UAE can produce oil while

Japan can produce electronics and cars. Thetwo nations can trade with each other and

both are satisfied.

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How does a country decide

what to trade and with whomto trade?

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Adam Smiths theory of AbsoluteAdvantage-

Simplest example- Imagine USA needs 10 workers

to manufacture 1 helicopter but takes 20 men tobuild a luxury car.

Germany on the other hand needs 20 workers to

manufacture a

helicopter while only10 workers for the car.

Do they have anyDo they have any

advantage to trade?advantage to trade?

Or can they continueOr can they continue

doing what theyve been doing?doing what theyve been doing?

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Theres only one logicalTheres only one logical

decision to be made by bothdecision to be made by both

countries-countries- US must export copters to Germany andimport cars in return! Because instead of

wasting 20 men for making a car, they can

make TWO copters. If US sells it to Germanythey can get back TWO CARS for the cost of

one!

The result is maximum productivity and profit.

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Every country having absolute

advantage in the production and

distribution of every good is not

possible. So international trade is

important to everyone.

That is why when sanctions are

imposed on our trade, it affects us

a lot. (India, Pak, Iraq, NorthKorea)

Trade also depends on

relationships between nations.

Reason why heads of state keep

meeting other heads to discussbetter ties for the future. Eg. India

& China, Russia, US etc.

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But what if a country cancanproduce all the goods it

needs or another countrycannotcannot produce any goods at

all.Does it mean they should notDoes it mean they should not

and cannot trade?and cannot trade?

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David Ricardos ComparativeAdvantage Theory Eg. Suppose India and France are cotton and

wine producing countries. France can

produce 1 unit of wine with 50 man hours and

1 unit of cotton with 60 man hours. India on the other, the cost of producing 1

unit of wine is 100 working hours and 1 unit

of cotton is 80 man hours.Does it make sense for France to trade with

India?

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Yes, France must trade withIndia! Because if we calculate, the

cost for France for making 1unit of wine is 50/60 and 1unit of cotton is 60/50.

Which means 1 unit of wine

costs 0.833 units of cottonand 1 unit of cotton costs1.2 units of wine. ForFrance cotton is moreexpensive to make thanwine.

For India, 1 unit of wine is1.25 units of cotton. and 1unit of cotton is 0.80 units ofwine. Here wine is moreexpensive.

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Therefore bothcountries can benefitif they are willing to

trade with each other.India can manufacturecotton and sell toFrance in exchange

for wine and France isalso benefited viceversa.

To understand thepoint further, if theworld market price for1 unit of cotton issimilar to 1 unit of

wine, then France

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Logic?

To make 1 unit of cotton France has to spend

60 man hours which has the same value as 1

unit of wine made in 50 hours. France can

leave the cotton making work to India andsave those 10hours or add those 10hours

extra for making more wine.

India on the other hand can save 20 hoursevery time it makes cotton and gets back

equivalent amount of wine as needed.

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Heckscher Ohlin Theory (H-OModel) Goods differ in terms of the factors of production. Eg.Manufacturing of textiles is labour intensive whereas

producing microprocessors is capital intensive. Countries differ w.r.t. their factor capabilities. Eg. India

is high in labour but UK is high in capital. A country manufactures and uses those factors which

it has in abundance. Eg. US exports capital intensivedefense goods.

As with previous theories,

HO Model too is weak in the fact

that it states markets as being static

with factors also being constant.

Present markets change using

innovation, intelligence

(Indian software), taste and

need for the goods and other reasons.

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Strategic Trade Theory-Combination of the latest

trade theories. Key factors Increasing returns to scale- firms will produce andexport more and more inorder to lower costs througheconomies of scale.

Product differentiation- there can also be intra-industry competition. i.e. within the same industry wecan have trade. Eg. Japan will trade Toyotas and Hondawith Germany in exchange for Mercedes and BMWs.

Imperfect competition- companies might have to facevarious hurdles to sell to other nations. Eg. India mightgive special subsidies to Videocon so as to keepJapanese Sony and Aiwa costlier than domesticplayers.

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Externalities & spillover effects-Once a new technology product issold outside, other countries might

reverse-engineer and make their ownversions. Thus the original makersuffers losses of loss of market. IPrights and patents play a role.

Irreversible investments- eg. When

earth-moving equipment companieslike Caterpillar suffered huge lossesin 1980s they had no choice but tocontinue as such because

the costs for market reentry

would have been sky high

(building distribution

networks, partners etc.)