Theories of International

Trade

Trade

Trade refers to exchange of goods & services betweenseller & buyer

Trade is of 2 types i.e. Domestic trade & InternationalTrade

Domestic Trade is carried out within the country &international trade refers to trade between countries

Similarities in Domestic & International

Trade

Both involve exchange of goods & services

Objective is Profit Maximization

Basis for trade is cost advantage

Both enhance consumer’s satisfaction by providingvarious goods & services

Comparative Cost Advantage Theory of

International Trade

According to David Ricardo, countries will exportproducts where they have cost advantage & surplusproduction

They will import goods where they have costdisadvantage

This theory is based on labour value i.e. Value of goodsdepends upon amount of labour used to produce it

Comparative Cost Advantage Theory of

International Trade

Assumptions for Cost Advantage Theory Labour is the only factor of production & is homogenous factor Cost of production of all commodities are measured in terms of

labour cost Labour is perfectly mobile within country but immobile between

countries Economy is Laissez-Faire i.e. No govt intervention Free Trade (Absence of Tariffs, Quotas etc.) Perfect Competition prevails in both countries Transport cost are ignored Full employment in both countries

Comparative Cost Advantage Theory of

International Trade

Ricardo explained this theory by using 2 country – 2commodity & 1 factor of production model

When both the countries do not have trade relations thenboth the items will be produced by each country & 1 goodwill be exchanged for other

This is known as domestic exchange rate

Countries No. Of Hours to produce 1 UnitWine Cloth

Portugal 80 90England 120 100

Comparative Cost Advantage Theory of

International Trade

For Portugal, 1 unit of wine = 0.88 units of cloth For England, 1 unit of wine = 1.2 units of cloth When trade takes place, 1 unit of wine will range from 0.88

units to 1.2 units of cloth Portugal would like to get more than 0.88 unit of cloth for

every unit of wine sold (as 0.88 is their own price) England would like to give less than 1.2 unit of cloth for

every unit of wine purchased (as 1.2 is their own price) Assuming, exchange ratio is 1 unit of wine = 1 unit of cloth,

then both the countries will benefit

Comparative Cost Advantage Theory of

International Trade

When countries specialize & trade, production of goodswill be more

If there was no trade then both the countries would beproducing both the products and having less benefitwith more of labour hours

Thus according to this theory, differences in comparisoncost advantage leads to international trade

Critical Evaluation Based on 2 country, 2 commodity & 1 factor model – restrictive in

nature Based on Labour value theory, which is unrealistic Full employment, Perfect Mobility etc. are not tenable

assumptions Only 1 factor of Labour is considered & others are ignored – Not

comprehensive Partial theory as emphasises only on supply and ignorant about

demand No proper Exchange rate

Heckscher – Ohlin Theory of Int.

Trade

This theory is also known as factor endowment theory

Comparative cost advantage theory only explained thatint. trade took place due to cost differences

However they did not explain the reasons for costdifferences

This theory explains the reasons for cost differences

Modern theory starts where cost comparative theoryends

Heckscher – Ohlin Theory of Int.

Trade

As per this theory, cost difference arises due to 2 reasons Different countries have different factor endowments

Factor proportions used for producing commodities aredifferent in different countries

Heckscher – Ohlin Theory of Int.

Trade

Assumptions 2 country, 2 commodity & 2 factor model

1 country is endowed with abundance of labour & other with capital Free Trade (Absence of Tariffs, Quotas etc.)

Full employment in both countries

Perfect Competition prevails in both product & factor market Factors of Production are perfectly mobile within country but

immobile between countries

No Transportation cost

Factors of Production are homogenous in both the countries

Heckscher – Ohlin Theory of Int.

Trade

As per this theory, countries will specialize inproduction of those products which uses the abundantfactor (labour / Capital)

Viz, capital rich country will specialize in capitalintensive goods & labour abundant country willproduce more of labour intensive products & export

This is so, as abundant factor is available easily & atcheaper rates

Advantages of International

Trade

Comparative Cost Advantage Specialization Optimum use of Resources Benefit to Consumer Increase in Production, Employment & N.I. Availability of Goods & Services Conservation of Scarce Resources Promotion of Inter-Dependence & Co-Operation

Questions

1. Explain Trade – Distinguish between Domestic &International Trade

2. Explain Comparative Cost Advantage Theory

3. Explain Heckscher – Ohlin Theory of InternationalTrade

4. Discuss the various benefits of International Trade