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International Trade 1

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24 views7 pages

International Trade 1

Uploaded by

Atta Khan
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© © All Rights Reserved
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August 30, 2024

International Trade Theory

International Economics:

International economics deals with the economic interdependence among the nations. It analyzes the
flow of goods and services and payments between a nation and rest of the world.

The policies are directed at regulating this flow and their effects on a nation’s welfare. This economic
dependence among the nations is affected by an inter-influence the politics, social, cultural and military
relations among the nations.

Scope of International Economics:

The international economics specifically deals with the international trade theory, international trade
policy, balance of payment, foreign exchange markets and open economy macroeconomics.

 International trade theory analyzes the basis and gains from the trade.
 International trade policy examines the reasons for the effects of trade restrictions and new
protectionism.
 The Balance of payment measures a nation’s total receipts from the total payment and rest of
the world.
 While foreign exchange markets are the frameworks of exchange one national currency for
another.
 Open economy macroeconomics deals with the mechanisms for adjustment in balance of
payment’s disequilibrium as well as the effects of macroeconomic interdependence among the
nation under different international monetary system and the effects of national welfare.

International Trade:

By international trade we mean the exchange of goods and services between the countries. It allows us
to expand our market for both goods and services. As a result of international trade, the market contains
greater competition and therefore more competitive prices which brings a cheaper product home to the
consumer.

Another definition: International trade is a set of action that aim to exchange goods and services
between foreign countries across the international borders. It allows firm to compete in the global
market and to employ competitive prices for their product and services. As more products become
available to the market, consumer meet their needs and satisfy their wants thus increasing consumer
satisfaction.
Significance of International Trade:

1. International trade activities provide us with a variety of goods and services.


2. As result of international trade, the specialization and efficiency of the world production increases.
3. International trade provides us a source of income.
4. It enables countries to obtain goods and services that are not available domestically or are too
costly to produce.
5. As a result of international trade, countries can expand their markets, leading to increased
production, innovation, and economic growth.

September 11, 2024

International Trade Theory:

Absolute Advantage theory By Adam Smith:

A country should specialize in the production of that commodity in which he got absolute advantage.

By absolute advantage we mean an advantage possessed by a country when using a given resource
input. It is able to produce more output than other countries possessing the same output.

The theory of absolute advantage was presented by Adam Smith. According to him, country should
specialize in the production of that commodity which it can produce more cheaply than others and
exchange it with the commodities which cost less in other countries.

Countries should produce what they're naturally good at, based on climate, soil, and resources, and then
trade with others to benefit both parties.

According to classical economists, trade is possible between two countries when the cost of production
of two goods in countries is different. To understand the absolute advantage, let us assume that there
are two countries A and B having absolute differences in cost, and each producing a commodity X and Y
respectively at lower cost of production than the other.

Countries Commodity X Commodity Y


A 8 4
B 4 8

Now if we assume that country A can produce 8X and 4Y with one unit of labor and B can produce 4X
and 8y with one unit of labor. Country A got absolute advantage in the production of commodity X and
country B has in the production of Y.
Gains

Production Production Gains from


before trade After Trade the Trade
Commodity X Y X Y X Y
Country A 8 4 16 - +8 - 4
Country B 4 8 - 16 -4 +8
+4 +4

Before trade both countries produce only 12 units of each commodity by applying one unit labor. If
country A specializes in the production of commodity X and apply both units of labor on it, its total
production will be 16 units of X. In the same way if country B specializes in the production of Y alone, its
total production will be 16 units of Y. The combine gain from both countries from trade will be 4 units of
each commodity X and Y.
Sept 13, 2024

Comparative Advantage theory:

This theory was presented by David Ricardo. According to him country will specialize in the production of
that commodity in which it has greatest comparative advantage or the least comparative disadvantage
and import that commodity in which its comparative advantage is less.

Due to differences in climate, natural resources and efficiency of labor a country can produce one
commodity at a lower cost than the other. So each country specializes in the production of that
commodity in which its cost of production is the least. That is why when a country enters into a trade, it
will export those commodities in which its comparative production cost are less and will import those in
which its comparative cost are high.

Trade is possible between two countries when one country has an absolute advantage in the production
of both commodities but a comparative advantage in the production of one commodity than other.

This can be explained with the help of the following example.

Men year of labor for producing one unit.

Country X Y
A 12 10
B 8 9

The table shows that the production of one unit of X in country A requires 12 men for a year while a unit
of Y requires 10 men for the same period. On the other hand, the production of one unit in country B
requires 8 and 9 men respectively.

Thus, country A uses more labor than B in producing both commodities. In other words country B’s labor
is more efficient in production , but B would benefit more by producing commodity X and exporting it to
country A because it has greater comparative advantage. This is because the cost of production of
commodity X is less than the Y.

On the other hand, it is the interest of country A to specialize in the production of Y in which it has the
least comparative disadvantage. Because the cost of production of Y is less than X.
Gains from the Trade:

Domestic Exchange Ratio:

Country A Country B
12X : 10Y (12/10) 8X : 9Y (8/9)
1 : 1.2 1 : 0.89
10Y : 12X ( 12/ 10) 9Y : 8X ( 9/8)
1 : 0.83 1 : 1.3
1-0.83 = 0.17 1-0.89 = 0.11

The above table shows that the domestic exchange ratio. In country A, one unit of Y is equal to 0.83 units
of X and in country B one unit of X is equal to 0.89 unit of Y.

If we assume the exchange ratio between the two countries that one unit of Y is equal to one unit of X.
So country A would gain 0.17 ( 1-0.83) unit of X by exporting one unit of Y to B. Similarly the gain of
country B, by exporting one unit of X to country A will be 0.11 ( 1-0.89) unit of Y. this trade is beneficial
for both countries.

Modern theory of factors Endowment:

Hecksher and Ohlin Theory:

According to Hecksher and Ohlin a country should specialize in the production of that commodity which
uses the country’s more abundant factors of production. The theory now says that countries that are rich
in capital will export capital intensive goods and countries that have much labor will export labor
intensive goods.

Heckscher and Ohlin contended that the immediate cause of international trade is difference in
commodity prices caused by differences in relative demand and supply of the factors. As a result of
differences in factor endowment between two countries, the relative shortage of supply in relation to
demand is essential for trade between two countries.

Commodities which use large quantities of the scarce factors are imported because their prices are high
while those using abundant factors are exported because their prices are low.

Factors Abundance In terms of Factor Prices:

Hecksher and Ohlin explained richness in factor endowment in terms of factor prices. Country A is
Abundant in capital if:

(Pc/ PL)A < ( Pc/ PL)B (P= price, C= capital, L= labor)

Where Pc and PL refers to the prices in capital and labor and A and B denote the two countries. In other
words, If capital is relatively cheap in country A, the country is abundant in capital and if labor is cheap in
country B, the country is abundant in labor. Thus, A will export capital intensive good and B will export
labor intensive good.

Factor Abundance in Physical Terms:

Another way to explain the theory is in physical terms of factor abundance. If country A is relatively
physical abundant and country B is relatively labor abundant then measured in physical amount.

(CA/LA) > (CB/LB)

Where CA and LA shows total amount of capital and labor respectively in country A and CB and LB shows
the total amount of labor and capital relatively in country B.

Difference Between Interregional and International Trade

Interregional Trade refers to trade between different regions within the same country, while
International Trade occurs between two nations or countries.

There has been a long-standing debate among economists. Classical economists believed there were key
differences between interregional and international trade, while modern economists argue that the
difference is more a matter of degree than kind.

1. Factor Mobility:

Labor and capital move freely within a country but face restrictions internationally due to language
barriers, cultural differences, government policies and political uncertainty. These obstacles don't exist in
interregional trade, allowing easier movement.

2. Natural Resources:

Different countries have different natural resources, which influence their production. i.e. Pakistan has
abundant labor but limited capital, while the U.S. has more capital and less labor. This leads to countries
specializing in the production of goods that they can make more efficiently.

3. Separate Markets:

National markets are often separated by cultural, legal, and consumer differences. i.e. the British use
right-hand drive cars, while the French use left-hand drive cars, creating distinct markets.

4. Different Currencies:

A key distinction between interregional and international trade is the use of different currencies. While
regions within a country use the same currency. International trade involves currency exchange, creating
complexities.

6. Balance of Payments Issues: International trade often faces balance of payments problems, which
do not occur in interregional trade. A country's policies to correct BOP imbalances, such as
devaluation or import restrictions, can create more economic challenges.
6. Geographical and Climatic Differences:

Due to geographical and climatic differences, countries cannot efficiently produce all goods. Countries
specialize in the goods that they can produce most efficiently and trade with other countries for different
products.

7. Political Differences: Interregional trade occurs within the same political unit, so the policies are
designed to benefit the entire country. In contrast, international trade involves different political units,
with each country acting in its own self-interest.

8. National Policies: Domestic trade is governed by uniform policies, while international trade faces
variouss barriers, such as tariffs, quotas, and customs regulations. These barriers make international
trade more complicated compared to interregional trade.

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