UNIT 1

Content

1.1 Introduction to International Trade

1.2 Importance of International Trade
1.3 Theories of International Trade- Adam Smith – Ricardo – Haberler – Hecksher Ohlin

1.1 INTERNATIONAL TRADE

International Trade is concerned with the exchange of goods between one country and another.
It is the movement of goods and services from one political territory to another. International
trade has two tasks to performs
1. Movement of goods and services
2. Movement of factors of production

International trade allows countries to expand their markets and access goods and services
that otherwise may not have been available domestically. As a result of international trade,
the market is more competitive. This ultimately results in more competitive pricing and brings
a cheaper product home to the consumer. Trading globally gives consumers and countries the
opportunity to be exposed to goods and services not available in their own countries, or more
expensive domestically. A product that is sold to the global market is called an export, and a
product that is bought from the global market is an import.

FEATURES OF INTERNATIONAL TRADE

Following are the features of International Trade

1. Participation of two or more countries

2. The nature of nature of international trade is heterogeneous. It deals with different
languages, traditions, culture, customs, taste and preferences.
3. Different currencies are used for international trade. Thus rate of exchange of currency
is also different
4. Each country has its own policies of trade, commerce, exports, imports and subsidies
5. At international level companies have to make production at large level to cover a
wider market and huge demand has to be met from other countries
 6. Immobility of resources are another feature. It is not easy or impossible to move the
factors of production or resources
7. In international trade there is higher transportation cost.

Some of the examples for international trade are as follows

Amazon, Microsoft, Facebook  USA

Samsung  South Korea

Benz  German

NestleSwitzerland

Toyota Japan

INTERNAL TRADE OR DOMESTIC TRADE

The other name for internal trade is domestic trade. This is the buying and selling of goods and
services within the confined boundaries of the nation. This may be sub-divided into two
categories, wholesale and retail. Wholesale trade is concerned with buying goods from
manufacturers or dealers or producers in large quantities and selling them in smaller quantities
to others who may be retailers or even consumers. Wholesale trade is undertaken by wholesale
merchants or wholesale commission agents.

DIFFERENCE BETWEEN INTERNATIONAL AND INTERNAL TRADE

Internal Trade International Trade

Meaning Buying and selling of goods Buying and selling of goods
within the geographical limit beyond the geographical
of a country limits of the country
Countries involved Only one country is involved Minimum two or more
countries are involved
 Risk Less risk involved More risk involved
Currency used Payment is made and Payment is made and
received in home currency received in foreign currency
Procedure involved No long procedure or Long procedure and many
formalities have to be formalities have to be
completed before starting completed before starting
business business
Mode of transport Road and railways Sea and Airways
Cost involved Operating cost is low Operating cost is high
Effect on foreign exchange No effect on foreign reserves Direct effect on foreign
reserves of the country

SIMILARITIES BETWEEN INTERNATIONAL AND INTERNAL TRADE

1. Both types of trade used a medium of exchange in assessing the worth of goods and
services involved. Money is involved
2. International and internal trade involves the exchange of buying and selling of goods
and services
3. Both involves cost in area of transport, insurance, advertising and warehousing known
as auxiliaries to trade.
4. Middlemen are involved in both

ADVANTAGES/BENEFITS/ MERITS OF INTERNATIONAL TRADE

The advantages of international trade can be divided into three categories

1. Advantages for exporting country

2. Advantages for importing country
3. Benefits to the whole world
1. Advantages for exporting country
Increased output: Due to international trade, the total production has to be increased
since there is a wide market to trade with. There will be full utilization of resources.
When the resources are used fully it will lead to lowering the cost of production for
the exporting country
 Greater Specialization: Some nations are endowed with certain advantages like
natural resources, workforce, technology and capital. These resources allow them to
engage in the production of certain kinds of goods and services at relatively cheaper
costs and sell it to other nations who need them. They can engage in large scale
production to cater to the needs of home domestic as consumption as well as serve the
international markets. They can also dispose of goods and services which they possess
in large quantities to other countries and improve their foreign exchange reserves in
return.
Faster Economic Growth: One of the top advantages of international trade is that you
may be able to increase your number of potential clients. Each country you add to your
list can open up a new pathway to business growth and increased revenues. Increased
revenue will lead to increase in the economic development and economic growth in
the country
Widened market and lower cost: The products of one country can be sold in almost
all countries in the world today i.e. the market is limitless. Selling products in native
country can limit the market size to that of the local market. However, exporting
products abroad gives you unlimited opportunities to showcase your talent and earn
big. Selling products globally can help in building up brand reputation and quintuple
your revenues.
Sale of Surplus Goods: When there is excess production in the market, the excess
good can be exported and the surplus goods can be used to earn higher foreign
exchange
Higher returns to factors of production: When there is an increase in the production
due to exporting, the demand for factors of production increases and it will help in
acquiring higher returns to the factors of productions.

2. Advantages for importing country

Availability of different types of goods and services: One of the major benefits of
international trade is that it enables a country to obtain goods and services that it is
unable to make on their own due to lack of resources or higher costs of production.
They can get these goods from outside the country at relatively lower costs.
Higher Economic Growth: When the imported commodities are raw materials
which are used for developmental activities or production, it helps in increasing the
economic growth of the country
 Reducing Costs: Another major benefit of importing is reduce in manufacturing
costs. Many businesses today find importing products, parts of products and
resources more affordable than producing them locally. There are numerous cases
when entrepreneurs find products of good quality which are inexpensive even when
the overall import expenses are included. So instead of investing in modern,
expensive machinery, entrepreneurs choose to import goods and reduce their costs.
In most cases, they end up ordering large quantities in order to get a better price and
minimize the costs.
Providing High Quality Products: Another benefit of importing is related to the
ability to market products of high quality. Lots of successful entrepreneurs travel
abroad, visit factories and other highly professional sellers in order to find high
quality products and import them into their own country. Moreover, manufacturers
may provide informative courses and training, as well as introduce standards and
practices to ensure the company abroad is well prepared to sell their products.
Exchange of technical know-how and establishment of new industries:
Underdeveloped countries can establish and develop new industries with the
machinery, equipment and technical know-how imported from developed countries.
This helps in the development of these countries and the economy of the world at
large.
3. Advantages for whole world
Benefits to all trade partners: Trade induced large production will lead to
specialization and increase in the world productivity. Increased production leads to
higher income and thus higher levels of economic growth for all the trade partners
International co-operation and understanding: The people of different countries
come in contact with each other. Commercial intercourse amongst nations of the
world encourages exchange of ideas and culture. It creates cooperation,
understanding, cordial relations amongst various nations.
Ability to face natural calamities: Natural calamities such as drought, floods,
famine, earthquake etc., affect the production of a country adversely. Deficiency in
the supply of goods at the time of such natural calamities can be met by imports from
other countries.

DISADVANTAGES OF INTERNATIONAL TRADE:

Though foreign trade has many advantages, its dangers or disadvantages should not be ignored.

1) Impediment in the Development of Home Industries: International trade has an

adverse effect on the development of home industries. It poses a threat to the survival
of infant industries at home. Due to foreign competition and unrestricted imports, the
upcoming industries in the country may collapse.
2) Economic Dependence: The underdeveloped countries have to depend upon the
developed ones for their economic development. Such reliance often leads to economic
exploitation. For instance, most of the underdeveloped countries in Africa and Asia
have been exploited by European countries.
3) Political Dependence: International trade often encourages subjugation and slavery. It
impairs economic independence which endangers political dependence. For example,
the Britishers came to India as traders and ultimately ruled over India for a very long
time.
4) Mis-utilisation of Natural Resources: Excessive exports may exhaust the natural
resources of a country in a shorter span of time than it would have been otherwise. This
will cause economic downfall of the country in the long run.
5) Import of Harmful Goods: Import of spurious drugs, luxury articles, etc. adversely
affects the economy and well-being of the people.
6) Storage of Goods: Sometimes the essential commodities required in a country and in
short supply are also exported to earn foreign exchange. This results in shortage of these
goods at home and causes inflation. For example, India has been exporting sugar to
earn foreign trade exchange; hence the exalting prices of sugar in the country.
7) Danger to International Peace: International trade gives an opportunity to foreign
agents to settle down in the country which ultimately endangers its internal peace.
8) World Wars: International trade breeds rivalries amongst nations due to competition
in the foreign markets. This may eventually lead to wars and disturb world peace.
9) Hardships in times of War: International trade promotes lopsided development of a
country as only those goods which have comparative cost advantage are produced in a
country. During wars or when good relations do not prevail between nations, many
hardships may follow.
1.2 IMPORTANCE OF INTERNATIONAL TRADE
Make use of abundant raw materials: Some countries are naturally abundant in raw
materials – oil (Qatar), metals, fish (Iceland), Congo (diamonds) Butter (New
 Zealand). Without trade, these countries would not benefit from the natural
endowments of raw materials. Countries will specialise in producing and exports
goods which use abundant local factor endowments. Countries will import those
goods, where resources are scarce.
Comparative advantage: The theory of comparative advantage states that countries
should specialise in those goods where they have a relatively lower opportunity cost.
Trade allows countries to specialise.
Greater choice for consumers: A driving factor behind the trade is giving consumers
greater choice of differentiated products. We import BMW cars from Germany, not
because they are the cheapest but because of the quality and brand image. Regarding
music and film, trade enables the widest choice of music and film to appeal to different
tastes. When the Beatles went on tour to the US in the 1960s, it was exporting British
music – relative labour costs were unimportant.
Specialisation and economies of scale – greater efficiency: Sometimes, countries
may specialise in particular industries for no over-riding reason. But, that
specialisation enables improved efficiency. For high value-added products,
multinationals often split the production process into a global production system. For
example, Apple designs their computers in the US but contract the production to Asian
factories. Trade enables a product to have multiple country sources. With car
production, the productive process is often even more global with engines, tyres,
design and marketing all potentially coming from different countries.
Service sector trade: Trade tends to conjure images of physical goods import bananas,
export cars. But, increasingly the service sector economy means more trade is of
invisibles – services, such as insurance, IT services and banking.
Global growth and economic development: International trade has been an
important factor in promoting economic growth. This growth has led to a reduction in
absolute poverty levels – especially in south East Asia which has seen high rates of
growth since the 1980s.

1.3 THEORIES OF INTERNATIONAL TRADE

There are four main theories of International Trade which are
1. Adam Smith’s Theory of Absolute Cost Advantage
2. Ricardo’s Theory of Comparitive Cost Advantage
3. Haberler’s Opportunity Cost Theory
 4. Heckscher-Ohlin theory

1. ADAM SMITH’S THEORY OF ABSOLUTE COST ADVANTAGE

. The theory of absolute advantage which was developed first by Adam Smithin his famous
book “The Wealth of Nations” published in 1776. Adam Smith, the father of economics,
thought that the basis of international trade was absolute cost advantage According to his
theory, trade between two countries would be mutually beneficial if one country could produce
one commodity at absolute advantage (over the other commodity) and the other countries
could, in turn, produce another commodity at an absolute advantage over the first.

Assumptions:

 Trade is between the two countries.

 It is a two-country and two-commodity framework for his analysis.
 There is no transportation cost.
 Costs of the commodities were computed by the relative amounts of labour required in
their respective production processes.
 Labour was mobile within a country but immobile between countries.
 No barriers to trade in goods.

The principle of absolute advantage refers to the ability of a country to produce a greater
quantity of a good, product, or service than competitors, using the same amount of resources.
Adam Smith first described the principle of absolute advantage in the context of international
trade, using labor as the only input.

Theory:

According to Adam Smith, countries should only produce and export goods in which they have
an absolute cost advantage.

If a country can produce a commodity at a lower cost than another country, it is said that the
country has an absolute cost advantage

Absolute cost advantage = Lowest cost of production

Good X Good Y
Country A 16 units 8 units
 Country B 8 units 16 units

Country A produces 16 units of Good X and 8 units of Good Y, whereas country B produces 8
units of Good X and 16 units of Good Y. Country A has an absolute cost advantage in the
production of Good X. Country B has an absolute cost advantage in the production of Good Y.
According to Adam Smith, Country A can specialize in producing Good X and not in the
production of Good Y. Country A can import Y from country B. Likewise country B should
produce Good Y and not in Good X. Country B can import Good X from Country A. Country
A can specialise in Good X and gain more and can produce twice of Good X.

2. RICARDO’S THEORY OF COMPARITIVE COST ADVANTAGE

David Ricardo believed that the international trade is governed by the comparative cost
advantage rather than the absolute cost advantage. A country will specialise in that line of
production in which it has a greater relative or comparative advantage in costs than other
countries and will depend upon imports from abroad of all such commodities in which it has
relative cost disadvantage. Suppose India produces computers and rice at a high cost while
Japan produces both the commodities at a low cost. It does not mean that Japan will specialise
in both rice and computers and India will have nothing to export. If Japan can produce rice at
a relatively lesser cost than computers, it will decide to specialise in the production and export
of computers and India, which has less comparative cost disadvantage in the production of rice
than computers will decide to specialise in the production of rice and export it to Japan in
exchange of computers.

Assumptions:

 Trade takes place between two countries only, say A and B.

 They are trading with only two commodities, say, cloth and wine,
 The cost of production of these two goods in both the countries is expressed in terms
of labour only
 The production of these two goods in both the countries taken place at constant costs,
 There is no transport cost, or the transport cost, if any, is so small a part of product
prices that it is ignored.

Ricardo was concerned about the position where a country was able to produce every
commodity at an absolutely lower real cost than another country. He suggested that in this case
 each country should specialise in the production of those goods where its comparative
advantage was greatest.

Wine Cloth
Amount of labour (man hours) required to produce 1 unit
Portugal 80 hours 90 hours
England 120 hours 100 hours

Ricardo developed his theory by comparing two countries, England and Portugal, and two
commodities, wine and cloth. The table shows that Portugal was more efficient in the
production of both goods, but Ricardo argued that both countries could benefit if they
specialised where their advantage was comparatively high and then traded. Portugal’s labour
costs were lower than England’s in both cloth and wine, but the comparative advantage was
greater in wine.

Ricardo showed that both countries would benefit if England specialised in cloth and Portugal
in wine and; if after specialisation, a unit of wine is exchanged for a unit of cloth. England
would gain 20 hours since it costs her 100 hours to produce cloth but 120 to produce wine.
Portugal would also benefit because she would trade a unit of wine which took 80 hours to
produce and receive a unit of cloth which would have taken her 90 hours to produce. Hence,
Portugal gains 10 hours. In the above example, Portugal has an absolute advantage in the
production of both the commodities since the input requirements for both the commodities are
less than those of England. But Portugal has a comparative cost advantage in wine. However,
a situation of equal advantage, where one country is superior to another in the same ratio in all
products, rules out the possibility of gainful trade.

3. HABERLER’S OPPORTUNITY COST THEORY

Opportunity cost of a commodity is defined as the amount of a second commodity that must
be given up to release just enough resources to produce one additional unit of the first. Haberler
used this concept to explain the law of comparative advantage. In this form, this law is referred
to as the law of comparative cost. Consequently, the nation with the lower opportunity cost is
said to have a comparative advantage in the production of that commodity and comparative
disadvantage in the production of other commodity.

Assumptions:
  There are only 2 countries, Country A and Country B
 There are only 2 factors of production, Labor and Capital
 Each country can produce 2 commodities, X and Y
 There is perfect competition in factor and commodity market
 Full employment exists
 No change in technology
 Factors are mobile within country
 Factors are immobile between 2 countries
 Trade is free and unrestricted

The existence of comparative advantage in costs of production is the principal cause of

emergence of international trade. Ricardo has given an example of trade between England and
Portugal is given below

Wine Cloth
Amount of labour (man hours) required to produce 1 unit
Portugal 80 hours 90 hours
England 120 hours 100 hours

From the above table, it is clear that Portuguese labour is more efficient than English lobour in
the production of wine as well as cloth. So Portugal has an absolute advantage in the production
of wine and cloth. The trade between England and Portugal can also be demonstrated by
introducing the concept of opportunity cost. The below table gives the opportunity costs for
producing wine and cloth in the two nations calculated below

Wine Cloth
Amount of labour (man hours) required to produce 1 unit
Portugal 80/90 = 0.83 90/80 = 1.13
England 120/100 = 1.20 100/120 = 0.82

This table shows that

In England, 1 unit of cloth = 0.83 units of wine. (Domestic exchange ratio of England)

In Portugal, 1 unit of wine= 0.82 units of cloth. (Domestic Exchange Ratio of Portugal)
Here, England has the lower opportunity cost of the two nations in producing cloth and Portugal
has lower opportunity cost in producing wine. Thus, England has comparative advantage in
producing cloth and Portugal has comparative advantage in producing wine. As long as the
opportunity cost of production for a good differs in the two nations. One nation has a
comparative advantage in the producing of one of the two goods, while the other nation has a
comparative advantage in the production of the other good. According to the theory, Country
must produce the commodity that has lower opportunity cost when compared to other country.

PRODUCTION POSSIBILITY CURVE

The production possibility curve (PPC) represents all the alternative combinations of two
commodities that a nation can produce by fully utilizing all its factors of production. In other
words, the production possibility curve shows the frontier beyond which production cannot be
carried on with the available resources and technology. Slope of PPC measures the amount of
goods that a country must give up in order to get an additional unit of second commodity. There
are 3 types of opportunity costs

1. Constant Opportunity Cost

2. Increasing Opportunity Cost
3. Decreasing Opportunity Cost

Trade under Constant Opportunity Cost

In the case of case of constant opportunity cost, the quantity of Good Y given up for Good X
is the same. PPC under constant opportunity cost is a straight line
Country A can produce OP of Commodity Y and OA of Commodity Y. Country B can produce
OP of Commodity Y and OB of Commodity X. At point E, country B can produce OY1 of
Commodity Y and OX1 of Commodity X. Opportunity cost of giving one unit in order to have
one more unit of another commodity is constant.

Trade under Increasing Opportunity Cost

The production under constant returns to scale can be possible, when it is assumed that there
are fixed factor proportions and that factors of production have equal efficiency in producing
relative outputs of two commodities. In actual life, factor specificity, lack of perfect
substitution and varied efficiency of factor units in different lines of production lead to
decreasing returns to scale and the opportunity cost may go on increasing. PPC curve in an
increasing opportunity cost is concave to the origin
As we move from A to A1, country A is giving up larger and larger units of Commodity Y to
produce additional unit of Commodity Y. Thus country A faces increasing opportunity cost as
it produces each additional units of Commodity X in which it is specialising.

Trade under Decreasing Opportunity Cost

If the production of both the commodities in the two countries is governed by increasing returns
to scale, the production possibility curve or transformation curve in both the countries will be
convex to the origin.
 As we move from A to A1, we are giving up lesser and lesser units if Commodity Y to produce
additional units of commodity X.

4. HECKSCHER-OHLIN THEORY

According to Ricardo and other classical economists, international trade is based on differences
in comparative costs. The theory was developed by the Swedish economist Bertil Ohlin (1899–
1979) on the basis of work by his teacher the Swedish economist Eli Filip Heckscher (1879–
1952). It is important to note that Heckscher and Ohlin agreed with this fundamental
proposition and only elaborated this by explaining the factors which cause differences in
comparative costs of commodities between different regions or countries.

According to Ohlin, the underlying forces behind differences in comparative costs are two-
fold:

1. The different regions or countries have different factor endowments.

2. The different goods require different factor-proportions for their production.

Assumptions:

1. There are two countries, 2 commodities,2 factors of production (2X2X2 model)

2. There is the presence of constant returns to scale
3. Same Technology is used by both countries
4. There is perfect competition in product and labour market
5. There is no tariff or non-tariff barriers and there is free trade
6. No complete specialization
7. Full employment situation exists

Let’s assume there are two countries – Country 1 and Country 2. The two commodities are-
commodity X (capital commodity) and commodity Y (agriculture commodity). Take
Commodity X be capital-intensive, that is, they can be produced with less labor relative to
capital and it has a higher capital-labor ratio and Commodity Y be labor-intensive commodity,
that is, it requires a substantial amount of labor relative to capital. Further assume that Country
1 specializes in producing the capital commodity and Country 2 is considered to be an
agricultural country and thus specializes in commodity Y

Factor Intensity
The term "factor intensity" refers to the relative proportion of the various factors of production
used to make a given product. In other words, factor intensity looks at how much an industry
uses capital, for instance, as opposed to labor. So when we say that commodity Y is labour-
intensive, it means that labor is used relatively more in the production of commodity Y than in
the production of Commodity X. In Hecksher Ohlin model, factor intensity is measured by K/L
ratio. It is the amount of Capital employed with one unit of Labour. A commodity will be
Capital intensive if K/L ratio of commodity is higher than that of the other commodity. Here
we assumed Commodity Y is Capital intensive that means K/L required for the production of
Y is higher than that of Commodity X. While talking about factor intensity, we always talk in
terms of capital per unit of labor and not in absolute terms

Factor Abundance

Factor abundance is the resource richness of nations. There are two definitions of factor
abundance: one in terms of physical quantities and other in terms of factor prices. According
to the definition in terms of physical units, the factor abundance of one country is defined by
the relative endowment of capital to labor in one country relative to another country. Country
1 is capital abundant if the ratio of the total amount of capital to the total amount of labor
(TK/TL) available in country 1 is greater than that in country 2 i.e. (TK/TL) Country 1>
(TK/TL) Country 2.

We will assume that country 1 is capital-abundant country and country 2 is labor-abundant

According to the definition in terms of factor prices, Nation 1 is capital abundant if the ratio of
the rental price of capital to the price of labor time (PK/PL) is lower in country 1 than in country
2. Since rental price of capital is usually taken to be the interest rate (r) while the price of labor
time is the wage rate (w), PK/PL = r/w. Then (PK/PL)) country 1 < (PK/PL) country 2 or (r/w)
country 1 < (r/w) country 2. This is because capital abundance in country 1 leads to a lower
price of it in the said nation and similarly higher price of the relatively scarce factor.

So we have country 1 as the capital abundant country and commodity X is the capital-intensive
commodity, country 1 can produce relatively more of commodity X and at a lower cost than
country 2. Country 2 is the Labour abundant country and commodity Y is the labour intensive
commodity, country 2 can produce relatively more of commodity Y and at a lower cost than
country 1.
In the above diagram, as shown earlier, the PPF for Country 2 is skewed towards commodity
Y- the labour-intensive commodity and PPF for Country 1 is skewed towards commodity X,
the capital-intensive commodity. Since tastes are assumed to be the same in both nations, the
preferences of consumers can be represented by a single IC. The same IC1 is tangent to both
nations’ PPF at point A and A' respectively. This is the autarky (no-trade) equilibrium where
the production and consumption points are same for both countries. The price line for both
countries is given by PB. The figure above shows how the two countries reach equilibrium
when they trade.

Country 2 will specialize in production of commodity Y and will reach point B'. Similarly,
Country 1 will specialize in production of commodity X and will reach point B where the PPF
of the two countries are tangent to their relative price line i.e. the rate at which they exchange
with each other. Country 2 will export commodity Y and Country 1 will export commodity X
and in this process they both will reach equilibrium point E on IC. Here we can see that,
Country 2 exports of commodity Y equals Country 1 imports of commodity Y and Country 1
exports of commodity 1 equals Country 2 imports of commodity X. The two trade triangles
BCE and B'C’E are equal. At point E, Country 2 has more of commodity X but less of
commodity Y than before it had at previous point but it still gains because point E is on a higher
IC. Similarly, at point E Country 1 involves more of commodity Y and less of commodity X
but it is also better off by trading because it is on a higher IC. So both nations gain from trade
by consuming on a higher Indifference Curve. Hence following the H-O theorem, the two
nations gain from trade.
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