Classical Theory of International Trade


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In this presentation, we will discuss about how or what conditions trigger international trade, which are further elaborated through various theories of international trade.
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Classical Theory of International Trade

  1. 1. International EconomicsLearning Objectives♥ Pre-Classical Theory of International Trade.♥ Adam Smith’s Theory of Absolute Cost Difference.♥ David Ricardo’s Theory of Comparative Cost Advantage.♥ JS Mill’s theory of Reciprocal Demand.
  2. 2. International Economics3.1 IntroductionTheory of International Trade [IT] addressesquestions like Why does or under what conditions does IT take place? What are the terms for the trade and how are they determined?Classical economists Adam Smith and DavidRicardo attributed the IT, to absolute andcomparative cost differences respectively.Explanation for these differences wasoffered by economist B Ohlin.
  3. 3. International Economics3.1 IntroductionEconomist Bertil Ohlin also argued thatthere is little difference between interregional trade and international trade andthere is no justification for insisting on aseparate theory for it.He argued that i] it is incorrect to say that labour &capital are perfectly mobile within a country &immobile outside. The truth is that they are tocertain extent immobile even within a country.Hence difference in mobility in inter regional& IT is that of a degree.
  4. 4. International Economics3.1 Introduction ii] Further labour moved freely toother countries to bring about economicdevelopment of USA, Australia, Canadaetc in 19th and early part of 20thcentury. iii] Goods move from areas where theyare plenty to areas where they arerelatively scarce. These areas can be in asame country [like USA, China or India] ordifferent countries [like Sri Lanka,Bangladesh and Pakistan]. In first case itis inter regional and in the next IT.
  5. 5. International Economics3.1 Introduction iv] As regards existence of differentcurrency system through which the IT iscarried, Ohlin states that rate of exchange inthese currencies reflects their respectivepurchasing power. Since they are convertibleinto each other, there is a problem ofconversion in IT. This cannot be a reason foran independent IT theory. v] Principle of specializing in productswhere it has a cost advantage is applicable tocountries as well as to regions. All trade,whether internal or international is based ondivision of labour.
  6. 6. International Economics3.1 Introduction However, other economists do not agreewith Ohlin. They argue that question ofdifferent currencies is complex, allcurrencies are not equally convertible,exchange rates vary and significantly affectexport earnings. Further complications are created bytariffs, import duties, export subsidiesintroduced by countries to restore theirbalance of payments.
  7. 7. International Economics3.1 Introduction More importantly IT is betweencountries with sovereign governments, theyadopt and revise their trade policies fromtime to time. All these considerations need aseparate study of IT. It is, therefore, concluded that both on theoretical & practical grounds, there is a necessity of a separate theory and study of International Trade.
  8. 8. International Economics3.2 Pre-Classical Theory of International Trade.With emergence of monetary economies thatreplaced barter trade, economists arguedthat the best way for the countries tosurvive and grow was to hold large stock ofGold & Silver.With this stock, they could build armies forprotection and buy necessities, notavailable locally, from other countries.
  9. 9. International Economics3.2 Pre-Classical Theory of International Trade. Gold can be stocked by exploring goldmines. But if mines were not there in thecountry, {as in case of UK], country has toexport goods / services to buy gold. This requirement, as per pre-classicaleconomists known as mercantilists, givesrise to international trade. To maximize the stock of gold , thecountry should increase exports and containimports. Means to accomplish this weresuggested by mercantilists.
  10. 10. International Economics3.2 Pre-Classical Theory of International Trade. The country that could export in excessof its imports, thus had a favourablebalance of trade as it added to its goldreserve. On the other hand if a countrycould not cover its imports by exports ,country’s gold stock would dwindle and itwill have an unfavorable balance of trade. Even though acquisition of gold is nomore considered to be the sole reason forIT, the terms ‘favorable’ & ‘unfavourable’continue to be used in connection withbalance of trade, though in new context.
  11. 11. International Economics3.3 Views of Physiocracy on International Trade. Around 1770 & 1775, French economistsbrought about a new economic thinking termedPhysiocracy. They claimed that activities thatproduced material surplus only can beconsidered productive. Agriculture was considered productive bythem and all other activities non productive.International trade was non productive as bothparties exchanged equal values & there was nosurplus. A small surplus can arise, they claimed,only if one party was weak and accepted lesservalue in this exchange.
  12. 12. International Economics3.3 Views of Physiocracy on International Trade. They were first advocates of freetrade, not to encourage trade, but becausethey considered every one should havefreedom to buy whatever is availabledomestically or abroad. Mercantilists prescribed import duty toreduce imports & preserve gold stock. Theysaid import duty is borne by the foreignexporter & thus does not burden domesticeconomy.
  13. 13. International Economics3.3 Views of Physiocracy on International Trade. French economists demonstrated that ifcommodity imported is required by consumersthey will be willing to pay its higherprice. Thus import duty cannot be passed onto foreigners. French economists further put forthfollowing argument to bring out fallacy inpre-classical theory. If a country following Mercantilist’stheory, decided to maximize its gold reserveand succeeded; it will have all the gold inthe world. Then what can it do with it?
  14. 14. International Economics3.4 Adam Smith’s Theory of Absolute Cost DifferenceAssumptions;1.Labour is the only factor of production. Exchange between goods was determined by the relative amounts of labour embodied in them.2.Full employment.3.Perfect mobility of labour within a country and zero mobility between two countries.4.Operation of law of constant returns.5.Two countries and two commodities.
  15. 15. International Economics3.4 Adam Smith’s Theory of Absolute Cost Difference Based on these assumptions, Smith stated that exchange of goods will take place, if each of two countries can produce a commodity at an absolutely lower labour cost of production than the other country. Thus England which produces cloth at least labour input can export it to Australia, and import wheat which it produces at the highest labour cost.
  16. 16. International Economics3.5 Ricardo’s Theory of Comparative Cost Advantage According to Smith absolute cost difference was required for trade to take place between two countries. Ricardo proved that, if there is even a comparative difference, still trade can take place. Thus in x man days if England produces 200 units of cloth or 200 units of wheat; and Australia either 80 units of cloth or 160 units of wheat, there is no absolute advantage to Australia in either products.
  17. 17. International Economics3.5 Ricardo’s Theory of Comparative Cost Advantage Still Ricardo claimed there is comparative cost advantage & trade can take place if England specializes in cloth and produces 200 units and Australia specializes in wheat and produces 160 units. Now England can export one unit of cloth and get anywhere up to less than two units of wheat [ against one unit available locally].
  18. 18. International Economics3.5 Ricardo’s Theory of Comparative Cost Advantage Australia by importing a unit of cloth saves two units of wheat, and benefits since it has to pay less than two units wheat to England for it. Thus Ricardo proved that comparative cost advantage has allowed both countries to trade in wheat and cloth to their mutual benefit.
  19. 19. International Economics3.5 Ricardo’s Theory of Comparative Cost AdvantageCauses for the cost difference :a] Provision of special facilities by nature such as climate and soil [ that permits plantation of rubber, jute, tea etc]. mineral resources like petroleum, coal, iron ore. land fertility, availability of abundant water.
  20. 20. International Economics3.5 Ricardo’s Theory of Comparative Cost AdvantageCauses for the cost difference :b] Provision of different human facilities in the form of physique, mental endowments, scientific and rational mind, spirit of enterprise etc.c] Legacy of the past, traditionally high levels of intelligence and education [provides head start in building infra structure].d] Uneven distribution of population that affects availability labour for production.
  21. 21. International Economics3.6 Assumptions of the Classical [Ricardian] Theory of IT• There are only two countries.• There are only two commodities which these countries can produce.• Labor is the only factor of production involved in production.• All units of labor are homogenous.• Perfect competition in labor and product markets.
  22. 22. International Economics3.6 Assumptions of the Classical [Ricardian] Theory of IT• Full employment in both countries.• Labor is perfectly mobile within country and immobile between the two.• The law of constant returns in operation in two countries.• No technological changes take place in the countries.• There are no transport costs involved.• There are no government restrictions on trade between the two countries.
  23. 23. International Economics 3.7 Criticism of the Classical [Ricardian] Theory of IT• There are more than 150 countries involved in active international trade, hence restricting the theory to two countries is unrealistic.• Production involves material, capital & enterprise in addition to labour, hence restricting it exclusively to the last factor is incorrect.• All units of labour are not homogenous. Some workers are more efficient than others.
  24. 24. International Economics 3.7 Criticism of the Classical [Ricardian] Theory of IT• Certain degree of unemployment is always there in each country, theory based on full employment, therefore, is unrealistic.• Labour is not perfectly mobile in a country, especially like India with its different languages, cultures and climates. Further workers in construction industry cannot move to IT industry with ease.
  25. 25. International Economics 3.7 Criticism of the Classical [Ricardian] Theory of IT• When output levels change there is corresponding change in requirement of labour inputs and usually law of diminishing returns is experienced. Hence theory cannot be based on constant returns.• In this dynamic world technological advances are increasing productivity effectively. The theory assumes no such changes & renders itself unrealistic.
  26. 26. International Economics 3.7 Criticism of the Classical [Ricardian] Theory of IT• Movement of goods from country to country involves significant transport costs. These are ignored by the theory.• International trade cannot be carried ignoring various restrictions / provisions that have to be prescribed by governments to protect their economies. Hence free trade assumed by the theory is incorrect.
  27. 27. International Economics3.7 Criticism of the Classical [Ricardian] Theory of IT• The theory considers only the supply side and ignores forces of demand on the markets.• Countries strategically rely on domestic supply for essentials for its defense & would not buy them from other countries.• Complete specialization on the basis of comparative cost advantage cannot work for larger economy in trade with smaller one, as the latter cannot absorb huge surplus of the larger economy.
  28. 28. International Economics3.7 Criticism of the Classical [Ricardian] Theory of IT• The theory fails to take into account time element for storage and ignores interest cost.• It unrealistically assumes that imports of a country will match with its exports. It fails to consider capital cash flows.• The theory assumes entire country benefits from the IT. In reality only some citizens stand to benefit & not the entire nation.
  29. 29. International Economics3.8 J S Mill’s Theory of Reciprocal DemandRicardo’s theory established in earlier example how England and Australia benefit by IT when there is no absolute cost advantage , but comparative advantage is there.He stated that so long as England gets between one to two units of wheat for a unit of cloth, it stands to benefit. But he could not state exact units of wheat that would be offered for export of cloth.
  30. 30. International Economics3.8 J S Mill’s Theory of Reciprocal DemandThe mechanism for determination of rate of exchange or terms of trade was discussed by JS Mill. He stated that the rate depends on England’s elasticity of demand for England’s cloth.‘Equilibrium would be established at that rate of exchange between the two commodities, at which quantities demanded by each country would be sufficient to pay for each other’ according to JS Mill.
  31. 31. International Economics3.8 J S Mill’s Theory of Reciprocal DemandHe further explains i] the possible range of barter terms is given by the respective domestic terms of trade as set by comparative cost advantage in each country { between one to two stated earlier}. ii] within this range, the actual terms of trade will depend on intensity of each country’s demand for other country’s produce. iii] finally those terms will be stable at which exports offered by a country will be sufficient to pay for its imports.
  32. 32. International Economics3.8 J S Mill’s Theory of Reciprocal DemandMill’s theory is based on the assumptions similar to those used by Ricardo.As such it is subject to same criticism as leveled against the classical theory of IT. The End
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