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Chapter 2 Theories Of International Trade
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Chapter 2 Theories Of International Trade


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  • 1. THEORIES OF INTERNATIONAL TRADE In this chapter we are going to discuss the following theories and various ways through which govt. discourage imports: • Theories of absolute advantage • Theories of comparative advantage • Heckscher-ohlin model • Imitation gap theory • International product life cycle theory THEORY OF ABSOLUTE ADVANTAGE:- In 1776 Adam Smith proposed the theory that takes place because one country may be more efficient in producing a particular good then another country and the other country may be capable of producing some other goods more efficiently then the first one. This provides an incentive to trade as both the countries can benefits from specialization and the resultant increase in productivity. Suppose there are two countries A & B. A can produce a super computer by using 10 units of labour while B uses 15 units of the labour for the same. On the other hand to produce an aircraft A country requires 20 units of labour and B requires 10 units of labour. All other factors are used in equal amount by both the countries. Here A enjoys the absolute advantage in producing super computers and country B in producing aircraft. According Adam smith in such a scenario, country A will restrict itself in producing super computers and B to aircrafts. This good will be then be traded among these two countries. Thus, international trade results is increasing the rate of economic growth of the both countries by utilizing the resources of both the countries more productively. If increasing returns to scale are experienced the benefits are further increased. LIMITATIONS:
  • 2. 1. It explains the causes of trade between two countries only in those situations, where both the countries enjoy absolute advantage in the production of atleast one product . 2. It assumes that the transportation costs involved in selling a commodity in country other than the one in which it was produced are either non –existent or in significant when compared to degree of comparative advantage . THEROY OF COMPARTIVE ADVANTAGE: According to absolute advantage theory, two countries entry into trade when both of them hold an absolute advantage In the production of atleast one product the question. Which arise here is whether two countries can benefit by trading with each other even if one of them has an absolute advantage in all the commodities. According to theory of comparative advantage propounded by David Ricardo in 1817, trade is possible as long as country experiencing the disadvantage is not equally less efficient in producing all the products i.e. both the countries enjoy comparative advantage in atleast one of the products. TABLE 1 EFFICIECCIES OF COUNTRIES AS REFLECTED BY LABOUR-HOUR USED. LABOUR- HOUR REQUIRED COUNTRY 1 UNIT OF STEEL 1 UNIT OF CEMENT A 5 10 B 15 20 As we see country A enjoys an absolute advantage in producing both steel and cement, as the number of labour-hours required to produce one unit of each commodity is lesser than that required by country B. Let us assume that both the countries have 600 units of labour-hours at there disposal and these labour units can be used for producing either steel or cement. If a country A utilizes these units for exclusively producing steel, then it will be able to produce 120 steel units. =600/5
  • 3. In case it goes for producing only cement its capacity would be =600/10=60 units of cement. Similarly, country B can produce either 40 units of steel or 30 units of cement. As we for producing each unit of steel, the production of a particular number of unit of cement has to be foregone and vice-versa. The quantity of cement thus foregone in order to produce one additional unit of steel is called the opportunity cost of steel. As the country A can either produce 120 units of steel or 60 units of cement with the available resources, the opportunity cost of steel for country A would be cost of steel for country A would be =60/120=0.5 The opportunity cost of producing steel and cement for the two countries can be similarly calculated. Opportunity cost Country steel Cement A 60/120=0.5 120/60=2.00 B 30/40=0.75 40/30=1.33 Enjoying comparative advantage for a country means having a lesser opportunity cost in producing a commodity than the other country. As we can see from the above table country A has lower opportunity cost and hence enjoying comparative advantage in producing steel, while B enjoys it in producing cement. According to the theory of comparative advantage, each country should produce that goods, in which it has a comparative advantage. Hence country A should produce steel and country B should produce cement. In explaining the theory of comparative advantage, David Ricardo made certain implicit assumptions. They are as follows:- 1. PERFECT COMPETITION:-Perfect competition with flexible prices and wages prevails in both the countries. This results in the prices of steel and cement being different in country A and B due to difference in the labour hours used and hence the production cost. 2. PRODUCTIVITY OF LABOUR:-Labour is the only factor of production and the average product of labour is constant for producing both the products in both
  • 4. the countries. It means that marginal product of labour is constant implying constant return to scale. HECKSCHER-OHLIN MODEL:- The theory of comparative advantage assumes a single factor of production i.e. labour and describes the situation where trade takes place between countries having different technologies i.e. the countries operating at different level of efficiency giving rise to comparative advantage. The Heckscher-Ohlin model explores the possibility of two nations operating at the same level of efficiency benefiting by trading with each other. According to this theory, there are two types of products. Labour intensive and capital intensive. The model further says that reason two countries operating at the same level of efficiency can and does benefit from trade can be traced to the difference in their factor endowments. The labour rich country is more likely to produce labour intensive goods and the country rich in capital will most probably produce capital intensive goods. The two countries will then trade these goods and reap the benefit of international trade. Just as having a higher per capita income, rather than having a higher national income should be the criteria for judging as to which country is richer, for judging as to which country is capital rich, the criteria should be greater physical amount of capital per unit of labour rather than abundance of capital. This theory is also not free from drawbacks:- 1. It assumes that factor endowments are given, whereas they can also be developed through innovations. 2. Due to existence of minimum wage act in some countries, the factor prices may change to such an extent, that an otherwise labour rich country may find it cheaper to import labour intensive goods than to produce them locally. 3. The finding of an empirical study by economists Wassily Leontief pointed out that despite being a capital rich country, US exports are more labour intensive than capital intensive.
  • 5. All factors highlight the fact that there are more to international trade than just factor endowment. IMITATION GAP THEROY: It is given by Porsenr, considers the possibility of trade between two countries having similar factor endowments & consumer tastes. According to this theory improvement in technology is a continuous process & the resulting inventions & innovations in existing products give rise to trade between such countries. The degree of trade between such countries will depend upon the difference between the demand lag &imitation lag. Demand lag is the difference between the time & new or an improved product is introduced in one country & the time when consumers in the other country start demanding it .Imitation lag is the difference between the time of introduction of the product in one country & time when the producers in the other country starts producing it . If the imitation lags shorter than the demand lag no trade will take place betn the two countries. However normally demand lag can be expected to be shorter than imitation lag. In such a case the country coming out with the innovation will be able to start exporting to the second country as the consumers there becomes aware of its product, and the export will keep growing as more consumers become aware. This export will continue to increase till the demand lag is over i.e. till all the consumers react to the innovation. If the producer can start producing the same product before this time period, they can arrest the growth of these imports into their country; otherwise the exports will continue and will stabilize at a particular level.
  • 6. TRADE BARRIERS Despite the benefit of international trade, governments have an inclination to put trade barriers in order to discourage imports. There two kinds of barriers: - Tariff & Non Tariff TARIFF BARRIERS: - Tariff is a tax levied on goods traded internationally. When imposed on goods being brought into the country, it is referred to as import duty. Import duty is levied to increase the effective cost of imported goods in order to increase the demand for domestically produced goods. Another type of tariff less frequently imposed is the export duty, which is levied on goods being taken out of the country, to discourage the exports of those goods. This may be done, → If the country is facing the shortage of particular commodity OR → If the government wants to promote the export of that goods in some other forms. Tariff can be imposed on three different basis. They are :-  FLAT DUTY:-It is based on the number of units regardless of the value of the goods. For example: - there may be a duty of Rs. 5000 per computer imported into India.  AD VALOREM DUTY: - It is expressed as a percentage of the value of goods. So as a person importing walkman worth Rs. 2000 carrying an import duty of 10% would have to pay Rs. 200 towards duty charges.
  • 7.  A COMPOUND DUTY:-It is a combination of specific and ad valorem duty. For example: - a book worth Rs.500 carrying a specific duty of RS. 25 and ad valorem duty of 2% would in effect be carrying a compound duty of Rs. 35. TECHNICAL BARRIERS:- Countries generally specify some quality standards to be met by imported goods for various health, welfare and safety reasons. This facility can be misused for blocking the import of certain goods from specific countries by setting up of such standards which deliberately exclude these products. The process is further complicated by the requirement that testing and certification of the products regarding their meeting the set standards be done only in the importing country. INTERNATIONAL PRICE FIXING:- Some commodities are produced by a limited number of producers scattered around the world. In such a case, these producers may come together to form a cartel and limit the production or price of the commodity so as to protect their profits. OPEC is an example of such cartel formation. CUSTOMS VALUATION:- There is widely held view that the invoice value of the goods traded internationally do not reflect their real cost. This gave rise to a very subjective system of valuation of imports and exports for levy of duty. If the value attributed to a particular product would turnout to be substantially higher than it’s real cost, it could result in affecting it’s competitiveness by increasing the total cost of the importer due to it’s excess duty. NON-TARRIF BARRIERS:- Non-tariff barriers include all the rules, regulations and bureaucratic delays which helping keeping foreign goods out of the domestic markets it is of three types:-
  • 8. 1. Quota 2. Embargo 3. Voluntary export restraint 4. Subsidies to local goods  Quota: - a quota is a limit on the number of units that can be imported or the market share that can be held by foreign producers. For example: - the US has imposed a quota on textile imported from India and other countries.  Embargo: - when imports from particular country are totally banned is called as embargo. It is mostly put in a place due to political reasons.  Voluntary export restraint: - a country facing a persistent, huge trade deficit against another country may pressurize it to adhere to a self imposed limit on the exports to the deficit facing country.  Subsidies to local goods: - government may directly or indirectly subsidized local production in an effort to make it more competitive in the domestic and foreign market.