notes

1. International Business
Meaning of Domestic Business-
 Business transaction taking place within the geographical boundaries of a nation is known as
domestic or national business.
 It is also referred to as internal business or home trade.
Meaning of International Business-
 Manufacturing and trade beyond the boundaries of one’s own country is known as international
business.
 International or external business can be defined as those business activities that take place
across the national frontiers. It involves not only the international movements of goods and
services, but also of capital, personnel, technology and intellectual property like patents,
trademarks, know-how and copyrights.

2.  Mostly people think of international business as international trade.
 But this is not true.
 International trade, comprising exports and imports of goods, has historically been an important
component of international business.
 The scope of international business has substantially expanded. International trade in services
such as international travel and tourism, transportation, communication, banking, ware-housing,
distribution and advertising has considerably grown.

3.  Increased foreign investments and overseas production of goods and services-
Companies have started increasingly making investments into foreign countries and undertaking
production of goods and services in foreign countries to come closer to foreign customers and serve
them more effectively at lower costs.
 All these activities form part of international business.
 To conclude, we can say that international business is a much broader term and is comprised of
both the trade and production of goods and services across frontiers.

4. Reason for International Business
 The fundamental reason behind international business is that the countries cannot produce equally
well or cheaply all that they need.
 This is because of the unequal distribution of natural resources among them or differences in their
productivity levels. Availability of various factors of production such as labour, capital and raw
materials that are required for producing different goods and services differ among nations. Moreover,
labour productivity and production costs differ among nations due to various socio-economic,
geographical and political reasons.
 Due to these differences, it is not uncommon to find one particular country being in a better position
to produce better quality products and/ or at lower costs than what other nations can do.

5.  Some countries are in an advantageous position in producing selected goods and services which
other countries cannot produce that effectively and efficiently, and vice-versa.
 As a result, each country finds it advantageous to produce those selected goods and services that it
can produce more effectively and efficiently at home, and procuring the rest through trade with
other countries which the other countries can produce at lower costs.
 This is precisely the reason as to why countries trade with others and engage in what is known as
international business.

6.  Fundamentally, it is for the same reason that domestic trade between two states or regions within a
country takes place.
 Most states or regions within a country tend to specialise in the production of goods and services for
which they are best suited.
 In India, for example, while West Bengal specialises in jute products; Mumbai and neighbouring
areas in Maharashtra are more involved with the production of cotton textiles.
 The same principle of territorial division of labour is applicable at the international level too. Most
developing countries which are labour abundant, for instance, specialise in producing and exporting
garments. Since they lack capital and technology, they import textile machinery from the developed
nations which the latter are in a position to produce more efficiently.

7.  The entities involved in international business range from large multinational companies with
thousands of employees doing business in many countries around the world to small one-person
company acting as an importer or exporter.
 International business encompasses for-profit, border-crossing transactions as well as
transactions motivated by non-financial gains.
 Non-financial gains-
 E.g. triple bottom line- companies should commit to focussing on social and environmental
concerns also along with profit. So, there should be three bottom lines- profit, people and the
planet.
 Corporate Social Responsibility
 Political reasons

8. Nature of International Business
“An international business is any firm that engages in international trade or
investment.”
International business has four dimensions-
1. Internationalisation of Market Presence
2. Globalisation of supply chain
3. Globalisation of capital base
4. Globalisation of corporate mind set

9. 1. Internationalisation of market presence-
 Refers to extent to which the company is targeting customers in all major
market throughout the world.
 Even within the same industry, globalisation of market presence can range from
relatively low to very high.
 E.g. In 2013, Wal-Mart generated 29% of its total revenues from outside the US.
In contrast, Target generated 100% of the revenues within the US and none
from foreign markets.

10. 2. Globalisation of supply chain-
 Refers to extent to which company is accessing the most optimal location for the
performance of various activities in its value chain.
 It is entirely possible for a company to have fairly local or regional market
presence and yet a highly globalised value chain/supply chain.
e.g. The British retailer Marks and Spencer has long relied on the global supply
chain for apparel goods with manufacturing hubs in Portugal, Morocco and
Sri Lanka
Caterpillar delivers products to customers in nearly 200 countries, operates
manufacturing centers in more than 24 countries and has research and design
technical centers in more than 9 countries. Caterpillar’s value chain represents a
complex global network.

11. 3. Globalisation of capital base-
 It refers to the extent to which the company is tapping into the most optimal
source of capital on a worldwide basis.
e.g. Baidu- China’s leading internet search and online advertising company
represents a good example of how it is entirely possible for a company to be quite
“local” along the dimensions of market presence and supply chain and yet have a
highly globalised capital base. It is listed only on US based NASDAQ exchange,
thereby it has got access to a broader base of investors.

12. 4. Globalisation of corporate mindset-
Refers to the extent to which the corporations collectively reflects an understanding
of diversity across cultures and markets coupled with an ability to integrate across
this diversity.
e.g. All General Electric businesses are managed through
 a global line of business structure,
 investment opportunities are identified and assessed on a global basis,
 it has global intellect,
 has a strong worldwide culture and
 diverse leadership in terms of nationalities

13. Features of International Business
1. Large scale operations-
To cope with global competition, all operations like production and marketing are conducted
on a very huge scale by using special purpose machinery and highly skilled labour.
2. Immobility of factors-
The degree of immobility of factors like labour and capital is generally greater between
countries than within a country due to immigration laws, citizenship, qualifications etc. These
restrictions slows down the international mobility of labour.
3. Heterogenous Markets-
The international markets lack homogeneity on account of differences in climate, language,
habits, customs, system of weights and measurements etc.

14. 4. Integration of economies-
International business integrates the economies of many countries by producing in one
country, using finance and labour from other countries and by selling in many countries.
5. Dominated by developed countries and MNCs-
International business is dominated by developed countries and their MNCs. MNCs
encompass a number of countries. Their sales, profits and the flow of production is reliant
on several countries at once. Such companies from large economies like the USA, UK, Japan,
China, Germany, India etc. dominate international trade. This is because they have large
financial resources, best technology and R & D facilities. They have highly skilled employees
and managers. This helps MNCs and developed countries to capture and dominate global
market.

15. 6. Keen competition-
International business increases competition in domestic markets and introduces new
opportunities in foreign markets. The global competition encourages companies to become
more innovative and efficient in their use of resources. For consumers, international business
introduces them to a variety of goods and services. But competition in the international
market is between unequal partners i.e. developed and developing countries. MNCs produce
superior quality products at low prices. Hence, developing countries find it very difficult to
face competition from developed countries.

16. 7. International Restrictions-
International business faces many restrictions on the inflow and outflow of capital,
technology and goods. The main types of trade restrictions are tariffs, quotas, licensing
requirements, standards and subsidies.
8. Sensitive Nature-
The international business is very sensitive in nature. Any changes in the economic policies,
technology and political environment etc. has a huge impact on it. Therefore, international
business must conduct marketing research to find out and study these changes and their
effect on the society. They must adjust their business activities and adapt accordingly to
survive changes.

17. 9. Use of different currencies-
International trade involves use of different types of currencies.
10. Benefits to participating countries-
International business gives benefits to all participating countries. Though major benefit is
gained by developed countries, the developing countries also get the benefit. They get
foreign capital and technology leading to more employment opportunities and rapid
industrial development. This ultimately results in economic development of developing
countries. Therefore, developing countries open up their economies through liberal
economic policies.

18. 11. Special role of science and technology-
International business gives a lot of importance to science and technology. Developed
countries use modern technologies. Therefore, they dominate global business.
International business helps to transfer such top high-end technologies to the developing
countries. Such technology transfers help people from developing countries to learn from
dynamic industry experts in a diverse learning environment.

19. Theories of International Trade
Mercantilism
 Economics as an organised science can be said to have originated with the publication in
1776 of the Wealth of Nations by Adam Smith.
 But writings on International Trade preceded this date in countries like England, Spain,
France, Portugal and Netherlands as they developed into modern National states.
 During the 17th and 18th centuries a group of men (merchants, bankers, govt. officials,
philosophers) wrote essays and pamphlets on international trade.
 These advocated an economic philosophy known as mercantilism.
 The mercantilists maintained that the way for a nation to become rich and powerful was
to export more than it imported.

20.  The resulting export surplus would then be settled by an inflow of bullion or precious
metals.
 The more gold and silver the nation had, the richer and more powerful it was.
 Thus the government had to do all in its power to stimulate the nation’s exports and
discourage and restrict imports( particularly the imports of luxury consumption goods)
 However, since all nations could not simultaneously have an export surplus and the
amount of gold and silver was fixed at any particular point in time, one nation could gain
only at the expense of other nations.
 So, mercantilists preached economic nationalism, resulting in conflict of national interests.
 The mercantilists measured the wealth of a nation by the stock of precious metals it
possessed.

21.  In contrast, today we measure the wealth of a nation by its stock of human, man-made and
natural resources available for producing goods and services.
 The greater the stock of useful resources, the greater is the flow of goods and services to
satisfy human wants and the higher the standard of living.
 There were more rational reasons for the mercantilists desire for accumulation of precious
metals.
 The mercantilists were writing primarily for rulers and to enhance national power.
 With more gold, rulers could maintain larger and better armies and consolidate their power
at home.
 Improved armies and navies also made it possible for them to acquire more colonies.
 In addition, more gold meant more money (i.e. more gold coins) in circulation and greater
business activity.

22.  By encouraging exports and restricting imports the government would stimulate national
output and employment.
 In any event, mercantilists advocated strict government control of all economic activities
and preached economic nationalism because they believed that a nation could gain in
trade only at the expense of other nations. i.e. trade was a zero sum game.
 These views of mercantilists are important for two reasons-
1. The ideas of Adam Smith, David Ricardo and other classical economists can best be
understood if they are regarded as reactions to the mercantilists views on trade and on
the role of government.
2. Today there seems to be resurgence of neo-mercantilism, as nations plagued by high
levels of unemployment seek to restrict imports in an effort to stimulate domestic
production and employment

23. The Classical Theory of Absolute Cost Advantage
Adam Smith, the first classical economist, advocated the principle of absolute cost
advantage as the basis of international trade.
Smith started with the simple truth that for two nations to trade with each other
voluntarily, both nations must gain. If one nation gained nothing or lost, it would simply
refuse to trade.
According to Adam Smith, trade between two nations is based on absolute advantage.
Meaning of absolute cost advantage- It refers to the ability to produce a certain good or
service at lower cost (i.e., more efficiently) than another party.

24. Statement of the theory, “When one nation is more efficient than another in the
production of one commodity but is less efficient than the other nation in producing a
second commodity, then both nations can gain by each specialising in the production of
the commodity of its absolute advantage and exchanging part of its output with the other
nation for the commodity of its absolute disadvantage.
By this process, resources will be utilised in the most efficient way and the output of both
commodities will rise.
This increase in the output of both commodities measures the gains from specialisation in
production available to be divided between the two nations through trade.

25. E.g. Because of climatic conditions, Canada is efficient in growing wheat but inefficient in
growing bananas. On the other hand, Nicaragua is efficient in growing bananas but
inefficient in growing wheat. Thus, Canada has an absolute advantage over Nicaragua in
the cultivation of wheat but an absolute dis-advantage in the cultivation of bananas. The
opposite is true for Nicaragua.
Under these circumstances, both nations would benefit if each specialised in the
production of the commodity of its absolute advantage and then traded with the other
nation.
So, Canada would specialise in the production of wheat and exchange some of it for
bananas grown in Nicaragua.
As a result, both more wheat and more bananas would be grown and consumed and
both Canada and Nicaragua would gain.

26. In this respect, a nation behaves no differently from an individual who does not attempt to
produce all the commodities she or he needs.
Rather, the individual produces only that commodity that he or she can produce most
efficiently and then exchange part of the output for the other commodities he or she
wants.
Thus, while the mercantilists believed that one nation could gain only at the expense of
another nation and advocated strict government control of all economic activity and trade,
Adam Smith and other classical economists believed that all nations would gain from free
trade and strongly advocated policy of laissez-faire (i.e. as little government interference
with the economic system as possible.)
Free trade would cause world resources to be utilised most efficiently and would maximise
world welfare.

27. In view of this belief, it seems paradoxical that today most nations impose many restrictions
on the free flow of international trade. Trade restrictions are advocated by the few
industries and their workers who are hurt by imports. As such, trade restrictions benefit the
few at the expense of many.

28. Numerical example of absolute advantage-
Table shows that, X no. of labour days produces 50kgs of wheat in the England or 100
meters of cloth. On the other hand, X no. of labour days produces 100kgs of wheat in
the Australia or 50 meters of cloth. Thus, the Australia is more efficient than, or has an
absolute advantage over, the England in the production of wheat, whereas the England
is more efficient than, or has an absolute advantage over, the Australia in the production
of cloth. With trade, the Australia would specialise in the production of wheat and
exchange part of it for British cloth. The opposite is true for the England.
England Australia
Wheat 50 100
Cloth 100 50

29. Terms of Trade-
Terms of trade is how much of an imported commodity a country can get in exchange by
exporting a unit of commodity to the other country.
For Australia the ratio of production between cloth and wheat is 0.5:1
For England the ratio of production between cloth and wheat is 2:1
So, Australia, in exchange for her 1 unit of wheat will demand from England anything
more than 0.5 units of cloth.
And England, in exchange for 1 unit of wheat from Australia will be ready to give anything
up to 2 units of cloth.
So, the terms of trade will be for 1 unit of Wheat, anywhere between the range
0.5 cloth < < 2 cloth.

30. The actual terms of trade will depend upon the bargaining strength between the two
countries and bargaining strength depends upon the urgency of demand or elasticity of
demand.
If England’s demand for Australian wheat is more urgent then, terms of trade would be
closer to 2 units of cloth, whereby Australia will benefit more and England will benefit less
from international trade.
If Australia’s demand for England’s cloth is more urgent then, terms of trade would be
closer to 0.5 units of cloth, whereby England will benefit more and Australia will benefit
less from international trade.

31. World Production with International trade
With 2X labour
Australia 200 kgs of wheat
England 200 meters of cloth
World Production without International trade
With 2X labour
Australia 50 meters of cloth and 100 kgs of wheat
England 100 meters of cloth and 50 kgs of wheat
So, total wheat production 150 kgs
Total cloth production 150 meters

32. Comparative Cost Advantage Theory by David Ricardo
 In 1817, Ricardo published his ‘Principles of Political Economy and Taxation’, in which he
presented the law of Comparative Cost Advantage.
 This is one of the most important and still unchallenged laws of economics, with many
practical applications.
Assumptions of the law-
 There are only two countries in the world, suppose England and Australia
 They produce the same two commodities say, cloth and wheat
 There are similar tastes in both the countries
 Labour is the only factor of production
 The supply of labour is unchanged

33.  All units of labour are homogenous
 Prices of two commodities are determined by labour cost, i.e. the number of labour units
employed to produce each commodity
 Commodities are produced under the law of constant costs or returns
 Technological knowledge is unchanged
 Trade between the two countries takes place on the basis of barter system
 Factors of production are perfectly mobile within each country but are perfectly immobile
between countries
 There is a free trade between the two countries, there being no barriers or restrictions in
the movement of commodities
 No transport costs are involved in carrying trade between the two countries

34.  All factors of production are fully employed in both the countries
 There is perfect competition in labour and product markets.
The Law of Comparative Advantage
According to the law of comparative cost advantage, even if one nation is less efficient than
(has an absolute disadvantage with respect to ) the other nation in the production of both
commodities, there is still a basis for mutually beneficial trade.
According to Ricardo, “each country will specialise in the production of that commodity in
which it has the greatest comparative advantage or least comparative disadvantage.”

35. Explanation of Ricardian theory
Let us assume that X number of man-days can produce,
In England, either 200 units of cloth or 200 units of wheat, and in Australia, either 80 units
of cloth or 160 units of wheat.
Under such circumstances, according to Ricardo, the rule is that the England should
specialise in the production of that commodity where she has the greatest comparative
cost advantage; and in the case of Australia, though she is at absolute disadvantage vis-à-
vis England in the production of both commodities, it would be beneficial from the point
of view of both the countries that the Australia should special in the production of that
commodity where her comparative cost disadvantage is the least.
England Australia
Wheat 200 160
Cloth 200 80

36. Terms of trade
In England, X number of man-days can produce either 200 units of cloth or 200 units of
wheat. This means in exchange of 1 unit of cloth, England would be prepared to accept
anything above 1 unit of wheat, but not less, because she herself can produce it by sacrificing
one unit of cloth.
On the other hand in Australia, since X number of man-days can produce either 80 units of
cloth or 160 units of wheat, it follows that in order to get 1 unit of cloth from England,
Australia would be willing to give anything up to 2 units of wheat, as she herself can produce
1 unit cloth in the country.
So, for 1 unit of cloth from England, Australia will give anything between 1< <2 units of
wheat to England.

37. The actual terms of trade will depend upon the urgency of want for each others commodity.
i.e. if England’s demand is more urgent, terms of trade will be closer to 1 and if Australia’s
demand is more urgent, terms of trade will be closer to 2.
Let us take a simple example from our everyday life. Suppose a lawyer can type twice as fast
as his secretary. The lawyer then has an absolute advantage over his secretary in both, the
practice of law and typing.
However, since the secretary cannot practice law without a law degree, the lawyer has a
greater advantage in practicing law and the secretary has comparative least disadvantage in
typing.

38. According to the law of comparative advantage, the lawyer should practice law and secretary
should do typing. If the lawyer earns $100 per hour practicing law and must pay his secretary
$10 per hour to do the typing, he would actually lose $80 for each hour that he typed.

39. The classical theory of international trade, though accepted for long as the valid basis of
international trade, has come to be subjected to severe criticism by economists like Bertil Ohlin
and Graham. According to them, the main point of criticism is the extremely unrealistic and
restrictive assumptions.
Following are the main points of criticism-
1. The assumption of existence of only two countries and two commodities is highly
unrealistic. In fact, there are more than 200 countries and thousands of commodities.
Under such circumstances, calculations of comparative cost advantage will not be simple.

40. 2. The classical theory has assumed labour as the only factor of production and the labour
theory of value according to which values of commodities are determined by labour
embodied in them. In fact, there are other factors of production like land, capital and
organisation which along with labour go to determine cost of production of commodities
and therefore the rate of exchange between any two commodities.
3. The classical theory has assumed that all units of labour are homogenous and one worker
can be perfect substitute for any other worker. This is highly unrealistic assumption. Some
workers are more efficient within the country and international differences are also there.
4. This theory has assumed full employment of labour in both the participating countries. But
in fact, problem of unemployment is common in all the countries.

41. 5. The theory has made another unrealistic assumption, namely labour is perfectly mobile
within a country and perfectly immobile between any two countries.
• There can be two objections to this assumption. E.g. in England some labour may be
specific and can produce only wheat and not cloth; similarly, in Australia there might be
some workers who can produce only cloth and not wheat. And therefore position in
England is not either cloth or wheat but it can be cloth plus some wheat. Same thing in
Australia also will hold. Thus, labour in both the countries being to some extent
occupationally immobile, the assumption of cloth or wheat is unrealistic. That is why we
find countries always producing some quantity of a commodity which that country also
imports in substantial quantity.
• The labour is mobile internationally also, as we can see a lot of labour migration from one
country to another country to upgrade their skills or in search of better work

42. 6. The theory has assumed the law of constant returns to scale. But in reality there can be
increasing or decreasing returns to scale.
7. The theory assumes no technological changes. But during the past century and in this
century there have been rapid technological changes. So, in England with the help of high-
breed seeds and chemical fertilisers wheat may come to be produced comparatively more
cheaply than in Australia. It is also possible that Australia may become better producer of
cloth due to technical progress.
8. The assumption of no transport costs in international movements of goods is highly
unrealistic. But heavy transport costs play an important role in determining the pattern of
international trade and exchange of goods. E.g. as water transport system was cheaper, textile
mills in Mumbai used to get their coal from England instead of from Bihar coal mines in the
country.

43. 9. The theory assumes no governmental barriers in international trade which is unrealistic.
But governments put barriers such as total prohibition of import of some commodities as well
as exports of some items, heavy import duties, export subsidies, quota fixation etc.
10. Complete specialisation on the basis of comparative cost advantage is impossible if one of
the trading countries is small and the other a big one. The smaller country will be in a position
to completely specialise and dispose of its surplus commodity in a bigger country; but if the
bigger country completely specialises, it will not be in a position to dispose of all its surplus in
the small country.
11. This theory is not applicable to defence goods as for protecting their political
independence they need to achieve self reliance, so countries produce them domestically
even if it is creating cost disadvantage.

44. 12. The theory has ignored an important issue of deficit or surplus in international trade.
13. The theory has assumed that the gains from international trade would be to the country
as a whole. But Sodersten has pointed out that all citizens are not gaining equally from
international trade, some will benefit and some will suffer.
Concluding remarks-
In the words of Samuelson, “Yet for all its simplifications, the theory of comparative
advantage has in it the most important glimpse of truth. Political economy has found few
more pregnant principles. A nation that neglects comparative advantage may have to pay a
heavy price in terms of lowering standards and potential rate of growth”.

45. Heckscher-Ohlin Theory of International Trade
Adam Smith, David Ricardo and Mill in their theories of international trade left two
important questions unanswered-
1. What is the reason for the difference in relative commodity prices and comparative
advantage between the two nations?
2. What is the effect of international trade on the earnings of factors of production in the
two trading nations?
H-O theory tries to answer these questions.

46. Assumptions of the theory
1. There are two nations (Nation 1 and Nation 2), two commodities (commodity X and
commodity Y), and two factors of production (labour and capital).
This assumption is made to explain the theory in two dimensional figure and its
relaxation , i.e. application of the theory to realistic situation of more than two
countries and two commodities will leave the conclusion of the theory basically
unchanged.
2. Both nations use the same technology in production
Both nations have access to and use the same general production techniques. Thus, if
factor prices were the same in both nations producers in both nations would use exactly
the same amount of labour and capital in the production of each commodity. Since
factor prices usually differ, producers in each nation will use more of the relatively

47. 3. Commodity X is labour intensive and commodity Y is capital intensive in both nations
It means commodity X requires relatively more labour to produce than commodity Y in
both nations. But this does not mean that labour to capital ratio for commodity X is the
same in Nation 1 and Nation 2.
4. Both commodities are produced under the constant returns to scale in both nations
i.e. doubling of the inputs, doubles the output.
5. There is incomplete specialisation in production in both nations
This means that even with free trade both nations continue to produce both commodities.

48. 6. Tastes are equal in both nations
This means that demand preferences, as reflected in the shape and location of
indifference curves are identical in both nations.
7. There is perfect competition in both commodities and factor markets in both nations
It means that producers, consumers, and traders of commodity X and Y in both nations
are each too small to affect the price of these commodities.
The same is true for each user and supplier of labour time and capital.
Perfect competition also implies that, in the long run commodity prices equal their costs
of production, leaving no economic profit after all costs (including implicit costs) are
taken into account.
Finally, perfect competition means that all producers, consumers and owners of factors of
production have perfect knowledge of commodity prices and factor earnings in all parts

49. 8. There is perfect factor mobility within each nation but no international factor mobility
It means that labour and capital are free to move, and indeed do move quickly, from areas
and industries of lower earnings to areas and industries of higher earnings until earnings for
the same type of labour and capital are the same in all areas, uses, and industries of the
nation. On the other hand, there is zero international factor mobility so that international
differences in factor earnings would persist indefinitely in the absence of international trade.
9. There are no transport costs, tariffs, or other obstructions to the free flow of
international trade-
10. All resources are fully employed in both the nations
11. International trade between two nations is balanced
It means that the total value of each nation’s exports equals to total value of the nation’s
imports.

50. Statement of the Theory
A nation will export the commodity whose production requires the intensive use of the
nation’s relatively abundant and cheap factor and import the commodity whose production
requires the intensive use of the nation’s relatively scarce and expensive factor.
i.e. the relatively labour rich nation exports relatively labour intensive commodity and imports
the relatively capital intensive commodity.
This means that nation 1 exports commodity X because commodity X is the L-intensive
commodity and L is the relatively abundant and cheap factor in Nation 1. Conversely, Nation 2
exports commodity Y because commodity Y is the K-intensive commodity and K is relatively
abundant and cheap factor in Nation 2.
H-O theory explains the comparative advantage rather than assuming it.
The difference in relative factor abundance and prices is the cause of pre-trade difference in

52. Explanation of the theory-
The H-O theory is illustrated in the following Figure

53. The left panel of the figure shows the production frontiers of Nation 1 and Nation 2. Nation
1’s production frontier is skewed along the X-axis because commodity X is the L-intensive
commodity. Nation 1 is the L-abundant nation, and both nations use the same technology.
Since the two nations have equal tastes, they face the same indifference map. Indifference
curve I is tangent to Nation 1’s production frontier at point A and to Nation 2’s production
frontier at A’. Indifference curve I is the highest indifference curve that Nation 1 and Nation 2
can reach in isolation , and points A and A’ represent their equilibrium points of production
and consumption in the absence of trade. The tangency of indifference curve I at points A and
A’ defines the no trade, or autarky, equilibrium-relative commodity prices of 𝑃𝐴 in Nation 1
and 𝑃𝐴′ in Nation 2. Since 𝑃𝐴 < 𝑃𝐴′ Nation 1 has a comparative advantage in commodity X and
Nation 2 has a comparative advantage in commodity Y.

54. The right panel shows that with trade Nation 1 specialises in production of commodity X and
Nation 2 specialises in the production of commodity Y. Specialisation in production proceeds
until Nation 1 has reached point B and Nation 2 has reached point B’, where the
transformation curves of the two nations are tangent to the common relative price line 𝑃𝐵.
Nation 1 will then export commodity X in exchange for commodity Y and consume at point E
on indifference curve II. On the contrary, Nation 2 will export Y for X and consume at point
E’, which coincides with point E.
Nation 1’s exports of commodity X equal Nation 2’s imports of commodity X (i.e. BC=C’E’).
Similarly, Nation 2’s export of commodity Y equal Nation 1’s imports of commodity Y (i.e.
B’C’=CE).

55. Point E involves more of Y but less of X than point A. Nation 1 gains from trade because point
E is on higher. Similarly, even thought point E’ involves more X but less Y than point A’, Nation
2 is also better off because point E’ is on higher indifference curve II.

56. Factor intensity of Major product categories
1. Arable land and other natural resource intensive products:-
Agricultural products (food and raw material)
Fuels and mining products (ores and other minerals, fuels and nonferrous metals)
2. Capital intensive products
Iron and steel
Agricultural chemicals
Automotive products (automotive vehicles, parts and engines)
3. R & D scientists and other highly skilled labour intensive products
Chemicals (pharmaceuticals and other chemicals)
Office and telecommunications equipment
Civilian aircraft, engines and parts
Machinery (power generating, nonelectrical and electrical machinery)
Scientific and controlling instruments
4. Unskilled labour intensive products
Textiles
Clothing and footwear
Personal and household goods

57. Criticism on H-O theory
1. Two by two model- Ohlin has been criticised for presenting two by two model based on
oversimplified assumptions. But Ohlin himself has pointed out that it can be extended to
many regions.
2. Static theory- This theory gives some characteristics of an economy at a given point in
time.
3. Production techniques not same- Production techniques are different for the same
commodity in two different countries. E.g. textiles may be produced with handlooms
which require more labour and less capital or with highly sophisticated power looms
requiring a small number of workers. So, trade may not follow the Ohlin pattern.
4. Tastes and demand patterns are not identical- For different income groups it cannot be.
With inventions in consumer goods, changes in tastes and demand patterns of consumers
also occur among developed countries. Commodities which consumers demand in the US
are different from what consumers demand in Germany.
5. No constant returns always-
6. Transport costs influence trade- in addition to this, costs of loading, unloading, port
charges etc. lead to price differences and affect the trade.

58. 7. Factor prices do not determine commodity prices- According the Ohlin, commodity prices
are determined by the factor prices. But according to Wijanholds, prices of commodities are
determined by their utility to the consumers, and that the prices of raw materials and labour
are ultimately dependent on the prices of final commodities. So, right approach is to start
with commodity prices rather than factor prices.