BASIS OF INTERNATIONAL
TRADE

CONTENTS
 INTRODUCTION
 BASIS OF INTERNATIONAL TRADE
1. Theory of absolute cost advantage
2. Theory of comparative cost advantage
3. Factor endowment theory
4. Theory of competitive advantage
5. Product life cycle theory
6. Theory of identical preferences
7. Product differentiation
8. Outlet for domestic surplus
 CONCLUSION

INTRODUCTION
 The reason for the emergence of international
trade is that the human wants are varied and
unlimited and no single country possesses the
adequate resources to satisfy all these wants.
Hence there arises a need for
interdependence between countries in the
form of international trade. So in order to
make effective utilisation of the world’s
resources international trade is to be boosted
and the problems faced by the countries
should be dealt with.

BASIS OF INTERNATIONAL TRADE
 No country is self sufficient in producing all
the required goods and services from its own
resources. This problem can be solved
through international trade where the
countries obtain those goods which it cannot
produce or cannot produce as cheaply as
possible in another country. However this is
not the only basis for doing international trade,
there are other reasons also. Trade
economists have laid down different theories
for international trade.

Contd….
 Theory of absolute cost advantage
 Theory of comparative cost advantage
 Factor endowment theory
 Theory of competitive advantage
 Product life cycle theory
 Theory of identical preferences
 Product differentiation
 Outlet for domestic surplus

THEORY OF ABSOLUTE COST
ADVANTAGE (By Adam Smith)
 Producing a good with fewer inputs (capital,
labor, land, raw materials, etc.) per unit of
output than other countries
 If input prices are the same in two
countries, the country with an absolute
advantage in a good will have a lower unit
cost of production for that good
 A country should produce and export
products in which it has an absolute
advantage
A country should import products in which it
has an absolute disadvantage

Per unit cost of production( Rs.)
Country Cotton Tea
India 5 10
Indonesia 10 5
 India has
absolute cost
advantage in the
production of
cotton and
Indonesia in the
production of tea
 Both countries
will gain if India
produces and
exports cotton
and Indonesia
produces and
exports tea.

THEORY OF COMPARATIVE COST
ADVANTAGE (By David Ricardo)
 Focus on comparative cost advantage not
on absolute cost advantage.
 Each country specialises in the production
of that commodity in which its comparative
cost of production is the least.
 A country will export those commodities in
which its comparative costs are less.
 A country will import those commodities in
which its comparative costs are high.

Commodities (Per unit cost of
production)
Country
A B C D E
X 10 12 13 14 15
Y 9 5 8 13 14
Cost
Difference
1 7 5 1 1
 Country Y has
comparative
advantage in products
B and C
 Country Y will put all its
resources in the
production of B and C
 Country X will produce
other products i.e. A,
D, and E.

FACTOR ENDOWMENT THEORY
(By Heckscher and Ohlin)
 A country that is relatively abundant in a factor
of production should export goods that use a lot
of that factor in the production process, and
import other goods
 Example: a country like China with a lot of
labour should export labour-intensive goods
 Why? If a factor is relatively abundant, it will be
relatively cheap, and a country will be more
globally competitive in products that use a lot of
that factor

THEORY OF COMPETITIVE
ADVANTAGE (By Micheal Porter)
 To compete in the world a country requires a
strategy to gain a competitive edge over the
others.
 Competitive advantage is created by
technological and institutional change, not just
inherited from a country’s natural endowments.

PRODUCT LIFE CYCLE THEORY
(By Vernon)
 Industrialised countries contribute more
resources to research and development which
results in development of new products
 In early stage they have monopoly on such
new products and enjoy easy access to
foreign markets
 Later other countries start imitating their
products and initial advantage disappears.

THEORY OF IDENTICAL
PREFERENCES (By Linder)
 Based on the principle that trade opportunities
are more among countries at similar stage of
development with similar demand structure
 E.g. USA and Japan are largest trade partners
because of identical consumer preferences and
similar stage of development.

PRODUCT DIFFERENTIATION
 Another reason or basis for international trade
can be the product differentiation.
 It means differentiating a product in some manner
such as adding different and new features in the
same basic products.

OUTLET FOR SURPLUS
 Most countries involve in international trade
because they have surplus production
 Surplus commodities or some unused
resources can be exported
 E.g. India had surplus wheat in 2000 and
there was no additional storage capacity, so it
was decided to export wheat at cheaper rates
in the international market.

CONCLUSION
To sum it up, we can say that there are multiple
basis for international trade. It can also be said
that these are the inevitable factors which force
a country to do international trade.

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