Internal and International Trade, Classical theories of International Trade, Reciprocal Demand Theory, Modern Theory (H-O Theory).

1. INTERNATIONAL
ECONOMICS
DR. PARUL SHARDA

2. International economics?
◦ International economics deals with the economic activities of various countries and their
consequences.
◦ In other words, international economics is a field concerned with economic interactions
of countries and effect of international issues on the world economic activity.
◦ It studies economic and political issues related to international trade and finance.
◦ International trade involves the exchange of goods or services and other factors of
production, such as labor and capital, across international borders.
◦ On the other hand, international finance studies the flow of financial assets or
investment across borders. International trade and finance became possible across
nations only due to the emergence of globalization.

3. Concept
◦ International economics refers to a study of international forces
that influence the domestic conditions of an economy and
shape the economic relationship between countries. In other
words, it studies the economic interdependence between countries
and its effects on economy.
◦ The scope of international economics is wide as it includes various
concepts, such as globalization, gains from trade, pattern of trade,
balance of payments, and FDI. Apart from this, international economics
describes production, trade, and investment between countries.

5. ◦By internal or domestic trade are meant transactions
taking place within the geographical boundaries of a
nation or region.
◦Trade within the territory (political boundary) of a
nation “internal” trade.
◦It is also known as intra-regional or home trade.

7. ◦ International trade, thus, refers to the exchange of goods and
services between one country or region and another. It is also
sometimes known as “inter-regional” or “foreign” trade.
◦ Briefly, trade between one nation and another is called
“international” trade,
◦ For all practical purposes, trade or exchange of goods between
two or more countries is called “international” or “foreign”
trade.
Thus, International trade, is trade among different countries
or trade across political frontiers.

8. Why International trade?
1. Human wants and countries’ resources do not totally coincide.
Hence, there tends to be interdependence on a large scale.
2. Factor endowments in different countries differ.
3. Technological advancement of different countries differs.
Thus, some countries are better placed in one kind
of production and some others superior in some other
kind of production.

9. 4. labor and entrepreneurial skills differ in different countries.
5. Factors of production are highly immobile between countries.
In short, international trade is the outcome of territorial division
of labor and specialisation in the countries of the world.

10. Distinguishing features of
international trade:
◦ (1) Immobility of Factors:
◦ The degree of immobility of factors like labor and capital is generally greater between
countries than within a country. Immigration laws, citizenship, qualifications, etc.
often restrict the international mobility of labor.
◦ International capital flows are prohibited or severely limited by different
governments. Consequently, the economic significance of such mobility of factors
tends to equality within but not between countries. For instance, wages may be equal
in Mumbai and Pune but not in Bombay and London.
◦ In this context, it may be pointed out that the price of a commodity in the country
where it is produced tends to equal its cost of production.

11. ◦ The reason is that if in an industry the price is higher than its cost,
resources will flow into it from other industries, output will increase
and the price will fall until it is equal to the cost of production.
Conversely, resources will flow out of the industry, output will decline,
the price will go up and ultimately equal the cost of production.
◦ But, as among different countries, resources are comparatively
immobile; hence, there is no automatic influence equalising price and
costs. Therefore, there may be permanent difference between the cost of
production of a commodity.
◦ For instance, the price of tea in India must, in the long run, be equal to
its cost of production in India. But in the U.K., the price of Indian tea
may be permanently higher than its cost of production in India. In this
way, international trade differs from home trade.

12. ◦ (2) Heterogeneous Markets:
◦ In the international economy, world markets lack homogeneity on
account of differences in climate, language, preferences, habit, customs,
weights and measures, etc. The behaviour of international buyers in
each case would, therefore, be different.
◦ (3) Different National Groups:
◦ International trade takes place between differently cohered groups. The
socio-economic environment differs greatly among different nations.
◦ (4) Different Political Units:
◦ International trade is a phenomenon which occurs amongst different
political units.

13. ◦ (5) Different National Policies and Government Intervention:
◦ Economic and political policies differ from one country to another. Policies
pertaining to trade, commerce, export and import, taxation, etc., also differ
widely among countries though they are more or less uniform within the
country. Tariff policy, import quota system, subsidies and other controls
adopted by governments interfere with the course of normal trade between
one country and another.
◦ (6) Different Currencies:
◦ Another notable feature of international trade is that it involves the use of
different types of currencies. So, each country has its own policy in regard
to exchange rates and foreign exchange.

14. Quick Look at features…

15. Domestic v/s International Trade
BASIS FOR COMPARISON DOMESTIC BUSINESS INTERNATIONAL BUSINESS
Meaning A business is said to be domestic, when its
economic transactions are conducted
within the geographical boundaries of the
country.
International business is one which is
engaged in economic transaction with
several countries in the world.
Area of operation Within the country Whole world
Quality standards Quite low Very high
Deals in Single currency Multiple currencies
Capital investment Less Huge
Restrictions Few Many
Nature of customers Homogeneous Heterogeneous
Business research It can be conducted easily. It is difficult to conduct research.
Mobility of factors of production Free Restricted

16. Conclusion
◦ Carrying out the activities of international business and its
management is far more difficult than conducting a domestic
business. Due to changes in political, economic, socio-
cultural environment across the nations, most business
entities find it difficult to expand their business globally. To
become a successful player in the international market firms
need to plan their business strategies as per the requirement
of the foreign market.

17. Classical Theories of International Trade
◦ Adam Smith and David Ricardo gave the classical theories of
international trade.
◦ According to the theories given by them, when a country enters in
foreign trade, it benefits from specialization and efficient resource
allocation.
◦ The foreign trade also helps in bringing new technologies and skills that
lead to higher productivity.

18. The assumptions taken under this theory’
are as follows:
◦ a. There are two countries producing two goods.
◦ b. The size of economies of these countries is equal
◦ c. There is perfect mobility of factors of production within countries
◦ d. Transportation cost is ignored
◦ e. Before specialisation country’s resources are equally divided to
produce each good.

19. Classification of Classical Theories

20. Theory of Mercantilism
◦ Mercantilism is the term that was popularized by Adam Smith, Father of
Economics, in his book, The Wealth of Nations.
◦ The theory of mercantilism holds that countries should encourage export and
discourage import.
◦ It states that a country’s wealth depends on the balance of export minus
import.
◦ According to this theory, government should play an important role in the
economy for encouraging export and discouraging import by using subsidies and
taxes, respectively.
◦ In those days, gold was used for trading goods between countries.

21. ◦ Thus, export was treated as good as it helped in earning gold,
whereas, import was treated as bad as it led to the outflow of gold.
◦ If a nation has abundant gold, then it is considered to be a Wealthy
Nation.
◦ If all the countries follow this policy, there may be conflicts, as no one
would promote import.
◦ The theory of mercantilism believed in selfish trade that is a one-way
transaction and ignored enhancing the world trade.
◦ Mercantilism was called as a zero-sum game as only one country
benefitted from it.

22. Theory of Absolute Advantage:
◦ Given by Adam Smith in 1776, the theory of absolute advantage stated that a country
should specialize in those products, which it can produce efficiently. This theory
assumes that there is only one factor of production that is labor.
◦ Adam Smith stated that under mercantilism, it was impossible for nations to become rich
simultaneously. He also stated that wealth of the countries does not depend upon the
gold reserves, but upon the goods and services available to their citizens.
◦ Adam Smith wrote in The Wealth of Nations, “If a foreign country can supply us with a
commodity cheaper than we ourselves can make it, better buy it of them with
some part of the produce of our own industry, employed in a way in which we have
some advantage”.
◦ He stated that trade would be beneficial for both the countries if country A exports the
goods, which it can produce with lower cost than country B and import the goods,
which country B can produce with lower cost than it.

23. ◦ An example can be used to prove this theory. Suppose there are two countries
A and B, which produce tea and coffee with equal amount of resources that is
200 laborers. Country A uses 10 laborers to produce 1 ton of tea and 20
laborers to produce 1 ton of coffee. Country B uses 25 units of laborers to
produce tea and 5 units of laborers to produce 1 ton of coffee.
Table:1-Resources used to produce a ton of Tea or Coffee without
Trade.
Country -A Country-B
Tea 10 25
Coffee 20 5

24. ◦ It can be seen from Table-2 that country A has absolute advantage in
producing tea as it can produce 1 ton of tea by using less laborers as
compared to country B.
◦ On the other hand, country B has absolute advantage in producing
coffee as it can produce 1 ton of coffee by employing less laborers in
comparison to country A.
◦ Table:2- Production without Trade
Country –A (in Tons) Country-B (in Tons)
Tea 10 4
Coffee 5 20

25. ◦ Now, if there is no trade between these countries and resources (in this
case there are total 200 laborers) are being used equally to produce tea
and coffee.
◦ Country A would produce 10 tons of tea and 5 tons of coffee and
country B would produce 4 tons of tea and 20 tons of coffee.
◦ Thus, total production without trade is 39 tons (14 tons of tea and 25
tons of coffee).
◦

26. ◦ If both the countries trade with each other and specialize in
goods in which they have absolute advantage, the total
production would be higher. Country A would produce 20
tons of tea with 200 units of laborers; whereas, country B
would produce 40 tons of coffee with 200 units of laborers.
Thus, total production would be 60 units (20 tons of tea
and 40 tons of coffee).
◦ Table:3- Production with Trade
Country –A (in Tons) Country-B (in Tons)
Tea 20 0
Coffee 0 40

27. ◦ Conclusively, we can say that without specialization, total
production of countries was 39 tons, which becomes 60 tons
after specialization.
◦ Therefore, the theory of absolute advantages shows that
trade would be beneficial for both the countries.

28. Ricardo’s Theory of Comparative Advantage
◦ Now the questions may come in mind after reading the absolute advantage theory that
what would happen if a country has absolute advantage in all the products or no
absolute advantage in any of the product.
◦ How such a country would benefit from trade?
◦ The answers of these questions was given by David Ricardo in his theory of
comparative advantage, which states that trade can be beneficial for two
countries if one country has absolute advantage in all the products and
the other country has no absolute advantage in any of the products.
◦ According to Ricardo, “…a nation, gains from the trade by exporting the goods or
services in which it has its greatest comparative advantage in productivity
and importing those in which it has the least comparative advantage. ”

29. Comparative Advantage??
◦ Comparative Advantage refers to the ability of a country to produce particular
goods or services at lower opportunity cost as compared to others in the field.

30. Assumptions of Comparative Advantage Theory
1.There are only two countries, assume A and B.
2.Both of them produce the same two commodities, X and Y.
3.labor is the only factor of production.
4.The supply of labor is unchanged.
5.All labor units are homogeneous.
6.Tastes are similar in both countries.
7.The labor cost determines the price of the two commodities

31. 8. The two countries trade on the barter system.
9.Technological knowledge is unchanged.
10. Factors of production are perfectly mobile within each country. However, they are
immobile between the two countries.
11.Free trade is undertaken between the two countries. Trade barriers and restrictions
in the movement of commodities are absent.
12. Transport costs are not incurred in carrying trade between the two countries.
13. Factors of production are fully employed in both the countries.
14.The exchange ratio for the two commodities is the same.

32. ◦ Suppose there are two countries X and Y, producing two commodities
wheat and wine with labor as the only factor of production. Now assume
that both the countries have 200 laborers and they use 100 laborers to
produce wheat and 100 laborers to produce wine.
◦ Table-4 depicts that country X can produce 20 units; whereas, country
Y can produce 15 units of wheat by using 100 laborers. In addition,
country X can produce 40 units; whereas, country’ Y can produce 10
units of wine by employing 100 laborers.
◦ Table:4- Production of Wheat and Wine by country X & Y before Trade.
Country –X Country-Y
Wheat 20 15
Wine 40 10

33. ◦ Thus, country X has absolute advantage in producing both the
products. As already discussed, country X employs same number of
laborers (100 laborers in production of each good) in producing both
wine and wheat; however, the production of wine is more than the
production of wheat.
◦ It shows that country’ X has comparative advantage in producing
wine. Similarly, country Y also employs same number of laborers (100
laborers in production of each good) in manufacturing wheat and wine;
however, its production of wheat is more than the wine. It indicates that
country Y has comparative advantage in manufacturing wheat.

34. ◦ For example, country X has decided to produce 60 units of wine by employing
150 laborers.
◦ It uses 50 laborers to produce 10 units of wheat.
◦ On the other hand, country Y has decided to use all the 200 laborers to
produce 30 units of wheat. It would not produce any unit of wine.
◦ Table:5- Production of country X & Y after specialization
Country –X Country-Y
Wheat 10 30
Wine 60 0

35. Country –X Country-Y
Wheat 24 16
Wine 46 14
◦ Now, country X exchanges 14 units of wine with 14 units of wheat produced by
country Y.
◦ It can be observed from Table-6 that both the countries have gained from trade.
Before trade, country X has 20 units of wheat and 40 units of wine; however, after
trade, country X has 24 units of wheat and 46 units of wine.
◦ On the other hand, country Y has 15 units of wheat and 10 units of wine before trade;
however, it has 16 units of wheat and 14 units of wine after trade.
◦ Therefore, theory of comparative advantage explains that trade can create
benefit for both the countries even if one country has absolute advantage
in the production of both the goods.
◦ Table:6- Production of country X & Y after specialization

36. CRITICISMS OF COMPARATIVE ADVANTAGE
1.The theory only considers labor costs and neglects all non-labor costs involved in the
production of the commodities.
2.The theory considers all labor to be homogenous. However, in reality, labor is heterogeneous
due to different grades and kinds.
3.The theory assumes similar tastes for all. However, the tastes differ with the growth of
economies and income brackets.
4.The theory assumes that a fixed proportion of labor is used in the production of all commodities.
However, in reality, utilization of the proportion of labor depends on the type of commodity being
produced.
5.The theory has an unrealistic assumption of constant costs. However, large-scale productions
lead to cost reduction and thereby increase the comparative advantage.
6.Transport costs play an essential role in determining the pattern of trade. But the Ricardo theory
neglects this independent factor of production.

37. 7.The assumption of the factors of production being mobile internally is unrealistic. The factors do
not move freely from one region to another or one industry to another. The greater the degree of
specializations in an industry, the more immobile the factor will be.
8.The assumption of the theory of having only two countries and two commodities is unrealistic as
international trade takes place among countries trading numerous commodities.
9.Every country implements restrictions on the movement of goods to and from the countries.
Thus, tariffs and trade restrictions play a role in world imports and exports. However, the theory
assumes free and perfect world trade.
10. The theory assumes full employment. However, every economy has an existence of
underemployment.
11. Country may or may not want to trade a commodity due to military, strategic or development
considerations. Therefore, self-interest stands in the operation of the comparative advantage
theory.
12.The Ricardian theory considers only the supply side of world trade and neglects the demand
side.
13.The theory only explains how two countries gain from international trade. But the theory fails to
explain how the gains from the trade are distributed between the two countries.

38. CONCLUSION
◦ Despite weaknesses, The Ricardian theory of comparative
advantage has remained significant over the years. The
basic structure of the theory still exists with a few
refinements. It is believed that a nation that neglects this
theory may have to pay a heavy price in terms of potential
rate of growth and living standards.

39. Concept of reciprocal demand in the theory of
comparative costs.
◦ Reciprocal demand means the relative strength and elasticity of
demand of the two trading countries for each other's product in terms
of their own product.
◦ A stable ratio of exchange will be determined at a level where the
value of imports and exports of each country is in equilibrium.

40. ◦ J.S.Mill made Ricardo’s theory of comparative cost determinate by
stating the conditions for equilibrium terms of trade. Comparative cost
difference between the countries sets the outer limits between which
international trade can take place profitably.
◦ It does not tell where, between the limits, international trade will actually
take place. Mill provides answer to this question.
◦ J. S. Mill propounded the theory of reciprocal demand or the law of
international values to explain the actual determination of
equilibrium terms of trade.

41. ◦ A stable ratio of exchange will be determined at a level where
the value of imports and exports of each country is in
equilibrium.
◦ In Mill’s own words, “The actual ratio at which goods are
traded will depend upon the strength and elasticity of each
country’s demand for the other country’s product, or
upon reciprocal demand.
◦ The ratio will be stable when the value of each country’s
exports is just enough to pay for its imports.

42. Mill’s theory is based on the following
assumptions-
◦ (i) Full employment conditions;
◦ (ii) Perfect competition;
◦ (iii) Free foreign trade;
◦ (iv) Free mobility of factors;
◦ (v) Applicability of the theory of comparative cost;
◦ (vi) Two country, two commodity model.

43. Ellsworth has summed up Mill’s theory of
reciprocal demand in the following way:
◦ (i) The possible range of barter terms is given by the respective
domestic terms of trade as set by comparative efficiency in each
country.
◦ (ii) Within this range, the actual terms depend on each country’s
demand for the other country’s produce.
◦ (iii) Finally, only those barter terms will be stable at which the exports
offered by each country just suffice to pay for the imports it desires.

44. Changes in Demand and Supply
Conditions:
◦ Mill’s theory of reciprocal demand is more than a simple truism. It indicates the forces
and their modus operendi which bring about international equilibrium. Mill analysed
the impact of changes in supply and demand conditions on the terms of trade.
◦ 1. Changes in Supply Conditions:
◦ Changes in supply conditions as a result of cost-reducing improvements in technology
bring changes in terms of trade. An improvement in the cloth industry of England
increases the productivity in that industry, makes cloth cheaper in terms of Indian
wheat (i. e., the same amount of wheat is exchanged for more cloth) and thus makes
the terms of trade in favour of India, the importer of cloth in exchange for wheat.

45. ◦ 2. Changes in Demand Conditions:
◦ The extent to which the barter terms of trade change depends not only on the
increased production in exporting country, but also on the importing country’s elasticity
of demand for imports in terms of its exports.
◦ (i) If India’s elasticity of demand for England’s cloth in terms of its own wheat is more
elastic, then the barter terms of trade will change in favour of India more than the fall
in price of cloth in terms of wheat.
◦ (ii) If India’s demand for cloth in terms of wheat is unitary elastic, then the barter
terms of trade turn in favour of India equal to the fall in the price of cloth in terms of
wheat.
◦ (iii) If India’s demand for cloth in terms of wheat is less elastic, then the barter terms
of trade will change in favour of India less than the fall in the price of cloth in terms of
wheat.

46. Reciprocal Demand Elasticity:
◦ The reciprocal demand elasticity refers to the ratio of proportional change in the quantity of imports
demanded to the proportional change in the price of exports relative to the price of imports. Thus,
elasticity of reciprocal demand-
◦ If e > 1, then terms of trade will be favourable for the concerned country and its share of gain
will be larger; if e < 1, terms of trade will for the concerned country and the share of gain will be
relatively less; if e = 1, the gain from trade will be equally distributed between the two countries.

47. Heckscher and Ohlin Theory – Modern
Theory of International Trade
◦ Heckscher and Ohlin theory, given by Swedish Economists Eli Hecksher
(1919) and Bertil Ohlin (1933), is an extension of theory of
comparative advantage.
◦ This theory introduces a second factor of production that is capital.
This theory also states that comparative advantage occurs from
differences in factor endowments between the countries.
◦ Factor endowment refers to the amount of resources, such as land,
labor, and capital available to a country.

48. ◦Every country has different factor endowments,
thus the costs of these factors differ depending
upon their availability.
◦For example, if a country has abundant
labor, then the cost of labor would be low in
that country.

49. ◦According to Heckscher and Ohlin theory, a country
would export products, which it produces by using
the abundant factor of production.
◦However, it would import goods, which require use of
scarce resources. Countries trade with each other
because they have different factor endowments.

50. ◦For instance, some countries may have more
labor and less machinery and some may have
more machinery and less labor.
◦ In such a case, the country with more labor
would specialize in labor-intensive products
and export those products to other country.

51. The assumptions of Heckscher and
Ohlin theory’ are as follows:
◦ (i) This theory considers a two-country, two- commodity and two factor (labour and
capital) case. It is possible, however, to extend the theory to a multi-factor and multi-
commodity case. But such an extension can be done only if the number of factors and
number of commodities are equal.
◦ (ii) The factors of production are perfectly mobile within their respective countries but
they are immobile between the countries.
◦ (iii) There is a state of perfect competition both in the product and factor markets.
◦ (iv) There is full employment of the factors of production in both the countries.
◦ (v) Production functions pertaining to both the commodities are linearly homogenous.
It implies that the production is governed by constant returns to scale.

52. ◦ (vi) The techniques of production in both the countries remain unchanged. In such a
situation, the input-output co-efficient in production functions will remain
unchanged.
◦ (vii) The consumer’s taste pattern and therefore the demand functions for different
goods are identical in both the countries.
◦ (viii) The factors endowments, in absolute terms, remain constant in both the
countries but the relative endowments of the two factors are disproportionate in the
two countries. Suppose country A has an abundance of capital while B has an
abundance of labour. In qualitative terms, however, the factors are homogenous in the
two countries.
◦ (ix) The production functions are such that the two commodities show different factor
intensities—one commodity is capital-intensive and the other is labour-intensive.
Although production functions for different commodities are different, yet the
production functions for each commodity are the same in both the countries.

53. ◦ (x) The factor intensities are not reversible.
◦ (xi) The trade between two countries is free and unrestricted.
◦ (xii) There is an absence of transport costs so that product
prices are related exclusively to factor costs.
◦ (xiii) There is incomplete specialisation in the trading
countries.
◦ The whole basis of differences in comparative costs,
according to H-O theory, rests upon two crucial elements—
factor endowments and factor intensities.

54. Factor Endowments:
◦It is an incontrovertible fact that regions or countries
differ from one another in respect of endowments or
availability of factors.
◦In country A, there may be an abundance of capital
and labour may be scarce. On the opposite, there may
be an abundance of labour in country B, while capital
may be scarce.

55. The terms ‘relative factor abundance,’ in
H-O model can be defined in terms of two
criteria:
◦ (i) The physical criterion of relative factor abundance, and
◦ (ii) The price criterion of relative factor abundance.
◦ (i) Physical Criterion:
◦ According to this criterion, a country is said to be relatively
capital abundant, if and only if, it is endowed with a higher
proportion of capital to labour than the other country.

56. ◦ The country A can be called as relatively capital abundant, if the following condition is satisfied:
◦ where K and L refer to capital and labour respectively. Bars over K and L signify the fixed factor quantities in each
country. The subscripts A and B refer to countries A and B.
◦ Similarly the relative scarcity of labour, in physical terms, in country A can be expressed as:
◦

57. ◦ For country B, relative labour-abundance can be indicated by:
◦
◦ And capital-scarcity in this country can be denoted by:
◦

58. ◦ Given the above conditions, H-O theory lays down that country A will produce capital-intensive commodity
(say machines) and country B will have a bias in producing labour-intensive commodity (say, cloth). If both
the countries produce machines and cloth in the same proportion and production occurs along OR in Fig.
7.1, the country A would be producing at C and country B at D. The points C and D lie on the respective
production possibility curves PQ and P1Q1 of these two countries.
◦

59. ◦ Since at point C, the slope of country A’s production possibility curve is more steep
than the slope of the production possibility curve of country B at D, this will imply that
MC of producing cloth in country A is higher than the MC of producing cloth in
country B. So if the production takes place at points C and D, machines can be
produced more cheaply in country A and cloth can be produced more cheaply in
country B.
◦ Since country A is capital-abundant and the production of machines is
capital-intensive, country A will tend to extend the production of
machines.
◦ Country B, at the same time being labour-abundant, will tend to extend
the production of cloth, which is relatively labour- intensive.

60. Conclusion
◦The Heckscher and Ohlin theory shows relationship
among various variables. The prices of the factors are
determined by their availability, which further
determines the price of the product. Cost advantage
and specialization occurs as a result of difference of
factor prices and product price.