This document discusses different theories of international trade. It begins by defining domestic and international trade, noting they both involve the exchange of goods and services between buyers and sellers. It then explains David Ricardo's comparative cost advantage theory, which states that countries will export products where they have a lower relative production cost and import goods with a higher relative cost. The document also outlines the Heckscher-Ohlin theory of international trade, which argues that differences in a country's abundant factors of production (e.g. capital vs. labor) lead to differences in production costs and drive trade patterns. Both theories posit that international trade allows for increased specialization and production.

1. Theories of International
Trade

2. Trade
 Trade refers to exchange of goods & services between
seller & buyer
 Trade is of 2 types i.e. Domestic trade & International
Trade
 Domestic Trade is carried out within the country &
international trade refers to trade between countries

3. Similarities in Domestic & International
Trade
 Both involve exchange of goods & services
 Objective is Profit Maximization
 Basis for trade is cost advantage
 Both enhance consumer’s satisfaction by providing
various goods & services

5. Comparative Cost Advantage Theory of
International Trade
 According to David Ricardo, countries will export
products where they have cost advantage & surplus
production
 They will import goods where they have cost
disadvantage
 This theory is based on labour value i.e. Value of goods
depends upon amount of labour used to produce it

6. Comparative Cost Advantage Theory of
International Trade
 Assumptions for Cost Advantage Theory
 Labour is the only factor of production & is homogenous factor
 Cost of production of all commodities are measured in terms of
labour cost
 Labour is perfectly mobile within country but immobile between
countries
 Economy is Laissez-Faire i.e. No govt intervention
 Free Trade (Absence of Tariffs, Quotas etc.)
 Perfect Competition prevails in both countries
 Transport cost are ignored
 Full employment in both countries

7. Comparative Cost Advantage Theory of
International Trade
 Ricardo explained this theory by using 2 country – 2
commodity & 1 factor of production model
 When both the countries do not have trade relations then
both the items will be produced by each country & 1 good
will be exchanged for other
 This is known as domestic exchange rate
Countries No. Of Hours to produce 1 Unit
Wine Cloth
Portugal 80 90
England 120 100

8. Comparative Cost Advantage Theory of
International Trade
 For Portugal, 1 unit of wine = 0.88 units of cloth
 For England, 1 unit of wine = 1.2 units of cloth
 When trade takes place, 1 unit of wine will range from 0.88
units to 1.2 units of cloth
 Portugal would like to get more than 0.88 unit of cloth for
every unit of wine sold (as 0.88 is their own price)
 England would like to give less than 1.2 unit of cloth for
every unit of wine purchased (as 1.2 is their own price)
 Assuming, exchange ratio is 1 unit of wine = 1 unit of cloth,
then both the countries will benefit

9. Comparative Cost Advantage Theory of
International Trade
 When countries specialize & trade, production of goods
will be more
 If there was no trade then both the countries would be
producing both the products and having less benefit
with more of labour hours
 Thus according to this theory, differences in comparison
cost advantage leads to international trade

10. Critical Evaluation
 Based on 2 country, 2 commodity & 1 factor model – restrictive in
nature
 Based on Labour value theory, which is unrealistic
 Full employment, Perfect Mobility etc. are not tenable
assumptions
 Only 1 factor of Labour is considered & others are ignored – Not
comprehensive
 Partial theory as emphasises only on supply and ignorant about
demand
 No proper Exchange rate

11. Heckscher – Ohlin Theory of Int.
Trade
 This theory is also known as factor endowment theory
 Comparative cost advantage theory only explained that
int. trade took place due to cost differences
 However they did not explain the reasons for cost
differences
 This theory explains the reasons for cost differences
 Modern theory starts where cost comparative theory
ends

12. Heckscher – Ohlin Theory of Int.
Trade
 As per this theory, cost difference arises due to 2 reasons
 Different countries have different factor endowments
 Factor proportions used for producing commodities are
different in different countries

13. Heckscher – Ohlin Theory of Int.
Trade
 Assumptions
 2 country, 2 commodity & 2 factor model
 1 country is endowed with abundance of labour & other with capital
 Free Trade (Absence of Tariffs, Quotas etc.)
 Full employment in both countries
 Perfect Competition prevails in both product & factor market
 Factors of Production are perfectly mobile within country but
immobile between countries
 No Transportation cost
 Factors of Production are homogenous in both the countries

14. Heckscher – Ohlin Theory of Int.
Trade
 As per this theory, countries will specialize in
production of those products which uses the abundant
factor (labour / Capital)
 Viz, capital rich country will specialize in capital
intensive goods & labour abundant country will
produce more of labour intensive products & export
 This is so, as abundant factor is available easily & at
cheaper rates

15. Advantages of International
Trade
 Comparative Cost Advantage
 Specialization
 Optimum use of Resources
 Benefit to Consumer
 Increase in Production, Employment & N.I.
 Availability of Goods & Services
 Conservation of Scarce Resources
 Promotion of Inter-Dependence & Co-Operation

16. Questions
1. Explain Trade – Distinguish between Domestic &
International Trade
2. Explain Comparative Cost Advantage Theory
3. Explain Heckscher – Ohlin Theory of International
Trade
4. Discuss the various benefits of International Trade