1. Theories of International Trade
• A well developed global financial system is
essential for supporting increased international
trade & the basis of this increase refers to the
evolution of certain major theories.
1. Theory of Absolute Advantage;
2. Theory of Comparative Advantage;
3. Heckscher-Ohlin Model;
4. Imitation Gap Theory;
5. International Product Life Cycle Theory.

2. 1) Theory of Absolute Advantage
• Developed by Adam Smith in 1776;
• Holds that consumers will be better-off if they can buy
foreign made products that are priced more cheaply than
domestic one.
• As per the theory, a country may produce goods more
efficiently because of a natural advantage (e.g. raw
materials or climate) or because of acquired advantage
(e.g. technology or skills).
• Assumptions: Full employment, No transportation
cost, comparability of price across countries & perfect
mobility of labour.

3. Theory of Absolute Advantage……
A Hypothetical Situation
– Country X Country Y
– Resource available 100 units 100 units
– Requirement to produce 1 TV 10 units 5 units
– Requirement to produce 1 ton rice 4 units 20 units
– Both countries use half of the total resources per product when there is no foreign trade.
– Production (without Trade) TV(units) Rice(units)
– Country X 5 12 ½
– Country Y 10 2½
– Total 15 15
– Production (with Trade) TV(units) Rice(units)
– Country X(only tons of Rice) - 25 tons
– Country Y(only TV) 20 -
– Total 20 25
– If each country specialized in the commodity for which it has an absolute advantage,
then production of both products can be increased.

4. Theory of Absolute Advantage……
Limitations
1) It explains the causes of trade between two countries
only in those situations where both the countries enjoy
absolute advantage in production of at least one
product.
2) It assumes non-existence or insignificant cost of
transportation, which does not always hold well.
3) The assumption that prices are comparable across
countries implies stability of exchange rate.
4) Theory assumes mobility of labour from other sectors
to a particular sector, where the country enjoys
comparative advantage in production, which does not
actually exist.

5. Theory of Comparative Advantage
• David Ricardo’s(1817) Comparative
Advantage theory holds that total output
can be increased through foreign trade,
even though one country may have an
absolute advantage in the production of all
products.

6. Theory of Comparative Advantage
A Hypothetical case
– Country X Country Y
Resource available 100 units 100 units
Requirement to produce 1 TV 10 units 5 units
Requirement to produce 1 ton rice 10 units 4 units
Both countries use half of the total resources per product when
there is no foreign trade.
– Production (Without trade-state of autarky) TV Rice
Country – X 5 units 5tons
Country – Y 10 units 12 ½ tons
Total 15 units 17 ½ tons
– Country Y has an absolute advantage in producing
both products, but has a comparative advantage in
producing rice.

7. Hypothetical case……….
– With trade - Increasing TV Production TV Rice
Country – X 10 units 0 tons
Country – Y 6 units 17 ½ tons
Total 16 units 17 ½ tons
– If the combined production of rice is unchanged from
where there was no trade, country Y can produce all 17
½ tons by using 70 units of resources and rest 30 units
can be used to produce TV.
– With trade - Increasing Rice Production TV Rice
Country – X 10 units 0 tons
Country – Y 5 units 18 ¾ tons
Total 15 units 18 ¾ tons

8. Hypothetical case……….
• If the combined TV production is unchanged from time
before trade, country X could produce 10 units by all
resources and country Y required 25 units of resources
to produce the rest 5 sets.
• The remaining 75 units of resources of country Y can
produce 18 ¾ tons of rice.
• Whether the production target is an increase of TV or
rice or both, two countries can gain by having X trade
some of its rice production to Y for some of that country’s
TV production.

9. Assumptions
1. Perfect competition with flexible prices and wages prevails in both
the countries. This results in the prices of TV & rice being different
in X & Y due to a difference in labour hours used & hence
production costs.
2. Labor is the only factor of production & the average product of
labour is constant for producing both the products in both the
countries.
3. There is full employment in both the countries.
4. Labour is perfectly mobile among various sectors but perfectly
immobile between countries.
5. No technological innovation takes place in any of the economies.
• It suffers from all the drawbacks associated with the assumptions; yet this
theory is one of the closest explanations of international trade.

10. HECKSCHER-OHLIN MODEL
(Factor-Proportion Theory)
• Model developed in 1920s holds that a country’s relative endowments
of land, labour and capital will determine the relative cost of these
factors.
• If labour were abundant in relation to land & capital, labour cost would
be low and land & capital costs high; & vice versa.
• These factor costs, in turn, will determine which goods the country can
produce more efficiently.
• The reason two countries operating at the same level of efficiency
can, and do benefit from trade can be traced to the differences in their
factor endowment.
• There are two types of products – labour & capital intensive, to be
produced by labour and capital rich countries respectively; then the two
countries will trade these goods to get the benefits of international
trade.

11. HECKSCHER-OHLIN MODEL
(Factor-Proportion Theory)…….
• Assumptions:
• No obstruction to trade (e.g. trade controls,
transportation cost etc.) are there;
• Both commodity & factor markets are perfectly
competitive;
• There are constant or decreasing return to scale;
• Both countries have same technology & hence operate
at same level of efficiency;
• Two factors of production exist – labour & capital. Both
are perfectly immobile for inter-country transfers, but
perfectly mobile for inter-sector transfer.

12. Limitations
• It assumes that factor endowments are given, where as
they can also be developed though innovations.
• Due to minimum wage laws 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.
• The findings of an empirical study by economist Wassily
Leontief pointed out that despite being a capital-rich
country,US exports are more labor-intensive than capital
intensive (Leontief Paradox).

13. IMITATION-GAP THEORY
• Developed by Posner, the theory considers possibility
between two countries having similar factor endowments
and consumer tastes because of existence of inventions
& innovations in existing products.
• Degree of trade between such countries will depend
upon the difference between the ‘demand lag’ and the
‘imitation lag’.
• Demand Lag is the difference between the times a new
or an improved product is introduced in one country, and
the time when consumers in the other country start
demanding it.

14. IMITATION-GAP THEORY…
• Demand Lag depends on:
1) speed & effectiveness of flow of information,
2) readiness of the consumers of the second
country to use innovative products, 3) ability &
timing to convert their desire to demands.
• Imitation Lag is the difference between the
time of introduction of the product in one
country, and the time when the producers in
the other country start producing it.

15. IMITATION-GAP THEORY…
• Imitation Lag depends on:
1. Readiness of the second country to adopt new technology;
2. Time taken by the second country to learn the new process;
3. Likelihood of the second country developing the technology on their own
due to a constant process of R&D.
• If due to any of the above factors, the imitation lag is shorter than the
demand lag, no trade will take place between the two countries.
• Normally demand lag is shorter than imitation lag – country coming out with
innovation starts exporting to the second country – as awareness create
demand there – export continues till demand lag is over.
• If local producers can start producing before the last part, they can
arrest the growth of the importers (imitation lag);
at the end of the imitation lag, the trade will start coming down and
shall be finally eliminated.

16. INTERNATIONAL PRODUCT LIFE
CYCLE THEORY
• Two important principles of this theory (Raymond
Vernon):
1. New products are developed as a result of
technological innovation;
2. Trade patterns are determined by the market structure
and the phases in new product’s life.
• The introduction stage is marked by:
1. Innovation in reference to observe need;
2. Exporting by the innovative country;
3. Near monopoly position – sales based on uniqueness
rather than price – evolving product characteristics.

17. INTERNATIONAL PRODUCT LIFE CYCLE
THEORY……………..
• The Growth stage is marked by:
1. Increases in exports by innovating country;
2. More competition – some competitors begin price cutting –
product becoming more standardized;
3. Increased capital intensity.
• The Maturity Stage is characterized by:
1. Factor requirement changes & also change in the centre of
production from innovative country to other developed
country – offering a cost advantage due to a more suitable
pattern of factor prices;
2. More standardization of product;
3. More capital intensity & increased competitiveness of price.

18. INTERNATIONAL PRODUCT LIFE CYCLE
THEORY……………..
• The Decline stage is marked by:
1. Concentration of production in LDCs as now it would become
possible to produce the good with relatively unskilled labour;
2. Innovating country becoming net importer.
• There are certain products for which production movements
do not take place:
1. Products having extremely short life cycle because of rapid
innovations (electronic products);
2. Luxury products for which cost is of little concern to the
consumer;
3. Products for which international transportation cost is high,&
so no opportunity for export in any stage of life cycle.

19. Intra-Industry Trade
• Refers to simultaneous import and export of the
same product by a single country;
• Reasons:
1. Transportation Costs (Geographical advantage);
2. Seasonal differences (for agricultural produce);
3. Product differentiation (superior quality capital-
intensive products vs. labour-intensive and lower
quality capital intensive products) :If demand for
both types of goods exists in both countries, it may
result in intra-industry trade.

20. Factors affecting International
Trade
1. High re-entry costs: A firm temporarily facing a slump
in international demand and/or price for its product
may have to continue its supply, even if it is not
economically justifiable, due to high re-entry costs.
2. Economies of Scale: A firm may be able to export even
without comparative advantage, as a result of
economies of scale.
3. Currency value: Exchange rates may increase or
decrease the competitiveness of a product in the
international market.

21. Factors affecting International
Trade…………
4. Strong customer tastes for costlier brand & imperfect
competition (because of non-availability of information of
cheaper product) would distort the trade patterns.
5. Although most trade theories deal with cross-country
benefits and costs, trading decisions are usually made at
the company level – companies must have competitive
advantages to be viable exporters.
6. Companies may seek trading opportunities in order to
use excess capacity, lower production costs, or spread
risk.