Theories of International Trade

Theories of International Trade

1.  The Classical Theory of International Trade

Introduction

Adam Smith (1776) developed the theory of absolute cost advantage. But it was David Ricardo who formulated as an explicit and precise theory, namely, the theory of comparative cost advantage, which was later improved and refined by the economists like J.S Mill, Cairnes, Bastable,Taussig and Haberler. We shall first discuss the Adam Smith’s theory of absolute cost advantage.

Classical Trade Theories

Mercantilism (pre - 16th century)

Takes an us-versus - them view of trade

Other country's gain is our country's loss

Free Trade theories

Absolute Advantage (Adam Smith,1776)

Comparative  Advantage  (David Ricardo, 1817)

Specialization of production and free flow of goods benefit all trading partner's economies

Free Trade refined

Factor - proporations (Heckscher - Ohlin, 1919)

International Product life (Ray Vernon, 1966)

2.  Adam Smith’s Theory of Absolute Cost Advantage

Adam Smith argued that all nations can be benefitted when there is free trade and specialisation in terms of their absolute cost advantage.

The Theory

According to Adam Smith, the basis of international trade was absolute cost advantage. Trade between two countries would be mutually beneficial when one country produces a commodity at an absolute cost advantage over the other country which in turn produces another commodity at an absolute cost advantage over the first country.

Assumptions

1. There are two countries and two commodities (2 x 2 model).

2. Labour is the only factor of production.

3. Labour units are homogeneous.

4. The cost or price of a commodity is measured by the amount of labour required to produce it.

5. There is no transport cost.

Illustration

Absolute cost advantage theory can be illustrated with the help of the following example.

Absolute Cost Advantage

From the illustration, it is clear that India has an absolute advantage in the production of wheat over China and China has an absolute advantage in the production of cloth over India. Therefore, India should specialize in the production of wheat and import cloth from China. China should specialize in the production of cloth and import wheat from India. This kind of trade would be mutually beneficial to both India and China.

3.  Ricardo’s Theory of Comparative Cost Advantage

David Ricardo , the British economist in his ‘Principles of Political Economy and Taxation’ published in 1817, formulated a systematic theory called ‘Comparative Cost Theory’. Later it was refined by J.S Mill, Marshall, Taussig and others.

Ricardo demonstrates that the basis of trade is the comparative cost difference. In other words, trade can take place even if the absolute cost difference is absent but there is comparative cost difference.

According to Ricardo, a country can gain from trade when it produces at relatively lower costs. Even when a country enjoys absolute advantage in both goods, the country would specialize in the production and export of those goods which are relatively more advantageous. Similarly, even when a country has absolute disadvantage in production of both goods, the country would specialize in production and export of the commodity in which it is relatively less disadvantageous.

Assumptions

1.        There are only two nations and two commodities (2x2 model)

2.        Labour is the only element of cost of production.

3.        All labourers are of equal efficiency.

4.        Labour is perfectly mobile within the country but perfectly immobile between countries.

5.        Production is subject to the law of constant returns.

6.        Foreign trade is free from all barriers.

7.        No change in technology.

8.        No transport cost.

9.        Perfect competition.

10.   Full employment.

11.   No government intervention.

Illustration

Ricardo’s theory of comparative cost can be explained with a hypothetical example of production costs of cloth and wheat in America and India.

Comparative Cost Advantage

(Units of labour required to produce one unit)

It is evident from the example that India has an absolute advantage in production of both cloth and wheat. However, India should concentrate on the production of wheat in which she enjoys a comparative cost advantage. (80/120 < 90/100). For America the comparative cost disadvantage is lesser in cloth production. Hence America will specialize in the production of cloth and export it to India in exchange for wheat. (Any exchange ratio between 0.88 units and 1.2 units of cloth against one unit of wheat represents gain for both the nations). With trade, India can get 1 unit of cloth and 1 unit of wheat by using its 160 labour units. In the absence of trade, for getting this benefit, India will have to use 170 units of labour. America also gains from this trade. With trade, America can get 1 unit of cloth and one unit of wheat by using its 200 units of labour. Otherwise, America will have to use 220 units of labour for getting 1 unit of cloth and 1 unit of wheat.

Criticisms

1. Labour cost is a small portion of the total cost. Hence, theory based on labour cost is unrealistic.

2. Labourers in different countries are not equal in efficiency.

4.  Modern Theory of International Trade

Introduction

The modern theory of international trade was developed by Swedish economist Eli Heckscher and his student Bertil Ohlin in 1919. This model was based on the Ricardian theory of international trade. This theory says that the basis for international trade is the difference in factor endowments. It is otherwise called as ‘Factor Endowment Theory’.

Factor endowment model

Developed by Heckscher and Ohlin

Countries  with  a  relative  factor abundance can specialise and trade

Abundance of      skilled         labour →  specialisation  →  export  → exchange for goods are services produced by      countries     with abundance of unskilled labour

Exports embody the abundant factor

Imports embody the scarce factor

Assumes a high degree of factor mobility

The Theory

The classical theory argued that the basis for foreign trade was comparative cost difference and it considered only labour factor. But the modern theory of international trade explains the causes for such comparative cost difference. This theory attributes international differences in comparative costs to:

i) difference in the endowments of factors of production between countries, and

ii) differences in the factor proportions required in production.

Assumptions

1.  There are two countries, two commodities and two factors. (2x2x2 model)

2.  Countries differ in factor endowments.

3.  Commodities are categorized in terms of factor intensity.

4.  Countries use same production technology.

5.  Countries have identical demand conditions.

6.  There is perfect competition in both product and factor markets in both the countries.

Explanation

According to Heckscher - Ohlin, “a capital-abundant country will export the capital –intensive goods, while the labour-abundant country will export the labour-intensive goods”. A factor is regarded abundant or scare in relation to the quantum of other factors. A country can be regarded as richly endowed with capital only if the ratio of capital to other factors is higher than other countries.

Illustration

In the above example, even though India has more capital in absolute terms, America is more richly endowed with capital because the ratio of capital in India is 0.8 which is less than that in America where it is 1.25. The following diagram illustrates the pattern of word trade.

Limitations

1. Factor endowment of a country may change over time.

2. The efficiency of the same factor (say labour) may differ in the two countries. For example, America may be labour scarce in terms of number of workers. But in terms of efficiency, the total labour may be larger.

5.  Comparison of Classical Theory and Modern Theory

Classical Theory of International Trade

1. The classical theory explains the phenomenon of international trade on the basis of labour theory of value.

2. It presents a one factor (labour) model

3. It attributes the differences in the comparative costs to differences in the productive efficiency of workers in the two countries.

Modern Theory of International Trade

1. The modern theory explains the phenomenon of international trade on the basis of general theory of value.

2. It presents a multi - factor (labour and capital) model.

3. It attributes the differences in comparative costs to the differences in factor endowments in the two countries.