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By:- Priyam Singh Calcutta Business School


Why trade? Comparative advantage theory Adaptation theory model Imitation gap Neo techno theory of trade or neo colonial models of trade (Marxist view) Engine of growth Vent for surplus theories Advantages of international trade Problems of trade


Countries engage in international trade for the following reasons: 1. Resources Reasons,
e.g.. Natural resources Favorable climate conditions and terrain Skilled workers and Capital Resources Favorable geographic location and transportation costs.

2. Economic Reasons e.g.. Comparative advantage

Strong domestic demand Scale economy Innovation or style

3. Political Reasons
In these cases, political objectives outweighed economic considerations. e.g.. Former Soviet Union and Cuba.

International Trade Theory

What Is

International Trade?

The exchange of goods, services, and technologies across national boundaries. It includes import and export operations.
All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders.

Classical trade theories:

explains national economy conditions--country advantages-

-that enable such exchange to happen

New trade theories:

explains links among natural country advantages,

government action, and industry characteristics that enable such exchange to happen

HOW DOES TRADE Suppose there are two imaginary countries in the world, Industria and Agriculturia WORK Industria is very efficient at producing

electronic goods. Agriculturia is less efficient at producing electronic goods, but very efficient at producing food. If each country decides to be 'self-sufficient', i.e. to produce its own food and its own electronic goods, both countries will be using some of their resources in a less efficient way.

However, if Industria specializes in producing electronic goods, and Agriculturia specializes in producing food, each country's output will be greater than it would otherwise have been.
Each country has made the most efficient use of its available resources, and the total output of electronic goods and food has been increased. In principle, the two countries can now trade their leftover goods to obtain the things that they are not producing for themselves. Both countries will then be better off.

Importance of International Trade

Without international trade, nations would be limited to the goods and services produced within their own borders. International trade is the backbone of our modern, commercial world, as producers in various nations try to profit from an expanded market, rather than be limited to selling within their own borders. There are many reasons that trade across national borders occurs, including lower production costs in one region versus another, specialized industries, lack or surplus of natural resources and consumer tastes.

Trade In India
Trade and commerce have been the backbone of the Indian economy right from ancient times. Textiles and spices were the first products to be exported by India. The Indian trade scenario evolved gradually after the countrys independence in 1947. From the 1950s to the late 1980s, the country followed socialist policies, resulting in protectionism and heavy regulations on foreign companies conducting trade with India.

India Trade: Imports

Indias major imports comprise of crude oil machinery, military products, fertilizers, chemicals, gems, antiques and artworks. Imported goods are divided into the following categories: Freely importable items: For these items, no import license is required. They can be freely imported by an individual or a firm. Canalized items: These items can only be imported by public sector firms. For example petroleum products fall under this category. Prohibited items: Items such as unprocessed ivory, animal rennet and tallow fat cannot be exported to India

India Trade: Exports

Indian exports comprise mainly of engineering and textile products, precious stones, petroleum products, jewelry, sugar, steel chemicals, zinc and leather products. Most of the exported goods are exempt from export duties. India also exports services to several countries, primarily to the US. In fact, India is among the worlds largest exporters of services related to information and communication technology (ICT). It is also the key destination for business process outsourcing (BPO).


Theories of absolute advantage Theories of comparative advantage Heckscher-ohlin model Imitation gap theory International product life cycle theory

Intro - Classical Theory of International Trade

In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. According to the classical theory every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.

Concept of Mercantilism

Practiced throughout Europe to 1776. Believed that the possession of wealth, gold and silver, was the sign of a strong nation. (it was also useful when the king desired to finance a foreign war) Trade was conducted under the authority of governments, and trading rights were generally sold to the highest bidder

Types of Cost Difference in Production

Economists speak about three types of cost difference in production, they are Absolute cost difference, Equal cost difference, and Comparative cost difference.

1.Theories of absolute advantage

Adam Smith: The Wealth of Nations, 1776 Mercantilism weakens country in long run; enriches only a few A country -Should specialize in production of and export products for which it has absolute advantage; import other products -Has absolute advantage when it is more productive than another country in producing a particular product

Theory of Absolute Advantage

Source :

2.Comparative Advantage
David Ricardo: Principals of Political Economy, 1817 Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces Absolute advantage is really a special case of comparative advantage Countries have comparative advantage in goods for which the opportunity cost of production is relatively low

Comparative advantage: Bollywood

Theory of Comparative Advantage

Country A has absolute advantage in both cocoa and rice, but its comparative advantage is in cocoa. Country B has comparative advantage in rice .

Determinants of Competitive Advantage in nations

Company Strategy, Structure, and Rivalry

Two external factors that influence the four determinants.

Factor Conditions

Demand Conditions

Related and Supporting Industries


Absolute Advantage Versus Comparative Advantage

A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does. A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower cost in terms of other goods.

Comparative Advantage &offshoring of service jobs.

INDIA 1 billion people

Citizens who speak English

Indian IT industry Is growing rapidly!

Tax, Financial services, Insurance, telemarketing

India has a comparative advantage in production of goods & services requiring large amounts of labor and relatively little capital Good opportunities to reduce cost in specific industries by offshoring parts of these service industries

3.Heckscher (1919)-Ohlin (1933) Theory

The Heckscher-Ohlin model explores the possibility of two nations operating at the same level of efficiency benefiting by trading with each other. According to this theory, there are two types of products. 1) Labor intensive and 2) capital intensive.

The model further says that reason two countries operating at the same level of efficiency can and does benefit from trade can be traced to the difference in their factor endowments. The labour rich country is more likely to produce labour intensive goods and the country rich in capital will most probably produce capital intensive goods. The two countries will then trade these goods and reap the benefit of international trade.

The Heckscher-Ohlin theory states that each country exports the commodity which uses its abundant factor intensively. The HO theory was generally accepted on the basis of casual empiricism. Moreover, there wasn't any technique to test the HO theory until the input-output analysis was invented.


Diagram Explaining Heckscher Ohlin's H-O Theory


Explanation of the theory as per the diagram(fig:-3)

Let us take an example of same two countries say; England :-capital rich India :-labor abundant nation XX:- is the isoquant (equal product curve) for the commodity X produced in England. YY :-is the isoquant representing commodity Y produced in India.

It is very clear that XX is relatively capital intensive while YY is relatively labour incentive. The factor capital is represented on Y-axis while the factor labour is represented on the horizontal X-axis.

PA tangent to XX at E = price line or budget line of England. The price line PA is also tangent to YY isoquant at K. The point K will help us to find out how much of capital and labour is required to produce one unit of Y in England.
P1B tangent to YY at I =price line of India. The price line RS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how much of capital and labour is required to produce one unit of commodity X in India. Under the given situations, the country England will choose the combination E. Which means more specialization on capital goods. It will not choose the combination K because it is more labour intensive and less capital intensive. Thus according to Ohlin, England will specialize on production of goods X by using the cheap factor capital extensively while India specializes on commodity Y by using the cheap factor labour available in the country.

The Ohlin's theory concludes that :The basis of internal trade is the difference in commodity prices in the two countries. Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries. A capital rich country specialises in capital intensive goods & exports them. While a Labour abundant country specialises in labour intensive goods & exports them.

Leontief's paradox

In 1954, Leontief found that the U.S. (the most capital-abundant country in the world) exported labor-intensive commodities and imported capital-intensive commodities, in contradiction with Heckscher-Ohlin theory ("H-O theory"). Result: Leontief reached a paradoxical conclusion that the USthe most capital abundant country in the world by any criterionexported labor-intensive commodities and imported capital- intensive commodities. This result has come to be known as the Leontief Paradox. [para = contrary to, doxa = opinion] Leontief's paradox in economics is that the country with the world's highest capital-per worker has a lower capital/labor ratio in exports than in imports.

Trade pattern of India

Bharadwaj (1962) studied India's trade pattern. India's exports were laborintensive. Consistent with HO theory. However, Indian trade with the US was not. Indian exports to the US were capital-intensive.


5.Imitation gap theory

It is given by Porsenr, considers the possibility of trade between two countries having similar factor endowments & consumer tastes. According to this theory improvement in technology is a continuous process & the resulting inventions & innovations in existing products give rise to trade between such countries. The degree of trade between such countries will depend upon the difference between the demand lag &imitation lag.

Demand lag is the difference between the time & new or an improved product is introduced in one country & the time when consumers in the other country start demanding it .Imitation lag is the difference between the time of introduction of the product in one country & time when the producers in the other country starts producing it . If the imitation lags shorter than the demand lag no trade will take place between the two countries. However normally demand lag can be expected to be shorter than imitation lag. In such a case the country coming out with the innovation will be able to start exporting to the second country as the consumers there becomes aware of its product, and the export will keep growing as more consumers become aware. This export will continue to increase till the demand lag is over i.e. till all the consumers react to the innovation. If the producer can start producing the same product before this time period, they can arrest the growth of these imports into their country; otherwise the exports will continue and will stabilize at a particular level.

The theory is also called Theory of Comparative Advantage. According to this theory every country should specialize in production. It should export those goods in which it has greater comparative advantage and import those goods in the production which it has greater comparative disadvantage.


6.Product life-cycle Theory- R. Vernon,(1966)


products mature, both location of sales and optimal production changes Affects the direction and flow of imports and exports Globalization and integration of the economy makes this theory less valid

Vent for surplus.

Vent for surplus is a theory that was formulated by Adam Smith and later revised by Hla Myint on his thesis of South East Asia. The theory states that when a country produces more than it can consume it produces a surplus. This underutilization causes an inward movement on the production possibilities frontier. Trade with another country is then used to vent off this surplus and to bring the production possibilities frontier back to full capacity.

Vent for surplus explained via production possibilities curve


The vent for surplus theory may be expressed in terms of a shift from a point inside (say X)to the frontier itself (say A to B).Here the production of exportable increases by the utilization of underemployed resources without any reduction in the production of other goods. The actual shift from point A to point B takes place not along the PPC but along an inside path such as AY (dotted arc)and if the adjustment in the economy becomes rather difficult the economy may permanently remain inside the frontier & it can never arrive at B .The role of trade as an engine of economic growth may be explained in terms of an outward shift in the whole production PPF as in the figure 2.

Engine of economic growth(fig 2)

The opening up of developing countries to the world market can be explained in terms of a shift along the PPF from A to B (fig 2).The shift indicates a move towards greater production of exportable. The countries should concentrate on the production of primary commodities in which they have got greater comparative advantage.

Engine of economic growth

Figure:- 2


Developing countries believe they get a raw deal when it comes to international trade. These problems include Relying on only one or two primary goods as their main exports They cannot control the price they get for these goods

The price they pay for manufactured goods increases all the time As the value of their exports changes so much long term planning is impossible
Increasing the amount of the primary good they produce would cause the world price to fall

Two important backwash effects of trade.

Hypothesis of export instability: refers to export earnings, which is the product of the volume of exports and price of exports. Deteriorating terms of trade: the hypothesis of secular deterioration of terms of trade was based partly on pure theoretical analysis and partly on weak empirical evidence .

Two specific aspects of export instability that may be detrimental to development are as follows :

1)The shortfall of earnings effect

2)The uncertainty effect

Evidence on terms of trade

The case for the deteriorating terms of trade was first put forward by Raoul Prebisch.Prebisch and Singer concluded that the distribution of trade has been unequal after the first world war. The world trading network consisted of a center and a periphery where UK was the center and north western Europe, USA formed the periphery. The flow of capital was from the center to the periphery.

Benefits of technical progress and industrialization where not received by the ldcs .The terms of trade went against the primary producing countries after the WWII as the regime of free trade received set back in general.


Despite the benefit of international trade, governments have an inclination to put trade barriers in order to discourage imports. There two kinds of barriers: Tariff & Non Tariff

1)The first problem is the assumption that trade is sustainable. But a nation exporting non-renewable resources may discover that its best move (in the short run) is to export until it runs out. The flip side of this problem is overconsumption. 2)Free trade increases inequality even if it makes the economy grow overall (which is itself questionable). Because free trade tends to raise returns to the abundant input to production (i.e:capital) and lower returns to the scarce input (i.e:labor), it tends to benefit capital at labor's expense.

3)The third problem is so-called "negative externalities," the economists' term for when economic value is destroyed without a price tag being attached to the damage. Environmental damage is the most obvious example.
4)The fourth problem is positive externalities, like the way some industries (mainly high technology) open up paths of growth for the entire economy. All industries are not alike, and the profits of an industry today do not necessarily predict the industry's long-term value for the economy. Free trade can allow these industries to be wiped out because it ignores this hidden value, harming the rest of the economy for decades to come.

The next four problems concern the all-important Theory of Comparative Advantage, the theoretical keystone of free trade economics. This theory, invented by the British economist David Ricardo in 1817, says that free trade will automatically cause nations to specialize in producing whatever they are relatively best at, and that this will lead to the best of all possible worlds.

5)Ricardo's theory assumes factors of production are mobile within nations. Unemployed autoworkers become aircraft workers, and abandoned automobile plants turn into aircraft factories. But this doesn't always happen, and when it does, it is often at considerable cost. 6)the assumption, in Ricardo's theory, that the inputs used in production (like labor, capital, and technology) are not mobile between nations. His theory says that free trade automatically reshuffles a nation's factors of production to their most productive uses. But if factors of production are internationally mobile, and their most-productive use is in another country, then free trade will cause them to migrate there--which is not necessarily best for the nation they depart.

7)Ricardo's theory assumes the economy is always operating at full output--or at least that trade has no effect on its output level. But if trade puts people and factories out of action, this isn't true. 8)Ricardo's theory assumes short-term efficiency is the origin of long-term growth. But long-term economic is not about being the most-efficient possible. History has shown time and again that the short-term inefficiencies of a tariff, properly implemented, are more than compensated for by the long-term spur to industry growth it can provide, largely because growth has more to do with the industry externalities mentioned above (problem number four) than short-term efficiency per se. 9)Ricardo's theory merely guarantees (if true, which is itself questionable due to problems five through eight) there will be gains from free trade. It does not guarantee that changes induced by free trade, like rising productivity abroad, will cause these gains to grow rather than shrink. So if free trade strengthens our economic rivals, then it may harm us in the long run by stiffening international competition, even if it was advantageous for us to buy goods from these rivals in the short run.

10)In the presence of scale economies, the perfectly-competitive international markets presumed by the theory of comparative advantage do not exist. Instead, industries tend to be imperfectly competitive and quasi-monopolistic. Under these conditions, outsize profits and wages accrue to nations that host such industries. And free trade will not necessarily assign any given nation these industries.

11)Collusion and cartels: Collusion is the term used when

firms seek to restrict competition by making agreements between them. They do this by forming a cartel - this is a group of producers who have decided on how the market is to be divided between them. In this way they can all charge higher prices and earn supernormal profits. In fact, the formation of a cartel is not easy. There is always a tendency for a cartel to break down. Firstly, the companies must make an agreement. Once an agreement has been reached, it is always in the interest of any one company to cheat, so the participating companies must have some way of preventing this. Finally, since the companies make abnormal (supernormal) profits, they must be able to prevent new entrants to the market, for otherwise their profits will be eroded. Cartels and collusive practices are bad for competition, for consumer prices and for efficiency. Therefore, governments legislate against their formation. It is illegal for companies to form a cartel and any trade agreements between companies must be published. Recent example would be: DLF being the major player in the market can quote any price as they want, as they provide in bulk quantity.


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