Economics Theories of International Trade

Economics theories of International Trade

Learning objectives in this chapter:

I. Mercantilism

II. The theory of absolute advantage and

III. The theory of competitive advantage.

Theories of International Trade

BASIC QUESTIONS ANSWEREDBasis for Trade:-(why does IT take place, under

what conditions)—reasons for & benefits from trade.

Pattern of Trade:-what commodities are traded (which commodities are imported & exported by a nation)

Terms of Trade:-what are the terms of trade & how are they determined?

Mercantilism ( Free Classical Theories)

Why do nations trade?Answer was given by Mercantilism

1. A political economic policy in the 17th and early18th centuries aimed at increasing nation’s wealth and power by encouraging export of goods in return for gold.

Explanation: A trade theory, which holds that a government can improve the economic well-being of the country by encouraging exports and stiffing imports,

• It result in positive balance of trade that leads to wealth ( Gold) flowing into the country.

Mercantilism:

Mercantilism mixed exchange trough trade with accumulation of wealth so government control the trade and introduce the following policies for trade,

1. Introduce a general policy of exports dominating imports.2. Trade Across the border- exports-was consider preferable to

domestic trade because exports earn Gold3. Imports duties, tariffs, subsidition of exports4. Restriction on the importation of many goods were used to

maximize the gain from exports over the cost of imports.5. laws were passed making it illegal to take gold or silver out of

the country.

• This was one-way trade, the trade of greed and power.

• As the Industrial Revolution introduce the benefits of mass production, lowering price and increasing the supplies of goods to all the exploitation of Mercantilism came to end. However, the governments still exercise considerable power and influence on the conduct of trade.

Theory of absolute advantage

Theory of absolute advantageThe father of economics, Adam Smith publishes The Wealth of Nations in

1776 in London. In this book, Smith explain the process by which markets and production actually operates in society.

Adam smith argued that a country could certainly gain by trading with other nations. Just as the tailor does not make its shoes but exchange a suit for shoes, and hence both the tailor and shoemaker gain by trading, in the same manner Smith argued that a country as a whole would gain by having trade relations with other countries.

According to Smith, if one country has absolute advantage over another in one line of production, and the other country has an absolute advantage over the first country in another line of production, then both countries would gain by trading.

Theory of absolute advantage

In other words we can explain this theory shortly as,

A trade theory, which hold that, by specializing in the product of good, which they can produce efficiently than any others, nations can increase the their economic well being.

For Example: if it take ,

STATEMENT OF THE THEORY

• The basis of trade between the two nations is the absolute advantage a nation has in producing a commodity over the other nations.

(Absolute advantage:-more output for the same resources)

Theory of Absolute Advantage

Assumptions

• Labor…The only factor of production• Full employment level• Mobility of labor• Two countries• Two commodities

Cont’

Let suppose that the example of tailor and shoemaker, considering two countries, country A, produce shoes (X), while country B produce clothes ( Y)

--------------------------------------------------------------------------------------------------------Country Commodity X Commodity Y________________________________________________________________A 10 5B 5 10_________________________________________________________________

Then both of the countries will gain by trading. After the opening of the trade, country A will specialize in the production of goods of X And country B will be specialize in the product Y

Explanation: The above table stated that country A can produce 10X or 5Y

with one unit of labor and country B can produce 5X or 10Y with one unit of labor.

In this case, country A has a absolute advantage in the production X ( 10X is grater than 5X), and country B has an absolute advantage in production of Y ( 10Y is grater than 5Y),

it can explain further from the following table:

Cont’dCommodity ↦ Production before trade

(1)Gain from Trade

country↧ X Y X Y

A 1o 5 +10 -5

B 5 10 -5 +10

Total production 15 15 +5 +5

The Law of Comparative Advantage

David Ricardo (1772-1823)

Works: Principles of Political Economy and Taxation

The Theory of Comparative Advantage

David Ricardo, in his 1819 work entitled “ On the Principles Economy and Taxation”, sought the to take the basic ideas set down by Smith a few steps further.

Ricardo noted that even a country possessed absolute advantage in the production of two products, it still must relatively more efficient than the other country in one goods production than the other.

Ricardo termed this the

“Comparative advantage”

Con’d

According to Ricardo, it is not absolute but the comparative differences in the cost that determine trade relations between two countries. Production cost differ in countries because of geographical division of labor and specialization in production. Due to differences in climate, natural resources, geographical situation, and efficiency of labor, a country can produce one commodity at lover cost than other.

In this way, each county specializes in the production of that commodity in which its comparative cost of production is the LEAST.

Con’d

Therefore, when a country enters into trade with some other country, it will export those commodities in which its comparative costs are less, and will imports such commodities in which comparative production are high.

This is the basic of international trade.

Explanation of the theory

This theory can be explain by the Ricardo example of trade between England and France as shown below:

Country Wheat clothEngland 120 100France 80 90 This table shows that the production of a unit of wheat in England requires 120

men for a year, while a unit of cloth requires 100 men for the same period.

On the other hand, the production of the same quantities of wheat and cloth in France requires 80 and 90 men respectively. Thus,

England use more labor than France in producing both wheat and cloth. So France possesses an absolute advantage in both products.

But France would benefit more by producing wheat and exporting to England because it possesses a grater comparative advantage in it. This is because the cost of wheat (80/120 men) is less the cost of production of cloth ( 90/100 men)

Con’d

On the other hand England’s interest to specialize in the production of cloth which it has the lest comparative advantage. This is because the cost of production of cloth in England in less ( 100/90 men) as compare with wheat ( 120/80 men)

Thus trade is beneficial for both countries.

Assumption of the Theory

The simple theory of comparative advantage outlined above makes a number of important assumptions:

• There are no transport costs.• Costs are constant .• There are only two economies producing two goods.• The theory assumes that traded goods are homogeneous (i.e.

identical).• Factors of production are assumed to be perfectly mobile.• There are no tariffs or other trade barriers.• There is perfect knowledge, so that all buyers and sellers know

where the cheapest goods can be found internationally.

Differences between Comparative and Absolute Advantage

• Absolute versus relative productivity differences

• Comparative advantage incorporates the concept of opportunity cost– Value of what is given up to get the good

KEY WORDS

Produce and export those goods and services for which it is relatively more productive than other countries

And

Import those goods and services for which other countries are relatively more productive than it is

Today Japan

The intense competitiveness of Japanese market forces manufacturers to continually develop and fine-tune new products

Assignment# 2

In what way was Ricardo's law of comparative advantage superior to Smith’s theory of absolute advantage? How do gains from trade rise with comparative advantage?

End of Chapter

ANY QUESTION

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