DAMODARAM SANJIVAYYA NATIONAL LAW UNIVERSITY

ECONOMICS - I

PROJECT

On

MODERN THEORIES OF INTERNATIONAL TRADE

By

K.S.S. HARSHA, 201256, 3RD SEMESTER.

DAMODARAM SANJIVAYYA NATIONAL LAW UNIVERSITY

VISKHAPATNAM

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Damodaram Sanjivayya National Law University.

Certificate

I, Mr/Miss __________________________________________ with Reg. No

__________________of _____ Semester prepared the Project on

________________________________________________________________

_________________

In partial fulfilment of his/her semester course in the subject

__________________________________

During the academic year 2012-2013 under my supervision and Guidance.

Signature of Faculty

INDEX:

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1. Introduction…………………………………………..4

2. Importance of international trade………………….4

3. Advantages of international trade………………….5

4. Disadvantages of international trade………………6

5. Smith’s theory of absolute cost…………………….6

6. Ricardo theory of comparative cost……………….8

7. Hescksher theory of international trade…………..10

8. Haberler’s cost theory of international trade……..12

9. Conclusion…………………………………………..13

10. Bibliography……………………………………….14

MODERN THEORIES OF INTERNATIONAL TRADE.

INTRODUCTION:

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International can be simply explained as the exchange of the good between the countries. It

differs in their demand for goods and in their ability to produce them. On the demand side a

particular country may be able to produce particular goods but not in the quantities it

requires. Also each country has its own money for exchange which is valid within the country

only and raises problem of foreign exchange for country to country trade. The major task of

international trade is to provide an understanding of the basis for trade among nations, and

how a nation’s international payments can be brought into balance with its receipts. The

natural resources and geographical conditions are almost different in different countries.

International of foreign trade is an important aspect of international economics.1

IMPORTANCE OF INTERNATIONAL TRADE:

An exchange in general is necessitated by the division of labour, so foreign trade appears

when the division of labour is pushed beyond national frontiers. It is the necessary

consequence of an international division of labour. International trade permits more people to

live to gratify more varied tastes and to enjoy a higher standard of living than would be

possible in its absence. So we need a separate theory for international trade because of:

Difference in the monetary system:

The principal difference between the inter-regional and international trade lies in

use of different currencies in foreign trade .Rupee is accepted throughout India from

north to the south and from east to the west, but if we cross over we must convert

rupee to buy goods and services there. Every time a change occurs in the value of one

currency in terms of another a number of economic problems arise. Further,

currencies of some countries like the American dollar and British pound are more

quickly used in the international transactions. Moreover, different countries follow

different monetary and foreign exchange policies which affect the supply of exports

or demand for the imports.2

Differences in natural resources:

Different countries are endowed with different types of natural resources. Hence they

tend to specialise in production of those commodities in which they are richly

endowed and trade them with others where such resource are scare. In Australia land

1 An introduction to economics- Dr.Ratna Chatterjee, central law publications, page no: 231.2International economics – M L Jhingan, vrinda publications, page no:3

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is abundant but labour and capital is scare. On the contrary in England labour and

capital is scare and land is abundant. Thus both the countries can trade each other’s

commodities on the basis of comparative cost differences in the production of

different commodities.

Differences in geographical conditions:

Every country cannot produce all the commodities due to geographical and climatic

conditions .For instance Brazil has favourable climate for the production of coffee and

Bangladesh for jute. So countries having climatic and geographical advantages

specialise in the production of particular commodities and trade them with others.

Different transport costs:

Trade between countries involves high transport costs as against inter –regionally

within a country because of geographical distances between different countries.

Immobility of factors:

The classical economists advocated a separate theory of international trade on the

ground that factors of production are freely mobile within each region and places .The

reasons for international immobility of labour are differences in languages, customs,

occupational skills, and family ties. There are wide spread legal and other restrictions

exist in the movement of labour and capital between countries.3

ADVANTAGES OF INTERNATIONAL TRADE:

The different advantages of international trade can be explained with the following factors

the advantages are:

Division of labour.

Lower price of the goods and services.

Optimum utilisation of resources.

Expansion of market.

Working of international monetary system.

Reduction in monopolistic exploitation.

Competition.

DISADVANTAGES OF INTERNATIONAL TRADE:

The disadvantages of the international trade are:

3 International economics – M L Jhingan, vrinda publications, page no: 2.

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It is a source of economic instability, interference in the national economy of the

country arises.

It is argued that “while international trade brings the blessings of a higher standard

of living for a nation” also implies the dependence on foreign markets as source of

supply.

It is said that the nation’s dependence on foreign sources of supply lacks defence

during war.

THE CLASSICAL THEORY OF COMPARATIVE ADVANTAGE:

The classical theory of international trade was first formulated by Robert Torrens, David

Ricardo and john Stuart mill. Their ideas relate to theory of comparative cost or

advantage .Adam smith, the first economist advocated the principal of absolute advantage as

the basis of international trade. This was discarded by Ricardo. But the Ricardian theory of

comparative advantage has been accepted and improved upon by modern economists like

Haberler.4

SMITH’S THEORY OF ABSOLUTE COST:

In the beginning of 1776 Adam smiths in his famous book ‘Wealth of nations’

explained the basis of international trade5. Basing on free trade, Adam smith explains

the advantage of trade between countries through his absolute cost theory .He

observes “Whether the advantage which one country has over another, be natural or

acquired is in this respect of no consequence. As long as the one country has those

advantages and the other wants them it will always be more advantageous for the

latter, rather to buy of the former than to make .According to smith’s theory of

international trade three kinds of gain accrue to a country from international trade:

(i) Productivity gain.

(ii) Absolute cost gain.

(iii) Vent for surplus gain.

According to smith trade between two countries is possible when a country

gets absolute advantage for production of a commodity A and the other

country gets absolute advantage in producing the other commodity B.

Absolute advantage means among the two commodities A and B one

commodity is produced at cheaper rates.

4 International economics – M L Jhingan, vrinda publications, page no: 26.5 An introduction to economics- Dr.Ratna Chatterjee, central law publications, page no: 233.

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To illustrate, let there be two countries, A and B, having absolute differences in costs

in producing a commodity each, X and Y respectively, at an absolute lower cost of

production than the other. The absolute cost differences are illustrated:

A produces 10 units of X and 5 units of Y in 10 hours labour. B produces 5 units of X

and 10 units Y by 10 hours of labour .Before trade both the countries produce both the

commodities.

Production before trade:

A = 10X+5Y

B = 5X +10Y

Total production = 15X+15Y

After specialisation A produces 10X+10X = 20X

1Y = 2X

5Y = 10X

B produces 10Y+10Y= 20Y

After specialization total production = 20X+20Y

It is clear that after specialization there is increase in X and Y both by 5 units each. It

is the profit by international trade. This theory was not very clear and dependable

practically. Theory was developed and refined by the several economists Ricardo was

one among them.

DAVID RICARDO THEORY OF COMPARATIVE COST:

According to David Ricardo, it is not the absolute but the comparative differences in

costs that determine trade relations between two countries. Production costs differ in

countries because of geographical division of labour and specialisation in production

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Due to differences in climate, natural resources, geographical situation and efficiency

of labour, a country can produce one commodity at a lower cost than the other .In this

way, each country specialises in the production of that commodity in which its

comparative cost of production is the least. Therefore, when a country enters into

trade with some other country, it will export those commodities in which its

comparative costs less, and will import those commodities in which its comparative

production costs are high. This is the basis of international trade, according to Ricardo

It follows that each country will specialise in the production of those commodities in

which it has the greatest advantage or the least comparative disadvantage. Thus a

country will export those commodities in which its comparative advantage is the

greatest and import those commodities in which its comparative disadvantage is the

least.6

ASSUMPTIONS:

The Ricardian theory of comparative advantage is based on the following assumptions:

1. There are only two countries say England and Portugal.

2. They produce the same commodities say wine and cloth.

3. There are similar tastes in both countries.

4. Labour is the only factor of production.

5. The supply of labour is unchanged.

6. All units of labour is homogeneous.

7. Technological knowledge is unchanged.

To illustrate take A and B produce Wine and cloth respectively with 10 hours of

labour.

6 International economics – M L Jhingan, vrinda publications, page no: 27.

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It is clear from the table that:

In country A, 1 unit of wine = 1 unit of cloth

In country B, 1 unit of cloth = 2 units of cloth.

A = 10X+10Y

B = 4X+8Y

Total production = 14X = 18Y

After specialisation A will produce only wine and B will produce only cloth. After

specialisation A will produce 20X and B will produce 16Y

Total production = 20X +16Y. By specialisation we get 6 unit excess production of wine.

The rate of exchange of A is 1:1 and B is 1:2.

CRITCISM:

The principle of comparative advantage has been the very basis of international trade for over

a century until after the first world war .Since then critics have been able only to modify and

amplify it’s rightly pointed out by “ If theories, like girls could win beauty contests

comparative advantage would certainly rate is high. But the theory is not free some defects it

has several times criticised are as follows:7

1. Unrealistic assumption of labour cost.

2. No similar costs.

3. Ignores transport cost.

4. Unrealistic assumption of free trade.

5. Neglects the role of technology.

6. Incomplete theory and one sided theory.

HESCKSCHER – OHLIN THEORY OF INTERNATIONAL TRADE:

The factor endowment theory was developed by Eli Hescksher, a Swedish economist and

Bertil Ohlin. This theory is also known as “Factor – proportions – Factor – Intensity theory.”

The Hescksher – Ohlin approach is not different from the comparative cost theory, but it

supplements .In fact, it goes a step farther than the comparative cost doctrine to investigate

7 International economics – M L Jhingan, vrinda publications, page no: 30.

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the basic cause of the relative differences in cost. They have traced the cause of cost

differences to relative factor endowments and relative factor intensities. They put forward the

view that since countries differ in their factor endowments and also employ factors of

production of exports in different intensities, there is scope for gains in international trade.

The Hescksher – Ohlin’s theory is also called the “General Equilibrium theory of

international trade” because it points out that the demand and supply analysis applicable to

inter – regional trade can generally be used without substantial changes in dealing with

problems of international trade .This theory indicates that international trade will ultimately

have equalisation of commodity prices and equalisation of factor prices.

ASSUMPTIONS OF OHLIN THEORY:

The assumptions of the Hescksher –Ohlin theory of international trade are:

1. Two by two model is considered for trade, in which the trade is between two

countries, for production of two commodities and there are only two factors of

production.

2. The markets are perfectly competitive.

3. There is no restriction in trade between two countries and there is no transport cost

also.

4. The factors of production have total mobility in the country.

5. There is free and unrestricted trade between the two countries.

6. The tastes and preferences of consumers and their demand patterns are identical in

both countries.

7. There is full employment of resources.

8. Production is performed under the constant return to scale.

RELATIVE FACTOR ABUNDANCE:

Ohlin uses the term factor abundant in his theory it consists:

FACTOR ABUNDANCE FOR PHYSICAL CRITERIA:

As the question of relative abundance of the ratio between factors of production. A

country is known as capital abundant if the ratio between capital and labour of a

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country(A) is greater in comparison to the ratio between capital and labour of the

other country(B) it can be expressed as

(C/L) A > (C/L) B

FACTOR ABUNDANCE FOR PRICE CRITERIA:

If the capital is relatively cheaper and labour is relatively costlier, it’s known as

capital abundant. Suppose A and B are two countries and P is the price of factor. C is

capital and L is the labour. The price criteria are expressed as:

(PC/PL) A < (PC/PL) B.

It is clear from the given expression in country A the capital is abundant in

comparison to country B. It is also clear that country A where capital is cheaper in

comparison to labour country A will export the product which is produced in the

country with the help of the factor which is cheaper and abundant in the country. 8

CRITICISM OF OHLIN THEORY:

1. This theory was criticised for representing two by two models. He demonstrated it in

the mathematical appendix to his book.

2. Ohlin theory is static in nature it gives some information of economy at some time.

3. This theory assumes the existence of homogenous factors in two countries.

4. Based on the assumption of identical tastes and demand patterns of consumption in

both countries.

5. No constant returns.

6. Transport costs influence trade.

7. Vague and conditional theory.

8. Partial equilibrium analysis.

HABERLER’S OPPORTUNITY COST THEORY OF INTERNATIONAL TRADE:

The Haberler’s theory of opportunity costs explains the doctrine of comparative costs in

terms of what he calls “the substitution curve.” The opportunity costs theory says that if A

country can produce either commodity X or Y the opportunity X is the amount of the other

commodity Y that must be given up in order to get one additional unit commodity. Thus the

exchange ratio between the two commodities is expressed in terms of their opportunity costs.

8 An introduction to economics- Dr.Ratna Chatterjee, central law publications, page no: 238.

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The concept of opportunity costs has been illustrated in international trade theory with

production possibility curves.

ASSUMPTIONS OF THE THEORY:

Under the following assumptions Haberler explained the theory of opportunity cost of

International Trade:

1. There exists perfect competition in factor and commodity markets.

2. Price of each commodity is equal to its marginal cost and production.

3. The factors are fully employed and the uniform price of each factor is equal to its

marginal productivity in each use.

4. The supply of available factors of production of a country is fixed.

5. The units of any factor of production have the same price in all employments

provided that they are mobile of substitutable for one another.

UNDER CONSTANT OPPORTUNITY COST CONDITIONS:

In this state the production possibility curve of a country will be a straight line .It’s clear from

the figure that the country will produce either 10 units of wheat or 5 units of cloth by its total

factors of production. If the country wants to produce both the commodity the possibilities

are shown by A, B, C, and D on the production possibility line PQ .The rate of substitution of

wheat and cloth is 2:1 in each production possibility. It is clear that the price of cloth is twice

that the price of wheat.

UNDER INCREASING OPPORTUNITY COST CONDITIONS:

In the below figure EEꞌ is the production possibility curve. Since the production takes place

under increasing opportunity cost condition the curve is concave to the origin .AB is the price

ratio line, which is tangent to EEꞌ at Q showing internal equilibrium production before trade

England produces ON units of wheat and OM units of cloth.

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Suppose, England wants International trade and specializes in wheat, the new price – line

will be AꞌBꞌ equilibrium point is Qꞌ and international trade equilibrium point will be Then the

new combination of products will ON2 of wheat and OM2 of cloth showing gains from

international trade.

UNDER DECREASING OPPORTUNITY COST CONDITIONS:

Under this condition England specialises completely in the production of wheat and Portugal

specialises completely the production of cloth and both the countries get comparative cost

advantage.9

CONCLUSION:

The International trade is necessary to the country. Trade between the nations helps to

promote the exports and imports and also exchange of currencies. Even gold from Australia

and diamonds from Hong Kong are been imported to India. Even is also part of international

trade as India exports wheat to USA and other exports and imports are also being done.

BIBLOGRAPHY:

1. BOOKS:

An introduction to economics - Dr.Ratna Chatterjee, central law publications,

2006 edition.

International economics – M L Jhingan, vrinda publications, 5th revised edition.

9 An introduction to economics- Dr.Ratna Chatterjee, central law publications, page no: 243.

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General Principles of Economics – S.R.Myneni, Allahabad law agency, 2008

edition.

Economics for law students – Surbhi Arora, Central Law Publications, 2012

edition.

Indian Economy – Dr.S.R.Myneni, , Allahabad law agency, 2007 Edition.

2. WEB SOURCES:

www.international.com

www.economicindia.com

www.theories.com

www.ssrnpapers.com

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