Module1:International Trade SEM VI

Syllabus
 Theories of International Trade - Ricardo’s Theory of Comparative Costs and the
Heckscher- Ohlin Theory
 Terms of Trade - Types and Limitations
 Gains from International trade - Offer Curves and Reciprocal Demand

Theories of International Trade: Comparative Cost Theory, Heckscher Ohlin Theory

Classical Theory of International Trade
The classical economists like Adam Smith and David Ricardo have made contributions to
economic theory in general and to the theory of international trade in particular. Adam Smith
has initiated the theoretical discussion on the causes, basis and process of international trade
and specialisation. Later, David Ricardo made further contributions to Smith’s theory.
Assumptions:
Like any other economic theory the classical theory of international trade is based on certain
assumptions. They are:-
1. A two country and two commodities model is assumed (2 x 2). In other words it
assumes that two countries are trading with each other with two goods.
2. The labour theory of value is assumed, therefore the value of a commodity is
measured in terms of labour hours required to produce that commodity.
3. Labour is regarded as the only factor of production.
4. All labours are homogeneous.
5. There is perfect mobility of labour with in the country and perfect immobility
between the countries.
6. Existence of perfect competition in both commodity and factor market.
7. Full employment of labour is assumed.
8. Absence of transport cost.
9. Constant returns to scale.
10. Free trade exists between the countries.

Absolute Cost Advantage

Adam Smith introduced the principle of absolute cost advantage to demonstrate how
international specialisation and trade takes place so that the country’s gain from the same.
According to him a country should specialise in the production and export of that commodity
in which it enjoys absolute cost advantage and should imports those goods in which it suffers
an absolute cost disadvantage.
This statement is explained with the help of following example to produce one unit of
commodity X and Y

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Commodity Domestic Exchange

Country
X Y Ratio
A 20 hours 10 hours 1X:2Y
B 10 hours 20 hours 1X:½Y
In the above example, country A has an absolute advantage in the production of
Commodity Y and should therefore produce and export Commodity Y. since it suffers from
an absolute disadvantage in the production of Commodity X, it should only import the same
from country B, since country B has an absolute advantage in the production of
Commodity X. the same is clear from the domestic exchange ratio too. It can be seen that
country A can produce 2 units of commodity Y for every 1 unit of commodity X. While
country B produces only ½ a unit of commodity Y for every unit of commodity X.

Comparative Cost Advantage

David Ricardo offers a more practical and universally valid principle of comparative cost
advantage as the basis of trade. According to him rather than the absolute cost advantage the
true basis of trade is comparative advantage.
According to him a country should specialise in the production of and export of that
commodity in which it enjoys greater comparative advantage and leave the production of the
other commodity to the other country.
Ricardian argument is better understood from the following example.

Commodity Domestic
Country
Wine Cloth Exchange Ratio
Portugal 80 hours 90 hours 1wine : 0.89cloth
England 120 hours 100 hours 1wine : 1.2cloth

The above table shows that an absolute advantage to Portugal in production of both the
commodities and England has an absolute disadvantage in both lines of production.
However, it can be seen that Portugal has a greater comparative advantage in the production
of Wine and England has a smaller comparative disadvantage in the production of Cloth.
Before trade starts between the two countries the domestic exchange ratio in Portugal is
1wine = 0.89 cloth. Therefore after trade Portugal will gain only if it secures more than 0.89
Cloth for every unit of Wine (1Wine).
Gains from International Trade:
Suppose that the international exchange ratio is 1Wine = 1Cloth. Portugal will get (1 – 0.89)
= 0.11Cloth more per unit of Wine from England. Similarly, England will save (1.2 – 1) = 0.2
Cloth per unit of Wine imported.
Thus, it is obvious that both countries gain from international trade.

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Modern Theory of International Trade - Heckscher Ohlin Theory

The modern theory begins where the classical theory ends. The classical theory is based on
the premise that gains from trade accrue due to differences in cost. However, the theory does
not provide any answer s to why such cost differences arise. The modern theory developed by
Heckscher and Ohlin attempts to explain why such cost differences rise and how country’s
can gain from international trade.
Assumptions:
The Heckscher-Ohlin theory makes the following assumptions:-
1. There are two countries trading with each other in two commodities. (India and Japan
trading in Car and Paddy)
2. There are two factors of production, labour and capital. (India is labour abundant
while Japan is capital rich)
3. The commodities are classified according to their production functions i.e. capital
intensive and labour intensive. ( Car is capital intensive product while paddy is the
labour intensive commodity)
4. Production function of different commodities is identical in all countries.
5. There is existence of perfect competition in product and factor markets.
6. The factor units are homogeneous or equally efficient.
7. There is full employment of resources.

Chief Tenets of the Modern Theory:-

1. Differences in commodity prices are the immediate cause of international trade.
2. Commodity prices differ due to differences in factor prices.
3. Factor prices differ due to differences in factor endowments.
4. A country which is abundant in capital will have cheap capital while labour abundant
country will have cheap labour.
5. It is the differences in factor endowments i.e. the ultimate basis international
specialization.
According to this theory “a country should specialize in the production of and export that
commodity which requires more of its abundance and therefore cheap factor and should
import that commodity, the production of which requires more of the scarce factor.” In other
words as per the example taken above India being laboured abundant will have lower cost of
labour (wages) and should therefore produce and export paddy. Japan being capital abundant
has low capital cost (interest) and should therefore produce and export cars.
The Heckscher-Ohlin theory can be presented in the form of diagram as shown below:-

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International Trade SEM VI

In the above figure FJ/FJ show the factors price ratio in capital rich Japan. FI/FI shows the
same labour for India. PP1 is the Iso
Iso-quant for Paddy and CC1 is the Iso-quant
quant for Car. Paddy
is the labour intensive product while Car is the capital intensive product.
Japan: The cost of producing a capital intensive product Car in capital rich country Japan is
OB of capital and OS of labour. The tangency between CC1 and FJ at point A indicates the
same. Japan requires more labour i.e. OT but the same amount of capital OB for producing
Paddy. This can be seen from the tangency at point D between PP1 and FJ. Thus in Japan Car
is more cheaply than Paddy.
India: India uses OP capital and ON labour for producing Ca
Cars
rs while it requires only OR
capital and the same amount of labour ON for producing Paddy. Thus, India can produce
Paddy more cheaply than Cars.
The above figure explain the Heckscher
Heckscher-Ohlin
Ohlin arguments that the capital rich country has a
greater advantage in producing capital intensive commodity, while the labour rich country
will gain by producing the labour intensive commodity. Hence, the international
specialisation is determined by relative factor endowments.
The concepts of factor abundance can be mentio
mentioned
ned with reference to two criteria.
1. Physical Criteria: A country said to be capital abundant or labour scarce when the
ratio of physical quantity of K to L is greater than that in another.
Symbolically, KJ/LJ > KI/LI

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2. Price Criteria: Alternatively the comparison between the ratio of prices of the two
factors interest (capital) and wages (labour) in the two countries can be indicated as
follows: iJ/wJ < iI/wI
Where i = interest
w = wages
Criticism of the Theory:
1. Unrealistic assumptions: Although the H-O theory intended to provide a better
explanation of international trade by analysing its causes yet, like the Ricardian theory
it is based on many unrealistic assumptions – 2 country – 2 commodity model, perfect
competition, no transport cost etc.
2. Static in nature: The theory assumes that there is no change in production function
thereby indicating a static nature.
3. Demand conditions neglected: According to the theory it is only the supply factor
that determines production. In reality demand also plays a major role in deciding what
is to be produced.
4. Leontief’s Paradox: an empirical survey conducted by W.W. Leontief shows that a
country likes U.S.A. was importing capital intensive products like cars and exporting
labour intensive product like wheat. This observation came to be called as Leontief’s
paradox.
5. Other factors neglected: The theory considers only 2 factors, labour and capital.
Others aspects such as technology, natural factors, different qualities of labour etc. are
ignored.
6. Commodity prices neglected: According to the theory commodity prices depend on
factor prices. Therefore the cause of international trade is difference in factor prices.
Critics however point out that the demand for a factor is derived demand and not the
other way round.

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Terms of Trade: Meaning and Types

The terms of trade refer to the rate at which the goods of one country exchange for the goods
of another country. It is a measure of the purchasing power of exports of country in terms of
its imports, and is expressed as the relation between export prices and import prices of its
goods.
A country may experience favourable or unfavourable terms of trade (ToT)
Favourable ToT: When the export prices of a country rise relatively to its imports price, its
ToT are said to have improved. In other words, the country gain from trade because it can
have a larger quantity of imports to exchange for a given quantity of exports.
Unfavourable ToT: When the import prices rise relatively to its export prices, its terms of
trade are said to have worsened. In other words, the country's gains from trade reduced
because it can have a small quantity of imports in exchange for a given quantity of exports
than before.
Jacob Viner and Meier have given the following types of terms of trade which are as follows:
1. Commodity or Net Barter Terms of Trade (NBTT):
It is the ratio between the price of a country's exports goods and import goods.
Symbolically,
Px
NBTT 
Pm
Where, NBTT = Net Barter Terms of Trade
Px = Price of exports
Pm = Price of imports
To measure changes in the commodity terms of trade over a period, the ratio of the
change in exports prices to the change in imports is taken.
Formula to calculate Commodity terms of trade is

Px1 Pm1
NBTT 
Px0 Pm0
Where the subscripts 0 and 1 indicate the base and end periods.
This concept has been used by economists to measure the gain from international trade.
2. Gross Barter Terms of Trade (GBTT):
It is the ratio between the quantities of a country's imports and exports.
Symbolically,
Qm
GBTT 
Qx
Where, Qm = quantities of imports
Qx = quantities of exports
The higher the ratio between quantities of imports and exports, the better the gross
terms of trade.

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To measure changes in the GBTT over a period, the index number of the quantities of
imports and exports in base period and the end period are related to each other.
Formula:
Qm1 Q x1
GBTT 
Q m0 Q x0
3. Income Terms of Trade (YTT):
It is the net barter terms of trade of a country multiplied by its export volume index.
Symbolically,
PX Index of Exports Pr ice  Export Quantity
YTT  NBTT  Q x   Qx 
Pm Index of Im port Pr ice

The income terms of trade is called the capacity to import. In other words, a rise in the
index of income terms of trade implies that a country can import more goods in
exchange for its exports.
4. Single Factoral Terms of Trade (SFTT):
It is calculated by multiplying the commodity terms of trade index by an index of
productivity changes in domestic export industries.
Symbolically,

PX
SFTT  NBTT  Fx   Fx
Pm

Where, Fx = Productivity index of export industries.

It show that a country's factoral terms of trade improves as productivity improves in its
export industries.
5. Double Factoral Terms of Trade (DFTT):
It takes into account productivity changes both in the domestic export sector and the
foreign export sector producing the country's imports.
Symbolically,
Fx PX Fx
DFTT  NBTT   
Fm Pm Fm

Where, Fx = Export productivity index

Fm = Import productivity index
A rise in the index of DFTT of a country means that the productive efficiency of the
factors producing exports has increased relatively to the factors producing imports in
the other country.

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6. Real Cost Terms of Trade (RCTT):

It is used to measure the real gain from international trade. It is calculated by
multiplying the single factoral terms of trade with the reciprocal of an index of the
amount of disutility per unit of productive resources used in producing export
commodities.
Symbolically,

PX
RCTT  SFTT  R x   Fx  R x
Pm

Where, Rx = Index of the amount of disutility per unit of productive resources used in
producing export commodities.
7. Utility Terms of Trade (UTT):
This index measures "changes in the disutility of producing a unit of exports and
changes in the relative satisfactions yielded by imports, and the domestic products
foregone as the result of export production." It is calculated by multiplying the real cost
terms of trade with an index of the relative average utility of imports and of domestic
commodities foregone.
u = average utility
a = domestic commodities whose consumption is foregone to use resources for export
production
U m1 U m0
u
U a1 U a0

where, u = index of relative utility of imports and domestically foregone commodities.

Thus, the utility terms of trade can be expressed as:

PX
UTT  RCTT  u   Fx  R x  u
Pm

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Gains from Trade (with Offer Curves)

J.S. Mill analysed the gains as well as the distribution of the gains from international trade in
terms of his theory of reciprocal demand. According to Mill, it is reciprocal demand that
determines terms of trade which, in turn, determine the distribution of gains from trade of
each country.
The term 'terms of trade' refers to the barter terms of trade between the two countries i.e., the
ratio of the quantity of imports for a given quantity of exports of a country.

Country Units of Labour Units of X Units of Y Domestic exchange ratio

A 2 10 10 1X:1Y
B 2 6 8 1X:1.33Y
For example, in country A, 2 units of labour produce 10 units of X and 10 units of Y, while in
country B the same labour produce 6X and 8Y. The domestic exchange ratio (or domestic
terms of trade) in country A is 1X = 1Y, and in country B, 1X = 1.33Y. This mean that one
unit of X can be exchanged with one unit of Y in country A or 1.33 units of Y in country B.
Thus the terms of trade between the two countries will lie between 1X or 1Y or 1.33Y.
However, the actual exchange ratio will depend upon reciprocal demand, i.e., "the relative
strength and elasticity of demand of the two trading countries for each other's product in
terms of their own product."
If A's demand for commodity Y is more intense (inelastic), then the terms of trade will be
nearer to 1X = 1Y. The terms of trade will move in favour of B and against country A. B will
gain more and A less.
On the other hand, if A's demand for commodity Y is less intense (more elastic), then the
terms of trade will be nearer to 1X = 1.33Y. The terms of trade will move in favour of A and
against B. A will gain more and B less.
The distribution of gains from trade is explained in terms of trade of the Marshall-Edgeworth
offer curves in below diagram. Q
R
T
A
Com mod ity
Y E B

O
K Com mod ity X

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In the above diagram, OA is the offer curve of country A, and OB of country B. OP and OQ
are the domestic constant cost ratios of producing X and Y in country A and B respectively.
These rays are, in fact, the limits within which the terms of trade between the two countries
lie. However, the actual terms of trade are settled at E, the point of intersection of OA and
OB. The line OT represents equilibrium terms of trade at E.
The cost ratio within country A is KS unit of Y : OK units of X. But it gets KE units of Y
through trade. SE units of Y is, therefore, its gain.
The cost ratio within country B is KR units of Y : OK units of X. But it imports OK units of
X from country A in exchange for only KE units of Y. ER units of Y is its gain.
Thus both countries gain by entering into trade.

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