International Trade

UNIT-I
Trade between two or more countries is called foreign trade or international trade. This
involves the exchange of goods and services between the citizens of two countries. When
citizens of one country exchange goods and services with the citizens of another country, it is
called foreign trade.
The aim of international trade is to increase production and to raise the standard of living of
the people. International trade helps citizens of one nation to consume and enjoy the
possession of goods produced in some other nation.

Classifications:
International trade must be classified into three ways:

Import Trade: The inflow of goods in a country is called import trade.

Export Trade: The outflow of goods from a country is called

export trade.

Entrepot Trade: Many times goods are imported for the purpose of re-export
after some processing operations. This is called entrepot trade.

Types:
There are four types of international trade transactions:

Direct Business: In direct business the importer places order

with manufacturer of the exporting country.

Consignment Business: Under consignment business the exporter sends the goods
to an agent in the importing country.
Indent Firms: The indent firms charge a commission for their services. The
indent firms are also called commission agents.
Merchant Shippers: This is a class of businessmen who buy goods on their own
account and sell them in a foreign country at a profit.
 Characteristics:
International trade is characterized by the following features:

Territorial specialization
International competition
Separation of sellers from buyers
Long chain of middlemen
International rules and regulations
Mutually acceptable currency

Government control

The Role and importance of international trade are as follows:

Division of labor and specialization

Optimum allocation and utilization of resources
Raises Standard of Living of the people
Generate employment opportunities
Equality of prices
Ensures quality and standard goods
Facilitate economic development
To improve quality of local products
Availability of multiple choices

There are some barriers to international trade:

Cultural and social barriers

Political barriers
Tariffs and trade restrictions
Standards
Boycotts
Anti-dumping Penalties
Monetary Barriers
 Advantages:
1.AVAILABILITY AND CHEAPNESS OF COMMODITIES
Because of international trade the consumers can get access to foreign goods at lower
prices. Normally foreign goods are imported because of their relative cheapness in
comparison with the prices of domestic goods.
2.LARGE SCALE PRODUCTION
Due to specialization, factors of production are put to the best use. Specialization followed
by large scale production and introduction of machinery will result in greater output. It
also results in stimulating their consumption and demand which cause further
specialization which lower the prices of goods and services all over the world.
3. CREATION OF INDUSTRIAL SOCIETY

International trade through specialization of large-scale production, usage of

machinery and exploitation of natural resources has resulted in the creation of a
new industrial society.

4.STABILIZATION OF INTERNAL PRICE With the help of international trade the

surpluses of the country could be exported to the other country and the deficits of one country
may be made up by imports. This will ultimately lead to stabilization of internal price level.

5. AVAILABILITY OF COMMODITIES WHOSE COSTS OF PRODUCTION ARE HIGH

With the help of international trade, the countries are able to acquire commodities
which they cannot produce locally due to the nonavailability of factors of
production, insufficient quantity, and due to high costs of production. Europe and
Africa could get tea and penicillin, respectively, only because of international
trade.

6.IMPROVEMENT IN TRANSPORT

International trade has resulted in the improvement in the means of transport in all
parts of the world.

Disadvantages
1. EXHAUSTION OF ESSENTIAL MATERIALS
International trade may result in the exhaustion of essential materials and minerals of a
country. Most of the minerals were exported to other countries. If they had been preserved
they would have brought better returns to the country.

2. AFFECTS DOMESTIC INDUSTRIES

International trade may adversely affect the consumption pattern of a country due to the
import of cheaply manufactured and at times harmful commodities. Indian handicrafts
suffered a severe set back through free trade and unrestricted imports of English textiles.
3. LOPSIDED ECONOMIC DEVELOPMENT
Due to the operation of comparative costs, international trade leads to specialization and one
sided economic development which is not conducive to the prosperity of the country.

4. EVIL EFFECTS OF DUMPING

Sometimes, certain countries use international trade to dump their goods on other countries
with a view to cheapen the value of the latter goods.

5. DEPENDENCE ON OTHER NATION

Though it ensures higher standard of living for a nation, it makes the countries dependent on
foreign markets not for raw materials but also for selling the finished products. This
dependence should be reduced or eradicated.

6. AGAINST NATIONAL DEFENCE

It is argued that a nation which depends on foreign sources of supply lacks defence during the
war. Eg: England – during the two world war is cited as a proof. England was blocked by
German submarines, which completely blocked the imports of goods and essential raw
materials.

7. INSTABILITY AND ECONOMIC PLANNING

It is a source of economic instability and it stands in the way of national economic planning
for development and growth.

International Theories
International trade theories has long held that some trade is better than no trade, and more
trade is better than less trade, and free trade is better than restricted trade.
Free trade is a situation where a government does not influence international trade through
quotas and tariffs

An overview of trade theory

• Early thinking: Theory of Mercantilism
• Adam Smith: The theory of absolute advantage, 1776
• Ricardo: The theory of comparative advantage, 1817
• Heckscher-Ohlin theory: 20th century
• “New” trade theory based on economies of scale
• Product Life Cycle theory
• Porter’s Competitive Advantage Theory

Theory of Mercantilism
• A trade theory prevailed during 16th to 19th centuries
• The wealth of a nation is measured based on its accumulated wealth in terms of gold and
silver
• Nations should accumulate wealth by encouraging exports and discouraging imports
• Theory of mercantilism aims at creating trade surplus and in turn accumulate nation’s
wealth

Absolute Advantage Theory

• Adam Smith, ‘An Enquiry into the Nature and Causes of the Wealth of Nations’, 1776
• There is international benefit from trade – Everyone better off without making anyone
worse off
• When one country can produce a unit of good with less cost than another country, the first
country has an absolute (cost) advantage in producing that good
• Cost is considered based on number of labour units used

Assumptions:
• Two countries (A&B), both producing two products (x&y)
• Labour is the only factor of production and its productivity remains the same
• Perfect mobility of labour between the sectors within a country
• No mobility of labour between the countries
• Assumes perfect competition – No transportation cost – No restrictions on the movement of
goods between the countries (free trade)

Limitations
• Explains the causes of trade only when both the countries enjoy absolute advantage in the
production of at least one product
• Assumes that transportation costs are either nonexistent or insignificant, which may not
always hold good
• Assumes that prices are comparable across countries, implying stability of exchange rate •
Perfect mobility of labour between sectors – labour may be mobile but to an extent

Comparative Advantage Theory

• David Ricardo, ‘The Principles of Political Economy & Taxation’, 1817.
• Nations can still gain from trade even without an absolute advantage. • Facilitator –
Difference in opportunity cost
• A country has a Comparative Advantage in producing a good if the opportunity cost of
producing that good in terms of other goods is lower in that country compared to other
countries
Even if countries do not have an absolute advantage, they can gain from trade by allocating
resources based on their comparative advantage and trade with each other
Assumptions: Mostly same as that of absolute advantage theory

Ricardian Model – An Overview

• Illustrates the potential benefits from trade
• Trade leads to international specialization
• With labour as the only factor, it moves from relatively less efficient industries to relatively
more efficient industries Gains from Trade (a) International trade brings in efficiency in
production and consumption, and (b) It provides a market for goods and services
Limitations (Implicit Assumptions)
• Assumption of Perfect Competition
• Productivity of labour constant for both products and in both countries, implying constant
returns to scale
• Labour is perfectly mobile between sectors but immobile between countries
• No technological innovation in any of the economies
• The above discussion on trade assumes that there is no restrictions on trade
• But in real life trade restrictions in the form of tariff and nontariff barriers, quantitative
restrictions, etc exist
• Thus, there is a deviation from the expected and actual gain from trade

The Heckscher – Ohlin Model

Cause of trade – International differences in labour productivity
– Ricardian view
– Differences in countries resources – H-O model.
• Developed by Eli Heckscher and Bertil Ohlin
• Also called Factor-proportions Theory – because it discusses:
– The proportions in which different factors of production are available in different countries,
and – The proportion in which they are used in producing different goods
Assumptions
– Two factors of production – capital & labour
– Two countries (India and Japan), differ in factor abundance/ endowments
– Two commodities – Steel and Cloth
– Steel is more capital intensive and Cloth is more labour intensive in both countries – Both
goods uses both factors and the relative factor intensities are the same for each good in the
two countries.
Based on these postulates, the H-O model predicts that the capital surplus country specializes
in the production and export of capital-intensive goods and the labour surplus country
specializes in the production and export of labour-intensive goods.