International

Trade Theory
1

Mr. Rohit Kumar Vishwakarma

1
(Asst. Professor)
 Why Nation Trade?
• To provide their citizens with an Increased
Standard of Living
• Countries experience unequal endowments
of resources.
• Natural Resources
• Human Resources
• Capital, and
• Technology
Mr. Rohit Kumar Vishwakarma
2
(Asst. Professor)
 International
Trade Theory
• Starting with Why Nations Trade, and
• Ending with a discussion of the Benefits to
Trade.

Mr. Rohit Kumar Vishwakarma

3
(Asst. Professor)
 Resource Endowment
• Lead to differing costs of production among
nations.
• Economists speak of this in terms of inputs
and outputs.
• They define the Efficiency of production as
the amount of
• output that can be produced with a given
amount of inputs.
Mr. Rohit Kumar Vishwakarma
4
(Asst. Professor)
 Theories to be discussed
• Mercantilism
• Absolute Cost Theory
• Comparative Cost Theory
• Opportunity Cost theory
• Factor Endowment Theory
• Complimentary trade Theories stopler
Sameulson Theorem
• International Product Life Cycle

Mr. Rohit Kumar Vishwakarma

5
(Asst. Professor)
 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.
Mr. Rohit Kumar Vishwakarma
6
(Asst. Professor)
 Governments Generated Money
From the Manipulation of
Trade Monopolies

• Export and import rights were sold.

• The idea of a wealthy society was to have
exports exceed imports so that the king’s
treasure chests could be filled with money.
• David Hume showed the inconsistency of X>I
in the long run by explaining inflation.

Mr. Rohit Kumar Vishwakarma

7
(Asst. Professor)
 Governments Generated Money
From the Manipulation of
Trade Monopolies

• Export and import rights were sold.

• The idea of a wealthy society was to have
exports exceed imports so that the king’s
treasure chests could be filled with money.
• David Hume showed the inconsistency of X>I
in the long run by explaining inflation.

Mr. Rohit Kumar Vishwakarma

8
(Asst. Professor)
 Absolute Cost Theory
• Adam Smith the father of Economics thought
that the basis of International Trade was
Absolute Cost Advantage.
• According to this theory, trade between 2
countries would be mutually beneficial if one
country could produce one commodity at an
absolute advantage and the other country
could, in turn , produce another commodity at
an absolute advantage over the first.

Mr. Rohit Kumar Vishwakarma

9
(Asst. Professor)
 Absolute Cost Theory
Absolute Cost Difference
USA UK

No. of Units of Wheat /Unit of Labor 10 4

No. of Units of Cloth /Unit of Labor 3 7

Here US has absolute advantage in the production of Wheat over UK

& UK has an absolute advantage in production of Cloth over US.

Mr. Rohit Kumar Vishwakarma

10
(Asst. Professor)
 Adam’s theory is based on the
following Assumption
• Production follows law of constant returns.
• There is only one factor of production i.e.
labor.
• Existence of full employment
• Labor is perfectly mobile within the country
but immobile between countries.

Mr. Rohit Kumar Vishwakarma

11
(Asst. Professor)
 Adam’s theory is Criticized
• This theory was criticized because it did not
explain what happen to trade if one country
has absolute advantage in both products.

• Hence the shortcoming of this theory were

improved upon by the theory of Comparative
Advantage given by David Ricardio.

Mr. Rohit Kumar Vishwakarma

12
(Asst. Professor)
 The Theory of comparative
Advantage: David Ricardo 1817
In a two product economy it can be shown that
Both Countries can gain from trade even if one
country has the Absolute advantage in the
production of both products.
Each country has a Comparative Advantage over
its trading partner in the production of that
good for which its Opportunity cost is lower
than that of its trading partner.

Mr. Rohit Kumar Vishwakarma

13
(Asst. Professor)
 Assumptions
1. Labor is considered as the only factor of production.
2. Homogeneous nature of Labor.
3. Labor is mobile in a country but immobile between two
countries.
4. Only 2 countries & 2 commodities are considered for
explanation of the theory.
5. There exist free trade between 2 countries.
6. Production cost meant only labor cost.
7. No transportation cost
8. Existence of full employment.
9. Perfect competition both in goods and factors market.
10. Involves no capital movements.
Mr. Rohit Kumar Vishwakarma
14
(Asst. Professor)
 This theory can be explained under 2
conditions.
1. If one country is more productive than
another country in all lines of production?
2. If country I can produce all goods with less
labor cost than country II does it still benefit
the countries to trade?

Ricardo’s answer was Yes

Mr. Rohit Kumar Vishwakarma

15
(Asst. Professor)
Table of Comparative Cost Advantage
Theory
Labor Cost of Production (in hours)

1 unit of wine 1 unit of cloth

Portugal 80 90

England 120 100

Opportunity Costs for

1 unit of wine 1 unit of cloth

Portugal 80/90=8/9 = .888 90/80=9/8 = 1.125

England 120/100=12/10 = 1.2 100/120=10/12= .8333

Mr. Rohit Kumar Vishwakarma
16
(Asst. Professor)
Table of Comparative Cost Advantage
Theory
Opportunity Costs for

1 unit of wine 1 unit of cloth

Portugal 80/90=8/9 = .888 90/80=9/8 = 1.125

England 120/100=12/10 = 1.2 100/120=10/12= .8333

According to this model, Portugal has an absolute advantage in the

production of wine as well as in the production of cloth, because the labor
cost of production of each unit of the two commodities is less in Portugal
than in England.
The above table shows that Portugal has the lower opportunity cost of the
two countries in wine, while England has the lower opportunity cost in
Mr.producing cloth.
Rohit Kumar Vishwakarma
17
(Asst. Professor)
Limitations of Comparative Theory
1. The theory is based on an incorrect assumption that wages
between industries do not vary.
2. Different goods have different elasticities of demand.
3. This theory of comparative costs is said to be unrealistic
because it takes only two commodities and 2 countries but
in reality there are nearly 180 countries and calculation of
comparative cost is not easy.
4. This theory assumed that internally factors of production are
completely mobile but internationally they are immobile.
This assumption is totally unreal on the ground that internal
factors of production whether labour capital are never
perfectly mobile.
5. This theory is assumed there is no transportation cost. This is
wrong and unrealistic.
6. Ricardo’s theory also assumed full employment which is also
not real in this world.
Mr. Rohit Kumar Vishwakarma
18
(Asst. Professor)
 Opportunity Cost Theory
1. One of the main drawbacks of the Ricardian
comparative cost theory was that it was
based on labor theory of value which stated
that the value or price of a commodity was
equal to the amount of labour time going
into the production of the commodity.
2. Gottfried Harberler gave new life to the
comparative cost theory by restating the
theory in terms of opportunity cost in 1933.
Mr. Rohit Kumar Vishwakarma
19
(Asst. Professor)
 Opportunity Cost Theory
“Opportunity cost of anything is the value of
alternative or other opportunities which have
to be foregone in order to obtain that
particular thing.”
Example: In a give resources we can either
produce 10 units of cloth or 20 units of wine.
Then opportunity cost of 1 unit of cloth is 2
unit of wine.

Mr. Rohit Kumar Vishwakarma

20
(Asst. Professor)
 Opportunity Cost Theory
According to the opportunity cost theory, the
basis of International trade is the differences
between nations in the opportunity costs of
production of Commodities.
According, a nation with lower opportunity
cost for a commodity has a comparative
advantage in that commodity and
comparative disadvantage in other country.

Mr. Rohit Kumar Vishwakarma

21
(Asst. Professor)
 Opportunity Cost Theory
Suppose that the opportunity cost of
one unit of X is 2 unit of Y in Country A
and 1.5 unit of Y in country B.
Then Country A must specialize in production of
Y and import its requirement of X from B,
and B should specialize in the production of X
and import Y from A rather than producing it
at home

Mr. Rohit Kumar Vishwakarma

22
(Asst. Professor)
 Factor Endowment theory
• The Factor Endowment theory was developed
by Swedish economist Eli Hecksher and his
student Berlin Ohlin. Paul Samuelson &
Wolfgang Stolpler have also made sinificant
contribution.
• The factor endowment theory consist two
important theorems, namely
1. Heckscher Ohlin Theorem
2. Factor Price Equalisation Theorem
Mr. Rohit Kumar Vishwakarma
23
(Asst. Professor)
 Heckscher – Ohlin Theorem
• H. O have explained the basis of international
trade in terms of factor endowments.
• The classical theory demonstrated that the
basis of international trade was comparative
cost difference.
• It made little attempt to explain the cause of
such comparative cost difference.

Mr. Rohit Kumar Vishwakarma

24
(Asst. Professor)
Pattern of trade under Heckcher Ohlin
Capital intensive goods

Capital Labour
Abundant Abundant
Country Country

Labor intensive goods

Mr. Rohit Kumar Vishwakarma

25
(Asst. Professor)
 Heckscher – Ohlin Theorem
• In country A: Supply of labor = 25 units
Supply of Capital = 20 units
Capital Labor Ratio = Capital 25 = 0.8
Labor 20
• In country B: Supply of labor = 12 units
Supply of Capital = 15 units
Capital Labor Ratio = Capital 15= 1.25
Labor 12
Mr. Rohit Kumar Vishwakarma
26
(Asst. Professor)
• In the above example, even though country A has more
capital in absolute term, country B is more richly endowed
with capital because the ratio of capital to labor in capital A
(0.8) is less than in country B (1.25).
• Though country A has more capital than B in absolute terms,
still Country B is more richly endowed with capital because
the capital other factor ration in this case capital labor ratio is
higher than country A’s capital labor ratio.
• Thus country B will export the said commodities whose capital
ratio is higher than that ofKumar
Mr. Rohit country A.
Vishwakarma
27
(Asst. Professor)
 Assumption Heckscher – Ohlin
Theorem
1. Both product and factor markets in both countries are characterized by
perfect competition.
2. Factor of production are perfectly mobile in a country but immobile
between two countries.
3. The quality of factors of production is identical in both the country.
4. Both the countries have fully employed the factors of production.
5. Free trade between the countries.
6. The proportions of factor endowments vary between the countries.
7. The technologies adopted by both the countries are same so that same
inputs mix is used for the production of goods resulting into same quality
and quantity of goods.
8. Prices are determined only by factor prices.
9. The goods being produced may vary in factor intensity i.e. some goods
are capital intensive (relatively more capital is required for production)
and some goods are labor intensive (relatively more labor require).
10. Factor supplies in both the country is fixed.
11. The demand of goods remain same in both the country.

Mr. Rohit Kumar Vishwakarma

28
(Asst. Professor)
Factor Price Equalization Theorem
The factor price equalization theorem states
that free international trade equalize factor
prices between countries relatively and
absolutely, and this serves a substitute for
international factor mobility.

Mr. Rohit Kumar Vishwakarma

29
(Asst. Professor)
Factor Price Equalization Theorem
The factor price equalization theorem states
that free international trade equalize factor
prices between countries relatively and
absolutely, and this serves a substitute for
international factor mobility.

Mr. Rohit Kumar Vishwakarma

30
(Asst. Professor)
Factor Price Equalization Theorem
International trade increases the demand for
abundant factors (leading to an increase in
their prices) and decreases the demand for
scarce factor (leading to fall in their prices)
because when nations trade, specialization
takes place on the basis of factor endowment.

Mr. Rohit Kumar Vishwakarma

31
(Asst. Professor)
Scarce Resource

Abundant Resource

Mr. Rohit Kumar Vishwakarma

32
(Asst. Professor)
Mr. Rohit Kumar Vishwakarma
33
(Asst. Professor)
Also refer class notes

Mr. Rohit Kumar Vishwakarma

34
(Asst. Professor)