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Lecture 33

Lecture 33

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Published by: praneix on Aug 11, 2009
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LESSON – 33International Trade TheoriesLearning outcomes
After studying this unit, you should be able to:
Identify the various International Trade theories
Differentiate between different Trade Theories
Know Opportunity Cost theory
Know Comparative cost theory
Know Absolute cost theory
Bases of International TradeABSOLUTE COST THEORY
Adam Smith,. the father of Economics, thought that the basis of international trade wasabsolute cost advantage. According to his theory: trade between two countries would bemutually beneficial if one country could produce one commodity at an absoluteadvantage (over the other country) and the other country could, in turn, produce another commodity at an absolute advantage over the first.TableUSA UK  No of units of wheat per unit of labour 10 4 No of units of cloth per unit of labour 3 7In the above hypothetical example, US has an absolute advantage in the production of wheat over UK and UK has an absolute advantage in the production of cloth over US.Hence, according to Adam Smith's theory, US should specialise in the production of wheat and meet its requirement of cloth through import from UK. On the other hand, UK should specialise in the production of cloth and would obtain wheat from US. Such tradewould be mutually beneficial.Adam Smith pointed out that the scope for division of labour (i.e. specialisation)depended on the size of the market. Free international trade, therefore, increases divisionof labour and economic efficiency and consequently economic welfare.In his treatise Wealth of Nations, Adam Smith observes:By means of it (foreign trade) the narrowness of home market does not hinder thedivision of labour on any particular branch of art or manufacture from being carried tothe highest perfection. By carrying a more extensive market for whatever part of the produce for their labour may exceed the home consumption, it encourages them to
improve its productive powers and to augment its annual produce to the utmost andthereby increase the real revenue and wealth of society.In short, according to Smith's theory of international trade, three kinds of gains accrue toa country from international trade: (i) Productivity gain, (ii) Absolute cost gain, and a (ii)Vent for surplus gain.The famous classical economist David Ricardo has demonstrated that the basis of trade isthe comparative cost difference-trade can take place even in the absence of absolute costdifference, provided there is comparative cost difference.COMPARATIVE COST THEORYThe Comparative Cost Theory was first systematically formulated by the Englisheconomist David Ricardo in his Principles of Political Economy and Taxation, publishedin 1817.1 It was later refined by 1.5. Mill, Marshall, Taussig and others.In a nutshell, the doctrine of comparative costs maintains that if trade is left free, each'country, in the long run, tends to specialize in the production and export of thosecommodities in whose production it enjoys a comparative advantage in terms of realcosts, and to obtain by importation those commodities which could be. Produced at homeat a comparative disadvantage in terms of real costs, and that such specialization is to themutual advantage of the countries participating in itThe Ricardian theory is based on the following assumptions:1. Labour is the only element of cost of production.2. Goods are exchanged against one another according to the relative amounts of labour embodied in them.3. Labour is perfectly mobile within the country but perfectly immobile betweencountries.4. Labour is homogeneous.5. Production is subject to the law of constant returns.6. International trade is free from all barriers.7. There is no transport cost.8. There is full employment:9. There is perfect competition.10. There are only two countries and two commodities.Ricardo's illustration of the Comparative Cost Theory, using a two country two-commodity model, shows that trade between nations can be profitable even if one of thetwo nations can produce both the commodities more efficiently than the other nation provided that it can produce one of these commodities with comparatively greater efficiency than the other commodity. The law of comparative advantage indicated that acountry should specialise in the production of those goods in which it is more efficientand leave the production of the other commodity to the other country. The two nationswill then have more of goods by engaging in trade.
 Ricardo, in his celebrated two-country-two-commodity model, has taken the hypotheticalexample of production costs of cloth and wine in England and Portugal, to illustrate thecomparative cost theory.TableCountry No of units of labour per unit of cloth No of units of labour per unit of wineExchange ratio between wine andclothEngland 100 120 1 wine = 1.2 clothPortugal 90 80 1 wine = 0.88 clothFrom the above example, it is evident that as an absolute superiority in both branches of  production. However, a comparison of the ratio of the cost (80/120). Labour with ratio of the cost production of cloth (90./100.)in both the countries reveals that though Portugal has an absolute superiority in both the branches of production of wine will pay her to concentrate on the production of wine inwhich she has comparative advantage over England (80/120 < 90/100 ), while importingcloth from England, which has a comparative advantage in cloth production. England willgain by specialising in producing cloth and selling it in Portugal in exchange for wine.In the absence of trade between England and Portugal, one unit of wine commands 1.2and 0.88 unit of cloth in En land and Portugal respectively. In the event of trade taking place, under the assumption that within each country, labour is perfectly mobile betweenvarious industries, Portugal will gain if it can get anything more than 0..88 units of clothin exchange for 1 unit of wine and England will gain if it has to part with less than 1.2units of cloth against 1 unit of wine. Hence, any exchange ratio between 0..88 units and1.2 units of cloth against one unit of wine represents a gain for both the countries. Theactual rate of exchange will be determined by the Reciprocal Demand.Thus, according to the comparative cost theory, free and unrestricted trade among nationsencourages specialisation on a larger scale. It, thereby, tends to bring about:1. The most efficient allocation of world resources as well as maximisation of world production2.A redistribution of relative product demand , resulting In greater equality of product prices among trading nations, and3. A redristribution of relative resource demand to correspond with relative productdemands, resulting in relatively greater equality of resource prices among trading nations.
Evaluation of the Theory
The Ricardian theory, though based on a number of wrong assmptions has been regardedas an important landmark in the development of the theory of international trade. PaulSamuelson remarks: "If theories, like girls, could win beauty contests, comparativeadvantage would certainly rate high in that it is an elegantly logical structure".3 He adds:

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