THEORIES OF INTERNATIONAL TRADE

In this chapter we are going to discuss the following theories and

various ways through which govt. discourage imports:
Theories of absolute advantage
Theories of comparative advantage
Heckscher-ohlin model
Imitation gap theory
International product life cycle theory
THEORY OF ABSOLUTE ADVANTAGE:-
In 177 !dam "mith proposed the theory that takes place because one
country may be more e#cient in producing a particular good then
another country and the other country may be capable of producing
some other goods more e#ciently then the $rst one. This provides an
incentive to trade as both the countries can bene$ts from
speciali%ation and the resultant increase in productivity.
"uppose there are two countries ! & '. ! can produce a super
computer by using 1( units of labour while ' uses 1) units of the
labour for the same. *n the other hand to produce an aircraft !
country re+uires ,( units of labour and ' re+uires 1( units of labour. !ll
other factors are used in e+ual amount by both the countries.
Here ! en-oys the absolute advantage in producing super computers
and country ' in producing aircraft. !ccording !dam smith in such a
scenario. country ! will restrict itself in producing super computers and
' to aircrafts. This good will be then be traded among these two
countries.
Thus. international trade results is increasing the rate of economic
growth of the both countries by utili%ing the resources of both the
countries more productively. If increasing returns to scale are
e/perienced the bene$ts are further increased.
0I1IT!TI*2":
1. It e/plains the causes of trade between two countries only in
those situations. where both the countries en-oy absolute
advantage in the production of atleast one product .
,. It assumes that the transportation costs involved in selling a
commodity in country other than the one in which it was
produced are either non 3e/istent or in signi$cant when
compared to degree of comparative advantage .
THEROY OF COMPARTIVE ADVANTAGE:
!ccording to absolute advantage theory. two countries entry into trade
when both of them hold an absolute advantage In the production of
atleast one product the +uestion. 4hich arise here is whether two
countries can bene$t by trading with each other even if one of them
has an absolute advantage in all the commodities.
!ccording to theory of comparative advantage propounded by 5avid
6icardo in 1717. trade is possible as long as country e/periencing the
disadvantage is not e+ually less e#cient in producing all the products
i.e. both the countries en-oy comparative advantage in atleast one of
the products.
T!'08 1 899I:I8::I8" *9 :*;2T6I8" !" 68908:T85 '< 0!'*;6-
H*;6 ;"85.
0!'*;6- H*;6 68=;I685
:*;2T6< 1 ;2IT *9 "T880 1 ;2IT *9 :8182T
! ) 1(
' 1) ,(
!s we see country ! en-oys an absolute advantage in producing both
steel and cement. as the number of labour-hours re+uired to produce
one unit of each commodity is lesser than that re+uired by country '.
0et us assume that both the countries have (( units of labour-hours
at there disposal and these labour units can be used for producing
either steel or cement.
If a country ! utili%es these units for e/clusively producing steel. then it
will be able to produce 1,( steel units.
>((?)
In case it goes for producing only cement its capacity would be
>((?1(>( units of cement.
"imilarly. country ' can produce either @( units of steel or A( units of
cement. !s we for producing each unit of steel. the production of a
particular number of unit of cement has to be foregone and vice-versa.
The +uantity of cement thus foregone in order to produce one
additional unit of steel is called the opportunity cost of steel.
!s the country ! can either produce 1,( units of steel or ( units of
cement with the available resources. the opportunity cost of steel for
country ! would be cost of steel for country ! would be
>(?1,(>(.)
The opportunity cost of producing steel and cement for the two
countries can be similarly calculated.
*pportunity cost
:ountry steel :ement
! (?1,(>(.) 1,(?(>,.((
' A(?@(>(.7) @(?A(>1.AA
8n-oying comparative advantage for a country means having a lesser
opportunity cost in producing a commodity than the other country.
!s we can see from the above table country ! has lower opportunity
cost and hence en-oying comparative advantage in producing steel.
while ' en-oys it in producing cement. !ccording to the theory of
comparative advantage. each country should produce that goods. in
which it has a comparative advantage. Hence country ! should
produce steel and country ' should produce cement.
In e/plaining the theory of comparative advantage. 5avid 6icardo
made certain implicit assumptions. They are as follows:-
1. PERFECT COMPETITION:-Berfect competition with Ce/ible
prices and wages prevails in both the countries. This results in
the prices of steel and cement being diDerent in country ! and '
due to diDerence in the labour hours used and hence the
production cost.
,. PRODUCTIVITY OF LABOUR:-0abour is the only factor of
production and the average product of labour is constant for
producing both the products in both the countries. It means that
marginal product of labour is constant implying constant return
to scale.
HECKSCHER-OHLIN MODEL:-
The theory of comparative advantage assumes a single factor of
production i.e. labour and describes the situation where trade takes
place between countries having diDerent technologies i.e. the
countries operating at diDerent level of e#ciency giving rise to
comparative advantage.
The Heckscher-*hlin model e/plores the possibility of two nations
operating at the same level of e#ciency bene$ting by trading with
each other. !ccording to this theory. there are two types of products.
0abour intensive and capital intensive. The model further says that
reason two countries operating at the same level of e#ciency can and
does bene$t from trade can be traced to the diDerence in their factor
endowments.
The labour rich country is more likely to produce labour intensive
goods and the country rich in capital will most probably produce capital
intensive goods. The two countries will then trade these goods and
reap the bene$t of international trade.
Eust as having a higher per capita income. rather than having a higher
national income should be the criteria for -udging as to which country
is richer. for -udging as to which country is capital rich. the criteria
should be greater physical amount of capital per unit of labour rather
than abundance of capital. This theory is also not free from
drawbacks:-
1. It assumes that factor endowments are given. whereas they can
also be developed through innovations.
,. 5ue to e/istence of minimum wage act in some countries. the
factor prices may change to such an e/tent. that an otherwise
labour rich country may $nd it cheaper to import labour intensive
goods than to produce them locally.
A. The $nding of an empirical study by economists 4assily 0eontief
pointed out that despite being a capital rich country. ;" e/ports
are more labour intensive than capital intensive.
!ll factors highlight the fact that there are more to international trade
than -ust factor endowment.
IMITATION GAP THEROY:
It is given by Borsenr. considers the possibility of trade between two
countries having similar factor endowments & consumer tastes.
!ccording to this theory improvement in technology is a continuous
process & the resulting inventions & innovations in e/isting products
give rise to trade between such countries.
The degree of trade between such countries will depend upon the
diDerence between the demand lag &imitation lag.
5emand lag is the diDerence between the time & new or an improved
product is introduced in one country & the time when consumers in the
other country start demanding it .Imitation lag is the diDerence
between the time of introduction of the product in one country & time
when the producers in the other country starts producing it .
If the imitation lags shorter than the demand lag no trade will take
place betn the two countries. However normally demand lag can be
e/pected to be shorter than imitation lag. In such a case the country
coming out with the innovation will be able to start e/porting to the
second country as the consumers there becomes aware of its product.
and the e/port will keep growing as more consumers become aware.
This e/port will continue to increase till the demand lag is over i.e. till
all the consumers react to the innovation.
If the producer can start producing the same product before this time
period. they can arrest the growth of these imports into their countryF
otherwise the e/ports will continue and will stabili%e at a particular
level.
TRADE BARRIERS
5espite the bene$t of international trade. governments have an
inclination to put trade barriers in order to discourage imports. There
two kinds of barriers: - TariD & 2on TariD
TARIFF BARRIERS: -
TariD is a ta/ levied on goods traded internationally. 4hen imposed on
goods being brought into the country. it is referred to as import duty.
Import duty is levied to increase the eDective cost of imported goods in
order to increase the demand for domestically produced goods.
!nother type of tariD less fre+uently imposed is the e/port duty. which
is levied on goods being taken out of the country. to discourage the
e/ports of those goods. This may be done.
If the country is facing the shortage of particular commodity
*6
If the government wants to promote the e/port of that goods in
some other forms.
TariD can be imposed on three diDerent basis. They are :-
90!T 5;T<:-It is based on the number of units regardless of the
value of the goods. 9or e/ample: - there may be a duty of 6s.
)((( per computer imported into India.
!5 G!0*681 5;T<: - It is e/pressed as a percentage of the value
of goods. "o as a person importing walkman worth 6s. ,(((
carrying an import duty of 1(H would have to pay 6s. ,((
towards duty charges.
! :*1B*;25 5;T<:-It is a combination of speci$c and ad
valorem duty. 9or e/ample: - a book worth 6s.)(( carrying a
speci$c duty of 6". ,) and ad valorem duty of ,H would in eDect
be carrying a compound duty of 6s. A).
TECHNICAL BARRIERS:-
:ountries generally specify some +uality standards to be met by
imported goods for various health. welfare and safety reasons. This
facility can be misused for blocking the import of certain goods from
speci$c countries by setting up of such standards which deliberately
e/clude these products. The process is further complicated by the
re+uirement that testing and certi$cation of the products regarding
their meeting the set standards be done only in the importing country.
INTERNATIONAL PRICE FIXING:-
"ome commodities are produced by a limited number of producers
scattered around the world. In such a case. these producers may come
together to form a cartel and limit the production or price of the
commodity so as to protect their pro$ts. *B8: is an e/ample of such
cartel formation.
CUSTOMS VALUATION:-
There is widely held view that the invoice value of the goods traded
internationally do not reCect their real cost. This gave rise to a very
sub-ective system of valuation of imports and e/ports for levy of duty.
If the value attributed to a particular product would turnout to be
substantially higher than itIs real cost. it could result in aDecting itIs
competitiveness by increasing the total cost of the importer due to itIs
e/cess duty.
NON-TARRIF BARRIERS:-
2on-tariD barriers include all the rules. regulations and bureaucratic
delays which helping keeping foreign goods out of the domestic
markets it is of three types:-
1. =uota
,. 8mbargo
A. Goluntary e/port restraint
@. "ubsidies to local goods
=uota: - a +uota is a limit on the number of units that can be
imported or the market share that can be held by foreign producers.
9or e/ample: - the ;" has imposed a +uota on te/tile imported from
India and other countries.
8mbargo: - when imports from particular country are totally banned
is called as embargo. It is mostly put in a place due to political
reasons.
Goluntary e/port restraint: - a country facing a persistent. huge
trade de$cit against another country may pressuri%e it to adhere to
a self imposed limit on the e/ports to the de$cit facing country.
"ubsidies to local goods: - government may directly or indirectly
subsidi%ed local production in an eDort to make it more competitive
in the domestic and foreign market.