Chapter - 2

Evolution of International Trade

 Evolution of International Trade
• Barter
• Mercantilism
• Absolute advantage (Classical)
• Comparative advantage
• Factor Proportions Trade
• International Product Cycle
• New Trade Theory
• National competitive advantage
• International trade has a rich history starting with barter system
(the first evidences of bartering is in 6000 BC) being replaced by
Mercantilism in the 16th and 17th Centuries. The 18th Century
saw the shift towards liberalism. It was in this period that Adam
Smith, the father of Economics wrote the famous book ‘The
Wealth of Nations’ in 1776 where in he defined the importance
of specialization in production and brought International trade
under the said scope.
• David Ricardo developed the Comparative advantage principle,
which stands true even today.

All these economic thoughts and principles have influenced

the international trade policies of each country.
 arter Theory
• Barter is the exchange of products and services for other products and
services. In a barter system, people do not use money for transactions.
The verb ‘to barter’ means to exchange goods and services for other
products and services.
• Sometimes bartering is just plain impractical because it takes a lot of
time and work.
• In the barter system, traders must decide on fair exchanges, which can
be difficult.
• It has a lot of disadvantages that the invention of currency solved.
The following are the main difficulties which were found in
the barter system:
1. Double Coincidence of Wants
– Owning to lack of generally acceptable medium of exchange, a difficult
problem of double coincidence of wants was faced by the persons
who wanted to sell and buy goods.
– “It is next to impossible that all wishes of bartering individuals should
coincide as to the kind, quality and quantity and value of things which
are mutually desired, especially in a modern economy in which on a
single day millions of persons may exchange millions of goods and
services.”
2. Lack of a Standard Unit of Account
A barter economy lacked not only a common medium of
exchange but also a standard unit of account in which prices
could be measured and quoted. In the absence of a common
unit of account, the number of exchange ratios (that is, prices of
goods expressed in terms of each other) between goods would
be very large. For example, two cows for one horse, one cow
for two quintals of wheat, one pen for three pencils and so on.
Thus, lack of a standard unit of account with which to
measure values of different goods and services made exchange
or trade difficult.
3. Impossibility of Subdivision of Goods
Another problem faced under the barter system for exchange
of goods was impossibility of subdivision of goods without
loss of their value. For instance, if a person has a cow and
wants to have 5 kg of wheat, obviously, it is too costly to give
one cow for 5 kg of wheat he requires. Then, to do this
transaction cow has to be divided. But cow cannot be divided
or cut into pieces because cow will lose much of its value if it is
divided. Thus, impossibility of division of goods for the
purpose of exchange posed a great difficulty and obstructed
the growth of trade.
4. Lack of Information
Another problem found in the barter system was that in it
traders required a good deal of information for exchange of
goods. For example, if Amit wants to have a saw in exchange
of a wooden table which he has made. Thus, if there exists a
medium of exchange, with well-known characteristics, it will
reduce the information costs of trading. Without the medium
of exchange information cost will indeed be very large.
5. Production of Large and Very Costly Goods not
Feasible
– Another problem of barter economy relates to the
production of large, costly goods. Suppose an individual
who has technical skill and equipment to manufacture a car
will not have much incentive to manufacture it in the
barter economy.
– This is because he can exchange a car with a person who
has enough goods having a value equal to a car so that
their exchange with a car can take place. The car maker
must obtain food, clothing and several other commodities
of day-to-day consumption in exchange for a car. It will be
very difficult, almost impossible to find a prospective buyer
who has enough of these goods and services to give in
return for a car.
 ercantilism Theory (mid-16th century)
“… trade theory holding that nations should accumulate financial
wealth, usually in the form of gold (forget things like living
standards or human development) by encouraging exports and
discouraging imports”.
• Mercantilism is an economic theory and practise where the government
seeks to regulate the economy and trade in order to promote domestic
industry – often at the expense of other countries. Mercantilism is
associated with policies which restrict imports (tariff barriers, quotas or
non-tariff barriers) increase stocks of gold and protects domestic
industries.
• Mercantilism is a national economic policy that is designed to
maximize the exports, and minimize the imports, of a nation.
These policies aim to reduce a possible current account deficit or reach
a current account surplus.

Mercantilism stands in contrast to the theory of free trade – which

argues countries economic well-being can be best improved through
the reduction of tariffs and fair free trade.
Mercantilism
• A nation’s wealth depends on accumulated treasure.
• Gold and silver are the currency of trade.
• Theory says you should have a trade surplus.
• Maximize export through subsidies.
• Minimize imports through tariffs and quotas.
• Flaw: restrictions, impaired growth.
Examples of mercantilism
• England Navigation Act of 1651 prohibited foreign vessels
engaging in coastal trade.
• All colonial exports to Europe had to pass through England
first and then be re-exported to Europe.
• Under the British Empire, India was restricted in buying from
domestic industries and were forced to import salt from
the UK. Protests against this salt tax led to the ‘Salt tax revolt’
led by Gandhi.
 odern Mercantilism
In the modern world, mercantilism is sometimes associated with
policies, such as:

• Undervaluation of currency. e.g. government buying foreign

currency assets to keep the exchange rate undervalued and
make exports more competitive. A criticism often levelled at
China.
• Government subsidy of industry for unfair advantage.
Again China has been accused of offering state supported
subsidies for industry, leading to oversupply of industries such
as steel – meaning other countries struggle to compete.
• A surge of protectionist sentiment, e.g. US tariffs on Chinese
imports, and US policies to ‘Buy American.’
• Copyright theft
Criticisms of Mercantilism
• Adam Smith’s “The Wealth of Nations” (1776) – argued for benefits of
free trade and criticised the inefficiency of monopoly.
• Theory of comparative advantage (David Ricardo)
• Mercantilism is a philosophy of a zero-sum game – where people
benefit at the expense of others. It is not a philosophy for increasing
global growth and reducing global problems. Also, increasing other
peoples wealth can lead to selfish benefits, e.g. growth of other
countries, increases markets for our exports. Trying to impoverish other
countries will harm our own growth and prosperity.
• Mercantilism which stresses government regulation and monopoly
tends to lead to inefficiency and corruption.
• Mercantilism justified Empire building and the poverty of colonies to
enrich the Empire country.
• Mercantilism leads to tit for tat policies – high tariffs on imports leads
to retaliation.
• The growth of globalisation and free trade during the post-war period
showed possibilities from opening markets and respecting other
countries as equal players.
• Economies of scale from specialisation possible under free trade.
Justification for neo-mercantilism
Despite many criticisms of mercantilism, there are arguments to
support the restriction of free trade in certain circumstances.
• Tariffs in response to domestic subsidies. Supporters argue that since
China’s steel is effectively subsidised leading to a glut in supply, it is
necessary and fair to impose tariffs on imports of Chinese steel to
protect domestic producers from unfair competition. US tariffs on
imports of steel from China 266%. In Europe, tariffs are 13%.
• Protection against dumping. If some countries have an excess supply
of goods, they can sell at a very low price to get rid of the surplus. But
, this can make domestic firms unprofitable. Protectionism can be
justified to protect against this dumping. Examples, include EEC
dumping excess agricultural production on world agricultural markets
and China’s dumping of steel.
• Infant industry argument. For countries seeking to diversify their
economy, tariffs may be justified to try and develop new industries.
When the industries have developed and benefited from economies
of scale, then the tariffs and protectionism can be dropped.
 bsolute Advantage Theory
Adam Smith: Wealth of Nations - 1776
“The Father of Modern Economics & Founder of Capitalism”

• Capability of one country to produce more of a product with the same

amount of input than another country.
• A country should produce only goods where it is most efficient, and
trade for those goods where it is not efficient.
• Trade between countries is, therefore, beneficial assumes there is an
absolute balance among nations.
 Absolute Advantage
• Absolute advantage means that an economy can produce a greater
total of goods for the same quantity of inputs.
• Absolute advantage means that fewer resources are needed to
produce the same amount of goods and there will be lower costs
than other economies.

Countries with an absolute advantage can decide to specialize

in producing and selling a specific product or service
and use the funds that good or service generated to
purchase goods and services from other countries.
Theory of absolute advantage
• … destroys the mercantilist idea since there are gains to be
had by both countries party to an exchange
• … questions the objective of national governments to acquire
wealth through restrictive trade policies
• … measures a nation’s wealth by the living standards of its
people
 Examples of Absolute Advantage
Almost all countries have an absolute advantage in the production
of at least one good or service. Absolute advantage is achieved
through low-cost production. For example, China and other Asian
countries are known to have an absolute advantage
in manufacturing because they can take advantage of low labor
costs. Canada is known to have an absolute advantage in
agricultural production because of its vast areas of low-cost.
 Example (1)
Hours of work necessary to produce one unit
Country Cloth Wine
England 80 100
Portugal 120 90

According to example 1, England commits 80 hours of labor to produce

one unit of cloth, which is fewer than Portugal's hours of work necessary
to produce one unit of cloth. England is able to produce one unit of cloth
with fewer hours of labor, therefore England has an absolute advantage
in the production of cloth. On the other hand, Portugal commits 90 hours
to produce one unit of wine, which is fewer than England's hours of work
necessary to produce one unit of wine. Therefore, Portugal has an
absolute advantage in the production of wine.
 Trade Based On
Absolute Advantage

• Consider this “simple” example involving the EU and India

• Only two products are produced, machines and cloth
• Labor is fixed, homogeneous within a country, the only factor
of production, and is fully utilized
• Technology and production costs are constant
• Transportation costs are zero and the countries barter (trade)
for goods
 Example (2)

Trade Based On Absolute Advantage

One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines 10 yards of cloth
India 2 machines 15 yards of cloth
 THE PRODUCTION POSSIBILITIES FRONTIER AND CONSTANT COSTS

The Production Possibilities Frontier (PPF) is a curve showing the various

combinations of two goods that a country can produce when all of a
country’s resources are fully employed and used in their most efficient
manner.

One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines 10 yards of cloth

India 2 machines 15 yards of cloth

 One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines 10 yards of cloth

India 2 machines 15 yards of cloth

Machines Production Possibilities Curves for the United States and India
5

Cloth
10 15
 India EU
Cloth Mach Cloth Mach
15 0 10 0
7.5 1 8 1
0 2 6 2
4 3
2 4
0 5

“Opportunity Cost” also known as “Relative Price”

India - Opportunity Costs EU - Opportunity Costs

Machine = 7.5 cloth Machine = 2 cloth

Cloth = 0.133 machine Cloth = 0.5 machine
• EU workers are more productive in producing machines
• The EU has an absolute advantage in machine production

• Indian workers are more productive in producing cloth

• India has an absolute advantage in cloth production
 Example of absolute advantage (3)

Saudi Arabia has an absolute advantage in the production of oil

because it only takes an hour to produce a barrel of oil compared
to two hours in the United States. The United States has an
absolute advantage in the production of corn.
To simplify, let’s say that Saudi Arabia and the United States each
have 100 worker hours
 Production Possibilities Frontiers. (a) Saudi Arabia can produce 100
barrels of oil at maximum and zero corn (point A), or 25 bushels of corn
and zero oil (point B).
It can also produce other combinations of oil and corn if it wants to
consume both goods, such as at point C. Here it chooses to
produce/consume 60 barrels of oil, leaving 40 work hours that can be
allocated to producing 10 bushels of corn, (b) If the United States
produces only oil, it can produce, at maximum, 50 barrels and zero corn
(point A’), or at the other extreme, it can produce a maximum of 100
bushels of corn and no oil (point B’).
Gains From Trade
 Absolute advantage in everything

In the above case, the US has an absolute advantage in producing

clothing (5 to 4) and also has an absolute advantage in producing
aero planes. (12 to 1)
Why countries buy so many things they already have?
 omparative advantage theory
(David Ricardo: Principles of Political Economy - 1817)

• Extends free trade argument

• Efficiency of resource utilization leads to more productivity
• Should import even if country is more efficient in the product’s
production than country from which it is buying.
• Look to see how much more efficient. If only comparatively
efficient, than import.
• Makes better use of resources
• Trade is a positive-sum game

Comparative advantage refers to a country’s ability to produce a

good at a lower opportunity cost/efficiently/better than another
country
 Sources of Comparative Advantage

• Differences in technology
• Differences in climate
• Differences in factor endowments
– Factors of production – land, labor and capital
– Factor intensity – the factor that is used intensively in
production
– Heckscher-Ohlin model
Assumptions and limitations
• Driven only by maximization of production and consumption
• Only 2 countries engaged in production and consumption of just 2
goods?
• What about the transportation costs?
• Only resource – labour (that too, non-transferable)
• No consideration for ‘learning theory’
• Output without trade

• For the UK to produce 1 unit of textiles it has an opportunity cost of

4 books.
• However for India to produce 1 unit of textiles it has an opportunity
cost of 1.5 books
• Therefore India has a comparative advantage in producing textiles
because it has a lower opportunity cost
• The UK has a comparative advantage in producing books. This is
because it has a lower opportunity cost of 0.25 (1/4) compared to
India’s 0.66 (2/3)
• If each country now specializes in one good then, assuming constant
returns to scale, output will double.
• Output after trade

• Therefore the total output of both goods has increased – illustrating

the potential gains from exploiting comparative advantage.
• By trading the surplus books and textiles, India and UK can enjoy
higher quantities of the goods.
There are many examples of comparative advantage in the real world
e.g. Saudi Arabia and oil, New Zealand and butter, USA and Soya
beans, Japan and cars e.t.c.