International Economics: An Introduction

GEC S5 02 (M)
Exam. Code: ECM5B
International Economics
SEMESTER V
ECONOMICS
BLOCK- 1
KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

Subject Experts
1. Professor Madhurjya Prasad Bezbaruah,
Dept. of Economics, Gauhati University
2. Professor Nissar Ahmed Barua, Dept. of Economics, Gauhati University
3. Dr. Gautam Mazumdar, Dept. of Economics, Cotton University
Course Coordinator : Bhaskar Sarmah, Ph.D., KKHSOU
SLM Preparation Team

UNITS CONTRIBUTORS
1 Dr. Swabera Islam, K C Das Commerce College (Retired)
Bhaskar Sarmah, KKHSOU.
2 Bhaskar Sarmah, KKHSOU.
3 Payel Priya Kashyap, Tyagbir Hem Baruah College, Jamugurihat.
4, 7 Dr. Surendra Jadhav,
Chetana's H. S. College of Commerce & Economics. Mumbai
5, 6 Dr. Parag Dutta, Dispur College.
Editorial Team
Content : Dr. Gautam Mazumdar,
Department of Economics, Cotton University
Language (English Version) : Dr. Debajit Das,
(Units 2, 3) Department of English, D.K. College, Mirza
Structure, Format & Graphics : Bhaskar Sarmah, Ph.D. KKHSOU
First Edition: May, 2019

ISBN: 978-93-89123-57-9
This Self Learning Material (SLM) of the Krishna KantaHandiqui State University is
made available under a Creative Commons Attribution-Non Commercial-ShareAlike4.0 License
(International): http.//creativecommons.org/licenses/by-nc-sa/4.0.
Printed and published by Registrar on behalf of the Krishna KantaHandiqui State Open University.
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The University acknowledges with thanks the financial support provided by the
Distance Education Bureau, UGC for the preparation of this study material.
CONTENTS
Pages
UNIT 1: INTRODUCTION TO INTERNATIONAL ECONOMICS 7–24

The Basis and Need of International Trade; Inter-regional and International
Trade: Classicists’ Views, Bertil Ohlin’s Views; Distinction between International
Trade and Regional Trade; The Theory of Absolute Advantage; The Theory of
Comparative Cost : The Basis of International Trade: Superiority of the Theory
of Comparative Cost Advantage Over the Theory of Absolute Advantage
UNIT 2: FREE TRADE VS. PROTECTION 25–34
Free Trade versus Protection: Arguments for Protection, Arguments for Free
Trade; Importance of Protection in Developing Countries; Measures of
Protection
UNIT 3: THE OPPORTUNITY COST THEORY 35–50

Haberler's Opportunity Cost Theory: Constant Opportunity Cost Curve,
Increasing Opportunity Cost Curve, Decreasing Opportunity Cost Curve,
Constant Opportunity Cost and International Trade, Increasing Opportunity
Cost and International Trade, Decreasing Opportunity Cost and International
Trade; Advantages of Haberler's Opportunity Cost Theory; Drawbacks of
Haberler's Opportunity Cost Theory
UNIT 4: THE HECKSCHER-OHLIN THEORY 51–66
The Heckscher-Ohlin Theory of International Trade: Assumptions of the

Hecksher-Ohlin Theory, Factor Abundance: Physical Criterion, Factor
Abundance: Factor Price Criterion; Factor intensity; Basic Ideas of Hechsher-
Ohlin Theory; Superiority of Hecksher-Ohlin Theory over Classical Theory;
Criticisms of the Hecksher-Ohlin Theory
UNIT 5: TERMS OF TRADE AND GAINS FROM TRADE 67–77

Meaning of Terms of Trade; Gains from Trade; Net Barter or Commodity Terms
of Trade; Gross Barter Terms of Trade; Income Terms of Trade; Factors
Affecting Terms of Trade
UNIT 6: TOOLS OF TRADE RESTRICTION 78–101
Classification of Tariffs; Effects of Tariffs: The Effects of Tariff under Partial

Equilibrium Analysis; Dumping: Meaning; Types and Effectss of Dumping:
Effects of Dumping; Anti-dumping Measures; Cartels: Advantages and
Disadvantages of Cartels; Custom Union: Meaning; Concepts of Trade
Creation and Trade Diversion; Quotas: Meaning and Types; Effects of Quotas
UNIT 7: ECONOMIC INTEGRATION 102–112

Economic Integration - Conceptual Framework; Preferential Trading
Agreement or Arrangement; Free Trade Area; Custom Union; Common Market;
Economic Union: European Union (EU); Concepts of Trade Creation and Trade
Diversion
COURSE INTRODUCTION
This is the third course of fifth semester of the BA (Major) programme in Economics. This course has
been entitled 'International Economics'. This course contains a total of fifteen units and has been divided
into two blocks. The first block contains 7 units while the second block contains the rest. We all know
that today a country cannot remain alone in terms of trade and commerce. It has to trade with other
countries, which means it has to export and import goods and services to and from other countries, or
the rest of the world. We call it international trade. In the discipline of Economics, the study of international
trade and the related issues have been offered as International Economics.
BLOCK INTRODUCTION
The first unit of the course entitled 'Introduction to International Economics' will introduce you to the
basic concepts in International Economics. This unit will be of immense help in acquiring knowledge
about inter-regional trade and international trade, distinction between international trade and regional
trade as well as two important theories of International Economics viz., Theory of Absolute Advantage
and Theory of Comparative Advantage. In the second unit, distinctions between free trade versus
protection have been discussed. The third unit of the course deals with one of the important theories of
international economics, viz., the opportunity cost theory of international trade put forward by Gottfried
Haberler. In this unit, a comparative discussion with the Ricardian theory of international trade has also
been made. The fourth unit also discusses another important theory of international trade, viz., the
Hecksher-Ohlin theory. Also called as neo-classical theory of international trade, this theory particularly
discusses how cost advantage and specialisation lead to international trade between countries. The
fifth unit of the course has been entitled Terms of Trade and Gains from Trade. This unit will be helpful
for you in acquiring knowledge about the concepts like gains from trade, gross barter terms of trade
and net barter terms of trade and factors affecting the terms of trade. The next unit deals with tools of
trade restriction. Thus, various instruments for trade restriction viz., tariffs and its effects, concept of
dumping, anit-dumping measures, concept of cartels, its advantages and disadvantages, custom union
have been discussed. The last unit of the first block deals with economic integration. Some of the
important concepts like preferential trade area, Free trade area, customs union, common market,
economic union has been discussed. The next block starts with the discussion on balance of payments
and balance of trade and concludes with the discussion on regional economic integration among
developoing countries.
While going through a unit, you will notice some along-side boxes, which have been included to help
you know some of the difficult, unseen terms. Some "ACTIVITY' (s) have been included to help you
apply your own thoughts. Again, we have included some relevant concepts in "LET US KNOW" along
with the text. And, at the end of each section, you will get "CHECK YOUR PROGRESS" questions.
These have been designed to self-check your progress of study. It will be better if you solve the problems
put in these boxes immediately after you go through the sections of the units and then match your
answers with "ANSWERS TO CHECK YOUR PROGRESS" given at the end of each unit.
6
UNIT 1: INTRODUCTION TO INTERNATIONAL
ECONOMICS
UNIT STRUCTURE
1.1 Learning Objectives

1.2 Introduction
1.3 The Basis and Need of International Trade
1.4 Inter-regional Trade and International Trade
1.4.1 Classicists’ Views
1.4.2 Bertil Ohlin’s Views
1.5 Distinction between International Trade and Regional Trade
1.6 The Theory of Absolute Advantage
1.7 The Theory of Comparative Cost : The Basis of International
Trade
1.7.1 Superiority of the Theory of Comparative Cost
Advantage Over the Theory of Absolute Advantage
1.8 Let Us Sum Up
1.9 Further Reading
1.10 Answers to Check Your Progress
1.11 Model Questions
1.1 LEARNING OBJECTIVES
After going through this unit, you will be able to-

 define the meaning of International Trade
 differentiate between international trade and inter-regional trade
 discuss Bertil Ohlin’s views on international trade.
1.2 INTRODUCTION
Just as no individual is self-sufficient, in a similar vein no country

is self-sufficient. A country cannot produce all the goods and services as
required by its people. Those commodities which are not produced by
the country are to be imported from the rest of the world. Hence, the
absence of self-sufficiency is the cause of mutual interdependence among
International Economics, Block-1 7
Unit 1 Introduction to International Economics
the countries. The mutual interdependence at the international level is

reflected in the transaction of commodities and inputs and these
transactions constitute international trade.
It is quite possible that a country can produce a commodity and yet
it chooses not to produce it and import it instead. The explanation lies in
the fact that the cost of production of the commodity will be too high and
the consumers will have to pay a high price for it. Therefore, it is better to
obtain the commodity from another country where its cost of production is
low. Such a step will also result in better utilisation of resources. The
resources used in the production of the high cost commodity will be released
for the production of other commodities with low cost of production.To
illustrate, India produces and exports tea; USA does not. However, a country
so advanced in the field of science and technology like USA can definitely
try and produce tea. But USA makes no such attempt. The cost of production
of tea in the USA will be too high compared to its cost in India. The factors
which are necessary for the production of tea, viz., climate, soil, supply of
labour etc. may not be available in abundance in the USA. Hence, USA
decides to import tea from India and utilize her resources in the production
of commodities where the costs are low.
International trade is based on specialisation. When a country does
not produce all the commodities but only those in which the cost is low
and exports these commodities, specialisation results.
1.3 THE BASIS AND NEED OF INTERNATIONAL

TRADE
One of the fundamental questions asked in the subject of

International Economics is ‘Why do nations trade?’ Nations trade each
other basically for the same reason that individuals trade with each other.
Just like the resources of an individual are not sufficient to fulfill ones’ all
wants, the resources of one country are also not sufficient to meet all the
needs of the country and the individual living therein. Owing to many
constraints, e.g., constraints in natural resource endowments, human
resources, technological resources, financial resources or others it is not
8 International Economics, Block-1
Introduction to International Economics Unit 1
possible for a country to meet all the needs of the country and its people.
Thus, it is evident that countries trade with each other when, on
their own, they do not have the resources, or capacity to satisfy their
own needs and wants. By developing and exploiting their domestic scarce
resources on certain specific uses, countries can produce a surplus, and
trade this for the resources they need.
Trade between countries dates back to thousands of years. Today,
in the current phase of globalisation, international trade occupies the centre
stage. In fact, many economists in a global economy credits international
trade for the development and prosperity of the modern industrialised world.
Goods and services are likely to be imported from a different
country for several reasons. For example, imported goods and services
may be cheaper, or of better quality. In many instances, there may not
be local alternatives available, making importing an all essential. For
example, Japan has no oil reserves of its own. But it is the world’s fourth
largest consumer of oil.
In the eighteenth century, Adam Smith explained the basis of
international trade on two major grounds: (a) the division of labour and
(b) specialisation. Division of labour means breaking down production
into small, interconnected tasks, and then allocating these tasks to different
workers based on their suitability to undertake the task efficiently. While
looked at the perspectives of international trade, a division of labour
means that countries produce just a small range of goods or services,
and may contribute only a small part to finished products sold in the
global markets. For example, a car manufacturer may import specific
parts from specific countries and then finally assemble those to offer the
final product ‘car’ to the customers. In that way, an individual country
may contribute, perhaps, just one ingredient to the final product.
Specialisation is the second fundamental principle pointed out by Smith.
In fact, specialisation results from the division of labour. Now, when each
worker, or each producer undertakes a specialist role, they are likely to
become efficient contributors to the overall process of production, and to
the finished product. Hence, specialisation can generate further benefits
in terms of efficiency and productivity.
Now, specialisation can be applied to different levels: say to

individuals, firms, machinery and technology, and to a country as a whole.
Looking from the perspectives of international economics, owing to
international specialisation, countries would be able to use their scarce
resources to produce just a small range of products in high volume. In this
way, mass production would generate a surplus of the good produced,
which can then be exported. This means that goods and resources must
be imported from other countries that have also specialised, and produced
surpluses of their own.
As a result of specialisation, countries are likely to become more
efficient over time. This is partly because a country's producers will
become larger and exploit economies of scale. Faced by large global
markets, firms may be encouraged to adopt mass production, and apply
new technology to increase their level of production and quality. This
can provide a country with a price and non-price advantage over less
specialised countries, making it increasingly competitive and improving
its chances of exporting in the future.
Thus, the basis of international trade is the gains or profits to be
made from exchange of goods and services. In the absence of such profits,
there will not be any motivation for international trade between countries.
1.4 INTER-REGIONAL TRADE AND INTERNATIONAL

TRADE
1.4.1 Classicists’ Views
According to the classical economists, there are basic

differences between inter-regional trade and international trade.
But according to economists like Bertil Ohlin, there are no such
differences. The classical economists have put forward three
arguments in support of their view. These arguments are explained
below
 Mobility of factors: Factor mobility is higher in case of
inter-regional trade than international trade. Within a country

the differences in language, laws and regulation, social
customs and practices are generally less pronounced. Hence,
factors like labour have greater mobility. At the international
level, however, these differences are quite considerable and
therefore the factors are less mobile. It is because of this
lack of mobility of factors that there is no tendency towards
factor price equalisation. In case of inter-regional trade, such
an equalisation is possible in theory. For instance, at the
inter-regional level, labourers can move from a low wage
industrial unit to a high wage one and such movements will
continue till the wage rates in all the industrial units are
equalised. Similar will be the case with regard to the
movement of the other inputs of production.
 Currency: In inter-regional trade, only one currency is used
as the medium of exchange; international trade uses the
currencies of as many countries as are involved in
international trade and commerce. The question of
determination of the external value of money or the rate of
exchange does not arise in case of inter-regional trade but
it is an important issue in international trade. For instance,
in trade relations between India and U.K. it becomes
necessary to fix a rate of exchange between the Indian
Rupee and the U.K. Pound Sterling.
 Monetary Policy: In case of inter-regional trade, the
monetary policy that prevails is same as the policy is
formulated by the central bank of the country. But there is
no world central bank to frame a monetary policy for all the
trading partners and different central banks of different
countries formulate their respective monetary policies.
On the basis of these arguments, the classical
economists advocate the formulation of a separate theory
for international trade.

1.4.2 Bertil Ohlin’s Views

As against the classical view, Bertil Ohlin asserts that it is
not necessary to have a separate theory for international trade. In
his book, “Inter-regional and International Trade”, he points out that
there is no basic difference between international trade and inter-
regional trade. According to him, “Countries are special types of
regions and that conclusions concerning trade between the latter
will therefore hold true for international trade.” Ohlin builds up his
case on the basis of three arguments. These are mentioned below
 Basis of trade: The basis of trade at both the levels, inter-
regional and international, is the same. This basis can be
explained in terms of the theory of comparative cost. According
to this theory, a country produces that commodity in the
production of which it enjoys a greater cost advantage. This
is true in case of regions which figure in inter-regional trade.
 Factor mobility: According to Ohlin, factors of production are
not mobile to the same degree as the classical economists
would have us believe. He refers to a group of workers, known
as the “non-competing group” which specialises in a particular
line of production. This group cannot be taken out of an
industrial unit and put into another. They do not have mobility.
On the other hand, it is interesting to find that factors are
sometimes more mobile at the international level.
It is a fact that the outflow of capital and labour from
Europe had contributed immensely towards the economic
development of America and Africa.
 External value of money: It is true that a number of foreign
currencies are involved in international trade. All the same,
however, one of the factors that determines the external
value or the rate of exchange of a country’s currency is the
internal value of money or purchasing power. In other words,
internal value of money is the common thread that runs
through the currencies of all the countries of the world.
On the basis of these arguments, Ohlin concludes, “The

most important distinction to be made is not between the
theory of international commerce and national commerce
but between the theory of prices for a single market and a
theory of prices that is valid for several markets.”
1.5 DISTINCTION BETWEEN INTERNATIONAL

TRADE AND REGIONAL TRADE
The following arguments may be put forward in favour of a

separate theory of international trade.
 Factor mobility: There is no doubt that the mobility of factors, say
labour, is much more across its domestic territory as compared to
the international territories. The legal requirements to enter a foreign
territory like passport, visa etc. makes international movements of
labour much more rigid. The other barriers may be differences in
language, culture etc.
Apart from labour, many countries also restricts the movement
of other factors of production. For example in India, we have not
opened all segments of our market to the foreign investors.
Restrictions are there on the share of investments a foreign company
can make in the Indian market, which basically depends on the
Government regulations.
 Different monetary systems: Each country follows a distinct
monetary systems with its own currency and a set of regulations
governing the financial and the monetary system. This necessitates
that the country must have an agreed exchange rate of it currency
against accepted foreign currencies like US Dollar, British Pound or
the Euro. However, as most of the countries today have opened up
their market, the exchange rates of the different currencies are
regulated by the relative strength of the currencies in the market.
However, considerable restrictions on the free convertibility of
the currencies through the operation of the market forces still exist.
 Different political boundaries: Each country has its own geographic
territory and a set of regulations that govern all its activities within its
geographical territory. Thus, each country follows different policies in
the matters like customs duties, quotas, exchange control etc. Many
countries may also be interested in safeguarding specific industries
from foreign competition on national interest.
Again, different set of regulations are also applicable for the
import/export of goods and serivces across the international
boundaries than under the domestic territory.
 Transportation cost: Having different geographical boundaries
increase the transportation cost significantly. Different modes of
transportation may also be involved in the transportation of goods
and services.
 Gains from trade: In international trade, Governments are always
interested in evaluationg the gains from trade. Every country wants
to have a favourable terms of trade. Thus, the importance of
studying gains from trade also necessitates a separate theory of
international trade.
 Balance of payment issues: In case of international trade, an
adverse external balance of payments disequilibrium may pose
serious problem for a country. No such problem occurs in case of
inter-regional disequilibrim in trade.
 Nature of commodities traded: The nature of commodities may
also be different in the international market. For example, the
electronic products manufactured in the USA may not be compliant
to the requiremens of India, and vice versa. Similarly, countries
have to manufacture goods and services keeping in view the
requiremens in terms of specification and quality of the target
international market, which may vary from country to country.
Thus, from the above discussion, it is clear that international
trade is significantly different from inter-regional trade and as such
it is necessary to study international trade as a separate theory.

CHECK YOUR PROGRESS

Q 1: State whether the following statements are
True or False.
(i) No country is self-sufficient. (T/F)
(ii) Bertil Ohlin asserts that there is no basic difference between
international trade and inter-regional trade. (True/False)
Q 2: Why is the factor mobility low in international trade as
compared to inter-regional trade? (Answer in about 40 words)
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1.6 THE THEORY OF ABSOLUTE ADVANTAGE

To explain the occurrence of international trade, Adam Smith put
forward the Absolute Advantage Theory. According to this theory, trade
between countries took place if the traders saw an absolute cost
advantage in buying a particular commodity from a foreign country rather
than producing that commodity domestically. Adam Smith adopted a
two-country two-commodity model to explain international trade between
the countries. Thus, in the model, Smith assumed that two countries
come forward for international trade with two commodities on the basis
of absolute advantage. Before explaining the model in detail, let us
consider the assumptions on which the model rests.
Assumptions of the Absolute Cost Advantage Theory: The
absolute cost advantage theory put forward by Adam Smith rests on the
following assumptions. –
 There are two countries, and the two countries come for trading of
two commodities.
 Labour is the only input. Labour is homogeneous. This means that
all the labor units are of same type. They can be freely moved from
the production of one commodity to another.
 Single currency prevails between the two countries. So, it is assumed

that there are no effects of the changes in exchange rate.
 Units of production are divisible in compact units.
 All factors of production are fully employed.
 There is no government restrictions on free trade.
Thus, according to this theory, trade between countries took place
if the traders saw an absolute cost advantage in buying a particular
commodity from a foreign country rather than buying or producing the
same good in the domestic economy. Let us suppose, India and England
come forward for international trade for two commodities viz., spices and
wine. The following table shows a statement of the production cost (units
of labour employed) each country has to incur in the production of each
unit of the product.
Table 1.1: Absolute cost advantage between India and England
Wine Spices
India 100 50
England 50 100
From the above Table 1.1, it can be seen that India can produce
wine with 100 units of labour while England can produce the same quantity
of wine with 50 units of labour. Clearly England can produce wine in a
more efficient manner than India. India would therefore import wine from
England. Further assuming that both countries have the same currency
(say $) and same wage rates (say 1 $ per unit of labour) – It can be seen
that the cost of production of wine in India would be 100$ while that of
producing the same quantity of wine in England would be 50$. Thus, it is
quite obvious that India would be in an advantageous position to buy wine
from England at anything less than 100$. England will also be happy to
sell wine to India at anything more than 50$. Thus, we see that both countries
stand to gain if India imports wine from England.
An exactly reverse logic can be applied to spices where it can be
shown that India would end up exporting spices to England.
Thus, it can be seen that trade takes place because India enjoys a

clear and absolute advantage in producing spices (50 units of labor as

against 100 unit required in England) and vice versa as regards to the
production of wine.
1.7 THE THEORY OF COMPARATIVE COST : THE

BASIS OF INTERNATIONAL TRADE
David Ricardo propounded the theory of comparative cost to

explain the basis of international trade. According to this theory, cost
differences lead to international trade. In the absence of cost differences,
the prices of the commodities in different countries of the world would
have been uniform and it would not have been necessary to exchange
commodities at the international level.
Assumptions of the Ricardian Theory of Comparative Cost :
The Ricardian theory of comparative cost advantage is based on a set
of assumptions. These are given below:
 There are two countries and two commodities.
 Both the countries produce both the commodities before trade.
 The cost of transportation is nil.
 The cost of production is expressed in terms of quantity of labour
used in the production of the commodity.
 Labour is homogeneous.
 The law of constant returns to scale is in operation.
 The factors of production are internally mobile, but internationally
immobile.
 There is free trade in the sense that no restrictions whatsoever are
imposed on the flow of commodities from one country to another.
It is to be borne in mind that comparative cost is different from
absolute cost. Adam Smith, the Father of Political Economy, has explained
the concept of absolute cost. The concept is explained with the help of
an example given below in Table 1.2.

Table 1.2: Comparative Costs between India and USA

Country X amount of tea Y amount of wheat
Cost of production Cost of production
India 5 days labour 10 days labour
United Sates 10 days of labour 5 days of labour
From the above table 1.2, it is seen that India enjoys an absolute
advantage over USA in the production of tea and USA enjoys a similar
advantage over India in the production of wheat. The cost of production of
both the countries is expressed in terms of labour cost. While India takes
5 days labour, USA takes 10 days labour to produce X amount of tea.
Therefore, the cost of production of tea in India is half of what it is in the
USA. Similarly, the cost of production of Y amount of wheat is half in the
USA compared to what it is in India. In such a situation, India will produce
tea and export it to the USA and the USA will produce wheat and export it
to India. This deal will benefit both the countries. In the absence of trade,
the price of tea in the USA will be higher and so also the price of wheat in
India.
Now, let us visualise a situation where both the commodities are
produced at a lower cost in one country compared to the other country.
Will there be trade in this situation? The answer cannot be provided on
the basis of absolute advantage. But, Ricardo, with the help of his concept
of comparative advantage, has provided the answer and it is that trade
will take place between the two countries to the advantage of both.
However, it is also possible that a country enjoys comparative cost
advantage over another country in production of both the commodities
and yet international trade takes place between them. This concept of
comparative advantage and international trade has been explained with
the help of the following example given by Ricardo himself, as shown in
Table 1.3.
Table 1.3: Comparative Labour cost of production
Country Commodity Commodity
A gallon of wine B metres of cloth
Portugal 80 units of labour 90 units of labour
England 120 units of labour 100 units of labour
From the above table 1.3 it can be seen that Portugal produces
both wine and cloth at a lower cost than England. Of these two
commodities again, Portugal’s comparative production cost is less or
comparative advantage is more in the production of wine (80/120<90/
100). Similarly, England’s disadvantage in the production of cloth is less
compared to its disadvantage in the production of wine. Given this
situation, Portugal will use its inputs more to produce wine releasing the
inputs from the production of cloth. England will use its inputs for the
production of cloth releasing inputs from the production of wine. Thus,
Portugal will not produce cloth and England will not produce wine. Portugal
will export wine to England and import cloth from it. England will export
cloth to Portugal and import wine. Both the countries will gain.
Now, in the absence of trade and specialisation in production, the
rate of exchange between wine and cloth in England will be 1:1.2. Similarly,
in Portugal, the rate of exchange between wine and cloth will be 1:0.88.
England = 120/100 = 1.2, Portugal = 80/90 = 0.88. Therefore, when
trade opens up, Portugal will gain if she can obtain more than 0.88 units
of cloth against 1 unit of wine. Similarly, England will gain if against the
export of 1.2 units of cloth she can import 1 unit of wine. Thus, the basis
of trade is provided by the law of comparative advantage.
Limitations of the Theory of Comparative Cost: The Ricardian
Theory of Comparative Cost is subject to a number of limitations. The
following are its limitations.
 The Ricardian theory is based on the labour theory of value. The
labour theory of value is based on unrealistic assumptions.
Therefore, the theory of comparative cost is also unrealistic. The
unrealistic assumptions of the labour theory of value are: (a) Labour
is homogeneous and (b) Amount of labour used in the process of
production determines the cost of production of a commodity.
 The theory is based on the law of constant returns. But, with the
increase in the amount of inputs applied in production of the
commodity, output may increase at a diminishing rate. In other
words, the law of diminishing returns may operate.
 According to Ricardo, the inputs are mobile only in case of inter-

regional trade and not mobile in the case of international trade.
Had it been so, the income earned by the inputs internally would
have been equal in all the production units. But, in reality it is not
so. The lack of mobility may be the cause of it.
 Ricardo assumes free trade. In reality, however, high tariff walls are
erected by the trading countries to achieve a number of objectives
like providing protection to indigenous producers, to collect revenues
for the government etc.
 In Ricardo’s analysis, transport cost is assumed to be zero. However,
the prices of the traded commodities are higher because of the
transport cost.
 According to Ricardo, as a result of international trade, a country
can achieve complete specialisation. This may not be found in
practice and specialization may be incomplete. If a big country
imports a small amount of a commodity produced by a small country,
the total demand for the commodity in the big country may not be
met and the big country may also have to produce that commodity
itself.
 The Ricardian theory is a short-run theory. It ignores long run
changes in the composition of output produced in a country in the
wake of technological changes. It will, for example, be wrong to
assume that the under-developed countries will be destined to
produce only labour-intensive commodities.
 Ricardo highlights only the cost factor in international trade. The
cost factor influences the supply of the commodity. But, like the
supply of the commodity traded, the demand for the commodity is
equally important.
 The demand side is ignored in the Ricardian theory.
In conclusion, it can be said that in spite of its limitations, the
Ricardian theory is useful as it provides the basis for the extension of the
pure theory of trade by such eminent economists as Hechsher, Ohlin,
Haberler, Mill, Johnson, Bhagwati and others.
1.7.1 Superiority of the Theory of Comparative

Advantage over the Theory of Absolute Advantage
The theory of comparative advantage put forward by Ricardo

is superior to the theory of absolute advantage put forward by Smith.
No doubt, the absolute cost advantage theory is much simpler.
However, the absolute cost advantage theory can explain occurance
of international trade between two countries only when each of the
participating countries have absolute advantage in the production
of one commodity over the other country. But it fails to explain a
more difficult question: what if one country enjoys absolute
advantage in the production of both the commodities over the other
country. The Ricardian Theory offered explanation of this
phenomenon through the use of labour theory of value. In his theory,
Ricardo explained how a country even after enjoying absolute
advantage in the production of both the commodities over another
country would go for international trade. Thus, it is not the absolute
cost advantage, rather, it is comparative advantage that motivates
countries to go for international trade. In fact, this is the reason why
the theory was widely used in the explanation of international trade
between the countries until the First World War. To quote Professor
Samuelson: “if theories, like girls, could win beauty contests,
comparative advantage would certainly rate high in that it is an
elegantly logical structure.” The implication of the theory, as argued
by Professor Samuelson is that a country that neglects comparative
advantage may have to pay a heavy price in terms of living standard,
and potential rates of growth.
CHECK YOUR PROGRESS

Q 3: State whether the following statements
are True or False.
(i) Adam Smith, the Father of Political
Economy, has explained the concept of absolute cost. (T/F).

(ii) According to the theory of comparative cost advantage, cost

differences lead to international trade. (T/F)
(iii) Ricardian theory is applicable in the long-run. (T/F)
Q 4: Mention any two important limitations of the Ricardian Theory.
(Answer in about 50 words)
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
1.8 LET US SUM UP
 A country cannot produce all the goods and services as required

by its people.
 The mutual interdependence at the international level is reflected
in trade between the countries.
 International trade is based on specialisation.
 According to the classical economists, there are basic differences
between inter-regional trade and international trade.
 The classical economists advocate the formulation of a separate
theory for international trade.
 Bertil Ohlin asserts that it is not necessary to have a separate
theory for international trade.
1.9 FURTHER READING
1) Dudley, D. (1981). The Economics of John Maynard Keynes. New

Delhi: Vikash Publishing House Pvt. Ltd.
2) Mannur, H. G. (1995). International Economics. New Delhi: Vikash
Publishing House Pvt. Ltd.
3) Rana, K. C. & Verma, K. N. (2004). International Economics.

Jalandhar: Vishal Publishing Co.
4) Shapiro, E. (1988). Macroeconomic Analysis. New Delhi: Galgotia
Publications Pvt. Ltd.
1.10 ANSWERS TO CHECK YOUR

PROGRESS
Ans to Q No 1: (i) True (ii) True

Ans to Q No 2: Within a country the differences in language, laws and
regulation, social customs and practices are generally less
pronounced. Hence, factors like labour have greater mobility. At
the international level, however, these differences are quite
considerable and therefore the factors are less mobile.
Ans to Q No 3: (i) True (ii) True (ii) False
Ans to Q No 4: Two important limitations of the Ricardian theory of
comparative cost are:
 The theory is based on the law of constant returns. But, with
the increase in the amount of inputs applied in production of
the commodity, output may increase at a diminishing rate. In
other words, the law of diminishing returns may operate.
 In Ricardo’s analysis, transport cost is assumed to be zero.
However, the prices of the traded commodities are higher
because of the transport cost.
1.11 MODEL QUESTIONS
A) Short Questions (Answer each question in about 150 words)

Q 1: Discuss the classicists’ views on international trade and inter-
regional trade.
Q 2: Discuss Bertil Ohlin’s views on international trade and inter-regional
trade.
B) Long Questions (Answer each question in about 300-500 words)

Q 1: What do you mean by international trade? Discuss the views
relating to international trade and inter-regional trade.
Q 2: Why do trade take place between two countries? Discuss.
Q 3: Critically discuss the theory of comparative cost put forward by
Ricardo.
*** ***** ***

UNIT 2 : FREE TRADE VS PROTECTION
UNIT STRUCTURE

2.2 Introduction
2.3 Free Trade vs Protection
2.3.1 Arguments for Protection
2.3.2 Arguments for Free Trade
2.4 Importance of Protection in Developing Countries
2.5 Measures of Protection
2.6 Let Us Sum Up
2.7 Further Reading
2.9 Model Questions
After going through this unit, you will be able to-

 put forward the arguments in favour of free trade argue the
case for protection
 discuss the importance of protection in the developing countries
explain the different measures of protection.
2.2 INTRODUCTION
This unit deliberates on free trade and protectionism. A free trade

policy is said to exist when there is no restriction on the exchange of goods
and services between different countries. Accroding to Adam Smith, a free
trade policy is "a system of commercial policy which draws no distinction
between domestic and foreign commodities and thus which neither imposes
additional burden on the latter nor grants any special favour to the former."
However, contrary to what Smith had said, every country has to safeguard
its industries from foreign competition to a varying degree. In this unit, we
shall discuss the argmuents in favour and against free trade among
Unit 2 Free Tfrade Vs Protection
countries. We shall also discuss the importance of protection for the

developing countries and the different measures of protections the
developing countries may adopt to protect their domestic industries.
2.3 FREE TRADE VS PROTECTION
Free trade proponents stand for an open trading system with few
limitations and little government involvement. Advocates of
protectionismbelieve that governments must take action to regulate trade
and subsidize industries to protect their domestic economy.
Although the amount of government involvement in trade varies
from country to country and product to product, the overall barriers to
trade have been lowered since World War II. All governments practise
protectionism to some extent. The debate is over how many, or how few,
such measures should be used to reach the country's long-term
macroeconomic goals. In the following we are delineating the important
arguments for protection and free trade respectively.
2.3.1 Arguments for Protection
There are many arguments forwarded by advocates of

protectionism:
 Cheap labour: Less developed countries have a natural
cost advantage as labour costs in those economies are low.
They can produce goods less expensively than developed
economies and their goods are more competitive in
international markets. Hence these products should be
prevented from entering the market to protect the interest of
those engaged in the production of the same commodities
in the developed countries.
 Infant industries: Protectionists argue that infant, or new,
industries must be protected to give them time to grow and
become strong enough to compete internationally, especially
industries that may provide a firm foundation for future growth,
e.g. computers and telecommunications.
Free Tfrade Vs Protection Unit 2
 National security concerns: Any industry crucial to national

security, such as producers of military hardware, should be
protected. In that way the nation will not have to depend on
outside suppliers during political or military crises.
 Diversification of the economy: If a country channels all
its resources into a few industries, no matter how
internationally competitive those industries are, it runs the
risk of becoming too dependent on them. Keeping weaker
industries competitive through protection may help in
diversifying the nation's economy.
 Lowering environmental standards: In a rush to meet the
world demand for their exports, some countries may
compromise on critical environmental standards. This is
particularly true for less developed countries that do not
have well defined environmental protection laws in place.
2.3.2 Arguments for Free Trade
The debate about how free a trading system should be is an

old one, with positions and arguments evolving over time. Advocates
of free trade typically argue that consumers benefit from freer trade
and forward many reasons in support of their position:
 Free trade and the resulting foreign competition forces
domestic companies to keep prices low
 Consumers have a larger variety of goods and services to
choose from in open markets
 Domestic companies have to modernise plants, production
techniques and technologies to keep themselves competitive
 Any kind of protectionist measures, like tariffs, often bring
about retaliatory actions from foreign governments, which
may restrict the sale of domestic goods in their markets.
 An open trading system creates a better climate for
investment and entrepreneurship than the one in which there
is fear of governments cutting off access to certain markets.
CHECK YOUR PROGRESS

True or False.
(a) Advocates of free tradebelieve that
governments must take action to regulate trade and subsidize
industries to protect their domestic economy. (T/F)
..........................................................................................................
(b) An open trading system creates a better climate for investment.
(T/F)
..........................................................................................................
Q 2: Mention any two important arguments in favour of free trade.
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................
..................................................................................................................................................................................................................................
2.4 IMPORTANCE OF PROTECTION IN DEVELOPING

COUNTRIES
Various arguments are put forward in favour of the need for

protection in developing countries. These are:
 Capital formation: In the developing countries, savings of the people
is very low. As a result, capital formation becomes very low. Restriction
imposed on import of luxury consumer goods in the form of prohibitive
import duties would help the developing countries in containing outflow
of limited domestic resources. Through such measures, savings can
be increased and this would also help in capital formation.
 Foreign investment: Protection may also act as a source of capital
formation. It may attract foreign direct investment. According to
Professor Mundell, protection leads to additional flow of foreign capital.
When a particular country imposes high rates of tariffs on import of
finished products while no tariffs are imposed on import of raw

materials, a foreign firm may set up its branch in that tariff imposing
country or may collaborate with domesitc corporations of that country.
As a result, the foreign firm may take the advantage of the tariff wall.
In this way, the foreign firms may be encouraged to invest in the tariff
imposing country.
 Revenue Generation: Protection measures like import and export
duties also help countries in revenue generation. The revenue
sources are very limited in the developing countries, and as such,
import and export duties can help the countries in revenue generation.
Again, by imposing higher rates of tariff on imported luxury consumer
goods, revenue generation may be significantly enhanced.
 Infant industry argument: According the 'infant industry' argument,
'infant' industries of the developed countries need protection from
foreign competition till they attain adulthood. The argument rests on
the proposition that in the developing countries there are some
industries which can be fruitfully developed in the domestic country
itself, provided they are protected from foreign competition. The period
between infancy and adulthood is generally characterised by a
transition of the economy from the agricultural stage to the industrial
stage.
 Terms of trade argument: Developing countries generally have
unfavourable terms of trade in relation to the developed countries.
Through imposition of tariffs, developing countries can shift the terms
of trade in their favour.
 Balance of payments: Developing countries are prone to balance of
payment disequilibrium. Total value of imports of the developing
countries generally outweigh the total value of exports. As a result,
serious balance of payment disequilibrim occur. Trade protection
measures, like tariffs can cut down import of goods and this can
significantly help the developing countries to correct their balance of
payment disequilibrium.
 Planned economic development: Most of the developing countries
follow the path of planned economic development. Thus, these

economies need to spend all the available resources in a planned
manner. The foreign exchange reserves of the developing countries
are also very limited and as such, they must be judiciously spent, as
per plan. To meet the demand of the domestic industries, these
countries have to import heavy machineries or raw materials, which
require significant amount of foreign exchange reserves. Thus, import
prohibit measures to control import of non-essential items may help
these countries save foreign exhange reserves, and thereby promote
economic development of the countries.
2.5 MEASURES OF PROTECTION
Governments use a variety of tools to manage their countries'

international trade positions. These include:
 Tariffs: Tariffs are taxes on imports. Tariffs can be levied both on
imports and exports. Import tariffs are levied on goods and services
to be imported from a foreign country to the home country, while
export tariffs are levied on goods and services to be exported from
the home country to a foreign country. Tariffs make the items more
expensive for consumers, thereby reducing the demand.
Tariffs may be of different types. They are specific tariff, ad
valorem tariff, compound tariff and sliding scale tariff. Specific tariff
is the fixed amount of money per physical unit or according to the
weight or measurement of the commodity imported or exported.
Such duties are levied usually on goods like wheat, rice, fertilisers,
cement, sugar clothes etc. However, they are not very much applied
to such commodities like diamond, jewellery, watches etc.
'Ad valorem' tariffis imposed as a fixed percentage of the value
of the commodity. Suppose, ad valorem tariff on imported watches
is 50%. Thus, an imported of Rs.10000/- would have an ad valorem
tariff of Rs. 5000/-. This means the price of the imported watch will
be Rs. 15000/.

Compound tariff is a combination of both the specific tariff and

ad valorem tariff. Thus, it means that products on which compound
tariff are imposed will bear both specific tariff and ad valorem tariff.
In this case, specific tariff is imposed on each unit of the commodity,
and a fixed percentage of ad valorem tariff is also charged on the
value of the product.
Sliding scale tariff means that import duties may vary depending
on the price of the imported commodity. The rate of tariff that has
been fixed may be either specific tariff or ad valorem tariff.
 Import Quotas: Governments sometimes restrict the sale of foreign
goods by imposing import quotas. Such restrictions may be imposed
both in terms of volume of imports or in terms of value of imports.
These measures help domestic producers by limiting the share of
the market that can be taken by foreigners. Import quotas may be
classified as tariff or custom quota, unilateral quota, bilateral quota
and mixing quota. Under the tariff or custom quota system, a certain
specified volume of a commodity is allowed to be imported by the
government of the importing country either duty free or at a low rate
of import duty. When the volume of imports is greater than the
specified limit, higher rate of tariff is imposed.
Under the unilateral quota system, the total volume of import of
a commodity remains fixed during a given period. Such import
quotas are fixed without any prior negotiation or agreement with the
foreign countries.
Under the bilateral quota system, the total volume of import of
a commodity remains fixed during a given period. Such import
quotas are fixed after negotiations between the importing and
exporting countries.
Under the mixing quota system, the domestic producers in the
quota-fixing country are required to make use of domestic raw
materials along with the imported raw material in a specified proportion.
 Voluntary Restraints: Sometimes governments negotiate
agreements whereby a country agrees to voluntarily limit its export
of a certain product. Japan voluntarily limited its export of cars to

the United States in 1992 to 1.65 million cars per year.
 Subsidies: Another way to achieve the goals of protectionism is to
make the domestic industry more competitive. Subsidies, which are
grants by the government to an industry, can accomplish this.
Subsidies can be:
 Direct-outright payments
 Indirect-special tax breaks or incentives, buying of surplus goods,
providing low-interest loans or guaranteeing private loans.
 Trade Ban: Sometimes governments ban trade with certain countries
for political reasons-during times of war or political crisis. Governments
also ban import of certain products to protect domestic industries.
CHECK YOUR PROGRESS

Q 3: How do the import duties help in capital
formation? (Answer in about 40 words)
................................................................................................................
................................................................................................................
................................................................................................................
Q 4: What do you mean by unilateral trade quota? (Answer in
about 40 words)
................................................................................................................
................................................................................................................
................................................................................................................
2.6 LET US SUM UP
 Free trade proponents stand for an open trading system with few
limitations and little government involvement.
 Advocates of protectionism believe that governments must take
action to regulate trade and subsidize industries to protect their
domestic economy.
 All governments practise protectionism to some extent.

 Developing countries need trade protection as it helps them in capital
formation, increases foreign investment, helps in revenue generation.
 Further trade protection in developing countries can also be judged
on the basis of infant industry argument and the terms of trade
argument.
 Trade protection also helps the developing countries in improving
their balance of payments position and it helps in their planned
economic development.
 Governments use a variety of tools to manage their countries'
international trade positions. These include tariffs, import quotas,
voluntary restraints, subsidies, trade ban etc.
2.7 FURTHER READING
1) Dudley, D. (1981). The Economics of John Maynard Keynes. New

Delhi: Vikash Publishing House Pvt. Ltd.
3) Rana, K. C. &Verma, K. N. (2004). International Economics.
4) Shapiro, E. (1988). Macroeconomic Analysis. New Delhi: Galgotia
Publications Pvt.Ltd.

PROGRESS
Ans to Q No 1: (i) False (ii) True

Ans to Q No 2: Two important arguments in favour of free trade are:
Free trade creates a better climate for investment and

entrepreneurship than the one in which there is fear of

governments cutting off access to certain markets.
Under the environment of free trade, consumers have a larger
variety of goods and services to choose from in open markets.
Ans to Q No 3: Restriction imposed on import of luxury consumer goods
in the form of prohibitive import duties would help the developing
countries in containing outflow of limited domestic resources.
Through such measures, savings can be increased and this would
also help in capital formation.
Ans to Q No 4: Unilateral trade quota is one of the instruments of trade
protection. Under the unilateral quota system, the total volume of
import of a commodity remains fixed during a given period. Such
import quotas are fixed without any prior negotiation or agreement
with the foreign countries.
2.9 MODEL QUESTIONS

Q 1: Put forward your arguments in favour of and against free trade.
Q 2: Write a short note on the tools of trade protection.

Q 1: Outline the importance of trade protection. Discuss the various
tools of trade protection that can be effectively used by the
developing countries.
*** ***** ***

UNIT 3 : THE OPPORTUNITY COST THEORY
UNIT STRUCTURE

3.2 Introduction
3.3 Haberler's Opportunity Cost Theory
3.3.1 Constant Opportunity Cost Curve
3.3.2 Increasing Opportunity Cost Curve
3.3.3 Decreasing Opportunity Cost Curve
3.3.4 Constant Opportunity Cost and International Trade
3.3.5 Increasing Opportunity Cost and International Trade
3.3.6 Decreasing Opportunity Cost and International Trade
3.4 Advantages of Haberler's Opportunity Cost Theory
3.5 Drawbacks of Haberler's Opportunity Cost Theory
3.6 Let Us Sum Up
3.7 Further Reading
3.9 Model Questions
After going through this unit, you will be able to:

 discuss the basis of trade in addition to absolute and comparative
advantage models
 distinguish between Haberler's opportunity cost theory and
Ricardian Comparative Cost Advantage theory
 elaborate how country gains from international trade when returns
to scale are different
 explain major limitations of Haberler's opportunity cost theory.
3.2 INTRODUCTION
In this unit, Haberler's opportunity cost theory has been discussed.

This theory offers and alternative explanation to the theory of international

Unit 3 The Opportunity Cost Theory
trade, particularly relating to the basis of international trade. This unit

begins with the discussion of the concept of opportunity cost. Then we
shall discuss its application. Finally, its advantages and disadvantages
have been discussed.
3.3 HABERLER'S OPPORTUNITY COST THEORY
The opportunity cost theory was put forward by Gottfried Haberler

in 1936. With the help of this theory, Haberlertries to explain the theory
of comparative advantage of international trade on the basis ofopportunity
cost. In Haberler's words, "the marginal cost of a given quantity (x) of a
commodity, say, A must be regarded as the quantity of commodity, say,
B must be forgone in order that X, instead of (X-1) units of A can be
produced. The exchange ratio on the market between A and B must
equal their costs in this sense of the terms."
According to the opportunity cost theory, the cost of a commodity
is the amount of a second commodity that must be given up to release
just enough resources to produce one additional unit of the fixed
commodity. This is basically a reformulation of the Comparative Advantage
Theory of international trade in terms of opportunity cost.
The opportunity cost theory analyses pre-trade and post trade
situations under constant, increasing and decreasing opportunity cost.
Unlike theRicardian theory, in this theory, Haberlerdidn't make assumption
that labour is the only factor of production and labour is homogenous. In
fact, it is not based on the labour theory of value. The theory is based
on the proposition that the country with the lower opportunity cost in
production of a commodity enjoys comparative advantage in that
commodity and a comparative disadvantage in the second commodity.
The theory rests upon the following assumptions:
 The economic system is in a state of full employment equilibrium.
 There is perfect competition in commodity and factor markets.
 Price of each factor equals its marginal product.
 Price of each commodity equals the marginal cost of producing it.
 The supply of factors is fixed.
36
International Economics, Block-1
The Opportunity Cost Theory Unit 3
 The state of technology is given.

 There are only two countries -A and B.
 Each country produces two commodities viz. commodity x and
commodity y.
 There are two factors of production viz. labour and capital.
Production
 Factors are perfectly mobile within the country but immobile between
Possibility or
countries. Transformation
 There is free trade between the countries. curve: shows the
Based on these assumptions, Haberler provides the exchange ratio maximum quantity of
two goods that an
between two commodities in terms of opportunity cost which can be
economy can produce
expressed in terms of production possibility or transformation curve. by fully utilizing its
The opportunity cost curve (or production possibility curve) may be a straight resources and
line, convex to the origin or concave to the origin depending on whether technology.
return to scale in a country is constant, increasing or decreasing respectively.
3.3.1 Constant Opportunity Cost Curve
In Figure 3.1, commodity-xis measured along the horizontal

axis and commodity-y is measured on the vertical axis. AB is the
opportunity cost curve. At every point on the straight line or
opportunity cost curve AB Marginal Rate of Transformation (MRT)
remains equal. That is
That is along the curve, the marginal cost of producing

commodity-x and commodity-y remains unchanged and production
of both the commodities is governed by constant returns to scale or
constant opportunity cost. In this, all factors are equally efficient in
all lines of production.
37
International Economics, Block-1
Figure 3.1: Constant Opportunity Cost Curve
LET US KNOW
If two commodities viz. X and Y are produced by a
country using two factors of production such that
X=f(L, K) or Y=f(L,K), and some quantities of labour
and capital are diverted from the production of
commodity-Y to the production of commodity X, the additional
production of commodity-X involves sacrifice of some quantities
of Y. Thus, the rate at which Y is substituted for one unit gain in
X is called as marginal rate of transformation. Symbolically,
MRT_xy=dy/dx=(  c/  x)/(  c  /  y).
3.3.2 Increasing Opportunity Cost Curve
Figure 3.2 representsthe case of increasing cost condition.

In the figure, AB is concave to the origin i.e.
It means that for production of each extra unit of commodity-

x a larger unit (amount) of commodity-y is to be forgone.

Figure 3.2: Increasing Opportunity Cost Curve
3.3.3 Decreasing Opportunity Cost Curve

Figure 3.3 representsthe case of decreasing cost condition.
It is the case of decreasing cost condition or increasing returns.
In figure 3.3, AB is opportunity cost curve and it is convex to the
origin. Here, the Marginal Rate of Transformation (MRT) is
decreasing.
Figure 3.3: Decreasing Opportunity Cost Curve

It means that for production of extra unit of commodity-x

a smaller amount of commodity-y is to be forgone. The convexity
of the opportunity curve implies a negative slope indicating a
decreasing MRT_xy.
Returns to scale: Let us now discuss international trade in terms of
the rate at which
opportunity cost under three returns to scale condition discussed
output changes as the
above.
quantities of all inputs
are varied in the same
proportion. If for CHECK YOUR PROGRESS
example, inputs are Q 1: What determines the shape of the
doubled and as a
opportunity cost curve? Answer in about 30
result output is also
doubled, constant words.
return to scale exist. If ...........................................................................
output goes by less ............................................................................................................
than the doubling of
............................................................................................................
inputs, decreasing
returns to scale
Q 2: Which tool did Haberler use to explain the comparative cost
prevails. Finally, if advantage theory of international trade? Answer in about 20 words.
output goes by more ............................................................................................................
than the doubling of
............................................................................................................
inputs, returns to scale
will be increasing
3.3.4 Constant Opportunity Cost and International Trade
returns to scale.
The MRTxy is constant and the opportunity cost curve is a

straight line when the production process is governed by constant
returns to scale. Thus, the relative cost of producing the
commodities x and y remains constant irrespective of the ratio in
which they are demanded. If the slopes of the opportunity cost
curves of two countries are same, i.e. the opportunity cost curves
are parallel to each other, then in this case no trade is possible
between them. This can be explained with the help of Figure 3.4.
In Figure 3.4, AB and A1B1 are opportunity cost curves of
country A and country B respectively. AB and A1B1 i.e. the
opportunity cost curves are parallel as their slopes are equal.

and are the slopes of AB and A 1 B 1 respectively
and .
Figure 3.4: International trade does not take place when slopes of
opportunity cost curves are same
From Figure 3.4 it can be seen that as the cost ratios of

A and B are equal therefore no international trade between the
countries take place. The gains from international trade can emerge
only when the slopes of opportunity curves are different. This has
been explained with the help of Figure 3.5.
Figure 3.5: International trade take place when slopes of opportunity
cost curves are different

In Figure 3.5, AB and AB1 are opportunity curves of Country

A and B respectively. The slopes of opportunity curves AB and
AB1 are different. The slopes of AB and AB1 signify that country
A has comparative advantage in the production of commodity-y
over country B and country B has comparative advantage in the
production of commodity-x over country A. Therefore, country A
specialises in the production of y and country B specialises in the
production of x. The exchange ratio between country A and country
B is shown by dotted line AB1. Suppose country A wants to
consume at R on AB1, then A can export AS (NR) quantity of Y
and import SR (or AN) quantity of commodity x. Similarly, if country
B wants to consume at AR1 on AB1, then country B can export S1
B1 (or R1 N1)quantity of x and import R1 S1 or B1 N1 quantity of
commodity-y. the opportunity cost curve AB shows that as quantity
of commodity Y can be exchanged for ST quantity of X in the
domestic market. But as international trade takes place in between
A and B, as quantity of commodity y can be exchanged for SR
quantity of x. Therefore, countryA gains TR quantity of commodity-
X, in the same way B1 S1 quantity of commodity-x can be
exchanged for S1 T1 quantity of commodity-Y in the domestic
market. While international trade permits the exchange of B1 S1
quantity of x for R1 S1 quantity of y. Thus the country B gains R1
T1 (=R1 S1-T1 S1) quantity of commodity-y.
3.3.5 Increasing Opportunity Cost and International Trade
When the production process is governed by decreasing

returns to scale the opportunity cost is increasing. The international
trade in this situation between country A and B can be explained
with the help of Figure 3.6.
The case of country A: In Figure 3.6, AB is the opportunity
cost curve for country A. It is concave to the origin. EE is the
domestic price ratio line before trade in country A. EE is tangent
to the opportunity cost curve AB at R. FF is the international price
ratio line. FF is tangent to AB at S.

Figure 3.6: Increasing opportunity cost and international trade
(Country A)
Country A specialises in the production of y and if the

point of consumption in A is at T then A will export SN quantity
of y to import NT quantity of x. The consumption point T will lie
on a higher community indifference curve from the point r before
trade. So A will increase its welfare after trade.
The case of Country B: In Figure3.7,A1 B1 is the opportunity
cost curve of country B.Before international trade, E1 E1 is the
domestic price ratio line and it is tangent to A1 B1at R1.
Figure 3.7: Increasing opportunity cost and international trade
(Country B)

When international trade takes place F1 F1 is the international

price ratio line and it is tangent to A1 B1at S1. Country B specialises
in the production of x. if the point of consumption is T1 country B will
export N1 S1 quantity of x and import N1 T1 quantity of y. Country B
will get higher satisfaction at T1 than at R1. When equilibrium situation
is achieved by A and B, the export of SN quantity of y equals the
import of N1 T1 quantity of y and export of N1 S1 quantity of x equals
the import of NT quantity of x.
LET US KNOW
If both countries are of equal size, there will be
complete specialisation in both the countries. If one
country is large and another is small, there will be
complete specialisation in the smaller country while the larger country
will have only partial specialisation. Thus, in this situation, the smaller
country gains more than the larger country.
In the situation of increasing costs, the countries will not specialise
completely because the increased production may result in loss
of comparative advantage vis-à-vis the other country.
3.3.6 Decreasing Opportunity Cost and International

Trade
When the production process in both countries A and B

are governed by decreasing returns to scale, the opportunity cost
curves are convex to the origin. The international trade in this
situation has been explained with the help of Figure 3.8.
In Figure 3.8, AB and A1 B1 are the opportunity curves of
country A and B respectively. EE is the domestic price ratio for
country A and FF is the domestic price ratio for country B. Before
international trade, EE is tangent to AB at R and it is production
equilibrium for country A and at that point, price line EE becomes
equal to the MRTxy. Similarly, in the absence of international
trade, the FF is tangent to A1 B1 at point S which determines the
production equilibrium for country B. When international trade

takes place, the international exchange ratio line is AB1.
Figure 3.8: Decreasing opportunity cost and international trade
The position of opportunity cost curve and the greater

steepness of domestic price line EE relative to international
exchange ratio line AB1 shows that A will specialise completely in
the production of y and it will export y and import commodity x.
while, the position of opportunity cost curve A1 B1 and relatively
greater steepness of AB1 than domestic price ratio line FF,
determines that country B will specialise completely in the
production of commodity x. Thus country B will export commodity
x and import commodity y.
The point of consumption equilibrium for A and B determined
by the tangency between opportunity cost curves and the
international exchange ratio line AB1. This tangency point will provide
a higher level of satisfaction than points R and S. Thus, there will be
gains from international trade for both the countries A and B.
3.4 ADVANTAGES OF HABERLER'S OPPORTUNITY

COST THEORY
Harberler's opportunity cost theory has the following advantages:

 It is more exact, precise and scientific in explanation of international
trade than real cost approach.

 It has better applicability than Ricardian approach as it discarded
the labour theory of value and attempted to build the model of
international trade more realistically with the assumptions like two
or more factors of production.
 Haberler's theory explained the international theory in situations of
constant, increasing and decreasing returns to scale.
 Haberler also tried to explain the international trade theory when
costs are increasing, decreasing and constant.
 Haberler took into account the factor substitution while explaining
gains from international trade.
3.5 DRAWBACKS OF HABERLER'S OPPORTUNITY

COST THEORY
Though Haberler's opportunity cost theory is very relevant to the

international trade, it has some limitations. These are:
 According to Jacob Viner, opportunity cost theory was inferior to the
real cost approach.He claimed that opportunity cost theory failed to
measure real costs in terms of strain, sacrifice and disutility.
 Jacob Viner also criticised the opportunity cost theory on the ground
that it neglects the changes in the factor supplies.
 The opportunity cost theory is based on many unrealistic and invalid
assumptions like absence of external economies of scale or
diseconomies of scale and perfect competition in both product and
factor markets fixed factor supplies etc.
 Jacob Viner also criticised the opportunity cost theory on the ground
that it failed to take into account the preference for leisure vis-à-vis
income.
Though Jacob Viner put several objections against the Haberler's
opportunity cost theory, those were not valid. In fact all these limitations
are disapproved by many economists like Kemp, V.C. Walsh, Samuelson
etc.

CHECK YOUR PROGRESS

Q 3: On what ground the Haberler's opportunity
cost theory is superior to the Ricardian theory of
international trade? Answer in about 40 words.
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Q 4: Mention any two major criticisms levelled against Haberler's
opportunity cost theory of international trade. Answer in about 40
words.
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..........................................................................................................
..........................................................................................................
3.6 LET US SUM UP
 Haberler's opportunity cost theory can be described as the

reformulation of comparative cost theory of international trade.
 Unlike other theories, this theory is mainly based upon opportunity
cost of producing one more unit of a good when a country produces
only two goods by fully employing its available resources.
 This theory proves to be an improvement over other theories because
it analyses international trade under increasing and decreasing
returns to scale besides constant return to scale.
3.7 FURTHER READING
1) Cherunilam, F. (2017). International Economics. New Delhi: McGraw

Hill Education.

3) Mithani, D. M. (2011). International Economics. Mumbai: Himalaya
Publishing House,
4) Rana, K. C. &Verma, K. N. (2004). International Economics.
5) Salvatore, D. (2004). International Economics. New Delhi: Willey-
India.
6) Vaish, M. C. & Singh, S. (2012). International Economics. New
Delhi: Oxford and IBH Publishing Co. Pvt. Ltd.

PROGRESS
Ans to Q No 1: The shape of the opportunity cost curve (or production

possibility curve) whether it will be a straight line, convex to the
origin or concave to the origin depends on whether return to
scale in a country is constant, increasing or decreasing respectively.
Ans to Q No 2: Haberler tries to explain the theory of comparative
advantage of international trade with the help of the concept
opportunity cost.
Ans to Q No 3: Haberler's theory of international trade is better that the
Ricardian theory as it discarded the labour theory of value and
attempted to build the model of international trade more realistically
with the assumptions like two or more factors of production.
Ans to Q No 4: Two major criticisms levelled against the Haberler's
opportunity cost of international trade include:
The opportunity cost theory utilised by Haberler neglects the
changes in the factor supplies.
The opportunity cost theory failed to take into account the
preference for leisure vis-à-vis income.

3.9 MODEL QUESTIONS
A) Very Short Questions (Answer each question in about 50 words)

Q 1: When did Haberlerpropose the opportunity cost theory?
Q 2: State Harberler's opportunity cost theory.
Q 3: State two differences between Ricardian Cost Advantage theory
and Harberler's Opportunity Cost Thoery.
Q 4: What is the shape of constant opportunity cost curve?
Q 5: What is the shape of increasing opportunity cost curve?
Q 6: What is the shape of decreasing opportunity cost curve?
Q 7: What is the shape of decreasing opportunity cost curve?
Define MRTxy.
Q 8: Who propounded the opportunity cost theory?
Q 9: Can international trade is possible when the opportunity cost curve
of two countries are parallel to each other?
Q 10: In which situation, complete specialisation in the countries of equal
size can be achieved?
B) Short Questions (Answer each question in about 150 words)

Q 1: Mention the assumptions on which the opportunity cost theory is
based on?
Q 2: Diagrammatically explain the Constant Opportunity Cost curve.
Q 3: With the help of diagram, show the shape of increasing opportunity
cost curve
Q 4: With the help of diagram, show the shape of decreasing opportunity
cost curve.
Q 5: How does Harberler's opportunity cost theory relevant to the
Q 6: What are the drawbacks of Harberler's opportunity cost theory?
Q 7: Make a critical evaluation of opportunity cost theory of international
trade.

C) Long questions (Answer each question in about 300-350 words)

Q 1: Explain Haberler's Opportunity Cost Theory.
Q 2: Discuss international trade under the condition of constant
opportunity cost based on Haberler's opportunity cost theory.
Q 3: Discuss international trade under the condition of increasing
Q 4: Discuss international trade under the condition of decreasing
Q 5: Critically explain the opportunity cost theory.
*** ***** ***

UNIT 4 : THE HECKSHER-OHILIN THEORY
UNIT STRUCTURE

4.2 Introduction
4.3 The Hecksher-Ohlin Theory of International Trade
4.3.1 Assumptions of the Hecksher-Ohlin Theory
4.3.2 Factor Abundance: Physical Criterion
4.3.3 Factor Abundance: Factor Price Criterion
4.4 Factor Intensity
4.5 Basic Ideas of Hechsher-Ohlin Theory
4.6 Superiority of Hecksher-Ohlin Theory over Classical Theory
4.7 Criticisms of the Hecksher-Ohlin Theory
4.8 Let Us Sum Up
4.9 Further Reading
4.11 Model questions

 put forward arguments of neo classical theory of international
trade
 state the assumptions of the Hecksher-Ohlin theory of international
trade
 describe the concepts like-factor endowment and factor intensity.
 discuss the superiorities of H-O theory over the classical theory
of international trade
 critically discuss the H-O theory of international trade.
4.2 INTRODUCTION
The rationale behind trade between nations is one of the fundamental

issues in international economics. Hosts of economists have put forward
Unit 4 The Hecksher-Ohilin Theory
their explanations of origin and propagation of international trade

emphasizing different aspects of trade. Accordingly we have a plethora of
theories on international trade. However, the pioneering work on international
trade theory is attributed to David Ricardo who gave us the theory of
Comparative Cost Advantage theory of trade by improving upon Adam
Smith's Absolute Cost Advantage theorem. Till date, most of the theories
on international trade can be traced to the Ricardian theory. The Heckscher-
Ohlin theory can be seen in the same light that extended the idea of
comparative cost advantage to a country's resource endowments. By using
the standard neo classical framework they could explain why a particular
country exports a particular product and imports another. Their theory is
recognized as the neo classical theory of international trade that has given
rise to certain important propositions that includes factor price equalization
among the trading countries. In this unit we are providing a simple
presentation of the Heckscher-Ohlin theory highlighting the essential
elements in it along with its theoretical and empirical limitations.
4.3 THE HECKSHER-OHLIN THEORY OF

INTERNATIONAL TRADE
The neo classical theory of international trade that is known as

Heckscher-Ohlin (H-O) theory was advocated by the Swedish economist
Eli Heckscher in an article published in year 1919. This theoretical idea
was further improved by Bertil Ohlin in his research paper title 'International
and Inter-regional Trade' in year 1933.
In the earlier unit, we have already discussed that the Ricardian
theory of comparative cost advantage explains that comparative advantage
is the base for international trade. But Ricardo fails to explain that what are
the sources of countries comparative advantage. The Hecksher-Ohlin theory
of international trade does explain the basis for comparative advantage in
terms of factor abundance and factor intensity. Therefore, it becomes
necessary to understand the postulates of the theory of international trade
and its two conceptual frameworks i.e. factor abundance and factor intensity.
The theory states that there is difference in factor endowments
The Hecksher-Ohilin Theory Unit 4
among different countries in the world. For example- there are countries
having comparatively large supply of labour. At the same time, there are
other countries where supply of capital is relatively large. As a result of the
difference in factor endowments, there is difference in cost of factors.
Therefore, having differences in the cost of factors, there is difference in
the costs of the goods. On the basis of this fact, this theory explains that
the primary cause of differences in comparative cost is the difference in
factor endowment. As a result, international trade takes place because of
diversity in factor endowments.
On the basis of this fact, this theory states that a country would
be exporting the commodity in the production of which such factor is
intensively used whose supply is relatively abundant. Similarly, a country
would import that commodity in the production of which that factor is
used less intensively whose is supply is relatively scare.
According to Bo Sodersten the fundamental principle of this theory
is 'some countries have much capital, other have much labour. The theory
now says that countries that are rich in capital will export capital intensive
goods and countries that have much labour will export labour intensive
goods'.
Salvatore describes that "The Heckscher-Ohlin Theory explains
the differences in relative factor endowments and factor prices between
nations and that is the most important cause of trade. This theory predicts
that each nation will export the commodity in the production of which a
great deal of relatively abundant and cheap factors is used and import
the commodity in the production of which a great deal of its relative
scares and expensive factor is used. The theory also predicts that trade
will lead to the reduction in the difference in factor prices between nations".
Further, Bertil Ohlin states that ' The immediate cause of inter-
regional trade is always that goods can be bought cheaper in terms of
money than they can be produced at home and here is the case of
international trade'.
In simple words, this theory advocates that 'a nation will export
the commodity whose production requires the intensive use the nation's
relatively abundant and cheap factor and import the commodity whose
production requires the intensive use of nation's relatively scare and
expensive factors'. It means that nation will export the product that uses
its most abundant factor intensively. The H-O theory explains the
comparative advantage of trade in terms of two crucial concepts i.e.
factor abundance and factor intensity.
4.3.1 Assumptions of the Heckscher-Ohlin Theory
 There are two countries, each having two factors of

production (Labour and Capital) and producing two
commodities i.e. X and Y.
 There is perfect competition in both commodity and factor
markets.
 All factors of productions are homogeneous of the first degree
i.e. production is subject to constant returns to scale.
 Factors of production are mobile within the country but
immobile between countries.
 Two countries differ in factor supply.
 He production functions are such that the two commodities
show different factor intensities.
 The production functions differ between commodities, but
are the same in both commodities. Technique of production
of X will be different from the technique of production of Y.
But good X is produced using the same technique in both
countries, and good Y is produced using the same technique
in both the countries.
 There exists full employment of factors in both the countries.
 Trade is free and there are no restrictions in the forms like-
tariff and non-tariff barriers.
 There is no transportation cost.
 Consumer's test and preferences are identical in the two
countries.

Before we take up the explanation of the theory using the

above assumptions, it is important to note that the factor abundance
can be interpreted in two alternative ways: one in terms of physical
criterion and the other in terms of factor price criterion.
4.3.2 Factor Abundance: Physical Criterion
In a two country model, if we say that country-I is capital

abundance, then it means that the ratio of total amount of capital
(TK) to the total amount of labour (TL) that is (TK/TL) in country-
I is greater than country-II.
TK1 TK 2

TL1 TL 2
In this analysis, we must remember that it is not the
absolute amount of capital and labour but the ratio of total amount
of capital to total amount of labour. Interestingly, Country -I may
have lesser quantity of capital as compared to Country -II, yet
Country -I would be capital abundance if TK to TL in Country -I
is greater than in Country -II.
 Graphical Presentation: A production function shows that
relationship between input of factors of production, in the
following analysis capital (K) and Labour (L), and the output of
goods. Factor abundance in physical term can also be
explained with the help of production possibility curve or
production frontier.

Figure 4.1: Factor Abundance in Physical Terms
 Explanation of the Figure: Figure 4.1 shows the production

possibility curve in context with two country, two commodities
and two factor model. K axis represents capital and L axis
shows Labour. Similarly, two commodities are produced X
and Y. In this diagram, country-I is capital abundance and as
a result the production possibility curve is tilted towards K
axis. On the other hand, country-II is labour abundant and
the production possibility curve is tilted towards L axis. In
this diagram, commodity Y is capital intensive and commodity
X is labour intensive.
PP1 and PP2are the domestic price lines of country-I
and Country-II respectively. The equilibrium points E and Q
are the points of consumption and production. Price line P1
and P2 shows that commodity Y is cheaper in country-I and
commodity X is cheaper in country-II. This is the basis for
In this figure, country-I would produce OA of commodity
Y (CA quantity more than country-II). At the same time
country-II would produce OD of commodity X (BD quantity
more than country-I). Country-I can produce more capital
intensive goods because its capital abundance country and

Country-II can produced more of labour intensive goods
because it's labour abundance country.
4.3.3 Factor Abundance: Factor Price Criterion
Under factor price criterion, a country is capital abundant

only when the ratio of the capital price to the labour price (PK/PL)
is lower. It can be stated as: -
TK1 TK 2

TL1 TL 2
We know that cost/price of factors such as capital and
labour is expressed in terms of interest (r) and wages (w).
Accordingly in country-I, if the price of capital (r- rate of interest)
is lower than the price of labour (w- wages), and in country-II, r
is more than w, then we have-
r1 r 2

w1 w 2
In this case, country-I is capital abundance. Graphical
explanation is given below.
Figure 4.2: Factor Abundance in Factor Price Terms

 Explanation of the Figure: Figure 4.2 depict a two country,

two commodity and two factor model. Here, we have country-
I and country-II, commodity a & b, and capital and labour
are the factors of productions. Commodity a is capital
intensive and b is labour intensive. There are two isoquants
aa & bb. The relative factor price in country-I is given by
factor price line PL. Assuming that the isoquants represents
1 unit of commodity a & b, country-I requires ON of capital
and OM of labour to produce 1 unit of a at point E, the point
of tangency between isoquants aa and factor price line PL.
Similarly, commodity b is produced with ON1 of capital
and OM1 of labour. It's possible to observe that in country-I
capital is cheaper than labour because more capital (OP) is
available than labour (OL). As a result, country-I would
specialize in the production of commodity a that is capital
intensive.
Country-II, price line is given by AB. In country-II, in
order to produce commodity b, it requires OR of capital and
OQ of labour.
In order to find out the requirements to produce
commodity a, in country-II, we draw a factor price line CD
parallel to AB. This line tells us that in order to produce
commodity a, country-II requires OR1 of capital and OQ1 of
labour. Commodity b is labour intensive, country-II is labour
abundance will specialized in commodity b. It means that
(Country-II, being a capital scare country it cannot specialized
in the production of commodity a that requires more capital.
In short, factor prices are low for capital in country-I and
for labour in country-II. This can be understood by their
respective factor price line PL and AB = CD. This paves the
way for country-I to specialize in commodity a that requires
more capital and that is available plenty in the country.
Country-II specialized in b that requires more labour that is
available in abundance making it cheaper.
CHECK YOUR PROGRESS

Q 1: Why does, according to the H-O theory,
international trade take place between two
nations? (Answer in about 60 words).
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
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Q 2: When does, according to the H-O theory, a country would
choose to export a commodity? (Answer in about 40 words).
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...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
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4.4 FACTOR INTENSITY
Factor intensity means relative proportion of the various factor of

production used in the production of commodity. Factor intensity explains
that in the production of commodity how much capital is used as compared
to labour.
In the production of commodity of Y, if capital - labour ratio (K/L)
is greater than (K/L) used in the production of commodity X, than we can
say that commodity Y is capital intensive. Intensity of factor of production
i.e. capital or labour is not measured in absolute terms but in terms of
ratio. For example-
Units of capital per labour
Units of labour per capital

Table 4.1
Commodity Capital Labour K/L Ratio
Y 04 04 1
X 02 08 1/4
If in the production of commodity Y, we require 04 units of
capital (4K) and 04 units of labour (4L), the capital - labour ratio (K/L)
would be 1.
4K
1
4L
Similarly, if in the production of commodity X, the required inputs
1
are 2K and 8L, than the capital - ratio is
4
Ratios:
K 4K
Commodity Y, the  1
L 4L
K 2K 1
Commodity X, the  
L 8L 4
On the basis of these examples, we can say that commodity Y is
capital intensive because capital - labour ratio in the production of
commodity Y is greater than the capital- labour ratio used in the production
of commodity X.
In an alternative condition (different combination of K & L), lets
assumes that- if units of capital and labour used in the production of Y
are 4K and 4L, and similarly for the production of commodity X, if 4K and
16L are required. Even in this alternative combination of factors, commodity
Y still remains capital intensive though commodity X requires more
capital.Why? Because, capital - labour ratio of commodity Y which is
capital intensive is 4/4 = 1, whereas X is labhour intensive because it's
capital - labour ratio is ¼. It must be noted that factor intensity is measured
by factor ratios and not by absolute units.
Table 4.2
Commodity Capital Labour K/L Ratio
Y 04 04 1
X 05 16 1/4
 Graphical Presentation: Figure 4.3 shows panels a and b,

which represent country-A and country-B respectively.
Figure 4.3: Panel (a)
4.5 BASIC IDEAS OF THE HECKSHER - OHLIN

THEORY
Based on the concept of factor endowments, the Hecksher-Ohline

theory maintains that every country has different factor endowments.
Thus, the costs of these factors in each country differs depending upon
their availability. For example, if a country has abundant labor, then the
cost of labor would be low in that country.
According to Heckscher and Ohlin theory, a country would export
products, which it produces by using the abundant factor of production.
However, it would import goods, which require the use of scarce resources.
Countries trade with each other because they have different factor
endowments. Thus, according to this theory, some countries may have
more labour and less machinery and some may have more machinery and
less labour. In such a case, the country with more labour would specialise
in labour-intensive products and export those products to other country.
The Heckscher and Ohlin theory also exhibits relationship among

various variables. Accoridng to the theory, the prices of the factors are
determined by their availability, which further determines the price of the
product. Cost advantage and specialization occurs as a result of difference
of factor prices and product price.
4.6 SUPERIORITY OF HECKSHER - OHLIN THEORY

OVER CLASSICAL THEORY
While comparing the Hecksher-Ohlin theory with classical theory

of international trade (Absolute cost advantage by Adam Smith and
Comparative cost advantage by David Ricardo), we must understand that
H-O theory does not contradict with classical explanation. On the contrary,
H-O theory modifies the classical explanations especially comparative
cost advantage.
In classical theory of international trade, labour is the only factor
of production; cost of production is measured in terms of labour only. The
neo classical theory of international trade gives importance to both labour
and capital as important factors of production.
Labour theory of value forms the basis of classical theory of
international trade. On the contrary, the neo classical of international
trade is based on cost of labour and capital, which is more realistic.
A classical theory states that absolute and comparative cost is the
base for international trade. The neo classical theory of international
trade takes in to account of relative prices of factors that influences
comparative costs of goods, that seems to be more realistic.
The reason behind the neo classical theory is an advance version
of international trade is that it emphasis on factor endowment, that is
realistic. The classical theory has is limited to absolute and comparative
cost advantage.
4.7 CRITICISMS OF THE HECKSHER-OHLIN

THEORY
Most of the criticism of the modern theory of international trades

comes in context with its assumptions. First, we will examine criticism

that is not related to assumptions of the theory.
Leontief's Paradox: One of the important ideas of the H-O theory
is 'Capital intensive country exports capital intensive goods and a labour
intensive country exports labour intensive goods'. But the conclusions of
Leontief's study are exactly apposite to what H-O theory proposes and
it's known as 'Leontief's Paradox'. His study includes the import-export
data of 192 counties of the world and takes 1947 as a base year. His
study concludes that America is capital intensive country, but exporting
labour intensive goods and importing capital intensive goods.
Partial explanation: Factor endowment is not the only one
determinant of international trade, according to critics. H-O theory ignores
other basis of international trade like- qualities of factor of production,
difference in production techniques and increasing returns to scale etc.
For this reason, this theory has limited applications.
This theory is not dynamic: At the end, this theory remains as a
static explanation because it shows the position and availability of factors
in a given period of time. This theory fails to show that how economy
would grow when there is change in production conditions.
Haberlar's criticism: Haberlar, while criticizing this theory said that
this theory is merely partial equilibrium analysis. This theory has failed do
developed a comprehensive general equilibrium model.
Assumption related criticism: There are several unrealistic
assumptions like - there exists two countries, two factors of production
and two goods are produced in the economy. Similarly, the assumption
of perfect competition and full employment are unrealistic. This theory
also assumes that factors of production in trading countries are
homogenous, that is not correct because labour may be classified in
several categories like-skilled, semi-skilled and un-skilled etc. This theory
also assumes that test of consumer remains constant but in reality test
of consumer never remains constant. The constant return to scale in
production is also a simplifying assumption. Increasing returns have been
shown to be one of the factors behind international trade. The identical
technique of production means that knowledge travels freely. This is also

hugely unrealistic. The theory also denies the possibility of factor intensity
reversal which appears to be common in the real world.
CHECK YOUR PROGRESS

Q 3: Mention any two improvements made by
the H-O theory of international trade over the
Classical theory. (Answer in about 60 words).
...........................................................................................................
...........................................................................................................
...........................................................................................................
...........................................................................................................
Q 4: Mention any two criticisms levelled against the H-O theory
of international trade. (Answer in about 40 words).
...........................................................................................................
...........................................................................................................
...........................................................................................................
............................................................................................................
4.8 LET US SUM UP
 Hecscher-Ohlin theory of International trade explains that difference

in factor endowment gives rise to international trade. More specifically,
a country rich in capital will export capital intensive products and a
country rich in labour will export labour intensive products,
 The richness in factor can be seen in two alternative ways : in
physical terms and in terms of factor price. In physical terms, CountryI
is rich in capital as compared to Country II if capital labour ratio of
the former is greater than the latter. In factor price terms, CountryI
is rich in capital as compared to Country II if capital is cheaper in
former as compared to CountryII.
 Although considered an improvement over the Classical theory, the
neo classical theory of trade suffers from several limitations both on

theoretical grounds and empirical ground.
4.9 FURTHER READING
1) Borkakoti, J. (1998). International Trade: Causes and Consequences.

New York: Palgrave MacMillan.
2) Kumar, R. (2008). International Economics. New Delhi: Excel Books.
India.
4) Sodersten, B. & Reed, G. (1994). International Economics. London:
MacMillan Press Ltd.

PROGRESS
Ans to Q No 1: According to the H-O theory, there is difference in factor

endowments The difference in the price of factor exists because
of the relative scarcity or abundance. This ultimately leads to the
differences in the costs of the goods. As a result, international
trade takes place because of diversity in factor endowments and
hence differences in prices.
Ans to Q No 2: According the H-O theory, a country would be exporting
the commodity in the production of which relatively abundant factor
is used. In such cases, the price would be relatively cheaper.
Ans to Q No 3: The major two improvements of the H-O theory over the
classical theory of international trade include:
 The classical theory is confined to the factor 'labour' only.
On the contrary, modern theory of international trade gives
importance to both labour and capital.
 Labour theory of value forms the basis of classical theory of
international trade. On the contrary, modern theory of

international trade is based on cost of money, which is more
realistic.
Ans to Q No 4: Two important criticisms levelled against the H-O theory
are:
 Factor endowment is not the only one determinant of
international trade. H-O theory ignores other basis of
international trade like- qualities of factor of production,
difference in production techniques and increasing returns
to scale etc.
 According to H-O theory, in long run, there will be factor
price equalization. If this is true, then how international trade
takes place? Because international trade arises due to
differences in factor prices. This in fact, is self contradictory,
to what it proposes.
Q 1: Explain Heckscher-Ohlin theory of International trade.

Q 2: Explain the concept of factor endowment
Q 3: Write a note on factor intensity
Q 4: What are the assumptions of H-O theory?
Q 5: Critically evaluate H-O theory of International trade.
Q 6: How is the H-O theory of International trade superior to the
Classical theory ? Explain.
Q 7: Explain the difference between Ricardian and H-O theory of
International trade.
*** ***** ***

UNIT 5 : TERMS OF TRADE AND GAINS FROM
TRADE
UNIT STRUCTURE

5.2 Introduction
5.3 Meaning of Terms of Trade
5.4 Gains from Trade
5.5 Net Barter or Commodity Terms of Trade
5.6 Gross Barter Terms of Trade
5.7 Income Terms of Trade
5.8 Factors Affecting Terms of Trade
5.9 Let Us Sum Up
5.10 Further Reading
After going through this unit, you will be able to–

 put forward the meaning of terms of trade
 discuss gains from trade
 explain the factors affecting terms of trade
 explain the measurement and distribution of terms of trade
5.2 INTRODUCTION
This unit aims to familiarise you to the meaning of terms of trade,

commodity terms of trade, gross barter terms of trade, income terms of
trade, factors affecting terms of trade, measurement and distribution of
terms of trade.
The theory terms of trade and commodity terms of trade are the
integral parts of international economics. Terms of trade refers to the rate
at which goods of one country is exchanged for the goods of another
Unit 5 Terms of Trade and Gains from Trade
country. It is a measure of the purchasing power of exports of a country

in terms of its imports, and is expressed as the relation between export
prices and import prices of the goods.
The terms of trade of a country are influenced by various factors
such as reciprocal demand, changes in factor endowments, changes in
technology, changes in tastes, economic growth, tariffs and devaluation
etc.
5.3 MEANING OF TERMS OF TRADE
As already mentioned in the introductory section, "terms of trade"

refers to the rate at which the goods of one country is exchanged for the
goods of another country. As such, terms of trade is expressed as the
relation between export price and import price. When export prices of a
country rise relatively to its import prices, the terms of trade is said to
have improved as the country can have larger quantity of imports in
exchange for a given quantity of exports. On the other hand, when its
import prices rise relatively to its export prices, its terms of trade are said
to have worsened. The country's gains from trade is reduced because it
can have a smaller quantity of imports in exchange for a given quantity
of exports than before. A detailed study on the gains from trade has been
carried out in the next section of the unit.
5.4 GAINS FROM TRADE
In the previous section, we have discussed the terms of trade of

a country. This section of the unit will deal with the gains from trade. The
gains from trade refer to the net benefits or increase in goods that a
country obtains by trading with other countries. It also means the increase
in consumption of a country resulting from exchange of goods and
specialisation in production through international trade.
Please note that since the days of classical economists, which
includes Adam Smith, the gains from international trade has been widely
discussed. However, here, we shall present the modern view on the gains
from international trade.
Terms of Trade and Gains from Trade Unit 5
According to the modern theory, the gains from international trade

may be clearly distinguished as gains from exchange and gains from
specialisation, as we have already noted. Let us take the case of a
closed economy first. The concepts of production possibility curve and
the community indifference curve have been taken for the analysis as
shown in Figure 5.1.
Figure 5.1: Gains from Trade
In Figure 5.1, commodity X has been shown along the horizontal

axis while commodity Y has been shown along the vertical axis. In the
figure, AA1 is the production possibility curve. PP is the domestic price
ratio line. It is tangent to the production possibility curve AA1at E. Thus,
in the absence of trade, E is the point of production equilibrium.
Please note that the point E also represents consumption
equilibrium. This is because PP is tangent to the community indifference
curve CI at point E. When trade commences, P1P1 is the international
exchange ratio line, which is tangent to the production possibility curve
AA1 at point F and to the community indifference curve CI2 at C1.
Thus, F is the point of production and C1 is the point of
consumption. After trade takes place, D1F quantity of the commodity Xis
exported and C1D1 quantity of the commodity Y is imported. The trade
causes two types of shifts in the country. First, the production point shifts
from E to F. It occurs because of specialisation in the production of the

commodity X and specialisation in factor use. This can be called as the
production effect. Second, the point of consumption shifts from E at the
community indifference curve CI to C1 at the higher community indifference
curve CI2. It means an increase in the satisfaction of the community.
This can be called as the consumption effect. Thus, the production effect
and the consumption effect both shows gains from international trade.
If a line P2E is drawn parallel to P1P1 from the original equilibrium
situation E, it signifies that there is no change in production but the
consumption equilibrium shifts from E to C at a higher community
indifference curve CI1. In this situation, CD quantity of Y has been
imported. Again, DE quantity of commodity X is exported in exchange of
CD quantity of Y. Although the volume of production is same at point E,
yet the shift of consumption equilibrium from E to C reflects gains from
trade. This is the trade gain from exchange.
After trade, as the specialisation in production and optimum factor
use takes place, the production equilibrium shifts from E to F along the
same production possibility curve AA1 while the consumption equilibrium
shifts from C to C1. In this situation, C1D1 quantity of the commodity Y
is imported and D1F quantity of commodity X is exported. As a result of
specialisation in production after trade, the shift in consumption equilibrium
from C to C1 reflects the trade gain from specialisation.
Thus, to sum up, we can say that the total gain from trade consists
of gain from exchange and gain from specialisation. The total gain from
trade can be measured by the movement from E to C1. This movement
takes place in two steps-the movement from E to C is the gain from
exchange and the movement from C to C1 is the gain from specialisation.
5.5 NET BARTER OR COMMODITY TERMS

OFTRADE
As discussed in the introductory section of the unit, the net barter

or commodity terms of trade is the ratio between the price of a country's
export goods and import goods. To measure the changes in commodity
terms of trade over a period, the ratio of change in export prices and
import prices is taken. The formula which is used to measure the
commodity terms of trade is:
Px 1
P
Tc  x 0
Pml
Pm 0
where Tc stands for the commodity terms of trade, P for the price,
the subscript x for exports and m for imports, 0 for the base year and 1
for the current year. The concept of the commodity or net barter terms
of trade has been used by the economist to measure the gain from
5.6 GROSS BARTER TERMS OF TRADE
From the above discussion, we have got an idea about net barter
terms of trade. But this measure of net barter terms of trade has its
limitations. To make up for the deficiency realised in the net barter terms
of trade, Professor Taussig devised the concept of gross barter terms of
trade. He pointed out that instead of relating import and export prices, we
should relate quantities of imports and exports. In this section of the unit,
a discussion is made regarding gross barter terms of trade. The gross
barter terms of trade is the ratio between the quantities of a country's
imports and exports.
Symbolically,
Qm
Tc 
Qx
where, Tg stands for gross barter terms of trade, Qm for quantities

of imports, Qx for quantities of exports.
It can be easily accessed from the above equation that higher the
ratio between quantities of imports and exports, the better the gross
barter terms of trade. To measure the changes in gross barter terms of
trade over a period, the index number of the quantities of imports and
exports in base period and the end period are related to each other. The
formula which is used for measuring gross barter terms of trade is:
Qm1
Q
Tg  TC  m 0
Qxl
QX 0
Taking 2001 as base year and expressing India's both import and
export quantities as 100, if we find that the index of quantity imports had
risen to 160 and that of quantity exports to 120 in 2011, then the gross
barter terms of trade has changed as follows:
160
Tg  100  133.33
120
100
It implies from the above equation that the gross barter terms of
trade has registered an improvement by approximately 33 percent in
2011 compared with 2001. On the other hand, if the quantity of import
index has risen by 130 and that of quantity exports by 180, then the
gross barter terms of trade would be 72.22
130
Tg  100  72.22
180
100
The above equation implies that there was deterioration in the
terms of trade by 18 percent in 2011 over 2001.
5.7 INCOME TERMS OF TRADE
We have already discussed about net and gross barter terms of

trade of a country. In this section, a discussion is carried out on the
income terms of trade. It was the famous economist Dorrance who has
improved upon the concept of the net barter terms of trade by formulating
the concept of the income terms of trade. The index takes into account
the volume of exports of a country and its export and import prices (the
net barter terms of trade). It shows a country's changing import capacity

in relation to changes in its exports. Thus, the income terms of trade is

the net barter terms of trade of a country multiplied by its export volume
index. It can be expressed as:
Index of export Prices x Export Quantity
Ty  Tc..Q x 
Index of Import Prices
where Ty is the income terms of trade, Tc the commodity terms
of trade and Qx the export volume index.
It is required to mention here that H. Imlah calculates this index
by dividing the index of the exports by an index of the prices of imports.
He calls it the "Export Gain from Trade Index"
As for example, taking 2001 as base year, if Px = 140, Pm = 70 and Qx
= 80 in 2001, then:
140  80
Py   160
70
It implies that there is improvement in the income terms of trade by
60 percent in 2011 compared with 2001. A rise in the index of income terms
of trade implies that a country can import more goods in exchange for its
exports. A country's income terms of trade may improve but commodity
terms of trade may deteriorate. Taking the import prices to be constant, if
export prices fall, there will be an increase in the sales and value of exports.
CHECK YOUR PROGRESS

True or False.
(a) There is a difference between gross and net
barter terms of trade. (True/False)
(b) Specialisation in production through international trade results
in increase in consumption of a country. (True/False)
Q 2: What is the income terms of trade? (Answer in about 30
words)
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5.8 FACTORS AFFECTING TERMS OF TRADE
Form the above discussion, we have learnt about net, gross and
income terms of trade. In this section of the chapter, we will discuss
about factors affecting terms of trade of a country. The terms of trade of
a country are influenced by a number of factors which are discussed
below.
 Reciprocal Demand: The terms of trade of a country depends
upon reciprocal demand, i.e. "the strength and elasticity of each
country's demand for the other country's product". Suppose there
are two countries, Germany and England, which produce linen and
cloth respectively. If Germany's demand for England's cloth becomes
more intense (inelastic), the price of cloth rises more than the price
of linen and the commodity terms of trade will moves against
Germany and in favour of England. On the other hand, if England's
demand for Germany's linen becomes more intense, the price of
linen will rise more than the price of cloth, and the commodity terms
of trade will move in favour of Germany and against England.
 Changes in Technology: Technological changes also affect terms
of trade of a country. The terms of trade may improved or deteriorate
with technological change.
 Changes in Factor Endowments: Changes in factor endowments
of a country affect its terms of trade. Changes in factor endowments
may increase exports or reduce them. With the taste remaining
unchanged, this may lead to changes in the terms of trade.
 Changes in Tastes: Changes in tastes of the people of a country
also influences its terms of trade with another country. Suppose
England's tastes shifts from Germany's linen to its own cloth. In this
situation, England would export less cloth to Germany and its
demand for Germany's linen would also fall. Thus England's terms
of trade would improve. On the contrary, a change in England's
taste for Germany's linen would increase its demand and hence the
terms of trade would deteriorate for England.

 Economic Growth: Economic growth is another important factor

which affects the terms of trade. The rising of a country's national
product or income over time is called economic growth. Given the
taste and technology in a country, an increase in productive capacity
may affect favorably or adversely its terms of trade.
 Tariffs: Tariff is a duty tax or duty imposed on goods when they
enter and leave the national boundary. Tariff has an impact on the
terms of trade of the country. An import tariff generally improves the
terms of trade of the importing country.
 Devaluation: Devaluation raises the domestic price of imports and
reduces the foreign price of exports of a country devaluing its
currency in relation to the currency of another country. The effects
of devaluation on the terms of trade have been much debated
among economists. According to Prof.Machlup, "Devaluation is
supposed to improve the balance of trade. A reduction in the physical
volume of imports in relation to physical volume of exports constitutes
an adverse change in the gross barter terms of trade." Thus
devaluation will be successful only if the gross barter terms of trade
become adverse.
CHECK YOUR PROGRESS

True or False.
(a) Tariff has an impact on terms of trade of a
country. (True/False)
(b) Professor Taussig devised the concept of gross barter terms
of trade. (True/False)
Q 4: How does devaluation help in improving balance of
trade?(Answer in about 30 words)
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5.9 LET US SUM UP
 Terms of trade refers to the rate at which goods of one country is

exchanged for the goods of another country.
 The gain from trade is measured by increase in consumption of a
country resulting from exchange of goods and specialization in
production through international trade.
 Distribution of the gains from trade basically depends on two factors
such as terms of trade and domestic cost ratio.
 The net barter or commodity terms of trade is the ratio between the
price of a country's export goods and import goods.
 The gross barter terms of trade is the ratio of total physical quantity
of imports and exports. It was professor Taussig who first devised
the concept of Gross Barter terms of trade.
 Income terms of trade is measured by multiplying volume of exports
with the net barter terms of trade.
 The terms of trade of a country are influenced by various factors
such as reciprocal demand, changes in factor endowments etc.
 Economist all over the world has put so much emphasis on
international trade that it can be considered as an engine of growth.

PROGRESS
Ans to Q No 1: (a) True (b) True

Ans to Q No 2: The income terms of trade is the net barter terms of
trade of a country multiplied by its export volume index. It can be
expressed as:
Index of export Prices x Export Quantity
Ty  Tc..Q x 
Index of Import Prices
where Ty is the income terms of trade, Tc the commodity terms

of trade and Qx the export volume index.
Ans to Q No 4: Devaluation is supposed to improve the balance of
trade. A reduction in the physical volume of imports in relation to
physical volume of exports constitutes an adverse change in the
gross barter terms of trade. Thus devaluation will be successful
only if the gross barter terms of trade become adverse.
5.11 FURTHER READING

2) Paul, R.R. (2006). Money, Banking and International Trade.
Jalandhar: Kalyani Publisher.
3) Rana, K. C. & Verma, K. N. (1998). Macroeconomic Analysis.
Jalandhar: Vishal Publications.

Q 1: What do you mean by terms of trade? Distinguish between net
and gross barter terms of trade.
Q 2: Discuss the concept of income terms of trade.

Q 1: Explain the factors which affect the distribution of the gain from
trade.
Q 2: Explain the factors which influence the terms of trade of country?
*** ***** ***

UNIT 6: TOOLS OF TRADE RESTRICTION
UNIT STRUCTURE

6.2 Introduction
6.3 Classification of Tariffs
6.4 Effects of Tariffs
6.4.1 The Effects of Tariff under Partial Equilibrium Analysis
6.5 Dumping: Meaning
6.6 Types and Effects of Dumping
6.6.1 Effects of Dumping
6.7 Anti-dumping Measures
6.8 Cartels
6.8.1 Advantages and Disadvantages of Cartels
6.9 Custom Union: Meaning
6.10 Concept of Trade Creation and Trade Diversion
6.11 Quotas: Meaning and Types
6.12 Effects of Quotas
6.13 Let Us Sum Up

 derive the meaning of tariffs and quotas and discuss their effects
 discuss the concept of dumping and custom union
 explain the anti-dumping measures
 discuss the concept of trade creation and trade diversion.
6.2 INTRODUCTION
This unit aims to familarise you with the meaning of tariffs,

Tools of Trade Restriction Unit 6
dumping, anti-dumping measures, custom union and trade creation and

trade diversion.
The concept and meaning of tariff, dumping and custom union
are the integral parts of international economics. A tariff is a tax or duty
levied on goods when they enter and leave the national frontier or
boundary. In this sense, tariff refers to the import duties and export
duties. Dumping refers to international price discrimination in which an
exporter firm sells a portion of its output in a foreign market in a very low
price and the remaining output in a very high price at home market. A
cartel is a group of producers in the same industry located in different
countries which agrees to limit competition and to regulate the production
and sales in order to earn high profits. In a custom union, the participating
countries adopt a common external tariff and commercial policy on imports
from the outside world, and abolish all tariff and trade barriers among
themselves. The theory of custom union analyses the effects and their
consequences on allocation of resources and on the welfare of the
members of a custom union and on the rest of the world.
A detailed discussion about these topics has been carried out in
this unit.
6.3 CLASSIFICATION OF TARIFFS
In the earlier unit, we have already discussed the concept of tariff.

In this unit, we shall discuss tariff in a detailed way. As already mentioned
in the introductory section, “tariff” is a tax or duty levied on goods when
they enter and leave the national frontier and boundary. It is required to
mention here that tariffs are classified in a number of ways.
On the basis of purpose, tariffs are classified as revenue tariff
and protective tariffs.
 Revenue Tariff: Revenue tariffs are meant to provide revenue to
the state. Revenue tariffs are levied on luxury consumer goods. It
is generally observed that the fall in import duties may lead to
increase in revenue collection. This is because the rise in the price
of the imported goods does not increase much with the imposition
Unit 6 Tools of Trade Restriction
of low import duties and the consumers do not normally shift their
demand to other domestically produced goods.
 Protective Tariffs: Protective tariffs are meant to “maintain and
encourage those branches of home industry protected by the duties.
Now a days, government levy import duties with the principal
objective of discouraging imports in order to encourage domestic
production of protected industry.
Tariff can also be classified into ad valorem, specific, compound
and sliding scale duties on the basis of origin and destination.
 Ad Valorem Duty: The most common type of duty is the ad valorem
duty. It is levied as a percentage of the total value of the goods,
e.g.; a fixed percentage of 300 percent imposed on the value of a
TV set imported. The duty is a fixed percentage of the cost, insurance
and freight value of the commodity.
 Specific Duty: Specific duties are levied on the quantity per physical
unit of the imported commodity, as cloth per metre, as oil per litre,
as fertilisers per tonne etc.
 Compound Duty: Often, governments levy compound duties which
are a combination of the ad valorem and the specific duties. In this
case, units of an imported commodity are levied a percentage of ad
valorem duty plus a specific duty on each unit of the commodity.
 Sliding Scale Duty: Sometimes governments levy import duties
which vary with the prices of commodities imported. Such duties
are known as sliding scale duties which may be either ad valorem
or specific. Normally, sliding scale duties are imposed on specific
basis.
On the basis of country-wise discrimination, the following types
of tariffs are levied on the basis of country-wise discrimination.
 Single Column Tariff: When a uniform rate of duty is imposed on
all similar commodities irrespective of the country from which they
are imposed, it is called single-column tariff. It is non-discriminatory
tariff which is simple and easy to design and administer.
 Double Column Tariff: Two different rates of duty exist for all or
some of the commodities, under this system. The government of

the country declares both the rates one at the beginning and
another after settling the rates under trade agreements. They can
be classified as follows:
 General and Conventional Tariff: The general tariff is the list
of tariffs which is announced by the government as its annual
tariff policy at the beginning of the year. It is a particular tariff
rate which is charged from all countries. On the other hand,
conventional tariff rates are based on tariff agreements/treaties
with other countries.
 Maximum and Minimum Tariff: Governments usually fix two
tariffs rates for importing the same commodity from different
countries. Countries with which it has a commercial agreement/
treaty, (under most favoured nation), minimum tariff is imposed.
On the other hand, maximum tariff rate is imposed on import
from the rest of the countries.
 Multiple or triple Column Tariffs: Under the multiple column tariff
system, two and more tariff rates are imposed on each category of
commodities. But the usual practice is to have three different rates
of tariffs, i.e., general, intermediate and preferential. Similarly the
intermediate rates are the minimum rates. The preferential rates
were levied on goods imported from Britain before independence
which had low rates or were duty free. Presently, imports among
the SAARC countries carry preferential duties on imports from each
other.
On the basis of Retaliation, there are two ways to levy import
duties:
 Retaliatory Tariffs: A retaliatory tariff duty is levied by one country on
the imports of another country in order to punish the latter for its trade
policy which harms its exports or balance of payments position
 Countervailing Duty: It is an additional duty which is imposed on
a commodity whose export price is reduced by the other country
through an export subsidy. The additional duty is levied to raise its
price in order to protect producers of the same commodity in the

importing country from the cheap foreign commodity.
ACTIVITY 6.1
What are the different ways to levy import duties?
Explain.
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6.4 EFFECTS OF TARIFFS
In the introductory part of the unit, a discussion is made regarding

effects of tariffs. Tariffs have a variety of effects which depend upon their
power to reduce imports. The effects of a tariff may be analysed from the
standpoint of the economy as a whole which is known as the general
equilibrium analysis. It can also be analysed from the point of view of
particular goods or market which is known as the partial equilibrium
analysis. A tariff is likely to alter trade, prices, output, and consumption,
and to reallocate resources, change factor proportions, redistribute income,
change employment and alter the balance of payments. All these effects
of tariffs have been discussed in the next section of the chapter.
6.4.1 The Effects of Tariff under Partial Equilibrium

Analysis
In this section of the unit, a discussion will be carried out

regarding the effects of tariffs under the partial equilibrium analysis.
The effects of tariff under partial equilibrium analysis relates to a
small industry in a small country. When a tariff is imposed on the
imports of a single commodity by a small country, it does not affect
the domestic economy and also the world price of the commodity.
The effect of a tariff under the partial equilibrium analysis is based
on the following assumptions. It is necessary to discuss the

assumptions of partial equilibrium analysis as produced below:
 There is only one small country.
 It imposes tariff on one commodity.
 The demand and supply curves of a commodity relate to the
country which levies an import duty.
 These curves are assumed to be given and constant.
 On the demand side, consumers’ tastes, incomes and prices
of other commodities are assumed to be fixed.
 On the supply side, changes in cost conditions such as
externalities, technological innovations, etc. do not take place.
 The world supply of commodity is perfectly elastic with respect
to price.
 The home country does not impose tariff on the imports of
materials required for producing the commodity.
 There are no transport costs.
 The foreign price of the commodity remains unchanged.
 The imported and domestically produced commodities are
perfect substitutes.
On the basis of the above assumptions, Prof.
Kindleberger has listed eight effects of tariffs:
 The protective effect
 Consumption effect
 Revenue effect
 Redistributive effect
 Terms of Trade effect
 Competitive effect
 Income effect
 Balance of payments effects.
Now, we shall discuss the different effects of tariffs which
has been shown in Figure 6.1.

Figure 6.1: Effects of Tariff under Partial Equilibrium Analysis
Y
S
P1 M N
P A a R b B
D
0 Q Q1 Q2 Q3
 Price Effect: The price effect of a tariff is explained in terms

of Figure 6.1 where D and S are the demand and supply curves
of a commodity. OP represents the constant world price at
which the foreign producers are prepared to sell their
commodity in the domestic market. Thus the horizontal line
PB is the supply curve of imports which is perfectly elastic at
OP price. Thus, under free trade (before the imposition of tariff),
the equilibrium market position is given by point B where the
domestic demand curve D intersects the world supply curve
PB at the price OP. The total demand for the commodity is
OQ3. The domestic supply is OQ. The difference between
domestic demand and domestic supply is met by importing
OQ3 quantity at OP price. Suppose a tariff of PP1 is imposed
on the imports of the commodity. Given a constant foreign
price, the domestic price of the commodity rises by the full
amount of the tariff of OP1. Thus the rise in the price of the
commodity by PP1 is the price effect of the commodity. As a
result, the new equilibrium market position is given by point N.
In response to the higher price, the domestic demand falls
from OQ3 to OQ2 and the domestic supply increases from
OQ to OQ1. The total demand for the commodity is OQ2 which

is partly met by domestic supply OQ1 and partly by importing
Q1Q2. Thus imports have fallen from OQ3 to Q1Q2 as a result
of the price effect.
 Protective Effect: The protective effect shows how the
domestic industry can be protected from foreign competition
by imposing an import duty. In Figure 6.1, under free trade,
OQ3 quantity of commodity is imported at OP price. With
the imposition of the import duty of PP1, imports are reduced
to Q1Q2, while the domestic production (supply) of the
commodity increases from OQ to OQ1. Thus the increase in
the domestic production of the commodity by QQ1 as a
result of the tariff is the protective or production effect.
 Consumption Effect: The consumption effect of tariff is to
reduce the consumption of the commodity on which the tariff
is imposed, as also to reduce consumer’s net satisfaction.
Before the imposition of a tariff, consumers were consuming
OQ3 quantity of the commodity at OP price. With the levying
of an import duty of PP1, the price of the commodity rises to
OP1. Now imports are reduced to Q3Q2 and the total
consumption of the commodity is also reduced from OQ3 to
OQ2. Thus Q3Q2 is the consumption effect of the tariff. This,
in turn, leads to a net loss of consumption effect of the tariff
which in turn, leads to a net loss of consumers’ satisfaction
equal to the area PP1NB. Prof Kinleberger calls the combined
protective and consumption effect as trade effect. The
imposition of PP1 tariff has the effect of reducing the total
volume of trade of the country equivalent of OQ3 – Q1Q2.
 Revenue Effect: The revenue effect is the change in
government receipts as a result of the tariff. In the case
illustrated in Figure 6.1 initially the tariff is assumed zero at
price OP. So when PP1 import duty is levied, the revenue to
the government is equal to the amount of the import duty
multiplied by the quantity of imports. The revenue effect is,

therefore, PP1 X Q1Q2, or the rectangular shaded area R.
 Redistributive Effect: The redistribution effect results from
producers receiving a higher price for the commodity after
the imposition of the tariff. This is shown in Figure 6.1 by the
area PP1MA. This amount is a surplus over production cost
and is an economic gain which goes to the producers.
According to Kindleberger, the redistribution effect “is an
addition or producers surplus derived by subtraction from
consumers’ surplus”.
 Balance of Payments Effects: A tariff has a favourable
balance of payments effect by reducing imports in a tariff
imposing country and reducing exports in the other country.
Thus a tariff reduces country’s international expenditure and
brings stability in the balance of payments. The balance of
payments effect is illustrated in Figure 6.1. Under free trade
conditions, QQ3 commodity is imported at OP price. The total
value of imports is represented by the rectangle AQQ3B. This
represents a balance of payments deficit since the price paid
by importers is the amount received by the other country. To
remove this deficit, PP1 import duty is levied on the imported
commodity. As a result, imports are reduced from QQ3 to
Q1Q2. The government gets revenue equal to the shaded
area.
CHECK YOUR PROGRESS

True or False.
(a) On the basis of purpose, tariffs are classified
into revenue tariff and protective tariffs. (Yes/No)
(b) Prof. Kindleberger has listed eight effects of tariffs (Yes/No)

Q 2: Why does the redistribution effect of tariff occur? (Answer in

about 20 words)
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6.5 DUMPING: MEANING
In the above sections, discussions have been made regarding the

classification and effects of tariffs. In the next few sections of the unit, we
will discuss the meaning and types and effects of dumping. As discussed
in the introductory section, dumping is an international price discrimination
in which the exporter firm sells a portion of its output in a foreign market
at a very low price and the remaining output at a very high price in the
home market. Haberler defines dumping as: “The sale of goods abroad
at a price which is lower than the selling price of the same goods at the
same price and in the same circumstances at home, taking account of
differences in transport costs”.
The concept of dumping may be explained with the help of Figure
6.2. In the figure, PDF is the demand curve of the foreign market, while
DH represents the demand curve of the domestic market. The demand
curve of the foreign market is perfectly elastic, this means, the demand
curve of the foreign market is very elastic to price changes. On the other
hand, the demand curve of the domestic curve is comparatively less
elastic. MC is the marginal cost of production curve. It should be noted
that the cost of production of the firm is the same, as the product sold
in the two different is also the same. Due to the variation in elasticity in
the two markets, the firm sets higher price in the domestic market and
lower price in the foreign market. Again, as we have already mentioned,
the volume of production sold in the foreign market is comparatively
higher than the domestic market.

Figure 6.2: Dumping

Y
T MC
M
Price & Cost

P R E DF
S
C DH
MRH
0 H F X
......................Output...........................
From the figure it can be seen that MRH is the marginal revenue
curve of the domestic market and PDF is the marginal revenue curve
(also the average revenue curve) of the foreign market. From the lateral
summation of these two marginal curves, we get TRDF as the marginal
curve representing the marginal product curve of the total market of the
firm. The MC curve intersects the TRDF curve at point E. Thus, E is the
equilibrium point. Corresponding to this equilibrium point E, the equilibrium
output is OF. Thus, OF is the total output the firm would sell in the two
markets. Now, of this total amount OF, the firm sells OH quantity of the
product at MH price in the domestic market. The remaining HF quantity
of the product is sold at the foreign market at price OP (=FE). Thus, it
can be seen that the monopolist firm sells less amount of output in the
domestic market having less elasticity of demand and more amount in
the foreign market having greater elasticity of demand. The total profit
earned by the firm from the two markets is TREC.
6.6 TYPES AND EFFECTS OF DUMPING
From the above discussion, we have framed an idea about the

meaning of dumping. In this section, a discussion is made regarding the
types and effects of dumping. Dumping can be classified in the following
three ways that are as follows:

 Sporadic or International Dumping: Sporadic dumping is adopted

under exceptional or unforeseen circumstances when the domestic
production of the commodity is more than the target or there are
unsold stocks of the commodity even after sales. In such a situation,
the producer sells the unsold stock at a low price in the foreign
market without reducing the domestic price. This is possible only if
the foreign demand for his commodity is elastic and the producer
is a monopolist in the domestic market. His aim may be to identify
his commodity in a new market or establish himself in a foreign
market to drive out competitors from a foreign market.
 Persistent Dumping: When a monopolist continuously sells a
portion of his commodity at a high price in the domestic market and
the remaining output at a low price in the foreign market, it is called
persistent dumping This is possible only if the domestic demand for
the commodity is less elastic and foreign demand is highly elastic.
When cost falls continuously along with increasing production, the
producer does not lower the price of the product more in the domestic
market because the home demand is less elastic. However, the
producer keeps a low price in the foreign market because the
demand is highly elastic there.
 Predatory Dumping: The predatory dumping is one in which a
monopolist firm sells its commodity at a very low price or at a loss
in the foreign market in order to drive out some competitors. But
when the competition ends, it raises the price of the commodity in
the foreign market. Thus, the firm covers loss if the demand in the
foreign market is less elastic.
6.6.1 Effects of Dumping
In this section of the unit, a discussion is carried out

regarding the effects of tariffs. Dumping affects both the importer
and exporter countries in the following ways:
 Effects on importing country: The effects of dumping on
the country in which a monopolist dumps his commodity,
depends on whether dumping is for short period or a long

period and what is the nature of the product and the aim of
dumping.
 If a producer dumps his commodity abroad for a short
period, then the industry of the importing country is
affected for a short while. Due to the low price of the
dumped commodity, the industry of that country has to
incur a loss for some time because less quantity of
that commodity is sold.
 Dumping is harmful for the importing country if it
continues for a long period. This is because its takes
time for change in production in the importing country
and its domestic industry is not able to bear competition.
 If the dumped commodity is a consumer good, the
demand of the people in the importing country will
change for the cheap goods. When dumping stops,
the demand will reverse, thereby changing the tastes
of the people which will be harmful for the economy.
 If the dumped commodities are cheap capital goods,
they will lead to the setting up of a new industry. But
when imports of such commodities stop, this industry
will also be shut down. Thus ultimately the importing
country will incur a loss.
 If the monopolist dumps the commodity for removing
his competitors from the foreign market, the importing
country gets the benefit of cheap commodity in the
beginning. But after the competition ends and he sells
the same commodity at a high monopoly price, the
importing country incurs a loss because now it has to
pay a high price.
 Effects on Exporting Country: There are different ways
the exporting country is affected by tariffs:
 When the domestic consumers have to buy the
monopolistic commodity at a higher price through

dumping, there is loss in their consumers’ surplus. But if
the monopolist produces more commodity in order to
dump it in another country, consumers benefit. This is
because with more production in the commodity, the
marginal cost falls. As a result, the price of the commodity
will be less than the monopoly price without dumping.
 The exporting country also benefits from dumping when
the monopolist produces more commodities.
Consequently, the demand for the required inputs such
as raw materials, etc, for the production of that
commodity increases, thereby expanding the means of
employment in the country.
 The exporting country earns foreign currency by selling
its commodity in large quantity in foreign market through
dumping. As a result, its balance of trade improves.
6.7 ANTI-DUMPING MEASURES
Now, we have an idea about the effects of dumping on both exporting

and importing countries. Here the discussion will be on anti-dumping
measures. Anti-dumping measures are adopted by the authorities to stop
dumping. The following measures are generally adopted to stop dumping:
 Tariff Duty: To stop dumping, the importing country imposes tariff
on the dumped commodity. Consequently, the price of the importing
commodity increases and the fear of dumping ends. But it is
necessary that the rate of duty on imports should be equal to the
difference between the domestic price of the commodity and the
price of the dumped commodity.
 Import Quota: The government can also impose Import quota to
stop dumping under which a commodity of a specific volume or
value is allowed to be imported into the country. For this purpose,
it includes the imposition of duty along with fixing quota, and providing
a limited amount of foreign exchange to the importers.
 Import Embargo: Import embargo is an important retaliatory

measure against dumping. According to this measure, the imports
of certain or all types of goods from dumping country are banned.
 Voluntary Export restraint: To restrict dumping, developed countries
enter into bilateral agreements with other countries from which they
fear dumping of commodities. These agreements ban the exports of
specified commodities so that the exporting country may not dump its
commodities in other country. Such bilateral VER agreements exist
between India and EEC countries in exporting Indian textiles.
ACTIVITY 6.2
How does tariff duty help to stop dumping? Explain.
..........................................................................................................
..........................................................................................................
..........................................................................................................
CHECK YOUR PROGRESS

True or False.
(a) If the dumped commodity is a consumer
good, the demand of the people in the importing country will
change for the cheap goods.
(b) Voluntary export restraint is an anti-dumping measure.
Q 4: How does tariff duty prevent dumping?(Answer in about 30
words)
............................................................................................................
............................................................................................................
............................................................................................................
6.8 CARTELS
We have discussed about dumping and anti-dumping measures

in the previous section of this unit. In this section, we will discuss cartel
and the advantages and disadvantages of dumping. An international cartel
is a group of producers in the same industry located in different countries

which agrees to limit competition and to regulate the production and
sales in order to earn high profits. According to Kindleberger, “Cartels are
international business agreements to regulate price, division of markets
or other aspects of enterprise….They are agreements to restrict selling
competition”. There are several reasons for forming an international cartel
such as cut throat competition among produces of a world traded
commodity. Second, the fear of fall in world prices in the event of
production of the commodity exceeding the current demand. Third reason
to forming a cartel is to have monopoly control in order to earn higher
profits. These are the reasons for forming a cartel. There are different
advantages and disadvantages of forming a cartel.
6.8.1 Advantages and Disadvantages of Cartels
There are both advantages and disadvantages of forming a cartel.

Economists all over the world have provided different opinion
about the merits and demerits of cartel. It is, therefore necessary
to discuss the advantages and disadvantages of international cartel
which is carried out in this section.
Advantages of International Cartel: The following
arguments are usually given in support of the formation of the
international cartels on the following grounds:
 Stable Prices: International cartels encourage members to
produce on a large scale and thus help in stabilising the
prices of commodities.
 Low tariffs: International cartel for a commodity can force
an importing country to lower or to remove tariffs on it. This
will tend to maximise world welfare.
 Eliminate Cut-Throat Competition: The formation of the
cartel eliminates cut-throat competition and price-war among
producers of a commodity.
 Saving in Advertisement Expenditure: With the formation
of a cartel, there is little need for advertising its product in
the world markets because the purchasing countries know

about the suppliers. Thus, there are savings in advertisement
expenditure.
 Providing Technical Knowhow: An international cartel
provides their members with the most up to date and cost
saving technical knowhow for the production of the goods.
This helps in reducing cost-saving technical knowhow for
the production of goods. This helps in reducing costs and
improving the products.
 No Excess capacity: In a cartel, each producer of the
commodity is allocated a fixed quota of the commodity to
be produced in keeping with the world demand for it. There
is no excess capacity and waste of production under a cartel.
 Promote International Cooperation: International cartels
are based on mutual agreements among producers of goods.
Thus they are instruments of economic co-operation among
nations.
Disadvantages of International Cartel: Although several
arguments are provided in favour of international cartel, however,
the majority of economists do not favour the formation of
international cartels for the following reasons:
 Restriction on Output: International cartels deliberately
restrict the output of cartelised goods so as to charge higher
prices from the importing countries. This is due to the absence
of competition.
 Inferior Goods: In the absence of competition, the cartel
often produces and supplies an inferior commodity. From
the welfare point of view, this is not desirable.
 Misallocation of Resources: In view of lack of competition,
international cartels lead to underutilisation and malallocation
of the world’s resources when they restrict output and follow
the system of production quotas.
 No reduction of Tariffs: It is generally argued that

international cartel do not help in reducing or removing tariffs.

 Short lived in nature: Cartels are usually short-lived because
of the mutual distrust, threatening attitude of large producer-
members and bargaining resorted to by them. These cartels
tend to be unstable.
6.9 CUSTOM UNION: MEANING
In the previous section of the unit, we have already discussed the

meaning, advantages and disadvantages of cartel. In this section, we will
discuss ab0ut custom union. There are four types of arrangements for
economic integration among nations. Custom Union is one of them. In a
custom union, the participating countries adopt a common external tariff
and commercial policy on imports from the outside world, and abolish all
tariff and trade barriers among themselves. Thus in custom union, all
members act as a unit in their trade relations with non-member countries.
The European Community is a custom union. The free trade area and
custom union are similar in that there is tariff-free movement of goods
among the members. But they differ in that while a free trade area
permits each members to retain its own tariff against non-members, the
custom union adopts a common external tariff against them.
6.10 CONCEPT OF TRADE CREATION AND TRADE

DIVERSION
The essential feature of a custom union is that the members’

countries adopt a common external tariff on imports from the rest of the
world and the abolition of all tariff and trade barriers on imports among
themselves. The establishment of a custom union changes the relative
prices of goods in the domestic markets of member countries which, in
turn, affect trade, production and consumption. The theory of custom
union analyses these effects and their consequences on allocation of
resources and on the welfare of the members of a custom union and on
the rest of the world. It studies these static effects in terms of the trade
creation and trade diversion.
Trade creation occurs when the consumption of higher-cost

domestic production of the home country is replaced with the lower cost
product of the partner country. This, in turn, leads to the production effect
and the consumption effect.
Trade diversion occurs when with the abolition of tariff on the partner
country, the home country imports the product from the higher cost partner
country instead of from the lower-cost rest of the world. Thus trade diversion
has two aspects: first, an increase in the cost of the good which was
previously imported from the lower-cost country to the higher cost country.
Secondly, a loss in consumers’ surplus as a result of the substitution of a
higher cost good for the lower cost good. These two effects together
constitute the trade diversion effect of a custom union.
6.11 QUOTAS: MEANING AND TYPES
A quota (also called as import quota) is a government-imposed

trade restriction that seeks to limit the quantity or monetary value of
goods that a country can import or export during a particular period of
time. Countries use quotas in international trade to directly regulate the
volume or value of trade between them and other countries. Countries
sometimes impose them on specific products to reduce imports and
increase domestic production. In theory, quotas boost domestic production
by restricting foreign competition.
 Differences between quotas and tariffs or customs: Quotas are
different from tariffs or customs. Governments impose both quotas
and tariffs as protective measures to try to control trade between
countries, but there are distinct differences between them. Quotas
focus on limiting the quantities (or, in some cases, cumulative value)
of a particular good that a country imports or exports for a specific
period, whereas tariffs impose specific fees on those goods.
Quotas are more effective in restricting trade than tariffs,
especially if domestic demand for something is not price-sensitive.
Quotas may be more disruptive to international trade than tariffs.
Applied selectively to various countries, they can be utilised as a
coercive economic weapon.

 Types of Quotas: The major types of import quotas are: (a) the
tariff or customs quota, (b) the unilateral quota, (c) the bilateral
quota, (d) the mixing quota and (e) import licensing.
 The tariff or customs quota is a widely acclaimed measure.
Under this system, import of a commodity up to a specified
quantity is allowed to be imported duty-free or at a special low
rate of duty. But imports in excess of this fixed limit are charged
a higher rate of duty. The tariff quota thus combines the
features of a tariff with those of quota.
 In the system of unilateral quota, a country places an absolute
limit on the import of a commodity during a given period. It is
imposed without prior negotiation with foreign governments.
 Under the system of bilateral quota, quotas are set through
negotiation between the importing country and the exporting
country (or foreign export groups).
 Under the system of mixing quota, producers in the coutnry
require to utilise a certain proportion of domestic raw materials
along with imported parts to produce finished goods domestically.
 Under the system of import licensing, prospective importers
are required to obtain a licence from the proper authorities for
importing any quantity within the specified quotas. Licences
are generally distributed among established importers keeping
in view their share in the country’s import trend.
6.12 EFFECTS OF QUOTAS
The import quotas can have various effects such as price effect,
protective or production effect, consumption effect, revenue effect,
redistributive effect, balance of payments effect etc. In this section, we
shall briefly summarise these affects.
 Price Effect: As a result of import quota restrictions, availability of
the product in the home market becomes limited. As a result, it
creates shortage in supply, whch consequently increases its price.
 Protective or Production Effect: An import quota has a protective

effect. As it reduces the imports, the domestic producers are induced
to increase the production of import substitutes. The increased
domestic production due to import quota is called as the protective or
production effect.
 Consumption Effect: Import quota leads to a rise in the domestic
price of the given commodity. As a consequence, the consumption
of the commodity gets reduced.
 Revenue Effect: Unlike tariff, the revenue effect of quotas is of very
complex nature and therefore very difficult to quantify in specific terms.
 Redistributive Effect: The fixation of import quota leads to a rise
in the price of the given commodity. Thus, it may result in a loss in
consumer’s surplus for the importing country. At the same time,
higher price and increased production ensures a gain in producer’s
surplus. Thus, import quota causes redistributive effect in the quota
enforcing country. There is the possibility that the redistribution effect
will involve a larger net loss in welfare in the domestic country.
 Balance of Payments Effect: One of the objectives of enforcing
import quota is to reduce the balance of payments deficit by
restricting imports. That portion of national income going into imports
can be utilised for investment in the import- substitution or export
industries. The expansion in exports, coupled with restriction of
imports is likely to bring about improvement in the balance of
payments position of the country.
CHECK YOUR PROGRESS

Q 5: When is trade creation said to occur?
...........................................................................
.........................................................................................................
.........................................................................................................

Q 6: How does cartels help in the stabilisation of prices?(Answer

in about 30 words)
.........................................................................................................
.........................................................................................................
6.13 LET US SUM UP
 A tariff is a tax or duty levied on goods when they enter and leave
the national frontier or boundary. Tariffs can be classified in a number
of ways.
 The effects of a tariff may be analysed from the standpoint of the
economy as a whole which is known as the general equilibrium
analysis. It can also be analysed from the point of view of particular
goods or market which is known as the partial equilibrium analysis.
 Dumping is an international price discrimination in which the exporter
firm sells a portion of its output in a foreign market at a very low
price and remaining output at a very high price in the home market.
Dumping can be classified into different catagories. Dumping affects
both importer and exporter countries differently.
 An international cartel is a group of producers in the same industry
located in different countries which agrees to limit competition and
to regulate the production and sales in order to earn high profits.
Economists all over the world have provided different opinion about
the merits and demerits of cartel.
 In a custom union, the participating countries adopt a common
external tariff and commercial policy on imports from the outside
world, and abolish all tariff and trade barriers among themselves.


PROGRESS

Ans to Q No 2: The redistribution effect results from producers receiving
a higher price for the commodity after the imposition of the tariff.
Ans to Q No 4: Imposition of tariff helps to stop dumping if the importing
country imposes tariff on the dumped commodity. As a result, the
price of the importing commodity increases and the fear of dumping
ends.
Ans to Q No 5: Trade creation is said to occur when the consumption
of higher-cost domestic production of the home country is replaced
with the lower cost product of the partner country. This, in turn,
leads to the production effect and the consumption effect.
Ans to Q No 6: Cartels encourage members to produce on a large
scale. This help in stabilising the prices of commodities.

India.

Q 1: What do you mean by tariff? Distinguish between ad Valorem

duty and specific duty.
Q 2: What are the advantages and disadvantages of forming a cartel?
Explain
Q 3: What do you mean by trade creation and trade diversion?
*** ***** ***

UNIT 7: ECONOMIC INTEGRATION
UNIT STRUCTURE

7.2 Introduction
7.3 Economic Integration - Conceptual Framework
7.4 Preferential Trading Arrangement or Arrangment
7.5 Free Trade Area
7.6 Custom Union
7.7 Common Market
7.8 Economic Union
7.8.1 European Union (EU)
7.9 Concept of Trade Creation and Trade Diversion
7.10 Let Us Sum Up
7.12 Answer to Check Your Progress
After going through this unit, you will be able to–

 describe the idea behind regional economic integration
 arrange different forms of regional economic integration in terms
of degree of integration
 explain the essential features of preferential trading arrangement,
free trade area, customs union, common market and economic union
 discuss the concepts of trade creation and trade diversion that
result from the formation of a customs union
7.2 INTRODUCTION
This unit deals with the discussion on regional economic integration

as a tool of promoting international trade between nations. Already you
have known the basis of trade of international trade, i.e., why trade
Economic Integration Unit 7
occurs between nations. We shall begin the unit with a discussion on the
basic conceptual framework of economic integration and then will move
towards discussing its different types.
7.3 ECONOMIC INTEGRATION - CONCEPTUAL

FRAMEWORK
Economic integration seems to be the one of most crucial factor

that is affecting the volume of international trade in the globe. Nation
states engaged themselves in the economic cooperation in order to use
their valuable resource more efficiently and draw maximum benefits from
any sort of an arrangement called economic integration.
Economic integration means unification of distinct economies into
a single larger economy. Nations wants to exploit their production
potentialities with the help of modern technology. Similarly, some countries
are more interested in having alliance with other countries that are located
in the same geographical area in order to exploit their production
potentialities. In order to maximize their production potential and export
goods and services, countries prefers to have expansion of market that
result in to economic integration.
In a broader sense, economic integration is a type of economic
arrangement where two or more countries integrate their economic region
by removing or relaxing different barriers on international trade in varying
degrees and present themselves as a group to the non-member countries.
Tinbergen while defining economic integration says that 'the
creation of most desirable structure of international economy, removing
artificial hindrance to optimum operation and introducing deliberately all
desirable elements of co-ordination and unification'.
7.4 PREFERENTIAL TRADING AGREEMENT OR

ARRANGEMENT
A preferential trading arrangement is primarily a trading block that

provides preferential access to certain products from member countries.
This is done by reducing trade barriers like-tariff and other forms of trade
Unit 7 Economic Integration
obstacles. This kind of an arrangement is possible through trade

agreement or trade pacts.
The best example of preferential trade area is Commonwealth
system of preferences. This system was established in year 1932. This
preferential trade agreement was lead by Great Britain. The member
countries of this trading block were all erstwhile British colonies collectively
called as the Commonwealth Group of Nations. This model was designed
to encourage trade within the British Empire and the instrument was
lowering the tariff rate among the member countries. But at the same
time, member countries maintained discriminatory tariff rate to the non-
member countries of commonwealth system. This imperial preferences
system was adopted among the commonwealth countries by Ottawa
agreement in 1932. It is also seen as one of the attempt to tackle the
problem of Great Depression of the world.
During the post-globalization period, the numbers of preferential
trade areas have grown considerably. For example-in 2010 the number
of preferential trade agreements (PTSs) in operation was four time higher
than in the 1990s. The participation in PTAs is widespread. For example-
in 2010 each member of WTO also participated in an average of 13
PTAs, up from 2 in 1990s. The proliferation of PTAs continued after the
formation of WTO.
7.5 FREE TRADE AREA
Free trade area (FTA) is an up gradation of the preferential trading

arrangements. A Free Trade Area is formed when two or more countries
come together, remove trade restrictions on each other's products while
maintaining their individual restrictions on non member countries. In FTA,
trade restrictions are removed by member countries themselves. Similarly,
member countries are free to decide their own policy against non-member
countries.
The best example of free trade area is European Free Trade
Association (EFTA). This association was formed in year 1959. The
members consists of this association includes United Kingdom, Austria,
Denmark, Norway, Sweden, Portugal, Switzerland and Finland. The other

example of free trade areas is Latin American Free Trade Association
(LAFTA). It was formed in year 1961 by 10 Latin American countries.
Similarly, there is North American Free Trade Area (NAFTA), SAARC
countries Free Trade Area (SAFTA) and so on.
7.6 CUSTOM UNION
Custom union is considered an improvement over free trade area

(FTA). Custom Union not only removes restrictions on trade but also
designs uniform commercial policy for non-member countries.
In custom union, member countries dismantle trade barriers on
the exchange of goods and services and also impose common external
tariff on non-member countries.
The first theoretical explanation of custom union was given by
Jacob Vinor. He said that custom union ensures, on the one hand, increase
competition among the member and, on the other, an increase measure
of protection against trade and competition from rest of the world. Viner
maintained that the synthesis of elements of competition and protection
might or might not increase the welfare of member nations.
The best example of custom union was the European Economic
Community formed by West Germany, France, Italy, Belgium, Netherlands
and Luxemburg in the year 1957. Other examples include:South African
Custom Union (SACU), Common Market for Eastern and Southern Africa
(COMESA), Association of Southeast Asian Nations (ASEAN), Caribbean
Community (CARICOM), Eurasian Custom Union (EACU) etc
CHECK YOUR PROGRESS

Q 1: Define a preferential trade agreement.
Answer in about 30 words.
..........................................................................................................
..........................................................................................................
..........................................................................................................

Q 2: State the basic objective of a custom union. Answer in about

30 words.
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..........................................................................................................
..........................................................................................................
7.7 COMMON MARKET
A common market has no barriers to trade among members and

has a common external trade policy. Besides, the factors of productions
are mobile among the member nation-states. In common market, it is
expected that the member countries needs to prepare themselves for
mutual cooperation especially in the areas like- monetary, fiscal and
employment policies.
In other words, a common market is also considered as kind of
custom union where the movement of factors of production (i.e. labour
& capital) is relatively free among the member countries.
The common market is one step ahead of the custom union.
Common market is in favour of free trade as well as free movement of
capital and labour within the common market jurisdiction. Common market
also applies uniform tariff policy against the non-member countries.
In common market tariff and other trade restrictions are removed
among member countries. In common market, member countries adopt
common external tariff. There also exists free and integrated movement of
goods and factors of production among the member countries. The best
example of common market was the European Common Market (ECM)of
1992 prior to the formation of the European Economic Community (EEC).
7.8 ECONOMIC UNION
In economic union, free movement of goods and services exists.

There exists free movement of factors of production as well. But, in order
to make a true economic union, there is need to have integration of
economic policies among the member countries. In economic union

member countries needs to harmonize their economic policies like-

monetary policy, taxation, government spending. Besides, a common
currency would be of a great advantage. In this type of arrangement,
member countries have greater coordination while designing macro-
economic and exchange rate policies.
Economic union is also considered as one step ahead of common
market. Because, economic union fulfills all the necessary conditions that
requires for the formation of common market like- free trade, free
movement of factors of production, unified tariff on non-members on
non-member countries etc.
Besides, the most significant point about economic union is that
it brings uniformity in the framework of national policies of member
countries. As a result of it, member countries initiates in establishing a
central bank, unified monetary & fiscal policies etc. This also regarded as
one of the advance economic integration that involves high degree of
economic cooperation in economic union.
The well known example of economic union is European Union
(EU). Another example of economic union is BENELUX (includes Belgium,
Netherlands, and Luxemburg) that formed in year 1948. Initially it was a
custom union but later was transferred or converted into an economic
union in 1960. These countries have now joined EU. The European
Economic Community EEC has transformed itself into an economic union
called EU in 1991. Now let's discuss some of the details of European
Union (EU) as an example of most successful economic integration.
7.8.1 European Union (EU)
The EU came in to existence on November 1st 1993 with

the approval of Maastricht Treaty. This economic organization
comprises 28 European countries that governs common economic,
social and security policies. European Union initially confined to
western European countries but rapidly expanded and ratified the
entry of central and eastern European counties. Today, the list of
EU member countries comprises-Austria, Belgium, Bulgaria,
Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland,

France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania,
Luxembourg, Malta, Netherlands, Poland, Portugal, Romania,
Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.
Countries like -Sweden, Austria and Finland joined EU on 1st
January 1995. The major European countries that are left remained
outside the EU include Iceland, Norway and Switzerland. The
United Kingdom has recently left the membership of EU which is
popularly described as BREXIT. In the present EU there is a
common currency called EURO, an European Central Bank (ECB),
as well as an European Parliament.
From the above discussion we can observe that there are
five major types of regional economic integration. In ascending
order of degree of integration we can delineate them as follows:\
 Preferential Trading Arrangement (1)
 Free Trade Area (2)
 Customs Union (3)
 Common Market (4)
 Economic Union (5)
Starting from the loosest form integration in a Preferential
Trading Arrangement, we end up with the highest form of economic
integration in an Economic Union. Thus, as we move from number
1 to 5, the degree of integration also increases with every jump
in the number.
7.9 CONCEPT OF TRADE CREATION AND TRADE

DIVERSION
 Trade Creation Effect: Regional integration expands markets and

promotes competition by eliminating barriers to trade among
constituent countries. This contributes to more efficient allocation of
resources and greater productivity among the constituent countries,
as well as having a "trade creation effect" that improves the economic
welfare of the members. These aspects are quite obviously positive
for the economies that are integrated. With regard to countries

outside the region, the creation of a expanded regional market as
a whole can be expected to have a positive side effect of an increase
of trade opportunity.
On the other hand, the positive trade creation effect can also in
fact be overshadowed by a negative "trade diversion effect" if the
elimination of barriers to trade between members of the region
causes trade that had been conducted with efficient non-regional
countries to be diverted to less efficient regional countries.
 Investment Diversion Effect: Interest has recently been growing
in the "investment diversion effect" of regional integration as well.
For example, in 1984 the EU received only one-third of the direct
investment that the United States received, but by 1989 was at the
same level of the United States. For foreign companies, the single,
unified market that regional integration creates is also an attractive
investment market, and the larger the integrated market, the greater
the scale merits and therefore the attraction of locating there.
However, in as much as investment resources are limited, this has
the effect of diverting investment away from other countries.
Naturally, investment decisions are part of a company's business
judgement and the investment diversion effect should be seen as
the result of this. But if regional integration brings with it trade
policies that discriminate against products from outside the region,
then it may distort the investment pattern between regions. (For
example, if regional integration results in stricter rules of origin for
non-regional products, then it will encourage direct investment in
the region rather than exports to it.
CHECK YOUR PROGRESS

Q 3: State the basic achievements of the
European Union. Answer in about 30 words.
.............................................................................................................
.............................................................................................................
.............................................................................................................
Q 4: State the basic argument put forward by Vincer for the
establishment of a custom union. Answer in about 30 words.
.............................................................................................................
.............................................................................................................
.............................................................................................................
7.10 LET US SUM UP
 Economic integration seems to be the one of most crucial factor

that is affecting the volume of international trade in the globe. Nation
states engaged themselves in the economic cooperation in order to
use their valuable resource more carefully and draw maximum
benefits from any sort of an arrangement called economic integration.
 A preferential trade area is primarily a trading block that provides
preferential access to certain products from member countries. This
is possible because of dismantling trade barriers like-tariff and other
forms of trade obstacles.
 Free trade area (FTA) is also a form of economic integration. This
primarily is an association of countries that facilitates free trade
among the member countries.
 In custom union, member countries dismantle trade barriers on the
exchange of goods and services. Similarly, custom union also adopts
common trade policy for all non-member countries.
 A common market has no barriers to trade among members and
has a common external trade policy. Besides, the factors of
productions are mobile among the member nation-states.
 Economic union is also considered as one step ahead of common
market. Because, economic union fulfills all the necessary conditions
that requires for the formation of an economic integration like- free
trade, free movement of factors of production, unified tariff on non-
members on non-member countries etc.
 Jacob Viner has established a framework and model of custom

union. In this model, the author shows that the formation of custom
union leads to enhance the welfare in some circumstances as well
as formation of custom union also reduces the welfare of others.
1) Jhingan, M. L. (2001). International Economics. New Delhi: Vrinda

Publications (P) Ltd.
3) Mithani,D. M. (2011). International Economics. Mumbai: Himalaya
Publishing House,
5) Vaish, M. C. & Singh, S. (2012). International Economics. New
Delhi: Oxford and IBH Publishing Co. Pvt. Ltd.
7.12 ANSWER TO CHECK YOUR

PROGRESS
Ans to Q No 1: A preferential trade area is primarily a trading block that

provides preferential access to certain products from member
countries. This is possible because of dismantling trade barriers
like-tariff and other forms of trade obstacles. This kind of an
arrangement is possible through trade agreement or trade pacts.
Ans to Q No 2: The basic objective of a custom union is to abolish trade
barriers (i.e. tariff and quotas) among the member countries in
order to encourage them for free trade of goods and services. A
custom union imposes common external tariff (CET) on non-
member countries.
Ans to Q No 3: The basic achievement of EU are: (i) a common currency

(Euro), (ii) establishment of the European Central Bank and (iii)
establishment of European parliament.
Ans to Q No 4: Jacob Viner has argued that the formation of custom
union leads to enhance the welfare in some circumstances as
well as formation of custom union also reduces the welfare of
others.
A) Short Questions (Answer each question in about 150 words).

Q 1: How the formation of preferential trading area helps its member
countries? Discuss.
Q 2: Discuss the concept of free trade areas.
Q 3: What is meant by a custom union? Discuss the role of a custom
union.
Q 4: Discuss the concepts of trade creation and trade diversion.
B) Long Questions (Answer each question in about 300 - 500 words).

Q 1: Compare the formation and role with respect to preferential trading
areas and free trade areas. Comment which of the two is a better
economic arrangement?
Q 2: Evaluate the role played by European Union in the overall
development of its member countries.
*** ***** ***

International Economics: An Introduction

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International Economics: An Introduction

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GEC S5 02 (M)

Exam. Code: ECM5B

KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

Course Coordinator : Bhaskar Sarmah, Ph.D., KKHSOU

SLM Preparation Team

First Edition: May, 2019

UNIT 1: INTRODUCTION TO INTERNATIONAL ECONOMICS 7–24

UNIT 2: FREE TRADE VS. PROTECTION 25–34

UNIT 3: THE OPPORTUNITY COST THEORY 35–50

UNIT 4: THE HECKSCHER-OHLIN THEORY 51–66

The Heckscher-Ohlin Theory of International Trade: Assumptions of the

UNIT 5: TERMS OF TRADE AND GAINS FROM TRADE 67–77

Classification of Tariffs; Effects of Tariffs: The Effects of Tariff under Partial

UNIT 7: ECONOMIC INTEGRATION 102–112

1.1 Learning Objectives

1.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

Just as no individual is self-sufficient, in a similar vein no country

the countries. The mutual interdependence at the international level is

1.3 THE BASIS AND NEED OF INTERNATIONAL

One of the fundamental questions asked in the subject of

Now, specialisation can be applied to different levels: say to

1.4 INTER-REGIONAL TRADE AND INTERNATIONAL

1.4.1 Classicists’ Views

According to the classical economists, there are basic

inter-regional trade than international trade. Within a country

International Economics, Block-1 11

1.4.2 Bertil Ohlin’s Views

On the basis of these arguments, Ohlin concludes, “The

1.5 DISTINCTION BETWEEN INTERNATIONAL

The following arguments may be put forward in favour of a

14 International Economics, Block-1

CHECK YOUR PROGRESS

1.6 THE THEORY OF ABSOLUTE ADVANTAGE

 Single currency prevails between the two countries. So, it is assumed

16 International Economics, Block-1

clear and absolute advantage in producing spices (50 units of labor as

1.7 THE THEORY OF COMPARATIVE COST : THE

David Ricardo propounded the theory of comparative cost to

International Economics, Block-1 17

Table 1.2: Comparative Costs between India and USA

 According to Ricardo, the inputs are mobile only in case of inter-

1.7.1 Superiority of the Theory of Comparative

The theory of comparative advantage put forward by Ricardo

CHECK YOUR PROGRESS

International Economics, Block-1 21

(ii) According to the theory of comparative cost advantage, cost

1.8 LET US SUM UP

 A country cannot produce all the goods and services as required

1.9 FURTHER READING

1) Dudley, D. (1981). The Economics of John Maynard Keynes. New

3) Rana, K. C. & Verma, K. N. (2004). International Economics.

1.10 ANSWERS TO CHECK YOUR

Ans to Q No 1: (i) True (ii) True

1.11 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

B) Long Questions (Answer each question in about 300-500 words)

*** ***** ***

24 International Economics, Block-1

2.1 Learning Objectives

2.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

This unit deliberates on free trade and protectionism. A free trade

* * *

* * *