INTERNATIONAL BUSINESS

Theories of International Trade

Presented By :Akhilesh Pratap Singh

Akhilesh Pratap
Akanksha Batham
Andrea Emmanuel

Introduction
International trade theories are simply different theories to explain
international trade. Trade is the concept of exchanging goods and
services between two people or entities. International trade is then
the concept of this exchange between people or entities in two
different countries.
But here are a number of theories that have been developed by the
international economists to explain how does international trade
takes place. And additionally we will explore the factors that impact
international trade and how businesses and governments use these
factors to understand better the aspects of international trade.
These theories include Mercantilism theory
Absolute cost advantage theory
Comparative cost advantage theory
Factor Endowment theory
Opportunity cost theory

Mercantilism Theory
Mercantilism was developed in the sixteenth
century. Mercantilism was one of the earliest effort
to develop an economic theory. This theory stated
that a countrys wealth was determined by the
amount of its gold and silver holdings. In its
simplest sense, mercantilists believed that a
country should increase its holdings of gold and
silver by promoting export and discouraging
import. The objective of each country was to have
a trade surplus, or a situation where the value of
export are greater than the value of import, and to
avoid a trade deficit, or a situation where the value
of import is greater than the value of export.

Absolute cost advantage

Theory
Adam smith propounded the theory of absolute cost
advantage as the basis of foreign trade: under such
circumstances an exchange of goods will take place
between tow countries only if each of the tow counties
can produce one commodity at an absolute lower
production cost in comparison to other country.

Reason for Absolute cost Advantage 1. Specialization- Specialization of labour leads to higher
productivity and less labour cost per unit of output.
2. Economies of scale- Economies of scale helps to reduce
the cost per unit of output due to the expansion of firm.
3. Climate condition
4. Technology

Explanation of Theory
Assume that the productivity of 1 unit of labour in India
and China is given belowCountry
India
China

Wheat
20
8

Pencil
10
25

1 unit of labour in India produce 20 units of wheat or 10

unit of pencil. Thus India is efficient in producing wheat.
similarly 1 unit of labour in china
produces 8 unit of wheat or 25 unit of pencil. Clearly
china has advantage in production of pencil.
So according to the Adam smith India will specialize in
production of wheat and china will specialize in
production of pencil.

Before Trade
Total Unit of Production

After Trade
2 Unit of Labour
Specialization

Wheat - 28

Wheat 40

Pencil - 35

Pencil 50

India - 30

India 40

China - 33

China 50

World - 63

World -90

If India decides to specialize in production of wheat,

it would shift its 1 unit of labour which is producing
pencil to produce the wheat. Now India produce
zero unit of pencil and 40 units of wheat.
Applying the same logic to china will specialize in
production of pencil only and will produce 50 unit of
pencil and zero unit of wheat.

Assumptions of the
theory
Trade is between two countries

1.
2.
3.
4.
5.

Only two commodities are traded

Technology remains the same
The only element of cost of production is labour.
Money is not involve trade between two countries
takes place on the basis of the barter system.
6. Factor of production are perfectly mobile within each
country but are perfectly immobile between the two
countries.
7. There is free trade between the two countries.
8. Commodities are produced under the law of constant
cost or returns.
9. Homogeneous factor of production.
10.No transport cost are involved in carrying trade
between the two countries.

Criticisms of The Theory

1. Unrealistic Assumption of Labour Cost
2. Unrealistic Assumption of Constant Returns
3. Ignores Transport
4. Mobility
5. Two Country Two Commodity Model is
Unrealistic
6. Unrealistic Assumption of Free Trade
7. Neglect The Role of Technology

Comparative Cost Advantage Theory

Absolute cost advantage theory fails to explain the
situation when one country has absolute cost advantage
in producing many products. David Ricardo a British
economist expanded the Absolute Cost Advantage Theory
to clarify this situation And developed the theory of
Comparative cost Advantage.
Comparative cost Advantage theory states that
if country A is better in the production of both the
commodities in comparison to country B then
international trade will take place between two countries
when country A will specialise in that product in which its
comparative advantage is more or comparative cost of
production is the least. Where as country B will specialise
in that product in which its comparative disadvantage is
less.

Explanation of Theory
Country

Pen

Pencil

Japan

60

India

50

Japan now produces 60 pens or 6 Pencil by 1 unit of labour.

Japan now has an absolute cost advantage in both the
commodities. Japan is more productive than India in both
the products. In this situation no trade will take place
between japan and India according to Absolute Cost
Advantage Theory.
Japan is 3 time better than India in pencil production and
1.2 time better in the production of Pen. Alternatively India
is only 0.33 as good as Japan in Pencil production but 0.83
as good as in Pen production. Thus comparatively Japan is
better in the production of Pencil and India is better in the
production of Pen.

Factor Endowment theory

Heckscher and Ohlins theory begins where the Ricardian
Theory of international trade ends. The Ricardian theory
states that the basis of international trade is the
comparative costs difference. But he did not explain how
this comparative costs difference arises.
Ohlins theory explains the real cause of this
difference. Ohlin did not invalidate the classical theory but
accepted the theory of comparative advantage as the
cause of international trade thats why Ohlins theory works
as supplements but does not supplant the Ricardian Theory.
We generally know that difference in factor price are due to
difference in factor endowments in different country. Thats
why trade occurs between countries because different
countries have different factor endowments. Ohlin theory
therefore is described as the factor endowment theory.

Ohlins theory is usually expounded in term of a

two factor model with Labour and capital as the
two factor of endowment.
According to Ohlin, trade arises due to the
differences in the relative prices of different goods
in different countries. The difference in countries
prices is due to the difference in factor prices [i.e.
costs]. Factor prices differ because endowments
[i.e. Capital and labour] differ in countries. Hence
trade occurs because different countries have
different factor endowments.

The heckscher and ohlin theorem is

counties which are rich in labour will export labour
intensive goods and countries which have plenty of
capital will export capital intensive products.

There are two postulate of the theory1. There exist difference in the availability of
factor of production in the different part of
the counter i.e. some factors are scarce and
some are abundant.
2. Factor intensity vary from product to
product.

Opportunity Cost Theory

Opportunity cost theory was given by Haberler. And
according to this theory If a given amount of factors of
production[combination of land, labour and capital]
can produce either one unit of commodities X or one
unit of commodities Y, then the opportunity cost of a
unit of X is the sacrifice of one unit of Y.
since Haberler makes all the assumption that were
made by Ricardo for his comparative cost theory, so
all assumptions and criticism are applicable here in
the opportunity cost theory.
Only plus point for Haberler is that along with labour,
he has considered all other factor of production.

Explanation of the Theory

Products

Country A

Country B

12

In country A opportunity cost of Product X is

4/2 = 2
Opportunity cost of Product Y is
2/4 =
Opportunity cost of X is grater than opportunity cost of Y
In country B
Opportunity cost of Product X is
6/12 =
Opportunity cost of Product y is
12/6 = 2
Opportunity cost of Y is grater than opportunity cost of X
So according to the theory country A will specialize is product Y
because its opportunity cost is less than the opportunity cost of product X.
And country B will specialise in Product X because its opportunity cost is less than the
opportunity cost of product Y.

THANK YOU