Why international trade?

Theory of absolute advantage

Theory of comparative advantage
Hecksher-ohlin model
Imitation gap theory
International product life cycle theory

Theory of absolute
advantage
In 1776, ADAM SMITH

proposed this theory, which is

still relevant.

Theory of absolute
advantage

Says, int. trade takes place because one

country may be more efficient in producing

a particular product than another country,
and that the other country may be capable
of producing some other product more
efficiently than the first one. Both countries
can specialise and increase their
productivity.

Absolute Advantage
An Absolute Advantage exists if one

country can produce a commodity

more cheaply than another
An absolute Advantage exists if one
nation can produce more of some
product than another with the same
amount of resources.

Example 1
Country A

Country B

Super comp.

10 hrs of
labour

15 hrs of
labour

Aircraft

20 hrs of
labour

10 hrs of
labour

Example 2: Say 1 resource

unit is one man day
Argentina

1 S

produces
Germany
5 S
produces
So, Germany can
produce more
steel for equal
sacrifices of food.

1F
1F

1 resource unit is a man day

Germany

Produces:
20
S+1F
TOTAL OUT PUT=
22 S + 3F = 25
units (tons)

Argentina

Produces:
2S
+ 2F
Suppose each
nation decides to
specialize:
Germany only
Steel, Argentina
only food.

Germany

Argentina

produces= 40 S +
0F
TOTAL OUT PUT
= 40 S + 4 F = 44
UNITS (tons)

produces= 0 S + 4
F
By specializing
according to
absolute
advantage the
increase in total is
19 tons, but it
masks the reason
why nations trade.

Theory of comparative
advantage
In 1817, DAVID

theory.

RICARDO propounded this

Theory of Comparative Advantage

Specialization in a specific commodity due to diversification

of economic resourcesClimatic Conditions, Geological
deposits, Supply of Labour and Capital.
Different technologies or resource endowments
encourage,
Argentina
to produce beef,
Japan to produce
electronic products,
Germany to produce steel.

Opportunity Cost
The decision to produce any goods or service has an

opportunity cost which is, The amount of another

goods or service that might otherwise have been
producedIt is more efficient to produce the goods with the
lower opportunity cost, using the increased
production of that goods to trade for the goods with
higher opportunity cost.

Theory of comparative
advantage
Says, trade is possible as long as the

country experiencing the disadvantage is

not equally less efficient in producing all
the products, i.e. both the countries enjoy
comparative advantage in atleast one of
the products.

Principle of Comparative
Adv.
Nations can increase output by producing those

products in which they are relatively most

productiveProducts in which they have the largest

comparative advantage ( or the _ _ _ _ _ _ _ _ _ )

Suppose Germany becomes

more productive in food:
Germany

Produces: 20 S +
4F

Argentina remains at:

2S+2F
Germanys greater
TOTAL OUT PUT= 22
comparative adv. is
S + 6 F= 28 tons
steel and Argentinas
smallest comparative
disadvantage is food.

The main reason for

International Trade is the
difference in prices, which in
global context reflects
international difference in
costs.
CONCLUSION:

When nations
specialize in the product of their comparative
advantage and have increasing opportunity
cost, they go in for international trade.

Another example each

country has 600 hrs totally
Country A

Country B

1 unit of steel

5 lab hrs

15 lab hrs

1 unit of cement

10 lab hrs

20 lab hrs

If each country produces only

one product, then
Country A

Country B

Steel

120 units

40 units

Cement

60 units

30 units

Lessons:
A should produce steel.
B should produce cement
Two countries can benefit by trading with

each other, even if one of them has an

absolute advantage in all commodities.

Heckscher Ohlin model

According to this model, there are two

types of products capital and labour

intensive. A labour rich country will produce
labour intensive products and a capital rich
country will go for capital intensive
products. Then they will trade among
themselves.

Imitation gap theory

According to imitation gap theory proposed

by Posner, the degree of trade between two

countries will depend upon the differences
between the demand lag and the imitation
lag.

Demand lag
Demand lag is the difference between the

time a new or an improved product is

introduced in one country and the time, the
consumers in other country start
demanding it.

Imitation lag
Imitation lag is the difference between the

time a new product is introduced in one

country and when the producers in other
country start producing it.

Lessons:
If imitation lag is less than demand lag,

then no trade will take place.

Normally demand lag will be lesser than

imitation lag and so international trade

takes place.

International PLC theory

The international PLC theory, given by

VERNON, explains the various stages in the

life of a new product and resultant
international trade.
Two important factors considered by this
theory are - technological innovation and
market structure

Different stages:
In the first stage, the product is producted

and exported by the country which

innovated the product.
In second stage, the production will shift to
other developed countries.
In the third and final stage, the production
will shift to lesser developed countries and
the same may be imported by the original
innovator.

I. Tariff barriers
Import duty
Export duty
Transit duty

It can be imposed on three different bases:

Specific duty
Ad volerem duty
Compound duty

II. Non tariff barriers

Quota
Embargo
Voluntary export restraint
Subsidies to local goods
Local content requirements
Technical barriers
Procurement policies
International price fixing
Exchange controls

Advantages of International
Trade
Additional output from the exchange of goods
Income levels & living standards go up through

international specialization & exchange

Development of vast markets- Economy of scale
Increased productivity through specialization of
resources
Assimilation of newer technologies

CULTURAL DYNAMICS:
UNITED STATES: People and

institutions in America want things to

happen faster; they exert more pressure
on results; they believe in direct
communication.
UNITED KINGDOM: Business in UK is
still top down and hierarichal. In
business negotiations, they tend to

Avoid confrontation and disagreement,

one reason why they are indirect,

reserved and tactical.
GERMANY: Have high regard for
authority and structure; it takes a longer
time to communicate. They check
everything is in order before moving on
to the next phase. Work oriented; do
not like to mix work & pleasure.Time
conscious- never arrive late for an
appointment.

JAPAN: Meeting go through 4

general stages- the getting

acquainted phase, information
exchange session, negotiation and
reaching final agreement. Several
sitting may be necessary to
accomplish each stage. You dont
talk about profit. Suggest that the
goal of your meetings is to establish
long term business relationship that
benefit all partners.