International Trade

• International trade is exchange of capital,

goods, and services across international
borders or territories. In most countries, it
represents a significant share of gross
domestic product (GDP).
 Importance

Countries benefit from foreign trade

• They can import resources they lack at home
• Higher standards of living and greater satisfaction
• They can import goods for which they are a relatively
inefficient producer
• Specialization often results in increased output and
economies of scale
• Contributes to global interdependence
 Risks
• Buyer insolvency (purchaser cannot pay);
• Non-acceptance (buyer rejects goods as different from the
agreed upon specifications);
• Credit risk (allowing the buyer to take possession of goods
prior to payment);
• Regulatory risk (e.g., a change in rules that prevents the
transaction);
• Intervention (governmental action to prevent a transaction
being completed);
• Political risk (change in leadership interfering with
transactions or prices); and
• War and other uncontrollable events.
 Theory Of Mercantilism
• The first theory of international trade called
Mercantilism in England, in mid-16th century.
• Gold and silver were the currency of trade
• Country’s interests was to maintain a trade
surplus, to export more than it imported
• By doing so, a country would accumulate gold
and silver and, consequently, increase its
national wealth and prestige—by an English
mercantilist writer Thomas Mun in 1630.
 Demerits:
• Problems with this theory is that it excludes
the fact that in some cases it is good to import
• If the import is completely refused, the
population will have to do without certain
consumer items.
 Theory of Absolute Advantage
• Proposed by Adam Smith in 1776 in his book
‘The Wealth of Nations’
• He was a Scottish Classical Economist
• Some of his great books are ‘The theory of
Moral Sentiments’ and ‘The Wealth of
Nations’
• He said, ‘ A country has an absolute advantage
in the production of a product more efficiently
than any other country

• He said, ‘Countries should specialize in the

production of goods for which they have
absolute advantage and then trade these for
goods produced by other countries.
• Smith’s basic argument that a country should
never produce goods that can buy at a lower
cost from other countries
Examples:
• England should specialize in the production of
textiles and French in wine and then trade these
• Ghana and South Korea doing trade of cocoa
and rice
 Comparative Cost Theory
• It is attributed to David Ricardo an English
political economist in 1817 in his book
‘Principles of Political Economy and Taxation’
• He was also a member
of Parliament, Businessman, Financier and
Speculator
• Some countries have the advantage of
producing some goods at a lower cost compared
to other countries.
 The countries in the long run should specialize
in the business in which they enjoy
comparatively low cost advantage and export
the product while it will import other goods in
which other countries have comparatively low
cost advantage, if free trade is allowed

e.g. Japan in producing electronics and India in

textile
 The basic message of this theory
• Potential world production is greater with
unrestricted free trade than it is with
restricted
• Consumers in all nations can consume more if
there are no restrictions on trade
• Trade is a positive sum game in which all
countries that participate realize economic
gains.
 Assumptions of this theory
• The only element of the cost of production is
labour
• There are no trade barriers
• Trade is free from cost of transportation
 Criticism
• An advanced nation may gain an advantage by
shifting labour and resources to more
profitable goods such as microchips and away
from less profitable goods like potato chips.
Thus there is a chance that the advanced
nation may buy all the potato chips it wants as
it has more wealth for microchips
• Advanced industrial countries may keep
undeveloped countries on agriculture instead
of developing their own manufactures (which
would have made them competition for the
industrialized nations)
 Hecksher-Ohlin Theory
• Swedish economists-Eli Heckscher(1919) &
Bertil Ohlin(1933)
• Ohlin-student of Hecksher
 Postulates
H-O Theory is based upon two postulates:
1.The factor endowments are different in different
countries.
– E.g. Land-Argentina & Australia
– Labour- INDIA & China
– Capital-U.S.A & U.K.
2.Different commodities require for their
production different proportions of the factors
of production.
• They gave a different explanation of comparative advantage
• They argued that comparative advantage arises from
differences in national factor endowments (land, labor,
capital)
• Different factor endowments among countries explain
differences in factor costs.
• The more abundant a factor, the lower its cost
• Export those goods that make intensive use of factors that
are locally abundant, while importing goods that make
intensive use of factors that are scarce
 Assumptions
• It is based on the neo-classical theory which considers
land ,labour and capital as the factors of production.
• Factor endowments vary in quantity but are
homogenous qualitatively.
• Resources are fully employed in the trading countries.
• The production are fully employed in the trading
countries.
• Technologies are same across countries
 MERITS OF H.O THEORY OVER CLASSICAL
THEORY
• H-O model takes these factors-land, labour & capital–
as against the one factor (labour) of the classical
model.
• It is cast within the framework of the general
equilibrium theory of value.
• It is more realistic because it is based on the relative
prices of factors which in turn influences the relative
prices of the goods, while Ricardian theory considers
the relative price of goods only.
• Considers differences in relative productivity of labor
and capital as a basis of international trade.
 Criticisms
• Theory explains trade being due to differences in factor
proportions between countries. This implies that no trade
will take place between countries endowed with similar
factor endowments
• Theory ignores factors such as-transport cost, economies of
scale, etc.
• Wijanholds-price of commodity not determined by factors
of production
• S.Linder(Swedish economist)-It is not applicable to
manufactured goods, where the costs largely depend upon
technology, management, scale of production, etc.
• Assumption that don’t hold good in a dynamic
world
– fixed factor endowments
– Technology
• J.H.Williams-contends the assumption of
immobility of factors between countries
• Theory is not supported by empirical evidence