Theories of International Trade

Dr. R. K. Das
 Some important concepts
• Free Trade (Laissez-faire)
• Autarky
• Means of production
• Returns to scale of production
 Free Trade
• When countries are involved in international
trade, there may be a lot of disparities/
disputes among them which may in turn
influence trade. Free trade restricts all such
disparities/ disputes during trade meaning
there is no restriction over the amount to be
exported or imported at a pre-determined
price.
 Autarky
• Autarky means the status of the country
before trade takes place (generally in terms of
domestic price of the product and quantity of
output produced). Autarky is important to
understand the gains from trade.
 Means of production
• This means the input of production (generally
labour and capital). In our theories we will
confine the discussion taking labour as the
only means of production.
 Returns to scale of production
• This means the economies of scale. There are
three types of returns to scale – increasing,
constant and decreasing.
• In our discussion we will consider constant
returns to scale implying the efficiency of the
input of production remains constant.
• For example, if it takes 2 hours to make one loaf
of bread in country A, then it should take 4 hours
to produce two loaves of bread. Consequently, it
would take 8 hours to produce four loaves of
bread.
 Absolute Advantage Theory of International
Trade
• This is the simplest model of trade theories developed
by Adam Smith.
• The statement: An exchange of goods will take place
only if each of the two countries can produce one
commodity at an absolutely lower
production cost than the other country.
• This means countries involved in international trade
should specialize over the good over which it holds
absolute advantage to produce that good at the lower
cost of production and export them to other countries
where cost of production is relatively higher.
 The assumptions of the model
• It is a two-country two-commodity model;
• Labour is the only means of production;
• Cost of labour is same among the trading countries
(implying migration of labour from one country to
another is restricted);
• Both the countries can produce and consume those
two commodities;
• Reselling of commodities is restricted;
• There is no restriction over the quantity of commodities
to be exchanged (meaning free trade prevails);
• Production process experiences constant returns to
scale in both the countries.
Two-country/ Two-commodity Model
• Let us consider two countries are country A and
country B;
• Two commodities are, let, X and Y;
• In country A, 20 man-hours of labour is required to
produce 1 unit of X and 12 man-hours of labour is
required to produce 1 unit of Y;
• Similarly, in country B, 15 man-hours of labour is
required to produce 1 unit of X and 18 man-hours of
labour is required to produce 1 unit of Y;
• As labour is the only means of production, cost of
hiring labour is the only cost of production as well as
the selling price in autarky in respective countries.
 Country
A B
X 20 15
Y 12 18

Autarky situation in country A:

Domestic price of X = 20 units; Domestic price of Y = 12 units;
Autarky situation in country B:
Domestic price of X = 15 units; Domestic price of Y = 18 units;

We are, for simplicity, assuming that both the countries are producing 1 unit of
each product.
So, in autarky, country A and country B produce 2 units of output in total.
Hence, the world output of X = 1 + 1 = 2 units, and world output of Y = 1 + 1 =
2 units.
 Country World Output
A B
In autarky,
X 20 15 X = 2 units
Y = 2 units
Y 12 18

• Country B holds absolute advantage in producing X, while

country A holds absolute advantage in producing Y.
• Hence, as per the absolute advantage theory, country A should
specialize in the production of Y and export it to country b, while
country B should specialize in the production of X and export it to
country A.
• Country A will only focus to produce Y and country B will only
focus to produce X, and import the other commodity from other
country.
• Country A will withdraw all the labour from the
production of X and employ them in the
production of Y. In the same way, country B will
withdraw all the labours from Y production and
employ them in the production of X.
• Country A now has (20 + 12 = 32) man-hours to
produce Y, and country B has ( 15 + 18 = 33)
man-hours to produce X.
• So country A will produce (32/12 = 2.67 units of
Y, and country B will produce (33/15 = 2.2 units
of X)
 Country World Output
A B
In autarky,
X 0 33 X = 2.20 units
Y = 2.67 units
Y 32 0

• So, specialization helps both the countries to

gain in output production, and the world is also
benefitted in terms of output production.
• Without specialization, world output was 4
units, but with specialization world output
becomes (2.20 + 2.67 = 4.87 units)
 Exchange price
Country Domestic Price Exchange Price

A 20 MU for X 12 MU for Y For Y, any price better than 12

MU but less than 18 MU
Þ12 MU < PY < 18 MU
Þ let PY be 15 MU

B 15 MU for X 18 MU for Y For X, any price better than 15

MU but less than 20 MU
Þ15 MU < PX < 20 MU
Þ let PX be 18 MU
 How much to export?
• Total output of Y by country A is 2.67 units and
total output of X by country B is 2.20 units.
• Each country will export 1 unit of their total
product to other country;
Þ Country A exports 1 unit of Y to country B, and
consumes the rest domestically.
Þ Country B exports 1 unit of X to country A and
consumes the rest domestically.
Distribution of revenue after trade
• For country A:
Selling 1.67 units of Y @ 12 MU and 1 unit @ 15 MU
to country B;
So, total revenue earned after trade = (12 X 1.67 + 15
X 1) MU = 35.04 MU
• For country B:
Selling 1.20 units of X @ 15 MU and 1 unit @ 18 MU
to country A;
So, total revenue earned after trade = (15 X 1.20 + 18
X 1) MU = 36.00 MU
 Gains in Revenue after trade
Before trade After trade Net gain
Country A (20 + 12) = 32 MU 35.04 MU 3.04 MU
Country B (15 + 18) = 33 MU 36.00 MU 3.00 MU

Gains in world revenue after trade:

Before trade revenue: (32 + 33) MU = 65 MU
After trade revenue: (35.04 + 36.00) MU = 71.04 MU
Net gain in revenue: (71.04 – 65.00) MU = 6.04 MU
 Conclusion
• The theory of absolute advantage
demonstrated that specialization helps the
trading countries to benefit themselves in
terms of output production as well as revenue
generation;
• The world also benefitted both from output
production as well as revenue generation.