INTERNATIONAL TRADE THEORIES

A.Mercantilism
The economic doctrine that prevailed preceding the development of classical theories of international
trade was mercantilism. Mercantilism is known as first theory of international trade which came in
existence during mid of 16th century. England was the originating country of this theory. At that time
gold and silver were the mainstays of national wealth. This concept was at the core of mercantilism.

The main emphasis in mercantilism was to increase export and decrease import so that country can
maintain trade surplus. For this purpose mercantilist doctrine gave emphasis on increasing government
intervention for balancing the balance of trade. To achieve this, imports were limited by imposing tariffs
and quotas, while exports of goods were subsidized heavily.

Following are the main features of mercantilism:

 Mercantilism theory is of very nationalistic in nature i.e. it gives prime importance to the well
being of own country and welfare of population of own country.
 It favored the regulation and planning of economic activities as an efficient and effective mean
for achieving the goals of the nation.
 It generally viewed foreign trade with suspicion. According to mercantilists, the most important
way a country could grow rich is to acquire precious metal especially gold and silver. They
favored exports so long as they brought gold into the country. Imports were to be discouraged
because they deprive the country of its true source of richness – precious metals. Therefore,
trade had to be regulated, controlled and restricted because no specific virtue being seen in
having a large volume of trade.
Basic flaw in the theory of mercantilism is that it says benefit or gain of one country is loss of another
country. It deals international trade as a zero sum game in which loss of one player is the gain of second
player.

B.Adam Smith’s Absolute Cost Advantage Theory

This theory was propounded by Adam Smith in his famous book, “The wealth of nations” in 1776. In the
book Smith argued that countries can gain advantage by trade only when they specialize in production
of only one product. He questioned to mercantilists assumption that a country’s wealth depends on its
holding of treasures (Gold and Silver). Rather, he suggested that real wealth of a nation is to make
available goods and services to country’s citizens. Smith said that different countries produce some
goods more efficiently than other countries.

This theory depends on following assumptions

 There are only two countries and two goods.

 There is no difference in cost of resources in both the countries.
  There is no transportation cost between two trading countries.
 Within a country movement of resources is free.
For understanding Smith’s doctrine we are taking following example

Let us assume that:

 Labor is the only factor of production

 There are two countries in the world (India and Kenya) and two commodities (Tea and Cloth)
 1 unit of labor in each of the two countries will produce:
Kenya India

Cloth 60 120

Tea 80 40

Note:

 India has an absolute advantage over Kenya in the production of Cloth

 Kenya has an absolute advantage over India in the production of Tea
It follows that:

 If India produces Cloth and Kenya produces Tea, and an exchange ratio can be arranged, both
countries will benefit from trade
Before Trade:

Kenya: 1 Cloth = 1.33Tea (i.e. 80/60)

India: 1 Cloth = 0.33 Tea (i.e. 40/120)

So if Kenya specializes in Tea and India specializes in Cloth, international trade would be beneficial for
both countries at any exchange rate between 0.33 and 1.33 Tea for 1 unit of Cloth.

Let’s now assume an exchange rate of 1 Cloth = 1 Tea

After Trade:

Kenya: 1 Cloth = 1 Tea (gets same unit of cloth for less Tea – i.e. gets more Cloth for same Tea)

India: 1 Cloth = 1 Tea (gets more Tea for same Cloth – i.e. gets same Tea for less Cloth)

Let’s further assume complete specialization and doubling of output in each country:

Before Trade (Autarky) Kenya India Total (World output)

Cloth 60 120 180

Tea 80 40 120
 Total Output 300

After Trade Kenya India

Cloth 0 240 240

Tea 160 0 160

Total Output 400

It is clear from the above table that free trade leads to greater world output

C.Ricardo’s Comparative Cost Advantage Theory

Now in the above example, if we consider that, India has absolute advantage over the Kenya in the
production of both goods, than there will not be any trade activity between India and Kenya. The
absolute advantage theory was not having any solution for these types of questions. David Ricardo
introduced the theory of comparative advantage to give answer to these questions. The theory of
comparative advantage states that nations should produce those goods for which they have the greatest
relative advantage. The key word here is relative (as opposed to absolute).

The Ricardian theory of comparative advantage is based on opportunity cost, i.e. opportunity cost of
one good in terms of the other. Opportunity costs are determined by labor productivity. So long as labor
productivity differs between countries, trade (exchange of goods and services between countries) could
lead to specialization gains and exchange gains, thereby leading to an increase in overall well-being

Thus there are gains from trade whenever the relative price ratios of two goods differ under international
exchange from what they would be under conditions of no trade (i.e. autarky).

For understanding Ricardian doctrine we are taking following example

Let us assume that:

 Labor is the only factor of production

 There are two countries in the world (India and Kenya) and two commodities (Tea and Cloth)
 1unit of labor in each of the two countries will produce:
Kenya India

Cloth 60 120

Tea 30 40

Note:
  India has an absolute advantage over Kenya in the production of both Cloth and Tea but the
relative productivity differs.
 India’s productivity in cloth is 120/60 = 2 times that of Kenya in Cloth, but India’s productivity in
Tea is 40/30 = 1.33 times that of Kenya in Tea. Hence India has greatest relative advantage
(comparative advantage) in Cloth. So India should specialize in production of Cloth.
 Kenya has comparative disadvantage in both Cloth and Tea, but its disadvantage is least in Tea,
so Kenya should specialize in Tea.
 Because India has greatest comparative advantage in Cloth rather than in Tea, the price of Cloth
relative to Tea (Pc/Pt) in India is lower than the relative price of Cloth in Kenya. For example:
(a) In India, 1 Cloth = 0.33 Tea (i.e. 40/120)

Or 100 Clothes = 33 Teas

(b) In Kenya, 1 Cloth = 0.50 Tea (i.e. 30/60)

Or 100 Clothes = 50 Teas

It follows that:

 If India can import more than 33 units of Tea for 100 units of Cloth, it will gain from trade
 If Kenya can import more than 100 units of Cloth for 50 units of Tea, it will also gain from trade
 Both countries can benefit from free trade at an exchange rate between 33 and 50 units of Tea
for 100 units of Cloth.
Let’s assume an international trade exchange rate of 40 units of Tea for 100 units of Cloth, then:

 India, which specializes in Cloth, now gets more Tea for the same Cloth
 Kenya, which specializes in Tea, now sacrifices less Tea for the same Cloth
So, even though India has absolute advantage in the production of both Tea and Cloth over Kenya, its
greatest comparative (Relative) advantage lies in Cloth (as opposed to Tea). Because of productivity
differentials between the two countries in the two goods, free trade leads to specialization and
exchange gains for both countries.

Should both countries completely specialise in the production of each product? It all depends on
whether or not both are of equal size. Size matters! Whilst small countries can specialise 100%
and still yet all the benefits associated with free trade, big countries need not specialise
completely.
For example:

Before Trade (Autarky) Kenya India Total (World output)

Cloth 60 120 180

Tea 30 40 70

Total Output 250

After Trade Kenya India

 Cloth 0 240 240

Tea 60 0 60

Total Output 300

Whilst the world output for Cloth increases from 180 units to 240 units, the world output of Tea declines
from 70 units to 60 units.

So, it pays for the bigger country to devote a bulk of resources (e.g. 70%) to the production of the good
it has greatest comparative advantage and the rest to the production of the good whose comparative
advantage is least.

Before Trade (Autarky) Kenya India Total (World output)

Cloth 60 120 180

Tea 30 40 70

Total Output 250

After Trade Kenya India

Cloth 0 204 204

Tea 60 12 72

Total Output 276

So, complete specialization of the smaller country combined with a partial specialization of the bigger
country (India) increases world output. Thus trade provides greater economic output and consumption
to the trading partners jointly as they specialize in production, exporting the goods in which they have a
comparative advantage and importing the goods in which they have a comparative disadvantage.

Summarizing the Ricardian theory:

 Ricardo was concerned with demonstrating that countries should specialize on the basis of
Comparative Advantage and not Absolute Advantage. This results in specialization gains.
 Free trade also results in exchange gains.
 A basis for trade exists when commodity price ratios differ between countries.
 Commodity price ratios are an inverse function of productivity ratios. I.e. the lower the price
ratios, the higher the productivity ratios and vice versa.
 All of this is based on the following assumptions:
 Constant Returns to Scale Production Functions,
 Perfect Competition,
  free mobility of factors between sectors within countries but immobility of factors
between countries.
 Zero transport costs
 A cursory look at differences in wage rates across nations and productivity differences may, to a
large extent, explain the growth of exports from developing countries in Ricardian goods.
 It is not clear whether these exports were responsible for unemployment and decline in wages
of the unskilled in the developed countries.
 Trade policy should not be used to solve social problems (distribution problems).

D.Haberler’s Opportunity Cost Theory

The opportunity cost theory was proposed by Gottfried Haberler in 1959. According to Haberler goods
are not produced by the labor only. Production of goods uses various combinations of factors of
production (land, labor, capital). Each country exports goods which it produces at lower opportunity cost
and imports those with higher opportunity costs(The opportunity cost is the value of alternatives which
have to be forgone in order to obtain a particular thing).

For understanding opportunity cost theory read following example

Let us consider that India can produce either 100 meters of cloth or 100 jute bags hence its all factors of
production are fully employed in the production of either cloth or jute bag. If we draw a curve by taking
cloth on vertical axis and jute bag on horizontal axis, than, we can find out different combinations of
both the products. Production possibility curve suggests that for the production of 1 meter cloth India
has to give up the production of 1 jute bag. The opportunity cost, therefore of a particular commodity
‘A’, is the benefit of opportunity lost if ‘A’ is instead put to its alternative use.

Thus, this theory provides the basis for international business in terms of exporting a particular product
rather than other products.

Haberler's theory of trade base on opportunity cost is re resented by production possibility

curves. A production possibility curve represents the production frontiers (of generally two
goods) that can be reached by using all the available factors of production. In simple words, the
production possibility curve shows the various combinations of two goods that can be produced
given the 'factor endowments of a country-factor endowments include all the factors of
production available to a country. In this sense, Haberler deviates from the classical assumption
of only one factor and introduces, in his model, all the factors of production.

Haberler's theory of trade is also called the neo-classical theory of trade.

Following are some assumptions of this theory

1.there are only two nationas.

2.There are only two commodities.

3.There are only two factors of productions such as labour & capital.

4.There is perfect competition in both the factors and commodity market.

5.Supply of each factor is fixed.

6. There is full employment in each country

7.There is no change in technology.

8. There is factor immobility of factors of productions between countries but they are fully mobile within
countries.

9.There is free and unrestricted trade between countries.

E.Hecksher-Ohlin Theory
The factor proportions model was originally developed by two Swedish economists, Eli
Heckscher and his student Bertil Ohlin in the 1920s. The H-O model incorporates a number of
realistic characteristics of production that are left out of the simple Ricardian model. The
standard H-O model begins by expanding the number of factors of production from one to two.
The model assumes that labor and capital are the two factors of production used in the
production of goods. Here, capital refers to the physical machines and equipment that is used in
production. Thus, machine tools, conveyers, trucks, forklifts, computers, office buildings, office
supplies, and much more, is considered capital. The assumption of two productive factors,
capital and labor, allows for the introduction of a realistic feature in production; differing factor
proportions both across and within industries. When one considers a range of industries in a
country it is easy to convince oneself that the proportion of capital to labor used varies
considerably. For example, production of industrial product generally involves large amounts of
expensive machines and equipment spread over perhaps hundreds of acres of land, but uses
relatively few workers, while in the agriculture industry, in contrast, harvesting requires
hundreds of labors. The amount of machinery used in this process is relatively small.
In the H-O model we define the ratio of the quantity of capital to the quantity of labor used in a
production process as the capital-labor ratio. We imagine, and therefore assume, that different
industries, producing different goods, have different capital-labor ratios. It is this ratio (or
proportion) of one factor to another that gives the model its generic name: the Factor
Proportions Model.
In a model in which each country produces two goods, an assumption must be made as to which
industry has the larger capital-labor ratio. Thus, if the two goods that a country can produce are
steel and clothing, and if steel production uses more capital per unit of labor than is used in
clothing production, then we would say the steel production is capital-intensive relative to
clothing production. Also, if steel production is capital intensive, then it implies that clothing
production must be labor-intensive relative to steel. Another realistic characteristic of the world
is that countries have different quantities, or endowments, of capital and labor available for use
in the production process. Some countries like England are well endowed with physical capital
relative to their labor force, while, in contrast many less developed countries like India have very
little physical capital but are well endowed with large labor forces. We use the ratio of the
aggregate endowment of capital to the aggregate endowment of labor to define relative factor
abundance among countries. Thus as an inference of above statement we can say that the
England has a larger ratio of aggregate capital per unit of labor than India's ratio, we would say
that the England is capital-abundant relative to India. By implication, India would have a larger
ratio of aggregate labor per unit of capital and thus India would be labor-abundant relative to
the England. A fundamental distinction between the H-O model and the Ricardian model is that
the Ricardian model assumes that production technologies differ between countries; the H-O
model assumes that production technologies are the same.
The Heckscher-Ohlin theorem states that a country which is capital-abundant will export the
capital-intensive good. Likewise, the country which is labor-abundant will export the labor-
intensive good. Each country exports that good which it produces relatively better than the other
country. In this model a country's advantage in production arises solely from its relative factor
abundance.
The H-O model assumes that the two countries (England and India) have same technologies,
meaning they have the same production functions available to produce steel and clothing. The
model also assumes that the aggregate preferences are the same across countries. The only
difference that exists between the two countries in the model is a difference in resource
endowments. We assume that the England is capital-abundant compared to India. Similarly,
India, by implication, is labor-abundant compared to the England. We also assume that steel
production is capital-intensive and clothing production is labor-intensive.
This is the Heckscher-Ohlin theorem. Each country exports the good intensive in the
country's abundant factor.

Assumptions of Heckscher Ohlin's H-O Theory ↓

Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following
assumptions :-

1. There are two countries involved.

2. Each country has two factors (labour and capital).
3. Each country produce two commodities or goods (labour intensive and capital intensive).
4. There is perfect competition in both commodity and factor markets.
5. All production functions are homogeneous of the first degree i.e. production function is subject
to constant returns to scale.
6. Factors are freely mobile within a country but immobile between countries.
7. Two countries differ in factor supply.
8. Each commodity differs in factor intensity.
9. The production function remains the same in different countries for the same commodity. For
e.g. If commodity A requires more capital in one country then same is the case in other country.
10. There is full employment of resources in both countries and demand are identical in both
countries.
11. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.
12. There are no transportation costs.
Given these assumption, Ohlin's thesis contends that a country export goods which use relatively a
greater proportion of its abundant and cheap factor. While same country import goods whose
production requires the intensive use of the nation's relatively scarce and expensive factor.

Price Criterion for defining Factor Abundance ↓

A country where capital is relatively cheaper and labour is relatively costly is said to be capital
rich country. Whereas a country where labour is relatively cheaper and capital is relatively costly
is said to be labour rich country.Price of the factor can be symbolically measured as follows :-

In above relation,
1. P refers to price of the factor,
2. K refers to Capital,
3. L refers to Labour,
4. E stands for England, and
5. I stands for India.
The above analysis highlights a fact that in England capital is cheap, and hence it is a capital
abundant country. Whereas in India, Labour is cheaper, and thus it is a labour rich country.

Diagram Explaining Heckscher Ohlin's H-O Theory

Let us take an example of same two countries viz; England and India where England is a capital
rich country while India is a labour abundant nation.
In the above diagram XX is the isoquant (equal product curve) for the commodity X produced in
England. YY is the isoquant representing commodity Y produced in India. It is very clear that
XX is relatively capital intensive while YY is relatively labour incentive. The factor capital is
represented on Y-axis while the factor labour is represented on the horizontal X-axis.
PA is the price line or budget line of the country England. The price line PA is tangent to XX at
E. The price line PA is also tangent to YY isoquant at K. The point K will help us to find out
how much of capital and labour is required to produce one unit of Y in England.
P1B is the price line of the country India, The price line P1B is tangent to YY at I. The price line
RS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how much
of capital and labour is required to produce one unit of commodity X in India.
Under the given situations, the country England will choose the combination E. Which means
more specialisation on capital goods. It will not choose the combination K because it is more
labour intensive and less capital intensive.
Thus according to Ohlin, England will specialise on production of goods X by using the cheap
factor capital extensively while India specialises on commodity Y by using the cheap factor
labour available in the country.
The Ohlin's theory concludes that :-
1. The basis of internal trade is the difference in commodity prices in the two countries.
2. Differences in the commodity prices are due to cost differences which are the results of
differences in factor endowments in two countries.
3. A capital rich country specialises in capital intensive goods & exports them. While a Labour
abundant country specialises in labour intensive goods & exports them.
Limitations of Heckscher Ohlin's H-O Theory ↓

Heckscher Ohlin's Theory has been criticised on basis of following grounds :-

1. Unrealistic Assumptions : Besides the usual assumptions of two countries, two commodities, no
transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of
production, identical production function, constant return to scale, etc. All these assumptions
makes the theory unrealistic one.
2. Restrictive : Ohlin's theory is not free from constrains. His theory includes only two
commodities, two countries and two factors. Thus it is a restrictive one.
3. One-Sided Theory : According to Ohlin's theory, supply plays a significant role than demand in
determining factor prices. But if demand forces are more significant, a capital abundant country
will export labour intensive good as the price of capital will be high due to high demand for
capital.
4. Consumers' Demand ignored : Ohlin forgot an important fact that commodity prices are also
influenced by the consumers' demand.
5. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory under U.S.A
conditions. He found out that U.S.A exports labour intensive goods and imports capital intensive
goods, but U.S.A being a capital abundant country must export capital intensive goods and
import labour intensive goods than to produce them at home. This situation is called Leontief
Paradox which negates H-O Theory.
6. Other Factors Neglected : Factor endowment is not the sole factor influencing commodity price
and international trade. The H-O Theory neglects other factors like technology, technique of
production, natural factors, different qualities of labour, etc., which can also influence the
international trade.