Trade Theories

UNIT 4 TRADE THEORIES

Objectives

After reading this unit you should be able to:

 understand the analytical foundations of international trade;

 know how the nations decide their trade policy;

 understand different trade theories; and

 know FDI approaches to international trade.

Structure

4.1 Introduction
4.2 Classification and Importance of Trade Theories
4.3 International Trade Theories
4.4 Heckscher-Ohlin Theory
4.5 Foreign Direct Investment (FDI) Theories
4.6 Summary
4.7 Key Words
4.8 Self-Assessment Questions
4.9 References /Further Readings

4.1 INTRODUCTION
From ages to civilizations; world history is essentially a story of wars and trade. Major
wars were primarily fought mainly for economic reasons rather than conflict of political;
cultural or social ideas. For examples; Britons set up their colonies world over for
trade; U. S. invaded Iraq and Libya mainly for economic reasons. Africa was colonised
for trade and commerce so was the story of Latin America. Historians, World over,
generally believe that most of wars were fought for trade-related reasons. Theories of
international trade and its applications help us understand the motives and reasons
behind such wars explaining trade pattern and the benefits that flow from trade. An
understanding of international trade theory helps us as investors or consumers, buyers
or sellers, companies and governments to determine how to act for their own benefit
within the global trading system.

4.2 CLSSIFICATION AND IMPORTANCE OF

TRADE THEORIES
International Trade Theories are broadly classified into following categories as shown
in Figure 4.1.

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International Trade

Figure 4.1: International Trade Theories

Firstly; international trade theory helps us explain the trade patterns; trade motives;
trade trends and observed trade. It helps us explain the characteristics of trade pattern
of a trading country, and from those characteristics it can be deduced what; why;
where and how they actually trade. Various trade theories provide us easy understanding
and explanations about reasons; characteristics and motives behind trade. Secondly,
trade theory also helps us understand and to know about the effects of trade on the
domestic economy/sectors of economy and helps diagnose cause and effect relationship
which in turn help the country policy makers to evaluate different kinds of policies. As
a result; government can plan for policy interventions to boost up trade and international
commerce and brining prosperity to country thus generating welfare in society.
International Trade Theories helps us understand that why do countries trade? Why
not a strong economy like United States of America should produce all goods and
services at back home rather than to import them from countries such as China and
India? Why do countries specialize in trade for example; a strong economy like Japan
import wheat, corn, chemical products, aircraft, manufactured goods, and informational
services from other countries. In nutshell; international trade theories attempt to solve
following questions as shown in Figure 4.2.

Figure 4.2 : Reasons for Studying International Trade Theories

Answer is that countries world over are endowed with different natural, human, and
capital resources. Each country varies from each other in combining these resources
(Land; Labor and Capital). In a globalized set-up each country cannot be efficient as
the best at producing the goods and services that their residents demand. As a result;
they have to trade off their decisions to produce any good or service based on opportunity
cost. Opportunity cost model helps us understand the “choice of producing one
good or another”. The production decision of the country will be dependent on
72 conundrum that it is more efficient to produce the goods and services with the lower
opportunity cost with increased and specialized production; to trade those goods; with Trade Theories
the goods of higher opportunity cost.

4.3 INTERNATIONAL TRADE THEORIES

International business began with international trade operations, which were facilitated
by the global economy’s laissez faire attitude. It improved the well-being of many
nations, and the position of trade barriers reduced trade gains, giving rise to the search
for alternative avenues to boost net exports. Alternative trade routes resulted in the
establishment of companies in foreign countries via FDI. In this context, it is critical to
comprehend the determinants and consequences of international trade and FDI on
trading partners, multinational corporations’ international operations, and the economies
of home and host countries. Several theories have been developed across countries
over time, which have served as the foundation for international trade and FDI.
Theory of Mercantilism
From the sixteenth to the eighteenth centuries, world trade was based on the economic
theory and practice of mercantilism, particularly in Western Europe, namely France,
England, and Germany. It included elements such as belief in protectionism, nationalism,
and the welfare of the nation. Furthermore, it included the planning and regulation of
economic activities in order to achieve national goals, as well as the reduction of imports
and promotion of exports. The trade revolution gave rise to a new economic concept
known as ‘Mercantilism.’According to this theory, agriculture practices have a very
limited impact on a country’s economic development because agriculture becomes
unproductive after a certain period of time. However, economic development through
the use of industries has no bounds.The mercantilists, primarily European countries,
believed that a nation’s power lies in its wealth, which grew by increasing gold and
silver reserves. This was thought to be possible by establishing a favourable trade
balance. This belief gained traction on the grounds that gold could be used to fund
military expeditions and wars, and that exports would create jobs in the economy.
Adam Smith and Ricardo criticized mercantilism theory by emphasizing the importance
of individuals and pointing out that their welfare was the welfare of the nation. They
believed in liberalism and defined national wealth as “the sum of enjoyments” of
individuals in society. Their trade doctrines were founded on the laissez faire principle
and specialization in the production of goods for which resources were most suitable
and easily available. The critics of mercantilism accepted any activity that would increase
people’s consumption. Mercantilists failed to recognize that export promotion and
import substitution are not possible in all countries, and that mere possession of gold
cannot improve people’s well-being. Keeping resources in the form of gold reduces
production of goods and services, lowering the welfare of citizens. The concentration
of production of goods for domestic consumption through less efficient use of resources
will result in less production and lower gains from international trade.
Theory of Absolute Cost Advantage
Adam Smith advocated the theory of absolute cost advantage. Many factors influence
bilateral trade between the two countries, including transportation costs, tariffs, internal
and external factors, national and international aspects, and so on. Every country should
invest in the production of the commodity that it can produce more cheaply than the
other country and exchange it for the commodity that is less expensive in the other 73
International Trade country. Keeping all the variables constant, the following are the assumptions of the
absolute cost advantage theory:
 Labor is the only factor of production that is used in the production of goods;
 The cost of production is the cost of labour; the skill of labour is the same in
both countries; and
 The factor of production, labour, is perfectly mobile.
There is free trade between countries, which means that trading countries do not have
to pay any tariffs; additionally, there are constant returns to scale, and technical progress
is also found to be constant. Finally, both countries manufacture the same commodity.
The example in Table 4.1 will help you better understand the theory:
Table 4.1: Labour Cost of Production (in Hours)

Country Labour Cost Per Day (in hours)

Tractor Truck Before After

Trade Trade

India 10 5 15 20

France 5 10 15 20

According to this theory, trade between the two countries will take place only when
there is an absolute cost difference between the goods produced by the two countries.
Prior to trade, India produced 10 tractors and 5 trucks. At the same time, France
produced 5 tractors and 10 trucks. If these two countries trade, they will specialize in
terms of absolute advantage and gain from trading with each other. India has an absolute
cost advantage in tractor production, while France has an absolute cost advantage in
truck production. India can produce 10 tractors and only 5 trucks in one hour of
labour. However, in the case of France, the situation is the inverse. If both countries
produce both goods, they will be able to trade in that condition. Only 15 tractor and
truck units are manufactured. At the same time, if India and France engage in
international trade with their specialized goods, they can produce 20 units of each. It
means that India, which has an absolute cost advantage in tractor production, will
produce tractors, while France, which is specialized in trucks, will produce only trucks.
Theory of Comparative Cost Advantage
Adam Smith’s theory of absolute advantage failed to explain the basis of trade when a
country has an absolute advantage in producing both goods. To address this issue,
David Ricardo in 1817 explained that if both trading countries do not have an absolute
advantage in either of the two goods, how can international trade take place? He
emphasized that a cost advantage for both trading countries is not required for trade to
occur. Even if one country can produce all goods at a lower labour cost than the other,
it would still benefit both trading countries.
Table 4.2 : Labour Required for Producing One Unit

Country Jute Leather

India 120 100

France 80 90
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The Table 4.2 shows that France has an absolute cost advantage in the production of Trade Theories
both goods, namely jute and leather, when compared to India. India has a comparative
cost advantage in the production of leather, while France has a comparative cost
advantage in the production of jute. However, this means that India needs 100 men
per year to produce leather and 120 men to produce jute. On the other hand, the same
amount of Jute and Leather France requires 80 and 90 labours, respectively. As a
result, India employs more labour than France in the production of jute and leather. In
other words, France is more capable than India in producing both goods, and it has an
absolute advantage in the market. Nonetheless, France would benefit more from jute
production and will export it to India because it has a greater comparative advantage
in it. It is due to the fact that the cost of producing Jute (80/120 labour) is less than the
cost of producing Leather (90/100 labour). At the same time, India will shift its
production to leather production because the country has the least disadvantage.
International trade will benefit both countries in this manner.
Haberler’s Theory of Opportunity Cost
Ricardo’s theory of comparative cost advantage was criticized because it was based on
the labour theory of value. According to the labour theory of value, the value of a good is
equal to the amount of labour time involved in its production. Ricardo discovered that
labour was the only factor of production, that it was homogeneous, and that it was used
in fixed proportions in the production of all commodities. Although all of these assumptions
were found to be unrealistic because there are other factors of production besides labour,
labour cannot be used in uniform proportions, and labour can be substituted with capital
in countries where capital is cheaply available. Because of these flaws, Haberler developed
his theory of Opportunity Cost. According to the theory, if a country produces either A or
B commodity, the opportunity cost of commodity A is the amount of commodity B
sacrificed in order to obtain an additional unit of commodityA. Nonetheless, the exchange
ratio of the two goods is expressed in terms of opportunity cost. Along with the production
possibility curve, the concept has been used in international trade theory. Haberler’s
theory is based on the following assumptions:
 There are only two trading countries, each of which has two factors of
production, namely labour and capital;
 Each country produces two goods;
 There is perfect competition in the factor and goods markets;
 There is full employment in both countries, factors are immobile between the
two countries but completely mobile within the country;
 Trade between the countries was assumed to be free; and
 The supply of goods was assumed to be unlimited.
According to the theory, a production possibility curve (PPC) depicts various alternative
combinations of the two commodities that a country can produce more efficiently by
utilizing both factors of production and the technology at hand. The slope of PPC
calculates the amount of one good that a country must give up in order to obtain an
additional unit of another good. The slope of PPC, on the other hand, explains the
marginal rate of transformation (MRT). Haberler’s theory was thought to be superior
to the comparative costs theory of international trade. Its superiority stems from an
examination of pre-trade and post-trade conditions under constant, increasing, and
decreasing opportunity costs, whereas comparative cost theory was founded on 75
International Trade constant production costs within a country and comparative advantage and disadvantage
between the two countries. Despite its contributions to international trade, Jacob Viner
has criticized the theory of opportunity cost on the following grounds:
 The opportunity costs approach was found to be inferior as a tool of welfare
evaluation to the classical real cost approach, as the theory fails to measure
real costs in the form of sacrifices made in providing productive services.
 Viner also criticized the PPC for failing to take into account changes in factor
supply, and the assumptions of two countries, two commodities, two factors,
and perfect competition were also found to be unrealistic.
Mill’s Theory of Reciprocal Demand
J. S. Mill applied Ricardo’s concept of comparative cost. This means that labour
productivity varies by country. According to Mill, reciprocal demand is the ratio in
which two commodities are traded based on the strength of demand elasticity in both
countries for both A and B commodities. J.S. Mill used the concept of an offer curve in
his theory. Although, Marshall and Edgeworth introduced the concept of offer curves,
the theory is predicated on the following assumptions:
 There are two countries, two goods, and two factors of production;
 It is based on the comparative cost principle, there is perfect competition,
and there is full employment; goods are produced under constant returns.
The theory can be explained using the example given in Table 4.3 based on the above
assumptions:
Table 4.3 : Quantities of Commodities Produced

Country Linen Jute

France 10 10
Italy 6 8

Assume France produces 10 units of linen or jute in one year, whereas Italy produces
6 units of linen or 8 units of jute with the same labour and time factors. According to
J.S. Mill, “It will benefit Italy to import linen from France and France to import jute
from Italy.” It is because France has an absolute advantage in both the production of
linen and jute, while Italy has the least comparative disadvantage in the production of
jute. Prior to entering into trade with each other, France’s domestic cost ratio was 1:1,
and France’s domestic cost ratio was found to be 3:4. However, if they trade with
each other, France has a 5:3 (or 10:6) advantage over Italy in the production of linen,
while Italy has a 5:4 advantage in the production of jute (or 10:8). Nonetheless, 5/3 is
greater than 5/4. In the production of linen, France has a greater comparative advantage.
As a result, France will benefit from exporting linen to Italy in exchange for jute. Similarly,
Italy’s position in the production of linen was determined to be 3/5 (or 6/10), while its
position in the production of jute was estimated to be 4/5 (or 8/10). However, 4/5 is
greater than 3/5, so it is advantageous for Italy to export Jute to France in exchange for
Linen. Nonetheless, Mill’s theory of reciprocal demand is concerned with the possible
trade terms under which the two goods were exchanged between the two countries.
However, the terms of trade refer to the barter terms of trade between the two countries,
i.e. the proportion of a country’s imports to its exports. Furthermore, the domestic
exchange ratios recognized by the relative efficiency of labour in both countries set the
76 limits of possible international trade barter terms. However, it is clear from the example
(Table 4.3) above that France, with two labor-time inputs, produces 10 units of linen Trade Theories
and the same number of units of jute, whereas Italy, with the same labour time, can
produce 6 units of linen and 8 units of jute. However, in France, the domestic exchange
proportion between linen and jute is 1:1, while in Italy, it is 1:1.33. As a result, the
maximum possible terms of trade in France were 1 Linen: 1 Jute, while in Italy it was
calculated to be 1 Linen: 1.33 Jute. As a result, the trade terms between the two goods
were determined to be 1 Linen or 1 Jute or 1.33 Jute.
Activity 1
Choose two countries of your choice producing wheat and rice. Compare their
absolute advantage and disadvantage.
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4.4 HECKSCHER-OHLIN THEORY

Heckscher-Ohlin trade theory was another name for the Heckscher-Ohlin trade model.
Heckscher published a paper in 1919 in which this theory was presented, but Ohlin
published a book in 1933 in which this model was presented. Furthermore, Ohlin was
awarded a Noble Prize for his theory in 1977. This model is also known as the H.O
Model. The model is 2x2x2 because it consists of two goods, two production factors,
and two countries. Capital and labour are the two factors. Ricardo failed to explain
how comparative advantage is determined. According to this theory, a country will
export commodities with abundant factors and import commodities with scarce factors.
However, in Adam Smith and Ricardo’s trade models, labour was the only factor
input, and the differences in the trade is determined by labour productivity. They pointed
out that different countries have different factor endowments, and that the differences
in factor endowments facilitate trade between trading partners. The theory is based on
the assumption that there are trade barriers and that goods and factor markets are
perfectly competitive. Furthermore, the theory is predicated on comparative advantage
in terms of relative factor prices. As a result, if a country has a large amount of capital,
it will produce capital-intensive products and export them in exchange for labor-intensive
products. While another country, which is rich in labour, will produce and export labor-
intensive goods. Despite this, it will import capital-intensive goods. The term “abundance”
has two meanings in this theory: it refers to the price of the factor and it refers to the
physical quantity of the factor. If there are two countries, A and B, then the prosperity
of the country in terms of factor prices means that the price of the factors of production
is relatively lower.
Unlike the classical trade model, H.O. trade theory cannot guarantee the desired income
distribution among the country’s various classes. Because of the greater demand for
producing respective goods for the global market, returns to capital are higher in country
A and returns to labour are higher in country B. The traditional trade models were
predicated on certain assumptions, such as no transportation costs and the free flow of 77
International Trade information to all producers and consumers. They do not account for the effects of
trade on global prices. These trade theories are static and ignore the effects of
technological progress on global economic growth. These are real concerns that must
be addressed in a customized description of classical and neoclassical theories. If a
country has a monopoly on a particular good, it can have an impact on global prices. It
can either supplement its gains through “optimal tariffs,” which seek to maximize the
welfare of the country. Trade has the potential to complicate the growth process. It can
have an impact on employment and even the overall well-being of the country. This is
possible in the case of exponential growth (when benefits from the higher output are
neutralized by the adverse terms of trade). The country ends up with lower real income
after growth because the benefits of higher output are washed out by deteriorating
trade terms. However, it should be noted that the adapted version of the basic theory
does not change the assumption that a country produces and exports the product in
which it has a comparative advantage, and uses the abundant factor in the production.
The country benefits from trade, but the distribution of gains can be distorted. Change
in trade is not free, but the short-term cost of adjustment should be balanced against
the long-term benefits of trade.
The theory was criticized on the following grounds: the assumption of 2x2x2 model
was found to be unrealistic; unlike classical theory, this theory was also static in nature;
the theory was based on the assumption of homogenous factors which was calculated
with the help of factor endowment; the techniques of production cannot also be
homogenous even for the same good in the two countries as assumed in H.O. model;
the theory is based on another assumption of similar taste. The theory was based on
the assumption of constant returns to scale, which is also not true because a country
with a rich factor endowment frequently obtains the benefits of economies of scale
through a smaller amount of production and exports, implying that there should be
increasing returns to scale; the theory does not take into account transport costs in
trade between trading countries; the impractical supposition of full employment and
perfect competition; the Leontief paradox has been proven.
The Leontief Paradox
Wassily Leontief conducted an input-output analysis using data from the United States in
1947 to validate the Heckscher-Ohlin model. He divided 200 industries into 50 sectors,
38 of which were discovered to be trading their goods directly on the international market.
Leontief discovered a paradoxical situation in which the United States was importing
capital-intensive goods from abroad despite being a capital-rich country and was found
to be exporting labor-intensive goods. The supporters of H.O. trade theory experienced
a slowdown in the early 1950s, when Leontief tested his hypothesis using data from the
US economy. His findings refuted the H.O. claim. It was shocking news for economists
that the United States, despite being a capital-rich country, was exporting labor-intensive
goods a several explanations were considered in order to resolve the Leontief paradox.
The following significant factors were identified as supporting the Leontief paradox: the
United States’ protective trade policy, the import of natural resources, and the investment
in human capital. William Travis investigated Leontief theory in the context of US tariff
policy.When Leontief tested his hypothesis, the United States was found to be importing
more capital-intensive items such as crude oil, paper pulp, primary copper, lead, metallic
ores, and newsprint. Thus, according to Travis, the United States’ protective trade policy
was to blame for Leontief’s findings.
The United States imports natural resources such as minerals and forest products and
78 exports farm products, according to Leontief’s presentation. Human capital investment
boosts labour productivity. Because of these factors, the United States’ exports were Trade Theories
labor-intensive, whereas its imports were capital-intensive and importing capital-intensive
goods. Leontief analysis was also found to be flawed on statistical and methodological
grounds. The main points of criticism were: the year 1947 was not a normal year for
testing the H.O. Model because of World War II, as the United States was the only
major industrial country that was not destroyed by war; economists criticized the
aggregation used in the input-output model for computing capital-labour ratios in some
way; it was argued that Leontief model with fixed input coefficients was found to be
mismatched with world trade equilibrium in which every country achieves.

4.5 FOREIGN DIRECT INVESTMENT (FDI)

THEORIES
Despite Multinational Enterprises’ dominance of world production and trade in the
post-World War II period, the search for FDI theories is a contemporary phenomenon.
Stephen, H. Hymer demonstrated in his doctoral thesis ‘The International Operations
of National Firms: A Study of Direct Investment’ (published in 1976) that traditional
theories of international trade and capital movements were incapable of illuminating the
contribution of MNEs in foreign countries in 1960. The existence of MNEs was due to
local firms manipulating market power and acting as agents. The approaches used to
clarify the activities of multinational enterprises have been classified into four groups.
The first is the market imperfection approach, whose theoretical framework considers
specific, also known as ownership advantages, enjoyed by an enterprise. Through
these benefits, FDI is restricted, and international companies also collude with other
firms to increase their profits. Second, the Product Life Cycle model examines various
stages of the company. There are chronological stages in the life cycle of a company’s
innovated products. Third, the failure of traditional theories of international trade and
capital movements based on the assumption of perfect competition, as well as its
prevalence in various segments of the international market, provide ample scope. It
gave rise to the transaction cost theory of FDI, which states that firms make foreign
investments to increase their competence and reduce transaction costs. Finally, the
eclectic paradigm that surrounds other FDI theories provides a logical framework for
conducting empirical investigations that are most relevant to the problem at hand. The
eclectic paradigm is not a theory in itself, but rather a synthesis of contradictory theories.
Market Imperfections Approach
The expansion of MNEs has always perplexed neoclassical economists because of
how these enterprises can make profits in foreign countries where production costs
are higher than in the domestic market. Because many people were unaware of the
host country’s history, it was difficult to take advantage of the situation. It may be
preferable for the foreign company to pass on its reward to local entrepreneurs, who,
along with other local (inherent) advantages, could supply at a lower cost than the
foreign investors. The response to this paradoxical situation was present in the existence
of the imperfect market in the foreign countries. Hymer presented a case for market
imperfection approach. According to him, the traditional theories of international trade
and capital movements were not enough to explain the association of MNEs in
international market. Their presence was observed to be due to market imperfections.
The supporters of this approach thought that the prevailing market imperfections were
‘structural’ (imperfections of monopolistic nature) and arose from the innovation of
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International Trade better technology, access to capital, control of distribution system, economies of scale,
differentiated products (by the introduction of different advertising methods) and
improved management. All these factors facilitated the foreign enterprises more than
offset the shortcomings from their operations in the foreign market and the additional
cost incurred there.
Hymer was primarily concerned about the market power of MNEs, which limited the
entry of other firms. Market power is the result of collusion with others in the industry
to avoid competition, resulting in higher profits. There is a one-way casual link between
the firm’s behaviour and the imperfect market structure. Market power was first
developed in the home country, and as profit margins in the home country shrank, the
firm invested abroad and gained control of the foreign market through patent rights.
Because the profit margin in the home country has decreased, the firm invests abroad
and controls the foreign market through patent rights.
The Eclectic Paradigm
This theory on FDI was proposed by John H. Dunning in 1979. Eclectic Paradigm has
three components:
 OLI Model (ownerships, locations, and internationalization).
The theory assumes that institutions will avoid transactions in the open market if the
cost of performing the same actions internally is lower.
Ownership Advantage - This term refers to the competitive advantages of enterprises
seeking FDI. The greater the investing firms’ competitive advantages, the more likely
they are to engage in this foreign production.
Locational/Geographical Attractions - Locational/Geographical Attractions refer
to alternative countries or regions for MNEs to undertake value-added activities. The
more immobile, natural, or created resources that firms must use in conjunction with
their own competitive advantages favour a presence in a foreign location, the more
firms will choose to augment or exploit their specific advantages through FDI.
Advantages of Internationalization- Firms can organize the creation and exploitation
of their core competencies. The greater the net benefits of internationalizing cross-
border intermediate product markets, the more likely it is that a firm will prefer to
engage in foreign production itself rather than licensing the right to do so to others.
In a nutshell, the theory states that if a company does not have an ownership advantage,
it will conduct its operations in the domestic market and will not seek FDI. If, on the
other hand, ownership advantage is available, the firm will examine whether it has a
locational or geographical advantage; if it does not, the firm will produce in its home
country and export its goods to other countries. Finally, it will examine the benefits of
internationalization and determine which process is the most cost effective, whether to
carry out production activities in the host country or to give the license to another
country, and whether or not to pursue FDI.

Activity 2
List the differences between international trade theories and FDI theories.
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 Trade Theories
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4.6 SUMMARY
The rational structure of international business is built around the activities of MNEs,
which are explained by the internalization process. Prior to the advent of multinational
corporations, the terms foreign trade and international business were simply
interchangeable. The international transactions were directed by international trade
doctrines based on labour cost differentials and free trade. MNEs’ innovative efforts,
technological development, and management styles have rendered international trade
theories obsolete. Theorists began to develop FDI approaches in support of international
business for the enhancement and welfare of the world economy.
Several theories have been developed over time to explain the foundations of
international trade and FDI. The doctrine of mercantilism was the first in international
trade. Its underlying assumption was that a country could become wealthy by acquiring
gold from abroad, which could only be accomplished by increasing exports and
decreasing imports. They were most concerned with the national interest. Adam Smith
and David Ricardo opposed mercantilist ideas on the grounds that the gains of individuals
were the gains of the nation, and any action that increased the consumption of the
people should be viewed favourably.
The investigation of FDI theories is a relatively a new phenomenon. Hymer discussed
in his doctoral dissertation in 1960 that traditional theories of international trade and
capital movements were unable to explain the association of MNEs with foreign
countries. There are four types of FDI approaches. The first is the market imperfection
approach, which assumes that MNEs have certain ownership advantages and control
FDI through them. The proponents of this approach believed that the existing market
imperfections were monopolistic structural imperfections that arose as a result of factors
such as innovation, superior technology, access to capital, distribution system
management, economies of scale, differentiated products, and improved management.
All of these factors aided MNEs in compensating for the disadvantages of their
operations in foreign environments.

4.7 KEY WORDS

Absolute Advantage : Greater advantage or efficiency in the
production of goods enjoyed by one country
over another country. This is the basis of
trade according to AdamSmith.
Basis of Trade : Factors that help in international trade.
Gains from Trade : Gains arising from international trade which
takes place on account of specialization
advantages of the trading partners.
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International Trade Comparative Advantage : It states that trade would still be gainful even
if one country is less efficient than the other,
but specializes in the production of
commodities or goods where its
disadvantages are relatively lower
(comparative advantage) and exports the
same.
Production Possibility Curve (PPC) : It shows the various possibilities of
production of two goods in a country, given
the factor endowments and technology.
H.O. Trade Theory : Postulation that countries specialize in the
production and export of those goods which
require their abundant or cheap factors. A
capital rich country exports capital intensive
goods and imports labour intensive goods.

4.8 SELF-ASSESSMENT QUESTIONS

1) Explain the theory of mercantilism. Can it be applied in the present context?
2) Examine the implications of AdamSmith’s theory of absolute cost advantage.
3) Critically examine Ricardo’s comparative cost theory of international trade.
4) Discuss the Heckscher-Ohlin Trade Model.
5) Discuss the Market Imperfections Approach. How do the company specific
advantages help the formulation of this theory?
6) What is eclectic paradigm? Discuss the applicability of this model in current
scenario.

4.9 REFERENCES/FURTHER READINGS

Krueger, A. O. (2020). International Trade: What Everyone Needs to Know. USA:
OUP.
Krugman, P., Melitz, M., and Obstfeld, M. (2018). International Trade: Theory
and Policy. Pearson.
Suranovic, S. (2010). International Trade: Theory and Policy. Saylor Foundation.

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