BASIS OF INTERNATIONAL TRADE

Differences in costs of production in two countries

make exchange of goods profitable.
Exchange will not be beneficial if goods are produced
at the same cost.
A lower cost of production gives an advantage to one
country over the other and vice versa.
 Contd…
The trade theory that first indicated importance of
specialization in production and division of labor is
based on the idea of theory of absolute advantage which
is developed first by Adam Smith in his famous book
The Wealth of Nations published in 1776.
Smith argued that it was impossible for all nations to
become rich simultaneously by following mercantilism
because the export of one nation is another nation’s
import and instead stated that all nations would gain
simultaneously if they practiced free trade and
specialized in accordance with their absolute advantage.
Smith also stated that the wealth of nations depends upon
the goods and services available to their citizens, rather
than their gold reserves.
 Contd…

While there are possible gains from trade with

absolute advantage, the gains may not be mutually
beneficial. Comparative advantage focuses on the
range of possible mutually beneficial exchanges.
Adam Smith argued that a country has an absolute
advantage in the production of a product when it is
more efficient than any other country producing it.
Countries should specialize in the production of
goods for which they have an absolute advantage
and then trade these goods for the goods produced
by other countries
 Contd..
In economics, principle of absolute advantage
refers to the ability of a party (an individual, or
firm, or country) to produce more of a good or
service than competitors, using the same amount
of resources
Assumptions
 Trade is between two countries
 Only two commodities are traded
 Free Trade exists between the countries
 The only element of cost of production is labour
 In simple terms
 Theory is based upon principle of division of labour.
 Free Trade among countries can increase a country’s
wealth
 Free Trade enables a country to provide a variety of goods
and services to its people by specializing in the production
of some goods and services and importing others.
 Every country should specialize in producing those
products at cost less than that of other countries and
exchange these products with other products produced
cheaply by others.
 When one country produces a product at a lower cost and
another country produces another product at lower cost,
both can exchange required quantity and can enjoy
benefits of absolute cost advantage.
 ILLUSTRATION
Suppose there are two countries A and B and they
produce two commodities X and Y. The cost of
producing these commodities is measured in terms of
labour involved in their production. If each country has
at its disposal 2 man-days and 1 man-day is devoted to
the production of each of the two commodities, the
respective production in two countries can be shown
through the hypothetical Table 2.1.
Contd…
 Contd…

In country A, I man-day of labour can produce 20 units

of X but 10 units of Y. In country B, on the other hand. I
man-day of labour can produce 10 units of X but 20
units of Y. It signifies that country A has an absolute
advantage in producing X while country B enjoys
absolute advantage in producing commodity Y. Country
A may be willing to give up 1 unit of X for having 0.5
unit of Y. At the same time, the country B may be
willing to give up 2 units of Y to have I unit of X. If
country A specialises in the production and export of
commodity X and country B specialises in the
production and export of commodity Y. both the
countries stand to gain.
 Contd…

The absolute cost advantage of country A in the

production of X and that of B in the production of Y can
also be expressed as below:
 Contd..

Adam Smith also emphasised that specialisation on the

basis of absolute cost advantage would lead to
maximisation of world production. The gains from trade
for the two trading countries can be shown through Table
2.2.
 Contd..

Before trade, Country A produces 20 units of X and 10

units of Y. After trade, as it specialises in the production
of X commodity, the total output of 40 units of X is
turned out by A and it produces no unit of Y. Country B
produces 10 units of X and 20 units of Y before trade.
After trade it specialises in Y and produces 40 units of Y
and no unit of X. The gain is production of X and Y
commodity each is of 10 units. The gain from trade for
country A is +20 units of X and -10 units of x so that net
gain to it from trade is +10 units of X. Similarly net gain
to country B is +10 units of Y.
 Contd…

An interesting aspect of Smith’s analysis of trade has

been his ‘Vent for Surplus’ doctrine.

According to him, the surplus of production in a country

over what can be absorbed in the domestic market can be
disposed of in the foreign markets.

In addition, this doctrine implies that the foreign trade

results in the fullest utilisation of the idle productive
capacity that is likely to exist in the absence of trade.
 Advantages
ABSOLUTE COST ADVANTAGE
Specialization : Specialization of labour leads to higher
productivity and allows to achieve less labour cost per
unit of output.
Suitability : Suitability of the skills of labour of the
country in producing certain products
Economies of Scale : Economies of Scale helps to
reduce the labour cost per unit of output
 Contd.

NATURAL ADVANTAGE
1.Natural Resources
2.Climatic Conditions : Examples :
India - Production of Rice, wheat, sweet mangoes,
grapes, Tea, Coconuts, Cashew nuts, cotton, etc. B.
Sri Lanka - Production of Tea & Rubber
USA - Production of wheat
ACQUIRED ADVANTAGE
Technology
Skills
Example : Japan - Advantages in steel production through
imports of steel & coal England - Production of Textiles
France - Production of Wine
 SIGNIFICANCE
More quantity of both products
Increased standard of living for both countries
Increased production efficiency
Increase in global efficiency and effectiveness
Maximization of global productivity and other
resources productivity
 LIMITATIONS
No absolute advantages for many countries
Country size varies
Country by country differences in specializations
Deals with labour only and neglects other factors of
production
Neglected Transport cost
Theory is based on an assumption that Exchange
rates are stable and fixed.
It also assumes that labor can switch between
products easily and they will work with same
efficiency which in reality cannot happen.
 CRITICISMS
The Absolute Advantage Theory assumed that
only bilateral trade could take place between
nations and only in two commodities that are to be
exchanged. Such an assumption was significantly
challenged when the trade, as well as the needs of
nations, started increasing.
More factors of production: In the real world, the
productions of goods are dependent of various
factors, such as land, labour, capital and many
other factors. Thus, the goods cannot be divided
according to their absolute advantage for a
country in production basis
 Contd…

Absence of absolute advantage: As according to the

absolute advantage theory, one country has an absolute
advantage in producing one good while the other
country has an absolute advantage in producing
another good. But, many developing countries are
lacking behind in the area of technology therefore they
are not able to compete in the global market in order to
the production of goods; hence they are unable to
benefit from the free trade market.
Intra-versus Inter industry trade: According to the
absolute advantage theory, there is an exchange of one
type of good with another type of good between two
countries. But in today’s world many countries do
exchange similar types of goods also, such as cars etc.
 Contd…

this type of trade is also becoming a trend in today’s

world. It can be based on market power and
economies of scale, as analysed in new trade theory.
‘Vent for Surplus’ doctrine of Adam Smith is not
completely satisfactory. This doctrine can have
serious adverse repercussions on the growth
process of the backward countries. These
countries do not sell their surplus produce in
foreign markets but are constrained to export
despite domestic shortages for the reasons of
neutralising their balance of payments deficit.
 Comparative Advantage Theory- Riccardo
In economics, a comparative advantage occurs when a
country can produce a good or service at a lower opportunity
cost than another country.
The theory of comparative advantage is attributed to political
economist David Ricardo, who wrote the book Principles of
Political Economy and Taxation (1817).
Ricardo used the theory of comparative advantage to argue
against Great Britain’s protectionist Corn Laws, which
restricted the import of wheat from 1815 to 1846.
In arguing for free trade, the political economist stated that
countries were better off specializing in what they enjoy a
comparative advantage in and importing the goods in which
they lack a comparative advantage.
 Corn Laws

The Corn Laws were tariffs and other

trade restrictions on imported food and
corn enforced in the United Kingdom
between 1815 and 1846. The word corn
in British English denotes all cereal
grains, including wheat, oats and barley.
 Opportunity Cost
To understand the theory behind a comparative
advantage, it is crucial to understand the idea of an
opportunity cost. An opportunity cost is the foregone
benefits from choosing one alternative over others.
For example, a labourer can use one hour of work to
produce either 1 cloth or 3 wines. We can think of
opportunity cost as follows: What is the forgone benefit
from choosing to produce one cloth or one wine?
Therefore:
By producing one cloth, the opportunity cost is 3
wines.
By producing one wine, the opportunity cost is ⅓ cloth.
 Contd..

Comparative advantage is a key principle in

international trade and forms the basis of why free trade
is beneficial to countries.
The theory of comparative advantage shows that even if
a country enjoys an absolute advantage in the
production of goods, trade can still be beneficial to both
trading partners.
For Example:
Consider two countries (France and the United States)
that use labour as an input to produce two goods: wine
and cloth.
In France, one hour of a worker’s labour can produce
either 5 cloths or 10 wines.
 Contd..

In the US, one hour of a worker’s labour can produce

either 20 cloths or 20 wines.
The information provided is illustrated below
 Contd…

It is important to note that the United States enjoys an

absolute advantage in the production of cloth and wine.
With one labour hour, a worker can produce either 20
cloths or 20 wines in the United States compared to
France’s 5 cloths or 10 wines.
The United States enjoys an absolute advantage in the
production of cloth and wine.
To determine the comparative advantages of France and
the United States, we must first determine the
opportunity cost for each output:
France:
Opportunity cost of 1 cloth = 2 wine
Opportunity cost of 1 wine = ½ cloth
 Contd…

The United States:

Opportunity cost of 1 cloth = 1 wine
Opportunity cost of 1 wine = 1 cloth
When comparing the opportunity cost of 1 cloth for both
France and the United States, we can see that the
opportunity cost of cloth is lower in the United States.
Therefore, the United States enjoys a comparative
advantage in the production of cloth.
Additionally, when comparing the opportunity cost of 1
wine for France and the United States, we can see that
the opportunity cost of wine is lower in France.
Therefore, France enjoys a comparative advantage in the
production of wine.
 Contd…

Opportunity Cost comparison

OC France USA

1 Cloth 2 wine 1 wine

1 wine ½ cloth 1 cloth

 Contd…

Comparative Advantage and its Benefits in Free Trade

First, let’s assume that the maximum amount of labour
hours is 100 hours.
In France:
If all labour hours went into wine, 1,000 barrels of wine
could be produced.
If all labour hours went into cloth, 500 pieces of cloth
could be produced.
In the United States:
If all labour hours went into wine, 2,000 barrels of wine
could be produced.
If all labour hours went into cloth, 2,000 pieces of cloth
could be produced.
 Contd…

USA
1 labour hour= 20 clothes or 20 wines
100 labour hours
Clothes = 100 x 20 = 2000
Wine = 100 x 20 = 2000

France
1 labour hours = 5 clothes or 10 wines
100 labour hours
Clothes = 100 x 5 = 500
Wine = 100 x 10 = 1000
 Contd…

Following Ricardo’s theory of comparative advantage in

free trade, each country specializes in what they enjoy a
comparative advantage and imports the other good.
 Hecksher- Ohlin theory of Factor endowment
Pure theory of international trade have relied heavily on
the factor proportions analysis developed by the eminent
Swedish economist Eli F. Heckscher and Bertil Ohlin
who extended the application of the theory of general
equilibrium theory of international trade.
Just as individuals specialize in economic activity in
which they have comparative advantages, similarly
countries specialize in the production of certain
commodities in which they have comparative advantage
on the basis of factor endowments.
Just as individual capabilities are the cause of exchange
between individuals, similarly differences in factor
prices is the cause of international trade
 Contd….

Bertil Ohlin thus extends the analysis which is

applicable to a single market to the determination of
values internationally. i.e. exchange between different
countries.
Assumptions
 Trade takes place between only two countries and in
only two commodities which are produced by only
two factors of production.
 Production of both commodities involves the use of
both the factors and is subject to constant returns to
scale There is perfect competition in the goods and
resources are fully employed.
 Transport cost, tariff and other barriers to trade are
absent.
 Contd….

 Relative factor endowments are different in the two

countries.
 Consumer tastes are fixed and identical in the two
countries.
 Based on factor intensity i.e. labour intensive goods
remains labour intensive in both countries at all the
different prices of labour.
 Factor supply (endowments) in each country is fixed.
 Factors are mobile within each country and immobile
between the countries.
 Contd….

Ohlin observes that “International trade is but a special

case of inter-local or inter regional trade.”
Hence according to Ohlin, there is no need to have
separate theory of international trade.
He says that some fundamental principle hold good of
all trade, whether it is international trade or internal
trade.
The classical theory of comparative cost is based on the
assumption of comparative immobility of the factors of
production as between different countries.
But Ohlin points out that this is to be found even in
different regions of the same country.
 Contd….

According to Ohlin, the immediate cause of

international trade is the difference in commodity prices
which in turn is due to the differences in factors prices.
Goods are purchased because it cheaper to buy them
from outside the country. The establishment of the rate
of exchange between the two countries facilitates the
comparison between commodity prices prevailing in the
two countries.
Thus in Ohlin’s opinion there are no fundamental
differences but only quantitative differences between
inter regional and international trade. Ohlin’s theory
represents a departure from the classical theory and
marks a great improvement on it.
 Doctrine of free trade
A policy of no restrictions on the movement of goods
between countries is known as the policy of free trade.
Restrictions placed with a view to safeguarding home
industries constitute the policy of protection.
In the words of Adam Smith, this term ‘free trade’ has
been used to denote “ that system of commercial policy
which draws no distinction between domestic and
foreign commodities and, therefore, neither imposes
additional burdens on the latter, nor grants any special
favours to the former.”
Free trade, however, does not require the removal of all
duties on commodities. It only insists that they shall be
imposed only for revenue and not at all for protection.
 Doctrine of free trade
As a practical policy, free trade is based on the theory of
international trade.
In the words of Cairnes “ If nations only engage in
trade when an advantage arises from doing so, any
interference with their free action in trading can only
have the effect of debarring them from an advantage.”
Long before Cairnes, Adam Smith wrote that
“ If a foreign country can supply us with a commodity
cheaper than we ourselves can produce, better buy it
from them with some part of the produce of our own
industry, employed in a way in which we have some
advantage.”
 Contd..

He continued further: “Whether the advantage which one

country has over another be neutral or acquired is in this
respect of no consequence. As long as one country has
those advantages and the other wants them, it will always
be more advantageous for the latter rather to buy of the
former than to make.”
The only exception that Adam smith would make was
industries necessary for defence. These might be protected
because defence is more important. The doctrine of free
trade is the extension of the doctrine of division of labour
to the international field. In short, the free trade theory is
that such a policy enables every country to devote itself to
those forms of production for which it is best suited on the
basis of comparative advantage.
 Tariff and non tariff barriers
Trade barriers are restrictions imposed on the
movement of goods between countries (import and
export).
The major purpose of trade barriers is to promote
domestic goods than exported goods and there by
safeguard the domestic industries.
Trade barriers can be broadly classified into tariff
and non tariff barriers.
The term tariff means tax or duty. Tariff barriers are
tax barriers or the monetary barriers imposed on
internationally traded goods when they cross the
national borders.
 Major tariff barriers
Specific duty: It is based n the physical
characteristics of the good. A fixed amount of money
can be levied on each unit of imported goods
regardless of its price. E.g. imposing 10 dollars on an
imported shoe.

Ad Valorem tariffs: The Latin phrase ad valorem

means according to the value. This tax is flexible and
depends upon the value or the price of the
commodity. For e.g. imposing a tax of 5 dollars for a
50 dollar shoe and 10 dollars for a 100 dollars shoe.
 Major tariff barriers
Combined or compound duty: It is a combination
of specific and ad valorem duty on a single product.
For e.g. there can be a combined duty when 10 % of
value (ad valorem) and 1 dollar per kilogram
(specific tax) are charged on metal.

Sliding scale duty: The duty which varies along

with the price of the commodity is known as sliding
scale duty or seasonal duties. These duties are
confined to agricultural products, as their prices
frequently vary because of natural and other factors.
 Major tariff barriers
Countervailing duty: It is imposed on certain import
where it is being subsidized by exporting governments.
As a result of the government subsidy, imports become
more cheaper than domestic goods. This will nullify the
effect of subsidy. This duty is imposed in addition to
normal duties.

Revenue tariff: A tariff which is designed to provide

revenue or income to the home government is known as
revenue tariff. Generally this tariff is imposed with a
view to earn revenue by imposing duty on consumer
goods, particularly on luxury goods whose demand from
the rich is inelastic.
 Major tariff barriers
Anti dumping duty: At times exporters attempt to
capture foreign markets by selling goods at rock bottom
prices, such practice is called dumping. As a result of
dumping, domestic industries find it difficult to compete
with imported goods. To offset anti dumping effects,
duties are levied in addition to normal duties.

Protective tariff: In order to protect domestic industries

from stiff competition of imported goods, protective
tariff is levied on imports. Normally a very high duty is
imposed, so as to either discourage imports or to make
the imports more expensive as that of domestic products.
 Classification of tariff on the basis of trade
relationship
Single column tariff: Here the tariff rates are fixed for
various commodities and the same rates are charged for
imports from all countries. Tariff rates are uniform for all
countries and discrimination between importing
countries is not made.

Double column tariff: Here two rates of tariff on all or

some commodities are fixed. The lower rate is made
applicable to a friendly country or the country with
which bilateral trade agreement is entered into. The
higher rate is made with all other countries.
.
 Classification of tariff on the basis of trade
relationship
Triple column tariff: Here three rates are fixed. They
are general rate, international rate and preferential rate.
The first two are similar to lower and higher rates while
the preferential rate is substantially lower than the
general rate and is applicable to friendly countries with
trade agreement or with close trade relationship
 Non Tariff Barriers
Any barriers other than tariff are known as non tariff
barriers. It is meant for constructing barriers for the free
flow of the goods. It do not affect the price of the
imported goods. It affects the quality and quantity of the
goods.

Licenses: It is granted by the government and allows

importing of certain goods to the country.

Voluntary Export Restrains (VER): These type of

barriers are created by the exporting country rather than
importing one. These restrains are usually levied on the
request of the importing country.
 Non Tariff Barriers
For e.g. Brazil can request Canada to impose VER on
export of sugar to Brazil and this helps to increase the
price of sugar in Brazil and protects its domestic sugar
producers.
Quotas: Under this system, a country may fix in
advance, the limit of import quantity of commodity that
would be permitted for import from various countries
during a given period. This is divided into the
following categories:
Tariff quota: Certain specified quantity of imports
allowed at duty free or at a reduced rate of import duty.
A tariff quota has combine features of a tariff and import
quota.
 Non Tariff Barriers
Unilateral quota: The total import quantity is fixed
without prior consultations with the exporting with the
exporting countries.
Bilateral quota : here quotas are fixing after
negotiations between quota fixing importing country and
exporting country.
Multilateral quota: A group countries can come
together and fix quotas for each country.
Foreign Exchange Regulations: The importer has to
ensure that adequate foreign exchange is available for
import of goods by obtaining a clearance from exchange
control authorities prior to the concluding of contract
with the supplier.
 Non Tariff Barriers
Embargo: Partial or complete prohibition of trade with
any particular country, mainly because of the political
tensions.

Other Non Tariff Barriers are Health and Safety

regulations, Technical formalities & Environmental
regulations.