Introduction to theories of International Trade
Some important theories of International Trade
1. Absolute Cost Advantage Theory
The principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input. Since absolute advantage is determined by a simple comparison of labor productiveness, it is possible for a party to have no absolute advantage in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party.
Assumptions of the Theory
1.Trade is between two countries
2.Only two commodities are traded
3.Free Trade exists between the countries
4.The only element of cost of production is labour.
Smith argued that it was impossible for all nations to become richsimultaneously by following mercantilism because the export of one nation is another nation’simport and instead stated that all nations would gain simultaneously if they practiced free tradeand 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 goldreserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial.
Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good. Similarly, if Country B was better at producing another good, it could focus on specialization as well. By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks. Production would also become more efficient, because there would be an incentive to create faster and better production methods to increase the specialization.
Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people.
Implications (Significance) of Absolute Advantage Theory
- More quantity of both products
- Increased standards of living of both countries
- Increased production efficiency
- Increase in global efficiency and effectiveness
- Maximization of Global productivity and other resources productivity
No absolute advantages for many countries
Country size varies
Country by country differences in specialization
Deals with labour only and neglects other factors (Variety of resources)
Neglected Transport cost (It plays significant role)
2. Comparative Advantage
David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries.
Comparative advantage refers to the ability of a party to produce a particular good or service at alower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will stillgain by trading with each other, as long as they have different relative efficiencies.For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts inan hour, each country can gain from trade because their internal trade-offs between shoes andshirts are different. The less-efficient country has a comparative advantage in shirts, so it finds itmore efficient to produce shirts and trade them to the more-efficient country for shoes. The net benefits to each country are called the gains from trade.
Assumptions of Comparative Advantage
- There are only two nations and two commodities.
- Free Trade: there are no barriers to trade.There are no regulations on trade between the two countries.
- Labour theory of value: Labour is the only factor of production.In other words,the cost of production of the commodities is measured by the labour time involved in producing them.
- Absence of transportation costs.
- Labour is perfectly mobile within a country but it is perfectly immobile between countries.The implication of this assumption is that the wage rate within a country is same throught because of perfect mobility of labour but as between nations wages may differ because of one country cannot migrate to another country.
- Constant costs of production: There are constant returns to scale in production i.e. the cost conditions remain same irrespective of the level of production.
- There is full employment of labour i.e. to produce more of one commodity labour will have to be diverted from the other commodity.Also, the total labour is constant.
- Technology remains unchanged.
Criticism of Ricardo’s Law of Comparative Advantage
Labour Theory of value:The most severe criticism of Ricardo’s theory was his assumption of labour theory of value.Under this assumption the price of a commodity depends exclusively on the amount of labour used in its production.The implication of this assumption is that:
- Labour is the only factor of production or
- Labour is used in the same fixed proportion in the production of all commodities.
- Labour is homogeneous.
None of the above implication is true.
First,Labour is not the only factor of production.The commodities require a number of factors of production such as land,labour,capital etc.
Second,Labour is not used in the same fixed proportion in the production of all the commodities.The production of textiles requires much more labour than the production of cars.Cars require more capital per unit than required in production of textiles.
Third,Labour is not homogeneous.It varies in productivity,skilltraining and consequently in wages.There is not one class of labour with a single wage but a number of non competing groups between which the wages are not equalized.
3. Ohlin Heckler Theory
The Heckscher – Ohlin theory is based on most of the assumptions of the classical theories of international trade and leads to the development of two important theorems –
(a) Heckscher – Ohlin theorem and
(b) Factor price equalizationtheorem