International Commodity Management, IIPMB

1. • International Trade refers to exchange of capital,
goods, and services across international borders.
• The main difference between the domestic trade and
the international trade is of “Cost of Doing Trade”
because the international trade involves border
costs such as tariffs & customs, time costs due to
distance and border delays and other costs associated
with cultural and economic differences between the
two countries.
• Further, the Labour and Capital are more mobile within
the country in comparison to cross border mobility.
• No country today is aloof from the international trade.

2. • Adam Smith said that trade between two
nations is based on absolute advantage.
• When one nation is more efficient than
another in the production of one commodity
but is less efficient than the other nation in
producing a second commodity, then both
nations can gain by each specializing in the
production of its absolute advantage and
exchanging part of its output with the other
nation for the commodity of its absolute
disadvantage.

3. • Suppose country A is better than country B in producing
roses, and country B is better than country A in producing
computers.
• This is because country A can produce more roses than
Country B with the same number of employees per hour
(read resources), while country B can produce more
computers than country A under the same conditions.
• Then, it will be an obvious case that each country will
specialize in the product that it can produce most
efficiently and then trade their products: country A will
export roses and import computers from B, while country B
will export computers and import roses from A.

4. • Under these circumstances, both countries would gain
if each specialized in the production of product of its
absolute advantage and traded with the other country.
As a result both the products would be produced and
consumed in more quantities and both the nations
would benefit.
• This means that the theory of Adam Smith refutes the
assumption that one nation could benefit only at the
expense of another nation Adam Smith believed that
all nations would gain from free trade and strongly
advocated a policy of laissez-faire i.e. free trade.

5. • Adam Smith’s theory could not explain why the trade
takes place even when one of the trading
countries does not have absolute cost advantage in
both the commodities compared to the other country.
• Absolute cost advantage theory can explain only a very
small part of world trade such as trade between
tropical zone and temperate zone or between
developed countries and developing countries.
• Most of the world trade is between developed
countries that are similar with respect to their
resources and development which is not explained by
absolute cost advantage.

6. Theory of Comparative Cost
• As in the absolute cost advantage theory, this
theory also says that international trade is solely
due to differences in the productivity of labour in
different countries.
• However, it says that the trade between countries
which don’t have absolute advantage can be
explained by the law of comparative advantage.
The theory is based upon some assumption such
as:

7. • Every country has a fixed endowment of resources
• The factors of production are perfectly mobile between alternative
productions within a country.
• Factors of production are completely immobile between countries.
• Labour is the only primary input to production
• The relative ratios of labour at which the production of one good can be
traded off for another differ between countries
• Countries use fixed technology
• Production is under constant cost conditions regardless of the quantity
produced.
• There is full employment in the macro-economy.
• The economy is characterized by perfect competition in the product and
market.
• There is no governmental intervention in the form of restriction to free
trade.
• Transport costs are zero.
• It is a two-country, two-commodity model.

8. • The summary of Ricardo’s theory is that International trade
is mutually profitable even when one of the countries can
produce every commodity more cheaply than the other.
• Each country should specialize in the product in which it
has a comparative advantage that is greatest relative
efficiency.
• When trade takes place between the two countries, the
terms of trade will be within the limits set by the internal
price ratio before trade.
• For both countries to gain, the terms of trade should be
somewhere between the two countries internal price ratios
before trade.

9. • Two Swedish economists, Eli Heckscher and Bertil Ohlin
gave one more model of International Trade. This theory
says that in reality, trade is not just determined by
technological differences, but it also reflects differences
in factor endowments across countries.
• For example, Canada exports forestry products to the
United States not because its workers are more efficient in
forestry, but because Canada is more endowed with
forests.
• To explain the importance of resources in trade Heckscher
and Ohlin, have developed a theory known as the “factor
proportion theory“. This theory essentially says that
countries will export products that use their abundant and
low-cost factors of production, and import products that
use the countries’ scarce factors.

10. • For example, in a capital abundant country, the cost of
capital will tend to be relatively low.
• As a consequence, the cost of production of the capital
intensive product, and its price, will tend to be
relatively low.
• The opposite will occur in a labour abundant country –
wages will tend to be relatively low and the cost of the
labour intensive products will be relatively low.
• Differences in relative prices of the two goods will lead
to trade. Both countries will produce more of the good
on which they have a comparative advantage.