eco chapter 11

1. Theories of International
Trade

2. Trade
 Trade refers to exchange of goods & services between
seller & buyer
 Trade is of 2 types i.e. Domestic trade & International
Trade
 Domestic Trade is carried out within the country &
international trade refers to trade between countries

3. Similarities in Domestic & International
Trade
 Both involve exchange of goods & services
 Objective is Profit Maximization
 Basis for trade is cost advantage
 Both enhance consumer’s satisfaction by providing
various goods & services

5. Comparative Cost Advantage Theory of
International Trade
 According to David Ricardo, countries will export
products where they have cost advantage & surplus
production
 They will import goods where they have cost
disadvantage
 This theory is based on labour value i.e. Value of goods
depends upon amount of labour used to produce it

6. Comparative Cost Advantage Theory of
International Trade
 Assumptions for Cost Advantage Theory
 Labour is the only factor of production & is homogenous factor
 Cost of production of all commodities are measured in terms of
labour cost
 Labour is perfectly mobile within country but immobile between
countries
 Economy is Laissez-Faire i.e. No govt intervention
 Free Trade (Absence of Tariffs, Quotas etc.)
 Perfect Competition prevails in both countries
 Transport cost are ignored
 Full employment in both countries

7. Comparative Cost Advantage Theory of
International Trade
 Ricardo explained this theory by using 2 country – 2
commodity & 1 factor of production model
 When both the countries do not have trade relations then
both the items will be produced by each country & 1 good
will be exchanged for other
 This is known as domestic exchange rate
Countries No. Of Hours to produce 1 Unit
Wine Cloth
Portugal 80 90
England 120 100

8. Comparative Cost Advantage Theory of
International Trade
 For Portugal, 1 unit of wine = 0.88 units of cloth
 For England, 1 unit of wine = 1.2 units of cloth
 When trade takes place, 1 unit of wine will range from 0.88
units to 1.2 units of cloth
 Portugal would like to get more than 0.88 unit of cloth for
every unit of wine sold (as 0.88 is their own price)
 England would like to give less than 1.2 unit of cloth for
every unit of wine purchased (as 1.2 is their own price)
 Assuming, exchange ratio is 1 unit of wine = 1 unit of cloth,
then both the countries will benefit

9. Comparative Cost Advantage Theory of
International Trade
 When countries specialize & trade, production of goods
will be more
 If there was no trade then both the countries would be
producing both the products and having less benefit
with more of labour hours
 Thus according to this theory, differences in comparison
cost advantage leads to international trade

10. Critical Evaluation
 Based on 2 country, 2 commodity & 1 factor model – restrictive in
nature
 Based on Labour value theory, which is unrealistic
 Full employment, Perfect Mobility etc. are not tenable
assumptions
 Only 1 factor of Labour is considered & others are ignored – Not
comprehensive
 Partial theory as emphasises only on supply and ignorant about
demand
 No proper Exchange rate

11. Heckscher – Ohlin Theory of Int.
Trade
 This theory is also known as factor endowment theory
 Comparative cost advantage theory only explained that
int. trade took place due to cost differences
 However they did not explain the reasons for cost
differences
 This theory explains the reasons for cost differences
 Modern theory starts where cost comparative theory
ends

12. Heckscher – Ohlin Theory of Int.
Trade
 As per this theory, cost difference arises due to 2 reasons
 Different countries have different factor endowments
 Factor proportions used for producing commodities are
different in different countries

13. Heckscher – Ohlin Theory of Int.
Trade
 Assumptions
 2 country, 2 commodity & 2 factor model
 1 country is endowed with abundance of labour & other with capital
 Free Trade (Absence of Tariffs, Quotas etc.)
 Full employment in both countries
 Perfect Competition prevails in both product & factor market
 Factors of Production are perfectly mobile within country but
immobile between countries
 No Transportation cost
 Factors of Production are homogenous in both the countries

14. Heckscher – Ohlin Theory of Int.
Trade
 As per this theory, countries will specialize in
production of those products which uses the abundant
factor (labour / Capital)
 Viz, capital rich country will specialize in capital
intensive goods & labour abundant country will
produce more of labour intensive products & export
 This is so, as abundant factor is available easily & at
cheaper rates

15. Advantages of International
Trade
 Comparative Cost Advantage
 Specialization
 Optimum use of Resources
 Benefit to Consumer
 Increase in Production, Employment & N.I.
 Availability of Goods & Services
 Conservation of Scarce Resources
 Promotion of Inter-Dependence & Co-Operation

16. Questions
1. Explain Trade – Distinguish between Domestic &
International Trade
2. Explain Comparative Cost Advantage Theory
3. Explain Heckscher – Ohlin Theory of International
Trade
4. Discuss the various benefits of International Trade