CA CoursePaper No.8B- Economics for Finance

INTERNATIONL TRADE Dr C. Anirvinna

▪ International Trade vs Internal Trade

▪ Free Trade or Liberal Trade advantages and disadvantages

❖ Theories of International Trade

▪Mercantilism

▪Absolute cost Advantage theory

▪Comparative Cost Advantage theory

▪Factor Endowment Theory/Modern Theory of International Trade/The Heckscher-Ohlin Theory of Trade

The Theories of International Trade- Learning outcomes

• International Trade has become an important of engine of economic growth not only for developed countries but developing countries as well. International trade involves exchange involves of goods, resources and services between the countries. It is involving exports and imports of goods and services which are in need

• it is highly complex due to

• multiple currencies,

• heterogeneity of customers and currencies,

• differences in legal systems,

• business practices and political systems,

• more elaborate documentation,

• exchange rate risks,

• complex procedures and formalities,

• high operating costs, issues related to shipping, insurance and transportation and

• D i v e r s e restrictionsand interventions from governments in the form of taxes, regulations, duties,tariffs, quotas, trade barriers, standards, and restraints to movement of specified goods and services.

INTERNATIONAL TRADE

• As against International Trade domestic trade or internal trade which involvesexchange of goods and services within the domestic territory of a country usingdomestic currency

• Economists argue in favour of free or liberal trade to facilitate the economic growth others feel international trade generates adverse effects on the welfare of citizens.

❖ Arguments in favour of International Trade

1.Optimal use of natural resources

2. Specialization and efficiency

3. Low cost of production

4. Precious foreign exchange earnings

INTERNATIONAL TRADE

5 Generates employment opportunities

6.Access to the new markets, resources and technology

7.Promotes investment

8. Promotes R &D

9.Large scale of production

10. International cooperation

Argument in favour of International Trade

I. Dependency on other countriesII. Impediment in the Development of Home IndustriesIII. Exhaustion of natural resourcesIV. Negative labour market outcomesV. Trade conflictsVI. Shift in consumer CultureVII. Global Injustice

Argument against of International Trade

VIII Lack of transparency and predictability with regard to international trade policies

IX May distort to actual investment needs of the country

X Export shortages leading to inflation

Argument against of International Trade

• First theory of IT believed that national wealth can be increased in increased by exporting goods collecting in return in gold and silver and containing imports.

• The problem with this theory emerged in England the increase in gold and silver due to increase in exports would increase in Money supply and inflation in England

• On the other hand for country like France out flow of gold and silver would decrease in MS and fall in price level. As a result France would buy fewer goods from England. As a result surplus balance of trade of England would disappear.

• This kind of trade is zero sum game where once country’s gain another country’s loss. In fact trade should be a positive sum game. Still many countries follow this kind of trade of boosting exports and restricting imports called neo mercantilism

MERCANTILISM

• Adam Smith put forward to Absolute cost Advantage theory argues that the trade is not a zero sum game rather it is unrestricted and free international competition.

• A country will specialize in the production and export of a good which it has absolute cost advantage (or lower production costs)

• The ability of nation is measured on the basis of time taken to produce the goods.

• The 2x2 model considers two countries India and Iraq, two goods namely Rice and Wheat

• It can be seen below table that India should produce Rice and export to Iraq and Iraq should produce Oil and export to India .

• Both the countries enjoy absolute advantage in one good: India –Rice and Iraq in oil

ABSOLUTE COST ADVANTAGE THEORY

ABSOLUTE COST ADVANTAGE THEORY

Country No of labourhours required per unit

No of labour hours required per unit

RICE Oil

India 10 20

Iraq 20 10

• Ricardo put forward to Comparative cost Advantage theory that international trade arises due to comparative cost advantage rather than absolute cost advantage.

• A country will specialize in that line of production in which it has a greater relative or comparative advantage in costs than other countries and will depend upon imports from abroad of all such commodities in which it has relative cost disadvantage

• Suppose France and US produce two goods cloth and wine respectively

COMPARATIVE COST ADVANTAGE THEORY

COMPARTIVE COST ADVANTAGE THEORY

Country One hour One hour

Cloth Wine

France 5 10

US 20 20

• 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.

• In the US, one hour of a worker’s labour can produce either 20 cloths or 20 wines.

• It is important to note that the United States enjoys an absolute advantage in the production of cloth and wine. With one labor 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.

COMPARATIVE COST ADVANTAGE THEORY

• 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• The United States:• Opportunity cost of 1 cloth = 1 wine• Opportunity cost of 1 wine = 1 cloth• When comparing the opportunity cost of 1unit of 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.

COMPARATIVE COST ADVANATAGE THEORY

• Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that:

• France enjoys a comparative advantage in wine.

• The United States enjoys a comparative advantage in cloth.

COMPARATIVE COST ADVANATGE THEORY

• The Heckscher-Ohlin theory of foreign trade can be stated in the form of twotheorems namely, Heckscher-Ohlin Trade Theorem and Factor-PriceEqualization Theorem

• countries in which capital is relatively plentiful and labour relatively scarce will tend to export capital-intensive products and import labour-intensive products, while countries in which labour is relatively plentiful and capital relatively scarce will tend to export labour-intensive products and import capital-intensive products

• Thus, countries with abundant capital should generally be able to produce capital-intensive goods relatively inexpensively, exporting them in order to pay for imports of labour-intensive goods.

• .

The Heckscher-Ohlin Theory of Trade

• How do we know whether there is a relative factor abundance or not?

• Two criteria – factor prices and factor proportions (physical test).

• Factor Prices Test

• We consider two countries X and Y and two factors Labour (L) and Capital (K)

• If Pk/ PL in X< Pk/ PL in Y ( In country X capital is cheap and labour is expensive)

• Since capital is cheap in country X it is considered capital abundant country irrespective of the fact whether or not the ratio of total of k to L in country X is higher than in country Y

The Heckscher-Ohlin Theory of Trade

• Factor Proportions / factor endowments test ( physical)

• Here we are considering total quantities of one factor say k in relation to L

• It is not the absolute quantities of factors that are important here. We are just considering relative factor proportions

• In absolute terms we can county Y has larger quantities of both capital and labour

• But in relative terms country X is capital abundant since it is twice that of labour and country Y is just one and half times as much as capital as labour

The Heckscher-Ohlin Theory of Trade

COUNTRY X COUNTRY Y

CAPITAL =100 units CAPITAL = 150 units

LABOUR =50 units LABOUR = 100 units

• However for country Y is labour abundant since it has two-thirds (100/150) as much as labour as capital

• But country X has only one-half (50/100) as much as labour as capital

• Thus it is the proportion of one factor to another really matters

• Thus according to factor proportion test, a country is relatively capital rich or capital abundant if it has a higher proportion of capital to labour than in other country

• which commodity country X and Y will produce?

The Heckscher-Ohlin Theory of Trade

COUNTRY X COUNTRY Y

CAPITAL =100 units CAPITAL = 150 units

LABOUR =50 units LABOUR = 100 units

▪ The factor price equalization theorem postulates that if the prices of the output of goods areequalized between countries engaged in free trade, then the price of the input factors will also be equalized between countries. How

▪ The basic assumption of the Heckscher-Ohlin theorem is that the two countries namely country 1 and 2 share the same production technology and that markets are perfectly competitive.

▪ Perfectly competitive means that factors of production namely labour and capital can move freely between the same countries and enjoy same return that is wage rate and interest in all trading countries.

▪ Labour and capital are assumed to be homogeneous and equally productive

▪ Country 1 is labour rich and capital poor and country 2 is completely opposite

▪ Before the trade starts between the two countries 1 and 2, the ratio of wage rate to rate of interest (w/r) in labour abundant country1 is lower than capital abundant country 2

▪ When trade starts country 1 increases the production of labour intensive good say X and reduces the production of Y

FACTOR EQUALISATION THEORM

▪ As a result the demand for labour becomes stronger and wage rate rises. Since the demand for capital is low and its demand gets weakened in country 1 hence ratio (w/r) increases.

▪ Just the opposite happens to factor prices in capital abundant country 2. There, productive resources are shifted from the labour intensive commodity X to the capital intensive commodity Y. Consequently in country 2 wage rate falls, rate of interest for capital increases and the factor- price ratio(w/r) declines.

▪ Thus as trade expands, the gap between factor price ratios (w/r) in two countries narrows and eventually vanishes. This result is known as factor equalization theorem

FACTOR EQUALISATION THEORM

▪ The relative factor price equlisation can be derived in another way also

▪ The H-O theory assumes that both countries 1 and 2 enjoy perfectly completive market such as homogeneous category of labour and capital, free mobility of factors of production and use same technology

▪ As a result trade brings equality between the relative prices of products of x and y

▪ It means country 1 (labour abundant country producing x good) (Px/Py) increases in country 1 and declines in country 2 ( capital rich producing y good) till the ratios become equal

▪ Finally it ensures that each country the ratio of factor prices wage rate/ interest rate (w/r) corresponds to the ratio of product prices (price of x/ price of y or Px/Py

▪ consequentially expansion of trade increases (w/r) in country 1 and lower in country 2 till the ratios becomes the same in both trading countries

FACTOR EQUALISATION THEORM- ALTERNATIVE EXPLANATION

A COMPARSION BETWEEN COMPARATIVE COST THEORY AND MODERN THEORY OF INTERNATOINAL TRADE

COMPARATIVE COST ADVANTAGE THEORY MODERN THEORY OF TRADE

Trade arise between two countries due to differences in comparative costs

Trade arises due to differences in factor endowments

Based on labour theory of value Based on money cost which is more realistic.

One factor model considers only labour as the sole factor

Two factor model considers both labourand capital

Treats International Trade as quite distinct from domestic trade

International trade is only a special case of inter-regional trade/inter local trade

Studies only comparative costs of the goods concerned

Considers the relative prices of the factors

Attributes the differences in comparative advantage to differences in productive efficiency of workers

Attributes the differences in comparative advantage to the differences in factor endowments

Does not take into account the factor price differences

Considers factor price differences as the main cause of commodity price differences

A COMPARSION BETWEEN COMPARATIVE COST THEORY AND MODERN THEORY OF INTERNATOINAL TRADE

COMPARATIVE COST ADVANTAGE THEORY

MODERN THEORY OF TRADE

Does not provide the cause of differences in comparative cost advantage

Explains the differences in comparative advantage in terms of differences in factor endowments

Normative; tries to demonstrate the gains from international trade

Positive; concentrates on the basis of trade

• Cost reduction and increase in variety of products: First a country focuses on the domestic market with a variety of products. If the domestic product is small there may not be economies of scale either products produced may be less with high cost of production or not produced at all

• First mover advantage: A firm that is the first mover in the world market has an advantage over with other firms which might difficult to match. Enjoy economies of scale, lower costs and dominate exports

• NTT argues that, because of substantial economies of scale and network effects, it pays to export products such as phones to sell in another country. Those countries with the advantages will dominate the market, and the market takes the form of monopolistic competition

• Airbus and Boeing dominate the exports of larger aircrafts

NEW TRADE THEORY

1. Explain Adam Smith’s absolute cost advantage theory

2. International trade arises due to comparative cost advantage rather than absolute cost advantage.

3. How Heckscher- Ohlin Trade theorem and Factor- price Equalization theorems are related to each other?

4. Write a short note on New Trade theory of international trade.

5. Differentiate comparative cost advantage theory and Modern theory of international trade

Practice questions

1. Absolute cost advantage theory of international trade leads to zero sum game

2. Comparative cost advantage theory explains in terms of factor endowments

3. Factor endowments will be different in two countries according to HO theory

4. According to new trade theory a country focuses first on foreign trade and later domestic market.

5. New trade considers opportunity cost as a part of the international trade

True or false questions

END OF PRESENTATION