international trad theories

8/3/2019 International Trad Theories

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1.Absolute advantage Theory

2.Comparative Cost AdvantageTheory

3.Heckscher-Ohlin Theorem

4.Purchasing Power Parity Theory

5.Product Life Cycle


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Any country produce good chipper than

other country it has absolute advantagein the product of that goods.

(given by Adam smith)

Same country countries should produce and export

surpluses in what they have absolute advantage. buywhatever else they need from rest of world.

A country has an absolute advantage economically

over other, in a particular good, when it can produce

that good more efficiently.

Theory of Absolute Advantage


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Principle of Absolute Advantage

A country has an absoluteadvantage over it trading

partners.

It is able to produce more of a

good or service with the same

amount of resources or the same

amount of a good or service with

fewer resources.


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1.Illustration

The Production Possibility Curve can

be used to illustrate the principles of

absolute advantage.


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2.Illustration

The following Example is given No of unitof Wheat per unit of labor of USA and UK

and No of unit of cloth per unit of labor in

USA and UK.

USA UK

No. of unit of

wheat per unit of

labor

10 4

No. of unit of

cloth per unit of

labor

3 7


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Assumptions It has not advocated quality, premium

and brand aspect of a product.

It has restricted itself only toconsidering the maximum to labourforce.

It has failed to take into account the factthat many cost reduction techniques areadopted in mass production.

There are many duties applicable whengoods enter into other countries, whichhas not been account for.

The nature of the commodity may incurhuge transportation cost, which may be

even greater than the cost of the labour.


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Limitation of Absolute Advantage

It is not fully applicable in thecurrent century.

although it was an accepted duringthe period of when industrialization

was catching up in Europe during

the period of Adam smith.


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It was David Ricardo, one of the prominent classical economist, who

Propounded the theory of Comparative Cost Advantage. In 1817 in hisBook called The Principles of Political Economy & Taxation.

According to him, it was the comparative difference in the cost thathas lead to the trade between two countries.

Each country specialize in the production of the commodity in whichit has complete advantage cost.

The country should import and export only those commodities in whichit has higher comparative advantage.


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Assumptions of the theory :-

There should be two countries producing same two commo

Cost of labour

Technology

Transportation cost.

Full employment of factors.

Homogeneity in consumption, buying behavior and afforda


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Illustration-1

Two men live alone in an isolated Island. To survive they must undertake aFew basic economical activities like water carrying, fishing, cooking and shelterConstruction.

The man is young, strong and educated and is much faster, better,

More productive at everything. He has an absolute advantage in all activitiesThe second man is old, weak and uneducated.

He has an absolute disadvantage In all activities. In some activities thedifferences between the two is great, in Other it is small.

How should they divide the work ?

The young man must spend more time on the task in which he is muchBetter and the old man must concentrate on the task in which he is only littleWorse. Such an arrangement will increase total production.


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Limitations:-

It considers as the only factor of production.

It considers labour as homogenous.

It assumes constant labour cost.

Uniformity in wages.

Theory only considers supply side.


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1. The citizens of the two trading countries have the same

needs.

2. The major factors of production, namely labor and capital

are not available in the same proportion in bothcountries.

3. Labor and capital do not move between the two countries.

4. There are no costs associated with transporting the goods

between countries.

5. The two goods produced either require relatively

more capital or relatively more labor.


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Initially, when the countries were not trading:

1) The price of capital-intensive good in capital-abundantCountry will be bid down relative to the price of the good inthe other country,

2) The price of labor-intensive good in labor-abundantcountrywill be bid down relative to the price of the good in theother country.


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y Once trade is allowed, profit-seeking firms will move their

y

products to the markets that have (temporary) higher price.y As a result:

1) The capital-abundant country will export the capital- intesive

y good

y 2) The labor-abundant country will export the labor-intensive

good.


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Wassily Leontief, a Russian-born U.S. economist observed thatthe United States was relatively well-endowed with capital. Accordingto the theory, the United States should export capital-intensive goodsand import labor-intensive ones. He found that the opposite was in fact

the case: U.S. exports are generally more labour intensive than the typeof products that the United States imports.

Because his findings were the oppositeof those predicted by the theory, they are known as the Leontief Paradox

LEONTIEF PARADOX


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what is purchasing power theory?

It is formulated by Gustan Cassel in 1920. It is method of using the longequilibrium exchange rate of two currencies to equalize the currenciesPurchasing power. It is based on law of one price.

Illustration:- U.S dollar exchanged and spent in the peoples republicOf China will buy much more than a dollar spend in U.S.


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Absolute ppp

For U.S dollar to buy as much in the UK as in the U.S. as is assumed under theLaw of one price of a basket of goods in pounds in the UK (denoted as: p)timesThe Spot exchange rate ( denoted as: $p) should equal the price of the samebasket in the U.S price in dollar (denoted as:$).

p($/)=$p

This implies that the exchange rate that equalize the value of a dollar ofpurchasing power (the ppp exchange rate) is :

($/)=$p/p\

Relative ppp

Relative ppp related the inflation rate (the exchange of price level) in eachcountry to the change in the market exchange rate

St P*/p*-1=

St-1 Pt/Pt-1


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1. Introductory Stage

2. Growth Stage

3. Maturity Stage

4. Decline Stage

It is propounded by Vernon, emphasizes that every producthas to pass through different stages called product life cycle.

There are four stages which are :-


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