INTERNATIONAL TRADE

Classical Trade Theory

The Theory of Absolute Advantage
Adam Smith The ability of a country to produce a product with fewer inputs than another country Capability of one country to produce more of a product with the same amount of input than another country. Produce only goods where you are most efficient, trade for those where you are not efficient. Assumes there is an absolute advantage balance among nations

Per quintal lab cost (man hr.)

Country rice jute

India

30

60

Bangladesh

50

20

Classical Trade Theory

Trade will benefit both nations as they will avail given their labour force, greater amount of both goods and at lower cost If both nations prod both goods, India: sacrifice 2 q rice for 1 q jute Bangladesh: sacrifice 2.5 q jute for 1 q rice

Classical Trade Theory

Domestic exchange rate India: 1 q rice for 0.5 q jute (30/60) 1q jute = 2 q rice (60/30) Domestic exchange rate Bangladesh: 1 q jute for 0.4 q rice (20/50) 1q rice= 2.5 q jute (50/20)

Classical Trade Theory

With specialisation: India : 1 q rice gets 2.5 q jute Bangladesh : 1q jute gets 2q rice Both country gain if India specialises in rice and Bangladesh specialises in jute Trade possible if a country has absolute adv in prod of atleast 1 commodity and absolute disadvantage in production of atleast 1 commodity

Classical Trade Theory

Theory of Comparative Advantage Possibility of trade even if one nation has absolute disadvantage in prodn. of both goods As long as a nation has comparative advantage in prodn. of atleast I comm. specialisation and trade is possible and advantageous

Classical Trade Theory

Assumptions Labour is homogenous Labour only factor Labour is perfectly mobile No cost of transportation Perfect competition Supply side of trade

Per quintal lab cost (man hr.)

Country rice jute

India

30

60

Bangladesh

50

80

Classical Trade Theory

India: comparative advantage rice 30/50 i.e 60% rice prod cost of Bangladesh comparative disadvantage jute 60/80 i.e 75% jute prod cost of Bangladesh

Classical Trade Theory

Bangladesh: comparative advantage jute 80/60 i.e 133% jute prod cost of India comparative disadvantage rice 50/30 i.e 167% rice prod cost of India

Gains from Trade

Domestic exchange rate India: 1 q rice = 0.5 q jute (30/60) 1q jute = 2 q rice (60/30) Domestic exchange rate Bangladesh: 1 q jute = 1.6 q rice (80/50) 1q rice= 0.625 q jute (50/80) India

Gains from Trade

Gain occurs if external exchange rate i.e terms of trade is higher than domestic / internal exchange rate By specializing and exporting rice India can get 0.625 q jute instead of .5 q By specializing and exporting jute Bangladesh can get 2 q rice instead of 1.6 q Both nations gain from trade

Gains from Trade

Distribution of gains depends on commodity exchange rate between 2 nations Gainful exchange rate for India Between 0.5 and 0.625 q of jute for 1q rice Gainful exchange rate for Bangladesh Between 1.6 and 2 q of rice for 1q jute

 India more gain if it exports 1q rice for 0.625q jute or imports 1q jute for less than 2q rice Bangladesh more gain if it exports 1q jute for 2q rice or imports 1q rice for less than 0.625 q jute Gains are distributed on basis of their prodn. Efficiency-no nation gains at cost of the other

Limitations
No explanation of comparative advantage Labour is not homogenous-wage differentials Labour not only factor Labour is not perfectly mobile Cost of transportation Perfect competition unrealistic Demand side of trade ignored

Heckscher- Ohlin Theory of Trade

Factor endowment theory Overall availability of usable resourcesmanmade and natural Labour & Capital Labour surplus nation comparative advantage in labour intensive pdt. Capital surplus nation comparative advantage in capital intensive pdt.

Model
2 countries A and B 2 factors L and K 2 commodities X and Y Factor Abundance : Factor Ratio L/K Factor price ratio PL/Pk