International economy

• In the modern world today, you can hardly find a

country that does not sell its goods and services
abroad and does not buy goods and services from
foreign countries.

• In simple words, all countries today have foreign

transactions

• The international flows of goods, services, manpower

and finance constitute the international economy
 International economy
The international flows of goods, services, manpower
and finance constitute the international economy.
 International economy
The international economy is broadly constituted of
 International flow of goods and services
 International flow of capital including foreign investment
and borrowing and lending of funds
 Financial assistance provided by international monetary
organizations like the international monetary fund (IMF) and
the world bank
 International flow of manpower
 Sale and purchase of foreign currency
 Control and regulation of international trade by
international organizations like the General Agreement on
Tariffs and Trade (GATT), the World Trade Organization
(WTO) and Regional Trade Organizations (RTO).
• Foreign trade in goods plays the important role in shaping
the international economy

• International trade, has grown so rapidly and extensively

that it has led to international economic interdependence of
most countries of the world.

• The degree of global economic interdependence' is

measured as the percentage of the total word trade
(exports + imports) to world GDP.
• International economics, as a subject of study, seeks to find
answers to the following types of questions:
• What is the basis of international trade?
• What are the gains from foreign trade and how can these gains
be measured?
• How are the gains from foreign trade distributed between the
trading partners?
• What is meant by international division of labour and how is it
determined?
• How do protective trade policies affect the affect trade and
trade benefits?
• How is the foreign exchange rate determined?
• What is meant by balance-of-payments disequilibrium and what
are its consequences?
• What factors lead to international economic conflicts?
• Why do countries opt for international economic cooperation?
 International Trade - Definition
• International Trade is usually referred to the
exchange of goods, and services across international
borders or territories.

• In 2010, the value of international trade achieved

19 trillion (current US) dollars, i.e. about 30% of the
world GDP.

• One third of the produced goods and services are

exchanged internationally around the world.
 International Trade – Definition
• International trade is a set of actions that aim to
exchange capital, goods, and services between
foreign countries across their international borders.

• International trade allows firms to compete in the

global market and to employ competitive pricing for
their products and services.

• As more products become available to the market,

consumers meet their needs and satisfy their wants,
thus increasing customer satisfaction.
 What does international trade talk about?

• Pattern of trade (Trade Model)

The core subjects of trade theory are the pattern
and volume of trade: which goods are traded by
which countries, and how much of those goods are
traded. These questions will be investigated by
various international trade theories

• Gains from trade

Why should nations exchange their products and
services? Who is gainer and who is loser, if there is
any?
Protectionism
Should we protect our industries from international
competition? Using what selection criteria? What may
be economic consequences of trade protectionism or
trade liberalization?

Free Trade Agreements (FTAs)

What does mean a FTA? How to measure its impact on
trade between countries: members and non-members?
What are trade potentials of a hypothetical FTA (to be
admitted)? What are required criteria to benefit from
a special FTA? What are policies to be considered?
International policy coordination
To where does the world go in international trade
relations? What are related international
organizations, and what role they play?

Trade and development

What are the impact of trade on industrial
specialization? Industrialization? Economic growth?
Poverty? Income discrimination? Could be international
trade considered as a development engine for less
developed countries (special cases)?
Trade and labour economics
What are trade effects on employment, wages, and
wage inequality?

Trade and political economy

How trade affect the income distribution within a
country? How trade may affect the political regimes?
Are trade pro-democracy or anti-democracy?
 What is its importance?!

• According to "Global Policy Forum", till 2030, 60% of the world

economy be exchanged internationally.

• Many current evidences are in line with this prediction.

• For example, either country in the world is now member of, at least,
one international trade agreement. In such circumstances, domestic
economy will be affected more and more by the world economy.

• That is, the level of income, employment, wages, growth, and

development in a country is not only a result of its domestic policies,
but also determined by its position in the world economy.

• Consequently, a good knowledge of International Economics

becomes vital for any economist. Some times, a good economic
policy regarding his international relations is more beneficial than
any policy arranging domestic economic issues of that country.
 The Reasons for Trade
• There are different explanations or reasons why
trade takes place between countries.

• There are five basic reasons why trade may take.

• The purpose of each model is to establish a basis for

trade and then to use that model to identify the
expected effects of trade on prices, profits, incomes,
and individual welfare.
 The Reasons for Trade
1. Differences in Technology
2. Differences in Resource Endowments
3. Differences in Demand
4. Existence of Economies of Scale in Production
5. Existence of Government Policies
 Differences in Technology
• Advantageous trade can occur between countries if
the countries differ in their technological abilities to
produce goods and services.

• Technology refers to the techniques used to turn

resources (labor, capital, land) into outputs (goods
and services).

• The basis for trade in the Ricardian model of

comparative advantage is differences in technology.
 Differences in Resource Endowments
• Advantageous trade can occur between countries if
the countries differ in their endowments of resources.

• Resource endowments refer to the skills and abilities

of a country’s workforce, the natural resources
available within its borders (minerals, farmland, etc.),
and the sophistication of its capital stock (machinery,
infrastructure, communications systems).

• The basis for trade in the Heckscher-Ohlin model is

differences in resource endowments.
 Differences in Demand
• Advantageous trade can occur between countries if
demands or preferences differ between countries.

• Individuals in different countries may have different preferences

or demands for various products. For example, the Chinese are
likely to demand more rice than Americans, even if consumers
face the same price. Canadians may demand more beer, the
Dutch more wooden shoes, and the Japanese more fish than
Americans would, even if they all faced the same prices.

• There is no formal trade model with demand differences,

[although the monopolistic competition model] which
include a demand for variety that can be based on
differences in tastes between consumers.
 Existence of Economies of Scale in Production
• The existence of economies of scale in production is
sufficient to generate advantageous trade between
two countries.

• Economies of scale refer to a production process in

which production costs fall as the scale of production
rises. This feature of production is also known as
“increasing returns to scale.”
 Existence of Government Policies
• Government tax and subsidy programs alter the prices
charged for goods and services.

• These changes can be sufficient to generate advantages

in production of certain products. In these circumstances,
advantageous trade may arise solely due to differences
in government policies across countries.

• "Domestic Policies and International Trade“.

• "Production Subsidies as a Reason for Trade“
• "Consumption Taxes as a Reason for Trade" provide
several examples in which domestic tax or subsidy
policies can induce international trade.
 Introduction to International Trade Theories
The trade theories formulated by economists of different
schools of thought, can be classified under following
categories:
• Classical theories of trade
• Neo-classical theories of trade
• Modern theory of trade
However, since the basis and logic of the
classical and neo-classical theories of trade
is the same, i.e., comparative cost
advantage in the production of goods,
modem economists classify them under one
category, i.e., the theory of comparative
advantage.
The theories of international trade that fall under
the theory of comparative advantage include:

• Adam Smith's theory of absolute

advantage

• Ricardo's theory of comparative

advantage

• Haberler's opportunity cost theory of

trade
 Introduction to International
Trade Theories
1. The Mercantilists View on Trade

2. Absolute Advantage Theory – Adam Smith

3. Comparative Advantage – David Ricardo

 The Mercantilists View on Trade
[Pre-classical School o f Social Thinkers]
• This theory was developed in the sixteenth century and is considered to be
the oldest theory of International Trade. According to this theory, a country’s
wealth could be determined by the amount of its gold and silver holdings.

• A system of government policies, practices and institutions aimed at

increasing exports and decreasing imports is called as mercantilism.

• The countries should focus on having a ‘trade surplus’ i.e. value of exports
should be greater than the value of imports. ‘Trade deficit’ is to be avoided.

• Mercantilists believed that nation’s wealth depends on the size of the nation’s
precious metal gold. According to them, gold can be acquired by increasing
nation’s exports than its imports. That is a nation can acquire gold by running
a surplus in its international transactions.

• Therefore they believed those nations can acquire the gold at the expense of
other nations.
• It was Adam Smith who coined the term ‘Mercantile
System’.

• Adam Smith was also the one who heavily criticized

this theory.

• He argued that free trade benefits both the parties

i.e. the exporter and the importer.

• He also argued that ‘Mercantile System’ proved

harmful to the population in general as the consumers
received the goods at a higher price.
• This theory flourished during the 17th and the 18th century as
imperialism was being promoted by colonial empires.

• The countries used raw materials to manufacture goods and

sell them, thereby promoting exports.

• However, advocates of ‘free trade’ believe that mercantilism

promoted protectionism. Import restrictions were imposed by
countries that ultimately led to higher prices and severely
affected the consumers.

• The biggest promoters of this theory were British, Dutch and

Spanish Empires.

• Even today this theory is being followed to some extent by

export economies like Germany, Japan, and Singapore etc.
Some have dubbed the policy of these countries to be a kind
of neo-mercantilism.
The Mercantilists View on Trade
 Absolute Advantage Theory – Adam Smith
• In 1776, Adam Smith published a famous book, The
Wealth of Nations, in which he proposed this theory.

• According to Smith, trade between two nations takes

place based on absolute advantage.

• In this regard he emphasized that free trade is the

best policy for a nation.
 What is absolute advantage?
• Absolute Advantage theory believed that a nation
should specialize in producing those goods that it can
produce at a cheaper cost than that of other nations.
These goods should be exchanged with other goods
that are being cheaply produced by the other
nations.

• Absolute advantage means, each nation could

specialize and exports goods in which production it
has absolute advantage and imports those goods in
which it has absolute disadvantage.
 Absolute advantage can be the result of a country’s
Absolute Cost Advantage -
• Absolute Cost Advantage will exist because of specialization
of labor that would in turn lead to higher productivity and less
cost of labor.
• Economies of Scale will also exist as one country would
produce one type of goods at a large scale. This will
significantly reduce the cost of the goods.

Natural Advantage – A country would produce those goods that

are naturally favoring its climatic conditions. The type of goods
produced would also depend upon the availability of natural
resources. Presence of plenty of natural resources would
significantly provide advantage to such a country while
producing the goods.

Acquired Advantage – This would include advantage in

technology and level of skill development.
Absolute advantage can be the result of a country’s
Natural Endowment.
• Saudi drilling and extraction of oil
• The United States has some of the richest farmland in
the world, making it easier to grow corn and wheat
than in many other countries.
• Guatemala and Colombia have climates especially
suited for growing coffee.
• Chile and Zambia have some of the world’s richest
copper mines.
 Assumptions of the Theory
1. Factors of production can’t move between the
nations
2. There are no barriers to trade
3. Labour is the only relevant factor of production
4. Production exhibits constant returns to scale
between labour and output
5. Exports must be equal to imports. This assumption
means that we exclude trade imbalances, trade
deficits or surpluses.
 Implications of the Theory
• More quantity of both products
• Increased standards of living both countries
• Increased production efficiency
• Increase in global efficiency and effectiveness
• Maximization of Global productivity and other
resources of productivity
http://www.indiaclass.com/adam-smith-international-
trade-theory-of-absolute-cost-advantage/
 Criticisms of this theory
• This theory assumed that only bilateral trade could
take place between the nations and only in two
commodities that are to be exchanged.

• This assumption was significantly challenged when the

trade as well as needs of a nation started increasing.

• Thus this theory did not take into account the multi-
lateral trade that could take place between the
countries.
 Criticisms of this theory
• This theory also assumed that free trade exists
between the nations.

• It did not take into account that protectionist

measures that are adopted by the nations. These
protectionist measures were in many forms and
included quantitative restrictions, technical barriers to
trade, and restrictions on trade on account of
environment protection or public policy.
 Criticisms of this theory
• Another criticism of this theory is that it considered
labor as the only cost of production in manufacturing
goods.

• It neglected other significant elements like

transportation costs, technological costs etc. Also, it
became hard for countries to have absolute
advantage for many products.
• Adam Smith argues that the “proper international
division of labour will exist” – where countries
specialized in the production of goods in which they
have an absolute advantage.

• However, if a country has absolute disadvantage in

its both goods, what is the solution to this problem?.
So it is the main draw back in Adam Smith’s theory.
 Basis of Comparative Advantage
• It was observed that the theory of Absolute
Advantage was not able to answer all the problems
of International Trade.

• As trade started increasing between the nations, it

became more complex too.

• Also, there were countries that did not have Absolute

Advantage in any kind of goods. Absolute
Advantage was no solution for them.
 Comparative Advantage – David Ricardo

• In 1817 Ricardo published a book – Principles of

Political Economy, in which he presented the law of
comparative advantage.

• According to the law, even if one nation is less efficient

(absolute disadvantage) than the other nation in the
production of both commodities, there is till a basis for
mutually beneficial trade.

• That is the less efficient nation should specialize in which

its absolute disadvantage is less and export them at the
same time import in which its absolute disadvantage is
greater.
 Assumptions of the Theory

1. Two nations and two commodities

2. No transportation cost
3. No technology change
4. Constant cost of production
5. Perfectly mobile labour with in a nation but
completely immobile labour internationally
6. The labour theory of value
 Evaluation of Ricardo’s Law of Comparative Advantage

• Ricardo failed to explain the reasons for the

comparative advantage as well as the difference in
labour productivity.

• At the same time Ricardo based his explanation on

Labour theory of value. But this theory is rejected by
many economists. Since

1. Labour is not only the factor of production

2. Labour is not used as a constant proportion in all the
cases
3. Labour is not the same type. They may differ from skill
and production
• As per this theory, Comparative Advantage exists
when a country is able to produce a commodity
better and more efficiently than it does other
commodities.

• This theory focuses on the relative productivity

difference, whereas Absolute Advantage theory
focused only on absolute productivity.
 Merits of this Theory
• This theory demonstrates that trade between two
countries is possible even when a country is able to
produce all its goods at a cheaper cost than other
countries.
• The country is compensated more by focusing its skill
and knowledge on producing those goods in which it
has a better cost advantage.
• This theory also has the potential to incorporate costs
other than labour. Thus it can take more complex
situations into account than the absolute advantage
theory.

• It also takes into account the ‘Opportunity Cost’ of

producing the goods. A lower opportunity cost than
another country would signify comparative
advantage available to a particular country.
 Demerits and criticisms of Comparative Advantage
Theory
• This theory assumes that the internal economies of
countries are competitive. However, this is not true.
Most of the countries have industries that are
monopolistic in nature.

• This theory also assumes the existence of constant

returns. This is not possible as change in availability
of resources and other such dimensions directly
affect the economic structure of a country.
• This theory like Absolute Advantage again assumes
existence of free trade between the countries. It fails
to take into account factors like quantitative
restrictions, public policy, protectionist measures,
export subsidies etc.

• Another important criticism is that comparative

advantage though relative in nature measures only
static advantage and fails to take into dynamic
advantage. It does not provide answers as to how a
country could gain comparative advantage by
making the necessary investments.