Module -3 International trade theories

PRESENTED BY
RAYEES AHMAD MBA 2ND SEM

Trade theories
AIM

A number of theories have been developed by the international economists to explain how does international trade takes place.

THEORY OF MERCANTILISM
 This is the first theory of international trade emerged in England in the mid-16tcentury  Its major statement was that gold and silver were the mainstays of national wealth

 Gold & silver were the currency of trade between countries  A country could earn gold & silver by exporting goods The main tenet (principle) of mercantilism was that it was in a country s best interests to maintain a trade surplus, to export more than it imported.  By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige and power.

Objective
 the objective of mercantilism was to minimize imports that cost money and maximize exports and the trade that brought money in to the nation.

criticism
 International trade experts criticize the doctrine (policy, principle) of mercantilism on the ground that it believes in a Zero-sum game. ( A Zero-sum game is one in which a gain by one country results in a loss to another country OR Income of one nation is the expense of other nation)  But multinational trade is Positive-sum game in which all countries can benefit.

The wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. The theory also criticized because of it being too simple

THEORY OF ABSOLUTE ADVANTAGE

 In economics principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resource  The concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he countered (opposed) mercantilist ideas.

 Smith is the view that every country should specialize in producing those goods which it can produce at less cost than that of other countries and exchange those products produced cheaply by other countries  Absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; in that case, no trade will occur with the other party.

Assumptions of the Theory

Trade is between two countries. Only two commodities are traded Free trade exists between the countries. The only element of cost of production is labor.

Example of theory
Country machines per day Country A 100 Country B 250 Country C 500 no. of employees 200 200 200

Country C has the absolute advantage

 Country A can produce 100 Machines per day with 200 Employees.  Country B can produce 250 Machines per day with 200 Employees.  Country C can produce 500 Machines per day with 200 Employees.

 Considering that labor and material costs are all equivalent,  Country C has the absolute advantage over both Country B and Country A because it can produce the most machines per day at the same cost as other nations.  Country B has an absolute advantage over Country A because it can produce more machines per day with the same number of employees.  Country A has no absolute advantage because it can't produce more machines than either Country B or Country C given the same input.  It refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources.

Criticism
 No Absolute Advantage: In reality, most of the developing countries do not have absolute advantage of producing any product at the lowest cost.  Country Size: Countries vary in size. This theory does not deal with country-by-country differences in specialization  Transportation Cost: Though the cost of transportation plays a significant role in international trade, this theory ignored this aspect

Variety of Resources: Though there are several resources like labour, technology and natural resources, this theory deals with only labour and ignores all other resources. Absolute Advantage for Many Products: Some countries may have absolute advantage for many products. For example, Japan, the USA, France, the UK etc. But this theory does not deal with such situations.

COMPARATIVE ADVANTAGE THEORY (Ricardian Model)

Absolute advantage theory fails to explain the situation when one country has absolute advantage in producing many products.  David Ricardo a British economist in 1817 expanded the Absolute Cost advantage theory to clarify this situation and developed the Theory of Comparative Advantage.

Comparative cost advantage theory states that a country should produce and export those products for which it is relatively more productive than that of other countries and import those goods for which other countries are relatively more productive than it is.  The comparative cost advantage theory is based on relative productivity differences and incorporates the concept of opportunity cost.

Assumptions of the Theory

There are no trade barriers The only element of cost of production is labor. Production is the subject to the law of constant returns. Trade is free from cost of production Trade takes place only between two countries Only two products are traded There are no costs of transport

Criticism
 Two Countries: It is assumed that two countries participate in international trade. But, in reality more than two countries participate in international trade.  Transportation Cost: It is criticized that the assumption of non-existence of transportation cost does not hold good as transportation cost is part of the process of global trade.  Two Products: In reality many products are involved in international trade. As such the assumption of existence of two products does not hold good.  Services: Comparative advantage theory deals with products but not services. But trading in services assumes significant share in global business, particularly in recent times.