int' trade & investment report

8/7/2019 int' trade & investment report

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1. Classical Theory of International Trade:

Mercantilism is an economic theory that holds the prosperity of a state as dependent upon itssupply of capital that the global volume of international trade is "unchangeable," and that one

party may benefit only at the expense of another. "Unchangeable" in this sense may be taken tomean that the European and global economies are seen as zero-sum games, though that economicconcept did not yet exist in the mercantilist period. During it, economic assets (or capital) were

represented by bullion (gold, silver, and trade value), which was best increased through a

positive and healthy balance of trade with other states (exports minus imports).

The theory assumes that wealth and monetary assets are identical. Mercantilism suggests that theruling government should advance these goals by playing a protectionist role in the economy by

encouraging exports and discouraging imports, notably through the use of subsidies and tariffs

respectively. The theory dominated Western European economic policies from the 16th to thelate-18th century.[1]

ASSUMPTIONS:

Economic philosophy based on belief that -

a) A nation’s wealth depends on accumulated treasure, usually gold, and

b) To increase wealth, government policies should promote exports and discourage imports

c) Wealth and monetary assets are identical

CRITISISMS:

a) A nation’s wealth is not based on only treasure but also can be human resource, technological

knowledgw and “ know how”

b) No country is self sufficient and that’s why import is necessary. Moreover, always export may

not be logical if transportation cost is high.

c) Wealth and monetary assets of all country is not same.

http://en.wikipedia.org/wiki/Capital_(economics)

http://en.wikipedia.org/wiki/World_economy

http://en.wikipedia.org/wiki/International_trade

http://en.wikipedia.org/wiki/Zero-sum_game

http://en.wikipedia.org/wiki/Mercantilism#Origins

http://en.wikipedia.org/wiki/Bullion

http://en.wikipedia.org/wiki/Balance_of_trade

http://en.wikipedia.org/wiki/Protectionism

http://en.wikipedia.org/wiki/Subsidy

http://en.wikipedia.org/wiki/Tariffs

http://en.wikipedia.org/wiki/Western_Europe

http://en.wikipedia.org/wiki/Mercantilism#cite_note-econlib-0

http://en.wikipedia.org/wiki/Capital_(economics)

http://en.wikipedia.org/wiki/World_economy

http://en.wikipedia.org/wiki/International_trade

http://en.wikipedia.org/wiki/Zero-sum_game

http://en.wikipedia.org/wiki/Mercantilism#Origins

http://en.wikipedia.org/wiki/Bullion

http://en.wikipedia.org/wiki/Balance_of_trade

http://en.wikipedia.org/wiki/Protectionism

http://en.wikipedia.org/wiki/Subsidy

http://en.wikipedia.org/wiki/Tariffs

http://en.wikipedia.org/wiki/Western_Europe

http://en.wikipedia.org/wiki/Mercantilism#cite_note-econlib-0



Classical theory developed by Karl Marx. The theory is based on three basic assumptions.

ASSUMPTIONS:

a) Basis of international trade: All countries international trade is on same basis.

b) Export and import of trading countries: All countries are not exporting and importing same

goods.

c) Gains from international trade and distribution method: there are different bases of

international trade and different methods of distributions of goods.

CRITISISMS:

a) Basis of international trade is not same for all countries

b) Export and import capabilities of each country are different.

c) No country enjoys absolute cost advantages.

2. Ricardian Theory of International Trade

The Ricardian model focuses on comparative advantage (if one country is more efficient inthe production of all goods (absolute advantage), it can still gain by trading with a

less-efficient country, as long as they have different relative efficiencies), perhaps the

most important concept in international trade theory. In a Ricardian model, countries specializein producing what they produce best. Unlike other models, the Ricardian framework predicts that

countries will fully specialize instead of producing a broad array of goods.

The Ricardian model of international trade attempts to explain the difference in comparative

advantage on the basis of technological difference across the nations. The technologicaldifference is essentially supply side difference between the two countries involved in

international trade. The Ricardian model assumes all other factors to be similar across the

countries.

The Labor Theory of Value forms the basis of the Ricardian model of trade. This model putstress on technological difference as the prime reason behind the trading activities. Unlike other

international trade theories, which propose that trade is beneficial for some, but not favorable for

http://en.wikipedia.org/wiki/Absolute_advantage

http://en.wikipedia.org/wiki/Absolute_advantage



others, the Ricardian model of trade highlights on the fact that trade is beneficial for all the

countries involved in international trade. This model suggests that even a backward economy

that uses inferior technology is going to benefit from international trade.

The analysis of Ricardian model crucially depends on the implications of the Labor Theory of

Value. The major implications of labor theory of value include the following:

1) Labor is the only major factor of production.

2) Labor is absolutely mobile between sectors within the domestic boundary; however immobileacross countries.

3) Labor units are homogeneous within a country.

According to the Ricardian model of trade, the demand side conditions come in

handy in determining the trade compositions and gains from trade, after trade

opens up. Demand plays a crucial role in the determination of international terms of

trade in the Ricardian model only after opening up of trade.



Suppose there are two countries of equal size, India and Bangladesh, that both produce and consume two

goods, food and clothes. The productive capacities and efficiencies of the countries are such that if both

countries devoted all their resources to food production, output would be as follows:

• India: 100 tonnes• Bangladesh: 400 tonnes

If all the resources of the countries were allocated to the production of clothes, output would be:

• India: 100 tonnes• Bangladesh: 200 tonnes

Assuming each has constant opportunity costs of production between the two products and both

economies have full employment at all times. All factors of production are mobile within the countriesbetween clothes and food industries, but are immobile between the countries. The price mechanism must

be working to provide perfect competition.

Bangladesh has an absolute advantage over India in the production of food and clothes. There seems to be

no mutual benefit in trade between the economies, as Bangladesh is more efficient at producing both

products. The opportunity costs shows otherwise. India's opportunity cost of producing one tonne of foodis one tonne of clothes and vice versa. Bangladesh's opportunity cost of one tonne of food is 0.5 tonne of

clothes, and its opportunity cost of one tonne of clothes is 2 tonnes of food. Bangladesh has a comparativeadvantage in food production, because of its lower opportunity cost of production with respect to India,

while India has a comparative advantage in clothes production, because of its lower opportunity cost of

production with respect to Bangladesh.

To show these different opportunity costs lead to mutual benefit if the countries specialize production andtrade, consider the countries produce and consume only domestically. The volumes are:

Production and consumption before trade

Country Food Clothes

India 50 50

Bangladesh 200 100

TOTAL 250 150

http://en.wikipedia.org/wiki/Full_employment

http://en.wikipedia.org/wiki/Factors_of_production

http://en.wikipedia.org/wiki/Price_mechanism


http://en.wikipedia.org/wiki/Perfect_competition



http://en.wikipedia.org/wiki/Full_employment

http://en.wikipedia.org/wiki/Factors_of_production





This example includes no formulation of the preferences of consumers in the two economies which would

allow the determination of the international exchange rate of clothes and food. Given the productioncapabilities of each country, in order for trade to be worthwhile India requires a price of at least one tonne of

food in exchange for one tonne of clothes; and Bangladesh requires at least one tonne of clothes for twotonnes of food. The exchange price will be somewhere between the two. The remainder of the example workswith an international trading price of one tonne of food for 2/3 tonne of clothes.

If both specialize in the goods in which they have comparative advantage, their outputs will be:

Production after trade


India 0 100

Bangladesh 300 50

TOTAL 300 150

World production of food increased. Clothes production remained the same. Using the exchange rate of onetonne of food for 2/3 tonne of clothes, India and Bangladesh are able to trade to yield the following level of

consumption:

Consumption after trade


India 75 50

Bangladesh 225 100

World total 300 150

India traded 50 tonnes of clothes for 75 tonnes of food. Both benefited, and now consume at points outsidetheir production possibility frontiers.

http://en.wikipedia.org/wiki/Production_possibility_frontier

http://en.wikipedia.org/wiki/Production_possibility_frontier



Assumptions

• Two countries, two goods - the theory is no different for larger numbers of

countries and goods, but the principles are clearer and the argument easier

to follow in this simpler case.

• Equal size economies - again, this is a simplification to produce a clearer

example.

• Full employment - if one or other of the economies has less than full

employment of factors of production, then this excess capacity must usually

be used up before the comparative advantage reasoning can be applied.

• Constant opportunity costs - a more realistic treatment of opportunity

costs the reasoning is broadly the same, but specialization of production can

only be taken to the point at which the opportunity costs in the two countries

become equal. This does not invalidate the principles of comparative

advantage, but it does limit the magnitude of the benefit.

• Perfect mobility of factors of production within countries - this is

necessary to allow production to be switched without cost. In real economies

this cost will be incurred: capital will be tied up in plant (sewing machines are

not sowing machines) and labour will need to be retrained and relocated. This

is why it is sometimes argued that 'nascent industries' should be protected

from fully liberalised international trade during the period in which a high cost

of entry into the market (capital equipment, training) is being paid for.

• Immobility of factors of production between countries - why are there

different rates of productivity? The modern version of comparative advantage

(developed in the early twentieth century by the Swedish economists Eli

Heckscher and Bertil Ohlin) attributes these differences to differences in

nations' factor endowments. A nation will have comparative advantage in

producing the good that uses intensively the factor it produces abundantly.

For example: suppose the US has a relative abundance of capital and India

has a relative abundance of labor. Suppose further that cars are capital

intensive to produce, while cloth is labor intensive. Then the US will have a

comparative advantage in making cars, and India will have a comparative

advantage in making cloth. If there is international factor mobility this can



change nations' relative factor abundance. The principle of comparative

advantage still applies, but who has the advantage in what can change.

• Negligible transport cost - Cost is not a cause of concern when countries

decided to trade. It is ignored and not factored in.

• Test and production technique- consumer’s test of goods are same and

the technique of production is given. .

• Perfect competition - this is a standard assumption that allows perfectly

efficient allocation of productive resources in an idealized free market.

• Average cost of production- it is assumed that average cost of production is

stable within the countries.

• Value of labor theory- it is assumed that all labors are of same qualities,

trained and equally efficient.

http://en.wikipedia.org/wiki/Comparative_advantage

CRITISISM

For considerable period the theory of comparative costs formulated by DavidRicardo was the most acceptable explanation of the international trade. However,

Ricardo's theory was subjected to number of criticisms.

1. Restrictive Model

Ricardo's Theory is based on only two countries and only two commodities. But international

trade is among many countries with many commodities.

2. Labour Theory of Value

Value of goods is expressed in terms of labor content. Labor Theory of value developed by

classical economists has too many limitations and thus is not applicable to the reality. Value of

goods and services in the real world are expressed in money i.e. the prices are the valuesexpressed in units of money.

3. Full employment

The assumption of full employment helps the theory to explain trade on the basis of comparative

advantage. The reality is far from full employment. Cost of production, even in terms of labor,

may change as the countries, at different levels of employment move towards full employment.





4. Ignore transport cost

Another serious defect is that the transport costs are not consider in determining comparative

cost differences.

5. Demand is ignored

The Ricardian theory concentrates on the supply of goods. Each country specialises in the

production of the commodity based on its comparative advantage. The theory explains

international trade in terms of supply and takes demand for granted.

6. Mobility of factor of production

As against the assumptions of perfect immobility between the countries, we witness difficultiesin the mobility of labor and capital within a country itself. At the same time their mobility

between nations was never totally absent.

7. No Free Trade

Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the

countries which is unrealistic to assume not to have any restriction. What the real world

witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it

difficult to enjoy the comparative advantage in the production of labour intensive commoditiesdue to the protectionist policies followed by developed countries.

8. Complete specialisation

The comparative advantage theory comes to conclusion of complete specialization. In theRicardian example, England is specializing fully on cloth and Portugal on wine. Such complete

specialization is unrealistic even in two countries and two commodities model. It is possible if

two countries happen to be almost identical in size and demand. Again, a complete specializationin the production of less important commodity is not possible due to insufficient demand for it.

9. Static Theory

The modern economy is dynamic and the comparative cost theory is based on the assumptions of

static theory. It assumes fixed quantity of resources. It does not consider the effect of growth.

10. Not applicable to developing countries

Ricardian theory is not applicable to developing countries as these countries are nowhere near to

full employment. They are in the process of change in quality of their labour force, quality of



capital, technology, tapping of new resources etc. In other words developing countries exhibit all

the characteristics of dynamic economy.

11. Constant Returns to Scale

Another drawback of the Ricardian principle of comparative costs is that assumes constant

Returns to scale and thus constant cost of production in both the countries. The doctrine holds

that if England specialises in cloth; there is no reason why it should produce wine. Similarly if

Portugal has a comparative advantage in producing wine, it will not produce cloth; but import allcloth from England. If we examine the pattern of international trade in practice, we find it is not

so. A time will come when it will not be reasonable for Portugal to import cloth from England

because of increasing cost of production. Moreover, in actual practice a country produces a

particular commodity and also imports a part of it. This phenomenon has not been explained bythe theory of comparative costs.

http://kalyan-city.blogspot.com/2011/02/criticism-limitations-of-ricardian.html

Ricardo expounded the theory of comparative advantage without explaining the ratios at which

commodities would exchange for one another. It was J. S. Mill who discussed the problem of

ratios in detail in term of his theory of “Reciprocal Demand”. The term ‘reciprocal demand’ wasintroduced by Mill to explain the determination of the equilibrium terms of trade. It is used to

indicate a country’s demand for one commodity in terms of the quantities of other commodities

it is prepared to give up in exchange. It is reciprocal demand that determines the terms of trade

which in turn determine the relative share of each country. Equilibrium would be established atthat ratio of exchange between the two commodities at which quantities demanded by each

country of the commodity which it imports from the other should be exactly sufficient to pay for

another.

To explain his theory of reciprocal demand, Mill first restated the Ricardian theory of comparative costs, “Instead of taking as given the output of each commodity in two countries,

with the labour costs different, he assumed a given amount of labour in each country but

differing outputs. Thus his formation ran in terms of comparative advantage or comparativeeffectiveness of labour, as contrasted with Ricardo’s comparative labour cost.

Assumptions:

Mill’s theory of reciprocal demand is based on the following assumptions.

1. There are two countries, say, England and Germany.

2. There are two commodities, say, linen and cloth.





3. Both the commodities are produced under the law of constant returns.

4. There are no transport costs.

5. The needs of the two countries are similar.

6. There is perfect competition.

7. There is full employment.

8. There is free trade between the two countries.

9. The principle of comparative costs is applicable in trade relations between the two countries.

Given these assumptions Mill’s theory of reciprocal demand can be explained with the help of

following table.

Quantities of Commodities Produced:

Country Output

Linen Cloth

Germany 10 10

England 6 8

Suppose Germany can produce 10 units of linen or 10 units of cloth within one man-year and

England can produce 6 units of linen or 8 units of cloth with the same input of labour-time.According to Mill “This supposition then being made, it would be in the interest of England to

import linen from Germany and of Germany to import cloth from England”. This is becauseGermany has an absolute advantage in the production of both linen and cloth, while England has

the least comparative advantage in the production of cloth. This can be seen from their domesticratios and international exchange ratios.

Before trade, the domestic cost ratios of linen and cloth in Germany is 1:1 and in England is 3:4.

If they were to enter into trade Germany’s advantage over England in the production of linen is

5:3 (or 10:6) and in the production of cloth 5:4 (or 10:8). Since 5/3 is greater than 5/4. Germanypossesses greater comparative advantage in the production of linen. Thus it is in Germany’s

interest to export linen to England in exchange of cloth. Similarly England’s position in the

production of linen is 3/5 (or 6/10) and in production of cloth is 4/5 (or 8/10). Since 4/5 is greater

than 3/5, it is in the interest of England to export cloth to Germany in exchange for linen.

Miller’s theory of reciprocal demand relates to the possible terms of trade at which the two

commodities will exchange for each other between the two countries. The terms of trade refer to

the barter terms of trade between the two countries i.e. the ratio of the quantity of imports for given quantity of exports of a country. And “the limits to the possible barter terms of trade (the

international exchange ratio) are set by domestic exchange ratios established, by the relative

efficiency of labour in each country. To take an example in Germany 2 inputs of labour time



produce 10 units of linen and 10 units of cloth, while in England the same labour produces 6

units of linen and 8 units of cloth. The domestic exchange ratio between linen and cloth in

Germany is 1:1 and 1:1.33 in England. Thus the limits of possible terms of trade are linen: 1cloth in Germany and 1 linen: 1.33 cloths in England. Thus the terms of trade between the two

countries will be between 1 linen or 1 cloth or 1.33 cloths.

But actual ratio will depend upon reciprocal demand i.e. “the strength and elasticity of each

country’s demand for the other country’s product”. If Germany’s demand for England’s cloth ismore intense (inelastic) then the terms of trade will be nearer 1:1 Germany will be prepared to

exchange one unit of linen with one unit of cloth of England. The terms of trade will move

against it and in favour of England. Consequently Germany’s gain from trade will be less thanthat of England. On the other hand if Germany’s demand for England’s cloth is less intense

(more elastic) then the terms of trade will be nearer 1:1.33. Germany will be prepared to

exchange its one unit of linen with 1.33 units of cloth of England. The terms of trade will movein favour of Germany and against England. Consequently Germany’s gain from trade will be

greater than that of England.

In short “(1) The possible of barter terms is given by the respective domestic term of trade as set

by comparative efficiency in each country (2) with in this range, the actual terms of trade dependon each country’s demand for the other country’s produce and (3) finally, only those barter terms

of trade will be stable at which the exports offered by each country just suffice to pay for the

imports it desires”.

Criticism of the Theory:

Mill’s theory of reciprocal demand is based on almost the same unrealistic assumptions that wereadopted by Ricardo in his doctrine of comparative advantage. Thus the theory suffers from

weaknesses. Besides, there are some additional criticism made by Viner, Graham and others.

1. Mills theory of reciprocal demand does not take into account the domestic demand for theproduct, as pointed out by viner, each country would export its product only after satisfying its

home demand. Thus the demand curve for Germany would not be below the line until the

domestic demand was satisfied and same applies to England.

2. According to Graham Mills analysis is valid only if the two countries are of equal size and thetwo commodities are of equal consumption value. In absence of these two assumptions if one

country is small and the other large, the small country gains the most on both counts, first if it

produced a high value commodity, it will adopt the cost ratios of its big partner and second the

two trading countries being of unequal size the terms of trade will be fixed at or near thecomparative costs of the large country. Graham further criticises Mill for emphasising demand

and neglecting supply in determining international values. According to him the application of

the reciprocal demand makes it appear that demand alone is of interest he maintains thatproduction cost (supply) are also of paramount importance to international trade.



3. Another weakness of Mill’s reciprocal demand analysis is that it makes no allowance for

fluctuations in incomes in the two trading countries which are bound to influence the terms of

trade between them.

4. Further the theory is based on barter terms of trade and relative price ratios. Thus it neglects

all sickness of prices and wages, all transitional inflationary and over valuation gaps and allbalance of payment problems.

http://notesforpakistan.blogspot.com/2009/08/j-s-mills-reciprocal-demand-theory-

of.html

http://notesforpakistan.blogspot.com/2009/08/j-s-mills-reciprocal-demand-theory-of.html






Mercantilism (Thomas Mun 1630)

Initial trade theory that formed the foundation of economic

thought from 1500 – 1800 Based on concept that a nation’s wealth is measured by its

holding of treasure (gold).

The theory suggested that a government can improveeconomic well being of the country by increasing exportsand reducing imports.

The flaw of the theory was that it viewed trade as a zero sumgame.

3. The theory of Comparative Advantage (David

Ricardo 1817)

A country’s ability to produce commodity at a loweropportunity cost than its trading partner. (The opportunitycost is measured in terms of other goods)

Some countries have an absolute advantage in theproduction of many goods relative to their trading partners.

Some have an absolute disadvantage. This theory assumes that trade is a positive sum games in

which all countries that participate realize economic gains.

Ricardo’s Basic Arguments



A country can be benefited in the international trade if itspecializes in the production of those goods that it producesmost efficiently and to buy the goods that it produces lessefficiently from other countries, even if this means buying

goods from other countries that it could produce moreefficiently itself.

Assumptions:

Only two countries and two commodities

Transportation cost missing

Exchange rate not considered

Assumed resources can transfer freely

Assumed constant return to specialization Free trade does not change efficiency with which thecountry uses its resources

No effect of trade on the income distribution within acountry.……………………………………………………………………………………………………………………………………………………………………………………………………………………

Neo-Ricardian trade theory

Inspired by Piero Sraffa, a new strand of trade theory emerged and was named neo-Ricardian

trade theory. The main contributors include Ian Steedman (1941-) and Stanley Metcalfe (1946-).They have criticized neoclassical international trade theory, namely the Heckscher-Ohlin model

on the basis that the notion of capital as primary factor has no method of measuring it before the

determination of profit rate (thus trapped in a logical vicious circle).[14] This was a second round

of the Cambridge capital controversy, this time in the field of international trade.[15]

The merit of neo-Ricardian trade theory is that input goods are explicitly included to the

analytical framework. This is in accordance with Sraffa's idea that any commodity is a product

made by means of commodities. The limit of their theory is that the analysis is limited to small

country cases.

http://en.wikipedia.org/wiki/Piero_Sraffa

http://en.wikipedia.org/wiki/Heckscher-Ohlin_model

http://en.wikipedia.org/wiki/International_trade#cite_note-13

http://en.wikipedia.org/wiki/Cambridge_capital_controversy


http://en.wikipedia.org/wiki/Piero_Sraffa

http://en.wikipedia.org/wiki/Heckscher-Ohlin_model


http://en.wikipedia.org/wiki/Cambridge_capital_controversy




http://www.witiger.com/internationalbusiness/tradetheories.htm

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