International Trade Theories

Lec 3 International Trade TheoriesRicardos, H-O theory and Neo classical theory of international tradeComparative advantage theory: (David Ricardo)Assumptions of the theory:Two countries and two commodities (2*2 Model)Labour theory of valueLabour is mobile within the country but immobile between the countries.No transportation costsFree trade (No tariff and non-tariff barriers)

Comparative advantage theory: (David Ricardo)Even if a country has absolute advantage in the production of both the commodities, there is still a possibility for profitable trade. A country should specialize in the production and export of a commodity in which it has comparatively more advantage and import that commodity in which it has comparatively lesser advantage. Illustration of Comparative advantage theoryTable Shows the one labour hour produces 6 kgs of wheat and 4 meters of cloth in US and 1 kg of wheat and 5 meters of cloth in UK.

US has absolute advantage in the production of both the commodities but relatively more advantage in the production of Wheat.

USUKWheat (Kg/labour- hour )61Cloth (Meter/labour-hour)42After Trade Scenario:US will specialize in the production of wheat and exchange a part of it with UK cloth. UK will specialize in the production of cloth and exchange a part of it with the US Wheat. Gains form Trade:US exchanges 6 kgs of wheat with the 6 meters of cloth and gains 2 meters of cloth or half labour hour. UK gains 6 kgs of wheat and saves 6 labour hours. With 6 labour hours UK produces 12 meters of cloth and exchanges 6 with US to save 6 meters of cloth.

Question

Table Below shows bushels of wheat and the yards of cloth that the United States and the United Kingdom can produce with one hour of labor time under four different hypothetical situations.In each case, identify the cases in which the trade is possible between the United States and the United Kingdom according to Comparative advantage theory.In case A, trade is possible based on absolute advantage.In case B, trade is possible based on comparative advantage. In case C, trade is possible based on comparative advantage.In case D, no trade is possible because the comparative advantage that the United States has over United Kingdom is same in both the commodities.International Comparative advantageCountryCanadaIndiaSaudi ArabiaSouth KoreaNew ZealandSwitzerlandMexicoProduct LumberIT servicesPetroleumCarsDairy productsWatchesTomatoes1. The commodity in which the nation has the smallest absolute disadvantage is the commodity of its:a. absolute disadvantageb. absolute advantagec. comparative disadvantaged. comparative advantage2. If in a two-nation (A and B), two-commodity (X and Y) world, it is established that nation A has a comparative advantage in commodity X, then nation B must have:a. an absolute advantage in commodity Yb. an absolute disadvantage in commodity Yc. a comparative disadvantage in commodity Yd. a comparative advantage in commodity Y

Heckscher-Ohlin theory: Eli Hecksher and Bertil OhlinAssumptions:Two countries, two commodities and two factors of production model (2*2*2 Model)Labour is not the only factor of production rather capital is also a factor of production.Factors of production are mobile within the nation but immobile between the nations. Perfect competition in both commodity and factor market.

Heckscher-Ohlin theory:Eli Hecksher and Bertil OhlinA country will export those goods that make intensive use of locally abundant factors of production and import commodity that requires intensive use of nations scarce resources.Example

China exports footwear, because it is a labour intensive commodity and Chinese have abundance of labour.

South Korea exports cars because cars are capital intesive commodities and Koreans have abundant of capital.

Labour rich nations will export labour intensive commodities. Capital rich nations will export capital intensive commodities.

Superiority More Superior theory than Ricardo's comparative advantage theory. Introduces capital as the additional factor of production.Basis of trade is not the productivity of labour rather difference in factor endowments. Empirical tests of Heckscher-Ohlin (H-O) theory:

Leontief (1951) carried the first empirical test of H-O theory for the year 1947 for US economy.His analysis showed the contradictory results of US exporting labour intensive commodities and importing capital intensive commodities. Leontiff Paradox

Neo classical trade theoryOne commodityDemand CurveSupply Curve

Intersection give the price of aCommodity. Two commoditiesIndifference curveProduction possibility curve

Tangency gives the relative prices of two commodities.Trade between two nations arises due to difference in relative prices. Production possibility frontierProduction possibility Curve:It is a locus of points representing different combinations of commodities which can be produced with the given amount of resources and technology.

It is concave to the origin. This is because, for increasing the production of X, we have to give up more units of Y in order to release enough resources to produce extra unit of X.

This is because resources are not adoptable to multiple uses.

Slope =

16Autarky Production equilibriumPoint E is the Autarky equilibrium of producer.

Indifference curveIt is a locus of commodities representing different combination of commodities between which the consumer is indifferent.

Slope is convex to the origin. It is because when a consumer has enough y, he will release more Y to have extra unit of X.

It slope is given by

Consumers Equilibrium

Illustration of Equilibrium in IsolationIllustration of Equilibrium in Isolation

Illustration of Equilibrium with Trade

Production equilibrium = E Production equilibrium = e Consumption equilibrium = C Production equilibrium = e Country A imports Y3 Y2Country B exports Y5 Y6Country A exports X3 X2Country B imports X3 X6