Lec 3 International

Trade Theories
Ricardos, H-O theory and Neo
classical theory of
international trade

Comparative advantage theory:

(David Ricardo)
Assumptions of the theory:

Two countries and two commodities (2*2

Model)
Labour theory of value
Labour is mobile within the country but
immobile between the countries.
No transportation costs
Free 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 theory
Table Shows the one labour hour produces 6
kgs of wheat and 4 meters of cloth in US and
and 5 meters
US of cloth
UK in UK.
1 kg of wheat
Wheat (Kg/labourhour )
Cloth
(Meter/labour-hour)

US has absolute advantage in the production

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

 After 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

International Comparative advantage

Country

Product

Canada
India
Saudi Arabia
South Korea
New Zealand
Switzerland
Mexico

Lumber
IT services
Petroleum
Cars
Dairy products
Watches
Tomatoes

1. The commodity in which the nation has the smallest

absolute disadvantage is the commodity of its:
a. absolute disadvantage
b. absolute advantage
c. comparative disadvantage
d. comparative advantage
2. 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 Y
b. an absolute disadvantage in commodity Y
c. a comparative disadvantage in commodity Y
d. a comparative advantage in commodity Y

Heckscher-Ohlin theory:

Eli

Hecksher and Bertil Ohlin

Assumptions:
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 Ohlin

A 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

L
L

K ( China ) K ( Korea )

w
w

r ( China )
r ( Korea )

China exports footwear, because it is a labour

intensive commodity and Chinese have
abundance of labour.

K
K

L ( Korea )
L ( China )

r
r

w ( Korea ) K ( China )

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 theory

Trade between two nations arises due to
difference in relative prices.
One commodity
Demand Curve
Supply Curve
Intersection give the
price of a
Commodity.

Two commodities
Indifference curve
Production possibility
curve
Tangency gives the
relative prices of two
commodities.

Production
possibility
frontier
Production 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 =

MRT

MC x
MC y

Autarky Production
equilibrium

MC x Px
Point
E is
the Autarky
MRT
equilibrium
of producer. MC y
Py

Indifference
curve
It 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.
MU x
It slope is givenMU
byy
MRS

Consumers
Equilibrium

MU x Px
MRS

MU y Py

Illustration of Equilibrium in Isolation

Illustration of Equilibrium in Isolation

 Illustration of Equilibrium with Trade

Production equilibrium
=
E
Consumption
equilibrium
=C Y Y
Country A imports
3

Country A exports X3 X2

Production equilibrium
= e
Production
equilibrium = e
Country B exports Y5 Y6
Country B imports X3 X6