Theories of

A presentation on
Presented to.

International Trade Dr. Jitender Bhandari

Presented by:
Amol Garg Navneet Gupta Vishal Kamboj Adbhut Anand Mayank Shridhar
Contents

Purpose of Theories

Mercantilists View on Trade

Theory of Absolute Advantage

Theory of Comparative Advantage

Haberlers Theory of Opportunity Cost

New Trade Theory

Purpose of Theories

Basis of trade

Gains from trade

Reasons for trade restrictions

Effects of trade restrictions

Adbhut
What Role Does
Government Has In Trade?

The mercantilist philosophy makes a crude case for government involvement in

promoting exports and limiting imports

Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade

New trade theory and Porters theory of national competitive advantage justify
limited and selective government intervention to support the development of
certain export-oriented industries

Adbhut
Mercantilism

According to Wild, 2000, the trade theory that states that nations should
accumulate financial wealth, usually in the form of gold, by encouraging
exports and discouraging imports is called Mercantilism

Mercantilism views trade as a zero-sum game - one in which a gain by one

country results in a loss by another

Adbhut
Mercantilist Theory

Theory says you should have a trade surplus.

Maximize export through subsidies.
Minimize imports through tariffs and quotas
Flaw: restrictions, impaired growth

Problem with this theory is that it excludes the fact that its good to import in
some cases

If you completely refuse to import, the population will have to do with certain
consumer items

Adbhut
Theory of Absolute Advantage
Adam Smith, 1776

As per the theory, a Nation must produce and export commodity X in which it is relatively
efficient than another Nation and must import commodity Y in which it is less efficient.

As a result, both nations specializes in the production of a good in which they are efficient
i.e. they have Absolute Advantage

Both nations benefit by specialization with increased production and consumption

However, trade is good and beneficial as long as nations have absolute advantage and is not
beneficial if a nation has absolute disadvantage in production of both goods

A nation, therefore, must have absolute advantage in the production of one good to benefit
from trade
Mayank
Theory of Absolute Advantage

Assumption:

2 x 2 x1 Model

Free Trade

Perfect mobility within the nations

Constant cost of production

Mayank
Theory of Absolute Advantage

Mercantilists believed that one nation could gain only at the expense of another
nation and advocated strict government control of all economic activity and
trade

Adam Smith believed that all nations would gain from free trade and strongly
advocated a policy of laissez-faire (i.e., as little government interference with
the economic system as possible).

Free trade would cause world resources to be utilized most efficiently and
would maximize world welfare.

Mayank
Illustration of Absolute Advantage

Autarky Situation
US UK US has AA in Good Y, UK in Good X
Labour hrs Output Labour hrs Output World output for both goods is 4
Good X 6 1 2 1
Good Y 3 1 6 1
units
Total 9 2 8 2

Free Trade Situation

US UK US specializes and exports Good Y
Total Hrs Output Total Hrs Output
UK specializes and exports Good X
Good X 0 0 8 4
World output for both goods
Good Y 9 3 0 0
Total 9 3 8 4
increases to 7 units
Mayank
Theory of Comparative Advantage
David Ricardo 1817

According to the law of comparative advantage, even if one nation is less

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

The first nation should:

specialize in the production and export of the commodity in which its absolute disadvantage is
smaller (has Comparative Advantage), and
import the commodity in which its absolute disadvantage is greater (has Comparative
Disadvantage)

Amol
Assumptions

Only two nations and two commodities,

Free trade,
Perfect mobility of labour within each nation but immobility between the two
nations,
Constant costs of production,
No transportation costs,
No technical change, and
The Labour Theory of Value (either homogenous labour or labour being only
factor of production)

Amol
Illustration of Comparative Advantage

US UK UKs labour is one-sixth as productive as US

labour in X and half as productive in Y
Output/hr Output/Hr
Good X 12 2 UK has Comparative Advantage in Good Y
Good Y 6 3 since its labour is less inefficient in the
Total 18 5 production on Good Y

US would be indifferent if it receives 6Y in exchange of 12X as it can be produced

domestically with same resources and will not accept anything less than 6Y

UK would be indifferent if it receives 2X in exchange of 3Y and will not accept anything

less than 2X

Amol
Gains from Trade

US UK If US exchanges 12X for 12Y, US gains 6Y (1

Output/hr Output/Hr labour hour)
Good X 12 2
Good Y 6 3 UK receives 12X which would take 6 hours
Total 18 5 and could instead produce 18Y

Both US and UK gain by exchanging 12X and 12Y

Since US is indifferent with 12X-6Y terms, it gains for anything more than 6Y
In UK 12X = 18Y (both require 6 hours)

Range for terms of trade, therefore, is: 6Y < 12X < 18Y
For Example, if 12X and 12Y are exchanged, US gains 6Y, and UK gains 6Y. A total gain
of 12Y!
Amol
Opportunity Cost Theory
Haberler 1936

Improvement to the Ricardian Model

According to the opportunity cost theory, the cost of a commodity is the amount
of a second commodity that must be given up to release just enough resources
to produce one additional unit of the first commodity.

No assumption is made here that labour is the only factor of production or that
labour is homogeneous.

Nation with lower opportunity cost in production of a commodity has

comparative advantage in that commodity and disadvantage in other Navneet
 Depicted through Production Possibility Frontier which shows the combinations
of two goods that can be produced with given resources

There are constant opportunity costs if resources are either:

Perfect substitutes, or used in fixed proportion for production of both commodities
Units of same factor are homogeneous

Navneet
Illustration

To produce 1 additional unit of

wheat, US must give up 2/3 units and
UK must give up 2 units of cloth

To produce 1 additional unit of cloth,

US must give up 1.5 units and UK
must give up 0.5 units of wheat

This is a no trade situation.

US produces and consumes at point A

and UK at point A

Navneet
Gains from Trade

US specializes in wheat while UK in

cloth

Post trade, they can consume

outside the frontier which was not
possible in the absence of trade

Navneet
New Trade theory (NTT)

Developed by Paul Krugman

New trade theory (NTT) is a collection of economic models in international

trade which focuses on the role of increasing returns to scale and network
effects, which were developed in the late 1970s and early 1980s

New trade theorists relaxed the assumption of constant returns to scale

Brings monopolistic competition along with it

Product differentiation
No single firm controls the market
Some firms are larger than other firms

Vishal
New Trade theory (NTT)

It outweigh the more traditional theory of comparative advantage in a sense that in

some industries, two countries may have no discernible differences in opportunity cost
at a particular point in time. But, if one country specialises in a particular industry then
it may gain economies of scale and other network benefits from its specialisation.

Examples of New Trade Theory

Specialisation of IT in Silicon Valley US. Hewlett and Packard started their computer
business. Success attracted more IT firms to that area. Not because of any particular intrinsic
benefit but new firms start to get the network benefits of being around other IT set ups.
Globalisation has led to increased variety for consumers. Proliferation of brand clothing
labels. Firms competing in model of monopolistic competition and heavy branding. Neither
UK or Italy has particular comparative advantage in producing clothes, but consumers are
attracted to brand image of Italian and British fashion labels.

Vishal
New Trade Theory and Government regulation

New trade theory suggests that governments might have a role to play in promoting new industries
and supporting the growth of key industries through tariff protection and domestic subsidy.

encourage the creation of capital-intensive industries which with the help of government will be able
to exploit economies of scale

Some point to the Japanese car industry in the 1950s, which received substantial government
support. Other S.E. Asian economies also had some government protection and support.

Problems:
The government is likely to have poor information about which industry to support and how to
go about it.
It creates a tendency for powerful vested business interests Vishal
New Trade theory (NTT)

New trade theory is not primarily about advocating government intervention in

industry; it is more a recognition that economies of scale are a key factor in
influencing the development of trade.

It also suggests that free trade and laissez-faire government intervention may
be much less desirable for developing economies who find themselves unable to
compete with established multi-nationals.

Vishal
Conclusion

TRADE IS GOOD NO MATTER

WHAT !
THANK YOU!