Unit I: Theories of International Trade | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


INTERNATIONAL 
TRADE 
UNIT I: THEORIES OF INTERNATIONAL
TRADE 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Define international trade and describe how it differs from
internal trade
? Elucidate the arguments in favor of and against  liberal
trade
? Explain the mercantilists’ views on international trade
? Illustrate how trade can be based on absolute advantage
? Describe the Ricardian theory of comparative advantage
? Explain the basis  of trade  according to modern theory of
trade
CHAPTER 
4
Page 2


INTERNATIONAL 
TRADE 
UNIT I: THEORIES OF INTERNATIONAL
TRADE 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Define international trade and describe how it differs from
internal trade
? Elucidate the arguments in favor of and against  liberal
trade
? Explain the mercantilists’ views on international trade
? Illustrate how trade can be based on absolute advantage
? Describe the Ricardian theory of comparative advantage
? Explain the basis  of trade  according to modern theory of
trade
CHAPTER 
4
4.2 ECONOMICS FOR FINANCE 
 1.1 INTRODUCTION 
International trade is the exchange of goods and services as well as resources 
between countries. It involves transactions between residents of different 
countries. As distinguished from domestic trade or internal trade which involves 
exchange of goods and services within the domestic territory of a country using 
domestic currency, international trade involves transactions in multiple currencies.   
Compared to internal trade, international trade has greater complexity as it 
involves heterogeneity of customers and currencies, differences in legal systems, 
business practices and political systems, more elaborate documentation, 
exchange rate risks,  complex procedures and formalities, high operating costs, 
issues related to shipping, insurance  and transportation and diverse restrictions 
and interventions from governments in the form of taxes, regulations, duties, 
tariffs, quotas, trade barriers, standards, and  restraints to movement of specified 
goods and services. At present, liberal international trade is an integral part of 
international relations and has become an important engine of growth in 
developed as well as developing countries.  
While some economists and policy makers argue that there are net benefits from 
keeping markets open to international trade and investments, others feel that 
International Trade
Theories of International Trade
Important Theories of Internation al Trade
UNIT OVERVIEW
Page 3


INTERNATIONAL 
TRADE 
UNIT I: THEORIES OF INTERNATIONAL
TRADE 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Define international trade and describe how it differs from
internal trade
? Elucidate the arguments in favor of and against  liberal
trade
? Explain the mercantilists’ views on international trade
? Illustrate how trade can be based on absolute advantage
? Describe the Ricardian theory of comparative advantage
? Explain the basis  of trade  according to modern theory of
trade
CHAPTER 
4
4.2 ECONOMICS FOR FINANCE 
 1.1 INTRODUCTION 
International trade is the exchange of goods and services as well as resources 
between countries. It involves transactions between residents of different 
countries. As distinguished from domestic trade or internal trade which involves 
exchange of goods and services within the domestic territory of a country using 
domestic currency, international trade involves transactions in multiple currencies.   
Compared to internal trade, international trade has greater complexity as it 
involves heterogeneity of customers and currencies, differences in legal systems, 
business practices and political systems, more elaborate documentation, 
exchange rate risks,  complex procedures and formalities, high operating costs, 
issues related to shipping, insurance  and transportation and diverse restrictions 
and interventions from governments in the form of taxes, regulations, duties, 
tariffs, quotas, trade barriers, standards, and  restraints to movement of specified 
goods and services. At present, liberal international trade is an integral part of 
international relations and has become an important engine of growth in 
developed as well as developing countries.  
While some economists and policy makers argue that there are net benefits from 
keeping markets open to international trade and investments, others feel that 
International Trade
Theories of International Trade
Important Theories of Internation al Trade
UNIT OVERVIEW
4.3 THEORIES OF INTERNATIONAL TRADE 
trade generates a number of adverse consequences on the welfare of citizens.  As 
students of Economics, we need to have an objective understanding of the claims 
put forth by both sections. We shall first examine the arguments in support of 
international trade.  
(i) International trade is a powerful stimulus to economic efficiency and
contributes to economic growth and rising incomes. The wider market made
possible owing to trade induces companies to reap the quantitative and
qualitative benefits of extended division of labour. As a result, they would
enlarge their manufacturing capabilities and benefit from economies of
large scale production. The gains from international trade are reinforced by
the increased competition that domestic producers are confronted with on
account of globalization of production and marketing, requiring businesses
to compete against global businesses. Competition from foreign goods
compels manufacturers, especially in developing countries, to enhance
efficiency and profitability by adoption of cost reducing technology and
business practices. Efficient deployment of productive resources to their
best use is a direct economic advantage of foreign trade. Greater efficiency
in the use of natural, human, industrial and financial resources ensures
productivity gains. Since international trade also tends to decrease the
likelihood of domestic monopolies, it is always beneficial to the community.
(ii) Trade provides access to new markets and new materials and enables
sourcing of inputs and components internationally at competitive prices.
This reflects in innovative products at lower prices and wider choice in
products and services for consumers. Also, international trade enables
consumers to have access to wider variety of goods and services that would
not otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for sustaining
their economies.
(iii) International trade enhances the extent of market and augments the scope
for mechanization and specialisation. Trade necessitates increased use of
automation, supports technological change, stimulates innovations, and
facilitates greater investment in research and development and productivity
improvement in the economy.
(iv) Exports stimulate economic growth by creating jobs, which could potentially
reduce poverty, and augmenting factor incomes and in so doing raising
standards of livelihood and overall demand for goods and services.  Trade
Page 4


INTERNATIONAL 
TRADE 
UNIT I: THEORIES OF INTERNATIONAL
TRADE 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Define international trade and describe how it differs from
internal trade
? Elucidate the arguments in favor of and against  liberal
trade
? Explain the mercantilists’ views on international trade
? Illustrate how trade can be based on absolute advantage
? Describe the Ricardian theory of comparative advantage
? Explain the basis  of trade  according to modern theory of
trade
CHAPTER 
4
4.2 ECONOMICS FOR FINANCE 
 1.1 INTRODUCTION 
International trade is the exchange of goods and services as well as resources 
between countries. It involves transactions between residents of different 
countries. As distinguished from domestic trade or internal trade which involves 
exchange of goods and services within the domestic territory of a country using 
domestic currency, international trade involves transactions in multiple currencies.   
Compared to internal trade, international trade has greater complexity as it 
involves heterogeneity of customers and currencies, differences in legal systems, 
business practices and political systems, more elaborate documentation, 
exchange rate risks,  complex procedures and formalities, high operating costs, 
issues related to shipping, insurance  and transportation and diverse restrictions 
and interventions from governments in the form of taxes, regulations, duties, 
tariffs, quotas, trade barriers, standards, and  restraints to movement of specified 
goods and services. At present, liberal international trade is an integral part of 
international relations and has become an important engine of growth in 
developed as well as developing countries.  
While some economists and policy makers argue that there are net benefits from 
keeping markets open to international trade and investments, others feel that 
International Trade
Theories of International Trade
Important Theories of Internation al Trade
UNIT OVERVIEW
4.3 THEORIES OF INTERNATIONAL TRADE 
trade generates a number of adverse consequences on the welfare of citizens.  As 
students of Economics, we need to have an objective understanding of the claims 
put forth by both sections. We shall first examine the arguments in support of 
international trade.  
(i) International trade is a powerful stimulus to economic efficiency and
contributes to economic growth and rising incomes. The wider market made
possible owing to trade induces companies to reap the quantitative and
qualitative benefits of extended division of labour. As a result, they would
enlarge their manufacturing capabilities and benefit from economies of
large scale production. The gains from international trade are reinforced by
the increased competition that domestic producers are confronted with on
account of globalization of production and marketing, requiring businesses
to compete against global businesses. Competition from foreign goods
compels manufacturers, especially in developing countries, to enhance
efficiency and profitability by adoption of cost reducing technology and
business practices. Efficient deployment of productive resources to their
best use is a direct economic advantage of foreign trade. Greater efficiency
in the use of natural, human, industrial and financial resources ensures
productivity gains. Since international trade also tends to decrease the
likelihood of domestic monopolies, it is always beneficial to the community.
(ii) Trade provides access to new markets and new materials and enables
sourcing of inputs and components internationally at competitive prices.
This reflects in innovative products at lower prices and wider choice in
products and services for consumers. Also, international trade enables
consumers to have access to wider variety of goods and services that would
not otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for sustaining
their economies.
(iii) International trade enhances the extent of market and augments the scope
for mechanization and specialisation. Trade necessitates increased use of
automation, supports technological change, stimulates innovations, and
facilitates greater investment in research and development and productivity
improvement in the economy.
(iv) Exports stimulate economic growth by creating jobs, which could potentially
reduce poverty, and augmenting factor incomes and in so doing raising
standards of livelihood and overall demand for goods and services.  Trade
  
 
4.4 ECONOMICS FOR FINANCE 
also provides greater stimulus to innovative services in banking, insurance, 
logistics, consultancy services etc. 
(v) Employment generating investments, including foreign direct investment, 
inevitably follow trade. For emerging economies, improvement in the 
quality of output of goods and services, superior products, finer labour and 
environmental standards etc. enhance the value of their products and 
enable them to move up the global value chain.  
(vi) Opening up of new markets results in broadening of productive base and   
facilitates export diversification so that new production possibilities are 
opened up. Countries can gainfully dispose off their surplus output and, 
thus, prevent undue fall in domestic prices caused by overproduction. Trade 
also allows nations to maintain stability in prices and supply of goods 
during periods of natural calamities like famine, flood, epidemic etc.  
(vii) Trade can also contribute to human resource development, by facilitating 
fundamental and applied research and exchange of know-how and best 
practices between trade partners.   
(viii) Trade strengthens bonds between nations by bringing citizens of different 
countries together in mutually beneficial exchanges and, thus, promotes 
harmony and cooperation among nations.  
Despite being a dynamic force, which has an enormous potential to generate 
overall economic gains, liberal global trade and investments are often criticized as 
detrimental to national interests. The major arguments put forth against trade 
openness are: 
(i) Possible negative labour market outcomes in terms of labour-saving 
technological change that depress demand for unskilled workers, loss of 
labourers’ bargaining power, downward pressure on wages of semi-skilled 
and unskilled workers and forced work under unfair circumstances and 
unhealthy occupational environments.  
(ii) International trade is often not equally beneficial to all nations. Potential 
unequal market access and disregard for the principles of fair trading 
system may even amplify the differences between trading countries, 
especially if they differ in their wealth. Economic exploitation is a likely 
outcome when underprivileged countries become vulnerable to the growing 
political power of corporations operating globally. The domestic entities can 
be easily outperformed by financially stronger transnational companies.  
Page 5


INTERNATIONAL 
TRADE 
UNIT I: THEORIES OF INTERNATIONAL
TRADE 
LEARNING OUTCOMES 
 
At the end of this unit, you will be able to: 
? Define international trade and describe how it differs from
internal trade
? Elucidate the arguments in favor of and against  liberal
trade
? Explain the mercantilists’ views on international trade
? Illustrate how trade can be based on absolute advantage
? Describe the Ricardian theory of comparative advantage
? Explain the basis  of trade  according to modern theory of
trade
CHAPTER 
4
4.2 ECONOMICS FOR FINANCE 
 1.1 INTRODUCTION 
International trade is the exchange of goods and services as well as resources 
between countries. It involves transactions between residents of different 
countries. As distinguished from domestic trade or internal trade which involves 
exchange of goods and services within the domestic territory of a country using 
domestic currency, international trade involves transactions in multiple currencies.   
Compared to internal trade, international trade has greater complexity as it 
involves heterogeneity of customers and currencies, differences in legal systems, 
business practices and political systems, more elaborate documentation, 
exchange rate risks,  complex procedures and formalities, high operating costs, 
issues related to shipping, insurance  and transportation and diverse restrictions 
and interventions from governments in the form of taxes, regulations, duties, 
tariffs, quotas, trade barriers, standards, and  restraints to movement of specified 
goods and services. At present, liberal international trade is an integral part of 
international relations and has become an important engine of growth in 
developed as well as developing countries.  
While some economists and policy makers argue that there are net benefits from 
keeping markets open to international trade and investments, others feel that 
International Trade
Theories of International Trade
Important Theories of Internation al Trade
UNIT OVERVIEW
4.3 THEORIES OF INTERNATIONAL TRADE 
trade generates a number of adverse consequences on the welfare of citizens.  As 
students of Economics, we need to have an objective understanding of the claims 
put forth by both sections. We shall first examine the arguments in support of 
international trade.  
(i) International trade is a powerful stimulus to economic efficiency and
contributes to economic growth and rising incomes. The wider market made
possible owing to trade induces companies to reap the quantitative and
qualitative benefits of extended division of labour. As a result, they would
enlarge their manufacturing capabilities and benefit from economies of
large scale production. The gains from international trade are reinforced by
the increased competition that domestic producers are confronted with on
account of globalization of production and marketing, requiring businesses
to compete against global businesses. Competition from foreign goods
compels manufacturers, especially in developing countries, to enhance
efficiency and profitability by adoption of cost reducing technology and
business practices. Efficient deployment of productive resources to their
best use is a direct economic advantage of foreign trade. Greater efficiency
in the use of natural, human, industrial and financial resources ensures
productivity gains. Since international trade also tends to decrease the
likelihood of domestic monopolies, it is always beneficial to the community.
(ii) Trade provides access to new markets and new materials and enables
sourcing of inputs and components internationally at competitive prices.
This reflects in innovative products at lower prices and wider choice in
products and services for consumers. Also, international trade enables
consumers to have access to wider variety of goods and services that would
not otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for sustaining
their economies.
(iii) International trade enhances the extent of market and augments the scope
for mechanization and specialisation. Trade necessitates increased use of
automation, supports technological change, stimulates innovations, and
facilitates greater investment in research and development and productivity
improvement in the economy.
(iv) Exports stimulate economic growth by creating jobs, which could potentially
reduce poverty, and augmenting factor incomes and in so doing raising
standards of livelihood and overall demand for goods and services.  Trade
  
 
4.4 ECONOMICS FOR FINANCE 
also provides greater stimulus to innovative services in banking, insurance, 
logistics, consultancy services etc. 
(v) Employment generating investments, including foreign direct investment, 
inevitably follow trade. For emerging economies, improvement in the 
quality of output of goods and services, superior products, finer labour and 
environmental standards etc. enhance the value of their products and 
enable them to move up the global value chain.  
(vi) Opening up of new markets results in broadening of productive base and   
facilitates export diversification so that new production possibilities are 
opened up. Countries can gainfully dispose off their surplus output and, 
thus, prevent undue fall in domestic prices caused by overproduction. Trade 
also allows nations to maintain stability in prices and supply of goods 
during periods of natural calamities like famine, flood, epidemic etc.  
(vii) Trade can also contribute to human resource development, by facilitating 
fundamental and applied research and exchange of know-how and best 
practices between trade partners.   
(viii) Trade strengthens bonds between nations by bringing citizens of different 
countries together in mutually beneficial exchanges and, thus, promotes 
harmony and cooperation among nations.  
Despite being a dynamic force, which has an enormous potential to generate 
overall economic gains, liberal global trade and investments are often criticized as 
detrimental to national interests. The major arguments put forth against trade 
openness are: 
(i) Possible negative labour market outcomes in terms of labour-saving 
technological change that depress demand for unskilled workers, loss of 
labourers’ bargaining power, downward pressure on wages of semi-skilled 
and unskilled workers and forced work under unfair circumstances and 
unhealthy occupational environments.  
(ii) International trade is often not equally beneficial to all nations. Potential 
unequal market access and disregard for the principles of fair trading 
system may even amplify the differences between trading countries, 
especially if they differ in their wealth. Economic exploitation is a likely 
outcome when underprivileged countries become vulnerable to the growing 
political power of corporations operating globally. The domestic entities can 
be easily outperformed by financially stronger transnational companies.  
 
 
4.5 
 
THEORIES OF INTERNATIONAL TRADE 
(iii) International trade is often criticized for its excessive stress on exports and 
profit-driven exhaustion of natural resources due to unsustainable 
production and consumption.  Substantial environmental damage and 
exhaustion of natural resources in a shorter span of time could have serious 
negative consequences on the society at large. 
(iv) Probable shift towards a consumer culture and change in patterns of 
demand in favour of foreign goods, which are likely to occur in less 
developed countries, may have an adverse effect on the development of 
domestic industries and may even threaten the survival of infant industries. 
Trade cycles and the associated economic crises occurring in different 
countries are also likely to get transmitted rapidly to other countries. 
(v) Risky dependence of underdeveloped countries on foreign nations impairs 
economic autonomy and endangers their political sovereignty.  Such 
reliance often leads to widespread exploitation and loss of cultural identity. 
Substantial dependence may also have severe adverse consequences in 
times of wars and other political disturbances. 
(vi) Welfare of people may often be ignored or jeopardized for the sake of 
profit. Excessive exports may cause shortages of many commodities in the 
exporting countries and lead to high inflation (e.g. onion price rise in 2014; 
export ban on all non-basmati rice in an attempt to reign in soaring prices 
and to ensure sufficient stocks for domestic consumption as global reserve 
levels hit a 25-year low). Also, import of harmful products or international 
trade in hazardous chemicals may cause health hazards and environmental 
damage in those countries which do not have sufficient infrastructure or 
capacity to scrutinize such imports.   
(vii) Too much export orientation may distort actual investments away from the 
genuine investment needs of a country. 
(viii) Instead of cooperation among nations, trade may breed rivalry on account 
of severe competition  
(ix) Finally, there is often lack of transparency and predictability in respect of 
many aspects related to trade policies of trading partners.  There are also 
many risks in trade which are associated with changes in governments’ 
policies of participating countries, such as imposition of an import ban, high 
import tariffs or trade embargoes.