ICAI Notes- Unit 1: Theories of International Trade | Business Economics for CA Foundation PDF Download

 Page 1


LEARNING OUTCOMES 
 
 
 
UNIT - 1: THEORIES OF 
INTERNATIONAL TRADE 
 
 
 
After studying this Unit, you will be able to – 
? Define international trade and describe how it differs from internal 
trade  
? Elucidate the arguments in favour 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 
  
 
INTERNATIONAL TRADE 
 
    
 
 
CHAPTER 
9 
© The Institute of Chartered Accountants of India
Page 2


LEARNING OUTCOMES 
 
 
 
UNIT - 1: THEORIES OF 
INTERNATIONAL TRADE 
 
 
 
After studying this Unit, you will be able to – 
? Define international trade and describe how it differs from internal 
trade  
? Elucidate the arguments in favour 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 
  
 
INTERNATIONAL TRADE 
 
    
 
 
CHAPTER 
9 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.2 
 
 
 
 
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. If there is a point 
on which most economists agree, it is that trade among nations makes the world better off. 
International trade reduces production cost and improves living standards of people. The 
foreign producer also benefits by making more sales than it could selling solely in its own 
market and by earning foreign exchange (currency) that can be used by itself or others in the 
country to purchase foreign-made products. International trade is an integral part of 
international relations and has become an important engine of growth in developed as well 
as developing countries.  
Benefits 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 division of 
labour.  
(ii) 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. 
International Trade 
Theories of International Trade 
Important Theories of International Trade 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 3


LEARNING OUTCOMES 
 
 
 
UNIT - 1: THEORIES OF 
INTERNATIONAL TRADE 
 
 
 
After studying this Unit, you will be able to – 
? Define international trade and describe how it differs from internal 
trade  
? Elucidate the arguments in favour 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 
  
 
INTERNATIONAL TRADE 
 
    
 
 
CHAPTER 
9 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.2 
 
 
 
 
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. If there is a point 
on which most economists agree, it is that trade among nations makes the world better off. 
International trade reduces production cost and improves living standards of people. The 
foreign producer also benefits by making more sales than it could selling solely in its own 
market and by earning foreign exchange (currency) that can be used by itself or others in the 
country to purchase foreign-made products. International trade is an integral part of 
international relations and has become an important engine of growth in developed as well 
as developing countries.  
Benefits 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 division of 
labour.  
(ii) 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. 
International Trade 
Theories of International Trade 
Important Theories of International Trade 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.3 
INTERNATIONAL TRADE 
(iii) 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. It 
also enables nations to acquire foreign exchange reserves necessary for imports which 
are crucial for sustaining their economies.  
(iv) International 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.   
(v) Trade also provides greater stimulus to innovative services in banking, insurance, 
logistics, consultancy services etc. 
(vi) 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.  
(vii) Opening up of new markets results in broadening the productive base and   facilitates 
export diversification so that new production possibilities are opened up.  
(viii) 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.   
(ix) 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 criticised as detrimental to national 
interests. The major arguments put forth against trade openness are: 
(i) International trade is often not equally beneficial to all nations. Potential unequal 
market access and disregard for the principles of a fair trading system may even 
amplify the differences between trading countries, especially if they differ in their 
wealth.  
(ii) 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.  
(iii) Substantial environmental damage and exhaustion of natural resources in a shorter 
span of time could have serious negative consequences on the society at large. 
© The Institute of Chartered Accountants of India
Page 4


LEARNING OUTCOMES 
 
 
 
UNIT - 1: THEORIES OF 
INTERNATIONAL TRADE 
 
 
 
After studying this Unit, you will be able to – 
? Define international trade and describe how it differs from internal 
trade  
? Elucidate the arguments in favour 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 
  
 
INTERNATIONAL TRADE 
 
    
 
 
CHAPTER 
9 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.2 
 
 
 
 
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. If there is a point 
on which most economists agree, it is that trade among nations makes the world better off. 
International trade reduces production cost and improves living standards of people. The 
foreign producer also benefits by making more sales than it could selling solely in its own 
market and by earning foreign exchange (currency) that can be used by itself or others in the 
country to purchase foreign-made products. International trade is an integral part of 
international relations and has become an important engine of growth in developed as well 
as developing countries.  
Benefits 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 division of 
labour.  
(ii) 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. 
International Trade 
Theories of International Trade 
Important Theories of International Trade 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.3 
INTERNATIONAL TRADE 
(iii) 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. It 
also enables nations to acquire foreign exchange reserves necessary for imports which 
are crucial for sustaining their economies.  
(iv) International 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.   
(v) Trade also provides greater stimulus to innovative services in banking, insurance, 
logistics, consultancy services etc. 
(vi) 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.  
(vii) Opening up of new markets results in broadening the productive base and   facilitates 
export diversification so that new production possibilities are opened up.  
(viii) 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.   
(ix) 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 criticised as detrimental to national 
interests. The major arguments put forth against trade openness are: 
(i) International trade is often not equally beneficial to all nations. Potential unequal 
market access and disregard for the principles of a fair trading system may even 
amplify the differences between trading countries, especially if they differ in their 
wealth.  
(ii) 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.  
(iii) Substantial environmental damage and exhaustion of natural resources in a shorter 
span of time could have serious negative consequences on the society at large. 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.4 
(iv) 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) Too much export orientation may distort actual investments away from the genuine 
investment needs of a country. 
(vii) Finally, there is often a 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. 
1.2 IMPORTANT THEORIES OF INTERNATIONAL  
 TRADE  
You might have noticed that many goods and services are imported by us because they are 
simply not produced in our country for various reasons and therefore not available 
domestically.  However, we do import many things which can be produced or are being 
produced within our country. Why do we do so? Is it beneficial to engage in international 
trade? The theories of international trade which we discuss in the following sections provide 
answers to these and other related questions.  
1.2.1 The Mercantilists’ View of International Trade 
Mercantilism, which is derived from the word mercantile, “trade and commercial affairs”. 
Mercantilism according to Microsoft Encarta Dictionary (2009), is the economic policy 
trending in Europe from the 16th to the 18th centuries, where the government used power to 
control industry and trade with the theoretical belief that national power is achieved and 
sustained by having constant large quantities of exports over imports. Nations’ human and 
material resources are unevenly endowed, distributed and developed. This allows flow of 
labour, raw materials, capital and finished products across national boundaries and markets; 
thus resulting in “mercantilism” as the earliest international economic system that proposes 
massive and aggressive export over import to accumulate wealth, to have favourable balance 
of payment and trade and to be still relevant in today’s economy. 
© The Institute of Chartered Accountants of India
Page 5


LEARNING OUTCOMES 
 
 
 
UNIT - 1: THEORIES OF 
INTERNATIONAL TRADE 
 
 
 
After studying this Unit, you will be able to – 
? Define international trade and describe how it differs from internal 
trade  
? Elucidate the arguments in favour 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 
  
 
INTERNATIONAL TRADE 
 
    
 
 
CHAPTER 
9 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.2 
 
 
 
 
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. If there is a point 
on which most economists agree, it is that trade among nations makes the world better off. 
International trade reduces production cost and improves living standards of people. The 
foreign producer also benefits by making more sales than it could selling solely in its own 
market and by earning foreign exchange (currency) that can be used by itself or others in the 
country to purchase foreign-made products. International trade is an integral part of 
international relations and has become an important engine of growth in developed as well 
as developing countries.  
Benefits 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 division of 
labour.  
(ii) 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. 
International Trade 
Theories of International Trade 
Important Theories of International Trade 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.3 
INTERNATIONAL TRADE 
(iii) 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. It 
also enables nations to acquire foreign exchange reserves necessary for imports which 
are crucial for sustaining their economies.  
(iv) International 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.   
(v) Trade also provides greater stimulus to innovative services in banking, insurance, 
logistics, consultancy services etc. 
(vi) 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.  
(vii) Opening up of new markets results in broadening the productive base and   facilitates 
export diversification so that new production possibilities are opened up.  
(viii) 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.   
(ix) 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 criticised as detrimental to national 
interests. The major arguments put forth against trade openness are: 
(i) International trade is often not equally beneficial to all nations. Potential unequal 
market access and disregard for the principles of a fair trading system may even 
amplify the differences between trading countries, especially if they differ in their 
wealth.  
(ii) 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.  
(iii) Substantial environmental damage and exhaustion of natural resources in a shorter 
span of time could have serious negative consequences on the society at large. 
© The Institute of Chartered Accountants of India
  
 
BUSINESS ECONOMICS 
a
 
 
9.4 
(iv) 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) Too much export orientation may distort actual investments away from the genuine 
investment needs of a country. 
(vii) Finally, there is often a 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. 
1.2 IMPORTANT THEORIES OF INTERNATIONAL  
 TRADE  
You might have noticed that many goods and services are imported by us because they are 
simply not produced in our country for various reasons and therefore not available 
domestically.  However, we do import many things which can be produced or are being 
produced within our country. Why do we do so? Is it beneficial to engage in international 
trade? The theories of international trade which we discuss in the following sections provide 
answers to these and other related questions.  
1.2.1 The Mercantilists’ View of International Trade 
Mercantilism, which is derived from the word mercantile, “trade and commercial affairs”. 
Mercantilism according to Microsoft Encarta Dictionary (2009), is the economic policy 
trending in Europe from the 16th to the 18th centuries, where the government used power to 
control industry and trade with the theoretical belief that national power is achieved and 
sustained by having constant large quantities of exports over imports. Nations’ human and 
material resources are unevenly endowed, distributed and developed. This allows flow of 
labour, raw materials, capital and finished products across national boundaries and markets; 
thus resulting in “mercantilism” as the earliest international economic system that proposes 
massive and aggressive export over import to accumulate wealth, to have favourable balance 
of payment and trade and to be still relevant in today’s economy. 
© The Institute of Chartered Accountants of India
 
 
a
 
 9.5 
INTERNATIONAL TRADE 
1.2.2 The Theory of Absolute Advantage 
Adam Smith, the father of economics, thought that the basis of international trade was 
absolute cost advantage. According to his theory, trade between two countries would be 
mutually beneficial if one country could produce one commodity at absolute advantage (over 
the other commodity) and the other countries could, in turn, produce another commodity at 
an absolute advantage over the first. In other words, the principle of absolute advantage refers 
to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a 
good, product, or service than competitors, using the same amount of resources. Adam Smith 
first described the principle of absolute advantage in the context of international trade, using 
labour as the only input. Since absolute advantage is determined by a simple comparison of 
labour productivity, it is possible for a nation to have no absolute advantage in anything; in 
that case, according to the theory of absolute advantage, no trade will occur with the other 
nation. It can be contrasted with the concept of comparative advantage which refers to the 
ability to produce specific goods at a lower opportunity cost. 
Assumptions of the Absolute Advantage Theory:   
? Trade between the two countries.   
? He took into consideration a two-country and two-commodity framework for his 
analysis.  
? There is no transportation cost.  
? Smith assumed that the costs of the commodities were computed by the relative 
amounts of labour required in their respective production processes.   
? He assumed that labour was mobile within a country but immobile between countries.   
? He implicitly assumed that any trade between the two countries considered would take 
place if each of the two countries had an absolutely lower cost in the production of 
one of the commodities. 
1.2.3 The Theory of Comparative Advantage 
In one of the most important concepts in economics, David Ricardo observed that trade was 
driven by comparative rather than absolute costs (of producing a good). One country may be 
more productive than others in all goods, in the sense that it can produce any good using 
fewer inputs (such as capital and labour) than other countries require to produce the same 
good. Ricardo’s insight was that such a country would still benefit fr om trading according to 
its comparative advantage—exporting products in which its absolute advantage was greatest, 
and importing products in which its absolute advantage was comparatively less (even if still 
© The Institute of Chartered Accountants of India