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

Overview

Introduction

International trade refers to the exchange of goods, services, and resources between countries. It involves transactions between residents of different nations. Economists widely agree that trade among nations benefits the world by reducing production costs and improving living standards. Foreign producers also gain by making more sales and earning foreign currency, which can be used to purchase foreign goods. International trade is a crucial aspect of international relations and a significant driver of growth in both developed and developing countries.

Benefits of International Trade:
(i) Economic Efficiency and Growth

• International trade boosts economic efficiency and contributes to growth and rising incomes.
• It allows companies to benefit from the division of labor, both quantitatively and qualitatively.

(ii) Efficient Resource Deployment

• Foreign trade ensures the efficient use of productive resources, including natural, human, industrial, and financial resources.
• This leads to productivity gains and reduces the likelihood of domestic monopolies, benefiting the community.

(iii) Access to New Markets and Materials

• Trade provides access to new markets and materials, allowing for the sourcing of inputs and components at competitive prices.
• This results in innovative products at lower prices and a wider choice of products and services for consumers.
• It also helps nations build foreign exchange reserves necessary for crucial imports.

(iv) Technological Advancement and Innovation

• International trade encourages increased automation, supports technological change, and stimulates innovations.
• It facilitates greater investment in research, development, and productivity improvement.

(v) Innovative Services

• Trade stimulates innovative services in sectors such as banking, insurance, logistics, and consultancy.

(vi) Upgrading Global Value Chains

• For emerging economies, improving the quality of goods and services, product standards, and labor and environmental conditions enhances the value of their products.
• This enables them to move up the global value chain.

Benefits of Global Trade and Investment
(i) Trade opens up new markets, which expands the productive base and enables export diversification, leading to new production possibilities.
(ii) Trade contributes to human resource development by facilitating fundamental and applied research, as well as the exchange of know-how and best practices between trade partners. 
(iii) Trade strengthens bonds between nations by bringing citizens of different countries together in mutually beneficial exchanges, promoting harmony and cooperation among nations. 

Criticisms of Global Trade and Investment
(i) International trade is not always equally beneficial to all nations. Unequal market access and a lack of a fair trading system can exacerbate differences between trading countries, particularly those with varying levels of wealth. 
(ii) Economic exploitation can occur when underprivileged countries become vulnerable to the growing political power of global corporations. Domestic entities may struggle to compete with financially stronger transnational companies. 
(iii) Global trade can lead to significant environmental damage and the rapid depletion of natural resources, which can have serious negative impacts on society as a whole. 
(iv) Trade cycles and economic crises in different countries can quickly spread to other nations, creating instability. 
(v) Underdeveloped countries may become overly dependent on foreign nations, compromising their economic autonomy and political sovereignty. This dependence can lead to exploitation and cultural erosion, and it may have severe consequences during times of war or political unrest. 
(vi) Excessive export orientation can divert investments away from a country's genuine needs. 
(vii) There is often a lack of transparency and predictability regarding the trade policies of trading partners. Risks associated with changes in government policies, such as import bans, high tariffs, or trade embargoes, can also pose challenges.

Important Theories of International Trade

The theories of international trade provide answers to various questions related to the import and export of goods and services between countries.

The Mercantilists' View of International Trade:

• Mercantilism, an economic policy that prevailed in Europe from the 16th to the 18th centuries, focused on the belief that national power could be achieved and sustained by maintaining a surplus of exports over imports.
• The term "mercantile" refers to trade and commercial affairs, and mercantilism involved government control over industry and trade to accumulate wealth and ensure a favorable balance of payments and trade.
• Mercantilism recognized the uneven distribution and development of human and material resources among nations, leading to the flow of labor, raw materials, capital, and finished products across national boundaries.
• This early international economic system proposed aggressive export over import as a means to accumulate wealth, achieve a favorable balance of trade, and remain relevant in the global economy.

The Theory of Absolute Advantage:

• Adam Smith, known as the father of economics, proposed the theory of absolute advantage as the basis for international trade. According to this theory, trade between two countries would be mutually beneficial if each country could produce a commodity at an absolute advantage over the other.
• Absolute advantage refers to the ability of a party, whether an individual, firm, or country, to produce a greater quantity of a good, product, or service than competitors using the same amount of resources.
• Smith initially described this principle in the context of international trade, focusing on labor as the primary input. Since absolute advantage is determined by comparing labor productivity, it is possible for a nation to have no absolute advantage in any goods. In such cases, according to the theory, no trade would occur between the nations.
• Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.

Assumptions of the Absolute Advantage Theory

• Trade occurs between two countries.
• Analysis is based on a two-country, two-commodity framework.
• There are no transportation costs involved.
• Commodity costs are determined by the relative amounts of labor needed for production.
• Labor is mobile within a country but immobile between countries.
• Trade is assumed to occur when one country has a lower production cost for a commodity compared to the other.

The Theory of Comparative Advantage

David Ricardo introduced the concept of comparative advantage, which suggests that trade is based on comparative costs rather than absolute costs. Even if a country is more productive in all goods (absolute advantage), it can still benefit from trade by focusing on its comparative advantages.

For example, consider two countries:

• Country A can produce three kilograms of steel or two shirts in one hour of labor.
• Country B can produce one kilogram of steel or one shirt in one hour of labor.

Country A is more efficient in producing both products. Now, if Country B offers to trade two shirts for 2.5 kilograms of steel, the following happens:

• Country B diverts two hours of labor to produce two shirts, sacrificing two kilograms of steel.
• Country A reallocates one hour of labor to produce three additional kilograms of steel, reducing its shirt production by two.

Overall, the total production remains the same in terms of shirts, but more steel is produced:

• Country A produces three extra kilograms of steel, while Country B reduces its steel output by two kilograms.
• This results in an extra kilogram of steel, representing the gains from trade.
• Comparative Advantage and Trade

Even if a country is less efficient in producing all goods compared to another country, it can still benefit from trade by focusing on the goods it can produce relatively more efficiently. This principle is known as comparative advantage. For instance, if Country A is better at making steel and airplanes but also produces clothing, it should specialize in steel and airplanes, trading with Country B, which is relatively better at making clothing.

Trade based on comparative advantage improves living standards for all countries involved. Developing countries, even without an absolute advantage, can find goods they produce more efficiently and trade with developed economies, benefiting from the exchange.

The Heckscher-Ohlin Theory of Trade

The Heckscher-Ohlin theory, proposed by Swedish economists Eli Heckscher and Bertil Ohlin, suggests that a country's factor endowments, specifically its labour and capital resources, play a crucial role in determining its comparative advantage. According to this theory:

• Factor Endowments: Countries tend to export goods that use their abundant factors of production intensively. For example, countries rich in capital, such as factories and machinery, should export capital-intensive products, while those rich in labour should export labour-intensive products.
• Role of Competition and Efficiency: Increased competition from foreign firms pressures domestic firms to become more efficient. Less efficient firms may shrink, making room for more efficient ones. This dynamic leads to better technologies and new product varieties entering the market.
• Intra-Industry Trade: Trade allows for greater selection across different types of goods, leading to intra-industry trade. For instance, countries that export household refrigerators may also import industrial coolers, a phenomenon not fully explained by the factor endowment approach.
• Product Variety and Investment Efficiency: Trade enhances efficiency by increasing the variety of products available, not just in terms of quantity but also in quality. It also improves investment spending efficiency by giving firms access to a wider range and better quality of intermediate and capital inputs. For example, China’s manufacturing of lithium batteries for electric cars is more efficient than producing the cars themselves.
• Sustained Higher Growth: By facilitating innovation and improving overall investment, trade can contribute to sustained higher economic growth.
• Economic models that evaluate the impact of trade often overlook factors like technology transfer and pro-competitive effects, such as the increase in product varieties. This is because these factors are challenging to model, and incorporating them leads to greater uncertainty in the results. However, when researchers have included these elements, they found that the benefits of trade reforms, like reducing tariffs and non-tariff barriers, are significantly larger than what traditional models suggest.

Comparison of Theory of Comparative Costs and Modern Theory
Theory of Comparative Costs

• Focuses on the differences in comparative costs between countries.
• Uses labor as the sole factor of production, based on the labor theory of value.
• Treats international trade as fundamentally different from domestic trade.
• Examines only the comparative costs of the goods in question.
• Attributes differences in comparative advantage to the productive efficiency of workers.
• Does not consider factor price differences or provide a cause for differences in comparative advantage.
• Normative in nature, aiming to demonstrate the gains from international trade.

Modern Theory

• Explains differences in comparative costs as a result of variations in factor endowments.
• Based on money costs, which are more realistic than labor costs alone.
• Expands the analysis to include labor and capital as important factors of production, allowing for a more comprehensive understanding.
• Considers international trade as a specific case of inter-regional trade.
• Takes into account the relative prices of factors that influence comparative costs.
• Attributes differences in comparative advantage to differences in factor endowments.
• Considers factor price differences as a primary cause of commodity price differences.
• Provides an explanation for differences in comparative advantage based on factor endowments.
• Positive in nature, focusing on the basis of trade rather than the gains from it.

Globalization and New International Trade Theory

The emergence of the new trade theory in the 1980s, which introduced concepts like imperfect competition and increasing returns, did not invalidate the core principles of traditional trade theory. Instead, it reinforced the idea that trade is beneficial for all parties involved. The new trade theory highlights that international trade not only brings the benefits of comparative advantage but also enhances competition and allows for greater economies of scale by expanding markets. This means that the gains from trade are even greater than previously understood, making it a positive-sum game for participating countries.

New Trade Theory

The new trade theory suggests that many traded goods are produced by industries that are oligopolistic and benefit from external economies. This means that markets often lead to suboptimal results rather than a Pareto optimum.

Paul Krugman and the Nobel Prize 

• Paul Krugman, an American economist and journalist, won the 2008 Nobel Prize for Economics for his research in economic geography and international trade patterns.
• In the late 1970s, Krugman found that the prevailing model for explaining international trade did not align with the data.

The Heckscher-Ohlin Model

• The Heckscher-Ohlin model suggested that trade was based on the ratio of capital to labor.
• According to this model, capital-rich countries would export capital-intensive goods and import labor-intensive goods from labor-rich countries.

Krugman's Observation 

• Krugman observed that most international trade occurs between countries with similar capital-to-labor ratios.
• For example, Sweden and the United States, both capital-intensive countries, trade cars with each other.

Trade Patterns in India 

• India also exhibits similar trade patterns, importing and exporting goods like electronics, IT services, and automotive products despite having a domestic manufacturing base.

Krugman's Advocacy for Free Trade 

• Krugman has been a strong advocate for free trade, emphasizing its benefits for global welfare.
• In his article "In Praise of Cheap Labor," he argued that low-wage jobs in multinational companies are better alternatives for workers in poor countries, leading to improved living conditions.

Benefits of Importing Goods: Economies of Scale 

•  Economies of Scale  refer to the cost advantages that firms experience as they increase their production. When a company produces more units of a product, the cost per unit decreases.
• By serving both domestic and foreign markets, a firm can achieve a larger scale of production, leading to lower costs and higher profits. This is because fixed costs are spread over a larger number of units, and variable costs may also decrease as production increases.
• For example, a car manufacturer that exports vehicles to other countries in addition to selling them in its home market can reduce its production costs per unit. This increased efficiency can result in higher profit margins and a competitive advantage in the market.

Network effects describe how the value of a good or service to an individual is influenced by how much value that good or service holds for others. As more people use a product or service, its value increases. This phenomenon is also known as the "bandwagon effect." Consumers appreciate having choices, but they also prefer products and services that offer high utility. Network effects enhance the utility derived from these products compared to others. A clear example of this is seen in mobile apps like WhatsApp and software such as Microsoft Windows.