Basis of International Trade

There are various theories of international trade: Theory of Absolute Advantage, Theory of Comparative Advantage, Heckscher-Ohlin Theory and International Product Life Cycle Theory. We discuss each of them in brief.

8.2.1. The Theory of Absolute Advantage

The Theory of Absolute Advantage was proposed by Adam Smith in the year 1776.

The theory says that a country should produce only those goods which can be produced at a low cost. The country should have an absolute advantage in producing the particular product. The theory suggests that the surplus production should be exported and the country should buy whatever is needed. Adam Smith was of the opinion that this would result in specialization and would increase the productivity.

Table 8.1. Absolute Advantage

Country Electronic

Watch Shoes

USA 8 10

India 20 5

(Figures indicate number of man-hours required to produce one unit of output)

In the above two countries & two goods example, USA has absolute advantage in production of electronic watch and India has absolute advantage in production of shoes.

Therefore, USA should produce electronic watch and India should produce shoes and both countries should trade to import the other good.

There are certain assumptions that are made in this theory. A country excels in producing only one commodity and the transportation cost are insignificant. The third assumption made is that prices are comparable across countries.

8.2.2. Theory of comparative advantage

Theory of comparative advantage was proposed by David Ricardo. He was of the opinion that two countries would trade to increase the national welfare provided each has a comparative advantage in the production of one good over the other. The theory suggests that a country can be better off by concentrating on the production of goods in which it has the lower relative labour costs or higher relative labor productivity.

Suppose India and USA produce electronic watches and shoes. From Table 8.2 it can be seen that the production cost of electronic watches is lower in USA when compared to India. According to the Theory of Comparative Advantage, USA should specialize in production of electronic watches and exchange them for Indian tea. From doing so, it can obtain one unit of tea powder from India for eight hours of labor instead of ten hours that it would require at USA. Similarly, India can obtain electronic watches from USA for 15 hours of labor instead of 20 hours of labor that would be required to produce at home.

Table 8.2. Absolute Advantage Country Electronic

Watch Shoes

USA 8 10

India 20 15

8.2.3. Hecksher-Ohlin Theory

Ricardo’s theory was criticized because of its concentration only towards labor, other factors of production were completely ignored. The Hecksher-Ohlin theory aimed to remedy this deficiency by explaining trade in terms of relative factor intensities. The theory looks at the possibilities of two nations operating at the same level of efficiency,

getting benefited by trading with each other. The theory makes certain assumptions.

The first assumption made is that there are no obstructions to trade. Second, both commodity and factor markets are perfectly competitive. The third assumption is that the there exist constant returns to scale. The fourth assumption is that the countries have the same technology and operate at the same level of efficiency. The fifth assumption is that the there exist only two factors of production-labor and capital. Both are perfectly immobile in inter-country transfers, but perfectly mobile in inter-sector transfers.

The theory suggests that there are two type of products: Labor intensive and capital intensive. A country rich in capital would produce the capital intensive products.

Whereas, a labor intensive country would prefer producing labor intensive products.

The theory then suggests that both the countries would engage in trading their products with each other.

There are certain limitations to this theory as well. It assumes that factor endowments remain constant, but in reality it can be changed through innovation. With countries imposing minimum wage laws, producing labor intensive products is becoming costlier.

Hence, these countries prefer to import the product rather than producing it.

The conclusion is that labor rich country would produce labor intensive goods and a capital rich country would produce capital intensive goods. It is not always right. US, being a capital intensive country produces and exports labor intensive products as well.

This completely contradicts the theory.

8.2.4. International Product life Cycle Theory

The International Product Life-cycle (IPCL) theory was proposed by Vernon. The theory explains the various stages in life of a product and the international trade as a result of this. The factors that are crucial to this theory are technological innovation and the market structure.

The two important principles of the theory are:

 New products are developed as a result of technological innovations.

 Market structure and the life cycle of the new product determines the trade patterns.

The theory is based on the premise that the innovation is more common in developed and rich countries.

In the early stages of a new product's life cycle, it is produced and exported by the country which introduced the innovation. In the second stage of the life of the product, production may shift to other developed countries, where the factors of production are available in abundance and thus offer a cost advantage. In the third and the final stage, production shifts to less developed countries and the country that originally exported the goods now becomes the importer.

There are two reasons for innovations being largely confined to the capital-rich countries. First, the environment in these countries is conducive to research and

development, which is essential for innovations. Second, consumers in these countries generally have high incomes and are ready to try new products.

When a product is in its initial stage, it is beneficial, even essential, to have the production centers located close to the ultimate consumer. This is another factor that favours the production of innovative products in capital -rich countries. Initially, these goods are produced for local consumption and due to price inelasticity, the producers earn high profits. The high profits encourage increased production, and as supply starts outstripping demand, the country starts exporting these products to the rest of the world.

As the product enters the maturity stage, the center of production shifts from the country which initially introduced the product to other developed countries which may offer a cost advantage due to lower factor prices.