International

Business
Module -2
 Syllabus

Theories of International Trade: Classical theory of comparative

cost advantage-Absolute-Relative-Haberler 's theory of
opportunity cost-Mills theory of reciprocal demand-Factor
endowment theory-Country similarity theory-New trade theory-
Theory of mercantilism-International product lifecycle theory-
Implications of trade theories-Gains from International trade-
Terms of trade-Balance of Payment-India‘s foreign trade- an
overview, Trade Barriers-Tariff and Non tariff barriers.
Introduction to Theories of
International Trade
It is very important for international business managers to
find answers to some basic issues, such as
 why do nations trade with each other?
 Is trading a zero-sum game or a mutually beneficial
activity?
 Why do trade patterns among countries exhibit wide
variations?
 How can government policies influence trade?

Theories of international trade provide the reasons for most of

these queries. Trade theories also offer an insight, into the
potential product portfolio and trade patterns
Introduction to Theories of International
Trade…..contd

 The exchange of goods across national borders is

termed as international trade. Countries differ
widely in terms of the products and services
traded. Countries rarely follow the trade structure
of other nations; rather they develop their own
product portfolios and trade patterns for
exports and imports.
Introduction to Theories of
International Trade…..
 for countries with diversified resources, such as
India, the US, China, and the UK, engagement in
trade necessitates a logical basis.
 The trade patterns of a country are not a static
phenomenon; rather these are dynamic in
nature.
 Moreover, the product portfolio and trade
partners of a country do change over a period
of time
Theory of MERCANTILISM

 The theory of mercantilism ( 16th to 18th Century)

attributes and measures the wealth of a nation by
the size of its accumulated treasures.
Accumulated wealth is traditionally measured in
terms of gold, as earlier gold and silver were
considered the currency of international trade.
Nations should accumulate financial wealth
in the form of gold by encouraging exports
and discouraging imports.
Mercantilism….contd..

 Mercantilism was implemented by active

government interventions, which focused on
maintaining trade surplus. National
governments imposed restrictions on imports
through tariffs and quotas and promoted
exports by subsidizing production.
Criticisms of Mercantilism

 Zero-Sum Game: Critics argued that trade is not a

zero-sum game. Both parties can benefit from trade
through specialization and exchange.
 Inflation: Increasing the money supply (through an
inflow of gold and silver) could lead to inflation.
 Inefficiency: Government intervention and restrictions
on trade could lead to inefficiencies and hinder
economic growth.
Theory of Absolute Cost
Advantage
 Adam Smith (1776) criticized the theory of
mercantilism, argued that the wealth of a nation
does not lie in building huge stock of gold and
silver in its treasury, but the real wealth of a
nation is measured by the level of improvement in
the quality of living of its citizens. Smith
emphasized on productivity and advocated
free trade as a means of increasing global
efficiency.
 Free Trade occurs when a government does not
attempt to influence the trade, through quotas or
duties.
Theory of Absolute Advantage

 According to Smith, country’s wealth can be

improved by international trade with other
countries either by importing goods not
produced by it and by producing large
quantities of goods through specialization
and exporting the surplus.
 He illustrated “the tailor does not attempt to
make his own shoes, but buys them of the
shoemaker. The shoemaker does not attempt to
make his own clothes, but use the service of a
tailor”
Theory of Absolute Advantage

 According to him, an absolute advantage refers to

the ability of a country to produce a product more
efficiently and cost-effectively than any other
country.
 If a foreign country can supply us a commodity
cheaper than we ourselves can make it, better
buy it instead of producing it.
 Each country should specialize in producing those
goods that it can be produced more efficiently.
Theory of Absolute Advantage

 Such efficiency is gained through Repetitive

production of a product, which increases the skills of
the labor force and by switching production from one
product to another.
Example: If following is the out put per unit labor, then
country A should produce Rice and import Wheat from
country B. Likewise country B can produce Wheat and
import Rice from country A.

Rice Wheat
Country A 10 6
Country B 8 9
Theory of Absolute
Advantage contd
A country’s advantage may be either natural or
acquired.
 Natural:
The production of Tea or Cotton in India, petroleum in
Saudi Arabia, lumber in Canada, are all
illustrations of natural advantages.
 Acquired Advantage:
The Production of consumer electronics and
automobiles in Japan, software in India, watches in
Switzerland, and shipbuilding in South Korea may
be attributed to acquired advantage
Theory of Comparative
Advantage
 David Ricardo (1817) put foreword the theory of
comparative advantage, wherein a country
benefits from international trade even if it is less
efficient than other nations in the production of
two commodities.
 Comparative advantage may be defined as the
inability of a nation to produce a good more
efficiently than other nation, but its ability to
produce that good more efficiently compared to
the other goods produced the same country.
Comparative
advantage
 Therefore, a country should specialize in the
production and export of a commodity in which
the absolute advantage is higher than that of
another commodity.
 See the given example of maximum output for 2
countries, producing only two goods - motor cars
and commercial trucks.

COUNTRY COUNTRY
A B
CARS 30m 35m
TRUCKS 6m 21m
Comparative advantage

 Using all its resources, country A can produce

30m cars or 6m trucks, and country B can
produce 35m cars or 21m trucks. This is
summarized in the table.
 In this case, country B has the absolute
advantage in producing both products, but it has
a comparative advantage in trucks because it is
relatively better at producing them. Country B is
3.5 times better at trucks, and only 1.17 times
better at cars. So, country B will produce truck
and country A will produce Cars.
 Comparative Advantage Vs Absolute Advantage

 Absolute advantage is anything a country does more

efficiently than other countries. For example,
Nations that are blessed with an abundance of
farmland, fresh water, and oil reserves have an
absolute advantage in agriculture, gasoline, and
petrochemicals.

 Just because a country has an absolute advantage in

an industry doesn't mean that it will be its
comparative advantage. Say, its neighbor has no oil
but lots of farmland and fresh water. The neighbor is
willing to trade a lot of food in exchange for oil. Now
the first country has a comparative advantage in oil.
It can get more food from its neighbor by trading it
for oil than it could produce on its own.
 Comparative Advantage
Vs Absolute Advantage
 Comparative advantage is what you do best while also
giving up the least. For example, if you’re a great
plumber and a great babysitter, your comparative
advantage is plumbing. That's because you’ll make
more money as a plumber. You can hire an hour of
babysitting services for less than you would make
doing an hour of plumbing. Your opportunity cost of
babysitting is high. Every hour you spend babysitting
is an hour’s worth of lost revenue you could have
gotten on a plumbing job.
 Absolute & Comparative Advantage-
Example

Consider the trade relationship between the US and

Brazil, where the US has an absolute advantage in
producing both airplanes and clothing, but a comparative
advantage in producing airplanes. Brazil has a
comparative advantage in producing clothing. Therefore,
the US specializes in producing airplanes, and Brazil
specializes in producing clothing, which benefits both
countries through trade
Factor Endowment Theory of International Trade

 The earlier theories of absolute and comparative

advantage provided little insight into the of
products in which a country can have an
advantage. Heckscher (1919) and Bertil Ohlin
(1933) developed a theory to explain the reasons
for differences in relative commodity prices and
competitive advantage between two nations.
 According to this theory, a nation will export the
commodity whose production requires intensive
use of the nation’s relatively abundant and
cheap factors of production and import the
commodity whose production requires the
use of the nation’s scarce and expensive
factors.

 Thus, a country with an abundance of cheap labor

would export labor-intensive products and import
capital-intensive goods. It suggests that the
patterns of trade are determined by factor
endowment rather than productivity.
Example:

 China, with its abundant labor, specializes in

labor-intensive manufacturing (clothing,
electronics). Saudi Arabia, with its abundant oil
reserves, specializes in oil production.
 Country Similarity Theory

 As per the Heckscher-Ohlin theory of factor

endowment, trade should take place among countries
that have greater differences in their factor
endowments. Therefore, developed countries having
manufactured goods and developing countries
producing primary products should be natural trade
partners.
 A Swedish economist, Staffan B , observed that
the majority of trade occurs between nations that
have similar characteristics. The major trading
partners of most developed countries are other
developed industrialized countries.
 It was found that in natural resource-based
industries, the relative costs of production and
factor endowments determined the trade.
However, in the case of manufactured goods,
costs were determined by the similarity in product
demands across countries rather than by the
relative production costs or factor endowments.
Example

 The US and Canada, with similar cultures and incomes,

engage in significant trade in manufactured goods,
even though they could potentially produce many of
the same things.
 New Trade Theory

 International trade enables a firm to increase its

output due to its specialization by providing a much
larger market which results in enhancing its
returns.
 The theory helps explain the trade patterns when
the economies of scale are achieved by the
production of specific products. Decrease in the
unit cost of a product resulting from large scale
production is termed as economies of scale.
 Since fixed costs are shared over an increased
output, the economies of scale enable a firm to
reduce it’s per unit average cost of production and
enhance its price competitiveness.
Example

 The aircraft industry (Boeing, Airbus) benefits from

huge economies of scale, leading to specialization and
trade. The software industry also benefits from network
effects (more people using a software, the more
valuable it becomes), leading to dominance by a few
companies.
 International Product Life-Cycle
Theory
 International markets tend to follow a cyclical pattern
due to a variety of factors over a period of time, which
explains the shifting of markets as well as the location
of production. The level of innovation and technology,
resources, size of market, and competitive structure
influence trade patterns.

 In addition, the gap in technology and preference and

the ability of the customer in international markets also
determine the stage of international product life cycle
(IPLC).
 In the case of a country that has a large market size, as
in case of the US, India, China, etc., it can support mass
production for domestic sales. This mass market also
facilitates the producers based in these countries to
achieve cost-efficiency, which enables them to become
internationally competitive.

 However, in case the market size of a country is too

small to achieve economies of scale from the domestic
market, the companies from these countries can
alternatively achieve economies of scale by setting up
their marketing and production facilities in other cost-
effective countries.

 The theory explains the variations and reasons for

change in production and consumption patterns among
various markets over a time period.
 (i) Introduction:
Generally, it is in high-income or developed countries that the
majority of new product inventions take place
 (ii) Growth:
As the market begins to develop in other developed countries,
the innovating firm faces increased international competition in
the target market.
 (iii) Maturity:
As the technical know-how of the innovative process becomes
widely known, the firm begins to establish its operations in
middle- and low-income countries in order to take advantage of
resources available at competitive prices.
 (iv) Decline:
The major thrust of marketing strategy at this stage shifts to
price and cost competitiveness, as the technical know-how
and skills become widely available. Therefore, the emphasis of
the firm is on most cost- effective locations rather than on
producing themselves
Implications of International Trade Theories

 The trade theories provide a conceptual base for

international trade and shifts in trade
patterns. This point out the significance of
developing a conceptual understanding of the
trade theories as it deals with the fundamental
issues, such as why international trade takes
place, trade partners, shifts in trade patterns, and
determinants of competitiveness.
 Haberler’s theory of
opportunity cost
 Opportunity cost refers to the cost of a commodity in
terms of other commodity which must be foregone in
order to obtain the first.
 According to Haberler, the unit cost of production of a
commodity are equal to the value of commodities whose
production is forgone in order to produce it.

Let us see how opportunity costs can explain the basis of

and gains from trade
 According to Haberler, the ratio of prices in each
country in isolation is a reflection not only of the
money costs of production but more fundamentally
of opportunity costs.

 Opportunity cost refers to the cost of a commodity

in terms of other commodity which must be
foregone in order to obtain the first.

Example: If India decides to produce more rice, the

opportunity cost is the wheat production it gives up.
This helps determine which goods a country should
specialize in.
 Illustration of Haberler’s
theory
Cost of production: Cost of production:
Country A Country B
 I unit of X = Rs. 2  1 unit of X = Rs. 3
 1 unit of Y = Re. 1  1 unit of Y = Re. 1
 1 unit of X = 2 units  1 unit of X = 3 units
of Y. of Y.
ie, here X= 2Y ie, here X=3Y
In the above example, the equilibrium terms of trade can be
determined at, one unit of X=2.5 units of Y.

 People of country A are able to obtain only 2 units of Y

per one unit of X , but, with trade they obtain 2.5 units of
Y per unit of X given up.
 In country B, without trade each unit of X produced
involve the sacrifice of three units of Y; with trade they
obtain X at a rate of 2.5 units of Y per X.

Therefore, as a result of trade, each country has a greater

volume of goods available and make gains.
J. S. Mill’s Reciprocal Demand
Theory
 The term ‘reciprocal demand’ was introduced by
Mill to explain the determination of the
equilibrium terms of trade.
 By reciprocal demand, Mill meant the quantities of
exports that a country would offer at different
terms of trade, in return of varying quantities of
imports. In other words, reciprocal demand refers
to the intensity of demand for the product of one
country in the other country.
 Equilibrium would be established at that ratio of
exchange between the two commodities at which
quantities demanded by each country of the
commodity which it imports from the other should
be exactly sufficient to pay for another.
 In other words, the actual ratio at which
commodities are transacted between two
countries depends crucially upon the strength and
elasticity of each country’s demand for the
product of the other (reciprocal demand).
Terms of trade (TOT)
 Terms of trade relates to international trade is a
single number that represents the ratio of a
particular country’s exports and imports.
 Specifically, terms of trade represents the
relationship between the price a country receives
for its exported goods and the price it pays for
imported items.
 In general, terms of trade is considered to be
more favorable when the price of exports
exceeds the price of imports.
 In international economics and international
trade, TOT is calculated by dividing the value of
exports by the value of imports, then multiplying
the result by 100.
 The terms of trade is influenced by the exchange
rate because a rise in the value of a country's
currency lowers the domestic prices for its
imports but does not directly affect the
commodities it produces (i.e. its exports).
 The terms of trade effect equals capacity to
import less exports of goods and services in
constant prices.
 An improvement in a nations terms of trade (the
increase of the ratio) is good for that country in
the sense that it can buy more imports for any
given level of exports
 An increase in TOT can mean the overall welfare of
the country has improved, but not always. This
often depends on the reason for the change in
prices.
 The terms of trade can also be affected by the
value of a country’s currency. When interest rates
rise, currency value generally also increases.
 Historically, developing countries were considered
to be at a disadvantage regarding terms of trade.
This is because exports are more often raw goods
or commodities with lower prices than the
manufactured goods imported from more
developed counties.
 TOT is also known as the terms of trade index.
When commodity export prices are compared with
manufactured goods import prices, the ratio is
called the commodity terms of trade.
Balance of payments
(BOP)
 Balance of payments (BOP) accounts are an
accounting record of all monetary transactions
between a country and the rest of the world.
These transactions include payments for the
country's exports and imports of goods &
services, financial capital, and financial transfers.
 According to Kindle Berger, "The balance of
payments of a country is a systematic record of all
economic transactions between the residents of
the reporting country and residents of foreign
countries during a given period of time“.
Features of BOP
 It is a systematic record of all economic
transactions between one country and the rest of
the world.
 It includes all transactions, visible as well as
invisible.
 It relates to a period of time. Generally, it is an
annual statement.
 It adopts a double-entry book-keeping system. It
has two sides: credit side and debit side. Receipts
are recorded on the credit side and payments on
the debit side.
Components of BOP
1. Current Account Balance: BOP on current account
is a statement of actual receipts and payments in
short period. It includes the value of export and
imports of both visible and invisible goods. There
can be either surplus or deficit in current account.
The current account includes
- export & import of services, interests, profits,
dividends and receipts/payments from/to abroad.
2. Capital Account Balance : It is the difference between the
receipts and payments on account of capital account. It
refers to all financial transactions. The capital account
involves inflows and outflows relating to investments,
borrowings/lending. There can be surplus or deficit in
capital account. It includes: - private foreign loan flow,
movement in banking capital, official capital transactions,
reserves, gold movement etc.
3. Overall BOP -: Total of a country’s current and
capital account is reflected in overall Balance of
payments. It includes errors and omissions and
official reserve transactions. The errors may be due
to statistical discrepancies & omission may be due
to certain transactions may not be recorded. For
e.g.: A remittance by an Indian working abroad to
India may not yet recorded, or a payment of
dividend abroad by an MNC operating in India may
not yet recorded or so on. The errors and omissions
amount equals to the amount necessary to balance
both the sides
An overview of India's foreign Trade

 India's foreign trade has grown in

importance in recent years, with the country
becoming more open to international
trade[1][4]. Trade represents 49% of India's
GDP[1]. India exports approximately 7500
commodities to about 190 countries and
imports around 6000 commodities from 140
countries[2][3].
 Exports and Imports
 India's foreign trade includes the export and
import of goods (merchandise/commodities)
and services[3]. In 2022, India exported
$453.4 billion worth of goods, while imports
accounted for $720.4 billion[1].
 India's main exports are:
 Petroleum oils (20.9%)
 Diamonds (5.3%)
 Medicaments (3.9%)
 Articles of jewelry (2.7%)
 Telephone (2.4%)
 Rice (2.4%)
 India’s main imports include:
 Petroleum oils (23.7%)
 Coal and similar solid fuels (6.7%)
 Gold (5%)
 Petroleum gas and other gaseous hydrocarbons (4.4%)
 Diamonds (3.7%)
 Trading Partners
India's main export partners are the United States
(17.7%), the United Arab Emirates (6.9%), the
Netherlands (4.1%), China (3.3%), and Bangladesh
(3.1%)[1]. Imports come chiefly from China (14.0%), the
United Arab Emirates (7.4%), the United States (7.1%),
Saudi Arabia (6.3%), and Russia (5.5%)[1]. Asia has been
India’s largest export partner.

 Trade Agreements
India has signed free trade agreements with South
Korea and ASEAN and has entered into negotiations with
several partners, including the EU, MERCOSUR, Australia,
New Zealand, and South Africa[1]. In 2021, Brazil and
India signaled their interest in expanding the FTA that
India has with MERCOSUR .
Balance of Trade

 The difference in the value between what a

nation exports and imports is its balance of
trade.
 Tariff and Non Tariff Barriers

Tariff Barriers
 Tariff barriers are duties imposed on goods which
effectively create an obstacle to trade. These barriers are
also sometimes known as import restraints, because they
limit the quantity of goods which can be imported into a
country.
Non-Tariff Barriers
 Non-tariff barriers to trade (NTBs) are trade barriers that
restrict imports.
Types of NTB’s (Non Tariff Barriers)

 • Quotas • Import Licensing requirements •

Proportion restrictions of foreign to domestic
goods (local content requirements) • Embargoes •
Antidumping practices and Countervailing duties
• Tariff classifications • Documentation
requirements • Fees • Standard disparities •
testing methods and standards • Packaging,
labeling, and marking Government Participation
in Trade • Government procurement policies •
Export subsidies • Administrative fees • Special
supplementary duties • Border taxes • Bilateral /
Multilateral agreements etc.
Write an Assignment on “ Difference between BOP &BOT also explain
the types of Tariff and Non Tariff Barriers”