TRADE THEORY

D r. P r a d n y a V. S o n w a n eR o l l n o : 5 2

JOURNEY

• INTRODUCTION• TRADE THEROIES: 1. Mercantilism 2. Absolute Cost Advantage Theory. 3. Comparative Cost Theory. 4. Opportunity Cost Theory. 5. Factor Proportional Theory 6. New Trade Theory.

Journey:-..

Aims and Objectives:-..

• Free Trade occurs when a government does not attempt to influence, through tariffs, quotas, or other means, – what citizens can buy from other countries or – produce and sell to other countries

• The Benefits of Trade allow countries to be richer by specializing in products they can produce most efficiently

• There are lots of problems with trade – There may be some ways that some governments can

make things better by intervening (that is, by not practicing free trade)

• But government intervening in free trade is definitely dangerous

• Restrictions on trade have– kept some countries very poor– contributed to huge depressions

International Trade

• Trade: voluntary exchange of goods, services, assets, or money between one person or organization and another.

• International trade: trade between residents of two countries

International Trade:-

• The oldest of the dominant trade philosophy is known as Mercantilism.

• According to Mercantilism, economic activity was a Zero-sum game i.e. ones gain is the loss of another.

• This theory was challenged by Adam Smith &

David Ricardo who demonstrate trade was a positive sum game in which all trading nations can gain even if some benefits more than others.

Mercantilism:-

Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input can vary.

• Trade between two countries would be mutually beneficial if one country could produce one commodity at an absolute advantage(over the other country) & the other country could, in turn, produce another commodity at an absolute advantage over the first.

• A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient.

• GAINS:-1.Productivity gain 2. absolute gain. 3.Vent for surplus gain

Theroy of Absolute Advantage:-

• They believed that if people were left to trade on their own, they would naturally trade the goods in which their countries had comparative advantage– “Every individual seeks the most advantageous

employment for his capital…. – “Study of his own advantage necessarily leads him to

prefer that employment most advantageous to society” - Adam Smith, 1776

Methodology:

• It also called as Ricardo theory and Cost Advantage theory.

• It is given by David Ricardo (1772-1823) developed the theory of comparative advantage.

• It was showed rigorously in his Principles of Political Economy and Taxation (1817) that on the assumptions of perfect competition and the full employment of resources .

• Countries can reap welfare gains by specialising in the production of those goods with the lowest opportunity cost and trading the surplus of production over domestic demand, provided that the international rate of exchange between commodities lies between the domestic opportunity cost ratios.

Comparative Advantage Theory:-

• Assumptions: 1}Labour is the only element of cost production. 2}No transport cost. 3}Full employment. 4}Perfect competition. 5}Only two countries & two commodities.Evaluation: Though this maintains that comparative differences in labour

costs from the basis of Int. trade it does not explains what underlies such differences in relative costs of production.

Comparative Advantage Theory

• Gottfried Haberler gave a new life to the comparative cost theory in 1933.

• The opportunity cost of anything is the value of the alternative or other opportunity which have to be forgone in order to obtain that particular thing.

• Acc. To theory,the basis of Int. trade is the difference between nations in the opportunity cost of production of commodities.

• Trade is beneficial as long as opportunity costs differ.

Opportunity cost Theory :-

• Developed by Swedish Economist Eli Heckscher & Bertil Ohlin.

• Trade take place because of the differences in the factors qualities or assets of the various regions & the differences in the factor intensity of various products( capital intensive & labour intensive).

• Two important theorems, 1. Heckscher-Ohlin Theorem. 2. Factor Price Equalisation Theorem.

Factor Proportional ( endowment )Theory:-

• Capital• Abudant• country

CapitalAbudantcountry

Capital intensive goods

Labour intensive goods

. Factor Price Equalisation Theorem

• Factor Price Equalisation Theorem States that free international trade equalises factor prices between countries relatively and absolutely, and this serves as a substitute for international Factor mobility.

• In industries with high fixed costs:– Specialization increases output, – The ability to achieve economies of scale

increases through exporting– Learning effects are high.

• These cost savings come from “learning by doing”

New Trade Theory (developed 1970s & After)

In many industries, world demand will support few competitorsSuccessful firms may emerge because of “First-mover advantage”

Economies of scale may preclude new entrantsRole of the government becomes significant

Some argue that it generates a need for government intervention and strategic trade policy.

Conclusion ..

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