Theories of International Trade

The raison d’etre for international trade is to be found in the diversity of economic resources in different countries. Divergent scarcities of factors are the moving forces behind international trade. All countries have not been endowed by nature with the same productive facilities. There are differences in climatic conditions and geological deposits as also in the supply of labor and capital. Due to these differences, each country finds it advantageous to specialize in the production of some specific commodities. Such specialization would not be economically practicable but for the possibility of exchange of surplus production through international trade. In fact, in the absence of international trade, there would be no surplus available for export. International trade will take place when buyers find foreign markets cheaper to buy in and sellers find them more profitable to dispose of their products than the domestic market. Thus, a more effective use of world’s resources is made possible through international trade.

A country tends to specialize in the production of commodities for which it has got a comparative cost advantage or, in other words, where its costs are lower than in other countries. The point to be noted in this connection to that it is the comparative advantage and not the absolute advantage which determines whether international trade will place or not. This point can be clarified by taking the example made famous by Ricardo in his analysis of comparative cost.

Let it be assumed that there are two countries, England and Portugal. Two products, namely, cloth and wine are being produced. The amount of labor required to produce one unit of these items is:

Cloth Wine

England 100 120
Portugal 90 80

It is clear from the above figures that Portugal can produce both cloth and wine at a lower cost, because the amount of labor required per unit of output is lower. But if the relative difference in costs between Portugal and England is compared, it is found that Portugal is more efficient in producing wine. This can be verified from the fact that 80 / 120 (relative cost of wine), 90 / 100 (relative cost of cloth). In the absence of trade, the domestic exchange ratio which will reflect the relative costs of production of the two commodities will be:

Portugal 1Wine: 0.89 cloth
U.K. 1 Wine: 1.20 cloth

Now, if trade takes place, assuming zero transport cost and no other incidence, the traders in Portugal will find that while by exchanging one unit of wine, they can get only .89 unit of cloth domestically, they can get 1.20 units of cloth if the same one unit of wine is sold in the U.K. There is, therefore, a gain which can be derived from export of wine from Portugal, as a result of which Portugal will specialize in the production of wine and export it to the U.K. Conversely, traders in the U.K. will find that while it takes one unit of cloth to get only 0.83 unit of wine, they can get 1.12 units of wine by selling the same unit of cloth in Portugal. Therefore, the U.K. will specialize in the production of cloth and export the same to Portugal.

The Ricardian model of comparative costs is based on only one factor of production namely labor, and the basic hypothesis is that each country will export that product which it can produce at lower average labor cost. In other words, differential labor productivity is the cause of price differences.

There are certain limitations of the Ricardian theory. First, it is a one-factor model. In reality, even though labor cost constitutes an important segment of total cost, there are other cost elements also which, in some cases, can outweigh the labor cost differences. Secondly, even though cost difference is attributed to differential labor productivity, the Ricardian theory does not explain the reasons why labor productivity may differ from country to country. —