Chapter-1 CLASSICAL THEORY OF INTERNATIONAL TRADE Adam Smith’s theory of Absolute Differences in costs Adam Smith extolled the virtues of free trade. These are the result of the advantages of division of labour and specialisation both at the national and international levels. The division of labour at the international level requires the existence of absolute differences in costs. Every country should specialise in the production of that commodity which it can produce more cheaply than others and exchange it for the commodities which cost less in other countries. According to Smith, “Whether the advantage which one country has over another be natural or acquired is in this respect of no consequence.” To illustrate, let there be two countries, A and B, having absolute differences in costs in producing a commodity each, X and Y respectively, at an absolute lower cost of production than the other. The absolute cost differences are illustrated in Table 1.
Table 1. Absolute Differences in Costs Country
Commodity-X
Commodity-Y
A
10
5
B
5
10
The table reveals that country A can produce 10X or 5Y with one unit of labour and country B can produce 5X or 10Y with one unit of labour. In this case, country A has an absolute advantage in the production of X (10X is greater than 5X), and country B has an absolute advantage in the production of Y (for 10Y is greater than 5Y). This can be expressed as 10X of A 5Y of A >1> 5X of B 10Y of B Trade between the two countries will benefit both if A specialises in the production of X and B in the production of Y, as is shown in Table 2.
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Table 2. Gains from Trade Commodity
Production before Trade
Production after Trade
Gains from Trade
(1)
(2)
(3)
Country X
Y
X
Y
X
Y
A
10
5
20
-
+10
-5
B
5
10
-
20
-5
+10
Total Production
15
15
20
20
+5
+5
The above table reveals that before trade both countries produce only 15 units each of the two commodities by applying one labour-unit on each commodity. If A were to specialise in producing commodity X and use both units of labour on it, its total production will be 20 units of X. Similarly, if B were to specialise in the production of Y alone, its total production will be 20 units of Y. The combined gain to both countries from trade will be 5 units each of X and Y. Figure 1 illustrates absolute differences in costs with the help of production possibility curves, YAXA is the production possibility curve of country A which shows that it can produce either OXA of commodity X or OYA of Commodity Y. Similarly, country B can produce OXB of commodity X or OYB of commodity Y. The figure also reveals that A has an absolute advantage in the production of commodity X (OXA>OXB) and country B has an absolute advantage in the production of commodity Y (OYB>OXA).
But Smith has been criticised for his vagueness and lack of clarity. According to Ellsworth‟, Smith assumes without argument that international trade requires a producer of exports to have an absolute advantage, that is, an exporting country must be able to produce with a given amount of capital and labour a larger output than any rival. But this basis of trade is not realistic because there are many underdeveloped countries which do not
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possess absolute advantage in the production of any commodity, and yet they have trade relations with other countries. Thus, Smith‟s analysis is weak and unrealistic.
RICARDIAN THEORY The Theory of Comparative Advantage According to David Ricardo, it is not the absolute but the comparative advantage or differences in costs that determine trade relations between two countries. According to Ricardo each country will specialise in the production of those commodities in which it has the greatest advantage or the least comparative disadvantage. Thus a country will export those commodities in which its comparative advantage is the greatest and import those commodities in which its comparative disadvantage is the least.
Assumptions 1. There are only two countries, England & Portugal. 2. They produce the same two commodities, wine & cloth. 3. There are similar tastes in both countries. 4. Labour is the only factor of production. 5. Supply of labour is unchanged. 6. All units of labour are homogeneous. 7. Commodities are produced under constant returns. 8. Factors of production are perfectly immobile between countries. 9. There is free trade between the two countries 10. No transport cost is involved. 11. Factors of production are fully employed. 12. The international market is perfect, so that the exchange ratio for the two commodity is the same.
Theory Country
Wine
Cloth
England
120
100
Portugal
80
90
Ricardo in her theory shows that trade is possible between two countries when one country has an absolute advantage in production of both commodities, but a comparative advantage in the production of one commodity.
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In the above table Portugal can produce both the commodities by using less labour than England but has comparative advantage in producing wine and exporting it to England because cost of production of wine (80/120) is less than the cost of production of cloth (90/100). On the other hand England will specialise in the production of cloth since it has comparative advantage in it than wine as it uses more labour. Comparative advantage of both countries is shown as follows.
PL is the production possibility curve of Portugal and EG of England. Portugal produces PL of wine of OP of cloth and England produces OG of wine and OE of cloth. But the slope of ER (parallel to PL) reveals that Portugal has a greater comparative advantage in the production of wine because if it give up the resources required to produce cloth it can produce more wine with the same labour and export it to England in return for cloth. Viceversa England if give up the resources to produce wine it can produce more cloth and export it to Portugal in return for wine.
Gains from trade England
Portugal
Wine 120 : 100 Cloth (6/5)
Wine 80 : 90 Cloth (8/9)
1 : 1.2
1 : 0.89
Cloth 100 : 120 Wine (5/6)
Cloth 90 : 80 Wine (9/8)
1 : 0.83
1 : 1.13
Before trade, the cost of producing wine in England is more as against cloth because one unit of wine can exchange 1.2 unit of cloth. On the other band the cost of producing
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one unit of cloth is more than that of wine as one unit of wine can exchange for 0.89 unit of cloth. If trade begins, England will gain if it imports one unit of wine from Portugal in exchange for less than 1.2 unit of cloth & Portugal will gain if it imports one unit of cloth from England in exchange for more than 0.89 unit of wine.
The table shows that the domestic exchange ratio in England is one unit of cloth. 0.83 unit of wine, and in Portugal one unit of wine=0.89 unit of cloth. If we assume the exchange ratio b/w two countries to be unit of cloth=1 unit of wine, England would gain 0.17 (1-0.83) unit of wine by exporting one unit of cloth to Portugal. Similarly, the gain to Portugal by exporting one unit of wine to England will be 0.11 (1-0.89) unit of cloth. Thus trade is beneficial for both the countries. C1W2 depicts the domestic exchange ratio 1 unit of cloth = 0.83 unit of wine of England & line W1C2 that of Portugal 1 unit of wine = 0.89 unit of cloth. The line C1W1 shows the exchange rate of trade of 1 unit of cloth = 1 unit of wine b/w the two countries. At this exchange rate England gains W2W1 (0.17) of wine and Portugal gains C2C1 (0.11) of cloth. Thus each country exports that commodity in which it has comparative advantage and imports that commodity in which it has comparative disadvantage. Both the countries gain through trade and can increase the consumption of two commodities.
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Its Criticisms The theory has been severely criticised by Berlin Ohlin and Frank D. Graham. 1. Unrealistic assumption of labour cost. 2. No similar tastes. 3. State assumption of fixed proportions. 4. Unrealistic assumption of constant costs. 5. Ignores transport costs. 6. Factors are not fully mobile internally. 7. Two country-two commodity model unrealistic. 8. Unrealistic assumption of free trade. 9. Unrealistic assumption of full employment. 10. Self interest Hinders its operation. 11. Neglects the role of technology. 12. One sided theory. 13. Impossibility to complete specialisation. 14. A clumsy and dangerous tool. 15. Incomplete theory.
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Chapter-2 HABERLER’S THEORY Theory of Opportunity Costs Haberler criticised the Ricardian theory of comparative cost advantage because it was based on the labour theory of value, according to which labour is the only factor of production, labour is homogeneous and labour is used in the same fixed proportions in the production of all commodities. Haberler criticised all these assumptions and formulated new theory because labour is not the only factor of production, labour is not homogeneous, it is heterogeneous and labour is used in varying proportions.
Assumption 1. There are only two countries, say A and B. 2. Two factors of production labour & capital. 3. Country can produce two commodities say X & Y. 4. Perfect competition in both factor & commodity mkt. 5. Price of each commodity equals its marginal money costs. 6. The price of each factor equals its marginal value productivity. 7. The supply of each factor is fixed. 8. There is full employment. 9. There is no change in technology. 10. Factors are immobile b/w two countries and mobile within the countries. 11. Trade is completely free and unrestricted.
Theory The slope of production possibility curve under different conditions measures the amount of a commodity that a country must give up in order to get an additional unit of the second commodity. In other words, the slope of the production possibility curve is its marginal rate of transformation (MRT). The slope of PPC determines the basis and the gains from international trade.
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Trade Under Constant Opportunity Costs
Under constant opportunity costs the production possibility curve is a straight line. In fig.1 PA is PPC of country A and PB of country B. Country A can produce OP of Y of OA of X and similarly country. B can produce either OP of Y or OB of x. If they want to produce both the commodities their they must be on any one point of their respective PPC. for eg. at point E country B determines the relative prices of the two commodities, they are the same at all points on a straight line curve. This is because the opportunity cost of leaving a unit of one commodity in order to have an additional unit of the other is constant. Thus the cost ratio of the two commodities in country B is OP/OB and in country A, OP/PA. Since X is cheaper for country A it has the comparative advantage in the production of X and B has the comparative advantage in production of Y. Hence country A will export X commodity to country B & B will export Y commodity to A. Suppose B is a smaller country than A and enter into trade with it, PA will be international price ratio for B and now it will consumes PT of X by importing it from A and exporting TD of Y to it. Country B had gained after entering the trade & A has not gained from B because relative prices remain unchanged as shown by PA. But if PR is the new international price line B will specialise exclusively in the production of Y at P & its consumption level shifts from E to C on the international price ratio PR. It will how export TC of Y to country A in exchange for PT of X. In this situation, country B will not gain as much as in the previous example but country A will also gain.
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Trade Under Decreasing Opportunity Costs
When two countries experience decreasing opportunity costs, their production possibility curve is convex to the origin. Under this condition, each country completely specialises in only one commodity after trade. AA, is the production possibility curve of country A, and BB, is that of country B. The pre-trade consumption and production point of country A is K whereas of country B is K1. The slope of the domestic price line aa of country A shows that its comparative advantage is greater in the production of X. The slope of country B‟s domestic price ratio bb reveals its greater comparative advantage. But point K and K1 are not of stable equilibrium returns in the production of each commodity. After trade the int. price ratio line is BA1 which is steeper than the domestic price line aa of country A which means that X has become more expensive in int. market. So A will completely specialise in the production of X and move from point K to A1. On the other hand BA1 is flatter the price line bb of country B. It means that commodity Y has become more expensive in int. market and country B will specialise in its production and move from point K1 to B. Now the consumption point of both the countries reaches point C and A will export D1A1 of X to country B and import D1C1 of Y on trade triangle (1)1A1 and consume OD1 of X at home. Similarly B, will export DB of Y to country A and import DC of X from trade triangle BDC and consume OD of Y domestically.
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Trade Under Increasing Opportunity Costs The production curve under increasing opportunity costs is concave to the origin.
AA1 is the PPC of country A. The slope of this curve shows that the country will specialise in X. As we move from point A towards point A1, country A will give up larger and larger units of commodity Y in order to have additional units of X. On the other hand BB1 PPC of country B. It specialises in the production of Y. As we more from point B1 to B along this curve country will give up larger and larger units of X in order to produce additional units of commodity Y. Before trade country A produces some quantity of X & Y at point K, where line is tangent to the PPC AA1. The line aa indicates the domestic relative commodity price of X and Y. Similarly country B produces & consumes some quantity of both commodities at point K1 where is price-line bb is tangent to PPC curve BB1. Now, after trade the international price line is PL in country A and P1L1 in country B. Since PL is parallel to P1L1 the international terms of trade are the same for both the countries. In country A the new equilibrium point is E which means that country commodity X has become more expensive in int. mkt. that it is in the domestic market. Now country. A will shifts its factors of production from production of Y to X by moving its production level from point K to point E on the PPC where PL is tangent. It will thus produce OR of X, OQ of Y. The consumption point is at C. It will export TR of X and import QS of Y & consume OT of X and OQ of Y. Thus by entering into trade country A is able to consume more of both X and Y because point C is above and to the right of point K. [10] OSN Academy
Take country B where the new equilibrium point is E1 where P1L1 is tangent to PPC BB1 which means that commodity Y has become more expensive in int. mkt. This is because the slope of P1L1 is less steep than the domestic price line bb. The production level shifts from point K1 to E1. Now it will produce OQ1 of Y and OR1 of X. The consumption point of country B will be at C1 on the price line P1L1. It will import D1C1 of X and export D1E1 on Y of the ∆E1D1C1. It will domestically consume OS1 of Y and OR1 of X. Thus country B is also better off by entering into trade with country. A because it is able to consume more of both X and Y1 as the consumption point C1 after trade is above and to the right of point K1.
Trade Under Decreasing Opportunity Costs
The above fig. 5 shows that the PPC is concave in the portion AF which shows increasing opportunity costs and is convex in the region 𝑓B showing decreasing opportunity costs. The point which divides the two segments is called point of inflexion. In the region AF where international terms of trade line aa is tangent to point E country A is producing OX of commodity X and OY of commodity Y. Its consumption point is at C whereby its import DC of X, exports DE of Y. Since point C is outside PPC, the country is better off by trading with other country. Now production of X starts under decreasing opportunity costs and PPC becomes convex in the region FB of the AB curve. The country would ultimately reach point B where it completely specialises in commodity X. The new consumption point is NR of Y. The country gains more from trade at point R that at point C.
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Chapter-2 RECIPROCAL DEMAND THEORY J.S. Mill – The term reciprocal demand was introduced by J.S. Mill to explain the determination of equilibrium terms of trade. Reciprocal demand is a country‟s demand for one commodity in terms of the quantities of another commodity. It is prepared to give up in exchange. Thus by reciprocal demand we mean the relative strength and elasticity of the demand of the two trading countries for each other‟s product. It is a reciprocal demand which determines terms of trade and which in turn determine the relative share of each country. These terms of trade refers to barter terms of trade. To explain the theory of Reciprocal Demand Mill restated the Ricardian theory. Instead of taking given output with different labour cost he assumed a given amount of labour with diff. output.
Assumptions 1. There are two countries. 2. There are two commodities. 3. Both the commodities are produced under the law of constant returns. 4. There are no transport cost, perfect competition, full employment, free trade. 5. Needs of two countries are similar. 6. The principle of comparative costs if applicable. Country Germany
Linen 10
England
6
Output of
Cloth 10 8
Germany can produce 10 units of linen or 10 units of cloth within one man year. It would be in the interest of England to import linen from Germany and of Germany to import cloth from England because Germany has an absolute advantage in the production of both linen and cloth, while England has the least comparative disadvantage in the production of cloth. Before trade, the domestic cost ratio of linen and cloth in Germany is 1:1 and in England 3:4. If they were to enter into trade, Germany‟s advantage over England in the [12] OSN Academy
production of linen is 5:3 (or 10:6) and in the production of cloth 5:4 (or 10:8). Since 5/3 is greater than 5/4, Germany possesses greater comparative advantage in the production of linen. Thus it is in Germany‟s interest to export linen to England in exchange for cloth. Similarly, England‟s position in the production of linen is 3/5 (or 6/10) and in the production of cloth is 4/5 (or 8/10). Since 4/5 is greater than 3/5, it is in the interest of England to export cloth to Germany in exchange for linen. Mill‟s theory of reciprocal demand relates to the possible terms of trade at which the two commodities will exchange for each other between the two countries. The terms of trade refers to „the barter terms of trade.‟ The terms of trade between the two countries will be between (linen or cloth or 1.33 cloth). But the actual ratio will depend upon reciprocal demand i.e., the strength and elasticity of each country‟s demand for the other country‟s product.” If Germany‟s demand for England‟s cloth is more intense (inelastic), then the terms of trade will be nearer 1:1. Germany will be prepared to exchange one unit of linen with / unit of cloth of England. The terms of trade will move against it and in favour of England. On the other hand, if Germany‟s demand for England‟s cloth is less intense (more elastic), then the terms of trade will be nearer 1:1:33. Germany will be prepared to exchange its one unit of linen with 1.33 units of cloth of England. The terms of trade will move in favour of Germany and against England. Consequently Germany‟s gain from trade will be greater than that of England. Mill‟s theory of reciprocal demand is explained diagrammatically in terms of Marshall‟s offer curves.
England/Cloth Fig. 1
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In the fig. England producing only cloth is taken on the horizontal axis and Germany producing only linen is taken on vertical axis. The curve OE is England‟s offer curve. It shows how many units of cloth England will give up for a given quantity of linen. Similarly, OG is the offer curve of Germany which shows how many units of linen Germany is prepared to give up in exchange for a given quantity of cloth. The point T where the two offer curves OE and OG intersect is the equilibrium point at which OC of cloth is traded by England of OL of linen of Germany. The rate at which cloth is exchanged for linen is equivalent to the slope of the say OT. A change in the demand on the part of one country for the product of the other country brings about a change in the shape of its offer curves.
Criticisms 1. Unrealistic assumption of law of constant return. 2. Unrealistic assumption of perfect competition full employment, free trade. 3. Ignores transport cost. 4. No similar tastes. 5. As criticised by Vines, it does not pay attention to Domestic Demand. 6. Acc. To Graham Mill‟s analysis it is valid only if the two countries are equal in size and two commodities are of equal consumption value. 7. Graham also criticizes two-country, two-commodity model. 8. It makes no entry for fluctuations in income because fluctuations in income will affect the TOT. 9. It is based on the barter terms of trade and relative price ratios and neglects all stickiness of prices and wages transitional inflationary and over-valuation gaps and all BOP problems. Therefore the theory is abstract and unrealistic. But even then Viner says that the terms of trade can directly be influenced by the reciprocal demand and nothing else and reciprocal demand is ultimately determined by the cost condition and basic utility functions. The real fault in this theory is that it over emphasis the basic utility functions in comparison to the production cost.
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Chapter-4 THE PREBISCH-SINGER THESIS (Central-Periphery Thesis) The Prebisch-Singer Thesis enunciates that the secular deterioration in terms of trade has been an important factor in inhibiting the growth of LDCs. The terms of trade B/w the peripheral (LDCs) and the cyclical centres (LDCs) have shifted in favour of the latter.
Assumptions 1. On account of the operation of Engel‟s Law as income rises in DCs, the demand pattern shifts away from primary to manufactured products. 2. Demand for primary product of LDCs rises slowly in DCs. 3. Export market for DCs product is monopolistic and that for LDCs product is competitive. 4. Trade unions are weak in LDCs. 5. Substitutes of primary products of LDCs are available in the world market which decreases the demand of LDCs primary product. 6. Income terms of trade in the determining factor for economic growth in LDCs.
Explanation Prebisch assumes that the capacity to import or income terms of trade is the determining factor of economic growth in LDCs and the terms of trade is the most important „conduit‟ for transmission of productivity gains from cyclical centres (DCs) to the Peripheral countries (LDCs). His contention is that in the organic growth of the world economy, the primary producing LDCs have failed to share in gains of this world economic growth generated by the DCs and the reason has been their declining capacity to import. There is secular downward trend in the prices of primary goods relative to the prices of manufactured goods. There are various reasons for the deterioration of TOT of LDCs.
1.
Technical Progress Technical progress increases the income of the workers and entrepreneurs and a high price for their goods. Some of them are exported of LLDCs. But the benefits of technical progress do not flow to the LDCs. As a result, wages of workers do not rise prices of their [15] OSN Academy
primary goods which they export of their primary goods which they export in relation to their imports fall, thereby worsening their TOT.
2.
Relation b/w income and productivity The increase in income is less than that of productivity in LDCs due to two reasons:(a) Population pressure : Population pressure in LDCs due to increase in population and surplus manpower have led to rise in labour supply. Consequently, the level of wages falls. (b) Weak Trade Unions : Trade unions are mostly non-existent or weak in the large organised sector of LDCs. Therefore, they are incapable of raising wages for their workers.
3.
Monopoly Elements Another cause for deterioration in TOT of LDCs acc. To Prebisch, has been monopoly elements in product markets of DCs. The DCs have a high degree of monopoly. Power in manufactured industrial and capital goods for which they charge high prices from LDCs.
4.
Effects of Cyclical Instability and BOP difficulties Increased export earning lead to inflationary pressures, malallocation of investment expenditure and to balance of payment difficulties. As a result, there has been a secular deterioration in the income terms of trade of LDCs.
5.
Debt Problems of LDCs Another reason which singer advances for deterioration in TOT of LDCs in recent years has been their mounting debt. First, a large amount of proceeds from exports are utilised to repay their debts instead of paying for imports. Second, to repay their debts, LDCs compete with each other to increase their export earnings.
6.
Immiserising Growth Immiserising growth in LDCs lead to deterioration in the TOT of LDCs when (1) the economy‟s growth leads to the production of more exportables; (2) the demand for exports is inelastic, and (3) growth reduces the domestic production of importables at constant commodity prices.
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7.
Shortage of Intermediate Products Due to shortage of intermediate products in relation to their expanding demand, they are imported at relatively higher prices than the prices of exportables. These price differences, results in deteriorating TOT.
8.
Weak Bargaining Power Most of the primary products exported by LDCs to DCs are perishable. So they have to accept the conditions laid down by the DCs because of their weak bargaining power.
9.
Lack of Adaptability in Production The raw materials and agricultural of products of LDCs lack in adaptability to their world prices when their world prices start declining the producers of primary products cannot switch over production to some others goods whose prices are not decreasing. This leads to deteriorating.
10.
Dependence of DCs LDCs depend on DCs for capital equipment, machinery and know-how for their
development of import-substitution industries and infrastructures. These are supplied at high prices as compared to their export prices which worsen their TOT.
Criticisms 1.
LDCs also exports manufactures It is not correct to identify that all LDCs export primary products and all developed countries export manufactures because there are many LDCs like India that also export manufactures and DCs like Australia and Denmark also export Primary Products.
2.
Neglect of supply conditions The Prebish-Singer thesis discusses only demand conditions and ignores supply conditions in determining TOT. But relative prices depends not only on demand but also on supply conditions which are likely to change much over long periods.
3.
Not possible do assess changes in demand for primary products Tremendous changes have taken place in methods of production and transportation in world production and trade. Therefore, it is not possible to assess their impact on the changes in demand for primary products and on TOT. [17] OSN Academy
4.
Export instability not due to Price changes alone Acc. To Macbean, export instability in LDCs seems to arise from quantity fluctuations than from changes in prices.
5.
Foreign investment not the cause There is no empirical evidence to prove Singer‟s contention that the development of the export sector has been at the expense of the domestic sector foreign investment and trade have not always stood in way of domestic investment.
Conclusion Though this thesis has been criticised but is has been found that the developing countries suffer double jeopardy. Not only do the prices of their primary products decline relative to manufactured goods, but also the prices of these manufactured exports declines relative to those of developed countries reflecting, no doubt, the commodity composition of their exports.
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