Foreign Trade – Theory,

Procedures, Practices and

Documentation
(Export-Import Procedures and Documentation)

Dr. Khushpat S. Jain

Associate Professor,
Ph.D. (Commerce), M.Com. (Banking & Finance),
M.B.A. (Human Resource Management),
M.A. (Economics and Political Science), NET, SET.

Dr. Apexa V. Jain

Visiting Faculty,
Ph.D. (Commerce), M.Com. (Business Management),
M.Phil. (Commerce and Management)
M.B.A. (Human Resource Management)

Seventh Revised and Enlarged Edition : 2017

ISO 9001:2008 CERTIFIED

© Authors
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording and/or otherwise without the prior written permission of the publisher.

First Edition : 2004

Second Edition : 2005
Third Revised Edition : 2006
Fourth Edition : Jan. 2007
Fifth Edition : Aug. 2007
Sixth Revised Edition : 2010
Reprint : 2011, 2012, 2013, 2014, 2015
Seventh Revised and Enlarged Edition : 2017

Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd.,
“Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004.
Phone: 022-23860170/23863863, Fax: 022-23877178
E-mail: himpub@vsnl.com; Website: www.himpub.com

Branch Offices :

New Delhi : “Pooja Apartments”, 4-B, Murari Lal Street, Ansari Road, Darya Ganj,
New Delhi - 110 002. Phone: 011-23270392, 23278631; Fax: 011-23256286
Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018.
Phone: 0712-2738731, 3296733; Telefax: 0712-2721216
Bengaluru : Plot No. 91-33, 2nd Main Road Seshadripuram, Behind Nataraja Theatre,
Bengaluru - 560020. Phone: 08041138821, Mobile: 09379847017, 09379847005.
Hyderabad : No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda,
Hyderabad - 500 027. Phone: 040-27560041, 27550139
Chennai : New No. 48/2, Old No. 28/2, Ground Floor, Sarangapani Street, T. Nagar,
Chennai - 600 012. Mobile: 09380460419
Pune : First Floor, “Laksha” Apartment, No. 527, Mehunpura, Shaniwarpeth
(Near Prabhat Theatre), Pune - 411 030. Phone: 020-24496323/24496333; Mobile: 09370579333
Lucknow : House No 731, Shekhupura Colony, Near B.D. Convent School, Aliganj,
Lucknow - 226 022. Phone: 0522-4012353; Mobile: 09307501549
Ahmedabad : 114, “SHAIL”, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura, Ahmedabad - 380 009.
Phone: 079-26560126; Mobile: 09377088847
Ernakulam : 39/176 (New No: 60/251) 1st Floor, Karikkamuri Road, Ernakulam, Kochi – 682011.
Phone: 0484-2378012, 2378016 Mobile: 09387122121
Bhubaneswar : 5 Station Square, Bhubaneswar - 751 001 (Odisha).
Phone: 0674-2532129, Mobile: 09338746007
Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata - 700 010,
Phone: 033-32449649, Mobile: 07439040301
DTP by : Naina K. Jain
Printed at : Geetanjali Press Pvt. Ltd., Nagpur. On behalf of HPH.
Dedicated to the Unknown Teacher

“Great generals win campaigns but it is the unknown soldier who wins the war.
Famous educators plan new systems of pedagogy but it is the unknown teacher who directs
and guides the young. He lives in obscurity and contends with hardship. For him, no
trumpets blare, no chariots wait, no golden decorations are decreed. He keeps watch along
the borders of darkness and makes attack on the trenches of ignorance and folly. Patient in
his duty, he strives to conquer the evil powers which are the enemies of youth. He awakens
the indolent, encourages the eager and steadies the unstable. He communicates his own joy
at learning and shares with boys and girls the best treasures of his mind. He lights many
candles, which in later years will shine back to cheer him. This is his reward. Knowledge
may be gained from books, but the love for knowledge can be transmitted only by personal
contact. No one has ever deserved better of the republic than the unknown teacher. No one
is more worthy to be enrolled in a democratic aristocracy, King of himself and Servant of
mankind”.

– Henry Van Dyke

 Education

“Education, according to the Indian tradition, is not merely a means of earning

a living, nor it is only a nursery of thoughts or a school for citizenship. It is the
initiation into the life of spirit, a training of human soul in the pursuit of truth and
practice of virtue.”

So long as there is a one child who has failed to obtain the precise educational treatment
his individuality requires; so long as a single child goes hungry, has nowhere to play, fails
to receive the medical attention he needs; so long as the nation fails to train and provide
scope for every atom of outstanding ability it can find; so long as there are parents who do
not realise their responsibilities of bringing up immature brains; so long as there are
administrators or teachers who feel no sense of mission, who cannot administer or who
cannot teach, the system will remain incomplete.
 Preface to the New Edition

It gives us immense pleasure to place in your hand, the much awaited and thoroughly
revised enlarged edition of our book titled “Import Export Procedures and
Documentations” under a new title “Foreign Trade – Theory, Procedures, Practices
and Documentation” to justify its extended scope and contents.
We express our gratitude towards the Teacher’s and Student’s Community whose
regular reminders for the revision of the Book motivated us to work more meticulously on
the contents and bring it to the present stature. Probably, that is what has inspired us to
dedicate this enlarged Edition to all those “Unknown Teachers”, who had been an
inspirational force behind this book. We are also thankful to the students for flooding our
mail boxes with their suggestions and recommendations for the improvement of the
contents and making it user-friendly.
The book has been divided into Four Units – International Marketing Environment,
Introduction to International Marketing, Framework for India’s Foreign Trade and Foreign
Trade Procedures, each having five inter-related chapters. The book exclusively deals with
the issues pertaining to export import trade and documentations. Attempts have been made
to simplify complicated procedures without diluting the contents of the Policy declared by
the Government.
We hope that this revised edition would serve the expectations of teachers and
professionals associated with Foreign Trade and most importantly the students pursuing
their career in Foreign Trade at the undergraduate and postgraduate levels and in
professional courses.
Constructive suggestions for the qualitative improvement of the book will be received
and honoured with a deep sense of gratitude at ksjain2002@yahoo.com. We would be
amplyrewarded, if the volume meets the requirements of those for whom it is meant.
– Authors
 Contents
UNIT – 1
INTERNATIONAL MARKETING ENVIRONMENT

Chapter 1 – Evolution of International Trade 1 – 26

1.1 Introduction 2
1.2 Interdependence of Countries 2
1.3 Internal Trade vs. International Trade 3
1.4 Classical Theory of International Trade 3
1.5 Theory of Absolute Cost Differences or Advantages 4
1.6 The Ricardian Theory of Comparative Costs 6
1.7 Gains from International Trade 7
1.8 Comparative Costs Doctrine Expressed in Terms of Money 9
1.9 Evaluation of the Classical Theory of International Trade 11
1.10 Do We Need a Special Theory of International Trade? 12
1.11 General Equilibrium Theory of International Trade 13
1.12 Exchange Rate Mechanism and International Trade 19
1.13 A Complex Model of Ohlin 20
1.14 Criticisms of the Modern Theory of International Trade 21
1.15 Superiority of the Modern Theory of International Trade 22
1.16 Porter’s National Competitive Advantage Theory 23
1.17 Product Life Cycle Theory 25

Chapter 2 – International Trade Environment 29 – 56

2.1 Meaning of International Trade Environment 28
2.2 Components of International Trade Environment 31
2.3 Demographic Environment 35
2.4 Social Environment 36
2.5 Cultural Environment 37
2.6 Hofstede’s Cultural Dimension Theory 40
2.7 Economic Environment 42
2.8 Political Environment 45
2.9 Legal Environment 47
2.10 Technological Environment 48
2.11 Competitive Environment 51
 2.12 Michael Porter’s Five Forces Analysis 53
2.13 PEST Analysis for International Market 55

Chapter 3 – International Trade Organisations 57 – 80

3.1 General Agreement on Tariffs and Trade (GATT) 58
3.2 Uruguay Round of GATT (1986-93) 60
3.3 Objectives of the World Trade Organisation (WTO) 63
3.4 Principles of the WTO 64
3.5 Functions of WTO 66
3.6 GATT vs. WTO 66
3.7 Pros of WTO 68
3.8 Cons of WTO 70
3.9 WTO Ministerial Conferences 71
3.10 Doha Declaration 72
3.11 United Nations Co-operation for Trade and Development (UNCTAD) 73
Appendix 75

Chapter 4 – Regional Economic Groupings 81 – 100

4.1 Concept of Trade Barriers 82
4.2 Objectives of Trade Barriers 82
4.3 Types of Tariff Trade Barriers 83
4.4 Types of Non-tariff Trade Barriers: 85
4.5 Tariff Trade Barriers vs. Non-tariff Trade Barriers 87
4.6 Effects of Trade Barriers 87
4.7 Concept of Regional Economic Groups 89
4.8 Types of Regional Economic Groups 90
4.9 Positive Effects of Regional Economic Groups 90
4.10 Negative Effects of Regional Economic Groups 91
4.11 Major Trade Blocs 92
4.12 South Asian Free Trade Area (SAFTA) 97
Appendix 99

Chapter 5 – Globalisation, FDI and MNCs 101 – 127

5.1 Understanding LPG Model 102
5.2 Concept of Globalisation 103
5.3 Features of Globalisation 104
5.4 Stages of Globalisation 105
5.5 Concept of Multinational Corporations (MNCs) 107
 5.6 Merits of MNCs 107
5.7 Demerits of MNCs 108
5.8 MNCs in India 109
5.9 Concept of Foreign Direct Investment (FDI) 111
5.10 Role and Functions of FDI in Developing Countries 112
5.11 Factors Influencing FDI 114
5.12 FDI Operations in India 116
5.13 FDI Policy in India 118
5.14 Make in India 122
5.15 Foreign Investment Promotion Board (FIPB) 125
5.16 Foreign Investment Promotion Council (FIPC) 126

UNIT – 2
INTRODUCTION TO INTERNATIONAL MARKETING

Chapter 6 – Introduction to International Marketing 129 – 160

6.1 Concept of International Marketing 131
6.2 Features of International Marketing 132
6.3 Drivers of International Marketing 133
6.4 Importance of International Marketing 135
6.5 Motivation for Internationalisation 136
6.6 Orientations of International Marketing 138
6.7 Phases of International Marketing 139
6.8 Process of International Marketing 141
6.9 Concept of International Marketing Research 142
6.10 Need for International Marketing Research 142
6.11 International Marketing Research Process 144
6.12 Scope of International Marketing Research 147
6.13 Special Problems of International Marketing 149
6.14 Domestic Marketing vs. International Marketing 150
6.15 ‘12C’ Framework for International Marketing 151
6.16 Concept of International Service Marketing 152
6.17 Characteristics of Services 153
6.18 ‘7Ps’ of International Service Marketing 154
6.19 Features of International Service Marketing 155
6.20 Need for International Service Marketing 156
 6.21 Drivers of Global Service Marketing 157
6.22 A Note on Service Culture 158

Chapter 7 – Product Decisions 161 – 196

7.1 Concept of International Marketing Mix 163
7.2 Product Planning Decisions 164
7.3 Product Planning Strategies 164
7.4 Importance of Product Planning 166
7.5 New Product Development Process 167
7.6 Product Life Cycle 170
7.7 Concept of Branding 172
7.8 Role of Branding 174
7.9 Branding Decisions 176
7.10 Brand Piracy 177
7.11 Concept of Packing and Packaging 179
7.12 Requisites of Good Packaging 179
7.13 Functions of Packaging 180
7.14 Factors Influencing Packaging Decisions 181
7.15 Types of Packing Materials 183
7.16 Concept of Transport Packing 183
7.17 Materials for Transport Packing 184
7.18 Containerisation 186
7.19 Role of Indian Institute of Packaging (IIP) 189
7.20 Marking and Labelling 191
7.21 Product Warranties and After-sales Service 195

Chapter 8 – Pricing Decisions 197 – 216

8.1 Concept of Pricing 198
8.2 Factors Affecting Pricing Decisions 198
8.3 Importance of Pricing Decisions 199
8.4 Methods of Costing in International Market 200
8.5 Elements of Cost in Pricing Goods for International Market 203
8.6 Export Pricing Strategies 203
8.7 INCOTERMS 2011 or Export Price Quotations 204
8.8 FOB Quotation vs. CIF Quotation 206
8.9 Skimming Pricing vs. Penetration Pricing 207
8.10 Break-even Analysis 208
8.11 Information Required for Pricing in International Market 210
 8.12 Computation of FOB, CF and CIF Price 212
8.13 Impact of Incentives on Export Pricing 215

Chapter 9 – Distribution Channel Decisions 217 – 238

9.1 Concept of International Market Segmentation 218
9.2 Importance of International Market Segmentation 218
9.3 Bases of International Market Segmentation 220
9.4 Components of International Logistics 222
9.5 Meaning of Channels of Distribution 225
9.6 Levels of Distribution Channel 226
9.7 Types of Distribution Channels 227
9.8 Direct Marketing 229
9.9 Indirect Marketing 230
9.10 Direct Exporting vs. Indirect Exporting 231
9.11 Factors Influencing Channel Selection 232
9.12 Export Marketing Development through Internet 234
9.13 Benefits of Export Marketing Development through Internet 236
9.14 Warehousing and its Necessity in International Trade 237

Chapter 10 – Promotion Decisions 239 – 254

10.1 International Product Positioning 240
10.2 Product Positioning Strategies 241
10.3 Concept of Product Promotion 242
10.4 Techniques of Product Promotion 243
10.5 Factors Affecting Product Promotion 244
10.6 Role of Promotion Mix 246
10.7 Planning International Promotion Campaign 247
10.8 Barriers to International Promotion 248
10.9 International Advertising Programme 249
10.10 International Trade Fairs and Exhibitions 251
10.11 Indian Trade Promotion Organisation (ITPO) 252
Appendix 254
 UNIT – 3
FRAMEWORK FOR INDIA’S FOREIGN TRADE

Chapter 11 – Regulatory Framework for Foreign Trade 255 – 286

11.1 Introduction 256
11.2 Laws Governing India's Export Import Trade 256
11.3 The Customs Act, 1962 256
11.4 The Export Quality (Control and Inspection) Act, 1963 261
11.5 The Foreign Trade (Development and Regulation) Act, 1992 262
11.6 The Foreign Exchange Management Act, 1999 265
11.7 Foreign Exchange Management (Export of Goods and Services) Regulations, 2000 270
11.8 The Arbitration and Conciliation Act, 1996 273
11.9 International Commercial Practices 279
11.10 Central Board of Excise and Customs 281
11.11 Export Inspection Council (EIC) 282
11.12 Indian Council of Arbitration (ICA) 284
Appendix 285

Chapter 12 – India’s Foreign Trade Policy 287– 312

12.1 Introduction 288
12.2 General Objectives of EXIM Policy 288
12.3 Foreign Trade Policy – A Snapshot 289
12.4 EXIM Policy, 1992-97 296
12.5 EXIM Policy, 1997-2002 297
12.6 Foreign Trade Policy, 2004-2009 297
12.7 Foreign Trade Policy, 2009-2014 298
12.8 Foreign Trade Policy, 2015-2020 299
12.9 Implications of the Foreign Trade Policy, 2015-2020 306
12.10 Privileges of Status Holders 307
12.11 Negative List of Exports 309
12.12 Negative List of Imports 311
12.13 Board of Trade 311

Chapter 13 – Institutional Framework for Foreign Trade 313 – 348

13.1 Institutional Framework for Foreign Trade 314
13.2 Role of Export Promotion Organisations 314
13.3 Department of Commerce 316
 13.4 Director General of Foreign Trade (DGFT) 318
13.5 Directorate General of Commercial Intelligence and Statistics (DCI&S) 319
13.6 Agricultural and Processed Food Products Development Authority (APEDA) 321
13.7 Marine Products Export Development Authority (MPEDA) 324
13.8 Export Promotion Councils (EPCs) 325
13.9 Commodity Boards (CBs) 327
13.10 Indian Institute of Foreign Trade (IIFT) 329
13.11 Federation of Indian Export Organisations (FIEO) 330
13.12 National Centre for Trade Information (NCIT) 332
13.13 State Trading Corporation of India (STC) 334
13.14 Chamber of Commerce (CoC) 336
13.15 States Involvement in Promoting Foreign Trade 338
Appendices 339

Chapter 14 – International Trade Documents 349 – 382

14.1 Introduction 350
14.2 Aligned Documentation System (ADS) 352
14.3 Proforma Invoice 354
14.4 Commercial Invoice 355
14.5 Packing List 356
14.6 Shipping Bill 357
14.7 Certificate of Origin 358
14.8 Consular Invoice 360
14.9 Certificate of Origin vs. Consular Invoice 361
14.10 Commercial Invoice vs. Consular Invoice 361
14.11 Mate’s Receipt 362
14.12 Bill of Lading 363
14.13 Mate’s Receipt vs. Bill of Lading 365
14.14 Guaranteed Remittance (GR) Form 366
14.15 Bill of Exchange 367
14.16 Airway Bill 368
14.17 Import Documents 369
Specimen of Export Documents 373

Chapter 15 – Policy Assistance and Incentives 383 – 408

15.1 Incentives and Assistance for Exporters 384
15.2 Duty Drawback (DBK) 386
15.3 Procedure for Claiming Duty Drawback 388
 15.4 Exports from India Scheme 388
15.5 Export Promotion Capital Goods (EPCG) Scheme 391
15.6 Towns of Export Excellence (TEE) 394
15.7 Deemed Exports 396
15.8 Export Oriented Units (EOUs), Electronic Hardware Technology Parks (EHTPs),
Software Technology Parks (STPs) and Bio-technology Parks 397
15.9 Agri Export Zones (AEZs) 399
15.10 Special Economic Zones (SEZs) 400
15.11 Benefits Enjoyed by SEZs 403
15.12 Quality Control and Trade Disputes (QCTD) 404
15.13 Assistance to States for Developing Export Infrastructure and Allied Activities (ASIDE) 406
Appendix 407

UNIT – 4
FOREIGN TRADE PROCEDURES

Chapter 16 – India’s Foreign Trade 409 – 436

16.1 Introduction 410
16.2 Significance or Merits of Foreign Trade 410
16.3 Demerits of Foreign Trade 411
16.4 Growth of India’s Foreign Trade 413
16.5 Direction of India’s Exports 415
16.6 Direction of India’s Imports 417
16.7 Major Exports (Commodities) of India 419
16.8 Major Imports (Commodities) of India 422
16.9 Major Exports (Services) of India 424
16.10 India’s Share in World Trade and FTP 2015-2020 426
16.11 Prospects for India’s Foreign Trade Development 427
16.12 Challenges to India’s Foreign Trade Development 429
Appendices 431

Chapter 17 – Preliminaries for Export 437 – 456

17.1 Meaning of Exports and Imports 438
17.2 Classification of Exports and Imports 438
17.3 Categories of Exporters 440
17.4 Strategy and Preparation for Foreign Trade 442
17.5 Identifying Foreign Markets 444
 17.6 International Market Selection Process 446
17.7 Methods of Entering International Market 447
17.8 Constraints in Entering Foreign Markets 450
17.9 Export Contract 451
17.10 Force Majeure in Export Contract 453
17.11 Exchange Earner’s Foreign Currency (EEFC) Account 454

Chapter 18 – Export Procedure 457– 484

18.1 Introduction 459
18.2 Registration Procedure 459
18.3 Pre-shipment Procedure 460
18.4 Shipment Procedure 462
18.5 Post-shipment Procedure (Realisation of Export Proceeds) 463
18.6 Excise Clearance for Exportable Goods 464
18.7 Quality Control and Pre-shipment Inspection 467
18.8 Objectives of Quality Control and Pre-shipment Inspection 468
18.9 Methods of Quality Control and Pre-shipment Inspection 469
18.10 Procedure for Pre-shipment Inspection 470
18.11 Procedure for Shipping and Customs Clearance 471
18.12 Marine Insurance Policy 473
18.13 Procedure for Marine Insurance Policy 473
18.14 Types of Marine Insurance Policies 474
18.15 Procedure for Filing Marine Insurance Claim 476
18.16 Importer Exporter Code (IEC) Number 477
18.17 Registration-cum-Membership Certificate (RCMC) 478
18.18 Role of Customs House Agents (CHAs) 479
18.19 Exchange Rate Fluctuation Risks 480
18.20 Forward Contracts 481
18.21 ISO 9000 Certification 482
18.22 Procedure for Obtaining ISO 9001 Certification 483

Chapter 19 – Methods of Payments and Export Finance 485 – 514

19.1 Conditions for Realisation of Export Proceeds 487
19.2 Factors Affecting Export Payment Terms 487
19.3 Methods of Export Payment 488
19.4 Letter of Credit 490
19.5 Procedure for Opening Letter of Credit 490
 19.6 Types of Letter of Credit 491
19.7 Advantages of Letter of Credit 493
19.8 Types of Export Finance 494
19.9 Pre-shipment Finance 494
19.10 Features of Post-shipment Finance 496
19.11 Procedure for Obtaining Export Finance 499
19.12 Pre-shipment Finance vs. Post-shipment Finance 500
19.13 Institutional Framework for Export Finance 501
19.14 Role of Commercial Banks in Export Finance 501
19.15 Role of EXIM Bank in Export Finance 503
19.16 Forfeiting Scheme of EXIM Bank 506
19.17 Role of SIDBI in Export Finance 507
19.18 Risks in Export Marketing 510
19.19 Export Credit and Guarantee Corporation (ECGC) of India 511
19.20 Role of ECGC in Export Credit Insurance for Exporters 511
19.21 Role of ECGC in Providing Finance to Exporters 514

Chapter 20 – Import Procedure 515 – 535

20.1 Introduction 516
20.2 Categories of Importers 516
20.3 Import Licence 516
20.4 Import of Samples 518
20.5 Import Contract 519
20.6 Pre-import Procedure 520
20.7 Legal Dimensions of Import Procedure 520
20.8 Retirement of Import Documents 522
20.9 Customs Clearance for Imported Goods 523
20.10 Warehousing of Imported Goods 524
20.11 Exchange Control Provisions for Imports 526
20.12 Import Risks 528
20.13 Import Duties 529
20.14 Valuation for Customs Duty 531
20.15 Import Incentives under Special Schemes 532
20.16 Import of Personal Baggage 533
20.17 Import of Gifts 534

Glossary 537 – 545

 Evolution of
1. International Trade

Chapter Highlights:
1.1 Introduction

1.2 Interdependence of Countries

1.3 Internal Trade vs. International Trade

1.4 Classical Theory of International Trade

1.5 Theory of Absolute Cost Differences or Advantages

1.6 The Ricardian Theory of Comparative Costs

1.7 Gains from International Trade

1.8 Comparative Costs Doctrine Expressed in Terms of Money

1.9 Evaluation of the Classical Theory of International Trade

1.10 Do We Need a Special Theory of International Trade?

1.11 General Equilibrium Theory of International Trade

1.12 Exchange Rate Mechanism and International Trade

1.13 A Complex Model of Ohlin

1.14 Criticisms of the Modern Theory of International Trade

1.15 Superiority of the Modern Theory of International Trade

1.16 Porter’s National Competitive Advantage Theory

1.17 Product Life Cycle Theory

 Foreign Trade – Theory, Procedures, Practices and Documentation

1.1 Introduction
International trade existed in one form or the other since time immemorial. Indian traders crossed seven
seas and ventured to Java and Sumitra long back. International trade theories, however, were developed
much later. Fundamentally, in a market system, individuals trade because they expect to gain from the
exchange, i.e., they expect to be better off as a result of trading. In this respect, trade occurs for the same
reasons among nations as it does among regions within a given country. Thus, domestic trade occurs within
the political boundaries of a nation whereas international trade occurs across the political boundaries of
different nations.
“International trade consists of transactions between residents of different countries.”
– Wasserman and Haltman
The principle of comparative advantage is the basis of international trade. Each nation or region specialises
in the production of those goods and services in which it enjoys maximum comparative advantage and
imports or purchases its other requirements from the other nations. Thus, principle of division of labour
and specialisation is the basis of world trade.

1.2 Interdependence of Countries

No country in the world is self-sufficient in all its domestic requirements. The slogan ‘Export or Perish’
coined by Pandit Jawaharlal Nehru, is applicable to all the countries of the world, developed as well as
developing. There are various factors which give rise to interdependence among countries.
(a) Uneven Distribution of Natural Resources: Natural resources are distributed unevenly on the
surface of the earth. Some countries are rich in metallic and non-metallic minerals but are deficient
in natural and physical resources while some other countries are rich in natural resources but are
deficient in minerals. This gives rise to surplus and deficient regions, which direct the flow of goods
from surplus regions to deficient regions. For example, the Gulf countries are rich in mineral oil
while are deficient in many other resources. As a result, these countries export mineral oil and
import most of their other requirements.

(b) Difference in Level of Technology: Industrial revolution first took place in England in 1760 AD.
Later, it spread to different regions and countries of the world with different pace and intensity.
Technology became the driving force of growth and development of economies in the post-
industrial revolution period. Countries like Japan, the USA, the UK and Germany are highly
developed in terms of technology while most of the Afro-Asian and South American countries are
backward in technological development. This directs the flow of technology from technically
advanced countries to technically backward countries of the world.

(c) Advancement in Information Technology: Due to revolution in the field of communication and
information technology, new media of mass communication such as satellite, Internet and e-commerce
have become popular. These media have brought world closer and have promoted greater exchange
of ideas. Consumers from the underdeveloped and developing countries of the world have started
imitating the consumption pattern and lifestyle of the consumers in the advanced countries. This

2
 Evolution of International Trade

has created new needs in the society and led to the promotion of international trade in goods,
services and technology.

(d) Division of Labour and Specialisation: Trade rests on the principle of division of labour and
specialisation put forth by Adam and Smith. Each country enjoys comparative cost advantage in the
production of certain commodities due to favourable climate, technical know-how, easy access to
raw materials and efficient human resource. These factors enable it to produce some commodities
in excess of its requirements and exchange surplus production with other countries for the
commodities that it is deficient in and vice versa. Thus, the principle of division of labour that forms
the basis of domestic trade also applies to international trade.

1.3 Internal Trade vs. International Trade

It has been a matter of great controversy whether there is any difference between internal trade and
international trade. Holding a view that there are certain fundamental differences between internal trade
and international trade, the classical economists propounded a separate theory of international trade.
According to them, the basis of international trade was the comparative cost differences. On the other hand,
modern economists like Bertil Ohlin, Haberler, etc. have regarded these two as similar.

“International trade is but a special case of inter-local or inter-regional trade.” – Heckscher and Ohlin
“Domestic trade is among us; international trade is between us and them." – Friedman List
Nevertheless, there are several reasons to believe the classical view that international trade is basically
different from internal trade.
(a) Immobility of factors of production between nations.
(b) Different currencies.
(c) Differences in natural resources.
(d) Different national policies.
(e) Exchange and trade control.
(f) Separate markets.
(g) Problem of balance of payments.
(h) Different political groups.

1.4 Classical Theory of International Trade

The classical theory of international trade was first propounded by Adam Smith who introduced the
principle of absolute cost advantage as the basis of international exchange of commodities. It was further
developed by David Ricardo in terms of comparative cost advantage. Later, further refinements and
modifications were introduced by economists like J.S. Mill, Taussig and others. The classical economists
considered the principle of division of labour as the basis of international trade.
Assumptions of the Classical Theory of International Trade
The following are the explicit and implicit assumptions of the theory:

3
 Foreign Trade – Theory, Procedures, Practices and Documentation

(a) The classical economists assume 2 countries × 2 commodities model. It is further assumed that
these two countries are economically at par.
(b) They regarded labour as only factor of production. That means the production costs can be
expressed only in terms of labour units.
(c) They ignored the existence of money and considered cost of production in real terms, i.e., in terms of
the labour theory of value.
(d) According to them, the factors of production are perfectly mobile within the country but perfectly
immobile between different countries.
(e) They also assumed that all labourers are homogenous, i.e., all the labourers are equally skilful and
efficient.
(f) Production function is assumed to be linear and homogenous. It means there are constant returns to
scale.
(g) They advocated the policy of laissez-faire, i.e., there is free trade and the government does not
interfere at all.
(h) International trade takes place only in case of goods. There is no capital movement from one
country to another.
(i) This theory, like all other classical dogmas, assumes that there exists full employment in both the
countries.
(j) There exists free trade, i.e., there are no barriers of tariffs or controls to the trade between two
countries.
(k) The theory also assumes perfect competition both in commodity as well as factor market.
(l) Transport costs are zero. It means that the cost of labour is the only cost of production.
(m) Trade cycles are absent in the economy, i.e., the theory operates under normal conditions.

Given the above assumptions, the pre-trade commodity price depends on the average productivities of
labour contained in the production functions. The supply of the commodity depends on the labour content
and its price is equated to the value of its labour content.

1.5 Theory of Absolute Cost Differences or Advantages

Adam Smith (1723) was an economist and philosopher who wrote

what is considered the "bible of capitalism," The Wealth of
Nations, in which he details the first system of political economy.

4
 Evolution of International Trade

Adam Smith was the first economist who sowed the seeds of classical theory of international trade. He
was a staunch advocate of free trade and a critic of protectionism. He argues that the application of the
principle of division of labour to international trade is advantageous to all nations because it causes each
country to specialise in the production of those goods which it is best suited to produce most cheaply. He
held that free trade between countries brings about an optimum allocation of the productive resources of
the world, leading to an enhancement of real income of the trading countries.
In this context, Adam Smith developed the law of absolute cost advantage for international trade. According
to him, trade occurs between two countries if one of them has an absolute advantage in producing one
commodity and the other country having absolute advantage in producing some other commodity. In other
words, each country specialises in the production of that commodity in which it enjoys an absolute cost
advantage and trades with other countries in commodities in which they enjoy absolute cost advantage. The
trade between the countries would result in optimum allocation of the resources in the world and hence
productivity will boost.
Illustration
The Absolute Cost Theory can be illustrated with the help of an illustration. Suppose there are two
countries, A and B and each of them can produce say two commodities, wine and cloth. As per the
assumptions of the classical economists, all costs are measured only in terms of labour.
If in country A, one unit of labour per day can produce 25 barrels of wine or 10 bales of cloth and in country
B, the same amount of labour can produce 10 barrels of wine or 15 bales of cloth then the cost conditions in
country A and B can be represented as follows:

Evidently, country A has an absolute cost advantage over country B in the production of wine (for 25 barrels
are more than 10 barrels), while country B has an absolute advantage over country A in the production of
cloth (for 15 bales are more than 10 bales).
Thus, country A will specialise in the production of wine in which it has an absolute cost advantage over
country B and country B will specialise in the production of cloth in which it has an absolute cost advantage
over country A. Thus, trade between two countries will benefit both of them. It is can be seen from the
above table that with 2 units of labour, country A will now produce 50 barrels of wine and country B 30
bales of cloth as a result of specialisation and international trade. In the absence of international trade, with
same units of labour (i.e., 2 units of labour), the world production would have been restricted to just 35
barrels of wine and 25 bales of cloth.
Critical Analysis of the Absolute Cost Advantages Theory
Though Smith’s theory is clearly expressed, it is not convincing. His analysis is based on the assumption that
given the quantity of labour, the exporting country must be in a position to produce a commodity in a larger

5
 Foreign Trade – Theory, Procedures, Practices and Documentation

quantity than the rival country. But there are very genuine chances that a particular country may not be in a
position to specialise in any line of productivity. This may be the case of a relatively backward country
whose factors of production, as compared with those of any other developed nation, are inefficient in all
lines of production. There is no absolute advantage for such a backward country and yet we find that it has
international economic relations. Adam Smith’s theory clearly fails to analyse this sort of situation.

1.6 The Ricardian Theory of Comparative Costs

David Ricardo (1772) was a classical economist known for his Iron
Law of Wages, Labour Theory of Value, Theory of Comparative
Advantage and Theory of Rents. His most well-known work is
the Principles of Political Economy and Taxation (1817).

The doctrine of absolute cost advantage put forth by Adam Smith could not explain why there can be trade
between any two countries even when one of them had disadvantage in the production of all goods. To provide
an answer in such cases, Ricardo enunciated the principle of comparative costs in his ‘Principles of Political
Economy’ (1817), which incorporates the Smith’s principle of absolute cost advantages as a special case.
“Each country will specialise in the production of those commodities in which it has greater
comparative advantage or least comparative disadvantage.” – David Ricardo
Thus, according to the principle of comparative costs, under free trade conditions, a country specialises in
the production of a commodity in which its comparative advantage is greater or its comparative disadvantage
is lesser. Each country exports a commodity in the production of which it has a greater comparative
advantage or a lesser comparative disadvantage.
Illustration
Suppose that there are two countries, Portugal and England and that each of them can produce wine and
cloth. The relative cost conditions of both these countries are given in the table below:

From the above table, we can calculate the domestic ratio of exchange between two goods.
Domestic ratio of exchange in Portugal:
1 unit of wine = 0.89 units of cloth. (80/90)
1 unit of cloth = 1.13 units of wine. (90/80)

6
 Evolution of International Trade

Domestic ratio of exchange in England:

1 unit of wine = 1.2 units of cloth. (120/100)
1 unit of cloth = 0.83 units of wine. (100/120)
Now, let us note the comparative cost ratios of wine and cloth in the two countries.
Comparative cost ratio in Portugal:
For wine = 0.67. (80/120)
For cloth = 0.90. (90/100)
Comparative cost ratio in England:
For wine = 1.50. (120/80)
For cloth = 1.11. (100/90)
It can be seen from the above analysis that Portugal has comparative cost advantage in the production of
both wine and cloth. This is because the labour cost of producing 1 unit of wine in Portugal is only 67% of
the labour cost required to produce 1 unit of wine in England. Similarly, Portugal incurs only 90% of the
labour cost incurred by England on the production of 1 unit of cloth.
On the other hand, England incurs 150% and 111% of the labour costs incurred by Portugal on the
production of 1 unit of wine and 1 unit of cloth respectively. Thus, England has a comparative disadvantage
in the production of both commodities.
According to Ricardo, trade would still take place between Portugal and England because Portugal has
greater comparative cost advantage (67%) in the production of wine while England has comparatively a
lesser cost disadvantage (111%) in the production of cloth. Thus, Portugal will specialise in the production
of wine and England would specialise in the production of cloth.

1.7 Gains from International Trade

The gain from trade for each country would depend upon the rate of exchange or terms of trade between
the trading countries.
As a result of specialisations by Portugal in wine due to its greater comparative cost advantage and England
in cloth due to its lesser comparative cost disadvantage, there will be an increase in the output of both the
commodities. Hence, the trade between them will be beneficial to both for both of them gain from trade.
Illustration
No Trade Situation:

7
 Foreign Trade – Theory, Procedures, Practices and Documentation

In no trade situation, if each of them produces one unit of wine and one unit of cloth, Portugal will use 80 + 90
= 170 hours of labour and England will use 120 + 100 = 220 hours of labour. So, to produce 2 units of wine and
2 units of cloth, both the countries taken together would use 390 hours of labour (i.e., 170 + 220 = 390).

Post-trade Situation:

However after specialisation, Portugal will devote 170 hours of labour to produce wine only and England
will devote 220 hours of labour to produce cloth only. Hence, by devoting 2 units of labour, Portugal would
be able to produce 2.125 units of wine and England would be able to produce 2.200 units of cloth. Hence,
the same amount of labour produces a larger amount of both the commodities after specialisation.
Under the international trade, the exchange of commodities depends upon the domestic rates of exchange,
namely,
1 unit of wine = 0.89 units of cloth in Portugal for 0.89 (80/90) and
1 unit of wine = 1.20 units of cloth in England for 1.20 (120/100).

When Portugal and England trade with each other, the actual rate of exchange or the terms of trade will lie
between 0.89 and 1.20 units of English cloth for one unit of Portuguese wine.

When the international trade takes place, Portugal gains, if by exporting one unit of wine, it gets more than
0.89 units of cloth from England and England gains, if by exporting less than 1.2 units of cloth, it gets one
unit of wine from Portugal.

If, for instance, as Ricardo said, the rate of exchange fixed is one unit of wine for one unit of cloth, Portugal
benefits because it gets one unit of cloth at a labour cost of 80 hours of labour which would have costed 90
hours of labour if it had produced it at home. Hence, Portugal saves 10 hours of labour. It also means that
Portugal gets 0.11 units of extra cloth from England for one unit of wine exported. England benefits because
it gets one unit of wine for 100 hours of labour embodied in one unit of cloth. If England had produced one
unit of wine at home, it would have costed it 120 hours of labour. Hence, England is in a position to save 20
hours of labour. It also means that England gets 0.17 units of more wine for every unit of cloth exported.

Thus, this theory shows how countries tend to gain under the conditions of free trade when there is
international division of labour and specialisation based upon the comparative cost advantage. As a result, the
world output of goods produced with a given amount of resources will be larger than without international
specialisation.

8
 Evolution of International Trade

1.8 Comparative Costs Doctrine Expressed in Terms of Money

The Ricardian Theory of comparative costs is explained in terms of labour cost. But, in a money economy, all
costs are expressed in terms of money. International trade is, therefore, determined by absolute differences
in money prices rather than comparative differences in labour cost.
Prof. Taussig, has, therefore, expressed the comparative differences in labour costs in terms of money costs
and money prices. This would help us to find out the absolute differences in the prices of products.
The theory of comparative costs expressed in terms of money is discussed with the help of the following
assumptions:
(a) There are two countries, say, the USA and Germany. Each country can produce two commodities,
say, wheat and linen.
(b) The labour cost is expressed in terms of money on the basis of some arbitrarily fixed wage rate. The
other elements of cost of production are ignored.
(c) The wages and money prices in the USA and Germany are expressed in terms of a single currency,
viz., US dollar.
(d) There is international gold standard. Hence, the classified specie-flow mechanism operates to bring
about adjustments in the balance of payments.
With these assumptions, let us proceed to express the comparative labour cost in terms of money to find out
absolute differences in prices of wheat and linen.
Illustration
Suppose, in the USA,
10 day’s labour produces 20 units of wheat, and
10 day’s labour produces 20 units of linen.
At the same time, in Germany,
10 day’s labour produces 10 units of wheat, and
10 day’s labour produces 15 units of linen.

It can be seen from the above table that the USA has an absolute cost advantage in the production of both
commodities, wheat and linen. But its comparative advantage is greater in wheat than in linen. Hence, it will
specialise in wheat. At the same time, Germany suffers from comparative cost disadvantage in both
commodities. But its comparative disadvantage is less in linen. Hence, it will specialise in linen.
These comparative advantages and disadvantages in the production of wheat and linen can be expressed in
terms of dollars, on the basis of arbitrarily fixed daily wage rates. Suppose, the daily wage rate is $ 1.5 in the

9
 Foreign Trade – Theory, Procedures, Practices and Documentation

USA and $ 1 in Germany, then the relative price of both these commodities in dollar terms can be expressed
as follows:

Money Cost of Wheat and Linen in terms of Dollars

The price per unit of wheat is $ 0.75 in the USA and $ 1 in Germany. Hence, the USA will specialise in wheat
and export it to Germany. This clearly indicates that higher wage rate does not necessarily imply high
prices. At the same time, the price per unit of linen in Germany is $ 0.66 and in the USA $ 0.75. Hence,
Germany will specialise in the production of linen and export it to the USA. Thus, the result is compatible
with the doctrine of comparative costs (based upon labour).

The arbitrary money wage rates are taken for both the countries to calculate the price per unit of each
commodity. But, it does not falsify the doctrine of comparative costs for the ratio of money wages in the two
countries must lie between an upper limit and a lower limit. The upper limit for the wage rate in the USA is
fixed with reference to the cost advantage, which the Germany enjoys in wheat.

Since the same amount of labour produces 20 units of wheat in the USA as 10 units of wheat in Germany,
the upper limit is set by the ratio, 20/10 = 2. This mean that the wage rate in the USA cannot be more than
double the wage rate in Germany. For instance, if the daily wage rate in Germany is $ 1, the daily wage rate
in the USA cannot be more than $ 2. If at all the daily wage rate in the USA rises to $ 2, the cost per unit of
wheat as well as that of linen would be $ 1. As a result, the USA exports of wheat to Germany would cease
while its imports of linen from Germany would continue. This would cause a deficit in the balance of trade
of the USA and gold would flow out of the USA. As a result, the supply of money and credit would fall in the
USA, reducing the price level and the wage rate. Therefore, the wage rate in the USA cannot exceed $ 2.

On the other hand, the lower limit for the wage rate in the USA is fixed with reference to its cost advantage
in linen. Since the same amount of labour produces 20 units of linen in the USA and 15 units of linen in
Germany, the lower limit in the USA is set by the ratio 20/15 = 4/3 = 1.33. This means that the wage rate in
the USA cannot fall below $ 1.33. If the USA wage rate falls below $ 1.33, the exports of German linen to the
USA would cease while its imports of wheat from the USA will continue. Hence, there would be a surplus in
the balance of trade of the USA and gold would flow in the USA. As a result, the supply of money and credit
would increase in the USA, increasing the price level and the wage rate.

So the upper and the lower limits are not arbitrarily chosen. It is only the choice of one or the other ratios
that is arbitrary. Hence, when the wage rate in Germany is $ 1, the actual wage rate in the USA would lie

10
 Evolution of International Trade

between $ 1.33 and $ 2. The wage rate in the USA is bound to be higher than that in the Germany, because of
its greater efficiency. The actual wage rate between the upper limit ($ 2) and the lower limit ($ 1.33) would
be determined by the conditions of demand for each other’s goods.
Taussig’s contribution to the Classical Theory of International Trade suffers from the following defects:
(a) Taussig did not indicate how the terms of trade are actually determined. According to John Stuart
Mill, the exact terms of trade are determined by reciprocal demand.
(b) Like Ricardo, Taussig also took two-country, two-commodity model. This is unrealistic as in reality,
many countries participate in the world trade and each country exports and imports a number of
commodities.
(c) By expressing, the wage rates in the two countries in terms of a single currency (dollar), Taussig has
ignored the problems of determining foreign exchange rates between currencies of the trading
countries.
(d) Taussig has ignored other costs like rent while determining the total cost and underrated interest
cost and has given an undue stress to labour costs expressed in terms of money.

1.9 Evaluation of the Classical Theory of International Trade

Perhaps, the most celebrated doctrine of the classical economics is the theory of comparative costs. Ricardo’s
doctrine of comparative advantage furnishes a logical explanation of the pattern of trade. It also contains a
strong argument for gains of trade and terms of trade. In fact, for more than a century since its publication
in 1817, it has been widely acclaimed as the most correct explanation of international trade. Even now also,
developments in this field are more or less of a complementary nature. This basic classical principle has
been only modified and elaborated in the modern context by many economists of the present generation.

“If theories, like girls, could win beauty contests, comparative advantage would certainly rate high in
that. It is an elegantly logical structure.” – Prof. Sameulson
However, the theory appears to be oversimplified when we try to apply it to the intricate problems of real life.
We, in general, conclude that the theory has no touch with the wet clay of life. Samuelson correctly stated:

“Yet for all its oversimplification – the theory of comparative advantage has in it a most important
glimpse of truth. Any country, which ignores comparative advantage, may suffer a loss in growth. The
other side of the picture should not be glossed over.” – Prof. Sameulson
Classical theory of International Trade, however, suffers from many defects, which are stated by Bertin
Ohlin and Frank D. Graham. Some of these defects are:
(a) Labour – the Only Productive Factor: The classical theory considers labour as the only productive
factor. In reality, production is the combined result of many other factors – land, capital, technology, etc.
(b) Labour Mobility: The classical economists assume that labour is immobile internationally but mobile
locally. But labour is immobile locally due to several factors such as family bond, association, etc.
(c) Restrictive Theory: The classical model of international trade is restricted to two countries and two
commodities. But the world trade today is spread across many nations which deal in many commodities.

11
 Foreign Trade – Theory, Procedures, Practices and Documentation

(d) Homogeneity of Labour: The classical theory assumes that all units of labour are homogenous.
However, in real world, no two persons are same in their skills and abilities.
(e) Absence of Transport Cost: The classical economists completely ignored transportation costs.
However, transportation costs may nullify the comparative cost advantage of a country.
(f) Full Employment: The classical theorists believe in the condition of full employment. But in reality,
there is always a situation of unemployment or underdevelopment in the economy.
(g) Lop-sided: According to the critics, the classical theory considers only supply side, i.e., comparative
cost differences. It fails to consider the demand side of international trade.
(h) Static Theory: According to the modern economists, the classical theory is static in nature and
operates under a number of assumptions while the modern world is highly dynamic.
(i) Division of Labour and Specialisation: According to the modern economists, complete division of
labour and specialisation is not possible.

To sum up, it can be said that there is no essential difference between domestic and international trade.
Both rest on the same foundation, i.e., division of labour, which leads to specialisation and hence, higher
national income. If two nations have different production functions, their costs will also differ. In that case,
they will produce that commodity where the comparative cost advantage is the maximum and comparative
disadvantage is the minimum.
However, modern economists have rejected the classical theory of international trade (the Comparative
Cost Theory) primarily on the ground that it is based upon the obsolete labour cost theory of value. These
economists have increasingly turned to Bertil Ohlin’s theory of international trade, which, according to
them, furnishes a more direct, a more rational and a more realistic explanation of the phenomenon of
international trade. This theory is now dubbed as the modern theory of international trade.

1.10 Do We Need a Special Theory of International Trade?

Bertil Ohlin has strongly advocated that there was absolutely no need for developing a special theory of
international trade. According to his much-quoted statement:

“International trade is but a special case of inter-local or interregional trade.” – Bertil Ohlin

According to him, there are fundamental points of resemblance between inter-regional and international
trade and the kind of analysis applicable to inter-regional trade may be extended without any substantial
change to explain the phenomenon of international trade.
Bertil Ohlin has strongly refuted the arguments put forward by the classical economists in favour of a
separate theory of international trade.
(a) One argument advanced by the classical economists in favour of a special theory of international
trade was that while factors of production were perfectly mobile within the country, they were
immobile between countries. Thus, international immobility of the factors of production was sought
to be made the main reason for having a separate theory of international trade. Bertil Ohlin has,

12
 Evolution of International Trade

however, pointed out that factors of production are found to be immobile even between different
regions of the same country.
Ohlin has further pointed out that it would be wrong to conclude that factors of production are
wholly immobile between different countries. He cites historical examples where labour and capital
migrated from Europe to several parts of the world. Millions of Indians had gone and settled in
neighbouring countries in Middle East and South East.
(b) The classical economists sought to build up a separate theory of international trade on the ground of
the principle of comparative advantage. Bertil Ohlin has, however, pointed out that this principle of
comparative advantage underlies not only international trade but also internal or inter-regional
trade. Different areas or regions of the same country tend to produce those commodities in which
they possess comparative advantage. According to Ohlin, since the principle of comparative cost
advantage is the basis of all trade, there is no justification for developing a special theory of
international trade.
(c) The classical economists sought to justify a separate theory of international trade on the ground that
different currency systems exist in different countries of the world and that international trade was
conducted through the instrumentality of exchange rates mechanism. But Ohlin has refuted this
argument. According to him, the rate of exchange between two currencies is closely connected with
the cost-price structure in the two countries. The rate of exchange represents the external
purchasing power of a currency and the external purchasing power of a currency cannot be isolated
from its internal purchasing power. The external purchasing power of a currency is only a reflection
of its internal purchasing power. Hence, it is not possible to make any fundamental distinction
between local and international trade.

1.11 General Equilibrium Theory of International Trade

Eli Heckscher (1879) is celebrated for his contributions to

international trade theory, particularly the factor proportions
theory of comparative advantage in international trade known as
the Heckscher-Ohlin theory.

First developed by Eli Heckscher (1879-1952) and later refined by fellow Swedish economist Bertil Ohlin
(1899-1979) in 1933, Heckscher-Ohlin trade theory explains the existence and pattern of international
trade based on a comparative cost advantage between countries producing different goods. Heckscher-
Ohlin trade theory is essentially an extension of the generally accepted theory of value, the general
equilibrium (mutual interdependence) theory.

13
 Foreign Trade – Theory, Procedures, Practices and Documentation

Swedish Economist Bertil Ohlin(1899) received the Nobel Prize

in 1977, along with James Meade, for his “pathbreaking contribution
to the theory of international trade and international capital
movements.” Ohlin’s prize was based on his book Interregional and
International Trade, published in 1933.

In 1919, Prof. Heckscher pointed out that international trade is caused due to the differences in the
comparative costs resulting from the differences in relative scarcity (i.e., relative prices) of factors of
production in two countries. Ohlin developed this idea further. According to Ohlin, the differences in factor
prices are caused due to the differences in factor endowments in different countries and the differences in
production functions for different commodities. Hence, Ohlin’s theory is popularly known as factor
endowment theory.
Ohlin accepts Ricardo’s view that the comparative cost difference is the basis of international trade. But
Ricardo did not explain the cause of comparative cost differences in the production of any two commodities
in any two countries. Thus, the modern theory begins where the Ricardian theory ends.
Assumptions of the Simple Model of Hekscher-Ohlin Theory
(a) There are two countries or regions say country I and country II, each having a free paper currency
and each capable of producing any two commodities.
(b) Countries produce either capital-intensive or labour-intensive commodities depending upon the
relative proportion of different factors contained in their production.
(c) There are two factors of production, say, capital and labour, the supply of each being constant and
known. The supply of each factor is assumed to be homogenous.
(d) The relative endowment of these two factors in two countries is different. One country is, say,
capital abundant and the other country is, say, labour abundant.
(e) The factors of production are fully mobile within each region of a country while they are relatively
immobile in between any two regions or two countries.
(f) The demand conditions (consumers’ preferences), as also the physical conditions of production are
constant in both countries or regions.
(g) Perfect competition prevails in factor markets as well as commodity markets. There is full
employment of both the factors, in each of the two countries.
(h) Each country can produce two commodities. Each commodity is subject to the constant returns to
scale in both countries. There are no external economies or diseconomies.
(i) The method of production and the production function for both the commodities are same in
different countries.
(j) There is free trade between the two countries. Transport costs between the two countries are ignored.

14
 Evolution of International Trade

Simple Model of Heckscher-Ohlin Theory of Factor Proportions

According to the modern theory of international trade, differences in commodity prices are the immediate
causes of the inter-regional or international trade and specialisation. The differences in the commodity prices
are caused by the differences in the prices of factors. The differences in the factor prices in different regions or
countries are caused due to the differences in the factor endowments. So, the basis of trade is the differences
in factor endowments and differences in production function. Prof. Sodersten has rightly remarked:
“In a world where factors of production cannot move between countries but where goods can move
freely, trade in goods can be viewed as a substitution for factor mobility. – Prof. Sodersten
The modern theory of international trade has two aspects:
(a) Factor Endowment: According to the Heckscher-Ohlin model, factor endowment is the cause of
inter-regional and international trade.
(b) Factor Price Equalisation: According to the Heckscher-Ohlin model, factor price equalisation is the
effect of international trade.

Factor Endowment:
According to the modern theory of international trade, difference in the commodity prices in two regions or
countries is the basis of international trade. The differences in commodity prices are caused due to
differences in their cost of production. The cost differences between two countries are due to differences in
factor prices, resulting from the differences in relative factor endowments in two countries.
Factor endowments in two countries, viz., country I and country II, can be explained in terms of their
relative prices as under:
(a) In a capital rich country, the ratio of prices of capital to labour would be lower than labour rich
country:
Pk1 < Pk2
PL1 PL2
Thus, a capital rich country will export capital-intensive goods and import labour-intensive goods
from a labour rich country.
(b) In a labour rich country, the ratio of prices of labour to capital would be lower than capital rich
country:
PL2 < PL1
PK2 PK1
Thus, a labour rich country will export labour intensive goods and import capital-intensive goods
from a capital rich country.
In the above price relations,
PK1 stands for price of capital in country I.
PK2 stands for price of capital in country II.
PL1 stands for price of labour in country I.
PL2 stands for price of labour in country II.

15
 Foreign Trade – Theory, Procedures, Practices and Documentation

Ohlin’s theorem may be verified diagrammatically in Fig. 1.1.

LABOUR

Fig. 1.1 Heckscher-Ohlin Model of Factor Endowment

Fig. 1.1 depicts ‘xx’ and ‘yy’ isoquants (equal product curves) for two commodities ‘X’ and ‘Y’ respectively.
These two isoquants intersect only once so that the commodities ‘X’ and ‘Y’ can be classified unambiguously
according to factor intensity. It can be clearly seen that commodity ‘X’ is relatively capital-intensive, since
the amount of capital is represented on the vertical axis. Similarly, commodity ‘Y’ is labour-intensive, since
the amount of labour is represented on the horizontal axis.
Let us assume that there are two countries, country I and country II, of which country I is the relatively
capital-abundant and country II is labour abundant. Now all possible factor combinations (of labour and
capital) that can produce the given amounts of two commodities ‘X’ and ‘Y’ in each country can be read off
from the two isoquants.
Economically, the most efficient factor combination, however, depends upon the relative factor prices. To
consider this, let us assume that the slope of the line PA represents the relative factor prices in country I, i.e.,
(PK1/PL1). The line PA is tangent to isoquant ‘yy’ at point Q. Similarly, isoquant ‘xx’ is also tangential to PA at
point Z. Since we have assumed that (PK1/PL1) < (PK2/PL2), i.e., capital in country I is relatively cheaper, the
slope of the line representing relative factor prices (PK/PL) in country II must be less than that of PA. Thus,
line P’B is supposed to represent factor ratio in country II. Line P’B is tangent to the isoquant ‘yy’ at point T.
Now, the line RS is drawn parallel to P’B such that it becomes tangent to the isoquant ‘xx’ at point M. Line RS
lies above the line P’B implying that OR intercept of RS on the capital axis is greater than OP’, the intercept
of P’B on the same axis.
Under these assumptions, it appears that the equilibrium factor proportions are OZ for commodity X and OQ
for commodity Y in country I. That means, the cost of producing the given amount of commodity X in
country I is the cost of using the quantities of two factors – labour and capital – indicated by OZ at relative
factor prices given by PA. This is equal to the cost of using capital in the amount of OP (the point at which PA

16
 Evolution of International Trade

cuts the capital axis). Similarly, the cost of producing the given amount of commodity Y in country I is equal
to the cost of using capital in the same quantity (OP).

Similarly, in country II, the equilibrium factor proportions are OM for commodity X and OT for commodity
Y. The relative factor prices are shown by P’B (or RS). Therefore, the costs of producing the given amounts
of commodity X and commodity Y (as assumed for country I) in this country are, in terms of capital, OR and
OP respectively. Evidently, in country II the given amount of commodity X is more expensive than the given
amount of commodity Y.
Comparing the relative costs of the equal amounts of the two commodities X and Y in the countries I and II,
we find that commodity X is relatively cheaper in country I and commodity Y is relatively cheaper in country
II. That means, the capital-abundant country has a comparative cost advantage in producing a capital-
intensive commodity X. Thus, with the opening of trade with the other country, it must export commodity X.
Likewise, the labour abundant country must export labour-intensive commodity, i.e., commodity Y.

This is how the Heckscher-Ohlin theorem confines to the position that a country exports goods produced
relatively cheaper by using a relatively greater proportion of its relatively abundant factor.
In a nutshell, we can interpret Ohlin’s theory as under:
(a) Two countries I and II will involve themselves in trade, if relative prices of commodities X and Y are
different. To quote Ohlin, “the immediate cause of inter-regional trade is always that commodity can
be bought cheaper from outside in terms of money than they can be produced at home.”
(b) Under comparative market conditions, prices are equal to average costs. Thus, relative price
differences are an account of cost differences. Cost differences are taking place because of the factor
price differences in the two countries.
(c) Factor prices are determined by factors’ supply and demand. Assuming a given demand, it follows
that a capital-rich country has a cheaper or a lower capital price and a labour-abundant country has
a relatively lower labour price.
In short, a capital-rich and capital-cheap country exports capital intensive products while a labour-
abundant and labour-cheap country exports labour-intensive products.
It also follows that trade takes place because of factor-endowment difference and their international
immobility. Sodersten writes, “In a world where factors of production cannot move among countries but
where goods can move freely, trade in goods can be viewed as a substitution for factor mobility.”
Ohlin gives the illustration of Australia and England in support of his theory. In Australia, land is plenty and
cheap, while labour and capital are scanty and dear. So, Australia specialises in goods like wheat, wool, meat,
etc., which are relatively produced cheaper there on account of their specific production functions requiring a
larger proportion of land but little use of capital. On the other hand, England is capital-rich but labour- poor.
Thus, goods requiring plenty of capital will tend to be relatively cheaper in England. Examining the trade
between England and Australia, it may be observed that Australia imports manufactured or capital-intensive
goods from England and exports wheat, meat, etc. Thus, Australia’s import is indirectly an import of scarce
factors and her export is indirectly an export of factors in abundant supply.

17
 Foreign Trade – Theory, Procedures, Practices and Documentation

Factor Price Equalisation:

Factor price equalisation is an integral part of the Hecksher-Ohlin theory of international trade. According to
the Hecksher-Ohlin theory, the main cause of international trade is the differences in commodity prices
resulting from the differences in factor prices which are caused due to difference in factor endowments. Factor
Price Equalisation theorem analyses the effects of international trade on commodity and factor prices.
According to the Factor Price Equalisation theorem, under the condition of free trade and the absence of
transport cost, the relative prices of commodities tends to equalise in the trading countries and so are the
prices of factors of production. Thus, the main effect of international trade is that it tends to equalise the
prices of factors of production. However, complete factor price equalisation would not occur in the absence
of free movement of factors from one country to another country. A complete factor price equalisation can
occur only when factors are free to move between countries.
Country I is capital abundant country and country II is labour abundant country. Thus, capital is cheap and
labour is costly in country I. As per the theory of international trade, country I specialises in the production
of capital-intensive goods and imports labour-intensive goods from country II. Since country I specialises in
the production of capital-intensive goods, the demand for capital increases in country I and so does its price.
Since country I imports labour-intensive goods from country II, the demand for labour falls in country I and
so does its price. Thus, in country I, price of capital rises and that of labour falls. The opposite forces work in
country II, where the price of labour increases and that of capital falls. This continues till prices of both the
factors equalise in these countries. Thus, free movement of commodities between countries bring about
equalisation in the prices of factors in two countries.
Factor Price Equalisation theorem may be verified diagrammatically in Fig. 1.2.

A Country I
x

P
R
T y

C x
S
U
y Country II
X
O B L D
LABOUR

Fig. 1.2 Heckscher-Ohlin Model of Factor Price Equalisation

In the diagram 1.2, ‘xx’ is the isoquant for capital-intensive goods ‘X’ and ‘yy’ is the isoquant for labour-
intensive goods ‘Y’. These isoquants represent the production functions of the two commodities.

18
 Evolution of International Trade

Country I, being capital-intensive, produces commodity X at point R, where the factor price line AB is
tangent to the isoquant ‘xx’. Country II, being labour intensive, produces commodity Y at point U, where the
factor price line CD is tangent to the isoquant ‘yy’.
Thus, there is more demand for capital in country I and labour in country II. Therefore, the price of capital
will rise in country I and the price of labour will rise in country II. On the other, hand due to lack of demand,
price of labour will fall in country I and the price of capital will fall in country II. Thus, the factor price line
AB of country I becomes flatter and the factor price line CD of country II becomes steeper. This shifting
continues till factor prices in both the countries become almost same. This is depicted by the new factor
price line PL, which is tangent to the isoquant xx at point T and isoquant ‘yy’ at point S, indicating reducing
gap between the factors prices in country I and II. In reality, complete factor price equalisation does not
take place as the theory is based on several simplified assumptions.

1.12 Exchange Rate Mechanism and International Trade

Import and export of commodities between two regions or countries I and II also depend upon the rate of
exchange between their currencies. The rate of exchange helps to find out the differences in the prices of
same factors in regions or countries I and II. This gives an idea of absolute differences in commodity prices.
Suppose that countries or regions I and II have Rupee as their unit of account and that each of them
possesses four factors FA, FB, FC and FD. In the country I, the price per unit of each of these factors is Re. 1
and the price per unit of each of these factors in country Y is ` 0.40, ` 0.45, ` 0.60 and ` 0.70 respectively.
If the exchange rate between the Rupee of country I and the Rupee of country II is Re. 1 of country I = ` 2 of
country II, then the factor price in country II, in terms of the currency of country I, would be as shown in
column 4 of the following table. It shows that the factors FA and FB are cheaper in country II and that the
factors FC and FD are cheaper in country I. Hence, country or region I will specialise in commodities
requiring larger amounts of the factors FC and FD and country or region II will specialise in commodities
requiring larger amounts of FA and FB.
On the other hand, if the rate of exchange is Re. 1 of country I = Rs. 1.50 of country II, the factors FA, FB and
FC will be cheaper in country II and the factor FD will be cheaper in country I as shown in column 5. Hence
country I will specialise in commodities requiring a larger amount of FD and the country II will specialise in
commodities requiring larger amounts of factors FA, FB and FC.
1 2 3 4 5
Factors of Factor Price in Factor Price in Factor Price in Factor Price in
Production country I country II country II when the country II when the
(in ` Per Unit) (in ` Per Unit) rate of exchange is rate of exchange is
Re. 1 of I = ` 2 of II Re. 1 of I = ` 1.5 of II
FA 1 0.40 0.80 0.60
FB 1 0.45 0.90 0.671/2
FC 1 0.60 1.20 0.90
FD 1 0.70 1.40 1.05

19
 Foreign Trade – Theory, Procedures, Practices and Documentation

Thus, each region or country will specialise in and export ‘cheap factor-bounded commodities’ and import
‘dear factor-bounded commodities’.
When the trade takes place between countries I and II, the demand for cheaper goods produced by each of
them will go up. This is because each of them will have to produce not only to meet the internal demand but
also the foreign demand.
Further, Ohlin points out that the rate of exchange and the value of inter-regional or international trade are
determined by reciprocal demands.

1.13 A Complex Model of Ohlin

In order to make his theory more realistic, Ohlin has eliminated one after another, the assumptions on
which his simple model was based and has tried to analyse its effect on direction and composition of
international trade.
(a) Ohlin has extended the factor proportion approach or the general equilibrium approach to multi-
country, multi-commodity model without altering the conclusions.
(b) He has also proved that even if two countries have identical factor units, there can be specialisation
in these two countries and trade can take place.
(c) He has analysed the effect of increasing and decreasing cost conditions in both the countries on
international trade. When goods are produced under increasing cost conditions in different
countries, the volume of international trade would be reduced and vice versa.
(d) He has also considered the qualitative differences in factor resources in each country or region and
has sub-classified them into groups of separate factors. This would make it possible to have an inter-
regional and international comparison of the factor prices in the same group.
(e) Ohlin points out that because of the transport costs and the differences in its qualities, the same
commodity is both exported and imported by a country. Further, transport costs may obstruct the
tendency towards the factor price equalisation in any two countries.
(f) Ohlin also points out that due to the changes in the exchange rates, the prices of the internationally
traded goods will change. Hence, there will be a change in the composition and the flow of
international trade.
(g) Due to international trade, the demand for the abundant factors in each country would go up. Due to
increase in demand, there would be change in the relative factor prices, which in turn would affect
the flow and composition of foreign trade of each country.
(h) Ohlin’s simple model assumes a condition of perfect competition. But, in actual life, there is no
perfect competition. Ohlin has considered the imperfect competition and its effect on the flow and
the direction of international trade.
(i) A close contact between countries may enable a country to acquire new products, capital equipment
and the technical know-how from abroad. Ohlin has considered the effect of these changes on the
composition and direction of trade over a period of time.

20
 Evolution of International Trade

(j) Ohlin has also considered the effect of physical and social conditions on trade. He also considered
the influence on trade due to mobility of certain factors and immobility of certain others between
regions or countries.
(k) He has also considered the influence of tariffs, banking system, habits, language, customs formalities
etc., on the trade between countries.

However, Ohlin did not overcome the assumption of full employment.

1.14 Criticisms of the Modern Theory of International Trade

Though the Modern Theorem (or the Factor Proportions Theory) marks a considerable improvement over
the Classical Comparative Cost Theory of international trade, it is not completely free from criticisms.
(a) Unrealistic Character: The modern theory is grossly unrealistic in character in-so-far as it is
based on certain very oversimplified and unrealistic assumptions, such as, perfect competition,
full employment of productive resources, absence of transport costs, similarity of production
function in the two countries, absence of product differentiation, etc. These assumptions are
unrealistic and even wrong. A theory built on the basis of such assumptions cannot bear any
relationships to reality.

(b) A Partial Equilibrium Analysis: According to this theory, trade between two countries takes place
due to differences in the relative prices of commodities, resulting from differences in factor
endowments. However, the prices of commodities may differ due to other factors, viz., differences in
the quality of factors, production techniques, consumers’ demand, returns to scale, etc. which have
been ignored by the theory. Thus, the theory furnishes only a partial explanation of the phenomenon
of international trade.

(c) Leontieff Paradox: According to the modern theory, relative factor prices in the two countries are
determined by factor endowments, i.e., by the supply of productive factors. However, in reality, the
relative factor prices are determined not only by the supply of productive factors, but also by their
demand. Thus, if demand for a factor is more than its supply, then a capital-abundant country may
specialise in the production and export of labour-intensive goods and vice versa. This is known as
the Leontieff's Paradox.

(d) Commodity Prices Determine Factor Prices: According to this theory, trade between two
countries takes place due to differences in the relative prices of commodities, resulting from
differences in factor endowments in two countries. However, critics hold the view that price of a
commodity is determined by its utility to the consumers. The demand for the commodity is direct
while the demand for a productive factor is derived. Thus, it is the commodity prices, which
determine the factor prices and not vice versa.

(e) Product Differentiation: According to the modern theory, trade between two countries takes place
only when there are differences in their factor endowments. This is because the modern theory
assumes that the products produced by two countries are homogenous or identical. This is rather an

21