TRADE THEORIES

What is Trade?- Exchange of

goods and services
Why do we need to do trade?
 Differences in cost are the basic cause of

trade. Every country will have goods that can

be produced cheaper than others. This
promotes them to export that product for
another. Eg. UAE can produce oil while
Japan can produce electronics and cars. The
two nations can trade with each other and
both are satisfied.
 How does a country decide
what to trade and with whom
to trade?
Adam Smith’s theory of Absolute
Advantage-
 Simplest example- Imagine USA needs 10 workers

to manufacture 1 helicopter but takes 20 men to

build a luxury car.
Germany on the other hand needs 20 workers to
manufacture a
helicopter while only
10 workers for the car.

Do they have any

advantage to trade?
Or can they continue
doing what they’ve been doing?
There’s only one logical
decision to be made by both
countries-
 US must export copters to Germany and
import cars in return! Because instead of
wasting 20 men for making a car, they can
make TWO copters. If US sells it to Germany
they can get back TWO CARS for the cost of
one!

 The result is maximum productivity and profit.

 Every country having absolute
advantage in the production and
distribution of every good is not
possible. So international trade is
important to everyone.
 That is why when sanctions are
imposed on our trade, it affects us
a lot. (India, Pak, Iraq, North
Korea)
 Trade also depends on
relationships between nations.
Reason why heads of state keep
meeting other heads to discuss
better ties for the future. Eg. India
& China, Russia, US etc.
 But what if a country can
produce all the goods it
needs or another country
cannot produce any goods at
all.
Does it mean they should not
and cannot trade?
David Ricardo’s Comparative
Advantage Theory
 Eg. Suppose India and France are cotton and
wine producing countries. France can
produce 1 unit of wine with 50 man hours and
1 unit of cotton with 60 man hours.
 India on the other, the cost of producing 1

unit of wine is 100 working hours and 1 unit

of cotton is 80 man hours.
Does it make sense for France to trade with
India?
Yes, France must trade with
India!
 Because if we calculate, the
cost for France for making 1
unit of wine is 50/60 and 1
unit of cotton is 60/50.
 Which means 1 unit of wine
costs 0.833 units of cotton
and 1 unit of cotton costs
1.2 units of wine. For
France cotton is more
expensive to make than
wine.
 For India, 1 unit of wine is
1.25 units of cotton. and 1
unit of cotton is 0.80 units of
wine. Here wine is more
expensive.
•Therefore both
countries can benefit
if they are willing to
trade with each other.
India can manufacture
cotton and sell to
France in exchange
for wine and France is
also benefited vice
versa.

To understand the
point further, if the
world market price for
1 unit of cotton is
similar to 1 unit of
wine, then France
Logic?

 To make 1 unit of cotton France has to spend

60 man hours which has the same value as 1
unit of wine made in 50 hours. France can
leave the cotton making work to India and
save those 10hours or add those 10hours
extra for making more wine.
 India on the other hand can save 20 hours
every time it makes cotton and gets back
equivalent amount of wine as needed.
 Heckscher Ohlin Theory (H-O

Model)
Goods differ in terms of the factors of production. Eg.
Manufacturing of textiles is labour intensive whereas
producing microprocessors is capital intensive.
 Countries differ w.r.t. their factor capabilities. Eg. India
is high in labour but UK is high in capital.
 A country manufactures and uses those factors which
it has in abundance. Eg. US exports capital intensive
defense goods.

 As with previous theories,

HO Model too is weak in the fact
that it states markets as being static
with factors also being constant.
Present markets change using
innovation, intelligence
(Indian software), taste and
need for the goods and other reasons.
Strategic Trade Theory-
Combination of the latest
trade theories. Key factors
 Increasing returns to scale- firms will produce and
export more and more inorder to lower costs through
economies of scale.
 Product differentiation- there can also be intra-
industry competition. i.e. within the same industry we
can have trade. Eg. Japan will trade Toyotas and Honda
with Germany in exchange for Mercedes and BMWs.
 Imperfect competition- companies might have to face
various hurdles to sell to other nations. Eg. India might
give special subsidies to Videocon so as to keep
Japanese Sony and Aiwa costlier than domestic
players.
 Externalities & spillover effects-
Once a new technology product is
sold outside, other countries might
reverse-engineer and make their own
versions. Thus the original maker
suffers losses of loss of market. IP
rights and patents play a role.
 Irreversible investments- eg. When
earth-moving equipment companies
like Caterpillar suffered huge losses
in 1980’s they had no choice but to
continue as such because
the costs for market reentry
would have been sky high
(building distribution
networks, partners etc.)