Chapter 6

International Trade Theory

 Free Trade

Free trade is a situation where a

government does not attempt to
influence through quotas or duties
what its citizens can buy from another
country or what they can produce and
sell to another country.

• Each and every theory encourages the

free trade situation.
 Mercantilism
Mercantilism (mid-16th century) suggests that it is
in a country’s best interest to maintain a trade
surplus -to export more than it imports.

• At that time gold and silver were the currency of

trade between countries and country always tries
to accumulate more gold and silver to increase its
national wealth, prestige and power.

• The mercantilist doctrine advocates government

intervention to achieve a surplus in the balance of
trade.

• Mercantilism views trade as a zero-sum game.

 Smith’s Theory
Of Absolute Advantage

Adam Smith (1776) argued that a

country has an absolute advantage in
the production of a product when it is
more efficient than any other country
in producing it.
– countries should specialize in the
production of goods for which they
have an absolute advantage and
then trade these goods for goods
produced by other countries
 How Does The Theory
Of Absolute Advantage Work?
• Assume that two countries, Ghana and South
Korea, both have 200 units of resources(taka) that
could either be used to produce rice or cocoa
Cocoa (1 ton) Rice (1 ton)
Ghana 10 units resources 20 units resources
**Formula for Ab. Adv. A (100% invest)
South Korea 40 units resources 10 units resources
-Compare same product
with different countries A (100% invest)

-more efficient=Ab. Adv.

G SK
1. Finding Abs Adv C R
2. Specialized C R
3.Export C (-) R (-)
4.Import R (+) C (+)
 How Does The Theory
Of Absolute Advantage Work?
Without Trade
Cocoa (100 Resources) Rice (100 Resources) Total
Ghana (100/10) 10 tons (100/20) 5 tons 15 tons
South Korea (100/ 40) 2.5 tons (100/10) 10 tons 12.5 tons

With specialization
Cocoa Rice Total
Ghana (200/10)20 tons 0 ton 20 tons
South Korea 0 tons (200/10) 20 tons 20 tons

After Trade (Assume Ghana

Cocoacould trade 6 tonsRice
of cocoa to South Korea for 6 tons of rice)
Total
Ghana (20-6)14 tons (0+6) 6 tons 20 tons
South Korea (0+6) 6 tons (20-6)14 tons 20 tons

 Trade is a positive sum game

 Ricardo’s Theory
Of Comparative Advantage
• David Ricardo asked what happens when one
country has an absolute advantage in the
production of all goods???

• The theory of comparative advantage (1817)

- countries should specialize in the
production of those goods they produce
most efficiently and buy goods that they
produce less efficiently from other countries
– even if this means buying goods from
other countries that they could produce
more efficiently at home
 How Does The Theory Of
Comparative Advantage Work?

• Assume Ghana is more efficient in the production of

both cocoa and rice than South Korea (Total amount
of resources is 200Taka for both of the Countries)
Cocoa (1 ton) Rice (1 ton)
Ghana 10 units resources 13.5 units resources
**Formula for Comp. Adv. A/C (75%) A (25%)
-Compare different South Korea 40 units resources 20 units resources
products in same country (0% invest) C (100%)
-most efficient=Comp.
Adv. Ghana SK
1. Comp. Adv. C R
2. Specialization C R
3. Export C(-) R(-)
4.Import R(+) C(+)
 How Does The Theory Of
Comparative Advantage Work?
• Without Trade
Cocoa (100 Resources) Rice (100 Resources) Total
Ghana (100/10) 10 tons (100/13.5) 7.5 tons 17.5 tons
South Korea (100/40) 2.5 tons (100/20) 5 tons 7.5 tons
Total 12.5 tons 12.5 tons

• With Specialization
Cocoa Rice Total

Ghana 15 tons (150 Resources) 3.75 tons (50 Resources) 18.75 tons

South Korea 0 ton (0 Resources) 10 tons (200 Resources) 10 tons

Total 15 tons 13.75 tons

 How Does The Theory Of
Comparative Advantage Work?

• After Trade (assume Ghana exports 4 tons of cocoa to South Korea in exchange for 4
tons of rice)
Cocoa (100 Resources) Rice (100 Resources) Total
Ghana (15-4) 11 tons (3.75+4) 7.75 tons 18.75 tons
South Korea (0+4) 4 tons (10-4) 6 tons 10 tons
Total 15 tons 13.75 tons

• So If each country specializes in the production of the good in which it has a

comparative advantage and trades for the other, both countries gain
• Comparative advantage theory provides a strong rationale for encouraging free trade as
– total output is higher than before
– both countries get benefit

• Trade is a positive sum game

 The Heckscher-Ohlin Theory
• Eli Heckscher (1919) and Bertil Ohlin (1933) - comparative advantage arises
from differences in national factor endowments
– the extent to which a country is endowed with resources like land,
labor, and capital
• The more abundant a factor, the lower its cost=> efficient
• Unlike Recardo’s theory argues that international trade pattern is
determined by differences in factor endowment rather than differences in
productivity.
• Heckscher and Ohlin predict that countries will
– export goods that make intensive use of locally abundant factors
– import goods that make intensive use of factors that are locally scarce