The trade between the two countries is called international trade, foreign trade, or external trade. International trade is different from Domestic trade which is discussed in this article.
Roles of International Trade
- Proper Use of Factors of Production
- Effective Resource Allocation
- Optimum Production and Maximum Welfare
- Widening of Market
- Innovation in Methods
- Increased Savings and Investment
- Educative Effect on Concerned Countries
The importance of international trade
- Division of Labour and Specialization
- Rational Allocation of Resources
- Better Use of Surplus Production
- Availability of Multiple Options
- Price Equalization
- Economic Development
- Foreign Exchange
- International Cooperation
- Trade and Payment Balance
- Builds Cultural Relations
Domestic Trade vs. International Trade – Key Differences
Now let’s understand the distinction between domestic and international trade.
Mobility of Factors
Factors of production are more mobile within the country in the case of internal trade, while their mobility is highly restricted between countries in international trade.
In domestic trade, each country uses indigenous natural resources, which differ in quality and quantity. By contrast, in international trade, differences in natural resources lead to the production of different goods by different countries.
Unlike domestic trade, where workforces are similar, different countries have different types of workforces that vary in quality and quantity, as well as in technical knowledge and work culture.
Geographical and Climatic Conditions
Unlike domestic trade, in international trade, each country with different weather conditions produces commodities that are more suited to its own geographical and climatic conditions.
Cultural and Social Environment
In contrast to the homogeneity within the same country, external trade between countries involves dealing with differences in language, customs, traditions, relations, and other cultural and social environmental factors.
Political and Commercial Laws
Unlike internal trade, each country involved in foreign trade has different rules, regulations, and laws governing political and commercial systems, and mutual understanding needs to be arrived at.
Within a country, trade is carried out using the same currency, while international trade warrants the use of different currencies for trading.
Classical Theory of International Trade
Ricardian Theory (Classical Theory) of International Trade
states that “each country will specialize in the production of those commodities in which it has a greater comparative advantage or less comparative disadvantage.”
Assumptions in the Classical Theory of International Trade
- Two countries producing two commodities using one factor of production.
- All labour units are homogeneous.
- Factors of production are mobile within the country.
- Production is subject to laws of constant returns to scale.
- Trade is unrestricted or free.
- No transport cost is incurred in the trade between the two countries.
- There is perfect competition in the commodity market.
- All factors of production are fully employed.
Under these assumptions, consider two countries A & B and two commodities to be produced X & Y.
Cost differences are of three types
- Smith’s Comparative Cost Doctrine, there is Absolute cost difference and Equal cost difference.
- Ricardo’s Comparative Cost Doctrine includes Comparative cost difference.
Let us understand each of these in detail.
Absolute Cost Difference
Absolute costs differences occur when one country produces a commodity at a lower cost than the other.
The table shows that country A produces commodity X at a lower cost compared to country B, whereas country B produces commodity Y at a lower cost than country A.
If country A specializes in producing commodity X and exports it to country B, the former country can exchange 1 unit of commodity X for 2 units of commodity Y.
This is favourable from the viewpoint of country A because the domestic exchange ratio is 1 unit of commodity X for 1/2 unit of commodity Y.
Equal Cost Differences
Equal differences can be found when the two countries produce two commodities in the same ratio.
According to the table, country B can produce both commodities X and Y at a lower cost than country A. However, the two countries will not engage in trade because the labour cost of producing commodity X in terms of commodity Y is equal in both countries.
Given that the domestic exchange ratios of both countries are equal, neither country will benefit from trade.
Comparative Cost Differences
Comparative cost differences arise when one country wields absolute advantage in producing both commodities but the comparative advantage in only one.
According to the table, country A can produce both commodities X & Y at a lower labour cost than country B. However, country A can benefit more by specializing in producing commodity X because it stands to receive only 1/2 unit of commodity Y in exchange for 1 unit of commodity X domestically.
However, by trading with country B, country A can receive 2/3 units of commodity Y in exchange for 1 unit of commodity X.
Criticisms of Classical Theory of International Trade
- Unrealistic and Constant Assumptions
- Trade Restrictions
- Ignoring Transport Cost
- Differences in Labour Efficiency
- Restrictive Model
- One-Sided Theory
- Complete Specialization
- Full Employment Assumption
Heckscher–Ohlin or Factor Endowment Theory
The modern theory of international trade is called Heckscher–Ohlin’s Theorem or the Factor Endowment Theory.
According to this theory, “countries which are rich in labour will export labour-intensive goods and countries which have plenty of capital will export capital-intensive products.”
Assumptions of Modern Theory of International Trade
- There are two countries, A and B.
- There are two factors, labour and capital.
- There are two goods, X (labour-intensive) and Y (capital-intensive).
- Countries A and B are labour-abundant and capital-rich, respectively.
- There is perfect competition in both the commodity and the factor markets.
- There are constant returns to the scale because all production functions are homogeneous.
- There are transport costs in trade.
- Demand conditions in both countries are identical.
Explanation of Heckscher–Ohlin or Factor Endowment Theory
In the diagram, XS and YV indicate isoquants or equal product curves for two goods X and Y, respectively.
- Line PA is the Relative factor price in country A
- Line P1B is the Relative factor price in country B
- Line PA is tangential to isoquant XS at point T
- Line P1Bis tangential to isoquant YV at point M
- Now, line RS is plotted parallel to PA such that it is tangential to isoquant YV at point N.
Factor Intensity refers to commodity measurements in the absolute sense.
2. Factor Abundance
Factor Abundance refers to factor endowments in the relative sense.
Comparing the relative costs of equal amounts of two goods X and Y in countries A and B, we find:
Goods X and Y are relatively inexpensive in countries A and B, respectively.
The equilibrium factor proportions are as follows
In Country A: OM and OL for Goods Y and X, respectively
In Country B: OT and ON for Goods X and Y, respectively
Factor Abundance: The labour-abundant country can produce labour-intensive goods at a lower cost. Hence, when opening trade with the other country, it must export such goods only. Likewise, the capital-abundant country must export capital-intensive goods.
Conclusions of this theory
The difference between commodity prices in the two countries is the basis of international trade.
This difference can result from cost differences, which are caused by differences in factor endowments between the countries.
A capital-rich country specializes in the production and export of capital-intensive goods, whereas a labour-abundant country specializes in the production and export of labour-intensive goods.
Drawbacks of this theory
- Partial equilibrium
- One-sided theory
- Many possible explanations
- Defective logic