International Trade Theories

THEORIES OF ABSOLUTE ADVANTAGE & COMPARATIVE ADVANTAGE

Absolute Advantage – Adam Smith (1776)The ability of a country to produce a good using fewer

resources than another country

If U.S. workers are more productive in producing machines (e.g. computers) and Indian workers are more productive in producing cloth (e.g. ready made garments), thenThe U.S. has an absolute advantage in machine production.

India has an absolute advantage in cloth production.

Trade Based on Absolute Advantage

Principle of Absolute Advantage

Assumptions: Labour is the only factor of production and it is homogeneous.Cost or price of a good depends exclusively upon the amount of labour required to produce it. Thus, if U.S. uses less labour to produce a machine than India, production cost (of machine) will be lower in U.S.

So Adam Smith’s concept of cost was founded upon the Labour Theory of Value

In a two-nation two-product world, international trade and specialization will be beneficial when one nation has an absolute cost advantage in one good and the other nation has absolute cost advantage in the other good.

Absolute Advantage- An illustration

Country Output per labour day

Machine (no.) Cloth (yards)

India 2 15

United States 5 10

A case of Absolute Advantage when each nation is more efficient in the production of one good

India could get machines cheaper from U.S. U.S. could get cloth cheaper from India. Both countries benefit if trade occurs.

• U.S. produces machines and exports them to India

• India produces cloth and exports it to the U.S.

World output increases by 3 machines and 5 yards of cloth.

Absolute Advantage

Gains from Trade: Absolute Advantage

The Gains from Trade = The increase in world production and consumption resulting from specialization and trade.This increase in output is

allocated between U.S. and India through international trade.

Country Output per labour day

Machines (no.) Cloth (yards)

India -2 15

United States 5 -10

Change in World Output

+ 3 +5

A Question

•What happens if U.S. can produce both the goods (machines & cloth) more efficiently than India?

•Will there be still trade possible between U.S. and India?

•Answer is YES according to the Principle of Comparative Advantage

The Principle was developed by David Ricardo (1817) According to Ricardo mutually beneficial trade can occur

even when one nation is absolutely more efficient in the production of all goods.

The basis for international trade was comparative cost differences among the nations

Countries often develop comparative advantages resulting from natural advantages and acquired advantages

Principle of Comparative Advantage

World consists of two nations, each using a single input labour to produce two goods

Each nation has a fixed endowment of labour and labour is fully employed and homogeneous

Labour is perfectly mobile within a nation, not between the nations The level of technology is fixed for both nations Costs don’t vary with the level of output and are proportional to the

amount of labour used Perfect competition prevails in all markets Free trade between the nations (no. govt. intervention) Transportation costs are zero Firms seek profit maximization, while consumers utility maximization No money illusion Trade is balanced

Ricardo’s Comparative Advantage Principle: Assumptions

Comparative Advantage-An Illustration

Country Output per labour day

Machines (no.) Cloth (yards)

India 1 5

United States 5 15

U.S. is more efficient than India in the production of both the goods viz. machines and cloth. But U.S. is five times more efficient in machine production, but only thrice as efficient in cloth production. So U.S. has greater absolute advantage in machines than in cloth. India has lesser absolute disadvantage in cloth, as compared to machine production.

Trade Based on Comparative Advantage

U.S. has comparative advantage in machines and India in cloth. Each nation should specialize in the product in which it has comparative advantage and export it for obtaining other good(s). So, India should produce cloth and export it to the U.S., who, in turn, should specialize in machines production and buy cloth from India.

Comparative Advantage in Money Terms

 Country/ Product Computer RMG Av. wage/day

India 1 5 Rs. 900

US 5 15 US $90

  Cost of Production (in respective country currency)

India Rs. 900 Rs. 180  

US $ 18 $ 6  

  Cost of Production (in a common currency) 1 US $= Rs. 40

India $22.5 $4.5  

US $18.0 $6.0  

Even though U.S. has an absolute advantage in both goods, India has a comparative advantage in production of cloth.

Even if U.S. has an absolute advantage in both goods, beneficial trade is possible.

If both countries specialize according to their comparative advantage, they both gain from this specialization and trade. World output also increases.

Comparative Advantages: Summary

Ricardo considered labour as the only factor of production. But in reality labour is only one of several factor inputs.

It ignores the concept of opportunity cost. The Ricardian framework would collapse if the

trading partners are of unequal size. One country’s supply should be sufficient enough to meet its trading partner’s demand.

It does not consider other costs associated with trade e.g. freight, insurance etc.

The price of a product is determined not only by costs of production, but also by demand. But no role was assigned to the demand for products in determining trade between nations.

Limitations of the Comparative Advantage Theory

Ricardo’s theory implies that each country will export goods for which its labour is relatively productive compared with that of its trading partners.

However, comparative advantage in a product may vanish over time when productivity growth falls behind that of its foreign competitors

Productivity may also change due to change in technology

Is then the Theory of Comparative Advantage is valid in real world?

The first test on the model was done by a British economist G.D.A. MacDougall in 1951

Examined export patterns of 25 industries between US and UK.

His results strongly supported the Ricardian Theory

Evidence on Comparative Advantage

Another study was undertaken by Stephen Golub, who examined the relationship between relative unit labour costs (the ratio of wages to productivity) and trade for the United States vis-à-vis UK, Japan, Germany, Canada and Australia.

He found that relative unit labour cost helps to explain trade patterns for these countries.

The US and Japanese results lend particularly good support for the Ricardian model.

Evidence on Comparative Advantage

What are the sectors that India has comparative advantages?

According to a study by the ICRIER (2005) India has comparative advantages in a few sectors, such as

Organic chemicals, Textiles (cotton, silk, carpets, articles of

apparel accessories etc.), Iron & steel Pearls, precious stones, metals, coins etc. Tea, coffee & spices

India’s Comparative Advantage

India’s comparative advantage in ITES sector is well recognized world over ( India has become an attractive centre for BPO/ KPO activities)

Factors leading to India’s success in the sector are:

English speaking population India’s Education System (specially technical

education) Improving infrastructure (e.g. telecom ) Entrepreneurial Skills Govt. Policy (less interference in the sector) Others

Factors Contributing to India’s Comparative Advantage in ITES sector