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1. Classical Theory of International Trade:
Mercantilism is an economic theory that holds the prosperity of a state as dependent upon itssupply of capital that the global volume of international trade is "unchangeable," and that one
party may benefit only at the expense of another. "Unchangeable" in this sense may be taken tomean that the European and global economies are seen as zero-sum games, though that economicconcept did not yet exist in the mercantilist period. During it, economic assets (or capital) were
represented by bullion (gold, silver, and trade value), which was best increased through a
positive and healthy balance of trade with other states (exports minus imports).
The theory assumes that wealth and monetary assets are identical. Mercantilism suggests that theruling government should advance these goals by playing a protectionist role in the economy by
encouraging exports and discouraging imports, notably through the use of subsidies and tariffs
respectively. The theory dominated Western European economic policies from the 16th to thelate-18th century.[1]
ASSUMPTIONS:
Economic philosophy based on belief that -
a) A nation’s wealth depends on accumulated treasure, usually gold, and
b) To increase wealth, government policies should promote exports and discourage imports
c) Wealth and monetary assets are identical
CRITISISMS:
a) A nation’s wealth is not based on only treasure but also can be human resource, technological
knowledgw and “ know how”
b) No country is self sufficient and that’s why import is necessary. Moreover, always export may
not be logical if transportation cost is high.
c) Wealth and monetary assets of all country is not same.
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Classical theory developed by Karl Marx. The theory is based on three basic assumptions.
ASSUMPTIONS:
a) Basis of international trade: All countries international trade is on same basis.
b) Export and import of trading countries: All countries are not exporting and importing same
goods.
c) Gains from international trade and distribution method: there are different bases of
international trade and different methods of distributions of goods.
CRITISISMS:
a) Basis of international trade is not same for all countries
b) Export and import capabilities of each country are different.
c) No country enjoys absolute cost advantages.
2. Ricardian Theory of International Trade
The Ricardian model focuses on comparative advantage (if one country is more efficient inthe production of all goods (absolute advantage), it can still gain by trading with a
less-efficient country, as long as they have different relative efficiencies), perhaps the
most important concept in international trade theory. In a Ricardian model, countries specializein producing what they produce best. Unlike other models, the Ricardian framework predicts that
countries will fully specialize instead of producing a broad array of goods.
The Ricardian model of international trade attempts to explain the difference in comparative
advantage on the basis of technological difference across the nations. The technologicaldifference is essentially supply side difference between the two countries involved in
international trade. The Ricardian model assumes all other factors to be similar across the
countries.
The Labor Theory of Value forms the basis of the Ricardian model of trade. This model putstress on technological difference as the prime reason behind the trading activities. Unlike other
international trade theories, which propose that trade is beneficial for some, but not favorable for
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others, the Ricardian model of trade highlights on the fact that trade is beneficial for all the
countries involved in international trade. This model suggests that even a backward economy
that uses inferior technology is going to benefit from international trade.
The analysis of Ricardian model crucially depends on the implications of the Labor Theory of
Value. The major implications of labor theory of value include the following:
1) Labor is the only major factor of production.
2) Labor is absolutely mobile between sectors within the domestic boundary; however immobileacross countries.
3) Labor units are homogeneous within a country.
According to the Ricardian model of trade, the demand side conditions come in
handy in determining the trade compositions and gains from trade, after trade
opens up. Demand plays a crucial role in the determination of international terms of
trade in the Ricardian model only after opening up of trade.
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Suppose there are two countries of equal size, India and Bangladesh, that both produce and consume two
goods, food and clothes. The productive capacities and efficiencies of the countries are such that if both
countries devoted all their resources to food production, output would be as follows:
• India: 100 tonnes• Bangladesh: 400 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
• India: 100 tonnes• Bangladesh: 200 tonnes
Assuming each has constant opportunity costs of production between the two products and both
economies have full employment at all times. All factors of production are mobile within the countriesbetween clothes and food industries, but are immobile between the countries. The price mechanism must
be working to provide perfect competition.
Bangladesh has an absolute advantage over India in the production of food and clothes. There seems to be
no mutual benefit in trade between the economies, as Bangladesh is more efficient at producing both
products. The opportunity costs shows otherwise. India's opportunity cost of producing one tonne of foodis one tonne of clothes and vice versa. Bangladesh's opportunity cost of one tonne of food is 0.5 tonne of
clothes, and its opportunity cost of one tonne of clothes is 2 tonnes of food. Bangladesh has a comparativeadvantage in food production, because of its lower opportunity cost of production with respect to India,
while India has a comparative advantage in clothes production, because of its lower opportunity cost of
production with respect to Bangladesh.
To show these different opportunity costs lead to mutual benefit if the countries specialize production andtrade, consider the countries produce and consume only domestically. The volumes are:
Production and consumption before trade
Country Food Clothes
India 50 50
Bangladesh 200 100
TOTAL 250 150
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This example includes no formulation of the preferences of consumers in the two economies which would
allow the determination of the international exchange rate of clothes and food. Given the productioncapabilities of each country, in order for trade to be worthwhile India requires a price of at least one tonne of
food in exchange for one tonne of clothes; and Bangladesh requires at least one tonne of clothes for twotonnes of food. The exchange price will be somewhere between the two. The remainder of the example workswith an international trading price of one tonne of food for 2/3 tonne of clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will be:
Production after trade
Country Food Clothes
India 0 100
Bangladesh 300 50
TOTAL 300 150
World production of food increased. Clothes production remained the same. Using the exchange rate of onetonne of food for 2/3 tonne of clothes, India and Bangladesh are able to trade to yield the following level of
consumption:
Consumption after trade
Country Food Clothes
India 75 50
Bangladesh 225 100
World total 300 150
India traded 50 tonnes of clothes for 75 tonnes of food. Both benefited, and now consume at points outsidetheir production possibility frontiers.
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Assumptions
• Two countries, two goods - the theory is no different for larger numbers of
countries and goods, but the principles are clearer and the argument easier
to follow in this simpler case.
• Equal size economies - again, this is a simplification to produce a clearer
example.
• Full employment - if one or other of the economies has less than full
employment of factors of production, then this excess capacity must usually
be used up before the comparative advantage reasoning can be applied.
• Constant opportunity costs - a more realistic treatment of opportunity
costs the reasoning is broadly the same, but specialization of production can
only be taken to the point at which the opportunity costs in the two countries
become equal. This does not invalidate the principles of comparative
advantage, but it does limit the magnitude of the benefit.
• Perfect mobility of factors of production within countries - this is
necessary to allow production to be switched without cost. In real economies
this cost will be incurred: capital will be tied up in plant (sewing machines are
not sowing machines) and labour will need to be retrained and relocated. This
is why it is sometimes argued that 'nascent industries' should be protected
from fully liberalised international trade during the period in which a high cost
of entry into the market (capital equipment, training) is being paid for.
• Immobility of factors of production between countries - why are there
different rates of productivity? The modern version of comparative advantage
(developed in the early twentieth century by the Swedish economists Eli
Heckscher and Bertil Ohlin) attributes these differences to differences in
nations' factor endowments. A nation will have comparative advantage in
producing the good that uses intensively the factor it produces abundantly.
For example: suppose the US has a relative abundance of capital and India
has a relative abundance of labor. Suppose further that cars are capital
intensive to produce, while cloth is labor intensive. Then the US will have a
comparative advantage in making cars, and India will have a comparative
advantage in making cloth. If there is international factor mobility this can
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change nations' relative factor abundance. The principle of comparative
advantage still applies, but who has the advantage in what can change.
• Negligible transport cost - Cost is not a cause of concern when countries
decided to trade. It is ignored and not factored in.
• Test and production technique- consumer’s test of goods are same and
the technique of production is given. .
• Perfect competition - this is a standard assumption that allows perfectly
efficient allocation of productive resources in an idealized free market.
• Average cost of production- it is assumed that average cost of production is
stable within the countries.
• Value of labor theory- it is assumed that all labors are of same qualities,
trained and equally efficient.
http://en.wikipedia.org/wiki/Comparative_advantage
CRITISISM
For considerable period the theory of comparative costs formulated by DavidRicardo was the most acceptable explanation of the international trade. However,
Ricardo's theory was subjected to number of criticisms.
1. Restrictive Model
Ricardo's Theory is based on only two countries and only two commodities. But international
trade is among many countries with many commodities.
2. Labour Theory of Value
Value of goods is expressed in terms of labor content. Labor Theory of value developed by
classical economists has too many limitations and thus is not applicable to the reality. Value of
goods and services in the real world are expressed in money i.e. the prices are the valuesexpressed in units of money.
3. Full employment
The assumption of full employment helps the theory to explain trade on the basis of comparative
advantage. The reality is far from full employment. Cost of production, even in terms of labor,
may change as the countries, at different levels of employment move towards full employment.
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4. Ignore transport cost
Another serious defect is that the transport costs are not consider in determining comparative
cost differences.
5. Demand is ignored
The Ricardian theory concentrates on the supply of goods. Each country specialises in the
production of the commodity based on its comparative advantage. The theory explains
international trade in terms of supply and takes demand for granted.
6. Mobility of factor of production
As against the assumptions of perfect immobility between the countries, we witness difficultiesin the mobility of labor and capital within a country itself. At the same time their mobility
between nations was never totally absent.
7. No Free Trade
Ricardian theory assumes free trade i.e. no restriction on the movement of goods between the
countries which is unrealistic to assume not to have any restriction. What the real world
witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it
difficult to enjoy the comparative advantage in the production of labour intensive commoditiesdue to the protectionist policies followed by developed countries.
8. Complete specialisation
The comparative advantage theory comes to conclusion of complete specialization. In theRicardian example, England is specializing fully on cloth and Portugal on wine. Such complete
specialization is unrealistic even in two countries and two commodities model. It is possible if
two countries happen to be almost identical in size and demand. Again, a complete specializationin the production of less important commodity is not possible due to insufficient demand for it.
9. Static Theory
The modern economy is dynamic and the comparative cost theory is based on the assumptions of
static theory. It assumes fixed quantity of resources. It does not consider the effect of growth.
10. Not applicable to developing countries
Ricardian theory is not applicable to developing countries as these countries are nowhere near to
full employment. They are in the process of change in quality of their labour force, quality of
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capital, technology, tapping of new resources etc. In other words developing countries exhibit all
the characteristics of dynamic economy.
11. Constant Returns to Scale
Another drawback of the Ricardian principle of comparative costs is that assumes constant
Returns to scale and thus constant cost of production in both the countries. The doctrine holds
that if England specialises in cloth; there is no reason why it should produce wine. Similarly if
Portugal has a comparative advantage in producing wine, it will not produce cloth; but import allcloth from England. If we examine the pattern of international trade in practice, we find it is not
so. A time will come when it will not be reasonable for Portugal to import cloth from England
because of increasing cost of production. Moreover, in actual practice a country produces a
particular commodity and also imports a part of it. This phenomenon has not been explained bythe theory of comparative costs.
http://kalyan-city.blogspot.com/2011/02/criticism-limitations-of-ricardian.html
Ricardo expounded the theory of comparative advantage without explaining the ratios at which
commodities would exchange for one another. It was J. S. Mill who discussed the problem of
ratios in detail in term of his theory of “Reciprocal Demand”. The term ‘reciprocal demand’ wasintroduced by Mill to explain the determination of the equilibrium terms of trade. It is used to
indicate a country’s demand for one commodity in terms of the quantities of other commodities
it is prepared to give up in exchange. It is reciprocal demand that determines the terms of trade
which in turn determine the relative share of each country. Equilibrium would be established atthat ratio of exchange between the two commodities at which quantities demanded by each
country of the commodity which it imports from the other should be exactly sufficient to pay for
another.
To explain his theory of reciprocal demand, Mill first restated the Ricardian theory of comparative costs, “Instead of taking as given the output of each commodity in two countries,
with the labour costs different, he assumed a given amount of labour in each country but
differing outputs. Thus his formation ran in terms of comparative advantage or comparativeeffectiveness of labour, as contrasted with Ricardo’s comparative labour cost.
Assumptions:
Mill’s theory of reciprocal demand is based on the following assumptions.
1. There are two countries, say, England and Germany.
2. There are two commodities, say, linen and cloth.
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3. Both the commodities are produced under the law of constant returns.
4. There are no transport costs.
5. The needs of the two countries are similar.
6. There is perfect competition.
7. There is full employment.
8. There is free trade between the two countries.
9. The principle of comparative costs is applicable in trade relations between the two countries.
Given these assumptions Mill’s theory of reciprocal demand can be explained with the help of
following table.
Quantities of Commodities Produced:
Country Output
Linen Cloth
Germany 10 10
England 6 8
Suppose Germany can produce 10 units of linen or 10 units of cloth within one man-year and
England can produce 6 units of linen or 8 units of cloth with the same input of labour-time.According to Mill “This supposition then being made, it would be in the interest of England to
import linen from Germany and of Germany to import cloth from England”. This is becauseGermany has an absolute advantage in the production of both linen and cloth, while England has
the least comparative advantage in the production of cloth. This can be seen from their domesticratios and international exchange ratios.
Before trade, the domestic cost ratios of linen and cloth in Germany is 1:1 and in England is 3:4.
If they were to enter into trade Germany’s advantage over England in the production of linen is
5:3 (or 10:6) and in the production of cloth 5:4 (or 10:8). Since 5/3 is greater than 5/4. Germanypossesses greater comparative advantage in the production of linen. Thus it is in Germany’s
interest to export linen to England in exchange of cloth. Similarly England’s position in the
production of linen is 3/5 (or 6/10) and in production of cloth is 4/5 (or 8/10). Since 4/5 is greater
than 3/5, it is in the interest of England to export cloth to Germany in exchange for linen.
Miller’s theory of reciprocal demand relates to the possible terms of trade at which the two
commodities will exchange for each other between the two countries. The terms of trade refer to
the barter terms of trade between the two countries i.e. the ratio of the quantity of imports for given quantity of exports of a country. And “the limits to the possible barter terms of trade (the
international exchange ratio) are set by domestic exchange ratios established, by the relative
efficiency of labour in each country. To take an example in Germany 2 inputs of labour time
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produce 10 units of linen and 10 units of cloth, while in England the same labour produces 6
units of linen and 8 units of cloth. The domestic exchange ratio between linen and cloth in
Germany is 1:1 and 1:1.33 in England. Thus the limits of possible terms of trade are linen: 1cloth in Germany and 1 linen: 1.33 cloths in England. Thus the terms of trade between the two
countries will be between 1 linen or 1 cloth or 1.33 cloths.
But actual ratio will depend upon reciprocal demand i.e. “the strength and elasticity of each
country’s demand for the other country’s product”. If Germany’s demand for England’s cloth ismore intense (inelastic) then the terms of trade will be nearer 1:1 Germany will be prepared to
exchange one unit of linen with one unit of cloth of England. The terms of trade will move
against it and in favour of England. Consequently Germany’s gain from trade will be less thanthat of England. On the other hand if Germany’s demand for England’s cloth is less intense
(more elastic) then the terms of trade will be nearer 1:1.33. Germany will be prepared to
exchange its one unit of linen with 1.33 units of cloth of England. The terms of trade will movein favour of Germany and against England. Consequently Germany’s gain from trade will be
greater than that of England.
In short “(1) The possible of barter terms is given by the respective domestic term of trade as set
by comparative efficiency in each country (2) with in this range, the actual terms of trade dependon each country’s demand for the other country’s produce and (3) finally, only those barter terms
of trade will be stable at which the exports offered by each country just suffice to pay for the
imports it desires”.
Criticism of the Theory:
Mill’s theory of reciprocal demand is based on almost the same unrealistic assumptions that wereadopted by Ricardo in his doctrine of comparative advantage. Thus the theory suffers from
weaknesses. Besides, there are some additional criticism made by Viner, Graham and others.
1. Mills theory of reciprocal demand does not take into account the domestic demand for theproduct, as pointed out by viner, each country would export its product only after satisfying its
home demand. Thus the demand curve for Germany would not be below the line until the
domestic demand was satisfied and same applies to England.
2. According to Graham Mills analysis is valid only if the two countries are of equal size and thetwo commodities are of equal consumption value. In absence of these two assumptions if one
country is small and the other large, the small country gains the most on both counts, first if it
produced a high value commodity, it will adopt the cost ratios of its big partner and second the
two trading countries being of unequal size the terms of trade will be fixed at or near thecomparative costs of the large country. Graham further criticises Mill for emphasising demand
and neglecting supply in determining international values. According to him the application of
the reciprocal demand makes it appear that demand alone is of interest he maintains thatproduction cost (supply) are also of paramount importance to international trade.
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3. Another weakness of Mill’s reciprocal demand analysis is that it makes no allowance for
fluctuations in incomes in the two trading countries which are bound to influence the terms of
trade between them.
4. Further the theory is based on barter terms of trade and relative price ratios. Thus it neglects
all sickness of prices and wages, all transitional inflationary and over valuation gaps and allbalance of payment problems.
http://notesforpakistan.blogspot.com/2009/08/j-s-mills-reciprocal-demand-theory-
of.html
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Mercantilism (Thomas Mun 1630)
Initial trade theory that formed the foundation of economic
thought from 1500 – 1800 Based on concept that a nation’s wealth is measured by its
holding of treasure (gold).
The theory suggested that a government can improveeconomic well being of the country by increasing exportsand reducing imports.
The flaw of the theory was that it viewed trade as a zero sumgame.
3. The theory of Comparative Advantage (David
Ricardo 1817)
A country’s ability to produce commodity at a loweropportunity cost than its trading partner. (The opportunitycost is measured in terms of other goods)
Some countries have an absolute advantage in theproduction of many goods relative to their trading partners.
Some have an absolute disadvantage. This theory assumes that trade is a positive sum games in
which all countries that participate realize economic gains.
Ricardo’s Basic Arguments
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A country can be benefited in the international trade if itspecializes in the production of those goods that it producesmost efficiently and to buy the goods that it produces lessefficiently from other countries, even if this means buying
goods from other countries that it could produce moreefficiently itself.
Assumptions:
Only two countries and two commodities
Transportation cost missing
Exchange rate not considered
Assumed resources can transfer freely
Assumed constant return to specialization Free trade does not change efficiency with which thecountry uses its resources
No effect of trade on the income distribution within acountry.……………………………………………………………………………………………………………………………………………………………………………………………………………………
Neo-Ricardian trade theory
Inspired by Piero Sraffa, a new strand of trade theory emerged and was named neo-Ricardian
trade theory. The main contributors include Ian Steedman (1941-) and Stanley Metcalfe (1946-).They have criticized neoclassical international trade theory, namely the Heckscher-Ohlin model
on the basis that the notion of capital as primary factor has no method of measuring it before the
determination of profit rate (thus trapped in a logical vicious circle).[14] This was a second round
of the Cambridge capital controversy, this time in the field of international trade.[15]
The merit of neo-Ricardian trade theory is that input goods are explicitly included to the
analytical framework. This is in accordance with Sraffa's idea that any commodity is a product
made by means of commodities. The limit of their theory is that the analysis is limited to small
country cases.
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http://www.witiger.com/internationalbusiness/tradetheories.htm
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