Trade Theory

Why do nations trade?

The countries do trade to complete their needs and also increase production. They do trade for a better economy so they produce goods within the country and export these goods and receive revenue from them. Due to trade, a country can bring economic changes in its country as well as it can develop in every field of economic activities.

International Economics

1.      International Trade Theory:  International trade theory analyses the basis and the gain from trade.

2.      Trade Policy: Trade policy refers to the regulations and agreements that control imports and exports to foreign countries as well as it is about trade policy and trade restrictions.

3.      Balance of payments: It is a record of receive and payments. In the balance of payment, we study the current account, capital account, and foreign reserves.

Current Account:  It refers that government checks export and import level that how much goods exported and how much imported.

Capital Account:  In a capital account, we study the money. The country checks the money level and how much money receipt from foreign countries and how much is paid to them.

Foreign Reserves:  Foreign reserves mean how much foreign money has in the country such as the dollar.

4.      Open-Economy Macroeconomics: We study open economy and close economy.

Open economy: It refers to where foreign allowed doing trade.

Closed economy: There is no trade.

5.      Gains from trade: It refers after the trade how much revenue collects from trade.

 

1.      Mercantilist view: The view before Adam Smith's theory of international trade is called the mercantilist view. For being rich and powerful country needs to export more than import on basis of trade.

 

2.      Absolute advantage theory (Adam Smith)

Adam Smith has written the book “An Enquiry into Nature and Causes of Wealth of Nations” in 1776 and he explained this theory in his book.

The absolute advantage theory of Adam Smith refers to trade between two nations as based on their absolute advantage.

Labor required for production 1 unit

Country

Wheat

Cloth

U.S

6 laborers

10 laborers

U.K

10 laborers

6 laborers

This table shows that to produce 1 unit of wheat in the US with 6 laborers while the UK is produced the same unit of wheat with 10 laborers. On the other hand, the US is produced 1 unit of cloth with 10 laborers while UK is produced 1 unit of cloth 6 laborers. This shows US has an absolute advantage in the production of wheat and UK has an absolute advantage in the production of cloth. According to Adam Smith, the US should produce and specialize in the production of wheat, and the UK should produce and specialize in the production of cloth.

 

3.      Comparative difference in cost (David Ricardo)

David Ricardo wrote his book “Principles of Political Economy” in 1817 where he presented the theory of comparative costs, regarding international trade. Each country will specialize in the production of those commodities which it has the greatest comparative advantage or least comparative disadvantage.

According to Ricardo, one country should produce that good where the advantage is comparatively more and other countries produce that good where the advantage is comparatively less.

Assumption:

(1)   Two countries England and Portugal

(2)   Two commodities A (wine) and B (cloth)

(3)   Similar tastes in both countries

(4)   Labor is the only factor of production

(5)   Trade takes place on the basis of a barter system

(6)   There is free trade (it means there are no barriers)

(7)   Factor of production are perfectly immobile between the countries

Labor required for production 1 unit

Country

Wine

Cloth

England

120 laborers

100 laborers

Portugal

80 laborers

90 laborers

This example shows that to produce 1 unit of wine in Portugal with 80 laborers while to produce the same unit of wine in England with 120 laborers. On the other hand, In Portugal is produced 1 unit of cloth with 90 laborers but in England is produced 1 unit of cloth with 100 laborers. This is shown that Portugal has an absolute advantage in both commodities, wine, and cloth. But England has an absolute disadvantage in both commodities wine and cloth. 80/120(100) =67% This is for wine and 90/100(100) =90% this is for the cloth of Portugal. It shows that Portugal has a greatest comparative advantage in winemaking than cloth. On the other hand, England has a comparative disadvantage in the production of both goods. 120/80(100)=150 this is for wine and 100/90(100)=111% this is for the cloth of England. This shows the least comparative disadvantage of England in cloth. 

Production Possibility Curve

It shows the various combinations of the two commodities that a country can produce most effetely by fully utilizing its factor of production with the available technology. 

The PPC is concave downward, which shows that if the economy wants to increase the production of cloth, it will have to decrease the product

Heckscher Ohlin has presented H.O theory where he explained about the comparative advantage of a country that a country has a comparative advantage. He explained where the comparative advantage comes from and how the country uses the comparative advantage. Furthermore, he explained that a country has to produce which commodities.

Assumption

1.      Balanced trade:

2.      Commodity x is labor-intensive, and commodity y is capital intensive

3.      Constant return to scale

4.      No transport cost, no tariffs:

5.      Perfect mobility of factor within the country but no international factor mobility

6.      Same technology is used in both countries

7.      Taste in both countries are identical

8.      Two nations, two commodities (x and y), and two factors of production ( K and L)

 

There are two factors of production which are capital and labor and there are two nations or two countries that are producing two commodities which are x and y.

1.      : It means both countries are using the same technique or technology for production.

2.      : It means for the production of x you should hire more labor and for the production of y you should bring more capital. If we take the example of Pakistan so for the production of rice he hires more labor and for the production of Q-mobile, he uses more capital than labor.

3.      It means the taste of the commodity is the same in both countries such as the demand etc same in both countries.

4.      :  It means there is no international mobility such as the labor of Balochistan can go in Punjab or Sindh but they cannot go in Iran or Chine.

5.      It means there is no transport cost for export or import.

6.      It means both countries, import or export is same.

7.      : It means however you increase the factor of production and your output is also increased. 

Factor Intensity:

It refers to x as labor-intensive and y as capital intensive and here we see that Nation 1 has capital intensive or Labor intensive and Nation 2 has labor intensive or capital intensive. 

 

Factor Abundance:

Factor abundance says the reasons that what is the reason and a country is capital intensive and labor-intensive. There are two reasons which are physical unit and factor price. In the physical units, we see physical that what quantity of labor or capital within the country is. The 2nd one is relative to factor price where we see the ratio of capital and labor-intensive.

 

Factor Price Equilibrium Theory

This theory follows the H.O theory. Samuelson has presented this theory and it is also known as H.O Samuelson. In here, the trade of nation 1 and nation 2 is equal, and if there is been international trade so the factor price will be equal if H.O theory holds. 

 

Heckscher Ohlin has presented this theory where he explained the comparative advantage of a country that a country has a comparative advantage. He explained where the comparative advantage comes from and how the country uses the comparative advantage. Furthermore, he explained that a country has to produce which commodities.

Assumption

1.      Two nations, two commodities (x and y), and two factors of production ( K and L)

There are two factors of production which are capital and labor and there are two nations or two countries that are producing two commodities which are x and y.

2.      Same technology is used in both countries: It means both countries are using the same technique or technology for production.

3.      Commodity x is labor-intensive, and commodity y is capital intensive: It means for the production of x you should hire more labor, and for the production of y you should bring more capital. If we take the example of Pakistan so for the production of rice he hires more labor and for the production of Q-mobile, he uses more capital than labor.

4.      Taste in both countries are identical It means the taste of the commodity is the same in both country such as the demand etc same in both countries.

5.      Perfect mobility of factor within the country but no international factor mobility:  It means there is no international mobility such as the labor of Balochistan can go in Punjab or Sindh but they cannot go in Iran or Chine.

6.      No transport cost, no tariffs: It means there is no transport cost for export or import.

7.      Balanced trade: It means both countries, import or export is the same.

8.      Constant return to scale: It means however you increase the factor of production and your output is also increased. 

Factor Intensity:

It refers to x as labor-intensive and y as capital intensive and here we see that Nation 1 has capital intensive or Labor intensive and Nation 2 has labor intensive or capital intensive. 

 

Factor Abundance:

Factor abundance says the reasons. Furthermore, he explained that what is the reason why a country is capital intensive and labor-intensive. There are two reasons. The first one is physically intensive and we see physical that what quantity of labor or capital within the country is. The 2nd one is relative to factor price where we see the ratio of capital and labor-intensive.

 

By: Sumiya Dost 

The writer is a post-graduate student from Economics Department University of Turbat 

Turbat Kech Balochistan