International Trade Theory
Biswajit Nag

TWO BASIC QUESTIONS IN
INTERNATIONAL TRADE:
1) WHAT DETERMINES INTERNATIONAL TRADE?
2) WHY COUNTRIES WOULD GAIN FROM TRADE?

Historical Development of Trade Theory
 Mercantilism
– positive trade balance
 Absolute advantage (Adam Smith)
– Countries benefit from exporting what they
make cheaper than anyone else
 Comparative advantage (David Ricardo)
– Nations can gain from specialization, even
if they lack an absolute advantage
Foundations of trade theory

Absolute Cost Advantage Theory
(Adam Smith)
Assumptions: 1) Labour Theory of Value
2) Free Trade
Country 1 Unit of A 1 Unit of B
I 10 20
II 20 10
Labour Cost of Production (in Hours)
The Difference on absolute cost of producing the
commodities between the two countries in isolation will
serve a useful basis for opening up of mutually gainful
international trade between two countries.

David Ricardo
Theory of Comparative Cost Advantage
Basis of International Trade is the comparative cost
differences between two countries. According to this
theory, Adam Smith’s Absolute Cost Advantage
Theory is not quite unambiguous proposition. Cases
may arise where any one country may enjoy absolute
advantage over other country in both the goods.
Under such circumstances still trade may occur
given that there exists comparative cost difference.

Example
Labour Cost (in Hours) for 1 unit of production
Country Wine Cloth
Portugal 80 90
England 120 100
Portugal has absolute advantage in both cloth
and wine over England. According to Ricardo
trade is still worthwhile due to comparative cost
difference. In Portugal, 1 unit of wine= 8/9 units
of cloth, where as it is 12/10 in England. So,
opportunity cost of production of 1 unit of wine
in Portugal is 8/9 units of cloth but in England it
is 12/10. So, Portugal enjoys comparative cost
advantage in production of wine.

Country Wine Cloth
Portugal 80 90
England 120 100
Reference Table
Country Wine Cloth
Portugal 8/9 9/8
England 12/10 10/12
Opportunity Cost* for
*The opportunity cost for good X is the amount of other
goods which have to be given up in order to produce one
additional unit of good X.
Thus Portugal has lower opportunity cost of the two countries
in producing wine while England has lower opportunity cost in
producing cloth. So, Portugal has a comparative advantage in
production of wine and England has an advantage in production
of cloth.

So, in this case Comparative cost serve
as an useful basis for opening up of a
gainful international trade between
Countries. Each country seeks here to
specialise in production and export of
the commodity in which it has
comparative advantage and wants to
import the other commodity from its
trading partner.

Live Example
Suppose,
India 1US$= Rs. 50
Tanzania 1US$= Tnz
Shilling 1000
(Rates are assumed
for simplification of
calculation)
Water Beer Pw/Pb
India Rs. 10 Rs. 30 1/3
Tanzania Ts. 500 Ts. 700 5/7
In terms of absolute cost, both water and beer are cheaper in India
Suppose both the countries decide for a price ratio of ½, then India
will gain in selling water and Tanzania in Beer.
Explanation: Domestically in India a person has to sell 3 bottles of
water to get a bottle of beer but if he buys from Tanzania, he requires
to exchange only 2 bottles of water to get 1 bottle of beer. On the
other hand in Tanzania when a person sells a bottle of beer he/she
gets slightly more than a bottle of water, but if the beer bottle is sold
internationally to India, the gain is more as the person will get full 2
bottles of water in return.

Transformation schedules or Production Possibility
 Generalizes theory to include all factors, not
just labor
 Shows combinations of products that can be
made if all factors are used efficiently
 Slope, or marginal rate of transformation,
shows the opportunity cost of making more of
one good (how much of one good must be
given up to make more of another)
Comparative advantage

The opportunity cost version of Comparative
cost: The concept of Production Possibility
Curve (PPC)
Wheat
Cloth
The concept of Opp. Cost can
be described through PPC.
This shows alternative
combination of any two
products that can be
produced efficiently with
given resources and
technology. In virtue of full
employment and efficient use
of resources, it is true that
PPC will be downward
slopping. But it may either a
straight line or concave or
convex curve to the origin.
.
Slope of PPC measures marginal
opp. Cost of producing one
commodity in terms of others

Wheat
Cloth
Under condition of
constant cost in
production PPC becomes
a straight line.
Again if law of increasing
cost is operating then PPC
will be concave. This is so
because factors of
production may not be
adaptable completely to
the two alternative use.
In case of decreasing cost condition in
production, PPC will be convex to the
origin

Marginal Rate of Transformation
0
10
20
30
40
50
60
70
0 20 40 60 80 100 120 140
Autos
A
B
C
Slope = MRT = 0.5
Wheat

Wheat
Cloth
PPC and Price Line
Under constant cost condition PPC
coincides with the price line*
But this is not so in case of
varying cost condition because
in this case cost alone does not
determine the prices. We have
to consider the demand
conditions also. Given the
internal demand condition we
need to draw a separate price
line whose slope will represent
the ratio of exchange between
goods.
*The slope of the Price
line denotes the relative
price ratio of two
products.

Indifference curves
 Final pattern of trade depends not just
on supply, but also on demand - which
is determined by individual tastes
 Tastes can be shown graphically with
indifference curves, which show the
various combinations of two goods that
give a consumer the same total level of
satisfaction
Bringing demand into the model

A consumer’s indifference map
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7 8 9
Autos
Bringing demand into the model
A
B
C
D
E
I
II
III
Wheat

Indifference curves (cont’d)
 “Higher” indifference curves (those
farther from the origin) represent greater
levels of satisfaction
 Individual preferences cannot really be
added up into a “community indifference
curve” but it is useful to imagine that
they can for the purposes of trade
theory
Bringing demand into the model

Indifference curves (cont’d)
 Indifference curves have a negative
slope
– Keeping satisfaction constant means giving
up some of one good for more of another
 Indifference curves are convex
– As the consumer gets more of one good,
she is less willing to give up what is left of
the other
– The rate of substituting one good for
another is shown by the slope of the curve,
the marginal rate of substitution
Bringing demand into the model

Equilibrium
Black Line: Price Ratio
Red Curve: PPC
Green Curves: Community Indifference
curve (CIC), denotes preference pattern of
the community
Equilibrium
A Community’s demand
pattern is described by its
CICs. Production of the
goods by PPC. Price ratio
by the price line.
Y
X
Equilibrium occurs at R which we call the point
of autarky or equilibrium in absence of
international trade. At this point. PPC becomes
tangent to the highest achievable CIC (and also
price line).
R