Theories of Intl Trade

1. Ricardo’s Comp cost theory

2. Heckscher – Ohlin Theorem
Comparative Cost Theory – David Ricardo

• If trade is left free, each country, in the long run,

tends to specialize in the production and export
of those commodities in whose production it
enjoys a comparative advantage in terms of real
costs, and to obtain by importing those
commodities which could be produced at home
at a comp disadvantage in terms of real costs,
and that such specialization is to the mutual
advantage of the countries participating in it.
 Assumptions
• Labour is the only element of cost of production
• Goods are exchanged against one another according to
the relative amounts of labour embodied in them
• Labour is perfectly mobile within the country, but
perfectly immobile betn ctries.
• Labour is homogeneous
• Prod is subject to the law of constant returns
• Intl trade is free from all barriers
• No transport cost
• Full employment
• Perfect comp
• Only two countries and two commodities.
 Explanation
• Trade between nations can be profitable even if
one of the two nations can produce both the
commodities more efficiently than the other
nation provided that it can produce one of
these commodities with comparatively greater
efficiency than the other commodity.
• A country should specialize in the production of
those goods in which it is more efficient and
leave the production of the other commodity to
the other country.
 Illustration
Country No. of units No. of units Exchange
of labour of labour ratio
per unit of per unit of between
cloth wine wine and
cloth
England 100 120 1 wine = 1.2
cloth
Portugal 90 80 1 wine =
0.88 cloth
Comparative 90/100= 0.9 80/120 =
Cost Ratios 0.67
 Explanation
• Portugal has absolute superiority in both
branches of production. However, a comparison
of the ratio of cost of production of wine
(80/120) with ratio of cost of production of cloth
(90/100) reveals that though Portugal has an
absolute advantage in both branches of
production, it will pay Portugal to concentrate
on the production of wine in which it has comp
advantage over England.
Contd..
• England will gain by specialising in the production of
cloth and selling it in Portugal in exchange for wine.
• In the absence of trade between England and Portugal,
one unit of wine commands 1.2 and 0.88 unit of cloth
in England and Portugal resp. In the event of trade
taking place, under the assumption that within each
country, labour is perfectly mobile between various
industries, Portugal will gain if it can get anything more
than 0.88 units of cloth in exchange for 1 unit of wine.
• England will gain if it has to part with less than 1.2 units
of cloth against 1 unit of wine.
• Any exchange ratio between 0.88 units and 1.2 units of
cloth against 1 unit of wine represents gain for both
countries.
• Thus, according to Comp Cost Theory, free and
unrestricted trade among nations encourages
specialization on a larger scale.
1. Efficient allocation of resources as well as
maximization of world production
2. Redistribution of relative product demands
resulting in greater equality of product prices
among trading nations
3. A redistribution of relative resource demands to
correspond with relative product demands
resulting in greater equality of resource prices
among trading nations.
 Criticism
• Wrong assumptions
• Even if all assumptions are true, it will not lead to
complete specialization if one country is small and the
other big. Small country may be able to specialize
fully, however, the big ctry cannot sell its entire
surplus to the small country.
• Exact exchange ratio fixing is not shown in the theory.
- determination of terms of trade not explained.
• Differences in relative cost of production
unexplained( comparative difference in labour costs)
 Heckscher –Ohlin Theory
Factor Endowment Theory
• Consists of two important theorems:
1. Heckscher-Ohlin theorem
2. Factor-Price Equalization theorem
 Heckscher-Ohlin Theorem
• The H-O theorem examines the reasons for
comp differences in production and states that
a country has comp advantage in the
production of that commodity which uses
more intensively the country’s more abundant
factor
 Factor price equalization theorem
• Examines the effect of international trade on
factor prices and states that free international
trade equalizes factor prices between
countries, relatively and absolutely, and thus
serves as a substitute for international factor
mobility.
 Heckscher- Ohlin Theorem
• Developed by – Eli Heckscher and Bertil Ohlin
• Attempts to explain why comp cost differences
exist internationally. Attributed the cost
differences to:
1. Different prevailing endowments of the factors
of production
2. Fact that production of various commodities
requires that the factors of production be used
with different degrees of intensity.
• It is difference in factor intensities in the production
functions of goods along with actual differences in
relative factor endowments of the countries which
explains differences in comp cost of production
• A country will specialise in the production and
export of goods whose production requires
relatively large amounts of the factor with which the
country is relatively well endowed.
• Scarcity in relation to the quantum of other factors.
• A country can be regarded as richly endowed with
capital only if the ratio of capital to other factors is
higher when compared to other countries.
 Example
• In country A: supply of labour = 25 units
supply of capital = 20 units
Capital- labour ratio = 0.8
• In country B: supply of labour = 12 units
supply of capital = 15 units
Capital- labour ratio = 1.25
Thus, even though country A has more capital in
absolute terms, country B is more richly
endowed with capital because the ratio of capital
to labour in country A is less than in country B
Pattern of trade under H-O model

Capital intensive
goods

Capital Labour
abundant abundant
country country

Labour intensive
goods
 Assumptions
1. Perfect comp in both product and factor market
2. Fop are perfectly mobile within each ctry but immobile
b/w ctries
3. Identical quality of fop in both ctries
4. Factor supplies in each ctry are fixed
5. Fop are fully employed in both ctries
6. Factor endowments of one ctry vary from that of the
other.
7. Free trade b/w ctries
8. Intl trade is costless (no transport cost)
9. production techniques are identical
10.Factor intensity varies between goods.
11.Prod is s.t. law of constant returns.
Factor Price Equalization Theorem
• Free international trade equalizes factor prices
between ctries, relatively and absolutely, and this
serves as a substitute for intl factor mobility.
• Intl trade increases the demand for the abundant
factors (leading to an increase in their prices)
and decreases the demand for scarce factors
(leading to a fall in their prices) because when
nations trade, specialization takes place on the
basis of factor endowments.
• The effect of inter-regional trade is to equalise
commodity prices. Furthermore, there is also
a tendency towards equalization of prices of
fop which means their better use and a
reduction of the disadvantages rising from the
unsuitable geographical distribution of the
productive factors.
 Merits of H-O theorem
• Provides a more comprehensive and
satisfactory expln of existence of intl trade.
• Explains the reasons for diff in the cost of prod
in terms of differences in factor endowments.
• Comp cost diff are the bases for all trade – intl
or interregional