Economics Theories of
Economics theories of International Trade
Learning objectives in this chapter:
II. The theory of absolute advantage and
III. The theory of competitive advantage.
Theories of International Trade
BASIC QUESTIONS ANSWERED
Basis for Trade:-(why does IT take place, under
what conditions)—reasons for & benefits from
Pattern of Trade:-what commodities are traded
(which commodities are imported & exported
by a nation)
Terms of Trade:-what are the terms of trade &
how are they determined?
Mercantilism ( Free Classical Theories)
Why do nations trade?
Answer was given by Mercantilism
A political economic policy in the 17th and early18th
centuries aimed at increasing nation’s wealth and power
by encouraging export of goods in return for gold.
Explanation: A trade theory, which holds that a
government can improve the economic well-being of
the country by encouraging exports and stiffing
• It result in positive balance of trade that leads to
wealth ( Gold) flowing into the country.
Mercantilism mixed exchange trough trade with accumulation of wealth
so government control the trade and introduce the following policies
1. Introduce a general policy of exports dominating imports.
2. Trade Across the border- exports-was consider preferable to
domestic trade because exports earn Gold
3. Imports duties, tariffs, subsidition of exports
4. Restriction on the importation of many goods were used to
maximize the gain from exports over the cost of imports.
5. laws were passed making it illegal to take gold or silver out of the
This was one-way trade, the trade of greed and power.
As the Industrial Revolution introduce the benefits of mass
production, lowering price and increasing the supplies of
goods to all the exploitation of Mercantilism came to end.
However, the governments still exercise considerable power
and influence on the conduct of trade.
Theory of absolute advantage
Theory of absolute advantage
The father of economics, Adam Smith publishes The Wealth of Nations
in 1776 in London. In this book, Smith explain the process by which
markets and production actually operates in society.
Adam smith argued that a country could certainly gain by trading with
other nations. Just as the tailor does not make its shoes but
exchange a suit for shoes, and hence both the tailor and shoemaker
gain by trading, in the same manner Smith argued that a country as
a whole would gain by having trade relations with other countries.
According to Smith, if one country has absolute advantage over
another in one line of production, and the other country has an
absolute advantage over the first country in another line of
production, then both countries would gain by trading.
Theory of absolute advantage
In other words we can explain this theory
A trade theory, which hold that, by specializing
in the product of good, which they can
produce efficiently than any others, nations
can increase the their economic well being.
For Example: if it take ,
STATEMENT OF THE THEORY
• The basis of trade between the two nations is
the absolute advantage a nation has in
producing a commodity over the other
(Absolute advantage:-more output for the same
Theory of Absolute Advantage
Labor…The only factor of production
Full employment level
Mobility of labor
Let suppose that the example of tailor and shoemaker, considering two countries,
country A, produce shoes (X), while country B produce clothes ( Y)
Then both of the countries will gain by trading. After the opening of the trade,
country A will specialize in the production of goods of X And country B will be
specialize in the product Y
The above table stated that country A can produce 10X or 5Y
with one unit of labor and country B can produce 5X or 10Y
with one unit of labor.
In this case, country A has a absolute advantage in the
production X ( 10X is grater than 5X), and country B has an
absolute advantage in production of Y ( 10Y is grater than 5Y),
it can explain further from the following table:
Production before trade
Gain from Trade
The Law of
David Ricardo (1772-1823)
Works: Principles of Political Economy and Taxation
The Theory of Comparative Advantage
David Ricardo, in his 1819 work entitled “ On the
Principles Economy and Taxation”, sought the to
take the basic ideas set down by Smith a few
Ricardo noted that even a country possessed
absolute advantage in the production of two
products, it still must relatively more efficient
than the other country in one goods production
than the other.
Ricardo termed this the
According to Ricardo, it is not absolute but the comparative
differences in the cost that determine trade relations between two
countries. Production cost differ in countries because of
geographical division of labor and specialization in production.
Due to differences in climate, natural resources, geographical
situation, and efficiency of labor, a country can produce one
commodity at lover cost than other.
In this way, each county specializes in the production of that
commodity in which its comparative cost of production is the
Therefore, when a country enters into trade
with some other country, it will export those
commodities in which its comparative costs
are less, and will imports such commodities in
which comparative production are high.
This is the basic of international trade.
Explanation of the theory
This theory can be explain by the Ricardo example of trade between
England and France as shown below:
This table shows that the production of a unit of wheat in England requires 120
men for a year, while a unit of cloth requires 100 men for the same period.
On the other hand, the production of the same quantities of wheat and cloth in
France requires 80 and 90 men respectively. Thus,
England use more labor than France in producing both wheat and cloth. So France
possesses an absolute advantage in both products.
But France would benefit more by producing wheat and exporting to England
because it possesses a grater comparative advantage in it. This is because the
cost of wheat (80/120 men) is less the cost of production of cloth ( 90/100
On the other hand England’s
interest to specialize in
the production of cloth
which it has the lest
This is because the cost of
production of cloth in
England in less ( 100/90
men) as compare with
wheat ( 120/80 men)
Thus trade is beneficial for
Assumption of the Theory
The simple theory of comparative advantage outlined above
makes a number of important assumptions:
There are no transport costs.
Costs are constant .
There are only two economies producing two goods.
The theory assumes that traded goods are homogeneous
• Factors of production are assumed to be perfectly mobile.
• There are no tariffs or other trade barriers.
• There is perfect knowledge, so that all buyers and sellers
know where the cheapest goods can be found
Differences between Comparative and
• Absolute versus relative productivity
• Comparative advantage incorporates the
concept of opportunity cost
– Value of what is given up to get the good
Produce and export those goods and services for
which it is relatively more productive than
Import those goods and services for which other
countries are relatively more productive than
of Japanese market
forces manufacturers to
continually develop and
fine-tune new products
In what way was Ricardo's law
of comparative advantage
superior to Smith’s theory of
absolute advantage? How do
gains from trade rise with
End of Chapter