Pre-Classical Theory of International Trade. Adam Smith s Theory of Absolute Cost Difference. David Ricardo s Theory of Comparative Cost Advantage.

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1 Learning Objectives International Economics Pre-Classical Theory of International Trade. Adam Smith s Theory of Absolute Cost Difference. David Ricardo s Theory of Comparative Cost Advantage. JS Mill s theory of Reciprocal Demand.

2 3.1 Introduction International Economics Theory of International Trade [IT] addresses questions like Why does or under what conditions does IT take place? What are the terms for the trade and how are they determined? Classical economists Adam Smith and David Ricardo attributed the IT, to absolute and comparative cost differences respectively. Explanation for these differences was offered by economist B Ohlin.

3 3.1 Introduction International Economics Economist Bertil Ohlin also argued that there is little difference between inter regional trade and international trade and there is no justification for insisting on a separate theory for it. He argued that i] it is incorrect to say that labour & capital are perfectly mobile within a country & immobile outside. The truth is that they are to certain extent immobile even within a country. Hence difference in mobility in inter regional & IT is that of a degree.

4 3.1 Introduction International Economics ii] Further labour moved freely to other countries to bring about economic development of USA, Australia, Canada etc in 19 th and early part of 20 th century. iii] Goods move from areas where they are plenty to areas where they are relatively scarce. These areas can be in a same country [like USA, China or India] or different countries [like Sri Lanka, Bangladesh and Pakistan]. In first case it is inter regional and in the next IT.

5 3.1 Introduction International Economics iv] As regards existence of different currency system through which the IT is carried, Ohlin states that rate of exchange in these currencies reflects their respective purchasing power. Since they are convertible into each other, there is a problem of conversion in IT. This cannot be a reason for an independent IT theory. v] Principle of specializing in products where it has a cost advantage is applicable to countries as well as to regions. All trade, whether internal or international is based on division of labour.

6 3.1 Introduction International Economics However, other economists do not agree with Ohlin. They argue that question of different currencies is complex, all currencies are not equally convertible, exchange rates vary and significantly affect export earnings. Further complications are created by tariffs, import duties, export subsidies introduced by countries to restore their balance of payments.

7 3.1 Introduction International Economics More importantly IT is between countries with sovereign governments, they adopt and revise their trade policies from time to time. All these considerations need a separate study of IT. It is, therefore, concluded that both on theoretical & practical grounds, there is a necessity of a separate theory and study of International Trade.

8 3.2 Pre-Classical Theory of International Trade. With emergence of monetary economies that replaced barter trade, economists argued that the best way for the countries to survive and grow was to hold large stock of Gold & Silver. With this stock, they could build armies for protection and buy necessities, not available locally, from other countries.

9 3.2 Pre-Classical Theory of International Trade. Gold can be stocked by exploring gold mines. But if mines were not there in the country, {as in case of UK], country has to export goods / services to buy gold. This requirement, as per pre-classical economists known as mercantilists, gives rise to international trade. To maximize the stock of gold, the country should increase exports and contain imports. Means to accomplish this were suggested by mercantilists.

10 3.2 Pre-Classical Theory of International Trade. The country that could export in excess of its imports, thus had a favourable balance of trade as it added to its gold reserve. On the other hand if a country could not cover its imports by exports, country s gold stock would dwindle and it will have an unfavorable balance of trade. Even though acquisition of gold is no more considered to be the sole reason for IT, the terms favorable & unfavourable continue to be used in connection with balance of trade, though in new context.

11 3.3 Views of Physiocracy on International Trade. Around 1770 & 1775, French economists brought about a new economic thinking termed Physiocracy. They claimed that activities that produced material surplus only can be considered productive. Agriculture was considered productive by them and all other activities non productive. International trade was non productive as both parties exchanged equal values & there was no surplus. A small surplus can arise, they claimed, only if one party was weak and accepted lesser value in this exchange.

12 3.3 Views of Physiocracy on International Trade. They were first advocates of free trade, not to encourage trade, but because they considered every one should have freedom to buy whatever is available domestically or abroad. Mercantilists prescribed import duty to reduce imports & preserve gold stock. They said import duty is borne by the foreign exporter & thus does not burden domestic economy.

13 3.3 Views of Physiocracy on International Trade. French economists demonstrated that if commodity imported is required by consumers they will be willing to pay its higher price. Thus import duty cannot be passed on to foreigners. French economists further put forth following argument to bring out fallacy in pre-classical theory. If a country following Mercantilist s theory, decided to maximize its gold reserve and succeeded; it will have all the gold in the world. Then what can it do with it?

14 3.4 Adam Smith s Theory of Absolute Cost Difference Assumptions; 1.Labour is the only factor of production. Exchange between goods was determined by the relative amounts of labour embodied in them. 2.Full employment. 3.Perfect mobility of labour within a country and zero mobility between two countries. 4.Operation of law of constant returns. 5.Two countries and two commodities.

15 3.4 Adam Smith s Theory of Absolute Cost Difference Based on these assumptions, Smith stated that exchange of goods will take place, if each of two countries can produce a commodity at an absolutely lower labour cost of production than the other country. Thus England which produces cloth at least labour input can export it to Australia, and import wheat which it produces at the highest labour cost.

16 3.5 Ricardo s Theory of Comparative Cost Advantage According to Smith absolute cost difference was required for trade to take place between two countries. Ricardo proved that, if there is even a comparative difference, still trade can take place. Thus in x man days if England produces 200 units of cloth or 200 units of wheat; and Australia either 80 units of cloth or 160 units of wheat, there is no absolute advantage to Australia in either products.

17 3.5 Ricardo s Theory of Comparative Cost Advantage Still Ricardo claimed there is comparative cost advantage & trade can take place if England specializes in cloth and produces 200 units and Australia specializes in wheat and produces 160 units. Now England can export one unit of cloth and get anywhere up to less than two units of wheat [ against one unit available locally].

18 3.5 Ricardo s Theory of Comparative Cost Advantage Australia by importing a unit of cloth saves two units of wheat, and benefits since it has to pay less than two units wheat to England for it. Thus Ricardo proved that comparative cost advantage has allowed both countries to trade in wheat and cloth to their mutual benefit.

19 3.5 Ricardo s Theory of Comparative Cost Advantage Causes for the cost difference : a] Provision of special facilities by nature such as climate and soil [ that permits plantation of rubber, jute, tea etc]. mineral resources like petroleum, coal, iron ore. land fertility, availability of abundant water.

20 3.5 Ricardo s Theory of Comparative Cost Advantage Causes for the cost difference : b] Provision of different human facilities in the form of physique, mental endowments, scientific and rational mind, spirit of enterprise etc. c] Legacy of the past, traditionally high levels of intelligence and education [provides head start in building infra structure]. d] Uneven distribution of population that affects availability labour for production.

21 3.6 Assumptions of the Classical [Ricardian] Theory of IT There are only two countries. There are only two commodities which these countries can produce. Labor is the only factor of production involved in production. All units of labor are homogenous. Perfect competition in labor and product markets.

22 3.6 Assumptions of the Classical [Ricardian] Theory of IT Full employment in both countries. Labor is perfectly mobile within country and immobile between the two. The law of constant returns in operation in two countries. No technological changes take place in the countries. There are no transport costs involved. There are no government restrictions on trade between the two countries.

23 3.7 Criticism of the Classical [Ricardian] Theory of IT There are more than 150 countries involved in active international trade, hence restricting the theory to two countries is unrealistic. Production involves material, capital & enterprise in addition to labour, hence restricting it exclusively to the last factor is incorrect. All units of labour are not homogenous. Some workers are more efficient than others.

24 3.7 Criticism of the Classical [Ricardian] Theory of IT Certain degree of unemployment is always there in each country, theory based on full employment, therefore, is unrealistic. Labour is not perfectly mobile in a country, especially like India with its different languages, cultures and climates. Further workers in construction industry cannot move to IT industry with ease.

25 3.7 Criticism of the Classical [Ricardian] Theory of IT When output levels change there is corresponding change in requirement of labour inputs and usually law of diminishing returns is experienced. Hence theory cannot be based on constant returns. In this dynamic world technological advances are increasing productivity effectively. The theory assumes no such changes & renders itself unrealistic.

26 3.7 Criticism of the Classical [Ricardian] Theory of IT Movement of goods from country to country involves significant transport costs. These are ignored by the theory. International trade cannot be carried ignoring various restrictions / provisions that have to be prescribed by governments to protect their economies. Hence free trade assumed by the theory is incorrect.

27 3.7 Criticism of the Classical [Ricardian] Theory of IT The theory considers only the supply side and ignores forces of demand on the markets. Countries strategically rely on domestic supply for essentials for its defense & would not buy them from other countries. Complete specialization on the basis of comparative cost advantage cannot work for larger economy in trade with smaller one, as the latter cannot absorb huge surplus of the larger economy.

28 3.7 Criticism of the Classical [Ricardian] Theory of IT The theory fails to take into account time element for storage and ignores interest cost. It unrealistically assumes that imports of a country will match with its exports. It fails to consider capital cash flows. The theory assumes entire country benefits from the IT. In reality only some citizens stand to benefit & not the entire nation.

29 3.8 J S Mill s Theory of Reciprocal Demand Ricardo s theory established in earlier example how England and Australia benefit by IT when there is no absolute cost advantage, but comparative advantage is there. He stated that so long as England gets between one to two units of wheat for a unit of cloth, it stands to benefit. But he could not state exact units of wheat that would be offered for export of cloth.

30 3.8 J S Mill s Theory of Reciprocal Demand The mechanism for determination of rate of exchange or terms of trade was discussed by JS Mill. He stated that the rate depends on England s elasticity of demand for England s cloth. Equilibrium would be established at that rate of exchange between the two commodities, at which quantities demanded by each country would be sufficient to pay for each other according to JS Mill.

31 3.8 J S Mill s Theory of Reciprocal Demand He further explains i] the possible range of barter terms is given by the respective domestic terms of trade as set by comparative cost advantage in each country { between one to two stated earlier}. ii] within this range, the actual terms of trade will depend on intensity of each country s demand for other country s produce. iii] finally those terms will be stable at which exports offered by a country will be sufficient to pay for its imports.

32 3.8 J S Mill s Theory of Reciprocal Demand Mill s theory is based on the assumptions similar to those used by Ricardo. As such it is subject to same criticism as leveled against the classical theory of IT. The End