Project Paper on

“THEORY OF INTERNATIONAL TRADE”

SUBMITTED TO:

DR. FUSUN YILNMEZ

SUBMITTED BY:

AMIR AZAM

STUDENT NO: 306920143001

HOME INSTITUTION:

ABDUL WALI KHAN UNIVERSITY MARDAN PAKISTAN

HOST INSTITUTION:

ESKISHIER OSMANGHAZI UNIVERSITY TURKEY

DATE OF SUBMISSION:

24TH MARCH 2015

Table Of Content:

Introduction:.......................................................3

What is international economics?....................................3

Study background:...................................................5

Merchantilism school of thought and their view on international

trade:..............................................................5

Key features of mercantilist theory of international trade:.........6

Why did mercantilism fail?..........................................6

Origin of classical school of thought:...............................6

Absolute advantage: adam smith:......................................7

Limitation of absolute advantage theory:............................9

The principles of comparative advantage:............................9

Ricardo’s simplifying assumptions:.................................10

Numerical calculation of comparative advantage theory:.............11

Heckscher ohlin model of international trade:......................14

Assumption of ho model:............................................14

Factor intencities:................................................14

Trade equilibrium:.................................................16

International trade in the prospective of gravity model:...........18

Logic of gravity model:............................................18

Theory of economies of scale:......................................19

References:........................................................24

INTRODUCTION:

What is International Economics?International Economics uses the same fundamental methods of Analysis as other branches of Economics. The subject matter of International Economics consists of issues raised by the special problems of economic interaction between sovereign states.

International Economics comprises a huge field of study. It usually deals with international trade, and International trade occupies a huge scope not in modern era but since the origin of international trade. International Economics comprises the seven basic themes in itsstudy which are as follows.

(a) Gains from trade:

Probably the most important single insight in all of international economics is that there are gains from trade, that is when countries sell goods and services to each other, this exchange is almost always their mutual benefits.

(b) Pattern of Trade:

Once it has decided that there are gains from trade for both side, here the question rises that what the countries of the world trade with each other. For this question David Ricardo in 19th centaury

proposed a model based on labor productivity, that countries will maketrade among each other that they have comparative advantage.

(c) How much trade:

If the idea of gains from trade is the most important theoretical concept in international economics, the seemingly eternal rebate over how much trade to allow is its more important policy theme. The responsibility of state is to allow that how much trade such that its own economy can survive.

These three themes are also known as international trade. Through these three theme we can overcome three important international fact of these that these tells us that how international economies try to find how their abutment of deciding what they trade, how they gain from trade and what policies should govt adopt to survive its economies competing international competition.

(d) Balance of Payment:

Balance of payment of any economy tells that how much any nation or state is confined about its gains or lost from international trade. Ifthe economy is gaining means producing surplus shows that its exports are greater than its imports. It is a good sign for any region that its balance of payment is positively termed otherwise incase of deficit the state is reprisment lost of exceeding imports over exports.

(e) Exchange Rate Determination:

A key difference between international economics and other area of economics is that countries usually have their own currencies. The study of exchange rate determination is relatively new part of international economics. Usually the exchange rate for countries of the different geography demonstrates on the supply and its demand.

(f) International Policy Coordination:

This is also a newer concept introduced in international economics. International Economics comprises, sovereign states, each free to choose its own economic policy. So the nations of the world are focusing on adaptation of such trade policy which is beneficial for each other. The national dominate to give access to free trade withoutany barriers.

(g) International Capital Market:

Capital markets are those markets which are linked with the exchange of Bonds Treasury bills, and Securities and international money. The countries of the world are categorized into three categories, i.e. Developed, Developing and low developed countries, the develop countries usually interchange their surplus to the developing nations and earn profits.

The final four themes of International Economics deals with international money. How the economies of world establish new policiesto overcome the financial problems of the economies. They usually maketheir attention on Balance of Payments

Study background: In this study our focus will be on the first three themes of international Economics that are known as International trade. We willcheck out how International trade started from its origin. What was the view of different school of thought about international trade? We will make our attention on different economists views about international trade? The strong points which take their attention and some of their weak points on which different economists made criticismon their views.

MERCHANTILISM SCHOOL OF THOUGHT AND THEIR VIEW ON INTERNATIONAL TRADE:MERCANTILISM is one of the great whipping boys in the history of economics. The school, which dominated European thought between the 16th and 18th centuries, is now considered no more than a historical artifact—and no self-respecting economist would describe themselves asmercantilist. The dispatching of mercantilist doctrine is one of the foundation stones of modern economics. At the heart of mercantilism is the view that maximizing net exports is the best route to national prosperity. Boiled to its essence mercantilism is “bullionism”: the idea that the only true measure of a country’s wealth and success was the amount of gold that it had. If one country had more gold than another, it was necessarily better off. This idea had important consequences for economic policy. The best way of ensuring a country’sprosperity was to make few imports and many exports, thereby generating a net inflow of foreign exchange and maximizing the country’s gold stocks.

It was the dominant economic doctrine for more than three centuries (16th - 18th), mostly associated with the colonization era. It was often dubbed economic nationalism where the efforts to boost exports were backed by a powerful state protecting domestic monopolies (such as the British East India Company).  It was a way nation-states were competing with each other. The nation which had more gold (wealth)

could raise a stronger army, and thus be more powerful. The role of colonies was crucial in this power struggle, as they were the source of precious metals and raw materials, and on the other hand the recipients of exported goods. Mercantilism was characterized by a triangular trade system, where European countries were exporting manufacturing goods and textiles to Africa and America, America was sending raw materials to Europe, while Africa was "sending" slaves to America (see map below). It is in fact upon this system that many see the origins of the Great Divergence. However the Great Divergence started after the Industrial Revolution and its causes were completelydifferent and much more complex to be resorted to pure colonialism. After all, during the period of mercantilist dominance, the living standards of the population were still miserable, 

From the sixteenth to the eighteenth centuries, mercantilism was the policy of Europe’s Great Powers as they expanded their empires, and was the universal framework by which international trade was understood. Mercantilism focuses on maximizing exports in order to bring “specie” (precious metals) into the country: The more gold and silver that a country accumulates, the richer it is. Imports are discouraged with heavy tariffs on foreign goods. Trade under mercantilism is a zero-sum game, with winners who win only at the expense of losers. Huge spikes of inflation driven by increases in thedomestic money supply (which accumulates as exports are exchanged for specie) would regularly ravage the countries that pursued mercantilistpolicies. It was David Hume, in 1752, who first articulated a theory to explain this phenomenon, which evolved over time to be known as thequantity theory of money. Simply stated, increasing the amount of specie (money) in the economy does nothing to increase real wealth; instead, it just means that more money is required to trade for the same goods and services as before. Whereas mercantilism is couched in a historical context here, it must be noted that the inherent spirit of mercantilism—in which exports and imports have normative implications, exports considered “good” and “job-losing” imports considered “bad”—has been alive and well through economic history. In fact, as economies slow down, the age-old spirit of mercantilism oftenrears its head.

Key features of mercantilist theory of international trade:Mercantilism economic system of the major trading nations during the 16th, 17th, and 18th century, based on the premise that national wealth and power were best served by increasing exports and collectingprecious metals in return. The period 1500 - 1800 was one of religiousand commercial wars, and large revenues were needed to maintain armiesand pay the growing costs of civil government. Mercantilist nations were impressed by the fact that the precious metals, especially gold, were in universal demand. Foreign trade was favored above domestic trade and manufacturing or processing, which provided the goods for foreign trade, was favored at the expense of the extractive industries(e.g., agriculture). The state exercised much control over economic life, chiefly through corporations and trading companies. As the classical economists were later to point out, however, even a successful mercantilist policy was not likely to be beneficial, because it produced an oversupply of money and, with it, serious inflation. Henry VIII, Elizabeth I, and Oliver Cromwell conformed their policies to mercantilism. In France its chief exponent was Jean Baptist Colbert.

Why did mercantilism fail? 

A big part of the mercantilist doctrine was protectionism. Moreprecisely protectionism of business interests against any forms ofcompetition. Governments applied many forms of different protectionistpolicies, from guild rules and taxes, tariffs and quotas, prohibitionsof imports to big state-run monopolies. It provided capital toexporting industries and even prohibited exports of tools (technology)and skilled labor that would allow foreigners to produce the samegoods the home country is producing. In shipping for example the ruleswere even more absurd, where according to the famous BritishNavigation Act of 1651 all imports to England had to be carried on anEnglish ship, while colonial exports to Europe had to first land to anEnglish port before going further.

Origin of Classical School of Thought:At the half end of 18th Century a new group of thinker rose and proposed different concept in the field of Economics. These were namedas Physiocrats - school of French thinkers in the 18th century who

evolved the first complete system of economics. The founder and leader of physiocracy was Francois Quesnay. In the late 17th and the 18th century protest against the governmental regulationCharacteristic of mercantilism was voiced, especially by the physiocrats. That group advocated laissez-faire, arguing that businessshould follow freely the “natural laws” of economics without government interference. They regarded agriculture as the sole productive economic activity and encouraged the improvement of cultivation. In the 18th century the Scottish philosopher David Hume did important work in economics. His analysis of the natural advantages that some nations enjoy in the cultivation of certain products and his observations on the flow of commerce became the basisfor the theory of international trade. Huge spikes of inflation driven by increases in the domestic money supply (which accumulates as exports are exchanged for specie) would regularly ravage the countriesthat pursued mercantilist policies. It was David Hume, in 1752, who first articulated a theory to explain this phenomenon, which evolved over time to be known as the quantity theory of money. Simply stated, increasing the amount of specie (money) in the economy does nothing toincrease real wealth; instead, it just means that more money is required to trade for the same goods and services as before.

The most important work of the 18th century however, was Adam Smith’s Wealth of Nations (1776), which is considered by many to be the first complete treatise on economics. Smith identified self-interest as the basic economic force . . In 1776 appeared one of the most influential books of our time, The Wealth of Nations. Written by Adam Smith, it earned the author the title " The father of economics". Smith objected to the principal economic beliefs of his day. He differed with the physiocrats who argued that land was the only source of wealth. He alsodisagreed with the mercantilists who measured the wealth of nation by its money supply, and who called for government regulation of economy in order to promote a "favorable balance of trade". In Smith´s view, a nation´s wealth was dependent upon production, not agriculture alone.How much it produced, he believed, depended upon how well it combined labour and the other factors of production. The more efficient the combination, the greater output, and the greater the nation´s wealth. The heart of Smith´s economic philosophy was his belief that the

economy would work best if left to function on its own without government regulation. To explain why all society benefits when the economy is free of regulation, he used the metaphor of the "invisible hand": The invisible hand was Smith´s name for the economic forces thatwe today would call supply and demand, or the marketplace. He sharply disagreed with the mercantilists who, in their quest for favorable balance of trade, called for regulation of the economy. Instead, he agreed with the physiocrats and their policy of "laissez faire", letting individuals and businesses to function without interference from government regulation or private monopolies. In that way, the "invisible hand" would be free to guide the economy and maximize production.

Absolute Advantage: Adam Smith:Adam Smith was the first to articulate the possibility that international trade is not a zero-sum game and that, in fact, a single-minded reliance on exports is counterproductive. He explained that different countries will use different quantities of resources inproducing the same goods. Thus, each country should specialize in manufacturing only the good(s) that it can make with the fewest resources. Global output is thus maximized. Then, by trading freely, each trading country will end up with a greater quantity of goods thanbefore. We can see Smith’s theory in action with an example. Let’s consider a hypothetical world with only two countries: Adam Smith’s theory starts with the idea that export is profitable if you can import goods that could satisfy better the necessities of consumers instead of producing them on the internal market. The essence of Adam Smith theory is that the rule that leads the exchanges from any market, internal or external, is to determine the value of goods by measuring the labour incorporated in them.

According to the theory of absolute advantage international trade takes place because one country can produce the good more efficiently than the other and hence it provides the incentive for the country which is producing the good effiecntly to export it to another country.

In order to demonstrate its theory, Adam Smith analyzed for the beginning country A, using one factor of production, the productivity of labour, evaluated in the necessary of hours needed to produce a unit of measure of the products X and Y. He used a unifactorial system of economy. Symbolizing H-hours, L-labour, the unitary necessary of labourfor product X is HLX and for Y HLY. Because all the economies have limited resources, there are limits in the level of production, and ifa country wants to produce much of one product it has to give up producing another goods, existing in this case renounce of trade. Renouncescan be illustrated by a graphic.

PRODUCTION FRONTIER POSSIBILITY:

Output

HLY

HLY1

Labour

HLX HLX2

We have a single factor of production labour which results productivity. Let’s suppose that a country has a resource of labour 1

2

8+4=12 hours. With four hours of labour usage any country produce one kilogram of cheese and with 8 hours of labour a country can produce one kilogram of wine. The production possibilities illustrate the variety of the mixing of goods that can be produced by the economy. The opportunity cost is the number of measures units of product “Y” towhich the economy has to give up in order to produce one supplementaryunit of product “X”.

SPECIALIZATION IN PRODUCTION AND THE ADVANTAGE FROM

TRADE THROUGH ABSOLUTE ADVANTAGE:

COUNTRY

PRODUCTS

UNITS OF PRODUCT/ UNITS OF TIME

WITHOUT TRADE AFTER SPECIALIZATION AND TRADE

X Y X Y

A 6

3 12

-

B 3

6 -

12

TOTAL 9

9 12

12

This table gives us clear information about the economic situation of two countries. This table illustrates that Country A is more productive in the production of “X” good as compare to Country “B”. While Country ‘B” is more productive in the production of “Y’ good as compared to Country “A”. This shows that Country “A” has an absolute advantage over country “B” in the production of good X while country “B” has an absolute advantage of production “Y” good as compare to “A”. If both countries produce both goods then the total output become equal to 9 while by specializing in their absolute advantage product they can increase their output and total output rises to 12 and by trading these goods with each other they can both minimize the cost and can specialize in their respective field. This phenomenon of Adam Smith originates the theory of Absolute advantage.

Limitation of Absolute Advantage Theory:1 It doesn’t take into account transportation cost involved in

selling the product in international market.2 It is based on the assumption that exchange rates are stable

which is seldom the case and hence a limitation.3 It also assumes that labor can switch between products easily

and they will work with same efficiency which in reality cannot happen.

The Principles of Comparative Advantage:David Ricardo (1772-1823), in his theory of comparative costs suggested that countries will specialize and trade in goods and services in which they have a comparative advantage. It is easy to seethat if countries have an absolute advantage there are advantages to trade. However what happens if one country has an absolute advantage over its trading partners in the production of a number of goods. Specialization and trade can still result in there being welfare gainsmade from trade.

Ricardo’s Simplifying Assumptions:This is a good place to note that David Ricardo, in order to simplify his explication of the basic premise of comparative advantage, made certain assumptions. Our

Ricardian trade model initially incorporates these assumptions:

1. There are only two countries and two commodities.

2. There are only two factors of production, labor (L) and capital (K).8

3. There is perfect competition in all industries (including the factor market and the finished goods market).

4. Labor is all of the same level of skill and efficiency within each country.

5. Labor and capital are perfectly mobile within a country (and thus always able to fill any production need within that country) but cannot shift between countries.

6. There is free trade that involves no trade barriers or frictional transaction costs.

7. There are no transportation costs. Also, while not explicitly stated by Ricardo, it is implied that there are no environmental or infrastructure costs.

8. Production operates with constant returns to scale (“constant costs”).

A country has a comparative advantage in the production of a good or service that it produces at a lower opportunity cost than its trading partners. Some countries have an absolute advantage in the production of many goods relative to their trading partners. Some have an absolute disadvantage. They are inefficient in the producing anything,relative to their trading partners. The theory of Comparative costs argues that, put simply it is better for a country that is inefficientat producing a good or service to specialize in the production of thatgood it is least inefficient at compared with producing other goods.

The production possibility curve can be used to illustrate the principles absolute and comparative advantage.

Maize

B A

Wheat

Country A has an absolute advantage in the production of both maize and wheat. At all points its production possibility curve lies to the right of that of country B. Country B has an absolute disadvantage. Due to abundance of raw materials or more productively efficient production techniques country A is able to produce more wheat and moremaize that country B. Considering the opportunity cost of Country A producing one more unit of wheat. Two units of maize have been foregone. When country B produces one more unit of wheat only half a unit of maize is foregone. Fewer resources as foregone if Country specializes in the production of wheat

Numerical Calculation of Comparative Advantage Theory:Two Factor Economy:

Assumptions:

1 There are two countries i.e. Home and Foreign2 One Factor of Production i.e. Labour 3 Producing two goods i.e. tea and coffee

In the example of the two countries cited earlier, we see that for thesame labor required to produce 1 unit of tea (five laborers), Country Home could instead produce 2½ units of coffee (two laborers per unit).We can say that the opportunity cost to Country home of producing 1 unit of tea is 2½ units of coffee. Similarly, for each unit of tea

produced by Country Foreign, which requires 4 units of labor, it must sacrifice the production of 11 /3 units of coffee, which requires 3 units of labor. Foreign’s opportunity cost to produce 1 unit of tea is1 1/3 units of coffee.

Country A has an absolute advantage producing both goods X and Y, but B is more efficient than A, in terms of opportunity cost, at producinggood Y. The real “cost” of good X should be measured in terms of the opportunity cost of other goods—in this case, good Y—that are given upto produce or consume 1 unit of good X.The opportunity cost of producing 1 unit of good X in terms of good Y may be computed as the amount of labor required to produce 1 unit of good X divided by the amount of labor required to produce 1 unit of good Y. That is, how much Y (tea) do we have to give up in order to produce 1 more unit of good X (coffee)? So the opportunity cost to Country A of producing 1 unit of good X (coffee) in terms of good Y (tea) is given byaLx (units of labor required to produce 1 unit of X in A)

aLy (units of labor required to produce 1 unit of Y in A)

Home (A) Foreign (B)

Units of Labour

Opportunity Cost

Units of Labour

Opportunity Cost

Coffee

X

2

aLx

0.4

=aLx/ aLy

3

aLx

0.75

=bLx/bLy

Tea

Y

5

aLy

2.5

=aLy/aLx

4

bLy

1.33

=bLy/bLx

We see the opportunity costs to Countries A and B of producing each good, in terms of the alternative good. Each Country’s CA good is highlighted. The relative efficiencies of each country in producing its advantaged good are illustrated here. However, we already know

that Countries A and B possess absolute advantages in producing coffeeand tea, respectively. What about Country C, which is advantaged in neither coffee nor tea? Let’s compare Country C, which we may take to represent a developing country with little infrastructure, to Country A, a relatively advanced country that is a more efficient producer of both goods Country B is at an absolute disadvantage in producing both X and Y. However, when we look at the opportunity costs to Countries Aand B of producing each good, we find something interesting. For eachunit of tea that Country A produces, it must sacrifice the production of 2.5 units of coffee. However, Country B can produce 1 unit of tea and sacrifice only 1.25 units of coffee. We can see that while CountryB requires more labor than Country A to produce either good, Country Bdoes enjoy an advantage over Country A in terms of its relative efficiency in producing good Y.

Country A has an absolute

Advantage in the production

Of both Good X and Good Y

Units of Labour

Country A Country B

Coffee

X

2

aLx

8

bLx

Tea

Y

5

aLy

10

bLy

Fig shows:

Opportunitycostdeterminescomparativeadvantage.Country B, atan absolutedisadvantagein both goods,iscomparativelyadvantaged inthe productionof “Y” (tea)

This relationship is given by

bLy< aLybLx aLx1.25 < 2.5

That is, Country B’s opportunity cost to produce 1 unit of Y (tea) in terms ofX (coffee) is less than that of Country A. While it has no absolute advantage in either good, Country B enjoys a comparative advantage in producing good Y. Similarly, Country A can be said to enjoy a BA in producing good X, as

aLx < bLxaLy bLy

0.4 < 0.8

Goods Home (A) Foreign (B)

Units of Labour

Opportunity Cost

Units of Labour

Opportunity Cost

Coffee

X

2

aLx

0.4

=aLx/ aLy

3

aLx

0.75

=bLx/bLy

Tea

Y

5

aLy

2.5

=aLy/aLx

4

bLy

1.33

=bLy/bLx

It is a mathematical identity given two countries and two goods that each country will be comparatively advantaged in one of the goods.4 Inother words, if we have two countries, A and B, and two goods, X and Y, and if Country C has a CA in Y (tea), then this automatically implies that Country A will have a BA3 in X. In this situation, while acountry may be able to have an absolute advantage in both goods, it cannot have a comparative advantage in both goods. We may define comparative advantage as follows: Given two Countries A and B, producing two goods X and Y, Country A is said to have a comparative advantage in good X if the opportunity cost of making 1 more unit of Xin A (in terms of Y) is less than the opportunity cost of making 1 more unit of X in B (in terms of Y).

Criticism on David Ricardo Theory of Comparative Advantage:However, the principle of comparative advantage can be criticised in aseveral ways:

1. It may overstate the benefits of specialisation by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.

2. Complete specialization might create structural unemployment as some workers cannot transfer from one sector to another.

3. Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.

4. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade. Countries can develop new advantages, such as Vietnam and coffee production. Despite having a long history of coffee production it is only in the last 30 years that it has become a global player. seeing its global market share increase from just 1% in 1985 to 20% in 2014, making it the world's secondlargest producer.

3 In our example we have supposed thisA= HomeB= Foreign

5. Many countries strive for food security, meaning that even if they should specialise in non-food products, they still prefer tokeep a minimum level of food production.

6. The principle of comparative advantage is derived from a highly simplistic two good/two country model. The real world is far morecomplex, with countries exporting and importing many different goods and services.

7. According to influential US economist Paul Krugman, the continualapplication of economies of scale by global producers using new technology means that many countries, including China, can produce very cheaply, and export surpluses. This, along with an insatiable demand for choice and variety, means that countries typically produce a variety of products for the global market, rather than specialize in a narrow range of products, rendering the traditional theory of comparative advantage almost obsolete.

8. However, the underlying principle of comparative advantage can still be said to give some ‘shape’ to the pattern of world trade,even if it is becoming less relevant in a globalised world. 

Heckscher Ohlin Model of International Trade:The Heckscher-Ohlin (HO) model was developed by two Swedish economists– Eli Heckscher (in a 1919 article) and his student Bertil Ohlin (developed Heckscher ideas further in his 1924 dissertation). The HO model differs from the Ricardian model along two dimensions. Firstly, it adopts a more realistic framework as compared to Ricardian model byallowing for a second factor of production in the form of capital. Secondly, in the Heckscher-Ohlin model comparative advantage is determined by differences in endowments of factors across countries instead of differences in technology (as in the Ricardian model).

In the Heckscher-Ohlin model countries have the same production technologies. The first innovation implies that the production possibility frontier is going to be concave and hence result in increasing opportunity costs. As a result, complete specialization, asin the Ricardian model, is not very likely. Furthermore, trade will

cause redistribution of income between labor and capital. The second innovation of the model implies that a country will export goods that use its abundant factor intensively. For example, Canada is abundant in land and therefore it exports agricultural and forestry products aswell as petroleum; the United States, Western Europe and Japan have many high skilled workers as well as capital and therefore export sophisticated manufactured goods and services; China and other Asian countries have large number of unskilled workers and less capital and therefore export less sophisticated manufactured goods.

Assumption of HO model:1. Production functions for good X and Y are CRS.2. Production functions, which are same in both countries, differ in

factor-intensities. We will assume that X is labor-intensive whereas Y is capital intensive.

3. There is no factor-intensity reversal within each country.4. There is a fixed endowment of labor and capital, which are

homogeneous and perfectly mobile between industries within each country. However, labor and capital are immobile across countries.

5. There are no market distortions such as imperfect competition, taxes, tariffs, etc.

6. Preferences are identical and homogeneous.7. Countries differ in their relative factor endowments.

FACTORS ENDOWMENTS:

If the capital-labor ratio in the home country , A , is greater thanit is in the foreign country, B, then country A is relatively capital-abundant (and labor-scarce) whereas country B is relatively labor-abundant (capital-scarce). Mathematically, it means

K K

>

L A L B

FACTOR INTENCITIES:Good Y is relatively capital-intensive and good X is relatively labor-intensive if the capital labor

ratio used in producing good Y is higher than in producing good X, i.e.

K K

L x > L y

Effect of Differences in Relative Endowments

Let us analyze the impact of differences in relative factor endowments. point E represents identical relative factor endowment forthe two countries, i.e. labor endowment is L and capital endowment is K for both countries. The maximum possible outputs of X and Y are given by X and Y . Now, suppose the endowment of factors is different for country A, and is represented by point Eh. Thus country A is relatively capital-abundant - it has a greater endowment of capital and a smaller endowment of labor than country B (which is still at point E). As a result the maximum outputs of the two goods that can beproduced in country A are Xh and Y h. Since country A is capital-abundant, the output of the capital-intensive good, Y , increases (isoquant Y h lies above Y ) while the output of the labor intensive good, X, decreases (isoquant Xh lies below X).

The same analysis is also depicted in terms of production possibility frontiers in Figure2. Since country F is relatively-labor abundant, its production possibility frontier (XY) is biased toward the X axis, and by thesame logic the production possibility frontier of countryA (XhY h) is biased toward Y axis. Furthermore, in Figure 1, the relative endowment remains the same along the ray Okh as the endowment of the two factors shrinks or expands by the same factor. Due to CRS, this implies that output of the two goods expand or shrink by the same factor, which in turn means that theproduction possibility frontier shifts in or

4

Shifts out in a parallel fashion. Therefore, changing the endowment point from Eh to Eh, translates into an inward shift ofthe production possibility frontier from XhY h to hYh.

Trade Equilibrium: So, differences in relative factor endowments and relative factor-intensities determine the pattern of comparative advantage. So, what happens when we allow countries to trade? As we have seen, the relative price of good X is higher in country Athan in country F. Therefore, when countries trade, consumers in country H will shift some of their purchases of good X to countryB. On the other hand, consumers in B will shift purchases of Y tocountry A. This shifting of expenditure will continue till pricesof the two commodities are equalized. In response to this shift in demand, production will also have to adjust. Country B will increase the production of good X and country A will increase theproduction of good Y . Therefore, the production point for A willmove up its production possibility frontier toward the Y axis, which will imply that the slope of production possibility frontier will flatter. Similarly, production point for country B will shift toward X axis, which implies that slope of its production possibility frontier will become steeper. Therefore, the net effect is that the price ratio will fall (slope of price line will decrease) in country A and it will rise in country B (slope of price line will increase). The move from autarky to trade equilibrium is depicted in Figure 3.

4 Copied from the Article of Rahul Giri

Fig: 3 Trade Equilibrium with different Factors Endowments:

Under trade, the production equilibrium is established at point Qh for A and at point Qf for B; the consumption equilibrium is achieved at point Ch for A and at point Cf for B. A attains utility level I∗ h and B attains utility I∗ f . Both countries gain from trade because they consume on indifference curves that lie outside their respective production possibility frontiers. The equilibrium price ratio is p∗. Equilibrium price ratio ensures that the world excess demand for each good is zero. At p∗, country A imports OXh amount of good X (which is equal to BhChin and country B exports exactly the same amount of X (OXf = BhQh).The Heckscher-Ohlin Theorem: Given the assumptions of the model, a country will export the commodity that intensively uses its relatively abundant factor. As compared to the Ricardian model, the HO model has contrasting implications.1. Countries produce both goods. Thus, there is incomplete specialization as compared to complete specialization in the Ricardian model.

2. Trade results in equalization of commodity prices in the two countries.The Heckshier Ohlin model depicts International trade in more broad sense but this model also failed to resolve the complete result of international trade. Some of the weak points of the theory of Heckshier Ohlin model are as follows.1. Trade in the real world is not free. There are costs of trading such as tariffs and import quotas, which prevent commodity prices from being equalized.2. Furthermore, there are distortions like monopolies, in which case the owners get rents; there are trade unions which sustain wages higher than marginal products. Differences in government policies, in terms of differences in taxes and subsidies across sectors of an economy, can determine comparative advantage.3. The assumption of CRS production function may not hold. Then, country size may become an important determinant of trade or for that matter product differentiation too.4. Technologies are assumed to be the same across countries, which obviously does not hold.5. Labor and capital are assumed to be homogeneous. This is clearly a simplification. Workers differ by their skill levels. Capital may be sector-specific.

International trade in the prospective of Gravity Model:Who trades with whom? This phenomenon of international trade tells us that which countries of the world trade with each other.For answering this question the economist use the physics law of gravity, which states that gravitational attraction between two objects is proportional to the product of their masses and diminishes with distance the distance between them. As same like this law economists point out that the trade between any two countries is, other thing remaining same, trade is directly proportional to the product of their GDP’s and inversely related to the distance between them.Mathematically,

Tij= A * Yi + Yj Dij

Where

Tij = Value of trade

A = Constant

Yi = GDP of (i) country

Yj = GDP of (j) country

Dij= Distance between “I” and “j” countries

Logic of Gravity Model:Lets us assume we have four countries in the world i.e. A, B, C, D. A and B has a GDP of 4 trillion while C and D has GDP of 1 trillion. The total share of spending of A and B is 40% each while C and D share is 10% each.

Country % share of spending GDP (trillion)A 40 4B 40 4C 10 1D 10 1

Determination of trade value:

We can determine the value of trade of countries A, B, C, D. The share of A and B is much higher because their GDP is also greater than that of C and D. So value of trade will be

Country A B C DA …………. 40%*4= 1.6 10%*4=0.4 10%*4=0.4B 40%*4=1.6 ……………. 10%*4=0.4 10%*4=0.4C 10%*4=0.4 10%*4=0.4 ……………… 10%1=0.1D 10%1=0.1 10%1=0.1 10%1=0.1 ……………..

EXPLANATION OF THE TABLE:

This table shows that A and B has large GDP of 4 trillion which gives a trade value of 1.6 trillion with each other. C and D has a size of small GDP of One trillion so trade between C and D witheach other is 0.1 trillion. When the small size GDP country tradewith large GDP with small size economy shows greater value of trade. So from this example it is clear that greater will be the value of trade greater will be the size of economy.

THEORY OF ECONOMIES OF SCALE:One important motivation for international trade is the efficiency improvements that can arise because of the presence of economies of scale in production. Although economists wrote about these effects long ago, models of trade developed after the 1980s introduced economies of scale in creative new ways and became known as the “New Trade Theory.”

Another major reason that international trade may take place is the existence of economies of scale (also called increasing returns to scale) in production. Economies of scale means that production at a larger scale (more output) can be achieved at a lower cost (i.e., witheconomies or savings). When production within an industry has this characteristic, specialization and trade can result in improvements inworld productive efficiency and welfare benefits that accrue to all trading countries. Trade between countries need not depend on country differences under the assumption of economies of scale. Indeed, it is conceivable that countries could be identical in all respects and yet find it advantageous to trade. For this reason, economies-of-scale models are often used to explain trade among countries like the UnitedStates, Japan, and the European Union. For the most part, these countries, and other developed countries, have similar technologies, similar endowments, and to some extent similar preferences. Using classical models of trade (e.g., Ricardian, Heckscher- Ohlin), these countries would have little reason to engage in trade. Yet trade between the developed countries makes up a significant share of world trade. Economies of scale can provide an answer for this type of trade.

Another feature of international trade that remains unexplained with classical models is the phenomenon of intraindustry trade. A quick look at the aggregate trade data reveals that many countries export and import similar products. For example, the United States imports and exports automobiles, imports and exports machine tools, imports and exports steel, and so on. To some extent, intraindustry trade arises because many different types of products are aggregated into one category. For example, many different types of steel are produced,from flat-rolled to specialty steels. It may be that production of some types of steel requires certain resources or technologies in which one country has a comparative advantage. Another country may have the comparative advantage in another type of steel. However, since all these types are generally aggregated into one export or import category, it could appear as if the countries are exporting andimporting “identical” products when in actuality they are exporting one type of steel and importing another type. Nevertheless, it is possible to explain intraindustry trade in a model that includes economies of scale and differentiated products even when there are no differences in resources or technologies across countries. This model is called the monopolistic competition model. Its focus is on consumerdemand for a variety of characteristics embodied in the goods sold in a product category. In this model, advantageous trade in differentiated products can occur even when countries are very similarin their productive capacities.

Economies of scale in production means that production at a larger scale (more output) can be achieved at a lower cost (i.e., with economies or savings). A simple way to formalize this is to assume that the unit labor requirement in the production of a good is a function of the level of output produced. In Figure A "Unit-Labor Requirement with Economies of Scale", we present a graph of the unit labor requirement in steel production as a function of the scale (level of output) of production. At production level QS1, the unit labor requirement is given by aLS1. If production were to rise to QS2, then the unit labor requirement would fall to aLS2. This means that at the higher level of output, it requires less labor (i.e., fewer resources or a lower cost) per unit of output than it required at the smaller scale. A secondary assumption is that the additional savings

(or economies) fall as the scale increases. Graphically, this means that the slope of the curve in Figure A "Unit-Labor Requirement with Economies of Scale" becomes less negative as the scale of production (output) rises. Economists sometimes refer to this feature by saying the function is concave to the origin; that is, it is bowed inward. The reason this assumption is made is because it seems to correspond to what is observed in the world. We expect that the degree of cost savings will be largest in the earliest stages of production, when labor division is likely to be the easiest and most effective. This assumption, although a realistic feature, is not necessary to explain trade, however.

Fig: A: Unit Labour requirement with Economies of Scale:

With a simple adjustment, it is possible to show that increasing returns to scale in production means that an increase in resourceusage by, say, x percent results in an increase in output by morethan x percent. In Figure B "Productivity with Increasing Returnsto Scale", we plot labor productivity in steel production when production exhibits increasing returns to scale. This curve is derived by plotting the reciprocal of the unit labor requirement (i.e., 1/aLS) for each output level in Figure B "Productivity with Increasing Returns to Scale". As output (scale) increases from QS1 to QS2, labor productivity (given by the reciprocal of the unit labor requirement) also rises. In other words, output

per unit of labor input increases as the scale of production rises, hence increasing returns to scale.

Fig B: Productivity with Increasing Return to Scale:

Another way to characterize economies of scale is with a decreasing average cost curve. Average costs, AC, are calculated as the total costs to produce output Q, TC(Q), divided by total output. Thus AC (Q) = TC (Q)/Q. When average costs decline as output increases, it means that it becomes cheaper to produce theaverage unit as the scale of production rises, hence resulting ineconomies of scale.

Some features of the economies-of-scale model make it very different from the other models of trade, such as the Ricardian or Heckscher-Ohlin models. For example, it is possible to show that countries that are identical in every respect might

nevertheless find it advantageous to trade. Thus it is not alwaysdifferences between countries that stimulate trade. In this case,it is a feature of the production process (i.e., economies of scale) that makes trade gains possible

Second, this economies-of-scale model cannot predict which country would export which good. It doesn’t matter which country produces all the economies-of-scale good. As long as one country does so and trades it with the rest of the world, trade gains arepossible. Also, it may not matter whether your country ends up producing the economies-of-scale well or not because both countries will realize the benefits as long as an appropriate term of trade arises.

Despite these differences with other models, the main similarity is that gains from trade arise because of an improvement in productive efficiency. By reallocating resources between industries within countries, it is possible to produce more output with the same amount of resources. This remains the prime motivation in support of free trade.

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