international trade

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AS and A Level Economics

E1 A detailed explanation of how international trade leads to the benefits and costs identified using relevant theories.

David Ricardo:

David Ricardo was born at April eighteenth 1772 in London and died on the eleventh of September 1823. He was one of the most important British economist in 1800.

In , the theory of comparative advantage explains why it can be beneficial for two countries to , even though one of them may be able to produce every kind of item more cheaply than the other. What matters is not the absolute cost of , but rather the ratio between how easily the two countries can produce different kinds of things. The concept is highly important in modern international trade theory

The Theory of Comparative Advantage

Consider Table 1. It can be seen that Portugal can produce both wheat and wine more cheaply than England than it has an absolute advantage in both commodities. What David Ricardo saw was that it could still be mutually beneficial for both countries to specialise and trade.

Table 1

In Table 1, a unit of wine in England costs the same amount to produce as 2 units of wheat. Production of an extra unit of wine means foregoing production of 2 units of wheat so, the opportunity cost of a unit of wine is 2 units of wheat. In Portugal, a unit of wine costs 1.5 units of wheat to produce. Because relative or comparative costs differ, it will still be mutually advantageous for both countries to trade even though Portugal has an absolute advantage in both commodities.

Portugal is relatively better at producing wine than wheat: so Portugal is said to have a comparative advantage in the production of wine. England is relatively better at producing wheat than wine: so England is said to have a comparative advantage in the production of wheat.

Table 2 shows how trade might be advantageous. Costs of production are as set out in Table 1. England is assumed to have 270 man hours available for production. Before trade takes place it produces and consumes 8 units of wheat and 5 units of wine. Portugal has fewer labour resources with 180 man hours of labour available for production. Before trade takes place it produces and consumes 9 units of wheat and 6 units of wine. Total production between the two economies is 17 units of wheat and 11 units of wine.

Table 2 

If both countries now specialise, Portugal producing only wine and England producing only wheat, total production is 18 units of wheat and 12 units of wine. Specialisation has enabled the world economy to increase production by 1 unit of wheat and 1 unit of wine.

The simple theory of comparative advantage outlined above makes a number of important assumptions:

- There are no transport costs.

- Costs are constant and there are no economies of scale.

- There are only two economies producing two goods.

- The theory assumes that traded goods are homogeneous (ie identical).

- 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 internationally.

Heckschler-Ohlin theory:

Eli heckschler (1879-1952) developed with Berthil Ohlin ( 1899-1979) a theory to explain the existence of international trade based on a comparative cost advantage between countries producing different goods.

The Heckscher-Ohlin theory says that two countries trade goods with each other (and thereby achieve greater economic welfare), if the following assumptions hold:

  • The major factors of production, namely labour and capital, are not available in the same proportion in both countries.
  • The two goods produced either require relatively more capital or relatively more labour.
  • Labour and capital do not move between the two countries.
  • There are no costs associated with transporting the goods between countries.
  • The citizens of the two trading countries have the same needs.

For example:

Two countries that each produce both jeans and cell phones. Although both countries use the same production technologies, one has a lot of capital but a limited number of workers, while the other country has little capital but lots of workers.

The country that has a lot of capital but few workers can produce many cell phones but few pairs of jeans because cell phones are capital intensive and jeans are labour intensive. The country with many workers but little capital, on the other hand, can produce many pairs of jeans but few cell phones.

According to the Heckscher-Ohlin theory, trade makes it possible for each country to specialize. Each country exports the product the country is most suited to produce in exchange for products it is less suited to produce. The country that has a lot of capital specializes in the production of cell phones, whereas the country that has more labour specializes in the production of jeans.

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In this case, neither country has specialized in producing more of one of the two particular products , both countries produce about the same number of jeans and cell phones.

Country A – having more capital than labor  they

has specialized in producing more cell phones.

Country B – having more labor than capital they

has specialized in producing more jeans. In this case, trade may benefit both countries involved.

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international trade
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  • Level
    AS and A Level
  • Subject
    Economics
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