5 Trade Theories

TRADE THEORIES

What is Trade?- Exchange of goods and services Why do we need to do trade?  Differences in cost are the basic cause of trade. Every country will have goods that can be produced cheaper than others. This promotes them to export that product for another. Eg. UAE can produce oil while Japan can produce electronics and cars. The two nations can trade with each other and both are satisfied.

How does a country decide what to trade and with whom to trade?

Adam Smith’s theory of Absolute Advantage Simplest example- Imagine USA needs 10 workers to manufacture 1 helicopter but takes 20 men to build a luxury car. Germany on the other hand needs 20 workers to manufacture a helicopter while only 10 workers for the car. Do they have any advantage to trade? Or can they continue doing what they’ve been doing?

There’s only one logical decision to be made by both  countriesUS must export copters to Germany and import cars in return! Because instead of wasting 20 men for making a car, they can make TWO copters. If US sells it to Germany they can get back TWO CARS for the cost of one! 

The result is maximum productivity and profit.

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Every country having absolute advantage in the production and distribution of every good is not possible. So international trade is important to everyone. That is why when sanctions are imposed on our trade, it affects us a lot. (India, Pak, Iraq, North Korea) Trade also depends on relationships between nations. Reason why heads of state keep meeting other heads to discuss better ties for the future. Eg. India & China, Russia, US etc.

But what if a country can produce all the goods it needs or another country cannot produce any goods at all. Does it mean they should not and cannot trade?

David Ricardo’s Comparative Advantage Theory Eg. Suppose India and France are cotton and wine producing countries. France can produce 1 unit of wine with 50 man hours and 1 unit of cotton with 60 man hours.  India on the other, the cost of producing 1 unit of wine is 100 working hours and 1 unit of cotton is 80 man hours. Does it make sense for France to trade with India? 

Yes, France must trade with India! 

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Because if we calculate, the cost for France for making 1 unit of wine is 50/60 and 1 unit of cotton is 60/50. Which means 1 unit of wine costs 0.833 units of cotton and 1 unit of cotton costs 1.2 units of wine. For France cotton is more expensive to make than wine. For India, 1 unit of wine is 1.25 units of cotton. and 1 unit of cotton is 0.80 units of wine. Here wine is more expensive.

•Therefore both countries can benefit if they are willing to trade with each other. India can manufacture cotton and sell to France in exchange for wine and France is also benefited vice versa. To understand the point further, if the world market price for 1 unit of cotton is similar to 1 unit of wine, then France

Logic? 

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To make 1 unit of cotton France has to spend 60 man hours which has the same value as 1 unit of wine made in 50 hours. France can leave the cotton making work to India and save those 10hours or add those 10hours extra for making more wine. India on the other hand can save 20 hours every time it makes cotton and gets back equivalent amount of wine as needed.

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Heckscher Ohlin Theory (H-O Goods differ in terms of the factors of production. Eg. Model) Manufacturing of textiles is labour intensive whereas producing microprocessors is capital intensive. Countries differ w.r.t. their factor capabilities. Eg. India is high in labour but UK is high in capital. A country manufactures and uses those factors which it has in abundance. Eg. US exports capital intensive defense goods. As with previous theories, HO Model too is weak in the fact that it states markets as being static with factors also being constant. Present markets change using innovation, intelligence (Indian software), taste and need for the goods and other reasons.

Strategic Trade TheoryCombination of the latest  Increasing returns to scale- firms will produce and trade theories. Key factors export more and more inorder to lower costs through 

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economies of scale. Product differentiation- there can also be intraindustry competition. i.e. within the same industry we can have trade. Eg. Japan will trade Toyotas and Honda with Germany in exchange for Mercedes and BMWs. Imperfect competition- companies might have to face various hurdles to sell to other nations. Eg. India might give special subsidies to Videocon so as to keep Japanese Sony and Aiwa costlier than domestic players.

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Externalities & spillover effectsOnce a new technology product is sold outside, other countries might reverse-engineer and make their own versions. Thus the original maker suffers losses of loss of market. IP rights and patents play a role. Irreversible investments- eg. When earth-moving equipment companies like Caterpillar suffered huge losses in 1980’s they had no choice but to continue as such because the costs for market reentry would have been sky high (building distribution networks, partners etc.)