JosepThe exchange of goods and services across international borders is known as international trade. Unlike domestic trade, it also involves border costs, time costs, and other costs.
Some of the theories that explain the importance of international trade are the absolute difference theory, the theory of comparative cost, factor proportion theory, Mercantilism, National Competitive Theory, and more.Absolute Differences in Cost Theory of International Trade
Adam Smith came up with this theory. Adam Smith was a Scottish moral philosopher and a pioneer of political economy. He stated that trade between the two nations depends on the absolute advantage.
When one nation is more efficient than the other in the production of one commodity but is less efficient than the other in the production of a second commodity, then both the nations can gain by each specializing in the production of its absolute advantage and exchanging part of its output with the other country for the commodity of its absolute disadvantage.
However, the critics state that Adam Smith lacked behind in explaining the reason behind the trade between the two nations when one of the trading nations does not have an absolute advantage. They believe that this theory explains only a very small part of world trade.
Supposedly, there are two countries, A and B. Here, A is better at producing tea and B is better at producing Coffee. Additionally, the production of tea in Country A takes less time than in Country B due to its efficiency. In the case of Coffee, Country B experiences the same thing. Now, Country A will choose to import coffee rather than make it in their own country, which will take longer and cost more, and Country B will find it profitable to import tea rather than make it in their own country, which will take longer and cost more. Country A will ultimately import coffee and export tea in this scenario. Additionally, Country B will ultimately import tea and export coffee. This is what the absolute cost theory is trying to say.
- Theory of Comparative Cost
David Ricardo gave the theory of Comparative Cost. He accepts the Absolute Difference theory study. However, it is helpful in explaining one of the flaws of the Absolute difference theory. The theory of Comparative Cost is based on the following presumptions: The supply curve for any goods is horizontal.
There is full employment in the economy.
Perfect competition in the product and market.
No governmental intervention in the form of restrictions to free trade.
Zero transport costs.
The only primary component of production is labor. The relative ratios of labor at which the production of one good can be traded off for another differ between countries.
Fixed technology.
Every country has a fixed endowment of resources where all units of a particular resource are identical.
The factors of production are perfectly mobile between the alternative productions within a country.
Factors of production are immobile between countries.
The trade between the two countries can be jointly advantageous as long as the difference in comparative advantage breathes between the productions of two commodities.
Ricardo is of the opinion that even when one nation is able to produce every commodity at a lower cost than the other, international trade results in mutual profit. For example, there are two countries, A and B. Country A produces 1 unit of Cloth in an hour and Country B produces 1 unit of Cloth in 2 hours. In the same way, Country A produces 1 unit of Chips in 3 hours and Country B produces 1 unit of Chips in 4 hours.
Here, Country A has an absolute cost advantage in the production of both the commodities because it requires lesser labor hours in the production of Cloth and Chips which is 1 hour per unit of cloth and 3 hours per unit of Chips.
It shows that country A is twice as productive as country B in Cloth production whereas in Chips production it is only 4/3 times as productive as Country B. As a result, Country A has a greater comparative advantage when it comes to making cloth.
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