IV Semester BAE-4.1 International Economics Module 1: Introduction and Theories of International Trade. Meaning and importance of International Economics International economics refers to a study of international forces that influence the domestic conditions of an economy and shape the economic relationship between countries. In other words, it studies the economic interdependence between countries and its effects on economy. International trade studies goods-and-services flows across international boundaries from supply-and-demand factors, economic integration, international factor movements, and policy variables such as tariff rates and trade quotas. The scope of international economics is wide as it includes various concepts, such as globalization, gains from trade, pattern of trade, balance of payments, and FDI. Apart from this, international economics describes production, trade, and investment between countries. International economics has emerged as one of the most essential concepts for countries. Over the years, the field of international economics has developed drastically with various theoretical, empirical, and descriptive contributions. Generally, the economic activities between nations differ from activities within nations. For example, the factors of production are less mobile between countries due to various restrictions imposed by governments. The impact of various government restrictions on production, trade, consumption, and distribution of income are covered in the study of internal economics. Thus, it is important to study the international economics as a special field of economics. Difference between International Trade and Internal Trade There are, however, a number of things which make a difference between foreign trade and domestic trade and necessitate a separate theory of international trade. They are as under: (i) Immobility of Factors of Production: Labour and capital do not move freely from one country to another as they do within the same country. ―Man‖, declared Adam Smith, ―is, of all forms of luggage, the most difficult to transport‖. Much more so when a foreign frontier has to be crossed. Hence differences in the cost of production cannot be removed by moving men and money, the result is the movement of goods. On the contrary, between regions within the same political boundaries, people distribute themselves more or less according to opportunities. Real wages and standard of living tend to seek a common level, though they are not wholly uniform. As between nations, however, these differences continue to persist for wages and check population movements. Capital also does not move freely from- one country to another. Capital is notoriously shy. (ii) Different Currencies: ADVERTISEMENTS: Each country has a different currency. India for instance, has the rupee, the U.S.A. the dollar, Germany the mark, Italy the lira, Spain the peso, Japan the yen, and so on. Hence, buying and selling between nations give rise to complications absent in internal trade. (iii) Restrictions on Trade: Trade between different countries is not free. Very often there are restrictions imposed by custom duties, exchange restrictions, fixed quotas or other tariff barriers. For example, our own country has imposed heavy duties on import of motor cars, wines and liquors and other luxury goods. (iv) Ignorance: Knowledge of other countries cannot be as exact and full as of one‘s own country. Differences in culture, language and religion stand in the way of free communication between different countries. On the other hand, within the borders of a country, labour and capital freely move about. These factors, too, make internal trade different from international trade. (v) Transport and Insurance Costs: Then costs of transport and insurance also check- free international trade. The greater the distance between the two countries, the greater are these costs. Wars increase them still more. Conclusion: ADVERTISEMENTS: Thus, comparative immobility of labour and capital, restrictions on trade, transport and other costs, ignorance, and differences in language, customs, laws and currency systems make international trade different from domestic trade and necessitate a separate theory of international trade. Absolute cost advantage: Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than another entity that produces the same good or service. An entity with an absolute advantage can produce a product or service at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same good or service. Absolute advantage is when a producer can produce a good or service in greater quantity for the same cost, or the same quantity at lower cost, than other producers. Absolute advantage can be the basis for large gains from trade between producers of different goods with different absolute advantages. By specialization, division of labor, and trade, producers with different absolute advantages can always gain over producing in isolation. Absolute advantage is related to comparative advantage, which can open up even more widespread opportunities for the division of labor and gains from trade. The concept of absolute advantage was developed by Adam Smith in his book Wealth of Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the funds that good or service generates to purchase goods and services from other countries. By Smith‘s argument, specializing in the products that they each have an absolute advantage in and then trading products, can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations. General Example of Absolute Advantage Consider the two hypothetical countries, Atlantica and Krasnovia, with equivalent populations and resource endowments, which each produce two products, Guns and Bacon. Each year Atlantica can produce either 12 Guns or 6 slabs of Bacon, while Krasnovia can produce either 6 Guns or 12 slabs of Bacon. Each country needs a minimum of 4 Guns and 4 slabs of Bacon to survive. In a state of autarky, producing solely on their own for their own needs, Atlantica can spend ⅓ of the year making Guns and ⅔ making Bacon for a total of 4 Guns and 4 slabs of Bacon. Krasnovia can spend ⅓ of the year making Bacon and ⅔ making Guns to produce the same, 4 Guns and 4 slabs of Bacon. This leaves each country at the brink of survival, with barely enough Guns and Bacon to go around. However, not that Atlantica has an absolute advantage in producing Guns, and Krasnovia has an absolute advantage in producing Bacon. Absolute advantage also explains why it makes sense for individuals, businesses and countries to trade. Since each has advantages in producing certain goods and services, both entities can benefit from trade. If each country were to specialize in their absolute advantage, Atlantica could make 12 Guns and no Bacon, while Krasnovia makes no Guns and 12 slabs of Bacon. By specializing, the two countries divide the tasks of their labor between them. If they then trade 6 Guns for 6 slabs of Bacon, each country would then have 6 of each. Both countries would now be better off than before, because each would have 6 Guns and 6 Bacon, as opposed to 4 of each good which they could produce on their own. This mutual gain from trade forms the basis of Adam Smith‘s argument that specialization, the division of labor, and subsequent trade leads to an overall increase of wealth from which all can benefit. Theory of comparative cost: This theory is developed by a classical economist David Ricardo. According to this theory, the international trade between two countries is possible only if each of them has absolute or comparative cost advantage in the production of at least one commodity. This theory is based upon following assumption: There are only two countries and two commodities There is no governmental intervention in export and import Only labor is factor of production. Quantity of labor used gives cost of production There is perfect mobility of labor within the country but not between the countries There is no cost of transportation between the countries The law of constant returns to scale operates in production. The units of labor are homogeneous The units of each commodity in both countries are homogeneous According to comparative cost advantage theory of international trade, each country exports the commodity in which it has cost advantage and imports the commodity in which it has cost disadvantage. This theory can be explained as following: A. Comparative cost advantage If a country can produce both commodities with less cost than another country but in different ratio, the country is said to have comparative cost advantage. Country Labor required to produce Labor required to produce shoe clothe Nepal 10 4 India 20 12 ratio 10/20=0.5 4/12=0.33 In the above table, the cost of production of clothe in Nepal is only 50% of cost of production of clothe in India. In case of shoes, the cost of production is only 1/3rd of cost in India. It shows that Nepal can produce both commodities with fewer cots than India. But in order to take advantage, it produces only shoes land let India produce clothe for it. Nepal produces shoes and exports to India. India produces clothe and exports to Nepal. If they do so, both of them can take benefits. B. Absolute cost advantage: If a country can produce a commodity with less cost but has to bear more cost in the production of another commodity than another country then the country is said to have absolute cost advantage.