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According to A
 

,, the basis of international trade is the territorial
division of labour or international specialisation.
specialisation. Just as different individuals
have different abilities to produce different commodities, similarly different
countries have different degrees of efficiency to produce different commodities.
commodities.

If a country specialises in the production of a commodity in whose production

she enjoys the highest efficiency, then the production of that commodity will
increase..
increase

Hence each country should produce and export that commodity in whose
production she has a cost advantage, that is, in which the absolute cost is the
lowest..
lowest

This is the main theme of the theory of absolute advantage of Adam Smith.
Smith.
 Abs
A


 According to A
 


,, international trade takes place due to the differences in
the cost of production of different commodities in different countries.
countries.

To discuss the theory of Absolute Advantage, the following assumptions are made.
made.

 There are two countries-

countries- Country I and Country II producing two commodities
commodities--
Commodity A and commodity B.

 Labour is the only factor of production.

production. All costs are being measured in terms of
labour hour.
hour.

 The production techniques of two commodities are different in two countries

countries..

 There are constant returns to scale in production of both commodities in both

countries..
countries

 There are no transport costs or other trade barriers.

barriers.

 There is full employment of labour in both the countries.

countries.


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s
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  b

Commodity A Commodity B
Country I
0

Country II 0

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ºor example
example,, spending
units of labour, Country
can produce
unit
of commodity A. But to produce
unit of Commodity B, it has to spend
0 units of labour.
labour.

Suppose trade begins and international price ratio is

.

Now Country
can produce
unit of Commodity A by spending

units of labour and sending it to country II it can get one unit of
commodity B. So Country I gets commodity B at lower cost through
international trade.
trade.

Similarly, Country II gets Commodity A at lower cost by means of

international trade.
trade.
 ë

 s



Smith has assumed that labour is the only factor of production.

production. Here
the cost of production of any commodity is measured in terms of
labour.. This assumption of single factor of production is unrealistic.
labour unrealistic.

It is assumed that there is full employment of labour in both the

countries.. This is again unrealistic.
countries unrealistic.

Smith considered only two countries and two commodities

commodities.. But in real
world, there are many countries and many commodities.
commodities.

The model neglects the demand conditions and considers only the
supply conditions or cost conditions.
conditions. Here the model can¶t say how the
rate of exchange between commodities is determined.
determined.
The model assumes CRS CRS.. The model can¶t tell anything about the
pattern of trade under IRS or DRS
DRS..

The model assumes that there are no transport costs or other trade
barriers.. His assumption is also far from reality.
barriers reality.

In this model it is assumed that each country has an absolute

advantage in the production of one commodity.
commodity. But if one country can
produce both the commodities more cheaply than the other country, i.e.
one country enjoys an absolute advantage in the production of both the
commodities, trade can¶t take place profitably between the two
countries..
countries
 
 !
A

 s

This theory was advanced as an alternative to the Theory of Absolute
Advantage..
Advantage

Recardo has shown that even if one country has an absolute advantage in
the production of both the commodities, trade can take place if there are
differences in comparative costs.
costs.

Comparative cost differences exist if the ratios of the domestic unit costs
differ between the two countries
countries..
 Ass
 !
 


There are two countries producing two commodities and international

trade takes place in these two commodities.
commodities. Both the countries can
produce both the commodities.
commodities.

Each country uses only one factor of production, labour, in the

production of both the commodities.
commodities.

Labour is assumed to be homogeneous in both the countries.

countries. The cost
of production of each commodity is measured in terms of labour hours
required to produce each commodity.
commodity.

The value of any commodity is determined by the amount of labour

required to produce one unit of that commodity.
commodity. The greater the
labour hours, the greater is the value of the commodity.
commodity.
There are CRS in the production of both the commodities.
commodities. This means
that in each country the cost of production of one unit of each
commodity remains constant.
constant.

ºree international trade takes place between the two countries and
there is no restriction on the movement of commodities between the
two countries.
countries. There are also no transport costs.
costs.

 The amount of labour in each country is given and fully employed.

employed.

There is perfect competition in both the commodity and factor

markets in both the countries.
countries.

There is no movement of labour from one country to another though

labour is perfectly mobile within each country.
country.
Tastes are similar in both the countries.
There is no change in technology.
Trade between the two countries takes place on the basis of the
barter system.

On the basis of these assumptions, this theory shows that even if a

country enjoys an absolute advantage in the production both the
commodities, then also both the countries can trade profitably if the
domestic cost ratio differs between the two countries
countries..

When cost ratio differs, it is said that comparative cost differences

exist..
exist
 Recardo¶s theory can be elaborated and explained with the help of Recardo¶s famous
example.. Recardo took two countries, Œ
 and 
example  ,, producing two
commodities, 
and  ..

The unit costs in labour hours of these two commodities are shown in the Table
below
 
s
s b "

Wine Cloth

Portugal  9

England
0

It is seen that 
 has an absolute advantage in the production of wine as well as
in the production of cloth or England has an absolute disadvantage in the production of
both the wine and cloth.
This is because the labour cost of production for each unit of the two commodities is
less in Portugal than in England.
Here the concept of opportunity cost is introduced.
introduced.
The opportunity cost for good A is a the amount of other goods which
have to be given up in order to produce one additional unit of A.

The Table below gives the opportunity costs for producing wine and
cloth in Portugal and England.
England.
The costs have been computed on the basis of the information given in
the last table.
table.
r
 
s
s

Wine Cloth

Portugal  9  .9 9  
.

England
0 

.0

0  .

A country has a comparative advantage in producing a good if the
opportunity cost for producing the good is lower at home than in the
other country.
country.

The previous table shows that Portugal has a lower opportunity cost of
two countries in producing wine while England has a lower opportunity
cost in producing cloth.
cloth. Thus Portugal has a comparative advantage.
advantage.

Thus Portugal has a comparative advantage in the production of wine

and England has a comparative advantage in the production of cloth.
cloth.

Simply speaking, if the domestic cost ratios in the two countries are
different, comparative cost differences exist.
exist.

As long as the domestic cost ratios differ, both countries will gain from
trade regardless of the fact that one of the countries might have an
absolute advantage in the production of both the commodities.
commodities.
In the example, the domestic cost ratios differ because  9 
0 
.
So here comparative cost differences exist and hence trade will take
place..
place

Here Portugal has an absolute advantage in the production of both the

commodities, but her advantage is greater in wine than in cloth.
cloth. In this
case it is said that Portugal has a comparative advantage in the
production of wine.
wine.

Similarly England has an absolute disadvantage in the production of both

the commodities.
commodities. But her disadvantage is smaller in the production of
cloth.. Here it is said that England has a comparative advantage in the
cloth
production of cloth.
cloth.

It can be shown in an alternative manner.

manner. It is shown in the next slide.
slide.
Portugal takes  
(9 

9
of the English effort to produce

unit of cloth.

But Portugal takes only 
( 
0 


of the English effort
to produce
unit of wine.

Thus Portugal enjoys a comparative advantage in the production of  .

.

Similarly, England takes #$
(
0  


of the Portuguese
effort to produce
unit of wine.

But England takes only ###
(
9 


of the Portuguese
effort to produce
unit of cloth.


..
Thus England has a comparative advantage in the production of 

So trade will take place.

Portugal will specialise in the production of wine and will export it.

England will specialise in the production of cloth and will export it.
º
%

 
This theory was developed by Swedish economist Eli Heckscher and his
student Bertil Ohlin.
Ohlin. Paul Samuelson and Wolfgang Stolper have also made
significant contribution to this theory.
theory.

This theory consists of two important theorem

s &
s &r  

º
  %'s
 

The Heckscher
Heckscher--Ohlin theorem examines the reasons for comparative cost
differences in production and states that a country has a comparative advantage
in the production of that commodity which uses more intensively the country¶s
more abundant factor.
factor.

The Factor Price Equalisation theorem examines the effect of international

trade on factor prices and states that free international trade equalises factor
prices between countries, relatively or absolutely, and thus serves as a substitute
for international factor mobility.
mobility.
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Both product and factor markets in both countries are characterised by

perfect competition

ºactors of production are perfectly mobile within each country but

immobile between countries.

ºactors of production are of identical quality in both countries.

ºactor supplies in each country are fixed.

ºactors of production are fully employed in both the countries.

ºactor endowments of one country vary from that of the other.

other.
There is free trade between the countries, i.e., there is no artificial
barrier to trade.
trade.

International trade is costless, i.e., there is no transport cost.

cost.

Techniques of producing identical goods are the same in both

countries.. Due to this, the same input mix will give the same
countries
quantity and quality of output in both the countries.
countries.

ºactor intensity varies between goods.

goods. So some goods are capital-
capital-
intensive and some goods are labour-
labour-intensive.
intensive.

Production is subject to the CRS, i.e., input-

input-output ratio will remain
constant irrespective of the scale of operation.
operation.
 Heckscher and Ohlin have explained the basis of international trade
in terms of ºactor Endowments.
Endowments.

The alternative formulation of the comparative cost doctrine

developed by Heckscher and Ohlin attempts to which comparative
cost differences exist internationally.
internationally.

They attribute international (and inter-

inter-regional
differences in
comparative cost to

Different prevailing endowments of the factors of production

The fact that production of various commodities requires that the
factors of production be used with different degrees of intensity.
intensity.
In Heckscher
Heckscher--Ohlin model, factors of production are regarded
as scarce or abundant in relative terms, and not in absolute
terms.. That is, one factor is regarded as scarce or abundant in
terms
relation to the quantum of other factors.
factors.

Hence it is quite possible that even if a country has more

capital, in absolute terms, than other countries, it could be
poor in capital.
capital.

A country can be regarded as richly endowed with capital only

if the ratio of capital to other factors is higher when compared
to other countries.
countries.
# | 
A

Supply of labour  0 units

Supply of capital  0 units
Capital Labour Ratio  .

2| 


Supply of Labour 
0 units

Supply of Capital 
units
Capital--Labour Ratio 
.0
Capital

In the above example, even though Country A has more capital in

absolute terms, Country B is more richly endowed with capital because
the ratio of capital to labour in Country A is less than in Country B.
º
%'s
  
International trade increases the demand for abundant factors (leading to
prices
and deceases the demand for scarce factors
an increase in their prices

(leading to a fall in their prices

prices
because when nations trade,
specialisation takes place on the basis of factor endowments.
endowments.

According to Ohlin
³ The effect of inter-regional trade is to equalise commodity prices.
Furthermore, there is also a tendency towards equalisation of of the
prices of factors of production, which means their better use and the
reduction of the disadvantages arising from the unsuitable geographical
distribution of the productive factors.´

Since from each region, goods containing a large proportion of relative

abundant and cheap factors are exported, while goods containing a large
proportion of scarce factors are imported, ³«inter-regional trade serves
as a substitute for such inter-regional factor movements.´
 ï
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ï
ss 
This theory rightly points out that the immediate basis of international
trade is the difference in the final price of a commodity between
countries.