2 International Economics · 2.1 International economics: trade, institutions and growth
2.1.1 Trade theories: absolute and comparative advantage, Heckscher-Ohlin, terms of trade; free trade versus protection
Countries gain from trade by specialising in goods they make at a lower opportunity cost (Ricardo), and they tend to export goods that use their abundant factor intensively (Heckscher-Ohlin); free trade maximises world output, while protection is defended for infant industries, jobs, balance of payments and security.
- APPSC Paper I
- Advanced level
- 11 min read
- Free
Core facts
- Mercantilism (16th–18th century): wealth = gold and silver; export more, import less.
- Absolute advantage: Adam Smith, Wealth of Nations (1776). A country exports a good it makes with less labour than the other country.
- Comparative advantage: David Ricardo, Principles of Political Economy and Taxation (1817). Trade pays even if one country is better at both goods; each exports the good in which its advantage is greater (or disadvantage smaller).
- Ricardo's example: England and Portugal, cloth and wine; based on the labour theory of value.
- Opportunity cost theory: Gottfried Haberler (1936) restated comparative advantage without the labour theory of value.
- Reciprocal demand: J.S. Mill; the actual terms of trade between the two cost ratios depend on each country's demand for the other's good.
- Heckscher-Ohlin (H-O) theory: Eli Heckscher (1919) and Bertil Ohlin (1933). A country exports goods that use its abundant factor intensively.
- Capital-abundant country → exports capital-intensive goods; labour-abundant country → labour-intensive goods.
- Factor price equalisation theorem: Heckscher-Ohlin-Samuelson; free trade tends to equalise factor prices across countries.
- Leontief paradox (1953): the USA, the most capital-abundant country, was found to export labour-intensive goods and import capital-intensive ones (1947 data).
- Terms of trade (ToT): the rate at which exports exchange for imports.
- Net barter (commodity) ToT = (Px ÷ Pm) × 100 (export price index over import price index).
- A rise = improvement (favourable); a fall = deterioration.
- Prebisch-Singer hypothesis (1950): the ToT of primary-product exporters decline over the long run.
- Free trade: no tariffs or quotas. Protection: tariffs, quotas, subsidies and other barriers to imports.
- Infant industry argument: Alexander Hamilton (USA) and Friedrich List (Germany).
- Tariff types: specific (per unit), ad valorem (per cent of value), compound (both).
Explained
Absolute advantage: a worked example
One day of labour produces:
| Country | Cloth | Wheat |
|---|---|---|
| A | 10 | 5 |
| B | 4 | 8 |
- A is better at cloth (10 > 4); B is better at wheat (8 > 5).
- Without trade, each country spends 1 day on each good (2 days each): A makes 10 cloth + 5 wheat, B makes 4 cloth + 8 wheat. Total = 14 cloth + 13 wheat.
- With specialisation, A spends 2 days on cloth (20 cloth) and B 2 days on wheat (16 wheat).
- Gain to the world = 20 − 14 = 6 cloth and 16 − 13 = 3 wheat, with the same labour.
Comparative advantage: Ricardo's example
Labour (man-years) needed for one unit:
| Country | Wine | Cloth |
|---|---|---|
| Portugal | 80 | 90 |
| England | 120 | 100 |
- Portugal has an absolute advantage in both goods.
- Cost ratios (opportunity cost of 1 wine in cloth):
- Portugal: 80 ÷ 90 = 0.889 cloth
- England: 120 ÷ 100 = 1.2 cloth
- Wine is relatively cheaper in Portugal, so Portugal exports wine; cloth is relatively cheaper in England (1 cloth = 100 ÷ 120 = 0.833 wine, against 90 ÷ 80 = 1.125 wine in Portugal), so England exports cloth.
- Limits of the terms of trade: 1 wine must exchange for between 0.889 and 1.2 cloth. Outside these limits one country would not gain.
- At 1 wine = 1 cloth, Portugal gets a unit of cloth for 80 man-years instead of 90 (saves 10); England gets a unit of wine for 100 man-years instead of 120 (saves 20).
Heckscher-Ohlin theory
- Assumptions: two countries, two goods, two factors (labour, capital); same technology everywhere; goods differ in factor intensity; countries differ in factor endowment; perfect competition; no transport costs.
- Factor abundance can be defined by physical quantity (higher K/L ratio) or by factor prices (lower r/w ratio means capital-abundant).
- Cause of trade: different factor endowments lead to different factor prices, which lead to different commodity prices.
- Ricardo explains trade by labour productivity differences; H-O by factor endowment differences.
- Example: India (labour-abundant) exports textiles, garments, leather goods; imports capital-intensive machinery.
Kinds of terms of trade
| Concept | Formula | Associated with |
|---|---|---|
| Net barter (commodity) | (Px ÷ Pm) × 100 | F.W. Taussig |
| Gross barter | (Qm ÷ Qx) × 100 | F.W. Taussig |
| Income ToT | (Px ÷ Pm) × Qx | G.S. Dorrance |
| Single factoral | (Px ÷ Pm) × Zx | Jacob Viner |
| Double factoral | (Px ÷ Pm) × (Zx ÷ Zm) | Jacob Viner |
(Zx, Zm = productivity indices in export and import industries.)
Worked example: terms of trade
- Base year = 100. Current year: export price index 120, import price index 150, export volume index 140.
- Net barter ToT = 120 ÷ 150 × 100 = 80: the ToT have deteriorated by 20%.
- Income ToT = 80 × 140 ÷ 100 = 112: the capacity to import has risen 12%, because export volume grew faster than the ToT fell.
- Gross barter: if import volume index = 130 and export volume index = 110, gross barter ToT = 130 ÷ 110 × 100 = 118.2.
Free trade versus protection
| Free trade (for) | Protection (for) |
|---|---|
| Specialisation, higher world output | Infant industry needs time to grow |
| Cheaper goods, more choice for consumers | Protects jobs and domestic industry |
| Competition, efficiency, technology flow | Corrects balance of payments deficits |
| Wider markets, economies of scale | Defence and strategic self-reliance |
| Curbs monopoly power | Counters dumping; raises revenue; diversification |
Instruments of protection
- Tariff (customs duty): import duty, export duty.
- Quota: fixed limit on import quantity or value.
- Voluntary export restraint (VER): the exporter "agrees" to limit exports.
- Subsidies to domestic producers or exporters.
- Non-tariff barriers: licensing, standards, foreign exchange controls, state trading.
- Anti-dumping duty: against goods sold abroad below their home price (dumping).
Deeper
Effects of a tariff (small country, partial equilibrium)
- Demand: Qd = 100 − 4P. Supply: Qs = −20 + 4P. World price = 10. Tariff = 2 per unit.
- Free trade (P = 10): Qd = 60, Qs = 20, imports = 40.
- With tariff (P = 12): Qd = 52, Qs = 28, imports = 24.
| Effect | Calculation | Value |
|---|---|---|
| Loss of consumer surplus | 2 × (60 + 52) ÷ 2 | 112 |
| Gain in producer surplus | 2 × (20 + 28) ÷ 2 | 48 |
| Tariff revenue | 2 × 24 | 48 |
| Deadweight loss | 112 − 48 − 48 | 16 |
- The deadweight loss of 16 = production loss (½ × 2 × 8 = 8) + consumption loss (½ × 2 × 8 = 8).
- Named effects: price effect, protective (production) effect, consumption effect, revenue effect, redistribution effect, balance of payments effect.
- A large country can gain from a tariff if it lowers the world price (the optimum tariff argument), but this invites retaliation.
Effective rate of protection (ERP)
- Nominal tariff protects the price; ERP measures protection of value added.
- ERP = (t − a × ti) ÷ (1 − a), where t = tariff on the final good, ti = tariff on the input, a = share of the input in the final good's free-trade value.
- Example: t = 20%, ti = 10%, a = 0.5 → ERP = (0.20 − 0.05) ÷ 0.5 = 30%.
- ERP > nominal tariff when inputs are taxed less than outputs (tariff escalation).
More theory
- Offer curves (Marshall and Edgeworth) show reciprocal demand; their intersection fixes the equilibrium ToT.
- Stolper-Samuelson theorem: a rise in the price of a good raises the real return of the factor used intensively in it and lowers the other's.
- Rybczynski theorem: at constant prices, an increase in one factor raises output of the good using it intensively and reduces output of the other good.
- Explanations of the Leontief paradox: US labour is highly skilled (human capital); natural resources; demand bias; factor intensity reversal.
- New trade theory (Krugman): economies of scale and product differentiation explain intra-industry trade between similar countries.
- Gains from trade split into gains from exchange and gains from specialisation.
- Quota versus tariff: a quota fixes import quantity, so higher demand raises the price, not imports; the revenue goes to licence holders (quota rent) unless licences are auctioned.
Common traps
- ✗ "Comparative advantage was given by Adam Smith." ✓ Ricardo (1817); Smith gave absolute advantage (1776).
- ✗ "No trade is possible if one country is better at both goods." ✓ Trade still pays when comparative costs differ.
- ✗ "Opportunity cost theory is Ricardo's." ✓ It is Haberler's (1936).
- ✗ "H-O says trade arises from different technologies." ✓ From different factor endowments; technology is assumed the same.
- ✗ "Leontief found that the USA exports capital-intensive goods." ✓ He found labour-intensive exports: the paradox.
- ✗ "A fall in the net barter ToT index is favourable." ✓ A fall is a deterioration.
- ✗ "Gross barter ToT = Qx ÷ Qm." ✓ Qm ÷ Qx × 100.
- ✗ "Specific duty is a percentage of value." ✓ That is ad valorem; specific is per unit.
- ✗ "ERP equals the nominal tariff." ✓ ERP measures protection of value added and can be higher or lower.
Quick revision
- Smith 1776: absolute advantage; Ricardo 1817: comparative advantage.
- Haberler 1936: opportunity cost; Mill: reciprocal demand.
- H-O: export the good using your abundant factor.
- Leontief paradox 1953: US exports labour-intensive goods.
- Net barter ToT = Px ÷ Pm × 100; income ToT = (Px ÷ Pm) × Qx.
- Prebisch-Singer: primary exporters' ToT decline.
- Infant industry: Hamilton and List.
- ERP = (t − a·ti) ÷ (1 − a).
- Tariff deadweight loss = production loss + consumption loss.
Go deeper: Mains writing (beyond what APPSC Paper I usually asks)
Mains writing Mains writing
- Frame: comparative advantage makes the case for trade; the real debate is about sequencing, adjustment costs and dynamic advantage.
- Analysis:
- Static gains from free trade can conflict with building capabilities (infant industry).
- Protection that never ends breeds inefficiency, as India's pre-1991 import substitution showed.
- Tariff escalation raises effective protection far above nominal rates.
- The Prebisch-Singer view shaped import-substitution policy in developing countries.
- Way forward: time-bound, performance-linked protection; lower and simpler tariffs; trade remedies within WTO rules; investment in skills to create new comparative advantage.
- Example: India's 1991 reforms cut peak customs duty sharply and replaced import licensing with tariffs.
Practise this topic. Questions on Trade theory: free trade & protection, with answers explained.
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