PGEC-S3 03

Exam. Code: IEC

International Economics
SEMESTER-III

ECONOMICS
BLOCK- 1

KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

International Economics (Block 1) 1
Subject Experts
Professor Madhurjya Prasad Bezbaruah, Dept. of Economics, Gauhati University
Professor Nissar Ahmed Barua, Dept. of Economics, Gauhati University
Dr. Gautam Mazumdar, Dept. of Economics, Cotton University, Guwahati

Course Coordinator: Dr. Bhaskar Sarmah, Economics, KKHSOU

SLM Preparation Team

Units Contributors
1 Dr. Binita Tamuli Barman, Department of Economics, Pandu College, Assam.
2 Dr. Ruby Sarma, Department of Economics, Rangia College, Assam.
3 Dr. Ivy Das Gupta, The Bhawanipur Education Society College, West Bengal
4 Dr. Yogita Beri, Vasanta College for Women, Rajghat, (BHU) Varanasi, Uttar Pradesh.
5 Dr. Abhijit Sarkar, Department of Economics, Maharaja Bir Bikram College, Agartala,
Tripura
6 Dr. Bhaskar Sarmah, KKHSOU.
7 Dr. Surinder Singla, HOD, Dept of Economics, DAV College, Bathinda, Punjab.

Editorial Team

Content : Dr. Rani Mudiar Deka, Associate Professor, Dispur College, Guwahati
Structure, Format & Graphics : Dr. Bhaskar Sarmah

July, 2021

ISBN: 978-93-91026-31-8

This Self Learning Material (SLM) of the Krishna Kanta Handiqui State Open University is
made available under a Creative Commons Attribution-NonCommercial-ShareAlike4.0 License
(international): http://creativecommons.org/licenses/by-nc-sa/4.0/

Printed and published by Registrar on behalf of the Krishna Kanta Handiqui State Open University.

Head Office : Patgaon, Rani Gate, Guwahati-781 017

City Office : NH-37, Resham Nagar, Khanapara, Guwahati : 22
Web: www.kkhsou.in

The university acknowledges with thanks the financial support provided by the
Distance Education Bureau, UGC, New Delhi, for the preparation of this study material.
2 International Economics (Block 1)
 CONTENTS

Pages

Unit 1 : Introduction to International Trade 7-22

Concept of International Economics; Inter-regional and International
Trade: Definition of Internal and International Trade; Why Do Nations
Trade? Distinguishing Features of International Trade; Need for a
Separate Theory of International Trade; Importance of International
Trade

UNIT 2 : Theories of International Trade - I 23-42

The Theory of Absolute Advantage; The Theory of Comparative

Advantage: Assumptions, An Evaluation of the Theory of Comparative
Advantage; The Opportunity Costs Theory: The Production Possibility
Curve : Constant Opportunity Costs, The Basis for trade and the
Gains from Trade under Constant Opportunity Cost, The Production
Possibilities Curve: Increasing Opportunity Costs, The Basis for trade
and the Gains from Trade under Increasing Opportunity Costs;
Dynamic Factors and International Trade: Growth in Factor Supplies
and International Trade, Technological Improvement and International
Trade, Changes in Taste and International Trade

UNIT 3 : Theories of International Trade - II 43-65

Heckscher-Ohlin Theory of Trade: Relative Factor Abundance,

Relative Factor Intensity, Heckscher-Ohlin Theorem, Gains From
Trad; Leontief Paradox; Theorem of Factor Price Equalisation; The
Rybczynski Theorem; Stolper Samuelson Model

UNIT 4 : Theories of International Trade - III 66-80

Intra-Industry Trade: Meaning, Measurement; Vent-For-Surplus;

Availability Approach; Product-Cycle Model; Technological Gap Model

International Economics (Block 1) 3

UNIT 5 : Gains from Trade 81-101

Gains from Trade: Concept of Gains from Trade, Approaches to

Gains from Trade, Factors determining Gains from Trade; Offer Curve:
Derivation of Offer curve, Equilibrium terms of trade, Elasticity of Offer
Curve; Distribution of Gains from Trade in Terms of Offer Curves;
Trade as an Engine of Economic Growth

UNIT 6 : Terms of Trade 102-118

Meaning of Terms of Trade; Net Barter or Commodity Terms of Trade;

Gross Barter Terms of Trade; Income Terms of Trade; Factors
Affecting Terms of Trade; Gains from Trade; International Trade and
Domestic Prices; Relation of Foreign Trade to National Income

UNIT 7 : Trade, Growth and Immiserisation 119-147

Effects of Growth on Trade: Production Effects of Growth,

Consumption Effects of Growth, Combined Production and
Consumption Effects of Growth, Effects of Growth on Production,
Trade, Welfare and Terms of Trade of a Small Country; Immiserising
Growth: Explanation, Necessary Conditions for Immiserising Growth;
Prebisch-Singer Thesis: Explanation, Criticisms Distributive Effects

4 International Economics (Block 1)

COURSE INTRODUCTION

This course entitled ‘International Economics’ is one of the third semester courses of MA in
Economics programme offered by this University. The course deals with certain theoretical as well as
policy matters relating to the area of international economics. This course comprises 14 units and has
been divided into two blocks. The first block consists of seven units from Units 1 to 7, while the second
block consists of the rest of the units from Units 8 to 14.

BLOCK INTRODUCTION

The first unit of the course deals wiht a few basic concepts in international economics, viz., its meaning,
distincition between internal trade and international trade, causes of international trade, distinguishing
features of international trade, the need for a separate theory of international trade, as well as importance
of the study of international trade have been disucssed. In the next unit, we shall discuss the theories of
international trade like: the theories of Absolute Advantage, Comparative Advantage and Opportunity
Costs. In the third unit, the theories like the Heckscher-Ohlin Theory of Trade, Leontief Paradox, Factor
Price Equalisation theorem; the Rybczynski theorem as well as the Stolper-Samuelson model have
been discussed. In the fourth unit of the course, important concepts like intra-industry trade, as well the
Vent for surplus theorem have been discussed. Apart from those, concepts like availability approach of
international trade, producy cycle model as well as the relationship between demand lag and imitation
lag in technological gap theory have been discussed. The fifth unit entitled “Gains from Trade” discusses
the important concepts like gains from trade, offer curve and distribution of gains from trade between
the countries. The unit concludes with the discussion on trade and economic growth and development.
The sixth unit of the course is on Terms of Trade. In this unit, its meaning, different factors affecting
terms of trade as well as the relationships among international trade and domestic prices, and foreign
trade to national income have been discussed. The last unit of this block, i.e., Unit 7 deliberates on
Trade, Growth and Immiserisation. Here, different effects of growth on trade, viz., production effect,
consumption effect have been discussed. Further, the effects of growth on production, trade, welfare
has also been discussed. In addition, theoretical discussion on terms of trade of a small Ccuntry;
immiserising growth, the necessary conditions for immiserising growth and the Prebisch-Singer Thesis
have also been discussed. Thus, this block will provide you with a fair idea on the different concepts in
the couse International Economics. The next block of the Unit will contain the remaining 7 units. The
next block begins with the discussion on Theory of Interventions (Tariff) and concludes with the discussion
on international monetary order in Unit 14.

International Economics (Block 1) 5

 While going through a unit, you will notice some along-sode boxes, which have been included to
help you know some of the difficult, unseen terms. Some ‘ACTIVITY’ (s) has been included to help you
apply your own thoughts. Again, we have included some relevant concepts in ‘LET US KNOW’ along
with the text. At the end of sections, you will get ‘CHECK YOUR PROGRESS’ questions. These have
been designed to self-check your progress of study. It will be better if you solve the problems put in
these boxes immediately after you go through the sections of the units and then match your answers
with ‘ANSWERS TO CHECK YOUR PROGRESS’ given at the end of each unit.

6 International Economics (Block 1)

UNIT 1: INTRODUCTION TO INTERNATIONAL
TRADE
UNIT STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.2.1 Concept of International Economics
1.3 Inter-regional and International Trade
1.3.1 Definition of Internal and International Trade
1.4 Why Do Nation Trade
1.5 Distinguishing Features of International Trade
1.6 Need for a Separate Theory of International Trade
1.7 Importance of International Trade
1.8 Let Us Sum Up
1.9 Further Reading
1.10 Answer to Check Your Progress
1.11 Model Questions

1.1 LEARNING OBJECTIVES

After going through this unit, you will be able to

 know the basic concept of “International Economics”
 put forward the meanings of terms “internal trade” and
“international trade”
 explain about why do nation enters in to international trade
 discuss the distinguishing features of international trade
 analysis the need for a separate theory of international trade
 elucidate the importance of international economics.

1.2 INTRODUCTION

Economics is a science which studies human behaviour as a

relationship between ends and scarce means which have alternative uses.
International Economics broadly speaking, is that part of the study of
Economics which deals with the issue of adjustment between scarce
International Economics (Block 1) 7
Unit 1 Introduction to International Trade

resources and ends in a more specific way. In a closed economic system,

there may be severe constraints upon the optimization of production and
welfare. The international exchange of goods and services can facilitate
the optimum allocation of scarce productive resources not only in case of a
single country but also the entire world.

1.2.1 Concept of International Economics

The International Economics is that branch of economics in

general which deals with the international exchange of goods and
services. It is, of course, true that the dominant concern of
international economics is with the exchange of goods and services
among the different countries. But in reality, the international
economics is concerned with the whole gamut of economic
relationship on the international plane.
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. 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.

1.3 INTER-REGIONAL AND INTERNATIONAL TRADE

Trade signifies the exchange of commodities and services. This

exchange may take place between two individuals, firms or industries within
the same country or it may take place between two or more nations or
countries.
Internal or domestic trade means trade within the geographical
boundaries of a nation or region. It is also known as intra-regional trade.
International trade, on the other hand, is trade among different countries or
trade across the political boundaries. It is also known as foreign trade.

8 International Economics (Block 1)

Introduction to International Trade Unit 1

1.3.1 Definition of Internal and International Trade

We may define internal trade as exchange of goods and

services among the residents of the same country on the other
hand international trade may be defined as exchange of goods and
services between the resident of a given country and the rest of the
world.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True (T) or False (F)
(i) The International Economics is that branch of economics
in general which deals with the international exchange of
goods and services. (T/F)
(ii) International trade refers to trade between regions within a
country. (T/F)
Q.2: Define International Economics. (Answer in 40 Words)
_________________________________________________
_________________________________________________
_________________________________________________
Q.3: Distinguish between internal and international trade. (Answer
in 40 Words).
_________________________________________________
_________________________________________________
_________________________________________________

1.4 WHY DO NATION TRADE?

Human wants are varied and unlimited and no single country

possess the resources to satisfy all these wants. There has been an
unequal distribution of productive resources by the nature of the earth.
Countries differ in respect of climatic conditions, availability of cultivable
land, forest, mines, mineral products, labour, capital, technological
capabilities and managerial and entrepreneurial skills. Given these

International Economics (Block 1) 9

Unit 1 Introduction to International Trade

diversities no country has the potential to produce all the commodities in

the most efficient manner or at the least cost. For instance, India can produce
textiles at the lower cost while Japan can produce electronic goods and
automobiles cheaply.
Just as there is division of labour in the case of individuals, the
countries also adopt this principle at the international level.Each one of them
Comparative Cost specializes in the production of only such commodities, which it can produce
Advantage: when a
at comparatively lower cost than the others or they have comparative cost
country produces a good
advantage. They export such products to others and in return import those
or service for a lower
opportunity cost than products in the production of which they have comparative cost
other countries. disadvantage. The basis of International Trade is the gains or profits to be
made from exchange of goods and services. If there are no gains to be
obtained, there would be no such trade between countries.
The immediate cause of international trade, is the existence of
differences in the prices of goods and services between the countries. Price
difference arise either because of the differences in supply conditions or
because of differences in demand conditions or because of some
combination of both.
Differences in supply conditions may arise due to several factor-
natural endowments of economic resources, degree of efficiency with which
these factors are employed, the level of technology used in production,
labour skills, factor abundance etc
Differences in demand, which are largely a function of income levels
and taste patterns, are just as important as differences in the production
costs in contributing to international price differentials. For example,countries
A and B may be producing a given commodity at the same cost of
production, but that does not guarantee the same price in both the countries
for that product. If country B has a higher level of income matched by a
stronger taste for that product, the product will sell for a higher prices in
that country than in country A. In country A there may be lower levels of
demand for that product due to lower levels of income or taste. Hence, both
income and tastes, in their capacity to determine demand, would effect
international trade, by causing international price differences.
10 International Economics (Block 1)
Introduction to International Trade Unit 1

We are now in a position to answer the question as to why does

international trade take place or why do nation trade. Trade takes place
because of the differences in prices. Foreigners buy our goods because
they find them cheaper than anywhere else in the world; and we buy foreign
goods because we find them cheaper. Price differences, in turn, arise either
because of differences in supply conditions or because of differences in
demand conditions, or due to differences in both.

1.5 DISTINGUISHING FEATURES OF INTERNATIONAL

TRADE

The theories and models dealing with micro and macro aspects of
international trade have been built up by the modern writers like Samuelson,
Leontief, Johnson and Jagdish Bhagwati. These are quite distinct from the
theory related to internal trade. When it has been fully recognised that the
international trade is distinct from the internal trade, the most relevant
question concerns the distinguishing features of international trade. These
distinguishing features are as follows:
 Immobility of factors: The most prominent distinguishing features
of international trade, according to classical economists, was the
perfect geographical immobility of the factors of production like labour
and capital among the nations. In contrast, there is perfect mobility
of productive factors among the different regions of the same
country.The international mobility of factors is neither free nor perfect.
There are severe constraints upon the mobility of labour and capital
such as immigration laws, restrictions on the international capital
flows and legal restrictions. The additional barriers on factor mobility
are in the form of differences in language, climate, customs, religions,
political and educational systems. It is therefore, clear that there is
a relatively greater degree of factor mobility within the same country
than among the different countries.
 Immobility of products: There is relatively more free mobility of
products within the different regions of a country. The only barriers
to movement of goods are in the form of geographical distances
International Economics (Block 1) 11
Unit 1 Introduction to International Trade

and cost of transportation. In case of international trade, on the

contrary, there are several more man-made barriers to the free
movement of products apart from distance and transport costs.
These include import and export duties, quotas, exchange
restrictions, etc which restrict the mobility of goods at international
level.
 Heterogeneous Markets: In the international economy, world
markets lack homogeneity on account of differences in climate,
language, preferences, habit, customs, weights and measures, etc.
The behaviour of international buyers in each case would, therefore,
be different.
 Differences in currencies: The principal differences between inter-
regional and international trade lies in use of different currencies in

Foreign Exchange Rate: foreign trade, but the same currency in domestic trade. For instance,
It is the rate at which one all domestic transaction in India take place in terms of rupees, which
currency is exchanged for is the legal tender in this country. But in its trade with countries like
another.
the U.S,A., Germany, Japan, France and Britain, the payments have
to be made in terms dollars, marks, yens, francs and pound sterling
respectively. Each country follows different foreign exchange policies.
That is why there is the problem of Foreign exchange rates. The
complications in international trade, are therefore, caused by
availability or shortages of foreign currency reserves, exchange
rates, ease or difficulty in conversion, controls and restrictions on
foreign exchange etc.
 Differences in resource endowments: The different countries
have been endowed by nature with different types of natural
resources. Each country specializes in the production and export
of those commodities in which they are well-endowed. They import
such products, in the production of which they face a resource
deficiency. In Australia, land is in abundant but labour and capital
are relatively scarce. On the contrary, capital is relatively abundant
and cheap in England while land is scarce and dear there. Thus
commodities requiring more capital, such as manufactures can be
12 International Economics (Block 1)
Introduction to International Trade Unit 1

produced in England; while such commodities as wool, mutton,

wheat etc requiring more land can be produced in Australia. Thus
both countries can trade each other’s commodities on the basis of
comparative cost differences in production of different commodities.
 Different National Policies and Government Intervention:
Economic and political policies differ from one country to another.
Policies pertaining to trade, commerce, export and import, taxation,
Export: Goods or
etc., also differ widely among countries though they are more or
services produced in one
less uniform within the country. Tariff policy, import quota system, country that is bought by
subsidies and other controls adopted by governments interfere with someone in another
the course of normal trade between one country and another. country.
 Transport and Insurance Costs: Trade between countries involves Import: A commodity,
article, or service brought
high transport costs as against inter-regionally within a country
from abroad for sale Tariff
because of geographical distances between different countries. The
is a tax or duty levied on
greater the distance between the two countries, the greater are these goods and services when
costs. they enter and leave the
 Problem of Balance of Payments: Another important point which national frontier or
boundary.
distinguishes international trade from inter-regional trade is the
Import Quota is a type of
problem of balance of payments (BOP). The problem of balance
trade restriction that sets
of payments is perpetual in international trade while regions within a a physical limit on the
country have no such problem. This is because there is greater quantity of a goods that
mobility of capital within regions than between countries. can be imported into a
country in a given period
 Different Economic Environment: Countries differ in their
of time.
economic environment which affects their trade relations. The legal
BOP is a systematic
framework, institutional set-up, monetary, fiscal and commercial record of all its economic
policies, factor endowments, production techniques. Nature of transactions with the
products, etc differ between countries. outside world in a given
 Socio-Political Conditions:Finally, socio-political environment year.

varies from country to country, although such environment is

uni-form within a country. Market for commodity transactions
between different nations is largely governed by its own geographical
boundaries, social institutions and customs, habits, choice, etc.
Within a country, one observes same social institutions and business
International Economics (Block 1) 13
Unit 1 Introduction to International Trade

customs. Throughout the world, a uniform set of socio-political

envi-ronment can never exist.

CHECK YOUR PROGRESS

Q.4: State whether the following statements are

True (T) or False (F)
(i) A country export such products to others in which they have
comparative cost disadvantage.(T/F)
(ii) The immediate cause of international trade, is the existence
of differences in the prices of goods and services between
the countries.(T/F)
Q5. Why labour is immobile between two countries? (Answer in 40
Words).
__________________________________________________
__________________________________________________
__________________________________________________

1.6 NEED FOR A SEPARATE THEORY OF

INTERATIONAL TRADE

There has been a controversy among the economists on the issue

whether or not there is the need for a separate theory of international trade.
There are two opposite viewpoints on this issue. One of them is called as
the classical viewpoint, while the other is associated with Bertil Ohlin and
Haberler.
The classical school of economists like Adam Smith and David
Ricardo held that there are certain fundamental difference between inter-
regional or internal trade and inter-national trade, and so, there is a need for
a separate theory of international trade, and they propounded a separate
theory of international trade.
Modern economist like Bertil Ohlin and Haberler are of the view that
international trade is just a special case of inter-regional or internal trade,
and the differences between inter-regional and international trade are of

14 International Economics (Block 1)

Introduction to International Trade Unit 1

degree rather than of kind, and so, these is no need for a separate theory of
international trade.
Classical View: The classical writers including Adam Smith, Ricardo
and J.S. Mill recognize that the inter –regional trade is fundamentally different
from the international trade. Among the different regions of the same country,
there is a free mobility of labour and capital but serious constraints exist
upon the international mobility of labour and capital permits the different
countries to specialize in the production and export of specified goods. In
addition, there are differences in national policies, political organisations,
monetary systems and tariff and non-tariff restrictions among the different
countries. It signifies that the conditions governing the exchange of goods
within the different regions of the same country are not applicable in the
case of exchange of goods among different countries. Hence there is full
justification in having a separate theory of international trade.
Ohlin’s View: The writer like Bertil Ohlin and Haberler have refuted
the classical viewpoint. In their opinion, the difference between international
and inter-regional trade is only of degree and not of kind. “International trade
should be regarded as a special case within the general concept of inter-
regional or perhaps rather inter-local trade.” Within the same country, the
different regions specialise in the production of different commodities, skill
and efficiency of the people. The mobility of the factors is not perfect within
different parts of the same country.
Despite Ohlin’s rejection of the necessity of separate theory of
international trade on account of methodological reasons, it must be
concluded that there are certain distinct differences and complicating factors
involved in international trade. Comparative immobility of labour and capital,
restric-tions 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.

International Economics (Block 1) 15

Unit 1 Introduction to International Trade

1.7 IMPORTANCE OF INTERATIONAL TRADE

International trade plays a vital role in the economic development of

a country. No country is self-sufficient. Every country depends upon other
countries for export and imports. This gives rise to international trade. When
a country specialises in the production of those goods which it can produce
cheaper and import those goods which other can produce at a lower cost,
it gains from trade and there is increase in national income.
The classical and neo-classical economists believe that international
trade contributes greatly to the economic growth of a country. Robertson
calls international trade as an “Engine of Growth”. In the words of Haberler,
“International trade has made a tremendous contribution to the development
of less developed countries in the 19th and 20th centuries and can be
expected to make an equally big contribution in the future. The relevant
question, in this regard is why the prominent economist of all times have
given so great an importance to the international trade. The answer lies in
the immense advantages of international trade that are discussed below:
 International Division of Labour and Specialisation: The division
of labour and specialisation of products by individual firms accelerate
the rate of production, lower costs and maximises profits.
International trade ensures the application of the principles of division
of labour and specialisation to the fields of production and
international exchange of commodities by various countries.
 Greater Variety of Goods Available for Consumption:International
trade brings in different varieties of a particular product from different
destinations. This gives consumers a wider array of choices which
will not only improve their quality of life but as a whole it will help the
country grow.
 Efficient Allocation and Better Utilization of Resources:Efficient
allocation and better utilization of resources since countries tend to
produce goods in which they have a comparative advantage. When
countries produce through comparative advantage, wasteful
duplication of resources is prevented. It helps save the environment

16 International Economics (Block 1)

Introduction to International Trade Unit 1

from harmful gases being leaked into the atmosphere and also
provides countries with a better marketing power.
 Promotes Efficiency in Production:International trade promotes
efficiency in production as countries will try to adopt better methods
of production to keep costs down in order to remain competitive.
Countries that can produce a product at lowest possible cost will
be able to gain larger share in the market. Therefore an incentive to
produce efficiently arises. This will help to increase the standards
of the product and consumers will have a good quality product to
consume.
 More Employment:More employment could be generated as the
market for the countries’ goods widens through trade. International
trade helps generate more employment through the establishment
of newer industries to cater to the demands of various countries.
This will help countries to bring-down their unemployment rates.
 Consumption at Cheaper Cost: International trade enables a
country to consume things which either cannot be produced within
its borders or production may cost very high. Therefore, it becomes
cost cheaper to import from other countries through foreign trade.
 Stability of Prices: In the absence of International Trade, the
domestic surpluses or shortages in production invariably lead to
serious deflationary and inflationary trend and consequent
destabilization of the entire system Through the international trade
the domestic surpluses in production can be offset through exports
and shortages can be removed through imports. In this way,
international trade can efficiently deal with the problems of internal
inflation or deflation and ensure a greater degree of stability in prices.
 Promotion of Competition: The international trade promotes
competition among different countries. The international competition
increases the efficiency of production. It becomes possible to import
superior varieties of products at reasonable prices. Similarly, large
surpluses of domestic production can be disposed of in the foreign
markets to realize larger export earnings. In addition, the free
International Economics (Block 1) 17
Unit 1 Introduction to International Trade

competition can provide protection from the monopolistic exploitation

at the hands of domestic producers.
 Growth of International Economic Integration: The necessity of
promoting restriction free international trade, for ensuring efficient
Economic Integration is
system of exchange and payments and removing the shortages of
the unification of economic
policies between different international liquidity, led to the growth of several multilateral
states through the partial institutions like IBRD, IMF, IDA, UNCTAD and WTO. All these
or full abolition of tariff institutions are making efforts to create a new international economic
and non-tariff restrictions order,
on trade.
 Fosters Peace and Goodwill:International trade fosters peace,
goodwill, and mutual understanding among nations. Economic
interdependence of countries often leads to close cultural relationship
and thus avoid war between them.
From the above discussion, it becomes clear that the countries
can derive immense gains from international trade. No doubt the countries
can achieve continuous expansion of their productive capacity and
standards of consumption on the solid foundation of external trade.

CHECK YOUR PROGRESS

Q.6: State whether the following statements are

True (T) or False (F) Adam Smith and Ricardo are
of the view that international trade is just a special case of inter-
regional or internal trade - (T/F)
Q.7: Is there the necessity for a separate theory of international
trade? (Answer in 40 Words).
_________________________________________________
_________________________________________________
Q.8: State whether the following statements are True (T) or False
(F)
(i) International trade promotes efficiency in production. (T/F)
(ii) The international trade does not promotes competition
among different countries.- (T/F)

18 International Economics (Block 1)

Introduction to International Trade Unit 1

1.8 LET US SUM UP

 International Economics is a branch of Economics dealing with

transactions among countries in the fields of goods and services,
financial flows and factor movements.
 Internal trade is the exchange of goods and services among the
residents of the same country and international trade is the exchange
of goods and services between the resident of a given country and
the rest of the world.
 Internationaltrade take place because of the differences in prices.
Price differences arise either because of differences in supply
conditions or because of differences in demand conditions, or due
to differences in both.
 There are a number of factors which makes a difference between
internal trade and international trade. Distinguishing features of
international economics are:
 Immobility of factors of production
 Immobility of products
 Heterogeneous market
 Differences in currencies
 Differences in resource endowments
 Different national policies and government intervention
 Transport and insurance cost
 Problem of balance of payments
 Different economic conditions
 Socio-political condition
 There has been a controversy among the economists on the issue
whether or not there is the need for a separate theory of international
trade.
 The classical school of economists like Adam Smith and David
Ricardo held that there are certain fundamental difference between
internal trade and international trade. So, there is a need for a
International Economics (Block 1) 19
Unit 1 Introduction to International Trade

separate theory of international trade, and they propounded a

separate theory of international trade.
 Modern economist like Bertil Ohlin and Haberler are of the view that
international trade is just a special case of inter-regional or internal
trade, and the differences between inter-regional and international
trade are of degree rather than of kind. So, these is no need for a
separate theory of international trade.
 Despite Ohlin’s rejection of the necessity of separate theory of
international trade it must be concluded that there are certain distinct
differences involved in international trade and necessitate a separate
theory of international trade.
 International trade plays a vital role in the economic development of
a country.
 The classical and neo-classical economist believe that international
trade contributes greatly to the economic growth of a country. The
importance of international trade that are discussed below:
 International Division of Labour and Specialisation
 Greater Variety of Goods Available for Consumption
 Efficient Allocation and Better Utilization of Resources
 Promotes Efficiency in Production
 More Employment
 Consumption at Cheaper Cost
 Stability of Prices
 Promotion of Competition
 Growth of International Economic Integration
 Fosters Peace and Goodwill

1.9 FURTHER READING

(1) Jhingan M.L.: International Economics, Vrinda Publishing Pvt. Ltd.

(2) Mannur H.G : International Economics, Vikash Publishing House
Pvt. Ltd

20 International Economics (Block 1)

Introduction to International Trade Unit 1

(3) Mithani D.M.: International Economics, Himalaya Publishing House

(4) Rana K.C. ; Verma .N. International Economics, Vishal Publishing
Co
(5) Sodersten, B & Reed, G. International Economics, Mac Millan.

1.10 ANSWERS TO THE CHECK YOUR

PROGRESS

Ans to Q No 1: (i) True (ii) False

Ans to Q No 2: The International Economics is that branch of economics
in general which deals with the international exchange of goods and
services. It refers to a study of international forces that influence the
domestic conditions of an economy and shape the economic
relationship between countries.
Ans to Q No 3: Internal trade means the trade which is conducted within
the political and boundaries of a country. It is also called Domestic
trade. International trade means the trade that takes place between
the two countries. It is also called External trade.
Ans to Q No 4: (i) Fales (ii) True
Ans to Q No 5: The reason for international immobility of labour are
differences in languages, customs, occupational skills, unwillingness
to leave familiar surroundings, and family ties, the high travelling
expenses to the foreign country, and restrictions imposed by the
foreign country on labour immigration.
Ans to Q No 6: False
Ans to Q No 7: Some differences and complicating factors involved in
international trade. Comparative immobility of labour and capital,
restric-tions on trade, transport costs, differences in language,
customs, laws and currency systems make international trade different
from domestic trade and necessitate a separate theory of international
trade.
Ans to Q No 8: (i) True (II) False

International Economics (Block 1) 21

Unit 1 Introduction to International Trade

1.9 MODEL QUESTIONS

Short Questions (Answer each questions in about 150 words)

Q 1: Why do nation participate in international trade?
Q 2: How do cost and price differences give rise to international trade?
Q 3: How do factor and product mobility influence International trade?
Q 4: “The difference between inter-regional and international is of degree
and not of kind”. Discuss

Essay-type Questions(Answer each questions in about 300-500 words)

Q 1: Elucidate the distinguishing features of international trade.
Q 2: Discuss the need for a separate theory of international trade.
Q 3: Explain the importance of international trade for a country.

*** ***** ***

22 International Economics (Block 1)

UNIT 2 : THEORIES OF INTERNATIONAL TRADE - I
UNIT STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 The Theory of Absolute Advantage
2.4 The Theory of Comparative Advantage
2.4.1 Assumptions
2.4.2 An Evaluation of the Theory of Comparative Advantage
2.5 The Opportunity Costs Theory
2.5.1 The Production Possibility Curve : Constant Opportunity
Costs
2.5.2 The Basis for trade and the Gains from Trade under
Constant Opportunity Costs
2.5.3 The Production Possibilities Curve: Increasing
Opportunity Costs
2.5.4 The Basis for trade and the Gains from Trade under
Increasing Opportunity Costs
2.6 Dynamic Factors and International Trade
2.6.1 Growth in Factor Supplies and International Trade
2.6.2 Technological Improvement and International Trade
2.6.3 Changes in Taste and International Trade
2.7 Let Us Sum Up
2.8 Further Reading
2.9 Answers to Check Your Progress
2.10 Model Questions

2.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 discuss the theories of Absolute Advantage, Comparative Advantage
and Opportunity Costs as the basis for trade and gains from trade
among countries of the world.

International Economics (Block 1) 23

Unit 2 Theories of International Trade-I

 outline the role of various dynamic factors in explaining the

emergence of trade.

2.2 INTRODUCTION

In the introductory unit of this paper, you have learnt about

distinguishing features of international economics ,as a distinct and separate
discipline of applied economics. You have also learnt about importance of
the discipline along with increasing interdependance among nations. This
unit examines “basis for trade” and “gains from trade” through the doctrines
of Adam Smith (Theory of Absolute Advantage), David Ricardo (Theory of
Comparative Costs) and G. Haberler (Theory of Opportunity Costs).The
second section discusses about the role of dynamic factors in explaining
the emergence of trade. That is, how changes in tastes, technology and
factor endowments effect the trade relation among nations.

2.3 THE THEORY OF ABSOLUTE ADVANTAGE

Adam Smith, in his famous book The Wealth of Nations advocated

the free trade is the best policy for the nations of the world. This free trade
should be based on “absolute advantage”. That is, a nation should produce
and export only those commodities in which it had an absolute advantage
(or could produce more efficiently than other nations). At the same time a
nation should import only those commodities in which it had an absolute
disadvantage (or could produce less efficiently than the other countries..
In this way, all nations can gain by each specializingin the production and
export of the commodities of its absolute advantage and importing the
commodities of its absolute disadvantage. Output worldwide would
increase as a result of this international specialization of factors in
production. This increase in output will be shared by the trading nations.
Thus, a nation need not gain at the expense of other nations. All nations
could gain simultaneously.

24 International Economics (Block 1)

Theories of International Trade-I Unit 2

Table 2.1: Theory of Absolute Advantage

Items Countries
U.S. U.K.
Wheat (Quintals per labour-hour) 6 1
Cloth ( Kilometres per labour-hour) 1 2

Table 2.1 shows trade relation between two countries: United States
(U.S.) and United Kingdom (U.K.). It is clear from the table that U.S. has an
absolute advantage over the U.K. in the production of wheat and U.K. has
an absolute advantage in the production of cloth. Now, let us suppose that
U.S. produces and specializes in the production of wheat only and the U.K.
produces and specializes in the production of cloth only. In that situation,
total production of wheat will be 12 quintiles and total production of cloth is
4 kilometers. Thus, combined output will be greater and both the countries
can gain through exchanging the products voluntarily.
Thus, according to Smith, after showing specialization by the trading
countries, output of all commodities traded would increase and this increase
would be shared by the trading nations. Gains from trade will be maximum
when there is little intervention by the government in the functioning of the
domestic economy as well as in international trade. In this, way, free trade
will lead to maximization of welfare of the whole world.

2.4 THE THEORY OF COMPARATIVE ADVANTAGE

Smith’s theory of absolute advantage remained unquestionable for

a long period of 40 years. David Ricardo, 40 years later Adam Smith,
advocated that trade among countries should be based on “comparative
advantage”, not on absolute advantage. According to Ricardo, mutually
advantageous trade takes place with a country even if it has an absolute
disadvantagein the production of both commodities with respect to the other
nation. The less efficient nation (having absolute disadvantage in both
commodities) should specialize in the production and export of the
commodity in which its absolute disadvantage is less. That is, this is the
commodity in which the nation has a comparative disadvantage. As opposite
International Economics (Block 1) 25
Unit 2 Theories of International Trade-I

to this, the country should import the commodity in which its absolute
disadvantage is greater. That is, this is the area of its comparative
disadvantage. This is about Ricardo’s famous law of comparative advantage.
Table 2.2 can be used to explain the law. It is clear from Table 2.2 that it is
absolutely disadvantageous for U.K. to produce both wheat and cloth.
However, this disadvantage is less in the production in cloth than in wheat.
It implies that the U.K had a comparative advantage with respect to U.S. in
cloth and a comparative disadvantage in wheat. As opposite to this, from
Table 2.2 it is clear that the U.S. has an absolute advantage over the U.K. in
production of both wheat and cloth. However, this advantage is greater in
wheat (6:1) than in cloth (3:2). Thus, the U.S. has a comparative advantage
over the U.K. in wheat and a comparative disadvantage in cloth. Thus,
according to the law of comparative advantage, the U.S. can exchange
wheat (W) for cloth(C) with the U.K.
Table 2.2 : Theory of Comparative Advantage

Items Countries
U.S. U.K.
Wheat (Quintals per labour-hour) 6 1
Cloth ( Kilometres per labour- 4 3
hour)

It is clear from Table 2.2 that if the U.S. could specialze in production
of wheat, and U.K. in cloth, the U.S. could exchange 6W for 6C with the
U.K. Because, domestically, the U.S. can exchange 6W for only 3C. In
addition to this, to produce 6W itself, the U.K. would require 6 hours of
labour. Instead of this, the U.K. can use the 6 labour-hours to produce 12C.
And out of these 12C, the U.K. can exchange 6C for 6W from the U.S. and
end up with 6C more for itself. Thus, by exchanging 6W for 6C, the U.S.
would gain 3C and the U.K. 6C.
Besides 6W for 6C, there are many other ratios for exchange of W
for C that would be advantageous to both nations. Of course, the U.S. would
not be willing to exchange 6W for less than 3C. Because, domestically in
U.S., 1 labour-hour can produce either 6W or 6C. Similarly, the U.K. would
not be willing to exchange more than 12C for 6W. Because, to produce

26 International Economics (Block 1)

Theories of International Trade-I Unit 2

more than 12C , the U.K. would require more than 6 labour-hours, whereas
production of 6W require only 6 labour-hours in the U.K.
Thus, in order to have a mutually advantageous gain from trade,
6W must exchange for more than 3C(for the U.S. to gain) but less than
12C (for the U.K. to gain. Therefore, the rate of exchange of 6W would be in
between 3C and 12C. Thus, the range for mutual beneficial trade is:
3C<6W<12C
The difference of 9C(=12C-3C) is the total amount of gain from
specialization in production and trade. The closer the ratio of exchange
settles to 6W for 12C, the greater is the proportion of the total gains from
trade going to the U.S. On the otherhand, the closer the ratio of exchange
settles to 6W for 3C, the greater the proportion of total gains from trade
going to the U.K. The fixation of ratio of exchange also depends on demand
conditions in each nation.

2.4.1 Assumptions

David Ricardo’s theory of comparative advantage is based on the

following assumptons:
 The economy operates without government intervention.
 Perfect competition prevails in both product and factor markets.
 Static condition prevails in the economy without any change in
factor endowments, technology and tastes and preferances.
 Labour is the only factor of production and therefore cost of
production is expressed in labour hour.
 Labour is perfectly mobile within the country and perfectly
immobile among different countries.
 There is no transportation cost.
 Only two commodities are traded between the two countries.
 The economy is non-monetized and prices of different goods
are measured by their real cost of production.
 Full employment of resources prevails in both countries.
 Barter trading occurs between the two countries.

International Economics (Block 1) 27

Unit 2 Theories of International Trade-I

2.4.2 An Evaluation of the Theory of Comparative

Advantage

The law of comparative advantage is valid till date. However,

like any other theories under classical set-up, Ricardo’s law of
comparative advantage is based on a number of unrealistic
assumptions- like full employment of resources, static conditions,
non-monetized economy etc. One of these assumptions is the co-
called labour theory of value. With this, the value, and accordingly
the price of a commodity can be inferred from the amount of labour
time spared in its production. In today’s technology dominated world,
is completely rejected. Therefore, with this background, we must
reject Ricardo’s explanation of comparative advantage. But there is
no need to reject the law of comparative advantage itself. The law
is valid and can be explained in terms of opportunity costs, as
explained in section 3.5

2.5 THE OPPORTUNITY COSTS THEORY

The theory of opportunity cost was developed by G. Haberler in 1936.

According to this theory, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to
produce one additional unit of the first commodity. A nation with lower
opportunity cost in the production of a commodity has a comparative
advantage in that commodity (and a comparative disadvantage in the
second commodity). It is important to note that here, the basis of trade has
not been explained with the help of labour theory of value.

2.5.1 The Production Possibility Curve : Constant

Opportunity Costs

The Production Possibility Curve (PPC) or the transformation

curve can be used to illustrate opportunity costs. A PPC shows all
the various alternative combinations of the two commodities that a
nation can produce by fully utilizing all of its factors of production

28 International Economics (Block 1)

Theories of International Trade-I Unit 2

with the best technology available. The slope of the PPC then refers
to the Marginal Rate of Transformation (MRT). It refers to the amount
of a commodity that the nation must give up in order to get one
more unit of the second commodity. The PPC of a country is a
straight line if it faces constant costs or MRT. The straight line PPC
has an absolute slope equal to the constant opportunity costs or
MRT, which is also equal to the relative commodity price in the nation.

Table 2.3: Constant Opportunity Cost (PPC)

Items Countries
U.S. U.K.
Wheat (Thousand Quintals per year) 60 160
Cloth (Thousand Kilometres per 120 80
year)

For example, Table 2.3 shows the maximum amount of

wheat or cloth that the two countries the U.K. and the U.S. could
produce with the best technology available, and with full utilization
of productive resources at their disposal. Now, with constant
opportunity costs of producing wheat and cloth for each nation, the
resulting straight line PPC has been shown in Fig. 2.1. Each point
on the straight line PPC represents one combination of wheat and
cloth that the nation can produce. For example, at point A, the U.K.
produces 40C and 40W.At point A’, the

Figure 2.1: The Pure Theory of International Trade

W W

160 UK 160 US

140 140

120 120

100 100

A
80 80

60 60

A
40 40

20 20

0 20 40 60 80 100 120 C 0 20 40 60 80 100 120 C

International Economics (Block 1) 29

Unit 2 Theories of International Trade-I

U.S. produces 40C and 80W. The negatively slopped PPCs

of the countries implies that the more of one commodity the nations
produce,the less it is available to produce of the other. The (constant)
absolute slope of the curve for the U.K. is
60/120=1/2=MRTCW=PC/PW
And the same for the U.S. is:
160/80=2=MRTCW=PC/PW
Thus, under constant costs,the supply conditionsin each nation
exclusively determines the internal equilibriumPC/PW.

2.5.2 The Basis for trade and the Gains from Trade under
Constant Opportunity Costs

In the absence of trade (i.e; in autarky) a nation’s PPC or

Production Possibilities Frontier and its Consumption Frontier are
the same.It implies that a nation can produce only a combination of
commodities that it can produce. However, after trade, situation
changes. A country with trade, can consume more of both
commodities (than without trade) of comparative advantage as well
as disadvantage. Because, the country can specialize in the
production of the commodity of its comparative advantage, then
exchange part of this commodity for the commodity of its
comparative disadvantage, produced by the other nation (which
specializes in the production of that commodity).

Figure 2.2: The Basis for Trade

W W

U.K. 160
B’ U.S.

140
<

120 120
<

100 100 .E’

80 80
A’
.
E
60 60

40 .
A
< 40

<
20 20

B
0 20 40 60 80 100 120 C 0 20 40 60 80 100 120 140 160 C

30 International Economics (Block 1)

Theories of International Trade-I Unit 2

For example, Fig.2.2 reveals that in absence of trade, the

U.K. produces and consumes at point A while the U.S. does so t
point A’. It is clear that in the absence of trade, the marginal rate of
transformation, that is, the slope of the line AB is equal to ½ in U.K.
(MRTCW=1/2) . For country U.S. the same is 2, i.e;MRTCW=PC/PW=2
(the slope of the line A’ B’) . Thus, it is clear from Fig 2.2 that the U.K.
has a comparative in cloth and the U.S. has a comparative advantage
in wheat. Therefore, mutually advantageous trade is possible within
the limits: 1/2<PC/PW<2. If with trade, the PC/PW is stabilized at 1,
the U.K. can move from point A to point B in production. Out of 120
C produced at point B, the U.K exchanges 60C for 60W from the
U.S. and end up consuming at point E. Thus, trade involves a gain
in consumption of 20C and 20W over the no-trade consumption
point A. On the other hand, the U.S. moves from point A’ to point B’ in
production, 60 of its 160W (produced at point B’) for 60C from the
U/K. and ends up consuming at point E’. This is one possible
outcome showing the gain with complete specialization and trade
by each nation.

2.5.3 The Production Possibilities Curve: Increasing

Opportunity Costs

Opportunity costs, in real world increases in –stead- of

diminishing. Thus, the opportunity costs or MRT in producing more
units of a commodity increases. The PPC curve is such a situation
is concave to the origin. The country will then produce where MRT
equals the equilibrium relative commodity price in the nation. In case
of increasing costs, the equilibrium relative commodity price in the
nation is determined by demand and supply conditions in the nation.

International Economics (Block 1) 31

Unit 2 Theories of International Trade-I

Figure 2.3: PPC (Increasing Opportunity Costs)

W W

U.K. U.S.
.
160

140
.B’
120
.
100
.
.
80 80

.A
60
. 60
.A’
40 . 40

.B
20 20
.
. 0 20 40 60 80 100 C
0 20 40 60 80 100 120 140 C

Fig.2.3 shows hypothetical production possibilities curves

for the U.K. and the U.S. showing increasing costs. In the absence
of trade, the U.K. would produce at point A., where its MRT CW=PC/
PW=1/4. Here, PC/PW=1/4 is given by the internal equilibrium of
demand and supply. If PC/PW rises, it would pay for the U.K. to
produce more cloth and less wheat (a movement along the curve in
a downward direction). However, as the U.K. does this, its MRTCW
rises. Thus, at PC/PW=1, the U.K. produces at point B, where its
MRTCW =PC/PW=1.
Similarly, with PC/PW=4, the U.S. produces at A’, where MRT

CW
=PC/PW=4. If PC/PWfalls to 1, the U.S. will move to point B ‘. Thus,
the U.S. will produce less cloth and more wheat. It is clear that at
pointB ‘ the U.S. incurs a lowerMRT CW
, which means that its
reciprocal or MRT wc is higher than at point A ‘.

2.5.4 The Basis for trade and the Gains from Trade under
Increasing Opportunity Costs

When the production possibility curves are concave, each

nation incurs higher and highrt opportunity costs or MRTs, as it
specializes in the production of the commodity of its comparative
advantage. Specialization in production will continue until the rising
MRT in each nation equals the relative commodity price at which

32 International Economics (Block 1)

Theories of International Trade-I Unit 2

trade takes place. Through trade, each nation will then end up
consuming outside (and above) its no-trade consumption (and
consumption) frontier (Fig. 2.3 and Fig.2.4).
Let us suppose that in the absence of trade the internal
equilibriumPC/PW=1/4 in the U.K. and 4 in U.S. It is clear from Fig.
2.3 that the U.K. produces and consumes at point A while the U.S.
produces and consumes at point A ‘. In the absence of trade the
U.K. has a comparative advantage in cloth and the U.S. in wheat.
Since PC/PW is lower in the U.K. than in U.S. , mutually advantageous
trade is possible within the range¼ <P C/P W <4 .If P C/P W is
established at 1 with trade the U.K. can move from point A to point B
in production. At this stage the U.K. can exchange 60 of each 120C
(produced at point B) for 60 w from the U.S. and end up consuming
at point E (in Fig. 2.4). Thus the country is with a gain of 20C and
20W over point A.

Figure 2.4: Gains from Trade (Increasing Opportunity Costs)

W W

U.K. U.S.
.
160

140
.B’
120

100
<

.
<

E
80 80
.E’
<

60 60
A <
A’
40 40

20 .B 20

0 20 40 60 80 100 C
0 20 40 60 80 100 120 140 C

On the other hand, the U.S., moves from A’ to B’ in production. There

by it exchanges 60 W for 60C with the U.K.,and ends up at point E’.
Point E’ involves a gain of 20C and 20W than at point A’. It is
noteworthy that as the U.K. specializes in the production of cloth, it
incurs increasing costs in cloth production (That is, a higher MRTCW).
Similarly, that as the U.S. specializes in the production of wheat; it
incurs increasing costs in wheat production (That is, a higher

International Economics (Block 1) 33

Unit 2 Theories of International Trade-I

MRT wc). Specialization will continue in each countryuntil its

MRT CW
=PC/PW=1. It is also noteworthy that the U.S. and the U.K.
do not specialize completely in the production of one commodity as
in the case of constant costs. Thus, there is incomplete
specialization in case of increasing costs.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are true

(T) or false (F)
(a) Adam Smith advocated a protectionist policy for
international trade trade (T/F)
(b) According to Ricardo, a country should go for international
trade even if it has absolute disadvantage in the production
of both of the commodities.(T/F)
Q.2: What is the doctrine of Comparative Advantage? (Explain in
30-40 words)
...................................................................................................
...................................................................................................
Q.3: What does the theory of opportunity costs say? (Explain in about
30-40 words)
...................................................................................................
...................................................................................................

2.6 DYNAMIC FACTORS AND INTERNATIONAL

TRADE

Theories discussed in previous section were based on static

conditions. That is, we have assumed that each nation has given and
unchanging factor endowments and technology. Also each nation has given
and unchanging tastes. Changes in factor endowments and technology of
a country lead to shifts its production possibility frontier. On the other hand,
changes in tastes and preferences of a country may result in a different
indifference map.Accordingly, volume and terms of trade of the country

34 International Economics (Block 1)

Theories of International Trade-I Unit 2

underwent a change. This section examines impact of these dynamic

factors on volume and terms of trade of a country.

2.6.1 Growth in Factor Supplies and International Trade

Given the technology, if the factors of production available to

a nation increase, the nation’s production possibilities curved shifts
outward. If labour and capital grow in the same proportion, it is called
balanced growth. The new production possibilities curved has the
same shape as the old one. If the supply of labour increases
proportionately more than its supply of capital then , the nation’s
productions possibilities curved shifts more along the axis measuring
the L- intensive commodity than along the axismeasuring the K-
intensive commodity. Opposite shift occurs if only the nation’s supply
of capital more than proportionately than that of labour. A detail
account of this aspect given by T.M. Rybczynski is discussed in
Unit-3 of this paper.

2.6.2 Technological Improvement and International Trade

As a result of improvement in technology a nation’s

productions possibilities curved shifts outward. In general there
exist 3 types of technological progress:
 K-saving technical progress- in this type, the productivity of
labourincreases more than that of capital. As a result, L is
substituted for K in production. At unchanged w/r, L/K rises (K/
L falls). Since more units of L are used per unit of K, this type of
technical progress is called capital saving. It means that a given
output can now be produced with fewer units of L and K but
with a higher L/K(a lower K/L).

International Economics (Block 1) 35

Unit 2 Theories of International Trade-I

Figure 2.5: K-Saving Technical Progress

W
U.K.
80
.T’
60 T .
A
40

20
B
.
T T’
0 20 40 60 80 100 120 140 160 180 200 220 240 260 C

 L-saving technical progress - in this type, the productivity of

capital increases more than that of labour. As a result, K is
substituted for L in production. At unchanged w/r, K/L rises (L/K
falls). Since more units of K are used per unit of L, this type of
technical progress is called labour saving. It means that a given
output can now be produced with fewer units of K and L, but
with a higher K/L (a lower L/K).
Figure 2.6: L-Saving Technical Progress
W
U.K.

120
T’

100

80

60 T
A
.
40

20
B
.
T T’
0 20 40 60 80 100 120 140 C

W
U.S.

T’
280

240

200

160
T

120
.
80

40
.
T T’
0 40 80 120 C

36 International Economics (Block 1)

Theories of International Trade-I Unit 2

 Neutral technical progress increases the productivity of L and

K in the same proportion. With unchanged relative factor prices
(w/r), K/L remains the same after this type of technical progress.
That is, there is no scope for substitution of L for K (or vice
versa) in production. Thus this type of technical progress implies
that a given output can now be produced with less L and less
K.).
Figure 2.7: Neutral Technical Progress
W
U.K.

120
T’
100

80

60 T .
A
40

20 .
B
T T’
0 20 40 60 80 100 120 140 160 180 200 C

W
U.S.
T’
180

160
T

.
140

120
B’

100

80

.
60

40
A’

20

T T’
0 20 40 60 80 100 120 C

2.6.3 Changes in Taste and International Trade

Offer Curve shows how much of its import commodity a

nation requires in exchange for various quantities of its export
commodity. Ultimately it reflects the terms of trade of the country

International Economics (Block 1) 37

Unit 2 Theories of International Trade-I

(Detail in Unit-4). A change in tastes and preference of a country

alters the volume of trade and ultimately, the nation’s terms of trade.
For example, if the people of a country (other things being equal)
start to prefer its exportable commodity in place of importable
commodity, the volume of trade of the country declines and the
country’s terms of trade improve. Fig. 2.8 explains the fact.
Let us suppose that cloth and wheat are respectively the
exportable and importable item of U.K. Both U.K. and U.S. are in
equilibrium at point J as directed by their respective offer curves.
Other things being equal, now suppose that the U.K.’s tastes shifts
away from wheat toward cloth. In such a situation, the offer curve of
U.K. shifts away from U.K. to U.K.’. It is because of the fact that the
U.K. now wants less quantity of wheat and is willing to offer less of
its cloth than before. The new equilibrium will be established at J’,
where the U.K. exchanges only 20C for 40W. Thus, the terms of
trade of the U.K. improve to PG’=2 (from PB’=1). Since the terms of
trade improve, there is an increase in welfare for U.K. However,
there is also loss in welfare for U.K. due to reduction of specialization
and consequent fall in the volume of trade. Exact amount of gain/
loss will depend upon the relative strength of these two forces.

Figure 2.8: Changes in Taste and International Trade

U.K.
PB
60
PG E . U.S.
U.K.’
50

40 .J’
30

20
.Z
10

0 10 20 30 40 50 60 C

38 International Economics (Block 1)

Theories of International Trade-I Unit 2

Contrary to this, if the U.K.’s taste shifts from cloth to wheat,

the offer curve of U.K. will rotate clockwise. As a result, volume of
trade will increase, indicating gain in welfare. However, since there
is reduction in terms of trade, there is also the loss in welfare.Exact
amount of gain/loss will depend, as mentioned above,upon the
relative strength of these two forces.

CHECK YOUR PROGRESS

Q.4: State whether the following statements are true

(T) or false (F)
(a) Given the technology, if the factors of production available
to a nation increase, the nation’s production possibilities
curved shifts outward ? (Explain in about 40 words (T/F)
(b) L-saving technical progress increases the productivity of
labour.(T/F)
Q.5: What is the effect of change in tastes and preference of a
country on volume and terms of trade of a country. ( Answer in
about 30-40 words)
...................................................................................................
...................................................................................................

2.7 LET US SUM UP

 Adam Smith advocated the free trade is the best policy for the
nations of the world. This free trade should be based on “absolute
advantage”. This law of absolute advantage states that :
 A nation should produce and export only those commodities in which
it had an absolute advantage (or could produce more efficiently than
other nations). At the same time a nation should import only those
commodities in which it had an absolute disadvantage (or could
produce less efficiently than the other countries.

International Economics (Block 1) 39

Unit 2 Theories of International Trade-I

 Output worldwide would increase as a result of this international

specialization of factors in production. This increase in output will
be shared by the trading nations.
 David Ricardo introduced the law of comparative advantage. This
postulates that
 Even if one nation is less efficient than the other nation in
the production of both commodities, there is still a basis for
mutually beneficial trade.
 The less efficient nation should specialize in the production
and export of the commodity in which its absolute
disadvantage is smaller.
 According to opportunity costs theory, the cost of a commodity is
the amount of a second commodity that must be given up to release
just enough resources to produce one additional unit of the first
commodity.
 Under constant cost condition, complete specialization is possible.
 There is incomplete specialization in case of increasing costs.
 The dynamic factors have important bearing on volume and terms
of trade of a country.
 Given the technology, if the factors of production available to a nation
increase, the nation’s production possibilities curved shifts outward.
 As a result of improvement in technology a nation’s productions
possibilities curved shifts outward. Is is three types: K-Saving, L-
Saving and Neutral.
 A change in tastes and preference of a country alters the volume of
trade and ultimately, the nation’s terms of trade. This is reflected
through offer curve.

2.8 FURTHER READING

 Salvator D.(2014). International Economics, Tenth Edition, Wiley

Publication

40 International Economics (Block 1)

Theories of International Trade-I Unit 2

 Mannur, H. G.(1995). International Economics, New Delhi: Vikas

Publishing House Pvt. Ltd
 Rana, K.C.&Verma, K.N. (2010). International Economics, New
Delhi: Vishal Publishing Co.

2.9 ANSWERS TO CHECK YOUR

PROGRESS

Ans to Q No 1: a) False b) True

Ans to Q No 2: According to the doctrine of comparative advantage, mutually
advantageous trade takes place with a country even if it has an
absolute disadvantagein the production of both commodities with
respect to the other nation. The less efficient nation (having absolute
disadvantage in both commodities) should specialize in the production
and export of the commodity in which its absolute disadvantage is
less. That is, this is the commodity in which the nation has a
comparative disadvantage. As opposite to this, the country should
import the commodity in which its absolute disadvantage is greater.
That is, this is the area of its comparative disadvantage. This is about
Ricardo’s famous law of comparative advantage.
Ans to Q No 3: Opportunity cost the cost of a commodity is the amount of
a second commodity that must be given up to release just enough
resources to produce one additional unit of the first commodity. A
nation with lower opportunity cost in the production of a commodity
has a comparative advantage in that commodity (and a comparative
disadvantage in the second commodity). Under constant cost
condition, complete specialization is possible. There is incomplete
specialization in case of increasing costs
Ans to Q No 4: a) True b) True
Ans to Q No 5: A change in tastes and preference of a country alters the
volume of trade and ultimately, the nation’s terms of trade. For example,
if the people of a country (other things being equal) start to prefer its
exportable commodity in place of importable commodity, the volume

International Economics (Block 1) 41

Unit 2 Theories of International Trade-I

of trade of the country declines and the country’s terms of trade

improve. All these are reflected through the “offer cuve”.

2.10 MODEL QUESTIONS

Short Questions (Answer each question in about 150 words)

Q 1: Explain Adam Smith’s view on international trade.

Q 2: Explain international trade with the help of opportunity costs.
Q 3: Analyse the impact of change in taste and preference of the people
of a country on international trade.
Essay-type Questions (Answer each question in about 300-500 words)
Q 1: What are assumptions of Comparative Costs Theory? Critically
examine the theory.
Q 2: Explain various types of technical progress and their impact on
international trade.

*** ***** ***

42 International Economics (Block 1)

UNIT 3: THEORIES OF INTERNATIONAL TRADE - II
UNIT STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Heckscher-Ohlin Theory of Trade
3.3.1 Relative Factor Abundance
3.3.2 Relative Factor Intensity
3.3.3 Heckscher-Ohlin Theorem
3.3.4 Gains From Trade
3.4 Leontief Paradox
3.5 Theorem of Factor Price Equalisation
3.6 The Rybczynski Theorem
3.7 Stolper Samuelson Model
3.8 Let Us Sum Up
3.9 Further Reading
3.10 Answer to Check Your Progress
3.11 Model Questions

3.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 explain the Heckscher-Ohlin theory of international trade
 discuss the concepts of relative factor abundance and relative factor
intensity
 discuss the Leontief paradox
 explain the theRybczynski Theorem as well as theStolper
Samuelson model.

3.2 INTRODUCTION

In the previous two units you have learnt what do we mean by

international trade, what are the distinctive features of international trade
and who do we need a separate theory of international trade. You have also
known the importance of international trade. You have learnt two very
International Economics (Block 1) 43
Unit 3 Theories of International Trade-II

important theories of international trade – Absolute Advantage theory

propounded by Adam Smith and David Ricardo’s Comparative Cost Theory
in terms of labour theory of value. Not only you have understood that
opportunity cost is very crucial in determining comparative advantage of
the countries and the direction of trade, but also dynamic factors play a
very important role in international trade. You have also known the basis of
trade – how the changes in tastes, technology and factor endowments
explain the emergence of international trade. In fact Ricardian theory is
highly dependent on technological differences among the two countries.
In this unit you will broaden your concept from 2x2x1 (two countries-
two commodities-one factor) model to 2x2x2 (two countries-two
commodities-two factors) model of trade – Heckscher-Ohlin Theory of
international trade, which was a very dominant trade theory of the 20th
century. You will learn Leontief Paradox – under what circumstances
Heckscher-Ohlin theory of trade does not hold. You will further learn how
the factor prices get equalized among the two countries through international
trade even when the movement of physical factors is restricted among the
nations.
The Rybczynski Theorem will explain the product magnification
effect that fastest growing factor will increase the production of the
commodity, which uses the fastest growing factor intensively, at a greater
rate than both the factors of production, whereas, the production of the
other commodity will increase (if at all) at a lower rate than the slowest
growing factor.
On the other hand,Price Magnification effect by Stolper-Samuelson
explores the rate of change in factor prices due to change in relative of
price of the commodities.Stolper Samuelson Theorem states that the real
return to the intensive factor increases due to an increase in the price of
the commodity that uses the factor intensively and the real return to the
factor, which is not used intensively in the production of that commodity will
increase (if at all) at a lower rate.

44 International Economics (Block 1)

Theories of International Trade-II Unit 3

3.3 HECKSCHER-OHLIN THEORY OF TRADE

Comparative advantage of the country in Ricardian Comparative

Cost Advantage theory is explained by technological differences across
nations, whereas, Heckscher-Ohlin (H-O) theory relies on the differences
in relative factor endowments, that is why this model is known as factor
proportion model. This H-O theorem diverges from Ricardian Comparative
Cost theory in two important aspects. First, the model accepts the existence
of a second factor of production, which we call capital and second, it believes
in identical production functions instead of assuming technological
differences. To understand the H-O theorem clearly,we have to understand
the underlying assumptions of the theory. The assumptions are given below:
H – O Theory of Trade: It
 The Factor Proportion Model is a 2x2x2 model, i.e., there are two proposes that the country
countries A and B, they produce two commodities, X and Y and will trade that commodity
each country is endowed with fixed quantities of two factors, capital which uses intensively its
relatively abundant factor.
(K) and labour (L).
 Country A is relatively labour abundant and country B is relatively
capital abundant.
 Perfect competition prevails in factor markets as well as in
commodity markets in both the countries. It implies that in the long
run equilibrium P (price of the commodity) = AC (average cost) =
MC (marginal cost).
 There is complete factor mobility of factors across the two
commodity sectors but factors of production are completely
immobile between the two countries.
 It is assumed that the production functions are identical
internationally.
 The production functions are linearly homogeneous production
functions or putting in another way, production function shows
constant returns to scale (CRS). Therefore, if the factor inputs are
increased by a certain proportion, then the output will also increase
by the same proportion. This CRS also exhibits decreasing but
positive marginal products of the factor endowments.

International Economics (Block 1) 45

Unit 3 Theories of International Trade-II

 The production functions are such that the two commodities can
be separated by factor-intensity. Commodity is X is assumed to be
relatively labour intensive and commodity Y is relatively capital
intensive.
 And there is no factor-intensity reversal.i) There is neither any trade
barriers of any kind nor there is any transhipment cost. Thus,trade
among the countries if it prevails is free and costless.
On the basis of the above assumptions Heckscher - Ohlin theory
proposes that the country will trade that commodity which uses intensively
its relatively abundant factor. But what is relative factor abundance and
relative factor intensity?It is explained in the following sub-section.

3.3.1 Relative Factor Abundance

There are two different interpretations of relative factor

abundance – one is related to factor prices and the other one is
Relative Factor related to factor proportions. The first definition is known as ‘price
Abundance: Country A
definition of relative factor abundance’ and the second definition is
will be relatively labour
called ‘physical definition of relative factor abundance’. Ohlin chooses
abundant if its wage-
rental ratio is less than the price definition.
that in country B. According to Ohlin, the country A will be relatively labour
or, abundant if its wage-rental ratio is less than that in country B, i.e., if
A country will be
(w/r)A< (w/r)B or qA< qB, where q = w/r, the country A is said to be
considered as relatively
relatively labour abundant country where labour is relatively cheaper
labour abundant if its K/L
ratio is less than the and the country B will be relatively capital abundant country where
other country. capital is relatively cheaper. But this price definition of factor
abundance does not consider the comparison of factor endowment
ratios of the two countries.
The alternative definition of factor abundance, the physical
definition relies on the difference in physical factor endowment ratios.
As per this definition a country will be considered as relatively labour
abundant if its K/L ratio is less than the other country. Therefore,
country A will be relatively labour abundant if and only if it holds a
lower K/L ratio than country B, i.e, if (K/L)A< (K/L)B then country A
46 International Economics (Block 1)
Theories of International Trade-II Unit 3

will be relatively labour abundant country and country B will be

relatively capital abundant country. This physical definition of factor
abundance of the countries does not compare the relative factor
prices of the two countries.

3.3.2 Relative Factor Intensity

Factor intensity plays a very crucial role in Heckscher-Ohlin

theorem. Commodity X is said to be a relatively labour intensive
commodity and Y will be relatively capital intensive commodity if
capital-labour ratio used in the production of Y is higher than that in
the production of X, i.e., (K/L)Y> (K/L)X. However, this ranking may
be reversed, which is a case of Factor Intensity Reversal (FIR),
when one country can easily substitute capital for labour along the
isoquant. Existence of FIR may create problem in Heckscher-Ohlin
theory.The above mentioned two definitions of factor abundance
are certainly not equivalent. However, its need not to say according
to the price definition of factor abundance, the country rich in labour
will have a bias in producing labour intensive commodities and the
country rich in capital will prefer to produce capital intensive
commodities. Thus, given the price definition of factor abundance,
Heckscher-Ohlin theorem follows from the assumptions made
above that the labour abundant country will export labour intensive
commodity and capital abundant country will export capital intensive
commodity.

3.3.3 Heckscher-Ohlin Theorem Relative Factor

Intensity: A commodity is
The autarky situation of the two countries can be explained said to be relatively
in terms of Figure 3.1. In the figure, the production possibility curves labour-intensive
of the two countries are shown by AA and BB. Homogeneous and commodity if capital-
labour ratio used in the
identical consumption preferences are shown by two community
production of the
indifference curves CICA and CICB. Autarky point of country A is
commodity is less than
obtained where the highest community indifference curve is tangent that in any other
to the price line at the point QA on the production possibility curve commodity.

International Economics (Block 1) 47

Unit 3 Theories of International Trade-II

and on the other hand, is the autarky point of county B on its

production possibility curve. In the absence of trade, the production
point and the consumption point are same in both the countries
implying that whatever is produced is consumed in both the countries
and the factors of production are fully utilised. Therefore, in autarky
there is no idle resources. The domestic price line of country A is
clearly flatter than that of country B. It clearly implies that the relative
price of X in country A less than that in country B. Thus, commodity
X is relatively cheaper in country A than B and commodity Y is
relatively cheaper in country B than A, i.e.,
< ………………………………………………………(i)

Figure 3.1: Autarky Equilibrium

From the inequality (i) we can say that country A has relative efficiency
in producing X, i.e., country A can produce X at a relatively lower price than
B, whereas, country B produces Y at a relatively lower pricesince, the relative
price p is the relative price of X, i.e., p = PX/PY. Therefore, when trade opens
up among these two countries, residents of country B find commodity X
relatively cheaper in country A and residents of country A find commodity Y
relatively cheaper in country B. Thus, when trade is permitted, the
48 International Economics (Block 1)
Theories of International Trade-II Unit 3

consumers in country A will try to import commodity Y from B and likewise,

the consumers in country B will try to spend money on commodity X of
country A. Finally, two countries will mutually decide to trade at a common
price, which is known as world price or the Terms of Trade (TOT).At the
new world price, country specialises in the production of X, whereas country
B specialises in the production of Y. In post trade there will be reallocation
of resources according to the relative efficiency of the factors. Trade will be
balanced, i.e., total volume of exports will be equal to the total volume of
imports of each country.
The above phenomenon is described in Figure 3.3.2. In this figure
we can examine the impacts of international trade on the production and
consumption pattern of the two countries. We can see that as commodity
is produced at a relatively lower cost in country A compared to B, in post
trade situation country A will specialize in the production of commodity X
and its production point shifts to EA, clearly which lies to the right of the
previous production point QA. Similarly, country B specialises in the
production of Y. Production point of country B shifts to EBand clearly which
is to the left of the previous production point QB. Both the countries A and B
move to higher community indifference curve and respectively..
Country A consumes at CA and country B consumes at CB in post trade
situation. CAGEA is the trade triangle of which perpendicular CAG measures
volume of import of commodity Y of country A. GEA, the base measures the
volume of export of commodity X of country A and CAEA measures world
relative price or the TOT. Likewise, for country B, the trade triangle is EBFCB.
In this trade triangle of country B, perpendicular, EBF measures volume of
export, base, FCB measures volume of imports and hypotenuse, EBCB
measures the international price. Here in the diagram CAEA and EBCB are
two parallel lines that implies both the countries face the same terms of
trade. Thus, trade results in the equalization of the commodity prices of the
two countries since the slopes of the two parallel lines are equal.Hence,
given the assumptions of the model, the Heckscher-Ohlin theorem states
that the country will export the commodity that intensively uses its relatively
abundant factor.
International Economics (Block 1) 49
Unit 3 Theories of International Trade-II

CHECK YOUR PROGRESS

Q.1: What do you mean by Heckscher-Ohlin

Theorem?
...................................................................................................
...................................................................................................
Q.2: What is Factor Abundance?
...................................................................................................
...................................................................................................
Q.3: What is Factor Intensity?
...................................................................................................
...................................................................................................

Figure: 3.2: The Heckscher-Ohlin Theorem

Y
<

B
.E B

.
QB
CB
F
A
CA CICB1
. CICA1
QA
.
G EA

<
B A X

3.3.4 Gains from Trade

The most important perception in any theory of international trade is

gains from trade (GFT). GFT means that the countries involved in
the trade are benefitted as a whole from free trade. It does not mean
that every one of the countries will be benefitted. Countries always
50 International Economics (Block 1)
Theories of International Trade-II Unit 3

exchange their goods and services among themselves for their

mutual benefits. Ricardo explained two countries can gain from trade
even when one country has absolute advantage over the other
country in all lines of production. The international trade also provides
Gains from Trade: GFT
benefits to the countries by importing the commodities that use means that the countries
intensively the locally scarce factors at a relatively lower price than involved in the trade are
otherwise would have been in the absence of trade (Heckscher- benefitted as a whole from
Ohlin trade theory). free trade. It does not
mean that every one of
Now, when trade is permittedamong the countries, both the
the countries will be
countries are benefitted. In post trade there will be trade-off between
benefitted.
the two sectors of the economy. With an expansion in the production
of X in country A, which uses its abundant factor, there will be a
contraction in the import competing sector Y. Since, resources are
already fully employed in autarky situation, following free trade,
specialisation in the labour-intensive commodity of exportable X
needs reallocation of resources. Therefore, the real income of the
abundant factor increases at the cost of scarce factor capital in the
post trade. This increase in the real income actually improves the
level of welfare of the country.
Figure: 3.3: Gains from Trade

Y
<

CA
.
A

CICA1
QA
CICA

PA

EA
.

PA1 <
O A X

International Economics (Block 1) 51

Unit 3 Theories of International Trade-II

This is shown in the Figure 3.3. When trade is permitted, country

A faces world relative price or the TOT, as depicted in the figure.
This TOT, is clearly steeper than At this higher price country A
specialises in the production of labour-intensive commodity X and the
production point of country A shifts from QA to EA. Therefore, there is a
clear trade-off between labour-intensive commodity X and capital-
intensively commodity Y as a result of free trade. The income effect of
the price change leads to an increase in the consumption of both the
commodities shown by the movement from a lower CIC to a higher
CIC from QA to CA. Hence, a rise in the relative price of exportable of a
country A actually increases its welfare. By the similar explanation, it
can also be shown that country B will also be benefitted as a result of
free trade. Thus, it can be said that, if free trade occurs, the countries
involved in exchanging the commodities among themselves will definitely
gain from trade.

3.4 LEONTIEF PARADOX

A model must be tested empirically and the first test of the

Leontief Paradox: It Heckscher-Ohlin theorem was tested by Wassily Leontief in 1951. For this test
states that capital
he used the input-output table1 of the US economy for the year 1947. Again in
abundant countryexports
1956 he repeated the same experiment using 1947 input-output table of the US
labour-intensive
commodity. Trade pattern economy but considered 1951 trade data as the year 1951 is normally
is not consistent with H-O considered to mark the completion of post-world war reconstruction. As US
theorem. economy is more capital abundant country it was expected that US will
specialise in the production of capital-intensive commodities and will export the
same. He estimated factor intensity of US import substitutes rather than actual
US imports since foreign production data on actual US imports were not
available. The result of the test was surprising. US exports were 30% less
capital intensive than US import substitutes, i.e., though US was expected to
export relatively capital-intensive commodities but actually it exported relatively

1
Input-output table is a table that shows origin and destination of each product
produced in the economy. For discovery of input-output technique Leontief won
Nobel Prize in 1973.

52 International Economics (Block 1)

Theories of International Trade-II Unit 3

labour-intensive commodities. This phenomenon is actually the opposite of

what Heckscher-Ohlin theorem predicts and it is the famous Leontief Paradox.
The paradox states that the trade pattern of the US economy was not consistent
with Heckscher-Ohlin theorem, i.e., capital abundant US economy exports
relatively labour intensive commodities.
Different economists provided several explanations in support of
Leontief Paradox. Some have pointed out US tariff policy as a possible
source of bias. A tariff is nothing but a tax which is imposed on imports and
it protects import competing sectors. They argued that in US, labour-
intensive industries were heavily protected and it changed the pattern of
trade and supported the existence of Leontief Paradox. Some have argued
that Leontief did not consider human capital in his measure of capital. Human
capital is the capital that increases labour productivity and it refers to the
education, skill, training of the labourers. US labour embodies more human
capital than any labour of the foreign country and it makes US exports more
capital intensive than its import substitutes.
However, the most important explanation of Leontief Paradox can
be explained by the existence of factor intensity reversals (FIR). In the
presence of FIR, it is quite likely that a capital abundant country may export
labour intensive commodity. This phenomenon is explained in Figure 3.4.
We assume country A as relatively capital abundant compared to country
B as relative factor abundance of country A, ka is greater than that of country
B, kb. Two commodities are X and Y, whose factor intensity curves are
shown in the upper panel of the diagram by kX and kY respectively. The two
curves intersect at point R, which is the factor reversal point. The relative
factor ratios of the two countries A and B are such that the relative factor
intensity points of country A fall to the right of R, where as that of country B
fall to the left of R. From the figure it is clear that country A has a comparative
advantage in producing commodity Y, which is relatively labour-intensive in
country A since relative domestic price of country A, Pa>Pb, the relative
domestic price of country B. So when trade occurs, though country A is
comparatively capital abundant country it will export relatively labour intensive

International Economics (Block 1) 53

Unit 3 Theories of International Trade-II

commodity Y and will import comparatively capital intensive commodity X.

Thus, Leontief Paradox holds for country A.
Figure: 3.4: Leontief Paradox

After much empirical testing of Heckscher-Ohlin theorem,

economists concluded that the traditional Heckscher-Ohlin model can be
retained to explain trade between developed and developing countries, which
is commonly known as North-South trade and a restricted version of trade
can be used to explain trade among the developed countries (North-North
trade).

CHECK YOUR PROGRESS

Q.4: State whether following statements are true

(T) or false (F):
a) GFT implies everyone within a country will be benefitted.
b) H-O theorem states that labour abundant country will export
labour-intensive commodity.
Q.5: What do you mean by Gains from Trade?
...................................................................................................
...................................................................................................
54 International Economics (Block 1)
Theories of International Trade-II Unit 3

Q.6: What is Leontief Paradox?

...................................................................................................
...................................................................................................

3.5 THEOREM OF FACTOR PRICE EQUALISATION

In the absence of trade, labour abundant country A produces labour-

intensive commodity X at a relatively lower price than the capital abundant
country B. Difference in relative prices of X in the two countries actually
implies the difference in the relative price of factors, i.e., wage-rental ratio.
However, when trade opens up among the two countries, the relative
commodity prices of the two countries converge and this in turn converges
the relative factor prices. Thus, factor prices equalize among the countries
through free trade.
Now, when trade occurs between two countries A and B, it is more
than mere exchange of commodities. Country A sells commodity X, which
requires relatively more labour than the commodity Y that is imported by
country A. Therefore, country A sells labour to B not directly but through
exchange of the commodities. Similarly, country B sells its abundant factor
capital indirectly through the exchange of the commodities. Thus, labour
abundant country A exports labour embodied in its labour-intensive
commodity X while capital abundant country B exports capital embodied in
its capital-intensive commodity Y.
However, through free trade factor prices of the two countries A and
B are equalised though the factors of production are completely immobile
across the countries. This result is explained in the Figure 3.5. Initially, in
the autarky, the labour abundant country A is at point A with relative domestic
 w 
price ratio PA and factor price ratio  
 r 1
and capital abundant country B is
 w 
at A’ with relative price ration PA’ and factor price ratio  
 r 2
. Now PA< PA’

and thus labour abundant country A has a comparative advantage in

producing labour-intensive commodity X, whereas capital abundant country
has comparative advantage in producing capital-intensive commodity Y. As
trade occurs, country A will specialise in the production of X and country B

International Economics (Block 1) 55

Unit 3 Theories of International Trade-II

will specialise in the production of Y. Therefore, relative demand for labour

in country A and that for capital in country B will increase, which in turn will
increase wage-rental ratio in country A and will reduce the same in country
B. This causes relative price of X to increase in country A and to decrease
in country B as there is one-to-one correspondence between wage-rental
ratio and relative commodity price ratio. In the presence of perfect competition
and with the identical technology of production, this process will continue
until they reach to the point at B = B’where they will trade the commodities
*
 w 
at the same TOT, PB = PB’and the same wage-rental ratio   prevails in
 r 

both the countries.

Figure 3.5: Factor Price Equalisation

However, though it is very much apparent theoretically that free trade

will lead to factor price equalisation, there is a practical problem in real
world. In real world, there exist a wide range of wage rates across the
nations and that reflects the differences in the quality of labour. Therefore,
in real world relative factor prices may not get equalised through free trade.
Three assumptions crucial to the theory of factor price equalisation – (i)
identical technologies across the countries; (ii) equalisation of commodity
prices through costless trade and (iii) incomplete specialisation after trade,
are not always true in reality.

56 International Economics (Block 1)

Theories of International Trade-II Unit 3

 If the trading countries have different technologies of production,

the proposition of factor price equalisation may not hold. For example,
a country with inferior technology may have a lower factor price
ratio than a country with superior technology.
 In the real world, the relative commodity prices of the two countries
do not fully converge due to the presence of both tariff barriers and
non-tariff barriers like import quotas, transport costs and other Factor Price

restriction. Equalisation: Free

trade tends to equalise
 Even when the two countries produce the commodities with identical
relative factor prices
technology and face the same relative commodity price, factor price
among the trading
may not get equalised among the two countries since the countries through the
prerequisite for factor price equalisation is that the countries will equalisation of relative
produce same set of goods. Therefore, if the trading countries have commodity prices.

similar and congruent relative factor endowments and produce the

same set of commodities then only factor price may equalise through
free trade.
From the above discussion, factor price equalisation theorem can
be stated as below:
“Under identical constant-returns-to-scale production technologies,
free trade in commodities will equalise relative factor prices through
the equalisation of relative commodity prices, so long as both
countries produce both goods.”2

3.6 RYBCZYNSKI THEOREM

Rybczynski in 1955 proved that at a constant commodity prices, an

exogenous increase in the endowment of one factor of production changes
the output composition of the countries. According to Jones3, “If factor
endowments expand at different rates, the commodity intensive in the use
of the fastest growing factor expands at a greater rate than either factor
and the other commodity grows (if at all) at a slower rate than either factor.
2
Markusen, J. R., Melvin, J. R., Maskus, K. E., & Kaempfer, W. (1995). International
Trade: Theory and Evidence. McGraw Hill, Inc.
3
Jones, R. W. (1956-57). Factor Proportions and the Heckscher-Ohlin Model. Review
of Economic Studies.
International Economics (Block 1) 57
Unit 3 Theories of International Trade-II

Jones called this the Output Magnification Effect. Let us assume that labour
supply of country A increases more than its capital endowment so that
. Then according to magnification effect, production of labour-intensive
commodity will expand relatively more than either factor and the capital-
intensive commodity Y grow (if at all) at a smaller rate than both the factors.
In other words, if

where, = and = , such that the rate of change in labour

supply is greater than the rate of change in capital endowment;
then,
> > …………………………………………… (ii)
Where, = and = are the rate of changes in the commodities
Rybczynski Theorem: It
X and Y respectively.
states that at a constant
In the above ranking (ii), two things are very obvious. First, labour-
commodity prices, an
exogenous increase in the intensive commodity X increases more than the capital-intensive commodity
endowment of one factor Y and secondly, the endowment changes are trapped in between the output
of production changes the changes. In this chain of ranking, if , i.e., if the factor endowments
output composition of the
change at the same rate then, production of both labour-intensive and capital-
countries.
intensive commodities will change at the same rate. On the other hand, if
= 0, then capital-intensive commodity Y will not grow, rather this sector
will shrink.
Hence, Rybczynski theorem, more specifically the output
magnification effect proved that if there is a more than proportionate increase
in labour supply compared to the growth in capital, production of labour-
intensive commodity X increases more than the increase in either factor of
production and that in the production of capital-intensive commodity Y. This
result can also be explained by Edgeworth Box diagram in Figure 3.6.
The points A and B are the common tangency points between two
isoquants of two sectors X and Y. The rays OxA and OYA represents the
capital-labour ratios for the two industries X and Y respectively. Now suppose
only labour supply of the economy increases by ³%L with no change in
capital, which shifts the origin for commodity Y from OY to OY’. Assuming

58 International Economics (Block 1)

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constant relative commodity price and thereby constant relative factor price
as there exists a one-to-one correspondence between commodity price
ratio and factor price ratio, change in labour supply will definitely affect the
outputs of the two commodities. The ray OXA remains unaffected but there
will be a parallel shift of OYA towards OY’B. The point B will be the new
equilibrium point, which is further away from point A, clearly indicating that
labour-intensive industry X expands as it uses more labour and capital. On
the other hand, capital-intensive sector Y contracts.

Figure: 3.6: Rybczynski Theorem

3.7 STOLPER- SAMUELSON THEOREM

This theorem states that an increase in relative price of a commodity

will raise the return to the factor that is used intensively in the production of
that commodity. For example, tariff which is nothing but an import tax, raises
the relative price of its importable. In our specification country A is relatively
labour abundant country and country B is rich in capital. Therefore, as per
Heckscher-Ohlin theorem, when trade is permitted between the two
countries A and B, country A exports relatively labour-intensive commodity
X and imports relatively capital-intensive commodity Y from country B. Now,
if country A imposes import tariff to protect its import competing sector,
relative price of the commodity Y will increase since country A imports
commodity Y. As a result, according to Stolper Samuelson theorem, the

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Unit 3 Theories of International Trade-II

real return to the scarce factor capital, which is used intensively in the
production of Y in country A will rise at a greater rate than any other commodity
price and the return to the abundant factor labour. That is if,
>
where, = and = , such that, the rate of change in PY>
the rate of change in PX; then,
> > > …………………………………………(iii)
Stolper -Samuelson
where, = and = are the rate of change in return to capital
Theorem: This theorem
states that an increase in and rate of change in return to labour respectively.
relative price of a In the above inequality (iii), commodity price changes are trapped
commodity will raise the into the relative factor price changes. This is also referred to as the ‘Price
real return to the factor Magnification Effect’. As a special case, let us assume that = , i.e.,
that is used intensively in both the prices increase at the same rate, then both the factor price must
the production of that
rise at the same rate, i.e.,
commodity.
= = =
On the other hand, if = 0, i.e., if the price of X, which is a labour-
intensive commodity does not change, real return to the factor labour used
intensively in its production will fall.
The reason for this is that when relative price of the commodity Y,
increases, production of commodity Y becomes more profitable. As a
result, country A will produce more of relatively capital-intensive commodity
Y. Expansion of the sector Y requires more of capital in relation to labour.
And as the basic assumption is that there is full employment of factors of
production in the country, the additional demand for capital will raise the
relative return to the factor capital, w/r. Hence increase in the relative price
of commodity Y actually raises the earning of the scarce factor capital at
the expense of its abundant factor labour.
On the other hand, given an increase in the relative price of labour-
intensive commodity X in country A as a result of trade, the economy would
specialise in the production of X and produce less of capital-intensive
commodity Y. Therefore, after trade capital-intensive sector Y will release
more of capital than labour, whereas the demand for labour will be more in
labour-intensive sector X than compared to capital. Hence real return to the
factor labour will increase at a greater rate than either prices of the
60 International Economics (Block 1)
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commodity and the rate of return to the capital following an increase in the
relative price of the commodity X as a result of free trade.
Now suppose that the country A is a capital rich country and imposes
an import tariff on its importable X so that , and how this
will affect the relative factor prices can be explained graphically in Figure
3.7. In the figure we can see that an increase in relative price of X, PX/PY
due to imposition of an import tariff, leads the country to move from an
initial free trade equilibrium point B to point F on the contract curve signifying
that K/L ratio is higher in both the production of X and Y. Increase in capital-
labour ratio implies increase in marginal productivity of labour in both the
sectors in one hand and on the hand marginal productivity of capital reduces
in both the sector. Thus, real wage increases in both the sector, where as
real return to capital reduces in all the sectors. Therefore, tariff induces a
transfer of income from capital owners to labourers. Hence,Stolper-
Samuelson price magnification effect follows as below:

Figure 3.7: Stolper-Samuelson Theorem

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Unit 3 Theories of International Trade-II

CHECK YOUR PROGRESS

Q.7: What is Factor Price Equalisation?

.................................................................................
...................................................................................................
Q.8: What do you mean by Rybczynski Theorem?
...................................................................................................
...................................................................................................
Q.9: What is Stolper Samuelson Theorem?
...................................................................................................
...................................................................................................

3.8 LET US SUM UP

 There are lots of theories in international trade. Classical theories

like Adam Smith’s Absolute Advantage Theory and Comparative Cost
Advantage Theory depends on labour theory of value, i.e., labour is
the single factor of production.
 Heckscher-Ohlin theory rests on two factors of production – labour
and capital. Given the set of assumptions H-O theory states that
labour abundant country will export labour-intensive commodity and
capital abundant country will export capital-intensive commodity
when trade opens up.
 Physical definition of factor abundance demonstrates that a country
will be relatively labour abundant compared to the other country if
capital-labour ratio of the country is less than that of the other country.
 According to Price definition of factor abundance, a country will be
relatively labour abundant compared to the other country if wage-
rental ratio of the country is than that of the other.
 A commodity is said to be intensive in one factor of production, if the
said factor is used intensively than the other factor in the production
process.

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 A country will tend to produce more of that good, which uses its
abundant factor intensively.
 Gains from trade states that overall the countries engaged in the
trade will be benefitted. It does not mean that everyone within the
countries will be benefitted.
 Empirical validity of Heckscher-Ohlin theorem was first tested by
Leontief and he found a result which is not consistent with H-O
theorem. He found that though the US economy is capital abundant,
it exports labour-intensive commodities.
 Rybczynski’s output magnification effect finds that more than
proportionate exogenous growth in one factor of production expands
the sector that uses the factor intensively, more than the growth of
either factor and the other commodity (if at all).
 In the price magnification effect, it was found by Stolper-Samuelson
thatan increase in relative price of a commodity will raise the real
return to the factor that is used intensively in the production of that
commodity more than proportionately than either prices and return
to the other factor (if at all).
 International trade changes the relative price of the commodities in
the world market. It has a significant impact on the distribution of
income. The factor which is used intensively in the production of
that commodity whose relative price increases gain more than
proportionately.

3.9 FURTHER READING

 M. Chacoliades (1978): International Trade: Theory and Policy, New

York, McGraw- Hill
 R. Caves, J. Frankel and R.W. Jones:World Trades & Payments
(9th Ed); Pearson Education
 J.R. Markusen, J.R. Melvin, W.H. Kaempfer, K.E. Maskus (1995):
International Trade – Theory and Evidence, McGraw Hill

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Unit 3 Theories of International Trade-II

 R. Acharyya (2014): International Economics; Oxford University

Press

3.10 ANSWERS TO CHECK YOUR

PROGRESS

Ans to Q No 1: Heckscher-Ohlin theorem states that the country will export

that commodity which uses intensively its abundant factor.
Ans to Q No 2: Factor abundance means the factor of a country which is
available more in the country.
Ans to Q No 3:Factor intensity of a commodity means the factor, which is
used intensively in the production of that commodity.
Ans to Q No 4: (a) False (b) True
Ans to Q No 5: Gains from trade implies that the countries engaged in
trade will be mutually benefitted through free trade. It does not mean
that each and every one of the countries will be benefitted.
Ans to Q No 6: Leontief paradox states that in reality all the trade patterns
are not consistent with Heckscher-Ohlin theorem. He found that capital
abundant US economy exports labour-intensive commodities.
Ans to Q No 7: Factor price equalisation theorem states that relative factor
prices of the countries get equalised through the equalisation of relative
commodity prices after trade though the factors of production are
immobile across the nations.
Ans to Q No 8: Rybczynski theorem states that if a factor of production
increases more than proportionately than the other factor, the
commodity that uses the fastest growing factor intensively, will grow
at a greater rate than either factor and the other commodity.
Ans to Q No 9: Stolper Samuelson theorem states that if the relative price
of a commodity increases, the real return to the factor, which is used
intensively in the production of that commodity will increase more
than proportionate increases in either prices of the commodities and
the return to the other factor (if at all).

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3.11 MODEL QUESTIONS

Q.1: Write short answers to the following questions (within 150 words):
a) Consider the following factor endowments of two countries, A
and B:
Availability of Factors A B
Labour force (millions of labour hours 50 15
per year)
Capital stock (millions of machine 25 20
hours per year)

(i) Which country is capital abundant and why?

(ii) Which country is labour abundant and why?
(b) Suppose that there are two factors, capital and land, and that
the United States is relatively capital endowed while India is
relatively labour-endowed. According to the Heckscher-Ohlin
model, will the US capitalists support India-US free trade? Why?
(c) ‘If India and USA trade with each other, real wages will be equalized
in the two countries even in the absence of labour migration
across countries’- prove or disprove the statement.
(d) ‘Owners of a country’s abundant factor gain from trade while
owners of scarce factors lose’-do you agree? Explain.
(e) ‘Trading countries will expand their export sector and contract
their import competing sector after trade’ - do you agree? Explain.

Q.2: Answer the following questions within 500 words:

(a) Write an essay on Heckscher-Ohlin theorem.
(b) International trade leads to complete equalization of factor prices.
Discuss.
(c) Explain why the Leontief paradox contradicts the factor-proportion
theory. What are the possible reasons for this paradox?

*** ***** ***

International Economics (Block 1) 65

 UNIT 4: THEORIES OF INTERNATIONAL TRADE-III
UNIT STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Intra-Industry Trade
4.3.1 Meaning
4.3.2 Measurement
4.4 Vent-For-Surplus
4.5 Availability Approach
4.6 Product-Cycle Model
4.7 Technological Gap Model
4.8 Let Us Sum Up
4.9 Further Reading
4.10 Answers to Check Your Progress
4.11 Model Questions

4.1 LEARNING OBJECTIVES

After going through this unit, you will be able to –
 put forward the concept, importance and measurement of Intra-
Industry-Trade
 recognised Vent for surplus and its effectiveness in international
trade
 discuss the availability approach of International trade theory
 analyse the product cycle model of international trade
 discuss the relationship between demand lag and imitation lag in
technological gap theory.

4.2 INTRODUCTION
In the previous unit 1, 2 and 3 the concept of trade on all the theories
were based upon inter-industry trade. The exchange of Industry A with
Industry B is an exchange between the products of two different industries.
The classical, neo-classical, Heckscher-Ohlin theory all were based on

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inter-industry trade. But in real life a country simultaneously imports and

exports the different varieties of the product of the same industry. This is
termed as intra-industry trade. All the theories prior to this are dealing with
homogeneous products.

4.3 INTRA-INDUSTRY TRADE

Intra-industry trade arises in order to take advantages of economies

of scale, market imperfection and varieties of product. Intra-industry trade
benefits the consumers because of the wider range of choices available at
lower prices due to the economies of scale in the economy. It also stimulates
innovation in the country.

4.3.1 Meaning

Intra-industry trade refers to the exchange of similar products

belonging to the same industry. The term is usually applied in
International Trade, where the same types of goods or services are
imported and exported. The intra-industry trade arises because of
the economies of scale, product differentiation in a monopolistic
competition market, division of labour, rapid economic growth,
globalization etc..

4.3.2 Measurement

The level of intra-industry trade(IIT) can be measured by the

intra-industry trade index developed by Grubel-Llyod in the year 1967
and popularly known as GL index.
[Xi  Mi ]
GLi  1 
[Xi  Mi]
Where,
Xi = Value/Volume of Export
And Mi = Value/Volume of Import
 If Export of same product is equal to import of that product
Xi=Mi
Then

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Unit 4 Theories of International Trade-III

GLi=1
 There will be intra industry trade and no inter industry trade.
 If countries Either Export or Import of any good or service
 Either Xi=0
 Or Mi=0
 Then GLi=0
 There will be Inter industry trade between two countries and no
IIT.
Explanation
 If GLi=1
 Then,

[X i  Mi ]
1 1
[X i  M i ]
Xi  Mi
0
Xi  Mi
Xi  Mi  0
Xi  Mi

Export of a product is equal to import of that product, so there is IIT

in two countries
 If GLi=0
 Then,

[Xi  Mi]
1 0
[Xi  Mi ]
[Xi  Mi]
1
[Xi  Mi ]
Xi  Mi  Xi  Mi
Mi  0

 Thus Export or Import will be Zero, so there will be Inter Industry

trade between two countries.

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Theories of International Trade-III Unit 4

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True (T) or False (F)
(i) The intra-industry trade is the trade between two countries.
(T/F)
(ii) The classical theories of international trade were based on
the concept of intra-industry trade. (T/F)
Q.2: What is meant by the intra-industry trade?
...................................................................................................
...................................................................................................
Q.3: Explain Grubel-Llyodindex.
...................................................................................................
...................................................................................................

4.4 VENT-FOR-SURPLUS

The vent for surplus theory was developed by Adam Smith and later
it was revised by HlaMyint. The theory states that if a country produces
more than it absorbs it has a surplus. In the absence of international trade,
a surplus domestic productive capacity will be unutilised or underutilised
its natural resources and labour resources. In addition the process of
absorption may be slow. The international trade can absorb this surplus of
production without creating any adverse effects upon poor countries. The
export of surplus product will create new effective demand for the products
of less developed countries. The international trade absorb the surplus
domestic production and prevents any likely slump in the home market,
creates markets for product abroad and permit the imports of essential
products. In this way, the vent for surplus theory state that international
trade cannot be an obstacle but an opportunity for accelerating the process
of growth.
HlaMyint, therefore, considered the vent for surplus theory more
appropriate for the less developed countries than the principle of comparative
cost advantages.Myint made some points in this regards, in less developed
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Unit 4 Theories of International Trade-III

countries the utilised and under-utilised resources exist in a large numbers.

In such situation, the production can be increased with the surplus and it
results in new discoveries. Most of the less developed countries suffer with
the problem of poverty, therefore there market size is very limited with the
international trade they not only utilised their surplus in an effective manner
but can also expands market size. The vent for surplus approach helps in
increasing the mobility of labour and specific factor of production and gives
a way out from serious impediments. The approach also permits the
monetary and fiscal authorities to adopt measures suitable for the expansion
of exports. In this way we can say that the approach is more effective than
the traditional comparative cost theory.

4.5 AVAILABILITY APPROACH

An important extension of international trade theory given by

Heckscher-Ohlin is the availability approach to international trade. This
approach was given by Irving B. Kravis in 1956. According to Kravis, the
pattern of trade in any country depends upon the availability and non-
availability of resources in the nation. In other words, a country produced
and exported those goods which it had ‘available’, that is, goods developed
by its entrepreneurs and innovators. Availability means an elastic supply.
Trade takes place in only those goods which are not available at home. The
non-availability of goods in home country may either be in the absolute or
the relative sense. In the former sense, certain goods are not available at
all in the home country and in relative sense means that the domestic supply
of products is short of their demand.
Kravis has discussed four factors which influence availability. They
are natural resources, technical progress, product differentiation and
government policy. Firstly, if a country is rich in natural resource or availability
of scare natural resources determines the trade pattern of a country.
Secondly, the technical progress can have a significant impact upon factor
utilisation, expansion in the scale of production and improvement in the
quality of products which determined the trade direction of a country. The
third factor is product differentiation which confers temporary monopoly to
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a specific innovating country and it exports it until the importing country

imitates. The last factor is Government policy that is the tariff and non-tariff
trade restrictions that tend to restrict the international flows of goods.
The availability theory can be explained with the help of an example.
Supposed there are four countries- A, B, C and D. There are two
commodities-wheat and steel. The production of both the commodities
requires labour and capital. In addition the production of wheat requires
fertile agricultural land whereas the production of steel requires iron ore.
Out of four countries, A, B and C are endowed with agricultural land. The
countries B, C and D are endowed with iron ore. Given these the country A
can produce only wheat and country D can produce only steel. The countries
B and C can produce both wheat and steel. Now according to availability
approach country A will export wheat to country D and will import steel from
country D. Since B and C are capable of producing both the commodities
the trade between them will be governed by their respective comparative
cost advantages. Suppose the domestic exchange ratio between wheat
and steel in country B is 6 units of wheat = 1 unit of steel. It is 3 units of
wheat=1 unit of steel in country C. If the international exchange ratio is
settled at 4 units of wheat= 1 unit of steel, country B will export wheat to
country C and latter will export steel to country B.
Findlay argues that availability approach has superiority over factor
proportions approach. Although two countries have equal endowments of
labour and capital, yet country A produces and exports the capital intensive
commodity steel and country B produces and exports relatively less capital
intensive commodity wheat. It is not fully consistent with the factor
proportions theory. However, the availability theory recognizes that the trade
pattern between these two countries is governed by availability. Thus, this
theory seems to be better than the factor proportion theory.

CHECK YOUR PROGRESS

Q.4: State whether the following statements are True

(T) or False (F)

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Unit 4 Theories of International Trade-III

(i) HlaMyint propounded the concept of vent for surplus. (T/F)

(ii) Kravis’ theory is related international trade. (T/F)
Q.5: What is meant by vent for surplus approach?
...................................................................................................
...................................................................................................
Q.6: In what waydoes the domestic availability of products influence
the pattern of international trade?
...................................................................................................
...................................................................................................

4.6 PRODUCT-CYCLE MODEL

The product cycle model was developed by Prof. Raymond Vernon

in his article “International Investment and International Trade in Product
Cycle” published in the year 1966. According to this model, when a new
product is introduced, it requires highly skill labour to produce. As the product
matures and acquires mass acceptance, it became standardised it can be
produced by less skilled labours and by mass production techniques. In
other words a product is initially produced and exported by the innovating
country but finally it ends up as an importing country of the same product or
same differentiated variety of that product. The basic argument in this model
is that the factor requirements of a product differ over its lifetime, so that
there is a cycle in the production of it. The innovation of a new product
involves risks that can be borne by relatively rich firms.
According to the theory, the pattern of trade has been witnessed in
case of several products such as electronic goods, synthetic materials,
motion pictures, consumers’ durables and office machinery and
equipments. The classical example of the product cycle model is provided
by the experience of U.S. and Japanese manufactures of radio. Immediately
after the Second World War, the U.S. manufactures dominated the world
market of radios based on vacuum tubes. Within a few years, the Japanese
manufacturer copies the U.S. technology and captured a large part of the
world market. The U.S. then introduced transistors. Once again the Japan

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Theories of International Trade-III Unit 4

could produce them at lower costs and recapture the world market. Than
the U.S. manufacturers introduced the printed circuits. Even in this case
the Japan followed the technology and expanded its exports. Similar is the
pattern of trade concerning automobiles involving U.S. and Japan.
According to this theory, the products generally pass through five
different stages discussed below:
 STAGE -I or New Product Phase: The product is produce and
consumed only in the innovating country.
 STAGE-II or Product Growth Phase: At this stage, there is not yet
any foreign production of product, so that the innovating country
has a monopoly in both the home and export markets.
 STAGE-III or Product Maturity Phase: In this stage, the product
standardised and the innovating firm may find it profitable to
manufacture the product. Thus, the imitating country starts
producing the product for domestic consumption.
 STAGE-IV or Product Decline Phase: At this stage, the imitating
country facing lower labour and other costs now the product has
become standardized and the production of the product in the
innovating country starts declines.
 STAGE-V or Product Decline Phase: the imitating country starts
selling the product in the markets and the production of product in
the innovating country declines rapidly or collapse.
It can be visualised with the figure and it identifies the five different
stages of the product cycle.

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Unit 4 Theories of International Trade-III

Figure: 4.1: The Product Cycle Model

Criticism:
 The assumption that innovating firms have no information about
conditions in foreign market.
 Not exposed to different home environment from other advanced
countries.
 New products may not be initially developed in capital rich countries.
 Developing countries may not be late starters in the process of
absorbing the innovations of advanced countries.

4.7 TECHNOLOGICAL GAP MODEL

This theory is given by M.V. Posner in 1961.He analyzed the effect

of technology on international trade unlike Heckscher-Ohlin model which is
based on the assumption that technology is the same in all trading countries.
He regards technological changes as continuous process and a

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technological innovation in the form of production of a new good in one

country leads to the IMITATION GAP and DEMAND GAP in the other country.
This theory explains the sequence of innovation and imitation as it affects
the patterns of the trade. When a firm innovate a new product, it becomes
profitable in the domestic market and enjoys a temporary monopoly.This
product is exported to foreign market and has an absolute
advantage.Innovating country’s profit encourages imitation in other
country.Till the importing country learns the new process, the innovating
country will continue to export the product and have a comparative
advantage in it, this is the imitation gap.
According to Posner, the imitation gap has three components:
 Foreign reactions lag: time taken by the innovating firm to start
the production of the new product.
 Domestic reaction lag: time taken by other domestic producers to
follow and establish a hold on the domestic market.
 Learning period: time taken by domestic producers to master the
technique of producing the new product and selling it in the domestic
market.
There is also the ‘demand lag’ which is the time taken by consumers
in the importing country to acquire the taste for the new product. To obtain
the period during which its imports will continue, the demand lag must be
subtracted from imitation lag.
Figure: 4.2: Demand Lag
<
EXPORTS

<

O
t0
.
t1
.
t2
.
t3
.
t4
.
t5
.
t6

TIME
IMPORTS

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Unit 4 Theories of International Trade-III

Explanation of the Figure:

In the figure, there is no trade up to point t0, at t0 A innovates the
new product.If there is no imitation of the commodity in B, country A will
continue to export it till exports reach at time t3. The period from t0 to t3 is
the demand lag.If a producer in B starts producing the product by time t3,
the exports of A will decline.If producers in B are unable to adopt the
innovation of the new commodity till time t4, the country A will continue to
export. As country B starts imitating the new technology, there will be decline
in exports from A to B and this would fall down to zero in time t6.
Criticisms:
 It doesn’t explain the size of the technological gap
 Doesn’t explain the reason that technological gaps arise
 Posner didn’t discuss the factors responsible for innovation.
 The competitive pattern of innovations in the two countries is also
not explained.

CHECK YOUR PROGRESS

Q.7: State whether the following statements are True

(T) or False (F)
(i) According to product cycle model, product passes through
four stages. (T/F)
(ii) The technological gap is caused by foreign reaction lag.
(T/F)
(iii) Product cycle model was given by R.Vernon. (T/F)
Q.8: What is meant by imitation gap?
...................................................................................................
...................................................................................................
Q.9: Describe the main stages in the product cycle model.
...................................................................................................
...................................................................................................
Q.10: Explain briefly Demand lag.
...................................................................................................
...................................................................................................

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Theories of International Trade-III Unit 4

4.8 LET US SUM UP

 The classical, neo-classical, Heckscher-Ohlin theory all were based

on inter-industry trade.
 In real life a country simultaneously imports and exports the different
varieties of the product of the same industry. This is termed as intra-
industry trade.
 Intra-industry trade arises in order to take advantages of economies
of scale, market imperfection and varieties of product.
 The level of intra-industry trade (IIT) can be measured by the intra-
industry trade index developed by Grubel-Llyod index (GLi).
[Xi  Mi ]
 GLi  1 
[Xi  Mi ]
 The vent for surplus theory states that if a country produces more
than it absorbs it has a surplus. In the absence of international trade,
a surplus domestic productive capacity will be unutilised or
underutilised its natural resources and labour resources.
 According to vent for surplus approach if a country produces more
than it absorbs it has a surplus. It means that international trade
cannot be an obstacle but an opportunity for accelerating the process
of growth.
 According to Availability approach, the pattern of trade in any country
depends upon the availability and non-availability of resources in
the nation.
 According to the product cycle model, when a new product is
introduced, it requires highly skill labour to produce. As the product
matures and acquires mass acceptance, it became standardised
it can be produced by less skilled labours and by mass production
techniques.
 The technological gap model explains the sequence of innovation
and imitation as it affects the patterns of the trade.

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Unit 4 Theories of International Trade-III

4.9 FURTHER READING

 Rana, K. C. &Verma, K. N. (2009). International Economics. New

Delhi: Vishal Publishing Co.
 Salvatore, Dominick: International Economics, John Wiley
 Cherunilam Francis: International Economics (4th Edition) 2006 Tata
McGraw-Hill Companies
 Krugman Paul and Maurice Obstfeld: International Economics:
Theory and policy, latest edition, Pearson Education
 Sodersten B O & Reed Geoffrey: International Economics, 2003
McMillan Press Ltd.

4.10 ANSWERS TO CHECK YOUR

PROGRESS

Ans to Q No 1: (i) True` (ii) False

Ans to Q No 2: Intra-industry trade refers to the exchange of similar products
belonging to the same industry. The term is usually applied in
International Trade, where the same types of goods or services are
imported and exported.
Ans to Q No 3: The level of intra-industry trade (IIT) can be measured by
the intra-industry trade index developed by Grubel-Llyod in the year
1967 and popularly known as G-L index. It is calculated by:
[Xi  Mi ]
GLi  1 
[Xi  Mi]
Where,
Xi= Value/Volume of Export
And Mi= Value/Volume of Import
Ans to Q No 4: (i) False (ii) True
Ans to Q No 5: The vent for surplus approach states that if a country
produces more than it absorbs it has a surplus. In the absence of
international trade, a surplus domestic productive capacity will be
unutilised or underutilised its natural resources and labour resources.
78 International Economics (Block 1)
Theories of International Trade-III Unit 4

Ans to Q No 6: The pattern of trade in any country depends upon the

availability and non-availability of resources in the nation. In other
words, a country produced and exported those goods which it had
‘available’, that is, goods developed by its entrepreneurs and
innovators. Trade takes place in only those goods which are not
available at home. The non-availability of goods in home country may
either be in the absolute or the relative sense.
Ans to Q No 7: (i) False (ii) False (iii) True
Ans to Q No 8:The imitation gap has three components:
 Foreign reactions lag: time taken by the innovating firm to start
the production of the new product.
 Domestic reaction lag: time taken by other domestic producers
to follow and establish a hold on the domestic market.
 Learning period: time taken by domestic producers to master
the technique of producing the new product and selling it in the
domestic market.
Ans to Q No 9: The products generally pass through five different stages
discussed below:
 STAGE -I or New Product Phase: The product is produce and
consumed only in the innovating country.
 STAGE-II or Product Growth Phase: At this stage, there is not
yet any foreign production of product, so that the innovating
country has a monopoly in both the home and export markets.
 STAGE-III or Product Maturity Phase: In this stage, the product
standardised and the innovating firm may find it profitable to
manufacture the product. Thus, the imitating country starts
producing the product for domestic consumption.
 STAGE-IV or Product Decline Phase: At this stage, the imitating
country facing lower labour and other costs now the product has
become standardized and the production of the product in the
innovating country starts declines.

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Unit 4 Theories of International Trade-III

 STAGE-V or Product Decline Phase: the imitating country starts

selling the product in the markets and the production of product
in the innovating country declines rapidly or collapse.
Ans to Q No 10: The ‘demand lag’ which is the time taken by consumers in
the importing country to acquire the taste for the new product.

4.11 MODEL QUESTIONS

Short Questions (Answer each question in about 150 words)

Q.1: Write a short note on the concept of Vent for surplus of Adam Smith.
Q.2: Discuss the causes of intra industry trade.
Q.3: Explain Kravis theory of availability.
Q.4: Describe anti-inflationary measures other than fiscal measures.

Easy type Questions (Answer each question in about 300-500 words)

Q.1: Explain Product Cycle Model of international trade.
Q.2: Describe the Posner’s technological gap model of trade.
Q.3: Write an essay on the concept and measurement of intra industry
trade.

*** ***** ***

80 International Economics (Block 1)

UNIT 5: GAINS FROM TRADE
UNIT STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Gains from Trade
5.3.1 Concept of Gains from Trade
5.3.2 Approaches to Gains from Trade
5.3.3 Factors determining Gains from Trade
5.4 Offer Curve
5.4.1 Derivation of Offer curve
5.4.2 Equilibrium terms of trade
5.4.3 Elasticity of offer curve
5.5 Distribution of Gains from Trade in Terms of Offer Curves
5.6 Trade as an Engine of Economic Growth
5.7 Let Us Sum Up
5.8 Further Reading
5.9 Answers to Check Your Progress
5.10 Model Questions

5.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 put forward the meanings of the terms
 learn the concept of gains from trade and the approaches towards
it
 have an idea about offer curve and its derivation
 learn about distribution of gains from trade between trading countries
 know the role of trade in economic growth and development

5.2 INTRODUCTION

International trade between countries, whether developed or

developing or underdeveloped, is favourable for economic development of
the trading countries in particular and the world in general. A country under
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Unit 5 Gain From Trade

autarky or no trade (closed economy) can never prosper economically.

Trading countries ultimately can reap the fruits of gain or profit. However,
the distribution of gains may vary between countries. Large countries or
the countries having comparative advantage in production of any
commodity(especially manufactured commodities) may gain more
compared to the countries producing primary commodities. In other words,
gains from trade may be inequitable, but economists are of the view that
some trade is always better than no trade. There are various approaches
towards analysis of gains from trade, some of which are briefly discussed
in next sections. Adam Smith, David Ricardo, J.S. Mill and many eminent
economists had put forward various approaches to analyze the concept of
international trade and the gains that can be derived from it. Gains from
trade have been analyzed using the concepts of (i) comparative advantage,
(ii) offer curves, (iii) production possibility curve and community indifference
curves and so on. Gains from trade were measured by the classical
economists in terms of (i) increase in national income, (ii) Differences in
comparative costs, and (iii) Terms of trade. The modern economists
explained gains from trade as composition of gains from exchange and
gains from specialisation.But the basic proposition is that trade leads to
gain in welfare between the trading countries.

5.3 GAINS FROM TRADE

5.3.1 Concept of Gains from Trade

Gains from trade refer to the increase in welfare experienced

by a country by engaging in trade. It is advantageous for any country
of the world to involve in trade with another country. As trade is
mutually beneficial for both or all the trading countries, the countries
- whether developed or underdeveloped - trade with each other. But
it is to be kept in mind that the gains accrued from trade can never
be equal for all these countries. Some countries may reap more
gain, while for some the gain may be less. However, this situation of
trade is better than no trade or autarky condition.

82 International Economics (Block 1)

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5.3.2 Approaches to Gains from Trade

Gains from trade have been at centre of discussion since

the classical times. Various approaches have been put forward at
various times by eminent economists. In the next sub-sections, let
us have a bird’s eye view of few such approaches.
 Adam Smith’s Approach
According to Adam Smith, gains from trade arise due to the
division of labour and specialisation (improvement in the
productive capacity). A commodity is exported in trade whose
demand is comparatively less in the home market, whereas a
commodity which has more demand is imported. The trading
countries try to derive maximum welfare as well maximum
earnings from export. Specialisation in the production of a
commodity having cost advantage leads to optimum allocation
of productive resources. Specialisation along with increased
division of labour helps in broadening the market for the trading
countries that ultimately leads to maximisation of welfare.
 Ricardo-Malthus’s Approach
Comparative
David Ricardo emphasizes on comparative cost advantage. advantage is a
Comparative cost advantage theory proposes that trade can country’s ability to
be beneficial for all countries if they specialise in the production produce a commodity at
of those goods in which they have comparative advantage. a lower opportunity cost
compared to other
According to Ricardo, a country will export those commodities
countries with which the
in which it has comparative cost advantage. The commodities
country is engaged in
with comparative cost disadvantage will be imported. The use
trade.Comparative
of resources can be economised through international trade. advantage suggests that
Given the amount of resources, trade enables the countries to countries will engage
obtain a larger total income than if the countries attempted to in trade with one

produce everything domestically. In the words of David Ricardo, another, exporting those
commodities in which
the advantage to both places is not that they have any increase
they have a
in value but with the same amount of value they are both able to
relative advantage.
consume and enjoy an increased quantity of commodities.

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Unit 5 Gain From Trade

Malthus, however, criticised Ricardo on the ground that his

proposition on gains from trade is overestimated. The gains
from trade, according to Malthus, consists of the increased value
that results from exchanging what is wanted less for what is
wanted more. The international exchange on this basis
increases exchangeable value of possession, means of
enjoyment and wealth.
 J.S. Mill’s Approach
J. S. Mill considered his theory of gains from trade in terms of
his reciprocal demand theory. Ricardian approach of gains from
Reciprocal demand
trade was criticised on the ground that it could not explain the
means the relative
strength of the two trading
distribution of gains from trade among the trading countries.
countries for each other’s J.S. Mill, in an attempt to explain this distribution emphasised
produced commodity in upon the concept of reciprocal demand that determines terms
terms of their own product.
of trade. Terms of trade, the ratio of quantity imported to the
Mill, by reciprocal demand,
quantity exported by a given country, decides how the gains
meant the quantities of
exports that a country from trade is distributed between the trading countries. The
would offer at different approach is analysed with the help of offer curve.
terms of trade, in return of In this unit, we shall discuss only this approach of distribution of
changing quantities of
gains from trade using the concept of offer curve.
imports.
 Taussig’s Approach
Terms of trade is the The approach put forward by F. W.Taussig is to some extent
relationship between the different from the other approaches. His analysis was directed
prices at which a country
towards rise in income as the gain from international trade.
sells its exports and the
According to Taussig, trade brings about an expansion of the
prices paid for its imports.
If the prices of a country’s export industrythat resulted in requirement of more labour. The
exports rise relative to the employers start offering higher wages in order to absorb more
prices of its imports, it is labour in this industry. The economy witnesses a rise in the
said that its terms of trade
money wages in other industries as well;otherwise, there will
have moved in a
favourable direction, as it be accumulation of inefficiency in them. There is a general rise
now receives more in money incomes. The people of a country canincrease
imports for each unit of purchases of both domestically produced and imported goods.
commodities exported.
The country attains higher level of welfare.
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Gain From Trade Unit 5

 Modern Approach
Both the trading countries gain from trade when the trade takes
place based on the principle of comparative advantage. The
modern approach proposed that this gain from trade can be
decomposed into two types of gains — one gains from exchange
and the other gains from specialisation. Consumers of both the
trading countries enjoy a higher level of satisfaction, partly
because of improvement in terms of trade (exchange) and partly
due to greater specialisation in the use of economic resources
of the country.

5.3.3 Factors determining Gains from Trade

Few important factors that determine gains from trade are discussed
here briefly.
 Differences in cost ratios:
International trade takes place when the domestic cost ratios
of two commodities between two countries are different. Stated
alternatively, the gains from trade depend on differences in
comparative cost ratios of the two countries engaged in trade.
If a country A has a comparative advantage in the production of
commodity X, and country B has such advantage in production
of commodity Y, then both the countries will gain from trade.
However, the volume of gain will be dependent on differences
of comparative cost in these two countries. If for some reason,
the cost of production of X in country A falls, then country B will
gain from trade. Again, country A will gain from trade if cost of
production of commodity Y in country B falls. The larger the
differences in the comparative cost ratios, the larger are the
volumes of gain.
 Reciprocal Demand:
As stated earlier, the terms of trade is determined by reciprocal
demand (the relative strength and elasticity of demand of one
country for the commodity of the other country in exchange for

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Unit 5 Gain From Trade

its own commodity). If it is found that country A’s demand for

commodity Y is more inelastic, then the terms of trade will move
in favour of country  and against country A. The gain from
trade of country  will be more compared to country A. On the
contrary, if demand of country A for commodity Y is more elastic,
then the terms of trade will be in favour of country A. Country A
will gain more from trade compared to country B. Thus, a trading
country whose demand for foreign goods is highly elastic gains
the most from trade.
 Income level:
A country having a steady demand for its commodity in other
countries will have a high level of money income because high
demand for its exports will help in expanding the export
industries, as a result of which the level of money wages will
rise in these industries. The money wages in other industries
will also rise at least to the level of wages in export industries
due to competition for labour leading to increase in money
income in the country. If the prices of imported foreign goods
be low, people of this country will gain consuming cheap
imported goods. On the other hand, a country with high demand
for imported goods will have low money incomes and high prices,
as a consequence of which people will lose consuming those
imported goods.
 terms of trade:
It is already learnt that the terms of trade is the rate at which
one commodity of a country is exchanged for another commodity
of the other country. In both J.S. Mill’s theory and modern theory,
terms of trade determines gains from trade. But when
international trade takes place, the terms of trade change and
are different from the domestic terms of trade.
 Other factors:
Gains from trade also are influenced by the nature of exported
commodities (exporter of primary commodities having
86 International Economics (Block 1)
Gain From Trade Unit 5

unfavourable terms of trade and country exporting

manufactured commodities gaining more), Technological
advancement(country with advanced technology and
abundance of capital gaining more from trade), productive
efficiency and size of the country.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True (T) or False (F)
(i) Reciprocal demand theory was advocated by J.S. Mill
(T / F)
(ii) Terms of trade is determined with help of cost difference
(T / F)
Q.2: What does comparative cost theory suggest ? (Answer in about
40 words)
...................................................................................................
...................................................................................................
Q.3: On what factors gain from trade depends? (Answer in about 40
words)
...................................................................................................
...................................................................................................

5.4 OFFER CURVE

5.4.1 Derivation of Offer Curve

Offer curve or trade offer curve shows the quantities of any

commodity one country is willing to offer in exchange of certain
quantities of another commodity produced in the second country at
different relative prices. The concept of offer curve was first put
forward by Marshall and Edgeworth. However, Mill’s idea of reciprocal
demand is important to construct offer curves.
Let there are two countries A and B. Two commodities X
and Y are produced. The exportable commodity of country A is X,

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Unit 5 Gain From Trade

i.e. commodity X is importable of country B. Similarly, the exportable

commodity of country B is Y, i.e. commodity Y is importable of country
A. Let us assume that the price of commodity X increases relative
to price of Y under constant cost condition. In this context, let us
derive the offer curve of country A using the following diagram.
Fig 5.1: Offer curve for country A

FA
Commodity Y

P4
<

E4
P3
(Country B’s Importable)

P2

E3

P1

E2

P0
E1

O X1 X2 X3 X4 Commodity X
(Country B’s Exportable)

Commodity is plotted along the horizontal axis and

commodity Y along the vertical axis.If country A uses all its available
resources for producing commodity X, the maximum quantity of X
that can be produced is OX0. The initial price ratio line for the two
commodities is OP1. The price ratio line becomes steeper with the
rise in relative price ratio of commodity X to commodity Y. The
gradually changed price ratio lines are shown by OP2, OP3 and OP4
in the diagram. If the price ratio line is OP0, country A will not trade
as it represents a very low price of commodity X in terms of
commodity Y. The points of exchanges are E1, E2, E3 and E4. As
stated above, the maximum quantity of commodity X that is
produced in country A using all resources is OX0. If price ratio line is
OP1, country A keeps X1X0 quantity of commodity X for consumption

88 International Economics (Block 1)

Gain From Trade Unit 5

by home people and remaining OX1 will be exchanged with E1X1

units of commodity Y at point E1.Similarly, at points of exchange E2,
E3 and E4, the units exchanged between countries A and B are
respectively OX2 of X and E2X2 of Y, OX3 of X and E3X3 of Y and OX4
of commodity X and E4X4 of commodity Y. In other words, country A
exports OXi units of commodity X in exchange of EiXi units of
commodity Y from country B (where i = 1, 2, 3, 4). The offer curve
OFA (also known as reciprocal demand curve) of country A can be
traced out by joining the points E1, E2, E3 and E4 that gives the
demand of country A for commodity Y.
In the same way, offer curve for country B can be
constructed. In the diagram, commodity X or country B’s importable
commodity is plotted along the horizontal axis and commodity Y or
country B’s exportable commodity is plotted along the vertical axis.

Fig 5.2: Offer curve for country B

Commodity Y

P’0 P’0 P’0 P’0 P’0

<

E’4
Y4 FB
E’3
Y3
E’2
(Country B’s Exportable)

Y2

E’1
Y1

O Commodity X
(Country B’s Importable)

The steepness of the price ratio line decreases when the

price of commodity Y increases relative to that of commodity X. In
the same logic as explained above for country A, the offer curve
OFB for country B can be derived.

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Unit 5 Gain From Trade

5.4.2 Equilibrium Terms of Trade

The equilibrium terms of trade is determined when the export of

one country is equal to imports by other country for different
commodities. Graphically, this equilibrium point is determined at the
intersection point of offer curves of two trading countries.

Fig 5.3: Equilibrium terms of trade

FA
Commodity Y

<

E FB
Y*
Import by Country A
Export of Country B

O X* Commodity X

Export of Country A
Import by Country B

The diagram shows that offer curve of country A (OFA)

intersects the offer curve of country B (OFB) at point E. The
equilibrium terms of trade is indicated by the slope of ray OE. It may
be noted that, the export of commodity X by country A = the import
of commodity X by country B = OX*. Similarly, the import of
commodity Y by country A = the export of commodity Y by country B
= OY*. Therefore, there is equilibrium in both exports and imports.

5.4.3 Elasticity of Offer Curve

In this section, we shall discuss about derivation of a geometric

measure for elasticity of offer curve. Country A is the exporter of

90 International Economics (Block 1)

Gain From Trade Unit 5

commodity X and importer of commodity Y. If the quantity of X

exported is shown by x and quantity of Y imported is y, then elasticity
of offer curve may be expressed as

e= = =

Let us now consider the following diagram, where export of

commodity X by country A is plotted along the horizontal axis and
import of commodity Y by country B is plotted along the vertical
axis.

Fig 5.4: Elasticity of offer curve

<

EA
by Country A

.E
Import of Y

.E
2

.E 1

O D X1 X* Export of X
by Country A

OFA is the offer curve for country A. Let E1 be any point on

the offer curve in the upward rising positively sloped part. Let DE1
be a tangent to the offer curve at point X1. Here, at point E1quantity
of x is OX1, y is E1X1. Therefore, following the above formula,
elasticity of offer curve at point E1is

e= =

The elasticity of offer curve is greater than unity. Similarly, at

point E2, since the slope of the offer curve is infinity and the tangent

International Economics (Block 1) 91

Unit 5 Gain From Trade

is parallel to the vertical axis, the elasticity also tends to infinity. At

point E3, elasticity of offer curve is negative.

5.5 DISTRIBUTION OF GAINS FROM TRADE IN

TERMS OF OFFER CURVES
John Stuart Mill, in terms of his reciprocal demand theory, has
explained how trade takes place between countries and how gains from
trade are distributed. According to him, reciprocal demand determines ‘terms
of trade’. This ‘terms of trade’ determines each trading country’s distribution
of gains from trade. Now, what is terms of trade? Terms of trade is defined
as the ratio of quantity of imports for a given quantity of exports of a country.
Ricardo explained the concept of cost-difference, but could not explain terms
of trade. Mill proposed his theory based on the foundations laid down by
Ricardo. Given the cost-difference, the demand for commodities in both
the countries determines terms of trade.
In the next paragraphs, we shall discuss how terms of trade
determine the distribution of gains from trade for both the countries. Let
there be two countries A and B. Two commodities are produced X and Y.
Let 1 unit of labour in country A can produce 20 units of commodity X or 10
units of commodity Y. Again, 1 unit of labour in country B can produce 8
units of commodity X or 16 units of commodity Y. Therefore, the domestic
terms of trade (exchange ratio) is x : y = 2 : 1, where x and y are the quantities
of commodities. 1 unit of X will, therefore, be exchanged for ½ units of Y in
country A. Similarly, 1 unit of commodity X in country B will be exchanged
for 2 units of Y, i.e. y : x = 1 : 2.Mill proposed that reciprocal demand will
determine actual exchange ratio of commodities X and Y. It is the relative
strength and demand elasticity of each country engaged in trade for each
other’s product in terms of those countries’ own product. If country A’s
demand for commodity Y is less elastic or inelastic, then the terms of trade
will be closer to domestic price ratio (x : y = 2 : 1 or y : x = 1 : 2) and will
favour country B and disfavour country A.Country B will gain more compared
to country A. Conversely, if country A’s demand for commodity Y is more
elastic and country B’s demand for commodity X is less elastic or inelastic,
92 International Economics (Block 1)
Gain From Trade Unit 5

the terms of trade will be close to domestic exchange ratio (x : y = 1 : 2).

Country A will get the terms of trade in favour gaining more compared to
country B i.e., terms of trade will disfavour country B and the gain will be
less compared to that of country B.
In section 5.4, we have seen how offer curve can be constructed
for the trading countries. Let us now analyze with the help of offer curves
how gains from trade may be distributed. As stated in earlier section, let
OFA be the offer curve of country A, while OFB be the offer curve of country
B.

Figure 5.5: Distribution of gains from trade using offer curves

OCR2
Commodity Y
<

D FA

FB OCR1

O H Commodity X

Commodity X is plotted along the horizontal axis and commodity Y

along the vertical axis. OCR1 and OCR2 are the domestic cost ratios of
producing commodities X and Y in countries A and B. These two rays are
the boundaries within which the terms of trade should lie. The offer curves
OFAand OFB intersect each other at E. The equilibrium terms of trade is the
slope of the line OE. The cost ratio for country A domestically is GH units of
Y for OH units of X. But at point E, country A gets EH units of Y in exchange

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Unit 5 Gain From Trade

for OH units of commodity X. Country A gains EH – GH = EG units of

commodity Y due to trade with country B. On the other hand, the domestic
cost ratio for country B is DH units of Y for OH units of X. But country B
imports OH units of commodity X in exchange for EH units of commodity Y.
Thus, due to trade with country A, country B could gain DH – EH = DE units
of Y by sacrificing only EH units of Y instead of DH units. So, both the
countries could gain by engaging in trade, where the gain depends on
respective countries’ domestic cost ratio and terms of trade.

5.6 TRADE AS AN ENGINE OF ECONOMIC GROWTH

International trade contributes significantly in economic development

of any country. Economists, from time to time, have put forward different
theories in favour of international trade as a promoter of economic growth
and development.
The classical and neo-classical economists favoured trade as a
growth promoting factor. Classical economists Adam Smith and David
Ricardo had supported trade for economic development based on absolute
advantage and comparative advantage respectively. The classical
economists were in favour of laissez-faire doctrine (policy of minimum
governmental interference in the economic affairs) in international trade
which they believe would enhance welfare of the countries. Robertson
designated international trade as an ‘engine of growth’.
P. A. Samuelson and W. D. Nordhaus also advocated free trade
and were of the view that free trade allows each country to expand its
production and consumption possibilities.
According to A. C. Cairn, trade gives birth to the urge to develop the
knowledge and experience that make development possible, and the means
to accomplish it.
G.Haberler was of the opinion that trade provides capital goods,
machinery, raw materials that are indispensable for economic development;
helps in the dissemination of technological knowledge, transmission of ideas,
import of expertise, skills, entrepreneurship, etc.; helps in maintaining free
competition.
94 International Economics (Block 1)
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Let us now discuss how international trade contribute to economic

development of the trading countries.
 Firstly, a trading country generally specialises in the production of
some commodities in which it has comparative advantage. These
commodities are exported. The country also adopts division of
labour. Resources are more efficiently utilised. According to J.S.
Mill, trade adds to the efficiency of production.
 Due to proper division of labour and improvement in mechanisation
as well as more scope of innovation, productivity increases in the
trading countries.
 According to Prof. J. R. Hicks, international trade creates opportunity
for exchanging commodities having less growth potential with
commodities with more growth potential.
 Trade helps to explore the means to import capital goods, the basic
necessity to initiate the process of economic development. The
import of machinery, vehicles, technological know-how, medicines,
chemicals, etc. benefits developing countries. Moreover, the
movement of capital from developed countries facilitates growth
process in theunderdeveloped countries.
 Trade helps in better allocation of resources for promoting exports
as well as substituting imports.
 International trade stimulates the process investment and raises
rate of capital formation. Trade facilitates stability in the prices of
commodities.
 Underdeveloped or less developed countries can better their well-
being by specialising in and exporting the relatively less expensive
domestic commodities and importing commodities that are relatively
more expensive. These countries can industrialize themselves by
importing required capital goods from developed countries, and in
exchange may export primary commodities. The balance of payment
problem may thus be solved.

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Unit 5 Gain From Trade

 Due to specialisation, for most less developed countries,

comparative advantage in use of labour, the abundant factor, helps
to expand labour-intensive production instead of more modern,
capital-intensive production. International trade thus stimulates
employment.
 According to Watkins, due to international trade, many
underdeveloped countries specialise in the production of one or two
staple commodities. Export of these commodities, if possible, may
widen the market. Unemployment may be reduced. Output will be
more.
 International trade may assist in transforming subsistence sector
to monetised sector, if the farm products get market. Income and
standard of living of the farmers improves.
 Haberler was of the view that due to trade, international competition
increases, eliminating inefficient .monopolies and efficiency.
 Production for exportable commodities and increased imports of
goods bring about a chain of fine-tuning within the economic system
that ultimately induces not only the growth of export industries, but
also promotes the growth of infrastructure and services sector.
 The export sector allied ancillary industries expand rapidly with
increase in exports, creating more and more investment
opportunities. Foreign direct investments also add tothe investment
substantially in the export sector of the economy.
 Trade encourage competition among the producers. Quite naturally,
the producers in all the countries are bound to improve the quality of
products at the least costs in order to survive in the competition.
 Full employment does not prevail in less developed countries.
According to Hla Myint, actual output is always less than its potential
output as a consequence of unemployment. Utilising country’s
population fully, those countries can produce more commodities.
The supply may even exceed domestic demand. This excess supply
may be exported. Introduction of international trade opens up
possibility of ‘vent for surplus’ in these countries. The excess supply
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of primary commodities can be exported in exchange for

manufactured commodities from developed countries. Let us
consider the following diagram.

Figure 5.6: Vent for surplus

<
Manufactured Commodities

P
(Importables)

A E2

E1
M
E

O X1 X2 B
Primary Commodities
(Exportables)

Primary commodities or the exportable are plotted along the

horizontal axis and manufactured goods or the importable are along the
vertical axis. AB is the production possibility curve using the resources fully.
Let E be any point below the production possibility curve before trade when
the resources are not utilised fully. The country produces OX1units of primary
commodities and OMunits of manufactured commodities. Due to trade,
country produces more primary commodities and point E shifts to point E1
on the production possibility curve. Country produces OX2 units of primary
commodities, an excess of X1X2 units without reducing the production of
manufactured commodities. PP is the terms of trade line tangent to the
production possibility curve at E1. Now, EE1 or X1X2 units of primary
commodities are exchanged with E2E units of manufactured commodities
implying that international trade has taken the country to E2, a point outside
the production possibility curve AB.

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Unit 5 Gain From Trade

CHECK YOUR PROGRESS

Q.4: State whether the following statements are

True (T) or False (F)
(i) The concept of offer curve was first put forward by Marshall-
Edgeworth. (T / F)
(ii) Production possibility curve is convex to the origin (T / F)
Q.5: How Mill’s theory is advancement over Ricardo-Malthus theory?
(Answer in about 40 words)
...................................................................................................
...................................................................................................
Q.6: How does trade helps underdeveloped countries or LDCs?
(Answer in about 40 words)
...................................................................................................
...................................................................................................

5.7 LET US SUM UP

 All countries, be it developed or developing or underdeveloped,

engage in trade among themselves that leads to economic
development of the trading countries in particular and the world in
general. A country with no trade (closed economy) cannot prosper
economically.
 The countries engaged in trade can gain from trade, though the
distribution of gains may vary between countries.
 Several approaches on these gains have been proposed from time
to time by eminent economists.
 Adam Smith was of the view that gain from trade is a result of division
of labour and specialisation.
 According to Ricardo, a country exports only that commodity in which
it has comparative advantage.

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Gain From Trade Unit 5

 Mill explained his theory based on the concept of reciprocal demand

that determines terms of trade. The distribution of gains from trade
is explained in his theory.
 The modern approach divides gains from trade into gains from
exchange and gains from specialisation.
 This gain from trade is dependent on various factors, some of which
are difference in cost ratio, reciprocal demand, income level, terms
of trade, nature of exported commodities, advancement in
technology, efficiency in production, size of the country, etc.

5.8 FURTHER READING

(1) Heller H R (1998), Consumption & International Trade, International

Trade: Theory and Empirical Evidence, Prentice-Hall of India Private
Limited, New Delhi
(2) Heller H R (1998), Equilibrium in International Trade, International Trade:
Theory and Empirical Evidence, Prentice-Hall of India Private Limited,
New Delhi
(3) Lekhi (2019), Foreign Trade and Economic Development, The
Economics of Development and Planning, Kalyani Publishers,
Ludhiana.
(4) Mannur H G (2018), International Trade Equilibrium: Neo-classical
Analysis, International Economics, Vikas Publishing House, New Delhi
(5) Mannur H G (2018), The Classical Theory of International Trade:
Comparative Advantage Model, International Economics, Vikas
Publishing House, New Delhi
(6) Sarkhel J & Salim S. (2011), International Equilibrium, International
Economics, Book Syndicate (P) Ltd., Kolkata
(7) Sodersten B. & Reed G. (1994), International Economics, Palgrave
Pearson.

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Unit 5 Gain From Trade

5.9 ANSWERS TO CHECK YOUR

PROGRESS

Ans. to Q No 1: (i) True, (ii) False

Ans. to Q No 2: Comparative cost advantage theorysuggests trade to be
beneficial for all countries if they specialise in the production of those
goods in which they have comparative advantage. A country will export
those commodities in which it has comparative cost advantage and
will import those commodities in which it has comparative
disadvantage.
Ans. to Q No 3: Gain from trade is dependent on various factors like
difference in cost ratio, reciprocal demand, income level, terms of
trade, nature of exported commodities, advancement intechnology,
efficiency in production, size of the country, etc.
Ans. to Q No 4: (i) True, (ii) False
Ans. to Q No 5: Ricardo explained the concept of cost-difference, but
could not explain terms of trade – theratio of quantity of imports for a
given quantity of exports of a country. Mill proposed his theory based
on the foundations laid down by Ricardo. Given the cost-difference,
the demand for commodities in both the countries determines terms
of trade.
Ans. to Q No 6: Trade helps underdeveloped countries by the movement
of basic capital goods, like import of machinery, vehicles, technological
know-how, medicines, chemicals, etc. benefits from developed
countries. The export of primary commodities to developed countries
also facilitates welfare in underdeveloped countries.

5.10 MODEL QUESTIONS

Short questions (Answer in about 150 words)

Q.1: What is meant by gains from trade?
Q.2: What is comparative advantage?

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Gain From Trade Unit 5

Q.3: What is meant by reciprocal demand in the context of international

trade?

Q.4: What is an offer curves?

Q.5: What is meant by terms of trade?

Essay-type Questions (Answer each question in about 300-500 words)

Q.1: Discuss the various approaches to gains from trade.
Q.2: Explain the distribution of gains from trade between trading countries
with help of offer curves.
Q.3: Discuss Mill’s approach to gains from trade.
Q.4: Discuss the factors that may impact international trade.
Q.5: Discuss how trade may be considered as an engine of growth.

*** ***** ***

International Economics (Block 1) 101

 UNIT 6: TERMS OF TRADE
UNIT STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Meaning of Terms of Trade
6.4 Net Barter or Commodity Terms of Trade
6.5 Gross Barter Terms of Trade
6.6 Income Terms of Trade
6.7 Factors Affecting Terms of Trade
6.8 International Trade and Domestic Prices
6.9 Relation of Foreign Trade to National Income
6.10 Let Us Sum Up
6.11 Further Reading
6.12 Answers to Check Your Progress
6.13 Model Questions

6.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 put forward the meaning of terms of trade
 explain the factors affecting terms of trade
 explain the measurement and distribution of terms of trade
 discuss trade as an engine of growth.

6.2 INTRODUCTION

This unit aims to familiarise you tothe concept of terms of trade,

commodity terms of trade, gross barter terms of trade, income terms of
trade, factors affecting terms of trade, measurement and distribution of
terms of trade.
The theory terms of trade and commodity terms of trade are the
integral parts of international economics. Terms of trade refers to the rate
at which goods of one country is exchanged for the goods of another country.
It is a measure of the purchasing power of exports of a country in terms of
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its imports, and is expressed as the relation between export prices and
import prices of the goods.
The terms of trade of a country are influenced by various factors
such as reciprocal demand, changes in factor endowments, changes in
technology, changes in tastes, economic growth, tariffs and devaluation
etc.

6.3 MEANING OF TERMS OF TRADE

As already mentioned in the introductory section, “terms of trade”
refers to the rate at which the goods of one country is exchanged for the
goods of another country. As such, terms of trade is expressed as the
relation between export price and import price. When export prices of a
country rise relatively to its import prices, the terms of trade is said to have
improved as the country can have larger quantity of imports in exchange
for a given quantity of exports. On the other hand, when its import prices
rise relatively to its export prices, its terms of trade are said to have
worsened.
Equation/Formula:The terms of trade can be expressed in the form of
equation as such:
Price of Imports and Volume of Imports
Terms of Trade 
Price of Exports and Volume of Exports
The terms of trade are of economic significance to a country. If they
are favourable to a country, it will be gaining more from international trade
and if they are unfavourable, the loss will be occurring to it. When the country’s
goods are in high demand from abroad, i.e., when its terms of trade are
favourable, the level of money income increases. Conversely, when the
terms of trade are unfavourable, the level of money income falls.
Measurement of Change in Terms of Trade: The changes in
terms of trade can be measured by the use of an import and export index
number. We here take only standardized goods which have internal market
and give them weight according to their importance in the international
transactions. A certain year is taken as base year and the average of the
countries import and export prices of the base year is called 100. We then
work out the index of subsequent year. These indices then show as to how
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Unit 6 Terms of Trade

the commodity terms of trade move between two countries. The ratio of
exchange in export prices to the change in import prices is put in the form
of an equation as under:
Change in Export Prices
Commodity Terms of Trade 
Change in Import Price
Algebraically, it can be expressed:

Px1 Pm1
Te  
Px 0 Pm0
Here, Te represents commodity terms of trade; Px1represents export
price index for the required (or current) year; Px° Represents exports price
index of the base year; Pm1represents indices of prices of the required
year and Pm° represents indices of prices for the base year.
We now apply the above formula by taking a specific example. We
take the indices of export and import prices for the year 2000 as 100. We
assume also that the export prices index for the year 2020 is 530 and import
prices index 580. The ratio of change in export prices to the change in
import prices will be:
530 580
Te  
100 100

530 580
Te  
100 100
Thus, Te = 0.91
The above example shows that the prices of imports have increased
more than the exports prices. The terms of trade are unfavourable to the
country by 9 per cent. In other words, the country has to pay 9 per cent
more for a given amount of imports.

6.4 NET BARTER OR COMMODITY TERMS

OF TRADE

As discussed in the introductory section of the unit, the net barter or

commodity terms of trade is the ratio between the price of a country’s export
goods and import goods. To measure the changes in commodity terms of

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trade over a period, the ratio of change in export prices and import prices is
taken. The formula which is used to measure the commodity terms of trade
is:

Px1
Px0
Tc =
Pm1
Pm0

where Tc stands for the commodity terms of trade, P for the price,
the subscript x for exports and m for imports, 0 for the base year and 1 for
the current year. The concept of the commodity or net barter terms of trade
has been used by the economist to measure the gain from international
trade.

6.5 GROSS BARTER TERMS OF TRADE

From the above discussion, we have got an idea about net barter
terms of trade. But this measure of net barter terms of trade has its
limitations. To make up for the deficiency realised in the net barter terms of
trade, Professor Taussig devised the concept of gross barter terms of trade.
He pointed out that instead of relating import and export prices, we should
relate quantities of imports and exports. In this section of the unit, a
discussion is made regarding gross barter terms of trade. The gross barter
terms of trade is the ratio between the quantities of a country’s imports and
exports.
Symbolically,

Qm
Tg =
Qx
where, Tg stands for gross barter terms of trade, Qm for quantities
of imports, Qx for quantities of exports.
It can be easily accessed from the above equation that higher the
ratio between quantities of imports and exports, the better the gross barter
terms of trade. To measure the changes in gross barter terms of trade over
a period, the index number of the quantities of imports and exports in base

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Unit 6 Terms of Trade

period and the end period are related to each other. The formula which is
used for measuring gross barter terms of trade is:

Q m1
Q m0
Tg = TC =
Q x1
Q x0

Taking 2001 as base year and expressing India’s both import and
export quantities as 100, if we find that the index of quantity imports had
risen to 160 and that of quantity exports to 120 in 2011, then the gross
barter terms of trade has changed as follows:

160
Tg = 100 = 133.33
120
100
It implies from the above equation that the gross barter terms of
trade has registered an improvement by approximately 33 percent in 2011
compared with 2001. On the other hand, if the quantity of import index has
risen by 130 and that of quantity exports by 180, then the gross barter terms
of trade would be 72.22

130
Tg = 100 = 72.22
180
100
The above equation implies that there was deterioration in the terms
of trade by 18 percent in 2011 over 2001.

6.6 INCOME TERMS OF TRADE

It is the desire of every country that it should earn the maximum of

income out of international exchange by taking permanent favourable terms
of trade. In order to secure maximum gain, the country will try to increase
the volume and value of exports and reduce the volume of imports and buy
it also from the cheapest market. If the country is having a monopoly in the
supply of a commodity and the demand for products is inelastic, then it can

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fetch more income. Incase the terms of trade moveagainst the country,
then there will be drain of national income, the commodity terms of trade
depend upon the following factors:
 Ratio of import prices to export prices.
 The volume and value of exports and imports.
 The condition attached to export and import such as insurance
charges, supply of machinery and shipping, etc.
If the terms of trade are favourable which may be due to monopolistic
supply or inelastic demand or cheap and better kind of exports, etc., the
terms of trade will be favourable and the national income will rise. In case
of terms of trade are unfavourable over a period of time, the national income
will fall.
It was the famous economist G. S. Dorrance who has improved
upon the concept of the net barter terms of trade by formulating the concept
of the income terms of trade. The index takes into account the volume of
exports of a country and its export and import prices (the net barter terms
of trade). It shows a country’s changing import capacity in relation to changes
in its exports. Thus, the income terms of trade are the net barter terms of
trade of a country multiplied by its export volume index. It can be expressed
as:
Index of Export Prices x Export Quantity
Ty = Tc. .Q x =
Index of Import Prices
where Ty is the income terms of trade, Tc the commodity terms of
trade and Qx the export volume index.
It is required to mention here that Albert H. Imlah calculates this
index by dividing the index of the exports by an index of the prices of imports.
He calls it the “Export Gain from Trade Index”
As for example, taking 2001 as base year, if Px = 140, Pm = 70 and
Qx = 80 in 2001, then:
140 x 80
PY = = 160
70
It implies that there is improvement in the income terms of trade by
60 percent in 2011 compared with 2001. A rise in the index of income terms
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Unit 6 Terms of Trade

of trade implies that a country can import more goods in exchange for its
exports. A country’s income terms of trade may improve but commodity
terms of trade may deteriorate. Taking the import prices to be constant, if
export prices fall, there will be an increase in the sales and value of exports.

CHECK YOUR PROGRESS

Q 1: State whether the following statements are

True or False.
(a) There is a difference between gross and net barter terms of
trade. (True/False)
(b) Specialisation in production through international trade
results in increase in consumption of a country. (True/False)
Q 2: What is the income terms of trade? (Answer in about 30 words)
...................................................................................................
...................................................................................................

6.7 FACTORS AFFECTING TERMS OF TRADE

Form the above discussion, we have learnt about net, gross and
income terms of trade. In this section of the chapter, we will discuss about
factors affecting terms of trade of a country. The terms of trade of a country
are influenced by a number of factors which are discussed below.
 Reciprocal Demand: The terms of trade of a country depends upon
reciprocal demand, i.e. “the strength and elasticity of each country’s
demand for the other country’s product”. Suppose there are two
countries, Germany and England, which produce linen and cloth
respectively. If Germany’s demand for England’s cloth becomes
more intense (inelastic), the price of cloth rises more than the price
of linen and the commodity terms of trade will moves against
Germany and in favour of England. On the other hand, if England’s
demand for Germany’s linen becomes more intense, the price of
linen will rise more than the price of cloth, and the commodity terms
of trade will move in favour of Germany and against England.

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 Changes in Technology: Technological changes also affect terms

of trade of a country. The terms of trade may improved or deteriorate
with technological change.
 Changes in Factor Endowments: Changes in factor endowments
of a country affect its terms of trade. Changes in factor endowments
may increase exports or reduce them. With the taste remaining
unchanged, this may lead to changes in the terms of trade.
 Changes in Tastes: Changes in tastes of the people of a country
also influences its terms of trade with another country. Suppose
England’s tastes shifts from Germany’s linen to its own cloth. In
this situation, England would export less cloth to Germany and its
demand for Germany’s linen would also fall. Thus England’s terms
of trade would improve. On the contrary, a change in England’s
taste for Germany’s linen would increase its demand and hence
the terms of trade would deteriorate for England.
 Economic Growth: Economic growth is another important factor
which affects the terms of trade. The rising of a country’s national
product or income over time is called economic growth. Given the
taste and technology in a country, an increase in productive capacity
may affect favourably or adversely its terms of trade.
 Tariffs: Tariff is a duty tax or duty imposed on goods when they
enter and leave the national boundary. Tariff has an impact on the
terms of trade of the country. An import tariff generally improves the
terms of trade of the importing country.
 Devaluation: Devaluation raises the domestic price of imports and
reduces the foreign price of exports of a country devaluing its
currency in relation to the currency of another country. The effects
of devaluation on the terms of trade have been much debated among
economists. According to Prof. Fritz Machlup, “Devaluation is
supposed to improve the balance of trade. A reduction in the physical
volume of imports in relation to physical volume of exports
constitutes an adverse change in the gross barter terms of trade.”

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Unit 6 Terms of Trade

Thus, devaluation will be successful only if the gross barter terms

of trade become adverse.

CHECK YOUR PROGRESS

Q 3: State whether the following statements are

True or False.
(a) Tariff has an impact on terms of trade of a country.
(True/False)
(b) Professor Taussig devised the concept of gross barter terms
of trade. (True/False)
Q 4: How does devaluation help in improving balance of trade?
(Answer in about 30 words)
...................................................................................................
...................................................................................................

6.8 INTERNATIONAL TRADE AND DOMESTIC PRICES

To what extent are domestic prices influenced by trade? The

literature examining episodes of trade liberalization in developing countries
focuses on the pass-through of tariffs onto consumer prices. The tariff pass-
through elasticity indicates the extent to which prices are reduced for a 1
per cent reduction in tariff rates. There are various channels through which
tariffs affect prices. Earlier literature focused on the imperfect competition
among exporters, and showed that foreign exporters with market power
may not allow tariff reductions to be fully reflected in prices, as they find it
optimal to absorb a portion of the price effect.
On the other hand, the recent literature shows that domestic factors
also affect the transmission of prices from a country’s border to consumers.
This implies that pass-through rates may be different across regions within
the same country. In developing countries, certain markets are quite isolated
and do not have full access to the rest of the economy. The price
transmission in such rural markets is found to be lower than in the well-
connected urban markets. In India, a 100 per cent reduction in tariffs implied

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a close to 68 per cent reduction in domestic prices in urban areas, but only
about a 49 per cent reduction in rural areas. The local infrastructure,
especially transportation facilities such as paved roads and railways, may
further affect the rate at which trade policy influences local prices, and the
distance to the border or the distance to major ports could also be of
importance. For example, Mexican provinces that are closer to the US border
are found to have much higher tariff pass-through rates. The price
transmission in the manufacturing industry is as high as 70 per cent at the
US border, but declines to about 40 per cent when moving 1,000km away,
and to about 20 per cent at 2,000km.
Even when markets are not isolated and there are no regional
differences, there are still various factors that may lead to low pass-through
rates, or different pass-through rates across products. The organization of
the domestic market is expected to play an important role. In China, cities
with a higher share of state-owned enterprises have especially low pass-
through rates, potentially due to inflexible price-setting policies at these
enterprises. A city with an average sized private sector, by Chinese
standards, has about a 31 per cent pass-through rate; this rate increases
by about two percentage points with each 10 percentage point increase in
the size of the private sector. The lack of competition among retailers may
also affect price transmission. Recent evidence in the exchange rate pass-
through literature shows that the retail sector plays an important role in the
extent to which exchange rates pass through onto consumer prices. The
market penetration of imports is also important in determining the average
effect on the price of a commodity. If imported varieties constitute only a
small share of the market, then the average effect would be smaller, and
the expectation would be to observe less of an impact on a household’s
budget.
Metzler’s paradox: Metzler’s paradox indicates the possibility that
an import tariff will reduce the price of the imported good. However, this is
based on a theoretical idea. That is, that the possibility exists does not
indicate that it is so in reality. Thus, economist LloyedMetzler simply argued
that it could occur.
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Unit 6 Terms of Trade

One of the fundamental assumptions for this paradox to be possible

is that the country that imposes the tariff on the imported product must be
a large country with power to affect world demand for said good. In addition,
it must also be fulfilled that the internal demand for said good is inelastic. In
other words, a supply curve that does not change.
Explanation of the Metzler paradox:Metzler argued that a large
country with the power to influence the demand for a certain product, when
it imposes a tariff, could cause a reduction in demand that would lead to a
drop in prices.
According to Metzler, if the country imposes a tariff on the import of
a product, obviously the total demand will be affected. In theory, by the law
of supply and demand, a reduction in demand shifts the curve to the left.
According to Metzler, the diversion of productive resources from
export industry to import replacement industry, as supposed in Stopler-
Samuelson theorem (refer to Unit 3), can take place only if the domestic
price of export item falls relative to the import-substitute. However, the
imposition of tariff and consequent improvement in terms of trade signifies
a rise in the ratio of export price to import price (PX/PM). In such a situation,
the price of the abundant factor is likely to rise relative to that of the scarce
factor.
It may lead to the conclusion that the tariff, through improvement in
terms of trade will make the income distribution better in the tariff-imposing
country. This refutation of Stopler-Samuelson theorem attempted by L.A.
Metzler, was called as Metzler’s Paradox. This paradox can be illustrated
through Figure 6.2.

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Terms of Trade Unit 6

Figure 6.2: Metzler’s paradox

In Figure 6.2, cloth is the exportable commodity and steel is the

importable commodity. OB is the offer curve of the foreign country B. It
becomes less elastic and negatively sloped from point P1. In the free trade
situation, the exchange takes place at P where OA, the offer curve of the
home country A and OB intersect each other. The quantity imported of steel
is PQ and that of exportable commodity is OQ.
The terms of trade are measured by (QM/QX) = (PQ/OQ) = Slope
of Line OP. The slope of line OP expresses the ratio of price of exportable
commodity cloth (PX) to the price of importable commodity steel (PM).
When tariff is imposed by country A and its offer curve shifts to the left, the
exchange takes place at P1 where the terms of trade are more favourable
for the home country. It is measured by PQ/OQ1 slope of line OP1.
The quantity imported has risen after tariff. Since the slope of OP1
is greater than of OP, the ratio of prices of two commodities (PX/PM) is
higher after tariff. It implies a rise in wage rate relative to return on capital.
Thus tariff benefits the abundant factor labour and hurts the scarce factor
capital.

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Unit 6 Terms of Trade

Metzler recognized that expected result from the imposition of tariff

was an increase in the price of importable commodity in the home market
but the relative price of imports would fall in the home market, when the
following condition would apply:
ž = (1 – k)
Where η = demand elasticity of country B (foreign country) for the
exports of country A (tariff imposing country), (1-k) = The marginal propensity
to consume of its exports in country A.
If the demand elasticity of foreign country B for the export of country
A is larger than the marginal propensity to consume of the exportable [η <
(1-k)], the price of import of country A will rise. If this condition does not
apply and [η > (1- k)], the domestic price of imports will instead fall due to
tariff. Metzler’s conclusion will hold and Stopler-Samuelson theorem will
become invalid.
Larger is the marginal propensity to consume of a country of its
exportable, larger will be the amount of its tariff revenues spent on the
consumption of exportable good. Thus there will be excess demand for
exportable good. Consequently, the price of that good will rise. At the same
time, if the foreign country’s demand elasticity for exportable good of tariff-
imposing country is low, the demand for this good in that country will fall
very slightly despite a rise in its relative price.
So under these circumstances, the excess demand for exportable
good due to tariff in the home market will imply a relative fall in the price of
imports. If it happens, the return to the factor intensive in the exportable that
is abundant factor will rise and the return to scarce factor intensive in the
import good will fall. Thus the income distribution, subsequent upon the
imposition of tariff, will become favourable to the abundant factor and
unfavourable to the scarce factor.
Criticisms of the Metzler paradox
 Among the main criticisms of Metzler’s paradox is that of the size
of the country. For this to happen, a country must have enough
power so that the reduction in its consumption affects the world
total.
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Terms of Trade Unit 6

In this sense, based on Metzler’s criterion, a small country

could cause an increase in the prices of a certain product if it
imposes a tariff. This is why it is so important to indicate that first
this would only be applicable to very large and powerful countries
and, second, otherwise the effect would be the reverse.
 Furthermore, some economists have criticized this paradox
because it is based on a very basic assumption. It does not take
into account the factors that influence changes in supply and
demand. It assumes that everything else remains constant (ceteris
paribus). However, in the global economy it is practically impossible
that when one variable is affected it does not directly affect other
variables. Additionally, it is difficult to find industries whose supply
curve (paradox assumption) is perfectly inelastic or very inelastic.

6.9 RELATION OF FOREIGN TRADE TO NATIONAL

INCOME
Foreign trade plays an important role in the economies of backward
as well as advanced countries of the world. This can be seen from the fact
that in some of the countries like Canada, United Kingdom, Australia, etc.,
more than 20 per cent of the national income is derived from international
trade. In America the value of total imports and exports is about 15 per cent
of the national income.
The impact of international trade can be judged from the balance of
payments of a country. When the exports of a country exceed its imports,
there is a flow of money income in the country and the level of national
income and employment goes up. On the other hand, when imports exceed
exports, there is a withdrawal of national income. How much the volume
and value of exports of a country will be depends upon the extent of the
market for the goods of the country. The national, income has influence on
the export of a country. The imports are however, affected by the size of
national income. The larger the size of national income, the greater are the
imports and vice versa. The marginal propensity of imports of a nation is
small in a closed economy and greater in an open economy.
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Equation/Formula of National Income:The national income

equation thus is:
Y=C+I+G+X-M
Here:Y stands for national income; C stands for consumption
expenditure; I stands for gross private investment; G stands for government
consumption expenditure; X stands for volume and value of exports of goods
and services; M stands for volume and value of imports of goods and
services.
International Trade Multiplier:The Keynesian concept of multiplier
is also used for explaining the effect of balance of payments supplies and
deficit on national income and employment of a country.
When the country is having an export surplus in its balance of
payment, the excess money received by the exporters is spent on consumer
goods within the country. The income thus passes on from exporters to the
producers of consumers goods. How much the national income will rise
depends upon the value of the multiplier. If the export surplus in the balance
of payment of a country is Rs200 crore and the multiplier is 10, the national
income will rise by Rs2000 crore. If the multiplier is 4, the increase in national
income will be Rs800 crore.

6.10 LET US SUM UP

 Terms of trade refers to the rate at which goods of one country is

exchanged for the goods of another country.
 The net barter or commodity terms of trade is the ratio between the
price of a country’s export goods and import goods.
 The gross barter terms of trade is the ratio of total physical quantity
of imports and exports. It was professor Taussig who first devised
the concept of Gross Barter terms of trade.
 Income terms of trade is measured by multiplying volume of exports
with the net barter terms of trade.

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 The terms of trade of a country are influenced by various factors

such as reciprocal demand, changes in factor endowments etc.
 Economist all over the world has put so much emphasis on
international trade that it can be considered as an engine of growth.

6.11 FURTHER READING

1) Mannur, H. G. (1995). International Economics - Theory and

Practice. Noida: Vikash Publishing House Pvt. Ltd
2) Paul, R.R. (2006). Money, Banking and International Trade.
Jalandhar: Kalyani Publisher
3) Rana, K. C. &Verma, K. N. (1998). Macroeconomic Analysis.
Jalandhar: Vishal Publications.

6.12 ANSWERS TO CHECK YOUR

PROGRESS

Ans to Q No 1: (a) True (b) True

Ans to Q No 2: The income terms of trade is the net barter terms of trade
of a country multiplied by its export volume index. It can be expressed
as:
Index of Export Prices x Export Quantity
Ty = Tc. .Q x =
Index of Import Prices
where Ty is the income terms of trade, Tc the commodity terms of
trade and Qx the export volume index.
Ans to Q No 3: (a) True (b) True
Ans to Q No 4: Devaluation is supposed to improve the balance of trade. A
reduction in the physical volume of imports in relation to physical
volume of exports constitutes an adverse change in the gross barter
terms of trade. Thus devaluation will be successful only if the gross
barter terms of trade become adverse.

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6.14 MODEL QUESTIONS

Short Questions (Answer each question in about 150 words)

Q 1: What is meant by terms of trade? Distinguish between net and gross
barter terms of trade.
Q 2: Evaluate the relationship between foreign trade and national income.
Q 3: Briefly discuss the concept of Metzler’s paradox.

Long Questions (Answer each question in about 300-500 words)

Q 1: Explain the factors which influence the terms of trade of country?
Q 2: Explain the concept of income terms of trade.

*** ***** ***

118 International Economics (Block 1)

UNIT 7: TRADE, GROWTH AND IMMISERISATION
UNIT STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Effects of Growth on Trade
7.3.1 Production Effects of Growth
7.3.2 Consumption Effects of Growth
7.3.3 Combined Production and Consumption Effects of
Growth
7.3.4 Effects of Growth on Production, Trade, Welfare and
Terms of Trade of a Small Country
7.4 Immiserising Growth
7.4.1 Explanation
7.4.2 Necessary Conditions for Immiserising Growth
7.5 Prebisch-Singer Thesis
7.5.1 Explanation
7.5.2 Criticisms
7.6 Let Us Sum Up
7.7 Further Reading
7.8 Model Questions

7.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 describe the relationship between economic growth and
international trade
 analyse the production effect of growth on trade
 examine the consumption effect of growth on trade
 discuss the effects of growth on various economic aspects of a
small country
 derive the meaning of immiserising growth and examine the
immiserising growth in case of a developing and developed
countries
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 know the necessary conditions for immiserising growth

 critically examine the Prebisch-Singer hypothesis
 examine the how terms of trade get deteriorated in
underdeveloped countries.

7.2 INTRODUCTION

The pure theory of international trade is concerned with given conditions of

supply relating to factor endowments and technology. But these factors do
not remain constant over the long-run. When they change, they bring about
the growth of an economy. Economic growth may take the form of either
factor accumulation or technical progress or both. This unit analyses the
effects of factor accumulation or growth on production, consumption and
terms of trade. Further, the concept and a few issues relating to immiserising
growth has been discussed. Finally, the Prebisch-Singer hypothesis has
also been discussed.

7.3 EFFECTS OF GROWTH ON TRADE

Economic growth has production and consumption effects on

international trade.

7.3.1 Production Effects of Growth

As the process of economic growth facilitates the increased

supplies of factor inputs, there can be some change in the domestic
output of exportable commodities. The increased production of
exportable goods brings about an expansion in the volume of trade.
The large production of importable goods, on the other hand, causes
a contraction in the volume of trade.Although the effect of factor
growth upon production was analysed by Rybczynski in a quite
simple manner, a more elaborate analysis on this issue was made
by H.G. Johnson. He identified growth as neutral, export-biased, ultra-
export biased, import-biased and ultra-import biased.
Growth is said to be neutral, when the output of both
exportable and importable goods increases in the same proportion,

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consequent upon accumulation of factors and growth. Growth is

said to be export-biased or pro-trade, if the increase in the output of
exportable goods is more than proportionate to an increase in the
output of importable goods.The growth is supposed to be ultra-
export-biased or ultra-trade-biased, if the increased production of
exportable goods involves some reduction in the output of importable
goods. In case, the growth reduces the production of exportable
goods, it is said to be ultra-import- biased or ultra-anti-trade biased.
When growth results in a more than proportionate increase in the
output of importable goods than the exportable goods, it can be
regarded as import-biased or anti- trade-biased.
Assumptions:The varying implications of growth for the international
trade can be analysed on the basis of the following assumptions:
 The trade exists between two countries— A and B.
 The country A is the home country that experiences steady
growth.
 There are two productive factors—labour and capital.
 The quantities of the two factors of production increase over
the growth process.
 The trade is concerned with two commodities—X and Y.
 The X-commodity is the exportable and Y is the importable
commodity of the home country.
 The commodity X is labour-intensive, while Y is capital-intensive.
 There is no change in the techniques of production.
 There is incomplete specialisation.
 The international terms of trade, measured by the ratio of price
of exportable commodity to the price of importable commodity
remain constant.
Explanation: Given the above assumptions the production effects
of growth are expressed through Figure 7.1.

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Figure 7.1: Production Effects of Growth

In Figure 7.1, the labour-intensive commodity X, which is

the exportable commodity, is measured along the horizontal scale.
The capital-intensive commodity Y, which is the importable
commodity, is measured along the vertical scale. Originally PP1 is
the production possibility curve, given the factor supplies and
technology. TT1 is the term of trade line. The production takes place
at R where TT1 is tangent to the production possibility curve.As
growth occurs, the factor supplies increase and the production
possibility curve shifts to the right. The terms of trade line is
T2T3 which runs parallel to the original terms of trade line TT1. It
signifies that international price ratio of X and Y remains unchanged
despite growth. If production equilibrium occurs at S, the growth is
neutral because there is equi-proportionate increase in output of
two commodities and the two factors grow in the same proportion.If
the production takes place in the range S and N, the growth is export
biased. In this range, the proportionate change in the output of
exportable commodity X is greater than the proportionate change in
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the output of importable commodity Y. It also signifies that the use

of labour is proportionately more than that of capital.
If the production equilibrium is determined in the range N to
T 3, the growth is ultra-export biased because the increased
production of exportable commodity X involves a reduced production
of the importable commodity Y. In case the production equilibrium is
determined in the range S to M, the growth is import-biased.In this
range, the output of importable commodity increases more than
proportionately compared with the increase in output of exportable
commodity. In this type of growth, the use of capital is proportionately
greater than the use of labour. If the production equilibrium gets
determined in the range M to T2, the growth is said to be ultra-import
biased or ultra-anti-trade biased.
In this situation, the increased production of the importable
commodity Y involves a decline in the production of exportable
commodity X. The process of production in this range involves an
increased use of capital with possibly no increase in labour. The
ultra-export biased and ultra-import biased patterns of growth are
the extreme cases in terms of their effects on the self-sufficiency or
trade-dependence of a growing country and may exist in very few
cases.

7.3.2 Consumption Effects of Growth

The process of growth in a given country denoted by the

factor growth can bring about changes in its consumption pattern. If
there is an increased consumption of the importable commodity,
the volume of trade is likely to get enlarged. On the opposite, if the
consumption of exportable commodity registers an increase, there
is likely to be decline in the volume of trade. As in the case of
production, Johnson has classified the consumption effects of factor
growth as neutral, export-biased, ultra-export-biased, import-biased
and ultra-import-biased.The process of growth in a country,
expressed through increased factor supplies, can bring about an

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increase in real income. This can result in changes in the

consumption of exportable and importable commodities in varying
quantities. The relative changes in the quantities consumed of these
commodities determine the nature of growth process having varying
implications for international trade.
The growth process is said to be neutral, if the increase in
the demand for exportable commodity (X) takes place in the same
proportion in which the demand for importable commodity (Y)
increases. Growth is import-biased or anti-trade-biased, if the
increase in demand for importable good is less than proportionate
compared with the increase in demand for exportable good.The
process of growth can be regarded as ultra-import biased or ultra-
anti-trade-biased, if the demand for importable commodity
decreases in absolute terms. There is export-biased or pro-trade-
biased growth, when the demand for importable commodity
increases more than proportionately compared with the increased
demand for the exportable commodity. When the demand for
exportable commodity decreases in absolute terms, the growth
process is said to be ultra-export biased or ultra-pro-trade biased.
H.G. Johnson pointed out that the output elasticity of demand
for importable can measure the nature of growth in relation to trade.
The growth process is import-biased, neutral or export- biased, if
the output-elasticity of demand for importable commodity is less
than, equal to or greater than unity respectively. If the output-elasticity
of demand for importable commodity is negative, the growth process
is ultra-import-biased. On the opposite, if the output elasticity of
demand for exportable commodity is negative, the process of growth
is ultra-export-biased.
The consumption effect of growth, given the constancy of
tastes, terms of trade and distribution of income can be shown with
the help of Figure 7.2. The original position of production and
consumption equilibrium is determined at R. At this point, the terms
of trade line TT1 is tangent to the production possibility curve PP1,
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on the one hand, and tangent to the community indifference curve I,

on the other. If growth takes place, the production equilibrium shifts
to S. It is assumed that terms of trade remain unchanged so that
the terms of trade line T2T3 is parallel to TT1.

Figure 7.2: Consumption Effects of Growth

The consumption equilibrium may get determined at any

position on T 2T 3 where it becomes tangent to some higher
commodity indifference curve. If the consumption takes place at S,
and there are proportionate increases in the consumption of two
commodities, growth is neutral. If consumption takes place in the
range S to M, the growth is export-biased as the demand for
importable commodity Y increases at a proportionately greater rate
than the demand for exportable commodity.
If consumption takes place in the range M to T 2, the
consumption effect of growth is ultra-export-biased. In case, if
consumption occurs in the range S to N, there is an import-biased
consumption effect. When the consumption takes place in the range
N to T3, the consumption effect of growth is ultra-import- biased.

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The output or income elasticity of demand for imports can

determine the implication of growth on trade, if the growth results
from some factor other than population growth. In this connection,
H.G. Johnson writes:
[If growth is due to some other cause than population change,
income per hand will rise, and the type of growth will depend on the
average income elasticity of demand for imports. If imports are luxury
goods, growth will be pro-trade-biased; if they are necessary goods,
growth will be anti-trade-biased; if imports are inferior goods, growth
will be ultra-anti-trade- biased and if exports are inferior goods,
growth will be ultra-pro-trade-biased.]

So far in this analysis, it was supposed that the tastes pattern

and distribution of income remain the same. With the expansion in
income, subsequent to growth, there can be change in tastes pattern
and income distribution. These factors can bring about significant
change in the relative demand for the two commodities.

7.3.3 Combined Production and Consumption Effects of

Growth

In a growing country, the total effect of growth represents

the combined result of its effects on production and consumption.If
there is complete specialisation in production, the country does not
at all produce the importable commodity and the total effect of growth
is determined entirely by the shift in consumption equilibrium due to
the expansion of income. In such a situation, the overall effects of
growth can again be neutral, export-biased, ultra-export biased,
import-biased and ultra-import-biased depending upon the relative
changes in the demand for imports and supply of exports.
If there is incomplete specialisation, and the given country
produces both the commodities, the demand for her imports is
measured by the excess of total demand for and the domestic supply
of the concerned commodity. The total growth effect on the demand

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for imports is, therefore, the net effect of the production and
consumption effects of the importable commodity.This total effect
determines the extent or direction of shift in the offer curve of the
growing country. As shift takes place in the offer curve of the given
country, it becomes possible to ascertain its impact on the volume
and terms of international trade.If both consumption and production
effects are neutral, the overall growth effect in the growing country,
say A, is also neutral. But the domestic supply of importable
commodity being a smaller proportion of the total production than
the proportion of consumption of imports to the total consumption,
the price of importable commodity is likely to be relatively higher
than before. As a result, the terms of trade are likely to become
worse, despite neutral overall growth.
The overall effect of growth will be export- biased, if any one
of the following possibilities exists:
 The production effect is export-biased and consumption effect
is neutral,
 The production effect is neutral and consumption effect is export-
biased,
 Both consumption and production effects are export-biased.
The overall or total effect of growth will be import-biased, if:
 The production effect is import-biased and consumption effect
is neutral,
 The production effect is neutral and consumption effect is import-
biased, and
 Both production and consumption effects are import- biased.
The overall effect of growth is ultra- export-biased when the
production effect is ultra- export-biased. In such a situation, the
absolute demand for imports increases by more than the entire
increase in national income and the supply of exports rises more
than its rise in case of export- biased growth. In this situation, the
volume of trade gets enlarged but the deterioration in the terms of

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trade of the home country is more than that occurs in case of the
export-biased growth.
The overall effect of growth is ultra-import-biased, if there is
an absolute increase in the domestic output of importable and there
is an ultra-import bias in production. In this situation, there is an
absolute decline in the demand for imports and the supply of exports.
If the exportable commodity is not inferior, there will be an
improvement in the terms of trade of the home country in this case.
The overall or total growth effect has been explained with the help of
Figure 7.3. In the figure, OA is the offer curve of home country A and
OB is the offer curve of foreign country B. Originally the equilibrium
takes place at R. OQ quantity of X is exported and RQ quantity of Y
is imported. The terms of trade are determined by the slope of the
line OR. As growth takes place in country A, its offer curve will undergo
shifts while the offer curve of country B, not experiencing growth,
will remain unchanged.
Figure 7.3: Overall or Total Effect of Growth

If the overall or total effect of growth is neutral, the offer curve

of country A shifts to the right to OA1 and the equilibrium takes place
at R1. It shows an increase in the volume of trade but there is
worsening of terms of trade for country A. It means the neutral growth
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bias results in the transfer of gain from country A increasingly to the

foreign country. If the offer curve of country A shifts to the right to
OA2, the equilibrium takes place at R2.The increase in export is
proportionately more than that of imports. The volume of trade
increases and the terms of trade for country A get worsened. If the
growth is ultra-export-biased, the absolute demand for imports
increases by more than the increase in national income and the
exports increase by more than the rise in imports. As the offer curve
shifts to the right of OA2, say OA3, there is an increase in the absolute
volume of trade and the terms of trade get further worsened for the
home country A.
If the growth is import-biased, the offer curve of A shifts to
the left of OA1 say OA4, but to the right of original offer curve OA. In
this case the demand for imports and supply of exports increase
less than proportionately to the total output. The volume of trade
increases, although there is anti-trade bias in respect of production
or consumption or both.The terms of trade may still get worsened
for country A. If the growth is ultra-import-biased, the offer curve of
country A may shift to the left of OA, say OA5. There is absolute
reduction in the demand for imports and supply of exports resulting
in the absolute reduction in the volume of trade but the terms of
trade go in favour of the home country.

7.3.5 Effects Of Growth On Production, Trade, Welfare

And Terms Of Trade Of A Small Country

To analyse the effects of growth on trade and welfare of a

small country, we assume that (i) only one factor labour grows; (ii)
there are two commodities X and Y; (iii) growth of labour increases
the production of labour-intensive commodity X and decreases the
production of capital-intensive commodity Y; and (iv) the international
terms of trade remain constant for this country.
In the pre growth situation in Figure 7.4, the production
possibility curve is BA and P is the production point where the terms

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of trade line TT is tangent to it. C is the consumption point on the CI

curve. CRP is the trade triangle whereby the country exports RP of
X and imports RC of Y commodity.
Figure 7.4: Pre-Growth Situation

After the growth of labour, the production possibility curve

shifts outward to B1A1. Note that the shift along the horizontal axis
AA1 is greater than BB1 on the vertical axis representing capital even
if there has been no increase in the growth of capital. This is because
labour is also used in the production of Y commodity. The new
production point is P1 and the consumption point is C1 where the
constant T1T1 line is tangential. Point P1 shows higher output of both
X and Y commodities. The volume of trade also increases after
labour growth at point P1 because the new trade triangle C1R1P1 is
bigger than the pre-growth triangle CRP. Country’s exports increase
from RP to R1P1 and imports from RC to R1C1. The welfare of the
country also increases because the new consumption point C1 is
on the higher curve CI1 than the original point C on the Cl curve.
However, when there is labour growth in the country without capital
growth the per capita availability of capital decreases. As a result,
less capital is available per labour which reduces the per capita
productivity of capital. Therefore, the availability of commodities per

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person in the country is reduced which is likely to reduce the welfare

of the commodity despite increase in the volume of output and trade.
As the growing country is small, it trades at constant
international terms of trade even after growth because it is not in a
position to influence international terms of trade. The straight line
OT in Figure 7.5 shows constant terms of trade where the pre-
growth trade point is P and the post-growth point is P1 in country A.
Even at constant terms of trade, the country exports and imports
more quantities of X and Y commodities after growth, as point P, is
above P on the OT line.
Figure 7.5: Constant Terms of Trade in a Small Country:
Pre- and Post-Growth Stages

7.4 IMMISERISING GROWTH

The theory of immiserising growth relates to deterioration in the terms

of trade of the country experiencing growth. Francis Ysidro Edgeworth was
the first economist to suggest the possibility that economic growth may
lead to the worsening of the terms of trade of the growing country to such a
large extent that the gain in output resulting from growth may be wiped out
by the adverse terms of trade. JagdishBhagwati calls this phenomenon
“immiserising growth”. In his words, “Economic expansion increases output
which, however, might lead to a sufficient deterioration in the terms of trade
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to offset the beneficial effect of expansion and reduce the real income of
the growing country.”
Assumptions: The theory of immiserising growth assumes that :
 There are two countries A and B.
 Country A is the domestic country which experiences economic
growth.
 There are two commodities X and Y.
 Commodity X is an exportable and commodity Y is an importable.
 There is full employment of resources.
 There is mobility of resources between different countries.
 There is neutral technical progress.
 Growth takes place in the abundant factor labour.

7.4.1 Explanation

Given these assumptions, the case of immiserising growth

is illustrated in Figure 7.6. BA is the production possibility curve in
the pre growth situation. The country is producing at production point
P where the terms of trade line TT is tangent to the BA curve, and
consuming at point C, where the terms of trade line is tangent to the
commodity indifference curve CL.
Figure 7.6: Immiserising Growth

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The country imports CR of commodity Y and exports RP of

commodity X. Suppose economic growth occurs which pushes its
production possibility curve outwards to B1A1. But the terms of trade
deteriorate to offset the gain from growth so that the relevant price
(or terms of trade) line is T1T1 which is tangent to the production
possibility curve B1A1 at point P1 and to the community indifference
curve CI1 at point C1. As a result of growth, the country is worse off
than in the pre-growth situation by dropping to a lower community
indifference curve CI1 from CI. Consequently, the consumption of
importable is reduced from CR to C1R1 and the production of
exportable is increased from RP to R1P1.

7.4.2 Necessary Conditions for Immiserising Growth

According to Bhagwati, the following are the necessary

conditions for immiserising growth to occur:
 The country’s growth is biased in favour of its export sector.
 The growing country is large in the world market so that increase
in the supply of its exportable affects the world trade.
 The foreign demand for the country’s exportable is inelastic.
 The demand for importable increases with growth.
 There is free trade in the world market without any tariffs or
price distortions.
Thus the theory of immiserising growth is applicable to those
developing countries which are heavily dependent on world trade,
are large, and produce a large portion of the world market of a primary
commodity whose demand is inelastic. Brazil is a case in point
where a bumper coffee crop bids down the world price of coffee so
that Brazil’s terms of trade worsen and the country experiences the
immiserisinggrowth phenomenon. So the theory of immiserisation
growth highlights the fact that the worsening of the terms of trade
outweighs the gains from a large volume of production to such an
extent that welfare is decreased.

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Johnson regards the theory of immiserising growth as a

curiosum because with the expansion in output and exports, the
welfare of the society declines in a growing country. The remedy to
this problem for developing countries is industrialisation by import
substitution. They should produce industrial goods with high prices
and high income elasticity of demand, either for exports or for
domestic market.

7.5 PREBISCH-SINGER THESIS

There is empirical evidence related to the fact that the terms of

trade have been continuously moving against the developing countries. On
the basis of exports statistics concerning the United Kingdom between 1870
and 1940, Raul Prebisch demonstrated that the terms of trade had secular
tendency to move against the primary products and in favour of the
manufactured and capital goods.
This viewpoint has been strongly supported by H. W. Singer. The
essence of Prebisch-Singer thesis is that the peripheral or LDC’s(Less
Developed Countries) had to export large amounts of their primary products
in order to import manufactured goods from the industrially advanced
countries. The deterioration of terms of trade has been a major inhibitory
factor in the growth of the LDC’s.
Prebisch and Singer maintain that there has been technical progress
in the advanced countries, the fruit of which have not percolated to the
LDC’s. In addition, the industrialised countries have maintained a monopoly
control over the production of industrial goods. They could manipulate the
prices of manufactured goods in their favour and against the interest of the
LDC’s.
Except the success of OPEC (Oil & Petroleum Exporting Countries)
in raising the prices of crude oil since mid 1970’s, there has been a relative
decline in the international prices of farm and plantation products, minerals
and forest products. Consequently, the terms of trade have remained
unfavourable to the developing countries.

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Assumptions:
 As income rises in the advanced countries, the pattern of demand
shifts from primary products to the manufactured products due to
Engel’s law.
 There is slow rise in demand for products in the developed countries.
 The export market for product of LDC’s is competitive.
 The export market for products of developed countries is
monopolistic.
 Wages and prices are low in LDC’s.
 The appearance of substitutes for products of LDC’s reduces
demand for them.
 The benefit of increased productivity is not passed by the producers
of manufactured products in advanced countries to the LDC’s
through lower prices.
 The economic growth in the LDC’s is indicated by income terms of
trade.

7.5.1 Explanation

Prebisch assumes that the capacity to import or income

terms of trade is the determining factor of economic growth in LDCs
and the terms of trade is the most important ‘conduit’ for transmission
of productivity gains from cyclical centers (DCs) to the peripheral
countries (LDCs). His contention is that in the organic growth of the
world economy, the primary producing LDCs have failed to share in
the gains of this world economic growth generated by the DCs and
the reason for this has been their declining capacity to import. He
points out on the basis of the United Kingdom’s terms of trade with
the LDCs that between the 1870s and the 1930s there was secular
downward trend in the prices of primary goods relative to the prices
of manufactured goods. They give the following reasons for
deterioration in the TOT (Terms of Trade) of LDCs.
 Technical Progress. Technical progress increases the income
of workers and entrepreneurs and a high price for their goods,

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some of them are exported to the LDCs. But the benefits of

technical progress do not flow to the LDCs. As a result, wages
of workers do not rise. Prices of their primary goods which they
exports in relation to their imports fall, thereby worsening their
TOT. This has been due to technical progress in raw material
saving products like synthetic, jute and rubber, rayon etc. which
have adversely affected the traditional exports of LDCs.
 Relation between Incomes and Productivity. According
toPrebisch, the incomes of entrepreneurs and productive factors
increase relatively more than productivity in DCs, the increase
in incomes is less than that in productivity in LDCs for two
reasons:
 Population Pressure:Population pressure in LDCs due to
increase in population and surplus manpower have led to
the rise in labour supply which is absorbed mainly in those
sectors where labour productivity is already very-low.
Consequently, the level of wages falls further.
 Weak Trade Unions: Trade unions are mostly non-existent
in the large unorganised sector of LDCs and where they
exist, as in the organised sector, they are very weak. They
are, therefore, incapable of raising wages for their workers.
On the other hand, trade unions being very strong in DCs
are highly successful in raising wages of their members.
 Monopoly Elements. Another cause for deterioration in TOT
of LDCs, according to Prebisch, has been monopoly elements
in product markets of DCs. The DCs have a high degree of
monopoly power in manufactured industrial and capital goods
for which they charge high prices from LDCs. On the other
hand, the world prices of primary products of LDCs are low
because they are not properly organised. As a result, the TOTs
have remained unfavourable for the LDCs.

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 Effects of Cyclical Instability and Balance of Payments

Difficulties. Prebisch points out that, after the opening up of
LDCs to world markets, there has been phenomenal rise in
their exports. But this has not contributed much to the
development of the rest of the economy of these countries, as
the export sector has developed to the utter neglect of the other
sectors of the economy. On the other hand, too much
dependence on exports has exposed these economies to
international fluctuations in the demand for and prices of their
products. During a depression, the TOT become adverse and
foreign exchange earnings fall steeply. As a result, they suffer
from unfavourable balance of payments. But they are unable to
take advantage of a fall in prices of their products by increasing
their exports due to the inelastic nature of supply of their export
goods which are mainly agricultural and mineral products.
Similarly, they are unable to benefit from a boom in world market.
An improvement in their terms of trade due to a boom is not
accompanied by an increase in output and employment due to
market imperfections, inadequate overhead capital and
structural maladjustments. On the contrary, increased export
earnings lead to inflationary pressure, misallocation of
investment expenditure and to balance of payments difficulties.
As a result, there has been a secular deterioration in the income
terms of trade (or the capacity to import) of LDCs.
 Effects of Foreign Investments. Singer’s contention is that
the opening of the LDC’s to foreign trade and investment tended
to inhibit their development since the purpose and effect of these
investments have been to open up new sources of food for
people and for the machines of developed countries. The
specialisation of LDCs in exports of food and raw materials to
industrialised countries, largely as a result of investment by the
latter has been unfortunate for the LDCs for three reasons (i)
The investing countries have reaped the larger share of the
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cumulative multiplier effects of foreign investment as a result of

heavy profit remittances abroad. (ii) It has “diverted the
underdeveloped countries into types of activity offering less
scope for technical progress, internal and external economies
taken by themselves...” (iii) It has led to the deterioration in the
terms of the trade of LDCs.
Of the three factors, the last one has been crucial in
impoverishing the LDCs because the developed countries have
gained in the form of higher wages and profits by exporting
manufactured articles to the LDCs at higher prices whereas the
gains in food and raw material production in LDCs have been
dissipated in price reductions thereby against benefitting the
developed countries. This is reflected in rapidly rising standards of
living of the latter as against the former. The operation of Engel’s
Law has been a major factor in accentuating price differentials
between the ‘peripheral’ and the ‘centre’. As incomes rise, the
demand for food rises more slowly than the demand for
manufactured articles. As a result of technical progress in
manufacturing, there is reduction in the amount of raw materials
used per unit of output. Thus, the demand for raw materials falls.
This fall in demand along with low price elasticity of demand for
both raw materials and food results in large price falls, both cyclically
and structurally. ‘At the same time, the short-run supply is said to
be equally inelastic and equally subject to erratic shifts occasioned
by forces of nature; a drought or disease can decimate a crop or
the weather may produce a bumper harvest. Consequently, prices
are said to be very volatile. In general price fluctuations in the post-
war period have, however, been more often caused by changes in
demand than by changes in supply.’
This is illustrated in Fig. 7 where D and S represent world
demand and supply curves of primary products which are inelastic.

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Figure 7.7: Effects of Foreign Investment in LDCs

In Figure 7.7, the demand and supply curves intersect at

point E where OQ quantity is demanded and supplied at OP price.
A small increase in supply from S to S1 sets the new equilibrium at
point E2. This shows that a small increase in supply by QQ1 leads
to a large fall in price by PP1. Similarly, a small decrease in demand
from D to D1 establishes the new equilibrium at E1 so that a small
fall in demand by QQD brings about a large fall in price by PP1. Thus
the developed countries have enjoyed beneficial cumulative effects
in their dual capacity as consumers of imported food and raw
materials at low prices and as producers of high-priced exportable
manufactured articles, whereas the LDCs suffered both as
producers of low priced food and raw materials and consumers of
high-priced food and raw materials and consumers of high-priced
imported manufactures.
 According to Singer, the fairly widespread impression that this
trend toward deterioration in the terms of trade of primary
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Unit 7 Terms of Trade

producers has been reversed since pre-war days has not been
borne out by facts. The LDCs have failed to benefit from high
prices for their primary products because they use the profits
for expanding their production rather than investing them in
capital goods. Conversely, when prices are low they do not have
the means to industrialize, though the desire is great. Here again
it seems, writes Singer, “that the under-developed countries
are in danger of falling between two stools: failing to industrialize
in a boom because things are as good as they are, and failing
to industrialize in a slump because things are as bad as they
are.”
 Debt Problems of LDCs. Another reason which Singer
advances for deterioration in TOT of LDCs in recent years has
been their mounting debt. First, a large amount of proceeds
from exports are utilised to repay their debts instead of paying
for imports. Second, to repay their debts, LDCs compete with
each other to increase their export earnings.
 Immiserising Growth. According to Bhagwati, immiserising
growth in LDCs leads to deterioration in the TOT of LDCs when
(i) the economy’s growth leads to the production of more
exportable; (ii) the demand for exports is inelastic; and (iii) growth
reduces the domestic production of importable at constant
commodity prices.
 Shortage of Intermediate Products. Linder’ points towards
the shortage of intermediate products in LDCs as the cause for
deterioration in their terms of trade. Due to the shortage of such
products in relation to their expanding demand, they are imported
at relatively higher prices than the prices of exportable. These
price differences, results in deteriorating in TOT.
 Weak Bargaining Power. Most of the primary products
exported by LDCs to DCs are perishable. So they have to accept
the conditions laid down by the DCs because of their weak
bargaining power. The price and quantity conditions for exports
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are always against the LDCs which leads to worsening of their

TOT.
 Lack of Adaptability in Production. The raw materials and
agricultural products of LDCs lack in adaptability to their world
prices. When their world prices start declining the producers of
primary products cannot switch over production to some other
goods whose prices are not decreasing. This leads to
deteriorating in their TOT

7.5.2 Criticisms

 Not Firm Basis for Inference: The inference of secular

deterioration of terms of trade for the LDC’s rests upon the
exports of primary vis-a-vis manufactured products. In this
regards, it should be remembered that the LDC’s export wide
variety of primary products. Sometimes they export also certain
manufactured products. They, at the same time, do not import
only manufactured products but also a number of primary
products. It is, therefore, not proper to draw a firm inference
about terms of trade just on the basis of primary versus
manufactured exports.
 Faulty Statement of Gains and Losses of Primary
Exporters: JagdishBhagwati has pointed out that the index of
terms of trade employed in this thesis understates the gains of
exporters of primary products. At the same time, there is
over-statement of losses of primary producers.
 Faulty Index of TOT: The Prebisch- Singer hypothesis rests
upon the index, which is the inverse of the British commodity
terms of trade. This index overlooks the qualitative changes in
products, appearance of new varieties of products, services
like transport etc. The generalisation based on British terms of
trade for the period 1870 to 1930, according to Kindleberger, is
not true for the other developed countries of Europe.

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 Neglect of Supply Conditions: In the determination of terms

of trade, the Prebisch-Singer thesis considers only demand
conditions. The supply conditions, which are likely to change
significantly over time, have been neglected. The relative prices,
in fact, depend not only upon the demand conditions but also
on the supply conditions.
 Little Effect of Monopoly Power: One of the arguments in
support of this thesis was that the higher degree of monopoly
power existing in industry than in agriculture led to secular
deterioration of terms of trade for the developing countries. In
this connection, it was also agreed that the monopoly element
prohibited the percolation of benefits of technical progress to
the LDC’s. The empirical evidence has not supported such a
line of argument.
 Inapplicability of Engel’s Law: The secular decline in the
demand for primary products in developed countries was
attributed to Engel’s Law. But this is not true because this law
is applicable to food and not to the raw materials, which
constitute sizeable proportion of exports from, the LDC’s.
 Benefits from Foreign Investment: The deterioration of the
terms of trade for the LDC’s is sometimes linked not to non-
transmission of productivity gains to them by advanced
countries through lower prices of manufactured goods, yet the
benefits from foreign investments have percolated to the LDC’s
through the product innovations, product improvement and
product diversification. These benefits can amply offset any
adverse effects of foreign investment upon terms of trade and
the process of growth.
 Difficult to Assess Variation in Demand for Primary
Products: The secular deterioration in terms of trade of the
LDC’s during 1870 to 1930 period was supposed to be on
account of the declining world demand for primary products.
During that period, there were tremendous changes in world
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population, production techniques, living standards and means

of transport. Given those extensive developments, it is extremely
difficult to assess precisely the changes in world demand for
primary products and the impact of those changes upon the
terms of trade.
 Export Instability and Price Variations: The Prebisch-Singer
thesis suggested that export instability in the LDC’s was basically
due to variations in prices of primary products relative to those
of manufactured products. Mc Been, on the contrary, held that
the export instability in those countries could be on account of
quantity variations rather than the price variations.
 Development of Export Sector not at the Expense of
Domestic Sector: In this thesis, Singer contended that foreign
investments in poor countries, no doubt, enlarged the export
sector but it was at the expense of the growth of domestic sector.
This contention is, however, not always true because the foreign
investments have not always crowded out the domestic
investment. If foreign investments have helped exclusively the
growth of export sector, even that should be treated as
acceptable because some growth is better than no growth. It is
far-fetched to relate worsening of terms of trade to the non-
growth of domestic sector.
Despite all the objections raised against the Prebisch-Singer
thesis, the empirical evidence has accumulated in support of it. The
studies made by UNCTAD for 1950-61 and 1960-73 periods showed
that there was a relative decline in the terms of trade of LDC’s vis-
a-vis the developed countries. A study attempted by Thirlwall and
Bergevin for the period 1973-82 indicated that there was an annual
decline of terms of trade of LDC’s for all the primary commodity
exports at the rate of 0.36 percent.On the basis of their study related
to exports of manufactured products for LDC’s to the advanced
countries during 1970-87 period, Singer and Sarkar found that the
terms of trade of LDC’s declined by about 1 percent per annum.
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Even the World Development Report 1955 recognised that the world
prices of primary products declined sharply during I980’s and the
terms of trade of LDC’s deteriorated during 1980-93 period.

7.6 LET US SUM UP

 As the process of economic growth facilitates the increased

supplies of factor inputs, there can be some change in the domestic
output of exportable commodities. The increased production of
exportable goods brings about an expansion in the volume of trade.
The large production of importable goods, on the other hand, causes
a contraction in the volume of trade.
 Growth is said to be neutral, when the output of both exportable and
importable goods increases in the same proportion, consequent
upon accumulation of factors and growth.
 Growth is said to be export-biased or pro-trade, if the increase in
the output of exportable goods is more than proportionate to an
increase in the output of importable goods.
 The growth is supposed to be ultra-export-biased or ultra-trade-
biased, if the increased production of exportable goods involves
some reduction in the output of importable goods.
 In case, the growth reduces the production of exportable goods, it
is said to be ultra-import- biased or ultra-anti-trade biased. When
growth results in a more than proportionate increase in the output
of importable goods than the exportable goods, it can be regarded
as import-biased or anti- trade-biased.
 The process of growth in a given country denoted by the factor growth
can bring about changes in its consumption pattern. If there is an
increased consumption of the importable commodity, the volume
of trade is likely to get enlarged.
 On the opposite, if the consumption of exportable commodity
registers an increase, there is likely to be decline in the volume of
trade.

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 H.G. Johnson pointed out that the output elasticity of demand for
importables can measure the nature of growth in relation to trade.
 The growth process is import-biased, neutral or export- biased, if
the output-elasticity of demand for importable commodity is less
than, equal to or greater than unity respectively.
 If the output-elasticity of demand for importable commodity is
negative, the growth process is ultra-import-biased.
 On the opposite, if the output elasticity of demand for exportable
commodity is negative, the process of growth is ultra-export-biased.
 In a growing country, the total effect of growth represents the
combined result of its effects on production and consumption. If
there is complete specialisation in production, the country does not
at all produce the importable commodity and the total effect of growth
is determined entirely by the shift in consumption equilibrium due to
the expansion of income. In such a situation, the overall effects of
growth can again be neutral, export-biased, ultra-export biased,
import-biased and ultra-import-biased depending upon the relative
changes in the demand for imports and supply of exports.
 The overall effect of growth will be export- biased, if any one of the
following possibilities exists:
 The production effect is export-biased and consumption effect
is neutral,
 The production effect is neutral and consumption effect is export-
biased,
 Both consumption and production effects are export-biased.
 The overall or total effect of growth will be import-biased, if:
 The production effect is import-biased and consumption effect
is neutral,
 The production effect is neutral and consumption effect is import-
biased, and
 Both production and consumption effects are import- biased.
 The overall effect of growth is ultra- export-biased when the
production effect is ultra- export-biased. In such a situation, the
absolute demand for imports increases by more than the entire
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increase in national income and the supply of exports rises more

than its rise in case of export- biased growth. In this situation, the
volume of trade gets enlarged but the deterioration in the terms of
trade of the home country is more than that occurs in case of the
export-biased growth.
 The overall effect of growth is ultra-import-biased, if there is an
absolute increase in the domestic output of importable and there is
an ultra-import bias in production. In this situation, there is an absolute
decline in the demand for imports and the supply of exports. If the
exportable commodity is not inferior, there will be an improvement
in the terms of trade of the home country in this case.
 The theory of immiserising growth relates to deterioration in the terms
of trade of the country experiencing growth. Edgeworth was the
first economist to suggest the possibility that economic growth may
lead to the worsening of the terms of trade of the growing country to
such a large extent that the gain in output resulting from growth
may be wiped out by the adverse terms of trade. JagdishBhagwati
calls this phenomenon “immiserising growth”.
 According to Bhagwati, the following are the necessary conditions
for immiserising growth to occur:
 The country’s growth is biased in favour of its export sector.
 The growing country is large in the world market so that increase
in the supply of its exportable affects the world trade.
 The foreign demand for the country’s exportable is inelastic.
 The demand for importable increases with growth.
 There is free trade in the world market without any tariffs or
price distortions.
 There is empirical evidence related to the fact that the terms of
trade have been continuously moving against the developing
countries. On the basis of exports statistics concerning the United
Kingdom between 1870 and 1940, Raul Prebisch demonstrated that
the terms of trade had secular tendency to move against the primary
products and in favour of the manufactured and capital goods.

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7.7 FURTHER READING

(1) Bhatia, H.L. (2016). International Economics. New Delhi: Vikas

Publishing.
(2) Jhingan, M.L. (2009). International Economics, New Delhi: Varinda
Publications.
(3) Krugman, P. (2018). International Trade: Theory and Policy. Delhi:
Pearson.
(4) Murthy, G. (2008).International Economic Relations, New Delhi: Gyan
Publishing House.
(5) Salvatore, D. (2013). International Economics. New Delhi: John Wiley
& Sons.
(6) Vaish, M.C. and Singh, S. (2018) International Economics, Delhi: Oxford
and IBH Publishing Co. Pvt. Ltd.

7.8 MODEL QUESTIONS

A) Short Questions.(Answer the following questions in about 100-150

words)
Q 1: Discuss the production effects of growth.
Q 2: Discuss the consumption effects of growth.
Q 3: Discuss the concept of immiserisinggrowth.
Q 4: State the necessary conditions of immiserising growth.
Q 5: Discuss the Prebisch-Singer thesis with special reference to effects
of foreign investment in the production of LDCs
B) Essay type questions.(Answer the following questions in about 500
words)
Q 1: Discuss the effects of growth on trade.
Q 2: Discuss the effects of growth on production, trade, welfare and terms
of trade of a small country.
Q 3: Critically discuss the Prebisch-Singer Thesis on terms of trade and
growth.
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