foreign trade– theory, documentation7.11 concept of packing and packaging 179 7.12 requisites of...

Foreign Trade – Theory,Procedures, Practices and

Documentation(Export-Import Procedures and Documentation)

Dr. Khushpat S. JainAssociate Professor,

Ph.D. (Commerce), M.Com. (Banking & Finance),M.B.A. (Human Resource Management),

M.A. (Economics and Political Science), NET, SET.

Dr. Apexa V. JainVisiting Faculty,

Ph.D. (Commerce), M.Com. (Business Management),M.Phil. (Commerce and Management)M.B.A. (Human Resource Management)

Seventh Revised and Enlarged Edition : 2017

ISO 9001:2008 CERTIFIED

© AuthorsNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,mechanical, photocopying, recording and/or otherwise without the prior written permission of the publisher.

First Edition : 2004Second Edition : 2005Third Revised Edition : 2006Fourth Edition : Jan. 2007Fifth Edition : Aug. 2007Sixth Revised Edition : 2010Reprint : 2011, 2012, 2013, 2014, 2015Seventh Revised and Enlarged Edition : 2017

Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd.,“Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004.Phone: 022-23860170/23863863, Fax: 022-23877178E-mail: [email protected]; Website: www.himpub.com

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DTP by : Naina K. Jain

Printed at : Geetanjali Press Pvt. Ltd., Nagpur. On behalf of HPH.

DDedicated to the Unknown Teacher

“Great generals win campaigns but it is the unknown soldier who wins the war.Famous educators plan new systems of pedagogy but it is the unknown teacher who directs

and guides the young. He lives in obscurity and contends with hardship. For him, no

trumpets blare, no chariots wait, no golden decorations are decreed. He keeps watch along

the borders of darkness and makes attack on the trenches of ignorance and folly. Patient inhis duty, he strives to conquer the evil powers which are the enemies of youth. He awakens

the indolent, encourages the eager and steadies the unstable. He communicates his own joy

at learning and shares with boys and girls the best treasures of his mind. He lights many

candles, which in later years will shine back to cheer him. This is his reward. Knowledgemay be gained from books, but the love for knowledge can be transmitted only by personal

contact. No one has ever deserved better of the republic than the unknown teacher. No one

is more worthy to be enrolled in a democratic aristocracy, King of himself and Servant of

mankind”.

– Henry Van Dyke

EEducation

“Education, according to the Indian tradition, is not merely a means of earning

a living, nor it is only a nursery of thoughts or a school for citizenship. It is the

initiation into the life of spirit, a training of human soul in the pursuit of truth andpractice of virtue.”

So long as there is a one child who has failed to obtain the precise educational treatment

his individuality requires; so long as a single child goes hungry, has nowhere to play, fails

to receive the medical attention he needs; so long as the nation fails to train and providescope for every atom of outstanding ability it can find; so long as there are parents who do

not realise their responsibilities of bringing up immature brains; so long as there are

administrators or teachers who feel no sense of mission, who cannot administer or who

cannot teach, the system will remain incomplete.

PPreface to the New Edition

It gives us immense pleasure to place in your hand, the much awaited and thoroughlyrevised enlarged edition of our book titled “Import Export Procedures andDocumentations” under a new title “Foreign Trade – Theory, Procedures, Practicesand Documentation” to justify its extended scope and contents.

We express our gratitude towards the Teacher’s and Student’s Community whoseregular reminders for the revision of the Book motivated us to work more meticulously onthe contents and bring it to the present stature. Probably, that is what has inspired us todedicate this enlarged Edition to all those “Unknown Teachers”, who had been aninspirational force behind this book. We are also thankful to the students for flooding ourmail boxes with their suggestions and recommendations for the improvement of thecontents and making it user-friendly.

The book has been divided into Four Units – International Marketing Environment,Introduction to International Marketing, Framework for India’s Foreign Trade and ForeignTrade Procedures, each having five inter-related chapters. The book exclusively deals withthe issues pertaining to export import trade and documentations. Attempts have been madeto simplify complicated procedures without diluting the contents of the Policy declared bythe Government.

We hope that this revised edition would serve the expectations of teachers andprofessionals associated with Foreign Trade and most importantly the students pursuingtheir career in Foreign Trade at the undergraduate and postgraduate levels and inprofessional courses.

– Authors

Constructive suggestions for the qualitative improvement of the book will be receivedand honoured with a deep sense of gratitude at [email protected]. We would beamplyrewarded, if the volume meets the requirements of those for whom it is meant.

CContentsUNIT – 1

INTERNATIONALMARKETING ENVIRONMENT

Chapter 1 – Evolution of International Trade 1 – 261.1 Introduction 21.2 Interdependence of Countries 21.3 Internal Trade vs. International Trade 31.4 Classical Theory of International Trade 31.5 Theory of Absolute Cost Differences or Advantages 41.6 The Ricardian Theory of Comparative Costs 61.7 Gains from International Trade 71.8 Comparative Costs Doctrine Expressed in Terms of Money 91.9 Evaluation of the Classical Theory of International Trade 111.10 DoWe Need a Special Theory of International Trade? 121.11 General Equilibrium Theory of International Trade 131.12 Exchange Rate Mechanism and International Trade 191.13 A Complex Model of Ohlin 201.14 Criticisms of the Modern Theory of International Trade 211.15 Superiority of the Modern Theory of International Trade 221.16 Porter’s National Competitive Advantage Theory 231.17 Product Life Cycle Theory 25

Chapter 2 – International Trade Environment 29 – 562.1 Meaning of International Trade Environment 282.2 Components of International Trade Environment 312.3 Demographic Environment 352.4 Social Environment 362.5 Cultural Environment 372.6 Hofstede’s Cultural Dimension Theory 402.7 Economic Environment 422.8 Political Environment 452.9 Legal Environment 472.10 Technological Environment 482.11 Competitive Environment 51

2.12 Michael Porter’s Five Forces Analysis 532.13 PEST Analysis for International Market 55

Chapter 3 – International Trade Organisations 57 – 803.1 General Agreement on Tariffs and Trade (GATT) 583.2 Uruguay Round of GATT (1986-93) 603.3 Objectives of the World Trade Organisation (WTO) 633.4 Principles of the WTO 643.5 Functions of WTO 663.6 GATT vs. WTO 663.7 Pros of WTO 683.8 Cons of WTO 703.9 WTO Ministerial Conferences 713.10 Doha Declaration 723.11 United Nations Co-operation for Trade and Development (UNCTAD) 73

Appendix 75

Chapter 4 – Regional Economic Groupings 81 – 1004.1 Concept of Trade Barriers 824.2 Objectives of Trade Barriers 824.3 Types of Tariff Trade Barriers 834.4 Types of Non-tariff Trade Barriers: 854.5 Tariff Trade Barriers vs. Non-tariff Trade Barriers 874.6 Effects of Trade Barriers 874.7 Concept of Regional Economic Groups 894.8 Types of Regional Economic Groups 904.9 Positive Effects of Regional Economic Groups 904.10 Negative Effects of Regional Economic Groups 914.11 Major Trade Blocs 924.12 South Asian Free Trade Area (SAFTA) 97

Appendix 99

Chapter 5 – Globalisation, FDI and MNCs 101 – 1275.1 Understanding LPG Model 1025.2 Concept of Globalisation 1035.3 Features of Globalisation 1045.4 Stages of Globalisation 1055.5 Concept of Multinational Corporations (MNCs) 107

5.6 Merits of MNCs 1075.7 Demerits of MNCs 1085.8 MNCs in India 1095.9 Concept of Foreign Direct Investment (FDI) 111

5.10 Role and Functions of FDI in Developing Countries 1125.11 Factors Influencing FDI 1145.12 FDI Operations in India 1165.13 FDI Policy in India 1185.14 Make in India 1225.15 Foreign Investment Promotion Board (FIPB) 1255.16 Foreign Investment Promotion Council (FIPC) 126

UNIT – 2INTRODUCTION TO INTERNATIONAL MARKETING

Chapter 6 – Introduction to International Marketing 129 – 1606.1 Concept of International Marketing 1316.2 Features of International Marketing 1326.3 Drivers of International Marketing 1336.4 Importance of International Marketing 1356.5 Motivation for Internationalisation 1366.6 Orientations of International Marketing 1386.7 Phases of International Marketing 1396.8 Process of International Marketing 1416.9 Concept of International Marketing Research 142

6.10 Need for International Marketing Research 1426.11 International Marketing Research Process 1446.12 Scope of International Marketing Research 1476.13 Special Problems of International Marketing 1496.14 Domestic Marketing vs. International Marketing 1506.15 ‘12C’ Framework for International Marketing 1516.16 Concept of International Service Marketing 1526.17 Characteristics of Services 1536.18 ‘7Ps’ of International Service Marketing 1546.19 Features of International Service Marketing 1556.20 Need for International Service Marketing 156

6.21 Drivers of Global Service Marketing 1576.22 A Note on Service Culture 158

Chapter 7 – Product Decisions 161 – 1967.1 Concept of International Marketing Mix 1637.2 Product Planning Decisions 1647.3 Product Planning Strategies 1647.4 Importance of Product Planning 1667.5 New Product Development Process 1677.6 Product Life Cycle 1707.7 Concept of Branding 1727.8 Role of Branding 1747.9 Branding Decisions 176

7.10 Brand Piracy 1777.11 Concept of Packing and Packaging 1797.12 Requisites of Good Packaging 1797.13 Functions of Packaging 1807.14 Factors Influencing Packaging Decisions 1817.15 Types of Packing Materials 1837.16 Concept of Transport Packing 1837.17 Materials for Transport Packing 1847.18 Containerisation 1867.19 Role of Indian Institute of Packaging (IIP) 1897.20 Marking and Labelling 1917.21 Product Warranties and After-sales Service 195

Chapter 8 – Pricing Decisions 197 – 2168.1 Concept of Pricing 1988.2 Factors Affecting Pricing Decisions 1988.3 Importance of Pricing Decisions 1998.4 Methods of Costing in International Market 2008.5 Elements of Cost in Pricing Goods for International Market 2038.6 Export Pricing Strategies 2038.7 INCOTERMS 2011 or Export Price Quotations 2048.8 FOB Quotation vs. CIF Quotation 2068.9 Skimming Pricing vs. Penetration Pricing 207

8.10 Break-even Analysis 2088.11 Information Required for Pricing in International Market 210

8.12 Computation of FOB, CF and CIF Price 2128.13 Impact of Incentives on Export Pricing 215

Chapter 9 – Distribution Channel Decisions 217 – 2389.1 Concept of International Market Segmentation 2189.2 Importance of International Market Segmentation 2189.3 Bases of International Market Segmentation 2209.4 Components of International Logistics 2229.5 Meaning of Channels of Distribution 2259.6 Levels of Distribution Channel 2269.7 Types of Distribution Channels 2279.8 Direct Marketing 2299.9 Indirect Marketing 2309.10 Direct Exporting vs. Indirect Exporting 2319.11 Factors Influencing Channel Selection 2329.12 Export Marketing Development through Internet 2349.13 Benefits of Export Marketing Development through Internet 2369.14 Warehousing and its Necessity in International Trade 237

Chapter 10 – Promotion Decisions 239 – 25410.1 International Product Positioning 24010.2 Product Positioning Strategies 24110.3 Concept of Product Promotion 24210.4 Techniques of Product Promotion 24310.5 Factors Affecting Product Promotion 24410.6 Role of Promotion Mix 24610.7 Planning International Promotion Campaign 24710.8 Barriers to International Promotion 24810.9 International Advertising Programme 24910.10 International Trade Fairs and Exhibitions 25110.11 Indian Trade Promotion Organisation (ITPO) 252

Appendix 254

UNIT – 3FRAMEWORK FOR INDIA’S FOREIGN TRADE

Chapter 11 – Regulatory Framework for Foreign Trade 255 – 28611.1 Introduction 25611.2 Laws Governing India's Export Import Trade 25611.3 The Customs Act, 1962 25611.4 The Export Quality (Control and Inspection) Act, 1963 26111.5 The Foreign Trade (Development and Regulation) Act, 1992 26211.6 The Foreign Exchange Management Act, 1999 26511.7 Foreign Exchange Management (Export of Goods and Services) Regulations, 2000 27011.8 The Arbitration and Conciliation Act, 1996 27311.9 International Commercial Practices 27911.10 Central Board of Excise and Customs 28111.11 Export Inspection Council (EIC) 28211.12 Indian Council of Arbitration (ICA) 284

Appendix 285

Chapter 12 – India’s Foreign Trade Policy 287– 31212.1 Introduction 28812.2 General Objectives of EXIM Policy 28812.3 Foreign Trade Policy – A Snapshot 28912.4 EXIM Policy, 1992-97 29612.5 EXIM Policy, 1997-2002 29712.6 Foreign Trade Policy, 2004-2009 29712.7 Foreign Trade Policy, 2009-2014 29812.8 Foreign Trade Policy, 2015-2020 29912.9 Implications of the Foreign Trade Policy, 2015-2020 30612.10 Privileges of Status Holders 30712.11 Negative List of Exports 30912.12 Negative List of Imports 31112.13 Board of Trade 311

Chapter 13 – Institutional Framework for Foreign Trade 313 – 34813.1 Institutional Framework for Foreign Trade 31413.2 Role of Export Promotion Organisations 31413.3 Department of Commerce 316

13.4 Director General of Foreign Trade (DGFT) 31813.5 Directorate General of Commercial Intelligence and Statistics (DCI&S) 31913.6 Agricultural and Processed Food Products Development Authority (APEDA) 32113.7 Marine Products Export Development Authority (MPEDA) 32413.8 Export Promotion Councils (EPCs) 32513.9 Commodity Boards (CBs) 32713.10 Indian Institute of Foreign Trade (IIFT) 32913.11 Federation of Indian Export Organisations (FIEO) 33013.12 National Centre for Trade Information (NCIT) 33213.13 State Trading Corporation of India (STC) 33413.14 Chamber of Commerce (CoC) 33613.15 States Involvement in Promoting Foreign Trade 338

Appendices 339

Chapter 14 – International Trade Documents 349 – 38214.1 Introduction 35014.2 Aligned Documentation System (ADS) 35214.3 Proforma Invoice 35414.4 Commercial Invoice 35514.5 Packing List 35614.6 Shipping Bill 35714.7 Certificate of Origin 35814.8 Consular Invoice 36014.9 Certificate of Origin vs. Consular Invoice 36114.10 Commercial Invoice vs. Consular Invoice 36114.11 Mate’s Receipt 36214.12 Bill of Lading 36314.13 Mate’s Receipt vs. Bill of Lading 36514.14 Guaranteed Remittance (GR) Form 36614.15 Bill of Exchange 36714.16 Airway Bill 36814.17 Import Documents 369

Specimen of Export Documents 373

Chapter 15 – Policy Assistance and Incentives 383 – 40815.1 Incentives and Assistance for Exporters 38415.2 Duty Drawback (DBK) 38615.3 Procedure for Claiming Duty Drawback 388

15.4 Exports from India Scheme 38815.5 Export Promotion Capital Goods (EPCG) Scheme 39115.6 Towns of Export Excellence (TEE) 39415.7 Deemed Exports 39615.8 Export Oriented Units (EOUs), Electronic Hardware Technology Parks (EHTPs),

Software Technology Parks (STPs) and Bio-technology Parks 39715.9 Agri Export Zones (AEZs) 39915.10 Special Economic Zones (SEZs) 40015.11 Benefits Enjoyed by SEZs 40315.12 Quality Control and Trade Disputes (QCTD) 40415.13 Assistance to States for Developing Export Infrastructure and Allied Activities (ASIDE) 406

Appendix 407

UNIT – 4FOREIGN TRADE PROCEDURES

Chapter 16 – India’s Foreign Trade 409 – 43616.1 Introduction 41016.2 Significance or Merits of Foreign Trade 41016.3 Demerits of Foreign Trade 41116.4 Growth of India’s Foreign Trade 41316.5 Direction of India’s Exports 41516.6 Direction of India’s Imports 41716.7 Major Exports (Commodities) of India 41916.8 Major Imports (Commodities) of India 42216.9 Major Exports (Services) of India 42416.10 India’s Share in World Trade and FTP 2015-2020 42616.11 Prospects for India’s Foreign Trade Development 42716.12 Challenges to India’s Foreign Trade Development 429

Appendices 431

Chapter 17 – Preliminaries for Export 437 – 45617.1 Meaning of Exports and Imports 43817.2 Classification of Exports and Imports 43817.3 Categories of Exporters 44017.4 Strategy and Preparation for Foreign Trade 44217.5 Identifying Foreign Markets 444

17.6 International Market Selection Process 44617.7 Methods of Entering International Market 44717.8 Constraints in Entering Foreign Markets 45017.9 Export Contract 45117.10 Force Majeure in Export Contract 45317.11 Exchange Earner’s Foreign Currency (EEFC) Account 454

Chapter 18 – Export Procedure 457– 48418.1 Introduction 45918.2 Registration Procedure 45918.3 Pre-shipment Procedure 46018.4 Shipment Procedure 46218.5 Post-shipment Procedure (Realisation of Export Proceeds) 46318.6 Excise Clearance for Exportable Goods 46418.7 Quality Control and Pre-shipment Inspection 46718.8 Objectives of Quality Control and Pre-shipment Inspection 46818.9 Methods of Quality Control and Pre-shipment Inspection 46918.10 Procedure for Pre-shipment Inspection 47018.11 Procedure for Shipping and Customs Clearance 47118.12 Marine Insurance Policy 47318.13 Procedure for Marine Insurance Policy 47318.14 Types of Marine Insurance Policies 47418.15 Procedure for Filing Marine Insurance Claim 47618.16 Importer Exporter Code (IEC) Number 47718.17 Registration-cum-Membership Certificate (RCMC) 47818.18 Role of Customs House Agents (CHAs) 47918.19 Exchange Rate Fluctuation Risks 48018.20 Forward Contracts 48118.21 ISO 9000 Certification 48218.22 Procedure for Obtaining ISO 9001 Certification 483

Chapter 19 – Methods of Payments and Export Finance 485 – 51419.1 Conditions for Realisation of Export Proceeds 48719.2 Factors Affecting Export Payment Terms 48719.3 Methods of Export Payment 48819.4 Letter of Credit 49019.5 Procedure for Opening Letter of Credit 490

19.6 Types of Letter of Credit 49119.7 Advantages of Letter of Credit 49319.8 Types of Export Finance 49419.9 Pre-shipment Finance 49419.10 Features of Post-shipment Finance 49619.11 Procedure for Obtaining Export Finance 49919.12 Pre-shipment Finance vs. Post-shipment Finance 50019.13 Institutional Framework for Export Finance 50119.14 Role of Commercial Banks in Export Finance 50119.15 Role of EXIM Bank in Export Finance 50319.16 Forfeiting Scheme of EXIM Bank 50619.17 Role of SIDBI in Export Finance 50719.18 Risks in Export Marketing 51019.19 Export Credit and Guarantee Corporation (ECGC) of India 51119.20 Role of ECGC in Export Credit Insurance for Exporters 51119.21 Role of ECGC in Providing Finance to Exporters 514

Chapter 20 – Import Procedure 515 – 53520.1 Introduction 51620.2 Categories of Importers 51620.3 Import Licence 51620.4 Import of Samples 51820.5 Import Contract 51920.6 Pre-import Procedure 52020.7 Legal Dimensions of Import Procedure 52020.8 Retirement of Import Documents 52220.9 Customs Clearance for Imported Goods 52320.10 Warehousing of Imported Goods 52420.11 Exchange Control Provisions for Imports 52620.12 Import Risks 52820.13 Import Duties 52920.14 Valuation for Customs Duty 53120.15 Import Incentives under Special Schemes 53220.16 Import of Personal Baggage 53320.17 Import of Gifts 534

Glossary 537 – 545

Chapter Highlights:

1.1 Introduction

1.2 Interdependence of Countries

1.3 Internal Trade vs. International Trade

1.4 Classical Theory of International Trade

1.5 Theory of Absolute Cost Differences or Advantages

1.6 The Ricardian Theory of Comparative Costs

1.7 Gains from International Trade

1.8 Comparative Costs Doctrine Expressed in Terms of Money

1.9 Evaluation of the Classical Theory of International Trade

1.10 Do We Need a Special Theory of International Trade?

1.11 General Equilibrium Theory of International Trade

1.12 Exchange Rate Mechanism and International Trade

1.13 A Complex Model of Ohlin

1.14 Criticisms of the Modern Theory of International Trade

1.15 Superiority of the Modern Theory of International Trade

1.16 Porter’s National Competitive Advantage Theory

1.17 Product Life Cycle Theory

1. Evolution of International Trade

Foreign Trade – Theory, Procedures, Practices and Documentation

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1.1 Introduction International trade existed in one form or the other since time immemorial. Indian traders crossed seven seas and ventured to Java and Sumitra long back. International trade theories, however, were developed much later. Fundamentally, in a market system, individuals trade because they expect to gain from the exchange, i.e., they expect to be better off as a result of trading. In this respect, trade occurs for the same reasons among nations as it does among regions within a given country. Thus, domestic trade occurs within the political boundaries of a nation whereas international trade occurs across the political boundaries of different nations.

“International trade consists of transactions between residents of different countries.” – Wasserman and Haltman

The principle of comparative advantage is the basis of international trade. Each nation or region specialises in the production of those goods and services in which it enjoys maximum comparative advantage and imports or purchases its other requirements from the other nations. Thus, principle of division of labour and specialisation is the basis of world trade.

1.2 Interdependence of Countries No country in the world is self-sufficient in all its domestic requirements. The slogan ‘Export or Perish’ coined by Pandit Jawaharlal Nehru, is applicable to all the countries of the world, developed as well as developing. There are various factors which give rise to interdependence among countries.

(a) Uneven Distribution of Natural Resources: Natural resources are distributed unevenly on the surface of the earth. Some countries are rich in metallic and non-metallic minerals but are deficient in natural and physical resources while some other countries are rich in natural resources but are deficient in minerals. This gives rise to surplus and deficient regions, which direct the flow of goods from surplus regions to deficient regions. For example, the Gulf countries are rich in mineral oil while are deficient in many other resources. As a result, these countries export mineral oil and import most of their other requirements.

(b) Difference in Level of Technology: Industrial revolution first took place in England in 1760 AD. Later, it spread to different regions and countries of the world with different pace and intensity. Technology became the driving force of growth and development of economies in the post-industrial revolution period. Countries like Japan, the USA, the UK and Germany are highly developed in terms of technology while most of the Afro-Asian and South American countries are backward in technological development. This directs the flow of technology from technically advanced countries to technically backward countries of the world.

(c) Advancement in Information Technology: Due to revolution in the field of communication and information technology, new media of mass communication such as satellite, Internet and e-commerce have become popular. These media have brought world closer and have promoted greater exchange of ideas. Consumers from the underdeveloped and developing countries of the world have started imitating the consumption pattern and lifestyle of the consumers in the advanced countries. This

Evolution of International Trade

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has created new needs in the society and led to the promotion of international trade in goods, services and technology.

(d) Division of Labour and Specialisation: Trade rests on the principle of division of labour and specialisation put forth by Adam and Smith. Each country enjoys comparative cost advantage in the production of certain commodities due to favourable climate, technical know-how, easy access to raw materials and efficient human resource. These factors enable it to produce some commodities in excess of its requirements and exchange surplus production with other countries for the commodities that it is deficient in and vice versa. Thus, the principle of division of labour that forms the basis of domestic trade also applies to international trade.

1.3 Internal Trade vs. International Trade It has been a matter of great controversy whether there is any difference between internal trade and international trade. Holding a view that there are certain fundamental differences between internal trade and international trade, the classical economists propounded a separate theory of international trade. According to them, the basis of international trade was the comparative cost differences. On the other hand, modern economists like Bertil Ohlin, Haberler, etc. have regarded these two as similar.

“International trade is but a special case of inter-local or inter-regional trade.” – Heckscher and Ohlin

“Domestic trade is among us; international trade is between us and them." – Friedman List

Nevertheless, there are several reasons to believe the classical view that international trade is basically different from internal trade.

(a) Immobility of factors of production between nations.

(b) Different currencies.

(c) Differences in natural resources.

(d) Different national policies.

(e) Exchange and trade control.

(f) Separate markets.

(g) Problem of balance of payments.

(h) Different political groups.

1.4 Classical Theory of International Trade The classical theory of international trade was first propounded by Adam Smith who introduced the principle of absolute cost advantage as the basis of international exchange of commodities. It was further developed by David Ricardo in terms of comparative cost advantage. Later, further refinements and modifications were introduced by economists like J.S. Mill, Taussig and others. The classical economists considered the principle of division of labour as the basis of international trade.

Assumptions of the Classical Theory of International Trade The following are the explicit and implicit assumptions of the theory:


4

(a) The classical economists assume 2 countries × 2 commodities model. It is further assumed that these two countries are economically at par.

(b) They regarded labour as only factor of production. That means the production costs can be expressed only in terms of labour units.

(c) They ignored the existence of money and considered cost of production in real terms, i.e., in terms of the labour theory of value.

(d) According to them, the factors of production are perfectly mobile within the country but perfectly immobile between different countries.

(e) They also assumed that all labourers are homogenous, i.e., all the labourers are equally skilful and efficient.

(f) Production function is assumed to be linear and homogenous. It means there are constant returns to scale.

(g) They advocated the policy of laissez-faire, i.e., there is free trade and the government does not interfere at all.

(h) International trade takes place only in case of goods. There is no capital movement from one country to another.

(i) This theory, like all other classical dogmas, assumes that there exists full employment in both the countries.

(j) There exists free trade, i.e., there are no barriers of tariffs or controls to the trade between two countries.

(k) The theory also assumes perfect competition both in commodity as well as factor market.

(l) Transport costs are zero. It means that the cost of labour is the only cost of production.

(m) Trade cycles are absent in the economy, i.e., the theory operates under normal conditions.

Given the above assumptions, the pre-trade commodity price depends on the average productivities of labour contained in the production functions. The supply of the commodity depends on the labour content and its price is equated to the value of its labour content.

1.5 Theory of Absolute Cost Differences or Advantages

Adam Smith (1723) was an economist and philosopher who wrote what is considered the "bible of capitalism," The Wealth of

Nations, in which he details the first system of political economy.


5

Adam Smith was the first economist who sowed the seeds of classical theory of international trade. He was a staunch advocate of free trade and a critic of protectionism. He argues that the application of the principle of division of labour to international trade is advantageous to all nations because it causes each country to specialise in the production of those goods which it is best suited to produce most cheaply. He held that free trade between countries brings about an optimum allocation of the productive resources of the world, leading to an enhancement of real income of the trading countries.

In this context, Adam Smith developed the law of absolute cost advantage for international trade. According to him, trade occurs between two countries if one of them has an absolute advantage in producing one commodity and the other country having absolute advantage in producing some other commodity. In other words, each country specialises in the production of that commodity in which it enjoys an absolute cost advantage and trades with other countries in commodities in which they enjoy absolute cost advantage. The trade between the countries would result in optimum allocation of the resources in the world and hence productivity will boost.

Illustration The Absolute Cost Theory can be illustrated with the help of an illustration. Suppose there are two countries, A and B and each of them can produce say two commodities, wine and cloth. As per the assumptions of the classical economists, all costs are measured only in terms of labour.

If in country A, one unit of labour per day can produce 25 barrels of wine or 10 bales of cloth and in country B, the same amount of labour can produce 10 barrels of wine or 15 bales of cloth then the cost conditions in country A and B can be represented as follows:

Evidently, country A has an absolute cost advantage over country B in the production of wine (for 25 barrels are more than 10 barrels), while country B has an absolute advantage over country A in the production of cloth (for 15 bales are more than 10 bales).

Thus, country A will specialise in the production of wine in which it has an absolute cost advantage over country B and country B will specialise in the production of cloth in which it has an absolute cost advantage over country A. Thus, trade between two countries will benefit both of them. It is can be seen from the above table that with 2 units of labour, country A will now produce 50 barrels of wine and country B 30 bales of cloth as a result of specialisation and international trade. In the absence of international trade, with same units of labour (i.e., 2 units of labour), the world production would have been restricted to just 35 barrels of wine and 25 bales of cloth.

Critical Analysis of the Absolute Cost Advantages Theory Though Smith’s theory is clearly expressed, it is not convincing. His analysis is based on the assumption that given the quantity of labour, the exporting country must be in a position to produce a commodity in a larger


6

quantity than the rival country. But there are very genuine chances that a particular country may not be in a position to specialise in any line of productivity. This may be the case of a relatively backward country whose factors of production, as compared with those of any other developed nation, are inefficient in all lines of production. There is no absolute advantage for such a backward country and yet we find that it has international economic relations. Adam Smith’s theory clearly fails to analyse this sort of situation.

1.6 The Ricardian Theory of Comparative Costs

David Ricardo (1772) was a classical economist known for his Iron Law of Wages, Labour Theory of Value, Theory of Comparative Advantage and Theory of Rents. His most well-known work is

the Principles of Political Economy and Taxation (1817).

The doctrine of absolute cost advantage put forth by Adam Smith could not explain why there can be trade between any two countries even when one of them had disadvantage in the production of all goods. To provide an answer in such cases, Ricardo enunciated the principle of comparative costs in his ‘Principles of Political Economy’ (1817), which incorporates the Smith’s principle of absolute cost advantages as a special case.

“Each country will specialise in the production of those commodities in which it has greater comparative advantage or least comparative disadvantage.” – David Ricardo

Thus, according to the principle of comparative costs, under free trade conditions, a country specialises in the production of a commodity in which its comparative advantage is greater or its comparative disadvantage is lesser. Each country exports a commodity in the production of which it has a greater comparative advantage or a lesser comparative disadvantage.

Illustration Suppose that there are two countries, Portugal and England and that each of them can produce wine and cloth. The relative cost conditions of both these countries are given in the table below:

From the above table, we can calculate the domestic ratio of exchange between two goods.

Domestic ratio of exchange in Portugal: 1 unit of wine = 0.89 units of cloth. (80/90) 1 unit of cloth = 1.13 units of wine. (90/80)


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Domestic ratio of exchange in England:

1 unit of wine = 1.2 units of cloth. (120/100)

1 unit of cloth = 0.83 units of wine. (100/120)

Now, let us note the comparative cost ratios of wine and cloth in the two countries.

Comparative cost ratio in Portugal:

For wine = 0.67. (80/120)

For cloth = 0.90. (90/100)

Comparative cost ratio in England:

For wine = 1.50. (120/80)

For cloth = 1.11. (100/90)

It can be seen from the above analysis that Portugal has comparative cost advantage in the production of both wine and cloth. This is because the labour cost of producing 1 unit of wine in Portugal is only 67% of the labour cost required to produce 1 unit of wine in England. Similarly, Portugal incurs only 90% of the labour cost incurred by England on the production of 1 unit of cloth.

On the other hand, England incurs 150% and 111% of the labour costs incurred by Portugal on the production of 1 unit of wine and 1 unit of cloth respectively. Thus, England has a comparative disadvantage in the production of both commodities.

According to Ricardo, trade would still take place between Portugal and England because Portugal has greater comparative cost advantage (67%) in the production of wine while England has comparatively a lesser cost disadvantage (111%) in the production of cloth. Thus, Portugal will specialise in the production of wine and England would specialise in the production of cloth.

1.7 Gains from International Trade The gain from trade for each country would depend upon the rate of exchange or terms of trade between the trading countries.

As a result of specialisations by Portugal in wine due to its greater comparative cost advantage and England in cloth due to its lesser comparative cost disadvantage, there will be an increase in the output of both the commodities. Hence, the trade between them will be beneficial to both for both of them gain from trade.

Illustration No Trade Situation:


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In no trade situation, if each of them produces one unit of wine and one unit of cloth, Portugal will use 80 + 90 = 170 hours of labour and England will use 120 + 100 = 220 hours of labour. So, to produce 2 units of wine and 2 units of cloth, both the countries taken together would use 390 hours of labour (i.e., 170 + 220 = 390).

Post-trade Situation:

However after specialisation, Portugal will devote 170 hours of labour to produce wine only and England will devote 220 hours of labour to produce cloth only. Hence, by devoting 2 units of labour, Portugal would be able to produce 2.125 units of wine and England would be able to produce 2.200 units of cloth. Hence, the same amount of labour produces a larger amount of both the commodities after specialisation.

Under the international trade, the exchange of commodities depends upon the domestic rates of exchange, namely,

1 unit of wine = 0.89 units of cloth in Portugal for 0.89 (80/90) and

1 unit of wine = 1.20 units of cloth in England for 1.20 (120/100).

When Portugal and England trade with each other, the actual rate of exchange or the terms of trade will lie between 0.89 and 1.20 units of English cloth for one unit of Portuguese wine.

When the international trade takes place, Portugal gains, if by exporting one unit of wine, it gets more than 0.89 units of cloth from England and England gains, if by exporting less than 1.2 units of cloth, it gets one unit of wine from Portugal.

If, for instance, as Ricardo said, the rate of exchange fixed is one unit of wine for one unit of cloth, Portugal benefits because it gets one unit of cloth at a labour cost of 80 hours of labour which would have costed 90 hours of labour if it had produced it at home. Hence, Portugal saves 10 hours of labour. It also means that Portugal gets 0.11 units of extra cloth from England for one unit of wine exported. England benefits because it gets one unit of wine for 100 hours of labour embodied in one unit of cloth. If England had produced one unit of wine at home, it would have costed it 120 hours of labour. Hence, England is in a position to save 20 hours of labour. It also means that England gets 0.17 units of more wine for every unit of cloth exported.

Thus, this theory shows how countries tend to gain under the conditions of free trade when there is international division of labour and specialisation based upon the comparative cost advantage. As a result, the world output of goods produced with a given amount of resources will be larger than without international specialisation.


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1.8 Comparative Costs Doctrine Expressed in Terms of Money The Ricardian Theory of comparative costs is explained in terms of labour cost. But, in a money economy, all costs are expressed in terms of money. International trade is, therefore, determined by absolute differences in money prices rather than comparative differences in labour cost.

Prof. Taussig, has, therefore, expressed the comparative differences in labour costs in terms of money costs and money prices. This would help us to find out the absolute differences in the prices of products.

The theory of comparative costs expressed in terms of money is discussed with the help of the following assumptions:

(a) There are two countries, say, the USA and Germany. Each country can produce two commodities, say, wheat and linen.

(b) The labour cost is expressed in terms of money on the basis of some arbitrarily fixed wage rate. The other elements of cost of production are ignored.

(c) The wages and money prices in the USA and Germany are expressed in terms of a single currency, viz., US dollar.

(d) There is international gold standard. Hence, the classified specie-flow mechanism operates to bring about adjustments in the balance of payments.

With these assumptions, let us proceed to express the comparative labour cost in terms of money to find out absolute differences in prices of wheat and linen.

Illustration Suppose, in the USA,

10 day’s labour produces 20 units of wheat, and

10 day’s labour produces 20 units of linen.

At the same time, in Germany,

10 day’s labour produces 10 units of wheat, and

10 day’s labour produces 15 units of linen.

It can be seen from the above table that the USA has an absolute cost advantage in the production of both commodities, wheat and linen. But its comparative advantage is greater in wheat than in linen. Hence, it will specialise in wheat. At the same time, Germany suffers from comparative cost disadvantage in both commodities. But its comparative disadvantage is less in linen. Hence, it will specialise in linen.

These comparative advantages and disadvantages in the production of wheat and linen can be expressed in terms of dollars, on the basis of arbitrarily fixed daily wage rates. Suppose, the daily wage rate is $ 1.5 in the


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USA and $ 1 in Germany, then the relative price of both these commodities in dollar terms can be expressed as follows:

Money Cost of Wheat and Linen in terms of Dollars

The price per unit of wheat is $ 0.75 in the USA and $ 1 in Germany. Hence, the USA will specialise in wheat and export it to Germany. This clearly indicates that higher wage rate does not necessarily imply high prices. At the same time, the price per unit of linen in Germany is $ 0.66 and in the USA $ 0.75. Hence, Germany will specialise in the production of linen and export it to the USA. Thus, the result is compatible with the doctrine of comparative costs (based upon labour).

The arbitrary money wage rates are taken for both the countries to calculate the price per unit of each commodity. But, it does not falsify the doctrine of comparative costs for the ratio of money wages in the two countries must lie between an upper limit and a lower limit. The upper limit for the wage rate in the USA is fixed with reference to the cost advantage, which the Germany enjoys in wheat.

Since the same amount of labour produces 20 units of wheat in the USA as 10 units of wheat in Germany, the upper limit is set by the ratio, 20/10 = 2. This mean that the wage rate in the USA cannot be more than double the wage rate in Germany. For instance, if the daily wage rate in Germany is $ 1, the daily wage rate in the USA cannot be more than $ 2. If at all the daily wage rate in the USA rises to $ 2, the cost per unit of wheat as well as that of linen would be $ 1. As a result, the USA exports of wheat to Germany would cease while its imports of linen from Germany would continue. This would cause a deficit in the balance of trade of the USA and gold would flow out of the USA. As a result, the supply of money and credit would fall in the USA, reducing the price level and the wage rate. Therefore, the wage rate in the USA cannot exceed $ 2.

On the other hand, the lower limit for the wage rate in the USA is fixed with reference to its cost advantage in linen. Since the same amount of labour produces 20 units of linen in the USA and 15 units of linen in Germany, the lower limit in the USA is set by the ratio 20/15 = 4/3 = 1.33. This means that the wage rate in the USA cannot fall below $ 1.33. If the USA wage rate falls below $ 1.33, the exports of German linen to the USA would cease while its imports of wheat from the USA will continue. Hence, there would be a surplus in the balance of trade of the USA and gold would flow in the USA. As a result, the supply of money and credit would increase in the USA, increasing the price level and the wage rate.

So the upper and the lower limits are not arbitrarily chosen. It is only the choice of one or the other ratios that is arbitrary. Hence, when the wage rate in Germany is $ 1, the actual wage rate in the USA would lie


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between $ 1.33 and $ 2. The wage rate in the USA is bound to be higher than that in the Germany, because of its greater efficiency. The actual wage rate between the upper limit ($ 2) and the lower limit ($ 1.33) would be determined by the conditions of demand for each other’s goods.

Taussig’s contribution to the Classical Theory of International Trade suffers from the following defects:

(a) Taussig did not indicate how the terms of trade are actually determined. According to John Stuart Mill, the exact terms of trade are determined by reciprocal demand.

(b) Like Ricardo, Taussig also took two-country, two-commodity model. This is unrealistic as in reality, many countries participate in the world trade and each country exports and imports a number of commodities.

(c) By expressing, the wage rates in the two countries in terms of a single currency (dollar), Taussig has ignored the problems of determining foreign exchange rates between currencies of the trading countries.

(d) Taussig has ignored other costs like rent while determining the total cost and underrated interest cost and has given an undue stress to labour costs expressed in terms of money.

1.9 Evaluation of the Classical Theory of International Trade Perhaps, the most celebrated doctrine of the classical economics is the theory of comparative costs. Ricardo’s doctrine of comparative advantage furnishes a logical explanation of the pattern of trade. It also contains a strong argument for gains of trade and terms of trade. In fact, for more than a century since its publication in 1817, it has been widely acclaimed as the most correct explanation of international trade. Even now also, developments in this field are more or less of a complementary nature. This basic classical principle has been only modified and elaborated in the modern context by many economists of the present generation.

“If theories, like girls, could win beauty contests, comparative advantage would certainly rate high in that. It is an elegantly logical structure.” – Prof. Sameulson

However, the theory appears to be oversimplified when we try to apply it to the intricate problems of real life. We, in general, conclude that the theory has no touch with the wet clay of life. Samuelson correctly stated:

“Yet for all its oversimplification – the theory of comparative advantage has in it a most important glimpse of truth. Any country, which ignores comparative advantage, may suffer a loss in growth. The other side of the picture should not be glossed over.” – Prof. Sameulson

Classical theory of International Trade, however, suffers from many defects, which are stated by Bertin Ohlin and Frank D. Graham. Some of these defects are:

(a) Labour – the Only Productive Factor: The classical theory considers labour as the only productive factor. In reality, production is the combined result of many other factors – land, capital, technology, etc.

(b) Labour Mobility: The classical economists assume that labour is immobile internationally but mobile locally. But labour is immobile locally due to several factors such as family bond, association, etc.

(c) Restrictive Theory: The classical model of international trade is restricted to two countries and two commodities. But the world trade today is spread across many nations which deal in many commodities.


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(d) Homogeneity of Labour: The classical theory assumes that all units of labour are homogenous. However, in real world, no two persons are same in their skills and abilities.

(e) Absence of Transport Cost: The classical economists completely ignored transportation costs. However, transportation costs may nullify the comparative cost advantage of a country.

(f) Full Employment: The classical theorists believe in the condition of full employment. But in reality, there is always a situation of unemployment or underdevelopment in the economy.

(g) Lop-sided: According to the critics, the classical theory considers only supply side, i.e., comparative cost differences. It fails to consider the demand side of international trade.

(h) Static Theory: According to the modern economists, the classical theory is static in nature and operates under a number of assumptions while the modern world is highly dynamic.

(i) Division of Labour and Specialisation: According to the modern economists, complete division of labour and specialisation is not possible.

To sum up, it can be said that there is no essential difference between domestic and international trade. Both rest on the same foundation, i.e., division of labour, which leads to specialisation and hence, higher national income. If two nations have different production functions, their costs will also differ. In that case, they will produce that commodity where the comparative cost advantage is the maximum and comparative disadvantage is the minimum.

However, modern economists have rejected the classical theory of international trade (the Comparative Cost Theory) primarily on the ground that it is based upon the obsolete labour cost theory of value. These economists have increasingly turned to Bertil Ohlin’s theory of international trade, which, according to them, furnishes a more direct, a more rational and a more realistic explanation of the phenomenon of international trade. This theory is now dubbed as the modern theory of international trade.

1.10 Do We Need a Special Theory of International Trade? Bertil Ohlin has strongly advocated that there was absolutely no need for developing a special theory of international trade. According to his much-quoted statement:

“International trade is but a special case of inter-local or interregional trade.” – Bertil Ohlin

According to him, there are fundamental points of resemblance between inter-regional and international trade and the kind of analysis applicable to inter-regional trade may be extended without any substantial change to explain the phenomenon of international trade.

Bertil Ohlin has strongly refuted the arguments put forward by the classical economists in favour of a separate theory of international trade.

(a) One argument advanced by the classical economists in favour of a special theory of international trade was that while factors of production were perfectly mobile within the country, they were immobile between countries. Thus, international immobility of the factors of production was sought to be made the main reason for having a separate theory of international trade. Bertil Ohlin has,


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however, pointed out that factors of production are found to be immobile even between different regions of the same country.

Ohlin has further pointed out that it would be wrong to conclude that factors of production are wholly immobile between different countries. He cites historical examples where labour and capital migrated from Europe to several parts of the world. Millions of Indians had gone and settled in neighbouring countries in Middle East and South East.

(b) The classical economists sought to build up a separate theory of international trade on the ground of the principle of comparative advantage. Bertil Ohlin has, however, pointed out that this principle of comparative advantage underlies not only international trade but also internal or inter-regional trade. Different areas or regions of the same country tend to produce those commodities in which they possess comparative advantage. According to Ohlin, since the principle of comparative cost advantage is the basis of all trade, there is no justification for developing a special theory of international trade.

(c) The classical economists sought to justify a separate theory of international trade on the ground that different currency systems exist in different countries of the world and that international trade was conducted through the instrumentality of exchange rates mechanism. But Ohlin has refuted this argument. According to him, the rate of exchange between two currencies is closely connected with the cost-price structure in the two countries. The rate of exchange represents the external purchasing power of a currency and the external purchasing power of a currency cannot be isolated from its internal purchasing power. The external purchasing power of a currency is only a reflection of its internal purchasing power. Hence, it is not possible to make any fundamental distinction between local and international trade.

1.11 General Equilibrium Theory of International Trade

Eli Heckscher (1879) is celebrated for his contributions to international trade theory, particularly the factor proportions

theory of comparative advantage in international trade known as the Heckscher-Ohlin theory.

First developed by Eli Heckscher (1879-1952) and later refined by fellow Swedish economist Bertil Ohlin (1899-1979) in 1933, Heckscher-Ohlin trade theory explains the existence and pattern of international trade based on a comparative cost advantage between countries producing different goods. Heckscher-Ohlin trade theory is essentially an extension of the generally accepted theory of value, the general equilibrium (mutual interdependence) theory.


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Swedish Economist Bertil Ohlin(1899) received the Nobel Prize in 1977, along with James Meade, for his “pathbreaking contribution

to the theory of international trade and international capital movements.” Ohlin’s prize was based on his book Interregional and

International Trade, published in 1933.

In 1919, Prof. Heckscher pointed out that international trade is caused due to the differences in the comparative costs resulting from the differences in relative scarcity (i.e., relative prices) of factors of production in two countries. Ohlin developed this idea further. According to Ohlin, the differences in factor prices are caused due to the differences in factor endowments in different countries and the differences in production functions for different commodities. Hence, Ohlin’s theory is popularly known as factor endowment theory.

Ohlin accepts Ricardo’s view that the comparative cost difference is the basis of international trade. But Ricardo did not explain the cause of comparative cost differences in the production of any two commodities in any two countries. Thus, the modern theory begins where the Ricardian theory ends.

Assumptions of the Simple Model of Hekscher-Ohlin Theory (a) There are two countries or regions say country I and country II, each having a free paper currency

and each capable of producing any two commodities.

(b) Countries produce either capital-intensive or labour-intensive commodities depending upon the relative proportion of different factors contained in their production.

(c) There are two factors of production, say, capital and labour, the supply of each being constant and known. The supply of each factor is assumed to be homogenous.

(d) The relative endowment of these two factors in two countries is different. One country is, say, capital abundant and the other country is, say, labour abundant.

(e) The factors of production are fully mobile within each region of a country while they are relatively immobile in between any two regions or two countries.

(f) The demand conditions (consumers’ preferences), as also the physical conditions of production are constant in both countries or regions.

(g) Perfect competition prevails in factor markets as well as commodity markets. There is full employment of both the factors, in each of the two countries.

(h) Each country can produce two commodities. Each commodity is subject to the constant returns to scale in both countries. There are no external economies or diseconomies.

(i) The method of production and the production function for both the commodities are same in different countries.

(j) There is free trade between the two countries. Transport costs between the two countries are ignored.


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Simple Model of Heckscher-Ohlin Theory of Factor Proportions According to the modern theory of international trade, differences in commodity prices are the immediate causes of the inter-regional or international trade and specialisation. The differences in the commodity prices are caused by the differences in the prices of factors. The differences in the factor prices in different regions or countries are caused due to the differences in the factor endowments. So, the basis of trade is the differences in factor endowments and differences in production function. Prof. Sodersten has rightly remarked:

“In a world where factors of production cannot move between countries but where goods can move freely, trade in goods can be viewed as a substitution for factor mobility. – Prof. Sodersten

The modern theory of international trade has two aspects:

(a) Factor Endowment: According to the Heckscher-Ohlin model, factor endowment is the cause of inter-regional and international trade.

(b) Factor Price Equalisation: According to the Heckscher-Ohlin model, factor price equalisation is the effect of international trade.

Factor Endowment:

According to the modern theory of international trade, difference in the commodity prices in two regions or countries is the basis of international trade. The differences in commodity prices are caused due to differences in their cost of production. The cost differences between two countries are due to differences in factor prices, resulting from the differences in relative factor endowments in two countries.

Factor endowments in two countries, viz., country I and country II, can be explained in terms of their relative prices as under:

(a) In a capital rich country, the ratio of prices of capital to labour would be lower than labour rich country:

L1k1

PP <

L2k2

PP

Thus, a capital rich country will export capital-intensive goods and import labour-intensive goods from a labour rich country.

(b) In a labour rich country, the ratio of prices of labour to capital would be lower than capital rich country:

K2L2

PP <

K1L1

PP

Thus, a labour rich country will export labour intensive goods and import capital-intensive goods from a capital rich country.

In the above price relations,

PK1 stands for price of capital in country I.

PK2 stands for price of capital in country II.

PL1 stands for price of labour in country I.

PL2 stands for price of labour in country II.


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Ohlin’s theorem may be verified diagrammatically in Fig. 1.1.

Fig. 1.1 Heckscher-Ohlin Model of Factor Endowment

Fig. 1.1 depicts ‘xx’ and ‘yy’ isoquants (equal product curves) for two commodities ‘X’ and ‘Y’ respectively. These two isoquants intersect only once so that the commodities ‘X’ and ‘Y’ can be classified unambiguously according to factor intensity. It can be clearly seen that commodity ‘X’ is relatively capital-intensive, since the amount of capital is represented on the vertical axis. Similarly, commodity ‘Y’ is labour-intensive, since the amount of labour is represented on the horizontal axis.

Let us assume that there are two countries, country I and country II, of which country I is the relatively capital-abundant and country II is labour abundant. Now all possible factor combinations (of labour and capital) that can produce the given amounts of two commodities ‘X’ and ‘Y’ in each country can be read off from the two isoquants.

Economically, the most efficient factor combination, however, depends upon the relative factor prices. To consider this, let us assume that the slope of the line PA represents the relative factor prices in country I, i.e., (PK1/PL1). The line PA is tangent to isoquant ‘yy’ at point Q. Similarly, isoquant ‘xx’ is also tangential to PA at point Z. Since we have assumed that (PK1/PL1) < (PK2/PL2), i.e., capital in country I is relatively cheaper, the slope of the line representing relative factor prices (PK/PL) in country II must be less than that of PA. Thus, line P’B is supposed to represent factor ratio in country II. Line P’B is tangent to the isoquant ‘yy’ at point T. Now, the line RS is drawn parallel to P’B such that it becomes tangent to the isoquant ‘xx’ at point M. Line RS lies above the line P’B implying that OR intercept of RS on the capital axis is greater than OP’, the intercept of P’B on the same axis.

Under these assumptions, it appears that the equilibrium factor proportions are OZ for commodity X and OQ for commodity Y in country I. That means, the cost of producing the given amount of commodity X in country I is the cost of using the quantities of two factors – labour and capital – indicated by OZ at relative factor prices given by PA. This is equal to the cost of using capital in the amount of OP (the point at which PA

LABOUR


17

cuts the capital axis). Similarly, the cost of producing the given amount of commodity Y in country I is equal to the cost of using capital in the same quantity (OP).

Similarly, in country II, the equilibrium factor proportions are OM for commodity X and OT for commodity Y. The relative factor prices are shown by P’B (or RS). Therefore, the costs of producing the given amounts of commodity X and commodity Y (as assumed for country I) in this country are, in terms of capital, OR and OP respectively. Evidently, in country II the given amount of commodity X is more expensive than the given amount of commodity Y.

Comparing the relative costs of the equal amounts of the two commodities X and Y in the countries I and II, we find that commodity X is relatively cheaper in country I and commodity Y is relatively cheaper in country II. That means, the capital-abundant country has a comparative cost advantage in producing a capital-intensive commodity X. Thus, with the opening of trade with the other country, it must export commodity X. Likewise, the labour abundant country must export labour-intensive commodity, i.e., commodity Y.

This is how the Heckscher-Ohlin theorem confines to the position that a country exports goods produced relatively cheaper by using a relatively greater proportion of its relatively abundant factor.

In a nutshell, we can interpret Ohlin’s theory as under:

(a) Two countries I and II will involve themselves in trade, if relative prices of commodities X and Y are different. To quote Ohlin, “the immediate cause of inter-regional trade is always that commodity can be bought cheaper from outside in terms of money than they can be produced at home.”

(b) Under comparative market conditions, prices are equal to average costs. Thus, relative price differences are an account of cost differences. Cost differences are taking place because of the factor price differences in the two countries.

(c) Factor prices are determined by factors’ supply and demand. Assuming a given demand, it follows that a capital-rich country has a cheaper or a lower capital price and a labour-abundant country has a relatively lower labour price.

In short, a capital-rich and capital-cheap country exports capital intensive products while a labour-abundant and labour-cheap country exports labour-intensive products.

It also follows that trade takes place because of factor-endowment difference and their international immobility. Sodersten writes, “In a world where factors of production cannot move among countries but where goods can move freely, trade in goods can be viewed as a substitution for factor mobility.”

Ohlin gives the illustration of Australia and England in support of his theory. In Australia, land is plenty and cheap, while labour and capital are scanty and dear. So, Australia specialises in goods like wheat, wool, meat, etc., which are relatively produced cheaper there on account of their specific production functions requiring a larger proportion of land but little use of capital. On the other hand, England is capital-rich but labour- poor. Thus, goods requiring plenty of capital will tend to be relatively cheaper in England. Examining the trade between England and Australia, it may be observed that Australia imports manufactured or capital-intensive goods from England and exports wheat, meat, etc. Thus, Australia’s import is indirectly an import of scarce factors and her export is indirectly an export of factors in abundant supply.


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Factor Price Equalisation:

Factor price equalisation is an integral part of the Hecksher-Ohlin theory of international trade. According to the Hecksher-Ohlin theory, the main cause of international trade is the differences in commodity prices resulting from the differences in factor prices which are caused due to difference in factor endowments. Factor Price Equalisation theorem analyses the effects of international trade on commodity and factor prices.

According to the Factor Price Equalisation theorem, under the condition of free trade and the absence of transport cost, the relative prices of commodities tends to equalise in the trading countries and so are the prices of factors of production. Thus, the main effect of international trade is that it tends to equalise the prices of factors of production. However, complete factor price equalisation would not occur in the absence of free movement of factors from one country to another country. A complete factor price equalisation can occur only when factors are free to move between countries.

Country I is capital abundant country and country II is labour abundant country. Thus, capital is cheap and labour is costly in country I. As per the theory of international trade, country I specialises in the production of capital-intensive goods and imports labour-intensive goods from country II. Since country I specialises in the production of capital-intensive goods, the demand for capital increases in country I and so does its price. Since country I imports labour-intensive goods from country II, the demand for labour falls in country I and so does its price. Thus, in country I, price of capital rises and that of labour falls. The opposite forces work in country II, where the price of labour increases and that of capital falls. This continues till prices of both the factors equalise in these countries. Thus, free movement of commodities between countries bring about equalisation in the prices of factors in two countries.

Factor Price Equalisation theorem may be verified diagrammatically in Fig. 1.2.

Fig. 1.2 Heckscher-Ohlin Model of Factor Price Equalisation

In the diagram 1.2, ‘xx’ is the isoquant for capital-intensive goods ‘X’ and ‘yy’ is the isoquant for labour- intensive goods ‘Y’. These isoquants represent the production functions of the two commodities.

x

x

y

y

R

U

Y

A

P

C

O B L D

T

S

Country I

Country II

X

LABOUR


19

Country I, being capital-intensive, produces commodity X at point R, where the factor price line AB is tangent to the isoquant ‘xx’. Country II, being labour intensive, produces commodity Y at point U, where the factor price line CD is tangent to the isoquant ‘yy’.

Thus, there is more demand for capital in country I and labour in country II. Therefore, the price of capital will rise in country I and the price of labour will rise in country II. On the other, hand due to lack of demand, price of labour will fall in country I and the price of capital will fall in country II. Thus, the factor price line AB of country I becomes flatter and the factor price line CD of country II becomes steeper. This shifting continues till factor prices in both the countries become almost same. This is depicted by the new factor price line PL, which is tangent to the isoquant xx at point T and isoquant ‘yy’ at point S, indicating reducing gap between the factors prices in country I and II. In reality, complete factor price equalisation does not take place as the theory is based on several simplified assumptions.

1.12 Exchange Rate Mechanism and International Trade Import and export of commodities between two regions or countries I and II also depend upon the rate of exchange between their currencies. The rate of exchange helps to find out the differences in the prices of same factors in regions or countries I and II. This gives an idea of absolute differences in commodity prices.

Suppose that countries or regions I and II have Rupee as their unit of account and that each of them possesses four factors FA, FB, FC and FD. In the country I, the price per unit of each of these factors is Re. 1 and the price per unit of each of these factors in country Y is ` 0.40, ` 0.45, ` 0.60 and ` 0.70 respectively.

If the exchange rate between the Rupee of country I and the Rupee of country II is Re. 1 of country I = ` 2 of country II, then the factor price in country II, in terms of the currency of country I, would be as shown in column 4 of the following table. It shows that the factors FA and FB are cheaper in country II and that the factors FC and FD are cheaper in country I. Hence, country or region I will specialise in commodities requiring larger amounts of the factors FC and FD and country or region II will specialise in commodities requiring larger amounts of FA and FB.

On the other hand, if the rate of exchange is Re. 1 of country I = Rs. 1.50 of country II, the factors FA, FB and FC will be cheaper in country II and the factor FD will be cheaper in country I as shown in column 5. Hence country I will specialise in commodities requiring a larger amount of FD and the country II will specialise in commodities requiring larger amounts of factors FA, FB and FC.

1 2 3 4 5

Factors of Production

Factor Price in country I

(in `̀ Per Unit)

Factor Price in country II

(in ` Per Unit)

Factor Price in country II when the rate of exchange is Re. 1 of I = ` 2 of II

Factor Price in country II when the rate of exchange is

Re. 1 of I = ` 1.5 of II

FA 1 0.40 0.80 0.60

FB 1 0.45 0.90 0.671/2

FC 1 0.60 1.20 0.90

FD 1 0.70 1.40 1.05


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Thus, each region or country will specialise in and export ‘cheap factor-bounded commodities’ and import ‘dear factor-bounded commodities’.

When the trade takes place between countries I and II, the demand for cheaper goods produced by each of them will go up. This is because each of them will have to produce not only to meet the internal demand but also the foreign demand.

Further, Ohlin points out that the rate of exchange and the value of inter-regional or international trade are determined by reciprocal demands.

1.13 A Complex Model of Ohlin In order to make his theory more realistic, Ohlin has eliminated one after another, the assumptions on which his simple model was based and has tried to analyse its effect on direction and composition of international trade.

(a) Ohlin has extended the factor proportion approach or the general equilibrium approach to multi-country, multi-commodity model without altering the conclusions.

(b) He has also proved that even if two countries have identical factor units, there can be specialisation in these two countries and trade can take place.

(c) He has analysed the effect of increasing and decreasing cost conditions in both the countries on international trade. When goods are produced under increasing cost conditions in different countries, the volume of international trade would be reduced and vice versa.

(d) He has also considered the qualitative differences in factor resources in each country or region and has sub-classified them into groups of separate factors. This would make it possible to have an inter-regional and international comparison of the factor prices in the same group.

(e) Ohlin points out that because of the transport costs and the differences in its qualities, the same commodity is both exported and imported by a country. Further, transport costs may obstruct the tendency towards the factor price equalisation in any two countries.

(f) Ohlin also points out that due to the changes in the exchange rates, the prices of the internationally traded goods will change. Hence, there will be a change in the composition and the flow of international trade.

(g) Due to international trade, the demand for the abundant factors in each country would go up. Due to increase in demand, there would be change in the relative factor prices, which in turn would affect the flow and composition of foreign trade of each country.

(h) Ohlin’s simple model assumes a condition of perfect competition. But, in actual life, there is no perfect competition. Ohlin has considered the imperfect competition and its effect on the flow and the direction of international trade.

(i) A close contact between countries may enable a country to acquire new products, capital equipment and the technical know-how from abroad. Ohlin has considered the effect of these changes on the composition and direction of trade over a period of time.


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(j) Ohlin has also considered the effect of physical and social conditions on trade. He also considered the influence on trade due to mobility of certain factors and immobility of certain others between regions or countries.

(k) He has also considered the influence of tariffs, banking system, habits, language, customs formalities etc., on the trade between countries.

However, Ohlin did not overcome the assumption of full employment.

1.14 Criticisms of the Modern Theory of International Trade Though the Modern Theorem (or the Factor Proportions Theory) marks a considerable improvement over the Classical Comparative Cost Theory of international trade, it is not completely free from criticisms.

(a) Unrealistic Character: The modern theory is grossly unrealistic in character in-so-far as it is based on certain very oversimplified and unrealistic assumptions, such as, perfect competition, full employment of productive resources, absence of transport costs, similarity of production function in the two countries, absence of product differentiation, etc. These assumptions are unrealistic and even wrong. A theory built on the basis of such assumptions cannot bear any relationships to reality.

(b) A Partial Equilibrium Analysis: According to this theory, trade between two countries takes place due to differences in the relative prices of commodities, resulting from differences in factor endowments. However, the prices of commodities may differ due to other factors, viz., differences in the quality of factors, production techniques, consumers’ demand, returns to scale, etc. which have been ignored by the theory. Thus, the theory furnishes only a partial explanation of the phenomenon of international trade.

(c) Leontieff Paradox: According to the modern theory, relative factor prices in the two countries are determined by factor endowments, i.e., by the supply of productive factors. However, in reality, the relative factor prices are determined not only by the supply of productive factors, but also by their demand. Thus, if demand for a factor is more than its supply, then a capital-abundant country may specialise in the production and export of labour-intensive goods and vice versa. This is known as the Leontieff's Paradox.

(d) Commodity Prices Determine Factor Prices: According to this theory, trade between two countries takes place due to differences in the relative prices of commodities, resulting from differences in factor endowments in two countries. However, critics hold the view that price of a commodity is determined by its utility to the consumers. The demand for the commodity is direct while the demand for a productive factor is derived. Thus, it is the commodity prices, which determine the factor prices and not vice versa.

(e) Product Differentiation: According to the modern theory, trade between two countries takes place only when there are differences in their factor endowments. This is because the modern theory assumes that the products produced by two countries are homogenous or identical. This is rather an