Classical Theory of International Trade, International Economics Assignment Help

International Economics - Classical Theory of International Trade, International Economics

International Economics >> Classical Theory of International Trade

The first classical theory of interna­tional trade was propounded by Adam Smith, the founder of classical economics. His theory is known as the Theory of Absolute Advantage. It was later modified and improved by David Ricardo' and Robert Torrens'. The Ricardian Theory of Trade is known as Comparative Cost Theory of Trade. 

Weaknesses of Comparative Advantage Theory

Ricardo's theory of comparative advantage is based on certain simplifying as­sumptions. Although, it has still retained the interest of economists, it has been severely criticised over time for its simplifying assumptions. Ricardo's critics have suggested many improvements, which are briefly mentioned along with the criti­cism.

1.       Labour is not Homogeneous.

Ricardo assumed homogeneity of labour, which he considered as an 'approximation of reality'. This is, in fact, unrealistic. Labour is not homogeneous throughout the world. It varies in its skill and produc­tivity. With a high degree of specialisation, labour is not' mobile between occupa­tions. Therefore, wage differentials are quitelikely in the short-run, which affect both domestic' and external rate of exchange between commodities.

2.       Labour is not the Only Factor. Even if one assumes that labour is homoge­neous and wages ate uniform, labour is not the only factor of production. Ricardo's treatment of capital as being either insignificant or being used in fixed proportion td labour is again unrealistic. The factor combination varies from industry to in­dustry, depending on the technology used. Production of some goods may be highly capital-intensive resulting in large capital content in its cost. Under such condi­tions, the labour theory of comparative advantage would not apply.

Marshall tried to remove this shortcoming by expressing the value of traded commodities in terms of 'bales' which invariably represents the labour and capital in the cost. Another escape from this impasse has been provided by Haberler through the introduction of the concept of opportunity cost to the theory of trade. Accord­ing to him the cost of each commodity should be expressed in terms of loss of production of other commodities. For example, if per worker and per day produc­tivity in India is 10 kilogram of rice or 50 kilogram of jute, then the ,opportunity cost of 1 kilogram of rice is 5 kilograms of jute and vice versa. This improvement will be discussed later at length.

3.       Demand-side Ignored. The theory of comparative advantage concentrates only on the supply side of the trade, It means, so long as there is comparative advantage in trade, two countries will trade their produce between them. It also suggests that barter rates based on comparative advantage would be beneficial to the trading partners. The theory however does not answer the questions: (i) how are the price ratios determined between trading' partners? and (ii) what quantities would be traded? Attempts were later made by J.S. Mill, and then by Edge worth and Marshall to provide answer to these questions. J.S. Mill introduced the concept of reciprocal demand, i.e., the demand by each country for the produce of the other. Later, Edge worth and Marshall translated the concept of reciprocal de­mand into offer curve and used them for determining the quantum of trade be­tween the two-countries and price thereof. These improvements are discussed in detail in Chapter 4.

4.       Ricardo's Theory is Based on Invalid Labour Theory of Value. The most serious attack on Ricardo was 'on the point that his theory is based on the labour theory of value whose validity has been questioned. As mentioned above, goods are produced not by using. labour alone but by a combination of several factors of production, mainly labour and capital. Some industries are highly capital-inten­sive, e.g., car industry. The capital content in the cost of production of car is much larger than the labour content. The value of car based on its labour content alone would be highly unrealistic. This has a wider implication in the determination of internal or external rates of barter between the commodities. For instance, the labour content in car production would be much less than that in wheat produc­tion, on comparable basis. But it does not mean that car is cheaper than wheat. For example, suppose 100 man-hours and 10 machine-hours produce 10 quintals of wheat, and 100 man-hours and 100 machine-hours produce 1 car. If machine ­hours used in the car and wheat production are ignored, it will mean 1 car = 10 quintals of wheat. But this method of obtaining relative prices is absurd.

Ricardo had assumed that prices of commodities would be proportional to the labour time embodied in the commodities, and had argued thatthe trade pattern ' would be ultimately governed by the relative share of labour content in the traded commodities. J.S. Mill' and Nassua Senior", however pointed out later that prices might not be strictly proportional to labour-time and this might affect trade pat- ' tern. Mill argued also that it is not the labour-time but the labour productivity that matters.

5.       Ricardo Ignored the Cost of Transportation. In the real world, transporta­tion cost is an important determinant of internationally traded goods. High trans­portation cost might not only change the barter terms of trade, but also reverse the trade pattern. This might-change the pattern of specialisation contrary to one sug­gested by Ricardo's theory of comparative advantage without transportation cost. It has been empirically shown, by using distance as one of the variables determin­ing trade flows, that transportation cost alters materially the actual trade flows.

6.       Specialisation is Limited by the Size of Countries Graham has demon­strated that complete specialisation or international division of labour is not pos­sible in reality, even on the assumptions of comparative advantage theory. One practical limitation arises due to difference in the size of various countries. Some countries are much bigger in size and population than others. This difference introduces difference between their production possibilities, economic perfor­mance, and their needs. Such differences 'limit the possibility of complete between the larger and smaller countries. Recall our example of India and Bangladesh as two trading partners and look into their trade prospects. Bangladesh is assumed to be more efficient in jute production and India more efficient in rice' production. According to the theory of comparative advantage, India would specialise in rice and Bangladesh in jute production. But, while it may be possible for India to meet the total rice demand of Bangladesh, it may not be possible for Bangladesh to meet India's total demand for jute. Under these conditions, India will have to 'allocate a part of her labour force to jute production. Furthermore, Bangladesh may not be capable of buying the total exportable surplus of India. This imposes a limitation on India's specialisation in rice production.

7.       Nature of Goods Limit Specialization. Another kind of limitation to com­plete specialisation arises due to the commodities of high and low values. It will 'be easier for the countries producing commodities of high values to specialise in high­ value goods, but it is undesirable for the countries producing low-value goods to specialise in its production for a long time.' Consider the case of developed and developing countries. Most developing countries produce and export primary goods (raw materials, agricultural products, etc.) and import manufactured, high-price goods from the developed countries. This pattern of specialisation and trade seri­ously injures the long-term economic interest of the developing countries. These countries, therefore, adopt overtime the policy of import substitution. 

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