5 Trade Theories
Transcript of 5 Trade Theories
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TRADE THEORIES
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What is Trade?- Exchange ofgoods and services
Why do we need to do trade?
Differences in cost are the basic cause of
trade. Every country will have goods that can
be produced cheaper than others. This
promotes them to export that product for
another. Eg. UAE can produce oil while
Japan can produce electronics and cars. Thetwo nations can trade with each other and
both are satisfied.
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How does a country decide
what to trade and with whomto trade?
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Adam Smiths theory of AbsoluteAdvantage-
Simplest example- Imagine USA needs 10 workers
to manufacture 1 helicopter but takes 20 men tobuild a luxury car.
Germany on the other hand needs 20 workers to
manufacture a
helicopter while only10 workers for the car.
Do they have anyDo they have any
advantage to trade?advantage to trade?
Or can they continueOr can they continue
doing what theyve been doing?doing what theyve been doing?
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Theres only one logicalTheres only one logical
decision to be made by bothdecision to be made by both
countries-countries- US must export copters to Germany andimport cars in return! Because instead of
wasting 20 men for making a car, they can
make TWO copters. If US sells it to Germanythey can get back TWO CARS for the cost of
one!
The result is maximum productivity and profit.
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Every country having absolute
advantage in the production and
distribution of every good is not
possible. So international trade is
important to everyone.
That is why when sanctions are
imposed on our trade, it affects us
a lot. (India, Pak, Iraq, NorthKorea)
Trade also depends on
relationships between nations.
Reason why heads of state keep
meeting other heads to discussbetter ties for the future. Eg. India
& China, Russia, US etc.
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But what if a country cancanproduce all the goods it
needs or another countrycannotcannot produce any goods at
all.Does it mean they should notDoes it mean they should not
and cannot trade?and cannot trade?
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David Ricardos ComparativeAdvantage Theory Eg. Suppose India and France are cotton and
wine producing countries. France can
produce 1 unit of wine with 50 man hours and
1 unit of cotton with 60 man hours. India on the other, the cost of producing 1
unit of wine is 100 working hours and 1 unit
of cotton is 80 man hours.Does it make sense for France to trade with
India?
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Yes, France must trade withIndia! Because if we calculate, the
cost for France for making 1unit of wine is 50/60 and 1unit of cotton is 60/50.
Which means 1 unit of wine
costs 0.833 units of cottonand 1 unit of cotton costs1.2 units of wine. ForFrance cotton is moreexpensive to make thanwine.
For India, 1 unit of wine is1.25 units of cotton. and 1unit of cotton is 0.80 units ofwine. Here wine is moreexpensive.
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Therefore bothcountries can benefitif they are willing to
trade with each other.India can manufacturecotton and sell toFrance in exchange
for wine and France isalso benefited viceversa.
To understand thepoint further, if theworld market price for1 unit of cotton issimilar to 1 unit of
wine, then France
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Logic?
To make 1 unit of cotton France has to spend
60 man hours which has the same value as 1
unit of wine made in 50 hours. France can
leave the cotton making work to India andsave those 10hours or add those 10hours
extra for making more wine.
India on the other hand can save 20 hoursevery time it makes cotton and gets back
equivalent amount of wine as needed.
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Heckscher Ohlin Theory (H-OModel) Goods differ in terms of the factors of production. Eg.Manufacturing of textiles is labour intensive whereas
producing microprocessors is capital intensive. Countries differ w.r.t. their factor capabilities. Eg. India
is high in labour but UK is high in capital. A country manufactures and uses those factors which
it has in abundance. Eg. US exports capital intensivedefense goods.
As with previous theories,
HO Model too is weak in the fact
that it states markets as being static
with factors also being constant.
Present markets change using
innovation, intelligence
(Indian software), taste and
need for the goods and other reasons.
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Strategic Trade Theory-Combination of the latest
trade theories. Key factors Increasing returns to scale- firms will produce andexport more and more inorder to lower costs througheconomies of scale.
Product differentiation- there can also be intra-industry competition. i.e. within the same industry wecan have trade. Eg. Japan will trade Toyotas and Hondawith Germany in exchange for Mercedes and BMWs.
Imperfect competition- companies might have to facevarious hurdles to sell to other nations. Eg. India mightgive special subsidies to Videocon so as to keepJapanese Sony and Aiwa costlier than domesticplayers.
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Externalities & spillover effects-Once a new technology product issold outside, other countries might
reverse-engineer and make their ownversions. Thus the original makersuffers losses of loss of market. IPrights and patents play a role.
Irreversible investments- eg. When
earth-moving equipment companieslike Caterpillar suffered huge lossesin 1980s they had no choice but tocontinue as such because
the costs for market reentry
would have been sky high
(building distribution
networks, partners etc.)