The exchange of goods and services between two or more than two countries are known as international trade. In technical sense of expression, the export and import of goods and services between countries can be described as international trade.
Importance of international trade:
The significance of international trade can be described as follows:
i. Increase in GNP:
The international trade encourages the trading partners to produce more and more goods and services for export and import in each country. Such a situation helps to increase GNP of trading countries.
ii. Increase in income employment generation activities:
Due to international trade, the trading partners produce various exportable goods in the country. The production of exportable activities in the domestic economy.
iii. Encouragement to division of labor:
The foreign trade motivates trading countries to specialize the production of those goods and services in which concern countries have comparative advantage. In actual practice, such case also promotes the division of labor in the production of export promoting and import of substituting goods.
iv. Increase in the stock of foreign currencies:
The export of commodity by a country to (another) other countries helps to earn foreign currencies to the exporting countries. Such a case is known as resource gain, which increases the stock of foreign currencies of exporting countries.
v. Increase in Economic development:
The international trade helps to promote the development of the primary, secondary and tertiary sector of a country. The development of these sectors pushes up the level of economic development in trading country.
vi. Good foreign relation:
The international trade creates platform to improve the trade and foreign relation of the trading partners in actual practice.
vii. Availability of raw material
viii. Proper utilization of domestic resources:
Due to the function of export, the different countries produce the export promoting import substituting goods through the utilization of available domestic resources.
Comparative cost theory of international trade:
The concept of comparative cost theory was developed by David Ricardo, JS mills and others. According to this approach international trade is traded on the basis of difference in the cost of production. There are three cases or assumptions of differences in the cost of production of commodities between two countries.
Assumptions:
- Only two goods, say X and Y are produced.
- Only two countries, say Nepal and China are involved in trade
- There is free trade between these countries.
- The factor of production cannot move from one country to another.
The theory explains the conditions of international trade in three conditions:
- Equal costs differences
- Absolute costs differences and
- Comparative costs differences
a. Equal costs differences:
In the equal costs differences the ratio of cost to produce both goods will be equal in both countries.
Commodity Country
Nepal China
X 10 15
Y 20 30
1:2 1:2
According to the comparative cost theory, the international trade will not be beneficial because the cost ratio is equal.
b. Absolute cost difference
In the absolute cost difference, the ratio of cost will be just opposite to one and another.
Commodity Country
Nepal China
X 10 30
Y 20 15
Ratio 1:2 2:1
Opposite case,
In the table Nepal has absolute cost advantage in production of ‘X’ and China has the absolute cost advantage in production of ‘Y’. Therefore, there will be international trade in which Nepal produce only ‘X’ and China produces only ‘Y’. According to Adam Smith only the region for international trade is the absolute costs differences.
c. Comparative Cost difference:
Commodity Country
Nepal China
X 10 20
Y 20 30
1:2 2:3
In the comparative cost advantages. In the table Nepal has comparative advantages in production of both goods. But, Nepal will specialize in the production of ‘X’ only and ‘Y’ good is left for China. China will specialize in production of ‘Y’ because it will concentrate on the cost ratio of its production. By the production of ‘X’ Nepal will transfer all the resources from ‘Y’ to ‘X’ by which production and productivity will increase. On the other hand, China will use all the resources in the production of ‘Y’ only which also increases production and productivity. The cost of production will decrease in both countries.
According to Ricardo, the basis of international trade is the comparative cost differences among countries and he has extended the theory for more than two countries and two commodities.
Limitation:
Just two commodities and two countries.