International trade means an exchange of goods and services between one country and another. In the modern world the system of international trade is very complex and involves a large number of countries and a still larger number of commodities.
International trade brings in the following advantages:(a) Countries can obtain the benefits of specialization; (b) They can obtain benefits of large scale production;(c) International trade increases competition and efficiency in production; (d) It leads to political affinities.The origins of international trade date back to the preindustrial period (1500-1750).
The body of economic ideas, which originated during this period and which came to be known as ?Mercantilism, related essentially to international trade, and emphasized the power of the merchant. It linked national wealth with foreign trade and supported intervention of the State in the economic affairs to maximize national wealth. It also provided a theory of international trade (called the balance of trade theory), according to which a nation could only gain wealth (in terms of precious metals) through foreign trade if it had a favourable balance or an excess in the value of exports over imports. The Classical Theory of Comparative CostsThis theory is mainly due to Adam Smith, David Ricardo, and John Stuart Mill. The theory is based on these assumptions (a) that there is perfect competition; (b) that there are constant returns-to- scale; (c) that there are no transport costs; and (d) that labour is the only factor that determines values.Suppose there are two countries A and B producing two commodities X and Y, In cases where the relative cost of producing X to that of Y is the same in both countries (i.e., when there are no cost differences), no trade will take place between them because neither country will gain by exchanging either X for Y or Y for X. But when there are cost differences and the relative cost of producing the two commodities in the two countries is not the same, two distinct cases are possible.Case 1: Absolute cost differenceThis is the case when one commodity is produced more cheaply in one country, and the other commodity is produced more cheaply in the other. When this happens exchange will take place between the countries to their mutual advantage. To illustrate this, let us take the following numerical exampleMan-hours per unit of outputCountryCommodity XCommodity YA6050B4055It is seen that X is produced more cheaply in country B, and Y is produced more cheaply in country A. A will specialize in the production of Y, and B will specialize in the production of X, and the two commodities will exchange for one another, and such a trade will benefit both the countries in terms of higher production (cost remaining the same as when both the countries were producing both the commodities). It is easy to verify this. Without specialization A has IX and 1Y and B also has the same. With specialization (A producing only Y, and B producing only X) A will have 1 X and 1.2Y and B will have 1.375X and 1Y (with the exchange of IX for 1Y between the two). Further, without specialization, total production is 2X and 2Y. With specialization total production is 2.375Xand2.2Y.Case 2: Relative (or comparative) cost differencesIn this case both the commodities are produced more cheaply in one country, and trade will still take place to their mutual advantage if each country specializes in the production of the commodity where its relative cost is lower than the other. Let us take the following numerical example which gives the cost (in terms of man-hours) of producing per unit of output X and Y in the two countries A and B such that the cost differences are relative.Man-hours per unit of outputCountryCommodity XCommodity YA6050B4045Cost per unit of production for X and Y are lower in country B. But B will gain more if it specializes in the production of X, and exchanges it for Y made in country A. This is because by so doing B produces 2. 125X, and exchanging IX for 1Y, it is left with 1.125X and 1Y (which is more than IX and 1Y which it would have produced had there been no specialization). Similarly, A specializes in the production of Y where its relative cost is lower (or relative advantage is more) than that in X. By so doing it produces 2.2Y, and exchanging 1Y for IX, it is still left with IX and 1. 2Y (which is obviously more than 1X and 1Y which it would have got had it produced both X and Y at home). Further, with specialization the total production will be 2. 125X and 2.2Y which is more than 2X and 2Y which is produced by the two countries in the absence of specialization and mutual trade.Weaknesses of the Theory1. It is not realistic in the sense that the assumptions on which it is based do not obtain in real life.2. It does not explain the pattern of trade among countries; it only demonstrates the gains from international trade.3. It does not explain the reasons why there are differences in relative costs of production.Internal and External TradeInternal trade is also called home trade, or domestic trade, while external trade is called foreign or international trade. Internal and external trades are similar in many ways(a) Both become necessary because of specialization (which we will discuss below) which eventually leads to exchange.(b) Both are based on the differences in the availability of human (labour, enterprise, organization) and non-human (land and capital) resources; internal trade between various regions within the same country takes place because the regions are endowed differently with regards to their resources; external trade between different countries similarly takes place because different countries are endowed differently in terms of their natural and other resources. Internal and external trades are different in the following waysInternal Trade External Trade(a)Same currencyDifferent currencies(b)Mobility of factors of production is free and easyproduction between countriesis difficult(c)Movement of goods and services is free because of the same government control over tradeMovement of goods and services is difficult becauseof various trade restrictionslike custom duties, importduties and quotas, andexchange control regulations;Distances are long;(d)Distances are smallDistances are relatively higher(e)Relatively lower transport costsRelatively higher transport costs(f)Same legal system, weights and measures, and trading; practicesDifferent legal system, weights and measures, and trading practices, and Different LanguagesThis is the ratio of export prices to import prices, expressed in terms of index numbers. (The terms of trade are also defined in terms of the rate at which a country exchanges its exports for imports.) A rise in this ratio (resulting from higher export prices as compared to the import prices) implies that the terms of trade are favourable for the country concerned, and a fall in this ratio (resulting from higher import prices as compared to export prices) implies that the terms of trade are against that country. In practice terms of trade are measured by the following formula:Index of average price of exports divided by Index of average price of imports X 100 divided by 1PAGE PAGE 3