International trade: meaning, importance, and Ricardo's comparative cost theory

1. Meaning

International trade is the exchange of goods and services between countries. It is also called foreign or external trade, as distinct from internal (domestic or inter-regional) trade within one country. It consists of import trade, export trade and entrepôt trade (importing in order to re-export). Its historical background is in Historical perspectives and theories of international trade.

2. Internal and international trade distinguished

The classical economists said a separate theory was needed because factors of production move freely within a country but not between countries. The differences:

Ohlin argued that these are differences of degree rather than kind, and that international trade is only a special case of inter-regional trade.

3. Importance (merits) of international trade

1. International division of labour and specialisation: each country produces what it can make most cheaply, so world output rises.
2. Goods otherwise unavailable: oil, rare minerals, technology.
3. Wider markets and economies of scale for producers.
4. Lower prices and greater variety for consumers.
5. Economic development: developing countries import capital goods and technology and pay with exports.
6. Equalisation of prices of goods and, indirectly, of factors.
7. Relief in scarcity and famine: food can be imported.
8. Employment and income in export industries, and the foreign trade multiplier.
9. Competition and efficiency: domestic monopolies face foreign rivals.
10. Cultural and political ties and international co-operation.

Demerits

• Over-specialisation and dependence on a few exports, exposed to world price changes.
• Harm to infant domestic industries from cheap imports.
• Exhaustion of natural resources by heavy primary exports.
• Import of harmful or luxury goods; dumping.
• Transmission of booms, depressions and inflation across borders.
• Dependence in times of war; historically, economic domination and colonialism.

4. The comparative cost theory (David Ricardo)

Adam Smith (Wealth of Nations, 1776) explained trade by absolute advantage: each country exports what it can produce at a lower absolute cost. That leaves unexplained the case where one country is more efficient in everything. David Ricardo, in Principles of Political Economy and Taxation (1817), showed that trade is still beneficial if the comparative (relative) costs differ. A country should specialise in the good in which its comparative advantage is greatest (or comparative disadvantage least) and import the other.

Assumptions

• two countries and two commodities (2 × 2 model);
• labour theory of value: cost is measured in labour hours;
• labour is homogeneous, fully mobile within a country but immobile between countries;
• constant costs (constant returns to scale);
• full employment and perfect competition;
• free trade, no transport costs, and barter terms (no money).

Ricardo’s example

• Portugal is more efficient in both goods (absolute advantage in both).
• Its advantage is greater in wine: 80/120 = 0.67 of England’s cost, against 90/100 = 0.9 in cloth. So Portugal has a comparative advantage in wine.
• England’s disadvantage is least in cloth, so England has a comparative advantage in cloth.

Gains from trade. Without trade each country makes one unit of each good, using 220 + 170 = 390 labour units for 2 cloth and 2 wine. With specialisation England puts its 220 units into cloth and makes 2.2 cloth; Portugal puts its 170 units into wine and makes 2.125 wine. The same labour now yields 0.2 more cloth and 0.125 more wine. Both countries can gain if 1 wine exchanges for anything between 0.89 and 1.2 cloth: say 1 wine = 1 cloth, England gets wine for 100 labour units instead of 120, and Portugal gets cloth for 80 instead of 90.

Terms of trade: J.S. Mill’s reciprocal demand

Ricardo showed the limits (0.89 to 1.2 cloth per wine) but not where within them the ratio would settle. J.S. Mill (Principles of Political Economy, 1848) answered: the actual terms of trade are fixed by reciprocal demand, the strength and elasticity of each country’s demand for the other’s product. The country whose demand is less intense gets the better terms.

Criticisms

1. Labour theory of value is unrealistic: capital, land and enterprise also enter cost. Haberler restated the theory in terms of opportunity cost, which saves the conclusion without the labour theory.
2. Two-country, two-goods model is too simple (Graham).
3. Constant costs ignore increasing and decreasing returns; with increasing costs, specialisation is incomplete.
4. Transport costs are ignored, though they may wipe out the cost difference.
5. Full employment and free trade are assumed; in practice tariffs and unemployment exist (Keynes).
6. Factors are not wholly immobile internationally (capital and skilled labour move).
7. It does not explain why comparative costs differ; Heckscher and Ohlin did (next note).
8. Static: it ignores technical change and development; it can lock developing countries into primary exports.

Merits. Despite these criticisms, the theory is the basis of the case for free trade. It shows that trade is mutually beneficial even between unequal partners, and the core idea survives restatement in opportunity-cost terms.

How this is examined

For the comparative cost essay: Smith’s absolute advantage in two lines, Ricardo’s statement, the assumptions, the table, the gains from trade in figures, Mill’s reciprocal demand, and the criticisms. Check your arithmetic: 220 labour units make 2.2 cloth; 170 make 2.125 wine. For “importance of international trade” give eight to ten merits; if the question says “merits and demerits”, add section 3’s demerits. For the internal versus international note, the table is enough.