J

INTERNATIONAL
TRADE

1.1 Meaning of International Trade

1.2 Scope of International Trade
1.3 Importance of International Trade
1.4 Difference Between Interna I and International Trade

MEANING OF INTERNATIONAL TRADE

— —
International trade deals with the exchange of goods and services
between countries. No country is self sufficient, that is, it cannot
produce all the required goods and services. Like internal trade,
international trade is the consequence of human 'propensity to truck,
barter and exchange one thing for another'.1 Accordingly a country
produces goods and services which it can produce at a lower cost
and export them, after satisfying the domestic demand, to other
countries. Similarly, it imports those goods and services which it
cannot produce at home or it can produce but at a higher cost than
other countries.
Historically goods, consumer and capital comprise a major part of
international trade. Since the second half of the 20th century, trade
in services became prominent. Today, trade in services is larger than
trade in goods in the international trade of many countries. After
-
1. Adam Smith : English (Scottish) Economist Wealth of Nation (1776).
Considered as the Father of Economics.
2 international Economics (T.Y.B.A.: SEM^
the formation of WTO in 1995 and drive for globalisation, the sharQ
of international trade in the Gross National Product (GUI ) has been
increasing.

1.2 SCOPE OF INTERNATIONAL TRADE

The term 'scope' refers to the wide range of activities related to the
subject matter. Thus the scope of international trade covers the
following aspects.
1. Cause and need for trade : Trade takes place as countries
produce goods and services at a lower cost than others and
export them and import goods which will cost them more to
produce at home.
2. Terms of trade : Trade involves exchange of goods and services
The rate at which exchange takes place is called terms of trade
In money terms it is price ratio of exports and imports, that is
Px//Pnr
1 1

3. Foreign exchange marketand rate : International trade involves

different currencies. Accordingly, international trade leads to
foreign exchange market and determination of exchange rate.
4. Balance of payments : Foreign trade involves receipts and
payments hence an account is required to be kept, which
involves the study of deficit and surplus in balance of payments.
5. Foreign exchange reserves : Surplus in balance of payments
results in foreign exchange reserve. Reserves are required to be
maintained to enable a country to meet the deficit in payments.
It further leads to the study of foreign exchange components or
the currencies or assets in terms of which foreign exchange
reserves are to be maintained.
6. Trade policies : Free trade is advocated by many economist
and also by world trade organisations and other international
organisations. Each country, however, is required to determine
its trade policy, the liberal trade or restricted trade and the extent
of liberty and restrictions.
 International Trade 3
7. Instruments of trade policy : Implementation of trade policy
involves policy instruments, that is, tariffs, quotas, exchange
control, subsidies for exports and so on. A country needs to
understand the impact of each instrument on its economy.
8. Foreign investment : Foreign trade leads to flow of capital in
and out of the country in the form of Foreign Direct Investment
(FDI), Foreign Portfolio Investment (FPI) and also borrowing
from international institutions such as IMF, IBRD and also from
private multinational banks. All these requires proper
management in order to safeguard domestic economy.
9. Trade agreements : Many countries try to promote trade
through Regional Trade Agreements (RTA). Such agreements
must be formulated, keeping in mind domestic interest as well
as compliance of global trade norms.
10. Globalisation : In the post second World War (WW II),
international trade was regulated and guided by multinational
trade organisation, that is, by General Agreement on Tariffs
and Trade and since 1995 the World Trade Organisation (WTO).
It is obligatory for member countries to adhere to the rules of
such organisations. At present we have IBRD (World Bank),
International Monetary Fund (IMF) and World Trade
Organisation (WTO) besides regional institutions like Asian
Development Bank (ADB), Infrastructure Bank.
From the above analysis we can infer that international trade leads
to understanding and following the norms related to international
trade. Within the framework, the scope of international trade
demands a country to promote its development and welfare without
violating the laid down rules and regulations.

1.3 IMPORTANCE OF INTERNATIONAL

TRADE

The importance of international trade can be analysed through its

positive economic, political and cultural effects on the participating
countries. They are :
 25

HECKSCHER-OHLIN
THEORY

4.1 Introduction
4.2 General Equilibrium Approach
4.3 Heckscher-Ohlin or The Modem Theory
(A) Factor Intensity
(B) Factor Abundance
4.4 -
Factor Price Equalisation Effect of Trade
4.5 Limitations of Heckscher-Ohlin Theory
4.6 Comparison Between Ricardian and Heckscher-Ohlin
Theory
4.7 The Leontif Paradox

4.1 INTRODUCTION

The drawbacks of the classical theory of international trade induced

the Swedish economist Prof. E. Heckscher (1919) to develop an
alternate explanation of comparative advantage theory. His theory
was further improved by his pupil Bertil Ohlin (1933).
Heckscher-Ohlin (H-O) theory argues that there is no need for a
separate theory to explain international trade. According to it,
international trade is but a special case of interregional trade. Factor
immobility which was the base for a separate explanation of
 International Economics (T. Y .R
V economists, does not hold
»«,1 trade bv classical
27
even between two regions Heckscher-Ohlin Theory
re mobile or immobile international trade, space is important. Incorporating the space
element in international trade and applying the general theory of
ho.
j, rather than in nature. value, the prices of commodities can be determined in
of international trade, to
different
Ohlin is a
theory according
the regions of one nation may b markets. The theory and is based on a mutual interdependence
With political changes multi-market
different countries as it
happened with the former Union of s • approach.
Socialist Republic (USSR). The problem
of different currencies°Vlet
rate based on purchasing Po Can
be eliminated through the exchange
parih . Thus the major differences between internal and interna ti 4.3 HECKSCHER-OHLIN OR
trade disappear making the latter an extension of internal trade^1 THE MODERN THEORY
(H-O) or The Modem Theory explains the new
4.2 GENERAL EQUILIBRIUM APPROACH Heckscher-Ohlin
to comparative advantage on the basis of general
value
approach that work together in general equilibrium,
theory. From all the forces
OHin argued that the interregional trade is based on the principle differences in the physical availability or
ot general theory of value (general equilibrium). This approach H-O theory isolates the among the nations to explain the
based on mutual interdependence. According to this principle, prices
is supply of factors of production
commodity prices and trade between the
of commodities and factors of production are determined difference in relative theory "a nation will export the
and supply forces and these prices are
by demand countries. According to the requires the intensive use of the
mutually interdependent. commodity whose production
For example, commodity prices are cheap factor and import the
and supply . Demand for a commodity
determined by their demand nation's relatively abundant and intensive use of the
on its price and consumers income. besides other things depends commodity whose production requires the
the prices of factors which they Income of people depends on nation's relatively scarce and expensive factor".
own. Prices of goods are based on to international theory
H-O theory explains the modem approach:
the cost of production which in
turn depends on factor
to the factor owners. Demand prices paid
for goods and their on the basis of the following assumptions
factor prices (factor income) supply based on
determine the price of goods two factors (Labour and
Factor price is determined by 1. There are two countries, each having
Demand for a factor is a derived demand for and supply capital) and producing two commodities.
demand i.e. derivedoffrom a factor
commodity and factor
demand for commodities. An 2. There is perfect competition in both
in an increase in demand for increase in demand ror goods ..
the

—
j

depends on the abundance or

factors of production tosh Its markets.
scarcity of that Si of the first degree
The above description brings out
the factor ’ i k °* iaC*OrS 3. All production functions are homogeneous to scale.
and factors markets. All interdependent* °
economic forces i.e. production is subject to constant returns
the price of the final therefore joi comm°dity
commodities. jointly determine and immobile between
The general equilibrium
4. Factors are mobile within the country
analysis explained countries.
single market in a country. above is an
only the time element andAccording to Ohlin, it takes
snad'i?able
to a supply-
fails to consider the 5. The two countries differ in factor
P L cacc°unt
fact«r. tn 6. Each commodity differs in factor
intens’ y
 (T Y.B.A . SEM-V])
International Economics Heckscher-Ohlin Theory
the commodities but are same 29
28 k differs between i.e. if good X is labour be noted that it is not the absolute amount of capital and labour
7. Factor in^ns^> foreach commodity
both countries. However goods X and
the ratio of the total amount of capital to the total amount of
but
in
TvS be so in Country 1 may have a lesser quantity of capital than country 2,
labour.
country 1 will be capital abundant if TK to in country 1 is greater
yet
economies. than in country 2.
TL
8. full employmen!
of factor «»*» *
restrictions in the form of Factor Abundance and the Production Frontier
Trade is free i.e. there are no trade
9.
tariffs or non-tariff barriers. A country produces a large quantity of that commodity which
model; and Game theory . requires more of its abundant factor. If country II is labour abundant
10.No transport cost. then it will specialize in the production of the labour intensive
be stated that each country- differs commodity, Figure 4.1 explains the situation.
Based on above assumptions it can
in factor endowments leading to
difference in factor prices. A country
abundance, specialises m
where factor price in is low due to factor
the production of that commodity which requires intense use of its
abundant factor.
Heckscher-Ohlin theory requires to be explained in terms
A. Factor abundance
B. Factor intensity
Factor abundance is measured by two criteria - they are (1) Factor
abundance in physical terms (2) Factor abundance in terms of factor
price.

A. Factor Abundance Commodity X is labour intensive.

Commodity Y is capital intensive.
1. Factor Abundance in Physical
Terms Country II produces more of X because it has more labour. Similarly
Nations differ in factor country I produces more of Y as the country has more capital.
resources, some have more
given country's
factor
terms or in terms of
J
amount r pital
endowments. Some have more natt*r
of labour and others more of capita
abundance can be defined either in pbys^a
relative factor prices. In our two
if in physical terms
(Tk) to the total
country mode
the ratio of to
^ Accordingly the production frontier curve of country II is skewed
towards the X-axis labour abundant) and of country I towards the
Y-axis (capital abundant).
amount of labour (TJ that is
T0innatalisgtealerthanna(.on2.e > n
lM tL2 •
 International Economics a.Y.B.A.: SEM-Vlj
Heckscher-Ohlin Theory 31
It can be stated as :

^<^1
Pl, %
The two definitions give us the same meaning. The physical
abundance explains the supply side. The price ratios are based on
the prices of factors determined by the demand for and supply of
factors. The demand for factors is derived demand i.e. derived from
the demand for commodities produced with the help of the factors.
In our two nations model, demand is assumed to be the same in
both the nations. In a country where the supply of physical units of
capital (K) is more, its price has to be lower in comparison to the
other factor (L). If in nation 1, the price of capital i.e. interest (r) is
less than the price of labour i.e. wage (w) and in nation 2, r is more
than w, then we have
In Fig. 4.2 AB and CD are the production frontier curves of country
I and D respectively. Commodity Y is capital rl < A.
intensive and X is labour
intensive. Country I can produce OA of Y i.e. CA quantity more w1 w2
than country II. Similarly country
II can produce OD of^ i.e. Here nation 1 is a capital abundant country.
quantity more than country I.
which is labour intensive Country II can produce more of X
because it is a labour abundant country Above aspect can be explained with the help of Fig. 4.3.
and country' I can produce
to its abundant capital. more of Y which is capital intensive due

pointe ^eS
andconsurnnH^n,6 respective
316
and ^2 countries I and II. The
equilibrium points of production
Y is cheaper in r ^2 indicate that commodity
trade. Xin country II, providing the basis for

0(
F"°r Pri“
Price of ^erence in commodity price-
commodity
differs
f C °rdePends on factor prices
a °uerefore
C°St Pr°duction which in
Undance theory in terms Vffact°r prices.
necessary to explain
A nation is ™S °f
ca •
i
 International Economics (T.Y.B.A.: SEM-^
a and b shown by the tw0 Heckscher-Ohlin Theory 33
L arp two commodities
In Fig. 43 are countries Le. I and II. Commodity B. Factor Intensity
isoquantsaa^e b labour intensive. The relative factor
3
by the factor price line PL. Assuming that In our two country two commodity model, commodity Y is capital
•
pnce m country I is given
county of a and b, countrv j intensive if the capital-labour ratio (K/L) in the production of Y is
SoN of capital and OM of labour to produce 1 unit of a at
point E, the point of tangency between
isoquant aa and factor price
greater than K/L used in the production of X. To explain with an
example, if commodity Y requires 2 units of capital (2K) and 2 units
line PL. Similarly, commodity b is produced with ON1 of capital of labour (2L), the capital-labour ratio (K/L) for producing
and OMj of labour. It could be observed that in country I capital is commodity Y is 2/2 = 1. For commodity X, if the required inputs are
cheaper than labour as more capital (OP) is available than labour IK and 4L, the capital-labour (K/L) ratio is 1/4.
(OL). Therefore country 1 specialises in the production of commodity
a which is capital intensive. The ratios can be stated as :

Country Il's price line is given by AB. For country II to produce For Commodity Y, the K/L = 2K/2L 1
commodity b it requires OR of capital and OQ of labour. For Commodity X, the K/L = IK/ 4L = 1/4
To find out the requirements to produce Here commodity Y is capital intensive and X is labour intensive as
we draw a factor price line CD parallel commodity in country
a, 11
to AB which is tangent to aa shown in table 4.1.
at points. It tells us that to
produce commodity a, country II require*' Table 4.1
OR] of capital and OQ] of
intensive, country II which labour. As commodity b is labour
is
commodity b. Country II beinglabour abundant will specialise tn Commodity Capital Labour K/L Ratio
a capital scarce it can not
Production of commodity a whichcountry
requires more of
Y 2 2 1
incmmtrvTilP?^ low for capital
country 1 and for labour
X 1 4 1/4
lines PUmd
specialise in AB^^ bY *eir respective factor price
J 11 1S therefore' natural for country 1 tl
wblcb n^ires more
Capital or labour intensity is not measured in absolute terms but by
the ratio i.e. units of capital per labour or units of labour per capital.
available in plentv ’ capital and it * In our example, K/L ratio for Y is 1 and for X is 1/4.
specialises in b
abundance making it whfchC0Unt7 1 makin§ U
cheaP Country B
cheaper thT labour which it has in Instead, if units of capital and labour used in the production of Y
are 2K and 2L where as for X, 3K and 12 L, commodity Y still remains
capital intensive though X requires more capital in absolute terms
sSS1 tenns °f faCtOr
abundances, that is in
A COuntry obviously W#
i.e. 3K. Capital used per labour in the production of X is 3K/12L i.e.
intensive production of
tha^’ 3/12 = 1/4. Where as for Y it is 2K/2L = 1 as shown in table 4.2.
T«
unders^^^reh^^X ?Undant
intensity We require
to exphin
which re<luireS
and cheap factor- Table 4.2
the concept of factor
Commodity Capital Labour K/L Ratio
Y 2 2 1
X 3 12 1/4
 IntenwfioMl Economics (T-Y.B.A.: SEM-VJ) Heckscher-Ohlin Theory
the factor ratios and not
54 . is measured by
Factor intensity, tr errefore
by absolute units.
two factors and two countries,
,
two commodities,
Inourexampleof^o ,f capital.labour
Surf“Cater
}
than the K/L ratio of X. To illustrate the point
production of one unit of Y requires two units of
Xl
L
2 labour (2L)- The aPi,al’labour rati0 WM oi
Y 2/2 = 1. Similarly, if the production
of X requires 3K and 12L,
the capital-labour ratio of X is 1/4. Here we say Y is capital intensive
and X is labour intensive.
It is to be noted that goods are not categorised based on absolute
quantity or units of capital and labour used in the production of a
unit of a good Y or X but the ratio of capital-labour of each
commodity. For example if Y requires 5K and 5L and X requires 6K
and24L,here good X requires more capital in absolute number than
Y. Yet in terms of ratio, it is Y which is capital intensive (5/5 = 1) In Fig. 4.4 (a) and (b), countries A and B are shown. In country A,
where as X is labour intensive (6/ 24 = 1/4). one unit of Y is produced with the help of 2K and 2L (1/1 = 1) that
is with capital-labour ratio of 1. X in A is produced by using IK and
Based on International Economics" by Dominic Salvatore, let us 4L (1/ 4) that is capital-labour ratio of 1/4.
understand the term factor
f ‘ '
intensity with the help of following
Similarly in country B, Y is produced by using 4K and IL that is
with the K/L ratio of 4.
The ratios are given by the slope of the ray from the origin for each
commodity shown in the diagrams. From the K/L ratio, it can be
understood that commodity Y is capital intensive and commodity
X is labour intensive in both the countries. Country B uses more
capital in the production of both commodities than country A, which
uses more labour in the production of both Y and X.
From our above discussion we can derive the following
conclusions:
(i) Each country differs in factor endowments, some have
abundant labour, some possess plenty of land and others have
huge amount of capital and so on.
(ii) Abundance of a factor makes it cheaper in terms of its price.
 International Economics a Y.B.A.: SEM-^ Heckscher-Ohlin Theory
of that commodity
specialise* in the production
36 37

low cost of production and in tun,

w„r price result in
low commodity
prices.
is the basis of international trade.
w Low commodity price

4.4 FACTOR PRICE EQUALISATION EFFECT -

OF TRADE

In international trade, commodities move instead of factors.

According to Ohlin "Commodity movement acts as a substitute
for factor movements in bringing about factor price equalisation"
Country I exports capital intensive 'a' commodity and imports labour
In a two country model with relatively large differences in their intensive 'b' commodity from country II. As per our earlier
endowments (capital and labour), prior to trade the prices of these discussion, prices of capital tend to increase in country I and of labour
factors will be different. With the opening of trade, each country in country II. At the same time, prices of the scarce factor in both the
will export the product of its abundant cheap factor. When export countries due to declining domestic demand tend to fall. With no
demand is added to domestic demand, prices of their abundant restrictions on trade, the process continues till prices of both factors
cheap factor will rise. At the same time the
domestic demand for in both countries are equalised.
products of scarce factors tend to
of such products decline due to the availability In Fig. 4.5 the factor price line AB gradually rotates counter clockwise
through imports. This will lead to a decline in the
ln each country' due to the prices of the sliding alongwith aa isoquant. CD factor price line slowly rotates
abundant 311(1 scarce clockwise, sliding alongwith bb isoquant, until the two factor price
factors
ors of nma
production tend to
factor falling the prices of both lines (AB & CD) coincide at PL. PL is tangent to aa at T and bb at S,
move towards the same level. indicating that factor prices in both the countries are the same.
(“i) identical producti^T perfect competition (ii) free trade It should be noted that complete factor price equalisation depends
returns to scale and ml £ * transPort cost (v) constant on the validity of all the assumptions noted earlier. Besides the
trade logically
explained in Fig.should
45
Xul* m factor priceconditions international
equalisation. This
quality of factors in both countries must be the same. Factor intensity
of commodities, at all prices, must remain the same i.e. commo ity
Country I nr(xj a, which is capital intensive should remain the same at al set o
factor prices. In the real world, in the absence of the require
S? 1
°" isoquant and country » assumptions and conditions, what one could experience is on y e
tendency towards factor price equalisation.
respectively 1 and 11
are can-? 1*andUnderstood from th«
S?1n respective countries.
Pdas a, ^our abundan'
Imitations
theory
of heckscher-ohlin

„ aiutic Assumptions : The Heckscher-Ohlin theory

_
International Economics (T.Y.B.A.: SEM-Vj) Heckscher-Ohlin Theory

6.
39
factors like technology, natural factors, different qualities of
labour etc. which influence the cost of production and hence
commodity prices.
Commodity Prices Neglected : According to H.O. theory
commodity prices depend on factor prices therefore, the cause
of international trade
to provide a better explanation of international trade is the difference in factor prices. Critics,
However, this theory too, like Ricardian
by analysing^ cause. however, point out that the demand for a factor is a derived
theory, is based on many unrealistic
assumptions. Besides the demand. Therefore, it is the demand for commodities that
usual assumptions of two countries, two commodities, perfect influence the price of factors and not the other way round.
competition, no transport cost etc. the theory also assumes no
qualitative difference in factors of production, identical
production function, constant return to scale and so on. All these 4.6 COMPARISON BETWEEN RICARDIAN
assumptions make the theory unrealistic. AND HECKSCHER-OHLIN THEORIES
Static in Nature : Like the Ricardian Theory the H-O model is
also static in nature. The theory is based on a given state of Ricardian Theory H.O. Theory
economy and with a given production function and does not
accept any change. (1) Two Countries Two Countries
Two Commodities Two Commodities
3. Demand Condition Neglected :
Like the classical theory, HO One Factor (Labour) Two Factors
toeory also emphasises on supply conditions. The supply of 2-2-1 Model 2-2-2Model
etermines its price and also specialisation in the
(2) Labour is the responsible Factor abundance is the
changes md
3
Demand is assumed to be the same. If factor for comparative responsible factor.
advantage.
undergo a change. If the
inC°rPOra,e<l (3) Expressed in term of labour Expressed in terms of (money)
theory of value. price theory.
4. Leontief Paradox . . (4) International trade requires International trade is a special
empirically tested H n
k” econ°mist W.W. Leonti a separate theory for case or extension of inter-
theorJ
According to H.0
S^musteWtcap^ n Under US-A. conditions
^^8 a CaPital abundant explanation. regional trade.
hX goods than pr^?^a*8°°ds and import lab°Uf (5) Neglects space element - it Space aspect is considered. It is
b™ h°™ ('about is scarce is one market theory. a multi-market theory.
apiS‘ USA Huuugh his empirical (6) Difference in labour efficiency Difference in factor supply is
Paradox' ^^‘^ones thi k°ur lntensive goods and taken into account.
is taken into account.
5.
wb-
h.5 ^h-ahon is Leontief (7) Adopted a normative Adopted a positive approach
^pr^^cted;^!
10n approach concentrating on and explained the causes of
function of H-o are considered in welfare aspect. trade. J
y- There
are many other
 jntematiawl Economics a.Y.B.A.: SEM-^
Heckscher-Ohli n Theory 41
TV

factor supply isl Difference in factor supply is industries. It explains that the US import competiting industries were
in
(8) Difference the main cause of difference in relatively more capital intensive than the export industries.
not considered.
Concentrated / cost of production leading to
' more on factor efficiency. As stated by Leontif, "America's participation in the international
difference in commodity prices. division of labour is based on its specialisation in labour intensive
rather than capital intensive lines of production. In other words,
the country resorts to foreign trade in order to economise in its capital
47 the LEONTIF PARADOX and dispose-off its surplus labour rather than vice versa."

The Heckscher-Ohlin theory states that a country specialises in the

Limitations of Leontif Paradox
production of that commodity which requires intensive use of
relatively abundant factor. It will import those commodities which Economists have criticised Leontifs conclusions, that is Leontif
requires intensive use of relatively abundant factor. It will import paradox.
those commodities which requires intensive use of relatively scarce
Leontifs conclusion that USA is a labour abundant country is based
factors. W.W. Leontif tested the above conclusions of Heckscher-
on the higher efficiency of its labour. American workers, according
Ohlin theory to USA's exports and imports. He arrived at a
to Leontif are 3 times more efficient than foreign workers. This
paradoxical conclusion that USA which is relatively capital abundant
and labour scarce country, exported labour
contention of Leontif was questioned by economist and termed as
intensive goods and "conceptual awkwardness".
imported capital intensive goods.
This paradoxical conclusion is
called Leontif Paradox. -
The year of the study 1947 was not a typical year due to post-war
Leontif, applying economic disorganisation.
«^d the Heckscher-Ohlin theory to USA's external trade.
Jeoiy by usingl947 input-output data of the USeconomv
It is pointed out that the input-output models are logically
requirements to produce one incompatible with international trade.
dollar
of USA's im ° S exports and mill‘d
also °ne million dollars worth Demand conditions in a country may be such that it may require to
^uirementsPo^ As sports and imports.
he tested produce commodities with abundant factors to meet the domestic
demand but may not export that commodity.
Tariffs distort the pattern of trade, thus may not reflect factor
^We^iCapitalanJ, . endowment. Leontif has not taken into consideration the impact of
of us ExX.1 Retirements per Million tariffs on trade pattern.

Capital

Leontif.s- results
vaults
— P°rta"dl"'P«n Replacement. 1947
- Exports
^^JmpomReplacement
182312
$13,991
$3,091,339

1
170,004
$18,184
Leontifs study is based on identical production function for a given
commodity between trading countries. In reality, this condition does
not hold good.
Due to the criticism, Leontif re-tested the earlier results and still
found it valid though the capital intensity of US import replacement
was less by 6 percent compared to the earlier study.
replacement revealed that the
industries was 30 percent
capital-labour ratio in 1
higher than
the US e pod
 5.1
5.2
KRUGMAN'S MODEL
OF INTERNATIONAL
TRADE

Introduction
Propositions of The Theory
44

S"
Krugman's Model of International Trade

5.2 PROPOSITIONS OF THE THEORY

m

Krugman's1 model, also termed as

(i)
(ii) Internal economies of scale
al—

— port cos, and

New Trade Theory' explains a

new approach or model of international trade on the basis of
proposition which overrides the assumptions of earlier theories.
Krugman's model is based on
Monopolistic competitive market

A. Monopolistic Competitive Market -

(iii) Product differentiation Similar-similar trade
B. Internal Economies of Scale (iv) Economic geography leads to the decline in average cost due
C. Product Differentiation Similar-Similar Trade to external economies of scale
D.
-
Economic Geography External Economies of Scale (v) Large markets where demand is higher, attracts location of
E. Large Market Higher
Industry
- -
Demand Location of
industry
Let us explain the model based on the above propositions.
5.3 Trade Pattern
Significance of Intra-Industry A. Monopolistic Competitive Market
Trade
Difference Between Inter-Country and market
1 rade Intra-Industry The real world does not operate in a perfectly competitiveHere the
but in a monopolistically (imperfect) competitive market.
J

firms are aware that they can influence the prices of their products
and they can sell more only by reducing the price.
been widely
Since 1980 monopolistic competition models have
5.1

Ricardo,
INTRODUCTION
International trade theories
Heckscher-Ohlin
with trade
between
expounded
differential resultingcountries
assumptions of in
perfect
in
—
(H.O.) and otherby Adam Smith,
dissimilar goodseconomis S Jea^
price
earlier
differential. based on
applied to international trade.

assumptions to get around the problem

1 Each firm is assumed to be able
rivals. So, if consumers
that of its
of
makes the following
The theory of monopolistic competitioninterdependence.

to differentiate its product from

want to buy this firm's

competition, They are ba$e

constant returns to l. Paul Krussau : Nobel
Laureate, 2008
 International Economics (T.Y.B.A.: SEM-Vy
Krugman's Model of International Trade
* particular proc . they willslight
not rush to buy other firms'
price difference. ProdUct
47
necessarily on the size of any one firm. Internal economies of scale
of a
products jus that each firm has a monopoly in its occur when the cost per unit depends on the size of an individual
X r product with an
insulated from competition.
industry and is therefore somewhat firm but not necessarily on that of the industry.
External and internal economies of scale have different implications

- Each firm is assumed to take the

en. In other words, it ignores
the prices of other firms. As a
prices charged by its rivals as
the impact of its own price on
result, the monopolistic
for the structure of industries. An industry where economies of scale
are purely external (that is, where there are no advantages to large
firms) will typically consist of many small firms and be perfectly
competitive.
competition model assumes that even though each firm is in
reality facing competition from other firms, it behaves as if it
were a monopolist. C. Product Differentiation - Similar-Similar Trade
The industry consists of a number of firms which produce Monopolistic competition and economies of scale promotes intra¬
differentiated products (heterogeneous products). In other words, industry trade. It is trade between the similar industries in different
goods that are not exactly the same but are substitutes for one countries. Usually it is the exchange of manufactures for
another. Each firm is therefore a monopolist, in the sense that manufactures. Where or when industries or countries trade in
it is the only firm producing different goods, say capital goods (machinery) and consumer goods
that particular good, but the
demand for its good depends on the number (garments), it is inter-industry goods.
products available, and of other similar
on the prices of other firms in the
industry. Intra-industry trade does not reflect comparative advantage. Even
if the countries have same overall capital-labour ratio, their firms
^Internal Economies of Scale would produce differentiated products.
Monopolistic competitive firms with benefit of economies of scale
Firms do not operate produce a large quantity of differentiated products and enter into
returns to scale due tounder constant returns but enjoy
inputs, will economies of scale. It means, intra-industry trade to meet consumers' demand for differentiated
more than double the o the products. A comparison of pattern of trade between 1910 and 1990
produce a limited range output. If industries in a untjy
instead of producing of goods where it enjoys reveals industrial countries traded more among themselves in 1990
gca|e,
would enter with a whole range of products, economies o than in 1910. Even India's trade with other developing countries
due to trade in then such in (similar countries and similar products) has increased in recent
economies of scale.goods which they produce at a lower decades.
How does
cadi countrybeneficial trade arise as
specialises in a result of D. Economic Geography - External Economies of
enables it to produce producing a economies of scale. I
these goods more limited range of products, 11 Scale
io be able
°r
e^icientlu than if it tried to .
to
consume thefull range anomies pro^
of goods. then trade with each of 1 Intra-industry trade provides large market and cheaper products
to the consumer.
cwt p«
P external economies of Fig. 5.1 explains effect of larger market on intra-industry trade.
umt depend,
unit den
on the
of the
industry, but n<*t
 International Economics (T.Y.BA: SEM-^ Krugman's Model of International Trade 4g
48
Consumers would prefer to be part of a large market rather than a
small one. At point Ev a greater variety of products is available at a
lower price than a point E.

E. Large Market - Higher Demand - Location of

Industry
The number of firms in a monopolistically competitive industry and
the prices they charge are affected by the size of the market. In larger
markets there usually will be both more firms and more sales per
firm. Similarly, consumers in a large market will be offered both
lower prices and a greater variety of products than consumers in
small markets.
To place this in the context of the model outlined earlier; consider
Fig. 5.1 : Effects of a Larger Market the curve CC in Fig. 5.1. CC showed that the average costs per firm
In the above diagram, Y-axis are higher even when more firms are there in the industry. If the
number of firms. Curve P indicates price and X-axis shows market grows while the number of firms is held constant, sales per
the total number of shows the negative relationship between firm will increase and the average cost of each firm will decline.
positive
firms and product price. Curve C shows e Thus, if we compare two markets, one with higher total sales of the
relationship between the number of firms and cost o industry than the other, the CC curve in the larger market will be
production. Larger market
production, which is results in lower average cost o below that in the smaller one.
shown by the
due to external downward shift of average cost
curve, that is C ,
Intra-trade resulted in more trade among developed/ industrial
An increase in economies of scale.
the size of the countries. A great deal of international trade is intra-industry trade
to produce market allows each firm, in differentiated products as opposed to inter-industry trade in
more and thus
have lower averageceteris paribus, completely different products. USA exports automobiles and
cost. This is
automobile parts to Canada, Mexico, Europe and Japan than to other
a 1
CC. CC2 The result is 3
of
to
countries. European countries trade more in differentiated products
eland fat) in (and hence in the
the price of each among themselves than with the rest of the world.
oi p. product.
‘jadibriiim is at point E, with a price The above explanation can be extended to the developing countries,
"^ured b, industry their trade among themselves has been increasing in recent years.
» saUcV “grease in the size of the market,
“ «1« „„ B^^theCCcurveasexplainedabove
‘"crease in the
For example in agricultural commodities, we in India get apples
from Kashmir and also from other countries. We export apples and
size the market also import them from other countries but of different varieties. It is
2
1 10 n2,
is at point Er a case of intra-industry (sector) trade in differentiated goods.
while the price fa"s
jQRADE PATT^1__-
The discussion up
International Economics a Y.BA.: SEM-V^
_
.to now has said little about the pattern of trade
To do that we need to
Krugman's Model of International Trade

will prefer Foreign varieties, even though the Home country is

5/
Home country produce. Since some consumers in the Home country-
running a trade surplus in manufactures, will import as well as
export within the manufacturing industry. In other words, even if

-
that results tive advantage to determine the Home country is a net exporter of manufactured goods, it will
As said be(ore import as well as export manufactures.
competitive industry a number of firms produce ‘ We can thus think of world trade in a monopolistic competition
differentiated products. model as consisting of two parts. There will be two-way trade within
the manufacturing sector. This exchange of manufactures for
Let us assume: manufactures is called intra-industry trade. The remainder of trade
(i) A world economy consisting of two countries, Home and is an exchange of manufactures for food which is called inter¬
Foreign. industry trade.
(ii) Each of the countries has two factors of production, capital and Accordingly, we can notice four points about the pattern of trade:
labour.
1. Inter-industry (manufactures for food) trade reflects
(iii) The Home country has a
higher overall capital-labour ratio than comparative advantage. The pattern of inter-industry trade is
the Foreign country . That is, that the Home country (the capital abundant country), is a net
it is the capital abundant countn
exporter of capital-intensive manufactures and a net importer
(iv) There are two of labour-intensive food. So comparative advantage continues
industries, manufacturesand food.
() to be a major part of the trade story.
Manufactures is the more capital-intensive
industry. 2. Intra-industry trade (manufactures for manufactures) does not
neite' counh^0^”^
ProductsbyS
mode1' ^ause of economies of scale. reflect comparative advantage. Even if the countries had the

manufactures ^s^tho^hK^
??Ugh Entries may produce some
°f manufaC‘U^ same overall capital-labour ratio, their firms would continue
to produce differentiated products and the demand of
monopolistically comoetiH be producing different things. The consumers for products made abroad would continue to
makes an important diffp nature generate intra-industry trade. It is economies of scale that keep
manufactures industry each country from producing the full range of products for itself,
thus economies of scale can be an independent source of

»1
“T>» Produ« sin“ international trade.

w,i
manufactures «P'“' The pattern of intra-industry trade itself is unpredictable. We
“"Ponta would relalivelX larger supf1!
therefor^6 “ have not said anything about which country produces which
Now, assume
M export manufactures
goods within the manufactures sector because there is nothing
lh.,„
in the model to tell us that. All we know is that the countries
. orne country will produce different products. Since history and accident
competitive determine the details of the trade pattern, an unpredictable
^tor^in ProduceH°wevera- the foreign
^Porter
o
Other ftrms)’
“^ufactures and an
component of the trade pattern is an inevitable feature of a
world where economies of scale are important. However, that
Uffe^^thosem thethatmanufactures
firms in the
 (T.Y.B.A.: SEM-V])
International Economics of intra-
Krugman 's Model of International Trade 53
52
. While the precise pattern trade, over and above comparative advantage. This because
unpredictabiiity is n sector is arbitrary,
manufacturesmanufactures the intra-industry trade allows countries to benefit from larger
industry trade w between and food markets.
underlying
differences between countries (ii) By engaging in intra-industry trade a country can
that is inter-industry
trade. simultaneously reduce the number of products it produces and
of intra-industry and inter-industry increase the variety of goods available to consumers.
The relative importance
4 similar the countries are. If the Home
trade depends on how are similar in their capital-labour (iii) By producing fewer varieties, a country can produce each on a
and the Foreign countries interindustry trade, and intra-industry
larger scale, with higher productivity and lower costs.
ratios, there will be little
trade, which is based ultimately on
economies of scale, will be (iv) Consumers benefit from the increased range of choice.
dominant. On the other hand, if the
capital-labour ratios are
country However, all these benefits will only be realised when;
very different, so that, for example, the Foreign
specialises completely in food production, there will be no intra¬ (a) Countries are similar in their relative factor supplies, so that
industry trade based on economies of scale. All trade will be there is not much inter-industry trade, and
based on comparative advantage that is inter-industry or inter¬
country trade. (b) When economies of scale and product differentiation are
important, so that the gains from large scale and increased
choice are large. In these circumstances the income distribution
5.4 SIGNIFICANCE OF INTRA-INDUSTRY effects of trade will be small and whether will be substantial
gains from intra-industry trade. The result may well be that
TRADE despite the effects of trade on income distribution, everyone
gains from trade.
A growing proportion of world
trade consists of intra-industry trade, Since intra-industry trade tends to be prevalent between countries
that is, two-way exchanges of that are similar in their capital-labour ratios, skill levels and so on;
goods within standard industria
glassifications. Intra-industry trade plays a particularly large role in it will be dominant between countries at a similar level of economic
Tie trade in manufactured development. Gains from this trade will be large when economies
goods among advanced industria
ations, which accounts of scale are strong and products are highly differentiated. This is
for most of world trade. Over time, the
" US^ have become increasingly
similar in their level5 more characteristic of sophisticated manufactured goods rather than
of raw materials or more traditional sectors such as textiles or
Since the o' $ ^^hility of capital and skilled labour-
footwear. Trade without serious income distribution effects, then,
and resources - 2ations ^ave become similar in technology is most likely to happen in manufactures trade between advanced
an industry, and comParative advantage with111
much of industrial countries.
of two-way exchanges hade therefore takes the for^
of scale. ‘ndystries'Probably driven in larSe
part by economies Krugman points out that where there is clear differences in factor
driven by comparative
The importance of
advantag^ ^^'industry specialisation endowments and hence cost difference "the old trade theory has
regained relevance"?
intra-ina
following: ustrY ^ade may be determined by the 1- Paul Krugman : The Increasing Returns Revolution
(i) Nobel Prize, Lecture, December 8, 2008.
Intra-industry trade nmd„.
from international
 Krugman's Model of International Trade 55
intcmadonol .
irine in comparative cost
REVIEW QUESTIONS
Explain Krugman's model of international trade.
1.
Differentiate between inter-industry and intra-industry trade.
2.
3. Explain the pattern of trade under increasing returns and monopolistic
competition.
55 industry trade 4. Write short notes on :
a
(a) Proposition of Krugman's theory
(b) Intra-industry trade
Intra-Industry trade (c) Pattern of trade under intra-trade
Inter-Country Trade (Krugman's Model) (d) Significance of intra-industry trade.
(Classical)
1. More realistic assumptions
1. Based on highly restrictive OBJECTIVE QUESTIONS
assumptions.
1 Factor endowments leading Z
Based on acquired Choose the correct option and rewrite the statement :
to comparative advantage. comparative advantage. i. Classical trade theories explain
(b) inter-industry trade
3. Perfectly competitive 3. Monopolitically competitive (a) intra-industry trade
market. (c) domestic trade
market.
2. Intra-industry trade is explained by If
4. Constant cost 4. Decreasing cost (a) David Ricardo (b) Samuelson
5. No economies of scale, -
5. Economies of scale both
3.
(c) Paul Krugman
Product differentiation resulted in more trade between
hence cost is constant internal and external - are in (a) similar countries (b) dissimilar countries
operation - hence cost (c) both (a) and (b)
decreases with large scale 4. Economic geography leads to
production. (a) external economies of scale (b) internal economies of scale
6 Commodities need not be 6. Products are differentiated- (c) diminishing returns to scale
differentiated e.g. 5. Intra-trade is based on
(a) difference in factor endowments
^E^clothandu-ine.
7- Trade between (b) difference in acquired comparative advantage
two 7 Trade in differentiated (c) both (a) and (b)
6. Inter-country trade takes place in
cloth and wine
or commodities. For example (a) different but similar products
^^turesandraw different brands of cars - (b) different commodities
material similar-similar commodities (c) only in services
7. Intra-industry trade is based on the assumptions
of
I. Dominic Salvature
(Reprint 2021). ———
‘'"““'‘"“‘I 1 '
GO
(c)
^utak-o.mp'tltkn
Monopoly
(b) Perfect competition
r