Thalasar Ventures

Explain theory of Trade and Investment.

Ans. There have been a number of theoretical explanations on international trade and investment.

TRADE THEORY :

 Following are the trade theories: 

Classical theory :  there are two classical theories :

(i) Theory of Absolute Cost Advantage : Adam Smith compounded this theory of international trade in 1976.  He was of the opinion that productive efficiency differed among different countries because of diversity in natural and acquired resources possessed by them. The theory explains that a country having absolute cost advantage in the production of a product on the account of greater efficiency should specialize in its production and export. 

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For example, suppose country ‘A’ produces 1 kg of rice with 10 units of labour or it produces 1 kg of wheat with 20 units of labour.  Country ‘B’ produces the same amount of rice with 20 units of labour and same amount of wheat with 10 units of labour.  Each of countries has 100 units of labour. Equal amount of labour is used for the production of two goods in the absence of trade between them.  But when the trade is possible between two countries, ‘A’ will produce only rice and exchange a part of rice output with wheat from country ‘B’.  Similarly country ‘B’ will do. The total output of both the countries will rise because of trade.

(ii) Theory of Comparative Cost Advantage :  This theory is compounded by David Ricardo.  The theory explains that a country should specialize in the production and export of a commodity in which it possesses greatest relative advantage.  For example, Bangladesh and India, each of the two has 100 units of labour. In Bangladesh, 10 units of labour are required to produce to produce either one kg of rice or one kg of wheat.  On the contrary, in India, 5 units are required to produce one kg of wheat and 8 units are required to produce one kg of rice.

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From the viewpoint of absolute cost advantage, there will be no trade as India possesses absolute cost advantage in the production of both the commodities. But Ricardo is of the view that from the viewpoint of comparative cost advantage, there will be trade, because India possesses comparative cost advantage in the production of wheat.  This is because the ratio of cost between Bangladesh and India is 2:1 in case of wheat, while it is 1.25: 1 in case of rice.  Because of this comparative cost advantage, India will produce 20 kg of wheat with 100 units of labour and export apart of wheat to Bangladesh.  On the other hand, Bangladesh will produce 10 kg of rice with 100 units of labour and export apart of rice to India.  The total output of foodgrain in the two rises because of trade.

Govindam Business School

Limitations :   Despite of being simple, the classical theory of international business suffers of following limitations :

(i) It takes into consideration only one factor of production that is labour.  But in real world, there are other factors that play a decisive role in production.

(ii) The theory assumes the existence of full employment, but in practical, full employment is not possible.

(iii)   Theory stress too much on specialization that is expected to improve efficiency.  But it is not always the case in real life.

(iv) Classical economist feel that resources are mobile domestically and immobile internationally.  But neither of the two assumptions is correct

Summary : The Classical theory holds good even today insofar as it suggest how a nation could achieve the consumption level beyond what it would in absence of trade.

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