International Business

2 Basics of International Trade

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1. Theories of International Business-Theory of Absolute Advantage, Theory of

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 Theory Of Absolute Advantage
◉ According to Adam Smith, who is regarded as the father of modern economics, countries should only produce
goods that they have an absolute advantage in.
◉ A country is said to have an absolute advantage if the country can produce a good at a lower cost than another.
Furthermore, this means that fewer resources are needed to provide the same amount of goods as compared to
the other country. This efficiency in production creates “an absolute advantage,” which allows for beneficial
trade.
Assumptions in Absolute Advantage
◉ 1. Lack of Mobility for Factors of Production- factors of production cannot move between countries.
◉ 2. Trade Barriers- There are no barriers to trade for the exchange of good.
◉ 3. Trade Balance- Exports must be equal to imports. This assumption means that we cannot have trade
imbalances,
◉ 4. Constant Returns to Scale- We will get constant returns as production scales, meaning there are
no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it should
take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to produce 4
 Theory Of Absolute Advantage
◉ four loaves of bread. However, if there were economies of scale, then it would become cheaper for countries to
keep producing the same good as it produced more of the same good.
Example of Absolute Advantage
◉ we assume that there are two countries, which are represented by a blue and red line and there are only two
goods are produced, Good A and Good B. From the table below, we can determine how many hours it takes to
create one product.

BLUE COUNTRY RED COUNTRY

GOOD A 2 10

GOOD B 8 4

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 Theory Of Absolute Advantage
◉ The Blue country has an Absolute Advantage in the
production of Good A (2 hours). Blue county has an absolute
advantage because it takes fewer hours to produce a unit of 
Good A than Red country, which takes 10 hours.
◉ Red Country takes fewer hours to produce Good B (4 hrs).
Therefore Red Country has an Absolute Advantage in the
production of Good B.
◉ As a result, Blue Country will be better off if it specializes
in the production of Good A. Red Country will be better off if it
specializes in Good B.

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 Theory Of Comparitive Advantage
◉ According to David Ricardo Comparative advantage is when a country produces a good or service for a
lower opportunity cost than other countries. For Ex-

Countries Per unit cost of Per unit cost Cost of Wine(for 1 Cost of Cloth(for 1
Wine of cloth unit of wine how unit of cloth how
much cloth to be much wine to be
sacrificed) sacrificed)
Portugal 80L 90L 80/90=0.88 90/80=1.12

England 120L 100L 120/100=1.2 100/120=0.833

Portuguese labor is more efficient than England labor in producing both the products. So Portugal possess absolute
advantage in both wine and cloth but if we see the exchange ratio in England one unit of cloth=0.83 unit of wine
and in Portugal one unit of wine= 0.88 unit of cloth. It is clear Portugal is more efficient in production of wine and
England is more efficient in production of cloth.
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 Theory Of Comparitive Advantage
So, they will produce only these goods in which they are more efficient than other. Portugal has comparative
advantage in production of wine, so it will export wine on the other hand England has comparative advantage in
production of cloth, so it will export cloth.
Assumptions:
1. There is free trade and no trade barriers.
2. There is no transport cost.
3. Labor is only factor of production.
4. Technical knowledge is unchanged.

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 Nature & Scope Of International Trade

◉ International Trade- It is the exchange of goods and services among the countries.

◉ Imports- It is the goods and services purchased from the other countries.

◉ Exports- It is the good and services sold to the other countries.

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 Problems Of Trade
1. Distance- Due to long distances it becomes difficult to establish close relationship between the buyer and the
sellers.
2. Diversity of Languages- It becomes difficult to understand the language of traders in other countries.
3. Transport and Communication- Long distances in foreign trade create difficulties of proper and quick transport
and communication.
4. Risk and Uncertainty- As the goods have to be transported to long distance they are exposed to many risks.
These risks may be covered through marine insurance but this involves extra cost in foreign trade transactions.
5. Lack of information about foreign traders- the seller has to take special steps to verify the credit worthiness of
the buyer. It is difficult to obtain information regarding credit worthiness.
6. Import and Export Restrictions- Exporters and importers have to fulfil all the custom formalities as well as
follow rules controlling exports and imports.
7. Difficulties in Payment- Foreign trade involves the exchange of currencies because the currency of one country
is not the legal tender in the other country. But exchange rates go on fluctuating
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 Problems Of Trade
8. Various Documents to be used- Foreign trade involves the preparation of a large number of documents both by
the importer as well as exporter.
9. Study of Foreign Markets- Every foreign market has it own characteristics. It has its own requirements customs,
traditions, weights, and measures, marketing methods etc.

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 Trade Barriers
Trade barriers are restrictions imposed on the movement of goods between countries (import and export).

Major purpose of trade barrier is to promote domestic goods than imported goods and thereby safeguard the
domestic industry.

Trade barriers can be broadly divided into tariff and non-tariff barriers.

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 Trade Barriers
◉ Tariff Barriers- A tariff is a tax imposed by a nation on imported goods. It may be a charge per unit, or it may
be a combination.
Arguments for Tariffs:
a) Tariffs protect infant industries.
b) Tariffs protect jobs. Unions and others say tariffs keep foreign labor from taking away.
Arguments against Tariffs:
a) Tariffs discourage free trade, and free trade lets the principle of competitive advantage work most efficiently.
b) Tariffs raise prices, thereby decreasing consumers’ purchasing power.

◉ Nontariff Barriers- Governments also use other tools besides tariffs to restrict trade. One type of nontariff
barrier is the import quota, or limits on the quantity of a certain good that can be imported.
 
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 Tariff Barriers
 1. Specific duty: It is based on the physical characteristics of the good. A fixed amount of money can be levied on
each unit of imported goods regardless of its price. E.g. Imposing of INR 100 on an imported shoe.
2. Ad Valorem tariffs: The Latin phrase ‘ad valorem’ means “according to the value”. This tax is flexible and
depends upon the value or the price of the commodity. E.g. Imposing tax of INR 50 for a INR 500 shoe and INR
100 for a INR 1000 shoe.
3. Combined or compound duty: It is a combination of specific and ad valorem duty on a single product, for
instance , there can be a combined duty when 10% of value(ad valorem) and INR 10 per kilogram(specific tax) are
charged on metal M.
4. Sliding scale duty: The duty which varies along with the price of the commodity is known as sliding scale duty
or seasonal duties. These duties are confined to agricultural products, as their prices frequently vary because of
natural and other factors.
5. Countervailing duty: It is imposed on certain import where it is being subsidized by exporting governments. As
a result of the government subsidy, imports become more cheaper than domestic goods, to nullify the effect of
subsidy, this duty is imposed in addition to normal duties.
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 Tariff Barriers
6. Revenue tariff: A tariff which is designed to provide revenue or income to the home government is known as
revenue tariff. Generally this tariff is imposed with a view of earning revenue by imposing duty on consumer goods,
particularly on luxury goods whose demand from the rich is inelastic.
7. Anti –dumping duty: At times exporters attempt to capture foreign markets by selling goods at rock-bottom
prices, such practice is called dumping. As a result of dumping, domestic industries find it difficult to compete with
imported goods. To offset anti-dumping effects, duties are levied in addition to normal duties.
8. Protective tariff: In order to protect domestic industries from stiff competition of imported goods, protective
tariff is levied on imports. Normally a very high duty is imposed, so as to either discourage imports or to make the
imports more expensive as that of domestic products.

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 Non-Tariff Barriers
1. LICENSES: License is granted by the government, and allows the importing of certain goods to the country.
2. VOLUNTARY EXPORT RESTRAINS(VER): These type of barriers are created by the exporting country
rather than the importing one. These restrains are usually levied on the request of the importing company.
E.g. Brazil can request Canada to impose VER on export of sugar to brazil and this helps to increase the price of
sugar in Brazil and protects its domestic sugar producers.
3. Quotas: under this system, a country may fix in advance, the limit of import quantity of commodity that would
be permitted for import from various countries during a given period. This is divided into the following categories:
a) Tariff quota: certain specified quantity of imports allowed at duty free or at a reduced rate of import duty. A tariff
quota, therefore, combine the features of a tariff and import quota.
b) unilateral quota: the total import quantity is fixed without prior consultations with the exporting countries.
c) bilateral quota: here quotas are fixed after negotiations between the quota fixing importing country and the
exporting country.
d) multi lateral quota: a group of countries can come together and fix quotas for each country.
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 Non-Tariff Barriers
4. Product standards: here the importing country imposes standards for goods. If the standards are not met, the
goods are rejected.
5. Domestic content requirements: governments impose DCR to boost domestic production.
6. Product Labeling: certain countries insist on specific labeling of the products. E.g. EU insist on products
labeling in major languages in EU.
7. Packaging requirements: certain nations insist on particular type of packaging of goods. E.g. EU insist on
packaging with recyclable materials.
8. Foreign exchange regulations: the importer has to ensure that adequate foreign exchange is available for import
of goods by obtaining a clearance from exchange control authorities prior to the concluding of contract with the
supplier.
9. Embargo: partial or complete prohibition of trade with any particular country mainly because of the political
tensions.

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Thanks!

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