Hi friends, in today’s article we are going to know about the modern theory of international trade with example, assumptions, diagram. So let’s discuss in details.
Table of Contents
Modern Theory of International Trade with Example
Modern economist like Bartil Ohlin and Eli Heckscher criticizing the classical theory or International trade, put forwarded another explanation of international trade which is known as modern theory or factor endowment theory or factor proportion or general equilibrium theory of international trade.
According to modern economist the basic reason of international trade is not the differences in comparative costs but the reason why cost differences occurs.
It should be noted that the modern economist does not invalidate the classical theory rather powerfully supplements. According to modern theory, the basic reason of international trade is the relative availability of factor endowments.
Different countries or region are differently abundant with different types of resources. Again factor intensity of different commodities are different due to these two countries cost of production and price differs from region to region or from country to country due to price differences international trade arises.
Thus according to modern economists the difference in comparative cost advantage occurs due to the following two reasons –
- The difference in relative scarcity of the factors of production.
- The input of different factor proportions required in the production function of different commodities.
According to this theory one country will produce and export only those commodities which requires more abundant factors and leave the production of other goods to other countries.
According to this theory immediate cause of international trade is the differences in prices and ultimate cause is why cost of production differs from country to country or from commodity to commodity.
Assumptions of Modern Theory of International Trade
The modern theory of international trade is based on which assumption, it means following are the important assumptions of modern theory of international trade –
- It is two by two by two model that is there are two countries say A and B two commodities say X and Y and two factors say labour and capital.
- Different countries factors supplies are different in quantity but qualitatively they are same in all countries.
- The factor intensity of different commodities are different but same in both countries.
- There is perfect mobility of factor within the same country and zero mobility among the countries.
- Production function of different goods are different but homogenous in all countries.
- Production function is subject to constant returns to scale.
- International trade is free from any type of foreign restriction.
On the basis of above assumption we can explain this theory with the help of following two criterion –
(i) Factor abundancy in price criterion.
(ii) Factor abundancy in physical criterion.
(i) According to price criterion, a country having capital relatively cheap and labour relatively dare is regarded as capital abundant country. Thus if country,
A is capital abundant and B is labour abundant then the ratio of price of capital to price of labour in country. A will be lesser than the ratio of price of capital to price of labour in country B. Symbolically – (Pk/PL)A < Pk/PL)B
In this situation the country A will produce an export capital intensive goods and country B will produce an export labour intensive good.
This export import relationship between A and B for x and y can be understood with the help of following diagram where the isoquant XX represents one unit of X and YY represents 1 unit of commodity Y.
Now from the diagram it is evident that to produce 1 unit of Y OC of capital and OD of labour is needed on the other hand to produce 1 unit of X the countries requires OT of capital and OR of labour.
This Y is capital intensive and X is labour intensive. That is why the country A will produce and export Y and B will produce and export X.
(ii) Factor abundancy in physical criterion. According to this criterion, country A is relatively capital abundant when we get (K/L)A > (K/L)B
Where K represents physical quantity of capital and L represents physical quantity of labour. If this is so country A will produce and export capital intensive commodity and B will export labour intensive commodity.
Conclusion
So friends, this was the concept of modern theory of international trade. Hope you get the full details about it and hope you like this article.
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