Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
11.8 QUESTIONS 
 
1) Explain PPP theory in brief. 
2) What are the causes of BOP disequilibrium? 
3) How is BOP deficit corrected? 
4) Explain BOP adjustments with reference to Devaluation.
5) Write a note on Currency crisis. 
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12 
 
Module 7 
 
INTERNATIONAL TRADE 
 
Unit Structure 
12.0 
Objectives 
12.1 
Introduction 
12.2 
Classical Theories of International Trade 
12.3 
Theory of opportunity cost 
12.4 
The Heckscher Ohlin Model 
12.5 
Summary 
12.6 
Questions 
12.0 OBJECTIVES 
To study the meaning of trade 
To study Classical Theories of International trade 
To study the meaning of opportunity cost and the concept of 
Production Possibility Frontier 
To study Heckscher 
–Ohlin Factor Endowment model and 
Leontief Paradox 
 
12.1 INTRODUCTION OF TRADE 
 
Why do nations trade? This question has bothered the minds 
of economists since early days. Within a given country people were 
used to exchanging things. In a barter economy the farmer 
producing rice was welcome to exchange it in favour of potatoes. 
Market prices were fixed by exchange ratios i.e., in order to have 
one unit of potato how much quantity of rice had to be sacrificed. 
But as between nations exchange of commodities needed some 
theoretical explanation. 
12.2 CLASSICAL THEORIES OF INTERNATIONAL
TRADE 
12.2.1 Absolute Cost Advantage:
The simplest explanation of trade between two countries 
was provided by Adam Smith in his Wealth of Nations (1776). The 
principle he enunciated as the basis of trade is known as theory of 
absolute advantage. Two countries say U.K. and U.S.A. are seen to 
be producing two commodities each. Let these commodities be 
bread and wine. Although U.K. produces both bread and wine, she 

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sells only bread to U.S.A. Again U.S.A. which produces both the 
commodities sells only wine to U.K. Now the question is what 
decides the commodity to be offered for sale to the other country? 
The answer that Adam Smith provided was that international cost 
differences were the most important explanation of trade. The 
country that sold bread to its partner must have produced bread at 
a lower cost. The country with higher cost of production for bread 
would be too eager to buy it in order to save resources. Now 
difference in cost must be due to difference in productivity. Smith 
assumed labour to be the only factor of production which means 
labour in the U.S.A. is more efficient in producing wine than bread. 
The opposite thing happens in the case of U.K. To start trade one 
country must have absolute cost advantage over the other in regard 
to a particular commodity. A country can expect to sell a commodity 
internationally only if it is cheaper.