Ricardo's theory of comparative advantage shows that gains from trade are possible:

Only when one country has an absolute advantage in every good

Only under fixed exchange rates

Only when both countries have identical factor endowments

The Heckscher-Ohlin theory predicts that a capital-abundant country will:

Export only labour-intensive goods

Have no comparative advantage in anything

The Stolper-Samuelson theorem's key insight is that trade liberalisation:

Raises the real return to a country's abundant factor and lowers it for the scarce factor — trade has distributional consequences

Raises the return to every factor equally

Has no effect on factor returns at all

Intra-industry trade between similar developed economies (e.g. cars for cars) is best explained by:

The classical Ricardian model of comparative advantage in identical goods

The Balance of Payments always balances in an accounting sense because:

It is compiled using double-entry bookkeeping, so total credits equal total debits by construction

Governments legally require exports to equal imports

Exchange rates are always fixed

Remittances from workers abroad are recorded in the Balance of Payments under:

The current account (secondary income)

The capital/financial account only

A genuine balance-of-payments disequilibrium, as distinct from the routine accounting balance, refers to:

A persistent, unsustainable gap requiring policy adjustment

Any single year with a current account deficit

The fact that credits equal debits

A situation with zero foreign trade

Which of the following are components of a country's current account?

Primary income (investment income)

Foreign direct investment inflows

Theories of International Trade, Trade Under Imperfect Competition, and the Balance of Payments

Unit 5 turns to the economy's relationship with the rest of the world. This chapter covers the basic concepts and tools of international trade, the major theories explaining WHY countries trade, trade under imperfect competition, and the balance of payments; the next chapter covers exchange rates, gains from trade, trade multiplier, and trade policy/institutions.

1. International Trade: Basic Concepts and Analytical Tools

Adam Smith's theory of ABSOLUTE advantage says a country should specialise in and export the good it produces at a lower absolute resource cost than another country; David Ricardo's theory of COMPARATIVE advantage — the foundational result of trade theory — shows that mutually beneficial trade is possible even when one country is absolutely LESS efficient at producing everything, so long as its relative (opportunity-cost) efficiency differs across goods: each country specialises in the good in which its OPPORTUNITY COST is lowest relative to its trading partner, and both gain from trade regardless of which one is absolutely more productive overall.

⚠️ Absolute advantage is not required for gains from trade — comparative advantage is

The commonest error is thinking a country with no absolute advantage in anything cannot gain from trade. Ricardo's whole point is the opposite: comparative advantage is a RELATIVE concept (compare a country's own opportunity costs across goods, not one country's efficiency against another's in a single good), so as long as the two countries' relative opportunity-cost rankings differ at all, both can gain from specialising and trading.

2. Further Theories of International Trade

The Heckscher-Ohlin (factor-proportions) theory explains the PATTERN of comparative advantage itself, rather than just asserting it exists: a country will have a comparative advantage in, and export, the good that uses its RELATIVELY ABUNDANT factor of production intensively — a capital-abundant country exports capital-intensive goods, a labour-abundant country exports labour-intensive goods. The Stolper-Samuelson theorem, built on this framework, predicts that trade opening raises the real return to a country's abundant factor and lowers the real return to its scarce factor — trade has DISTRIBUTIONAL consequences within a country, not just aggregate gains, which is precisely why trade liberalisation creates winners and losers even when it raises total national income.

3. International Trade Under Imperfect Competition

Classical and Heckscher-Ohlin theories explain INTER-industry trade (exchanging entirely different goods, e.g. wheat for machinery) based on comparative advantage; they cannot explain the large volume of INTRA-industry trade actually observed between similar, similarly-endowed developed countries (e.g. Germany exporting cars to France while importing different models of cars from France). New trade theory (Krugman and others) explains this using economies of scale and product differentiation under monopolistic competition: even with identical factor endowments, firms in each country specialise in different varieties of a differentiated product, and trade lets consumers in BOTH countries access a wider range of varieties and lets each firm sell to a larger combined market, capturing scale economies that a purely domestic market could not support.

4. Balance of Payments: Composition, Equilibrium and Adjustment

The Balance of Payments (BoP) records all economic transactions between a country's residents and the rest of the world over a period, divided chiefly into the CURRENT ACCOUNT (trade in goods and services, income flows, and unilateral/current transfers) and the CAPITAL/FINANCIAL ACCOUNT (flows of financial assets — FDI, portfolio investment, loans, and changes in official reserves). Because the BoP is compiled using double-entry bookkeeping, it always balances in an ACCOUNTING sense (total credits equal total debits, by construction), but this is entirely different from ECONOMIC equilibrium: a current account deficit financed automatically by a capital account surplus (private capital inflows or reserve drawdown) is an accounting identity, while a genuine BoP DISEQUILIBRIUM refers to a persistent, unsustainable gap that requires policy adjustment (exchange-rate movement, reserve changes, or expenditure-switching/reducing policies) precisely because it cannot go on financing itself indefinitely.

Current account versus capital/financial account
Account	Chief components
Current account	Merchandise trade (visible), services trade (invisible), primary income (investment income, compensation of employees), and secondary income (remittances, grants).
Capital/financial account	Foreign direct investment, portfolio investment (equity/debt), external commercial borrowing, and changes in the central bank's foreign exchange reserves.

🎯 Why the BoP 'always balances' does not mean there is nothing to worry about

The accounting identity is a bookkeeping fact, not an economic judgement — a country can run a current account deficit financed by borrowing or reserve depletion for a long time, but if that financing is itself unsustainable (foreign lenders stop rolling over debt, reserves run low), the country faces a genuine balance-of-payments CRISIS despite the books having always technically balanced along the way. This distinction — accounting balance versus economic (dis)equilibrium — is exactly what the syllabus flags with its separate line on 'equilibrium and disequilibrium and adjustment mechanisms'.

Key takeaways

Ricardo's comparative advantage (relative opportunity cost) generates gains from trade even when one country has no absolute advantage in anything; only comparative advantage, not absolute advantage, is required.
Heckscher-Ohlin explains the PATTERN of comparative advantage via relative factor abundance; Stolper-Samuelson shows trade has distributional consequences — raising returns to the abundant factor, lowering returns to the scarce one.
New trade theory explains intra-industry trade among similar countries via economies of scale and product differentiation under monopolistic competition — something classical/H-O theory cannot explain.
The BoP's current account (trade, income, transfers) and capital/financial account (FDI, portfolio flows, reserves) always balance in an accounting sense; a genuine disequilibrium is a persistent, unsustainable gap needing policy adjustment.
Accounting balance of the BoP does not mean economic sustainability — a deficit financed by reserve depletion or borrowing can still culminate in a genuine balance-of-payments crisis.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Ricardo's theory of comparative advantage shows that gains from trade are possible:
1. Even when one country is absolutely less efficient at producing everything, so long as relative opportunity costs differ
2. Only when one country has an absolute advantage in every good
3. Only under fixed exchange rates
4. Only when both countries have identical factor endowments
Show answer
Answer: A — Even when one country is absolutely less efficient at producing everything, so long as relative opportunity costs differ
Comparative advantage is a relative, opportunity-cost concept: as long as the two countries' relative rankings of opportunity cost across goods differ, both can gain from specialisation, regardless of absolute productivity differences.
The Heckscher-Ohlin theory predicts that a capital-abundant country will:
1. Export capital-intensive goods
2. Export only labour-intensive goods
3. Refuse to trade at all
4. Have no comparative advantage in anything
Show answer
Answer: A — Export capital-intensive goods
The factor-proportions logic is that a country's relative factor abundance determines the pattern of its comparative advantage — a capital-abundant country has a comparative advantage in, and exports, capital-intensive goods.
The Stolper-Samuelson theorem's key insight is that trade liberalisation:
1. Raises the real return to a country's abundant factor and lowers it for the scarce factor — trade has distributional consequences
2. Raises the return to every factor equally
3. Has no effect on factor returns at all
4. Only affects the exchange rate
Show answer
Answer: A — Raises the real return to a country's abundant factor and lowers it for the scarce factor — trade has distributional consequences
Stolper-Samuelson shows trade opening is not distributionally neutral even when it raises aggregate national income — it creates winners (owners of the abundant factor) and losers (owners of the scarce factor) within each country.
Intra-industry trade between similar developed economies (e.g. cars for cars) is best explained by:
1. Economies of scale and product differentiation under monopolistic competition (new trade theory)
2. Absolute advantage alone
3. Fixed exchange rates alone
4. The classical Ricardian model of comparative advantage in identical goods
Show answer
Answer: A — Economies of scale and product differentiation under monopolistic competition (new trade theory)
Classical/H-O theory explains inter-industry trade based on comparative advantage between DIFFERENT goods; it cannot explain trade in similar/differentiated varieties of the SAME good, which new trade theory explains via scale economies and variety-seeking consumers under monopolistic competition.
The Balance of Payments always balances in an accounting sense because:
1. It is compiled using double-entry bookkeeping, so total credits equal total debits by construction
2. Governments legally require exports to equal imports
3. Exchange rates are always fixed
4. Capital flows are prohibited
Show answer
Answer: A — It is compiled using double-entry bookkeeping, so total credits equal total debits by construction
The double-entry accounting convention records every transaction as both a credit and a debit, so the BoP balances by construction — this accounting balance says nothing by itself about whether the underlying position is sustainable.
Remittances from workers abroad are recorded in the Balance of Payments under:
1. The current account (secondary income)
2. The capital/financial account only
3. Neither account
4. Foreign direct investment
Show answer
Answer: A — The current account (secondary income)
Remittances are unilateral (secondary income) transfers with no corresponding good, service or asset flowing back, and are recorded in the current account alongside grants — not in the capital/financial account, which records asset transactions like FDI and portfolio flows.
A genuine balance-of-payments disequilibrium, as distinct from the routine accounting balance, refers to:
1. A persistent, unsustainable gap requiring policy adjustment
2. Any single year with a current account deficit
3. The fact that credits equal debits
4. A situation with zero foreign trade
Show answer
Answer: A — A persistent, unsustainable gap requiring policy adjustment
A single year's deficit financed sustainably by capital inflows is not itself a disequilibrium; genuine disequilibrium is a persistent gap whose financing cannot continue indefinitely, forcing exchange-rate, reserve or expenditure-switching adjustment.
Which of the following are components of a country's current account?
1. Merchandise (visible) trade
2. Services (invisible) trade
3. Primary income (investment income)
4. Foreign direct investment inflows
Show answer
Answer: A — Merchandise (visible) trade; B — Services (invisible) trade; C — Primary income (investment income)
The first three are current account items; foreign direct investment is a capital/financial account item, recording an asset transaction rather than a flow of goods, services or income.
Name the trade theory (Heckscher-Ohlin extension) that shows trade liberalisation raises the real return to a country's abundant factor and lowers it for the scarce factor.
Numerical answer — type the value.
Show answer
Answer: Stolper-Samuelson theorem
The Stolper-Samuelson theorem is the standard name, and it is the theoretical basis for why trade opening, even when raising aggregate income, creates distributional winners and losers within a country.