The term “trading costs” should be assigned a comprehensive meaning by including a variety of costs relating to transport, insurance, banking, and customs duties, etc. Their impact on international trade is not uniform, and varies from good to item.
(i) Unaltered Basic Reasoning and Conclusions:
The existence of trading costs does not alter the basic reasoning and conclusions of the classical theory. Their presence only implies that a commodity would be traded only if its price difference exceeds these costs.
It is obvious that the volume of trade would be smaller with trading costs than without them, and some goods may no longer be traded.
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(ii) Reduced Relevance for Some Items:
In recent times, relevance of trading costs has drastically decreased for some items. International trade is undergoing a rapid transformation.
It is diversifying into categories of items like technology, information, and consultancy. They are almost “weightless” and their trading costs are very nominal.
(iii) Continued Strong Relevance for Other Items:
However, trading costs continue to be as important as ever for a large proportion of internationally traded items. For this reason, producers and traders are always seeking an opportunity to avoid them or reduce them.
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Of late, several multinational corporations have found a new method of side-stepping them, simply by establishing their production centres in foreign countries.
In doing so, they not only reduce their transport costs, but also reap other economic benefits, such as, (a) reduced distance from the consumption centres, (b) availability of cheap labour, and (c) avoidance of import duties or outright ban on imports. It is obvious that this type of relocation of production centres reduces the volume of international trade.
Rate of Exchange and Balance of Payments:
The classical theory assumes that trading countries are on gold standard. In that case, trading countries do not face long term problems associated with balance of trade and balance of payments. There is a self-adjusting mechanism to take care of these problems.
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Currently, however, national currencies are on paper standard with variable exchange rates. In addition, the authorities frequently adopt measures for adjusting balance of payments and rate of exchange.
Capital Flows:
Classical theory fails to take note of the modern phenomenon of large scale capital flows, both for “parking” and for investment purposes. It also fails to take into account the fact that a part of international trade is on credit.
Distribution of Income:
Ricardian theory ignores the impact of international trade on the distribution of income within a country. It is claimed that increased income inequalities may more than compensate the gains from international trade and thus lead to a net reduction in overall welfare of the society.
International Economics:
It should be possible to integrate international trade theory into a full-fledged subject of International Economics. This, however, is difficult with classical theory of international trade.