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Theory of International Trade

International Trade takes place because of the variations in productive factors in different countries. The variations of productive factors cause differences in price in different countries and the price differences are the main cause of international trade. There are numerous advantages of international trade accruing to all the participants of such trade. A few of such advantages are mentioned below:
  • Efficient use of productive factors: The biggest advantage of international trade relates to the advantages accruing from territorial division of labour and international specialization. International trade enables a country to specialize in the production of those commodities in which it enjoys special advantages. All countries are not equally endowed with natural resources and other facilities for the production of goods and services of various kinds. Some countries are richly endowed with land and forest resources, which others happen to have abundant capital resources. Some others have abundant supplies of labour power. Without international trade, a country will have to produce all the goods it requires irrespective of the costs involved. But international trade enables a country to produce only those goods in which it has a comparative advantage or an absolute advantage and import the rest from other countries. This leads to international specialisation or division of labour, which, in turn, enables efficient use of the productive factors with minimum wastages. Specialisation would also lead to economies of scale and which, in turn, would lead to reduction of cost of products and services.

  • Equality in commodity and factor prices: International trade leads to an equality of the prices of internationally traded goods and productive factors in all the trading regions of the world. It should, however, be remembered that the gains arising from international trade shall be available to the participating countries only if trade is free and unfettered. If the trade is subjected to tariff and non-tariff restrictions by the trading countries, the gains of international trade get nullified in the process to a large extend.

What is International Trade?

Indians drive cars made in Japan, use VCR�s made in Korea. Americans drive cars made in Germany, use VCR�s made in Japan and wear clothing made in China. Japanese watch American movies, Egyptians drink American cola and Swedes jog in American running shoes. The world economy is more integrated than ever before.

International Trade shapes our everyday lives and the world we live in. Nearly every time we make a purchase or sale, we are participating in the global economy. Products and their components come to our store shelves from all over the world.

Goods and services that a country buys from another country are called imports, and goods and services that are sold to other countries are called exports. Trade mostly takes place between companies. However, governments and individuals frequently buy and sell goods internationally.

Most international trade consists of the purchase and sale of industrial equipment, consumer goods, oil and agricultural products. Services such as banking, insurance, transportation, telecommunications, engineering and tourism account for one-fifth of the world exports.

The cost of international transportation and communication has fallen drastically, resulting in greater integration among the economies of the world. Because of this interdependence, economic trends and conditions in one country can strongly affect prices, wages, employment and production in other countries. Events in Tokyo, London and Mexico City have a direct effect on the everyday life of people in the U.S., just as the impact of events in New York, Washington and Chicago is felt around the globe.

If stocks on the New York Stock Exchange plummet in value, the news is transmitted instantly worldwide, and stock prices all over the world might change. This means that countries have to work together more closely and rely on each other for prosperity.

International trade occurs because individuals, businesses and governments in one country want to buy goods and services produced in another country. Trade provides people with greater selection of goods and services to chose from and often these goods are available at prices lower than those in the domestic economy.

International trade is the system by which countries exchange goods and services. Countries trade with each other to obtain things that are better quality, less expensive or simply different from what is produced at home.

What are the benefits of international trade?

To become wealthier, countries want to use their natural resources � land, labour, capital and entrepreneurship � in the most efficient manner. However, there are differences among countries in the quantity, quality and cost of these resources. The advantages that a country has may vary according to the following.

  • Abundant minerals
  • Climate suited to agriculture
  • Well-trained labour force
  • New innovative ideas
  • Highly developed infrastructure like good roads, telecommunication systems, etc.

Instead of trying to produce everything by themselves, countries often concentrate on producing things that they can produce most efficiently. They then trade those for other goods and services. In doing so, both the country and the world becomes wealthier.

Consider the following example:

Two economies, Cotton Land and Wood Land, have the same resources and produce both cloth and furniture.
Cotton Land Wood Land
Without trade, produces
8 bales of cloth
4 pieces of furniture

Without trade, produces
4 bales of cloth
8 pieces of furniture
Time taken to produce
1 bale of cloth = 1 hour
1 piece of furniture = 2 hours

Time taken to produce
1 bale of cloth = 2 hours
1 piece of furniture = 1 hour
With trade
16 bales of cloth
0 bales of furniture
With trade
0 bales of cloth
16 pieces of furniture

Since Cotton Land is more efficient in cloth production, it can double its cloth output to 16 bales a day by transferring all its resources to that industry. By doing so Cotton Land will eliminate its furniture industry. However, it can trade the surplus cloth for furniture.

Similarly, Wood Land can direct all its resources to the production of furniture and produce 16 pieces of furniture. Although its cloth industry will suffer it can trade the surplus pieces of furniture for cloth bales.

Through specialization and trade, the supply of goods in both economies increases, which brings the prices down, making them more affordable.


Law of Comparative Advantage: Even if a country can produce everything more efficiently than another country, there is still scope for trade. A country can maximize its wealth by putting its resources into its most competitive industries, regardless of whether other countries are more competitive in those industries. This is called the law of comparative advantage.

Suppose Cotton Land produces both cloth and furniture better than Wood Land.
Cotton Land Wood Land
Bales of cloth per day 10 2
Pieces of furniture per day 5 3

Cotton Land has an absolute advantage � is more efficient � in the production of both cloth and furniture. However to achieve greater wealth, each country should specialize in the item in which it enjoys greatest advantage among all the products it produces.

In terms of opportunity cost, or the cost of not transferring resources, Cotton Land is twice efficient in producing cloth as furniture.

Opportunity Cost
Cotton Land 1 piece of furniture = 2 bales of cloth.
Wood Land 1 piece of furniture = 2/3 bales of cloth.

Since Wood Land�s opportunity cost for furniture is less than Cotton Land�s, it makes economic sense for Wood Land to concentrate on furniture.

Cotton Land should continue producing cloth and trade for Wood Land�s furniture. Whereas, Wood Land should concentrate on furniture and trade it for cloth with Cloth Land. Channeling resources into the most productive enterprise in each country will result in more products to trade.


Benefits of diversification: Even though it makes economic sense to allocate resources to the most productive industries, no country wants to rely on only a few products. This makes the country vulnerable to changes in the world economy, such as recession, new trade laws and treaties, and new technologies.

A country that relies too heavily on one product is especially susceptible to market forces. If demand suddenly drops or if a cheaper alternative becomes available, the economy of that country could be damaged.

Many Middle East countries that are largely dependent on their oil exports see their economic fortunes rise and fall in tandem with the oil market.

The degree to which countries specialize is influenced by that country�s terms of trade � i.e. the relative prices of a country�s imports and exports. It is most advantageous to have declining import prices compared with the prices of exports. Exchange rates and productivity differences affect the terms of trade more than any other factors.

By developing a diversified economy, a country can make sure that even if some industries are suffering, other, more competitive industries will keep the economy relatively healthy.


Competitiveness: Competitiveness is used to describe the relative productivity of companies and industries. If one company can produce better products at lower prices than another, it is said to be more competitive. This is a matter of concern for governments, since it is difficult for uncompetitive industries to survive.

In the long run, competitive depends on:
  • A country�s natural resources
  • Its stock of machinery and equipment, and
  • The skills of its workers in creating goods and services that people want to buy

Natural resources are predetermined and must be used efficiently, but a country�s infrastructure and its workers� skills have to be developed over time. The ability of a society to do this effectively determines whether it can remain competitive in the global economy.


Economies of Scale: The law of comparative advantage says that a country can become more competitive by directing its resources to its most efficient industries. This enables a country to achieve economies of scale � increasing its output in a particular industry so that its costs per unit decrease. Such lower-cost goods are more in demand in international markets.

Certain industries that require heavy research and development or capital expenditures cannot be competitive unless they can spread the costs over many units. If a sophisticated weapons industry knows that it has access to foreign markets and could export, it may increase the scale of its manufacturing operations and become more efficient and competitiveness in the international markets.

Other factors affecting a country�s trade competitiveness can be complex.
  • Sometimes it is difficult to move resources from one industry to another � it would cost a great deal of money to turn a shoe factory into a car factory.
  • Governments often attempt to restrict or encourage international trade to achieve domestic economic goals � increasing employment in certain industries, or maintaining economic independence.

Free Trade v. Protectionism: All governments regulate foreign trade. The extent to which they do so is a matter of great controversy and debate. The news is full of reports of various groups protesting about:

  • New trade agreements
  • Adverse effects of trade on domestic industry, and
  • Dilution of the environmental and labour standards, especially in the developing economies.

Free trade proponents stand for an open trading system with few limitations and little government involvement. Advocates of Protectionism believe that governments must take action to regulate trade and subsidize industries to protect their domestic economy.

Although the amount of government involvement in trade varies from country to country and product to product, overall barriers to trade have been lowered since World War II. All governments practice protectionism to some extent. The debate is over how many, or how few, such measures should be used to reach the country�s long-term macroeconomic goals.


Arguments for Protectionism: There are many arguments forwarded by advocates of protectionism. The following are some of them.

Cheap Labour: Less developed countries have a natural cost advantage, as labour costs in those economies are low. They can produce goods less expensively than developed economies and their goods are more competitive in international markets.

Infant Industries: Protectionists argue that infant, or new, industries must be protected to give them time to grow and become strong enough to compete internationally, especially industries that may provide a firm foundation for future growth, e.g. computers and telecommunications. However, critics point out that some of these infant industries never "grow up".

National Security Concerns: Any industry crucial to national security, such as producers of military hardware, should be protected. That way the nation will not have to depend on outside suppliers during political or military crisis.

Diversification of the Economy: If a country channels all its resources into a few industries, no matter how internationally competitive those industries are, it runs the risk of becoming too dependent of them. Keeping weaker industries competitive through protection may help in diversifying the nation�s economy.

Lowering Environmental Standards: In the rush to meet the world demand for their exports, some countries may compromise on critical environmental standards. This is particularly true for less developed countries that do not have well defined environmental protection laws in place.


Methods of Protection: Governments use a variety of tools to manage their countries� international trade positions.

Tariffs: Tariffs are taxes on imports. Tariffs make the item more expensive for consumers, thereby reducing the demand.

Import Quotas: Governments sometimes restrict the sale of foreign goods by imposing import quotas. These limit the quantity of foreign goods that can be imported and help domestic producers by limiting the share of the market that can be taken by foreigners.

Voluntary Restraints: Sometimes governments negotiate agreements whereby a country agrees to voluntarily limit its export of a certain product. Japan voluntarily limited its export of cars to the United States in 1992 to 1.65 million cars per year.

With tariffs, it is the importing country that stands to gain through increases in the tax revenue. However, in case of quantitative restraints, the exporting country gains as the price of the imported good rises.

Both import quotas and voluntary restraints thwart the functioning of the free market. The quantity of goods remains constant while the price changes, instead of demand and supply determining both quantity and price.

Subsidies: Another way to achieve the goals of protectionism is to make the domestic industry more competitive. Subsidies, which are grants by the government to an industry, can accomplish this. Subsidies can be:

  • Direct � outright payments
  • Indirect � special tax breaks or incentives, buying of surplus goods,
  • providing low-interest loans or guaranteeing private loans.

Trade Ban: Sometimes governments ban trade with certain countries for political reasons � during times of war or political crises. Governments also ban imports of certain products to protect domestic industries. For instance, Japan bans importation of rice to protect its domestic rice industry.

Imposing Standards: Health, environmental and safety standards often vary from country to country. These may act as a barrier to free trade and a tool of protectionism. For example, the European Union has very stringent health and safety standards that goods have to meet in order to be imported.

Others: Apart from the legal restrictions there may be other less formal obstacles that impede trade. Cultural factors are one such obstacle.


Arguments for Free Trade: The debate about how free a trading system should be is an old one, with positions and arguments evolving over time. Free trade advocates typically argue that consumers benefit from freer trade and forward many reasons in support of their theory.

  • Free trade and the resulting foreign competition forces US companies to keep prices low.
  • Consumers have a large variety of goods and services to chose from in open markets.
  • Domestic companies have to modernize plants, production techniques and technology to keep themselves competitive.
  • Any kind of protectionist measures, like tariffs, often brings about retaliatory actions from foreign governments, which may restrict the sale of goods in their markets. This may result in inflation and unemployment in the US as the export industries suffer and prices of imports rise.
  • An open trading system creates a better climate for investment and entrepreneurship than one in which there is fear of government cutting off access to certain markets.
  • The cost of protection often outweighs the benefits.

Measures of Trade: Balance of Trade and Balance of Payments are the two statistical tools widely used to measure a country�s international trade position.

Balance of Trade is the difference between a nation�s exports and imports of both goods and services.

Balance of Payments gives a complete summary of all economic transactions that involve money flowing into or from a country.

Exports are the value of goods and services sold abroad over any specific period of time. Imports are the value of goods and services purchased from foreign countries over a specific period of time.

A 'favorable' balance of trade, or trade surplus, occurs when exports exceed imports. A �negative� balance, or trade deficit, occurs when the imports surpass exports.


Statistics can have different interpretations: Interpretations of trade statistics sometimes can differ sharply, depending on the question being asked. The US trade deficit has been viewed as good, bad, irrelevant, overstated, understated and illusory.

For example, a company that exports goods to the United States will view the deficit as a sign of a healthy US market. On the other hand, a US based trade union may consider the deficit as a sign that domestic industries are unable to compete in the world markets.

In a global economy that is measured in trillions of dollars, not every transaction is going to be reported accurately. Statistics for many types of transactions rely heavily on estimates made by statisticians, and even the best estimates are sometimes incorrect. This can produce a skewed measurement of what is actually happening in the economy.


Measuring Imports and Exports:

Imports: Importers file tax documents with the customs service describing the type and value of imported goods. These reports are processed and tabulated to arrive at the overall level of imports. Inaccurate reports, delays in processing data, and smuggling can affect their value.

Exports: There is no tax on exports and recording of data is done at the ports or other locations from where exports take place. All such individual records are totaled to arrive at the total exports in a particular year.

Sometimes, it is difficult to assign a particular value to goods. To compare the exports of two countries in a given year, it is necessary to convert the figures into the same currency. However, there can be distortions due to:

Exchange Rate Fluctuations: The exchange rate may distort the value of trade statistics. It may appear that one country is exporting more than another when, in fact, the distortions could be attributed to variations in exchange rates and not the quality or quantity of exports.

Real Estate Values: Real estate values have to be adjusted to current market prices.

Depreciation: Allowances for equipment, plant and machinery and other real assets that depreciate over time have to be made.

Inflation: Rising prices of commodities must be taken into account before assigning a value to exports.

Changes in trade statistics do not necessarily signify changes in a nation�s trading patterns; the change may merely result from a change in the way the data is presented.

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