International Trade
Domestic trade refers to the buying and selling of goods and services within a country’s borders and is also known as internal or intra-regional trade.
International trade involves the exchange of goods and services between nations. It goes beyond political boundaries and is often referred to as foreign or inter-regional trade.
By engaging in global trade, countries and consumers gain access to products not produced locally. Goods sold abroad are called exports, while those purchased from other countries are known as imports.
Global trade enables efficient use of resources such as land, labor, capital, and technology. Countries can focus on producing items they are best at, a concept known as specialization.
Advantages of International Trade
- Helps countries use their resources in the best possible way through specialization and labor division.
- Improves total production and economic output globally.
- Boosts national income and wealth by increasing trade value.
- Contributes to higher global production and output.
- Raises the overall economic welfare of participating countries.
- Promotes cultural exchange and international relationships.
- Supports stronger political ties between nations.
- Expands market reach for products.
- Helps overcome scarcity by importing needed goods.
- Encourages domestic industries to enhance product quality through competition.
Reasons Why International Trade Differs from Domestic Trade
- Factors like labor and capital cannot move freely between countries due to laws and policies.
- Markets differ in culture, climate, income levels, and consumer behavior.
- Nations follow diverse political systems and ideologies.
- Government policies, taxation, tariffs, and trade regulations vary widely across countries.
- Different currencies and exchange rate systems exist in every country.
- Mismatch between what countries need and what they can produce.
- Each nation has unique natural resources and production capabilities.
- Technological levels vary between countries.
- Workforce skills and entrepreneurial abilities differ.
- Comparative advantages are not the same for every country.
Disadvantages of International Trade
- Over-exporting certain goods may lead to depletion of natural resources.
- Countries might sell goods at lower prices abroad, a practice called dumping, which can hurt local industries.
- New and developing industries may struggle to grow due to international competition.
- Excessive reliance on imports may lower national savings and hinder investment in local infrastructure.
- Job opportunities in non-specialized sectors may decline.
- Heavy dependence on trade can reduce a country's self-reliance and increase vulnerability.
Due to these limitations, many countries enforce certain controls and regulations on international trade to protect their interests.
Theories of International Trade
Economists have proposed several theories to explain how and why international trade occurs. The three most notable theories are:
- Theory of Absolute Cost Advantage – by Adam Smith
- Theory of Comparative Cost Advantage – by David Ricardo
- Modern Theory of International Trade – by Bertil Ohlin and Eli Heckscher (also known as the Heckscher-Ohlin Theorem)
1. Adam Smith's Theory of Absolute Advantage
Adam Smith, a classical economist, introduced the concept of absolute advantage in international trade. He argued that trade between nations is beneficial when both countries gain from it voluntarily.
Key assumptions of the theory:
- Labor is the only factor of production.
- There is full employment in the economy.
- Labor is immobile between countries.
- Law of constant returns applies.
According to the theory, if one country is more efficient (has an absolute advantage) in producing one good, and the other country is more efficient in producing a different good, then both countries should specialize in what they produce best. By trading their surplus with each other, both nations can benefit and enjoy a higher combined output.
Adam Smith's Absolute Advantage (with Example)
The table below shows labor units needed to produce commodities X and Y in two countries:
Country A needs fewer labor units than Country B for commodity X (10 vs 20), so it has an absolute advantage in producing X.
For commodity Y, Country B is more efficient (10 vs 20 labor units), so it has an absolute advantage in producing Y.
Thus, A should specialize in producing X and B in Y. They can trade based on an agreed rate (e.g., 1X = 1Y).
Gains from Trade:
- Country A's internal exchange rate is 1X = ½Y. But by trading 1X for 1Y, A gains ½Y.
- Country B's internal rate is 1Y = ½X. By importing 1X in exchange for 1Y, B gains ½X.
This shows how both countries benefit by specializing and trading. However, this theory only explains part of world trade. Ricardo expanded it with the Comparative Advantage theory.
Ricardo's Theory of Comparative Cost Advantage
This theory, proposed by David Ricardo, explains that countries engage in international trade based on the differences in their production costs. A country specializes in the production of goods where its comparative cost is lower and imports goods where its comparative cost is higher. The theory is rooted in differences in labour costs and productivity among countries.
Main Factors Behind Comparative Cost Advantage
- Geographical division of labour and specialization
- Climate and natural resource differences
- Geographical location
- Labour efficiency
Due to these factors, countries can produce some goods more efficiently, leading them to specialize in those goods. They then export them and import goods that are costlier to produce domestically.
The theory claims: "Trade occurs even if one country has an absolute advantage in producing both commodities, as long as there is a comparative cost advantage in one."
Assumptions
- Only two countries involved
- They produce the same two commodities
- Labour is the only production factor
- All labour units are homogeneous
- Labour is mobile within countries, immobile between countries
- Constant supply of labour
- Identical tastes in both countries
- Linear production (constant returns to scale)
- Prices based on labour costs
- Unchanging technology
- Barter system of trade
- Perfect competition in markets
- No trade barriers
- No transport costs
Illustration
Table 1: Labour Years Required per Unit
| Country | Wine | Cloth |
|---|---|---|
| England | 120 | 100 |
| Portugal | 80 | 90 |
Comparative Cost Advantage (CCA) in Portugal
| Ratio of "W" in Portugal and England | Ratio of "Cl" in Portugal and England |
|---|---|
| 80/120 = 0.67 | 90/100 = 0.90 |
Conclusion: Portugal has CCA in Wine (0.67 < 0.90)
Comparative Cost Advantage in England
| Ratio of "Cl" in England and Portugal | Ratio of "W" in England and Portugal |
|---|---|
| 100/90 = 1.10 | 120/80 = 1.50 |
Conclusion: England has CCA in Cloth (1.10 < 1.50)
Domestic Exchange Rate (DER)
a. Wine to Cloth Ratio
| DER | England | Portugal |
|---|---|---|
| Wine to Cloth | 120/100 = 1.20 | 80/90 = 0.89 |
| Specialize in Cloth | Specialize in Wine |
b. Cloth to Wine Ratio
| DER | England | Portugal |
|---|---|---|
| Cloth to Wine | 100/120 = 0.83 | 90/80 = 1.13 |
| Specialize in Cloth | Specialize in Wine |
Gain from Trade
| Country | DER Ratios | Explanation |
|---|---|---|
| England | 1 Wine = 1.20 Cloth | Will import 1 Wine if Portugal is willing to take <1.20 Cloth |
| Portugal | 1 Wine = 0.89 Cloth | Will export 1 Wine if England gives >0.89 Cloth |
Conclusion: Both countries benefit from trade due to their respective comparative advantages.