Meaning of international trade
International trade is the exchange of goods and services between countries. It is based on international specialisation. That is to say, every country should only focus on what it can produce better than other countries. By concentrating their resources on what they are better at, they produce in large quantities and there is need to exchange with other nations. A country exports what it produces and depends on other countries for what it does not produce.
The principles of absolute advantage and comparative advantage form the basis for international trade.
Why do countries trade with one another?
Ownership of natural resources
The location of countries in different geographical areas can determine the kind of natural resources they possess, e.g. gold, diamond, crude oil, arable land, copper, etc. Countries depend on others for the resources they do not have. For example, India is one of the countries that have a lot of arable land for agriculture. Singapore, on the other hand, can produce limited agricultural products because it has less arable land. In addition, some nations have access to raw materials which can be exported to those countries that need them.
Weather and climate
Rainfall and temperature are some of the weather/climatic conditions that affect crop production. Some crops can only grow in certain regions of the world with suitable weather or climate. This gives rise to different agricultural products being grown in different countries. And there is a necessity for each country to exchange with other countries what it produces.
Quality and quantity of labour
Labour skills are not the same in all the countries of the world. Technical, managerial and entrepreneurial skills are different and they affect the quality and quantity of products to be produced. A country with a more skillful workforce can obtain more output from the inputs used. It can produce more for domestic consumption and export.
Cost advantage
Countries do not have the same level of efficiency. Some countries can produce at a lower cost than others. There is a necessity for a country to specialise in what it can produce cheaply. A country does not need to make a product if it can obtain it at a cheaper rate from another country.
Technology
Countries possess different levels and types of technologies which give rise to different capital assets and products being manufactured. For example, not every country has the technology to produce semiconductor chips like China or Taiwan. Other countries that need these chips in computers, electronics and military products have to buy from these countries. This is why some governments are sponsoring research and development to acquire competency in the technology.
Economies of scale
International specialisation helps countries to produce in large quantity. This means that they can produce more than what the domestic market requires. Therefore, the excess products have to be exported to countries that produce less than what their citizens want.
To achieve economic growth
A country can adopt a strategy of growing its economy through export trade. Export expansion creates jobs, provides incomes, improves living standards and increases Gross Domestic Product (GDP). Countries that have used export-led strategy to grow their economies include Singapore, Hong Kong and South Korea.
Benefits of international trade
Job creation
International trade provides direct and indirect employment opportunities. Apart from the workers directly employed in those industries producing for trade, other jobs that relate to importation and exportation are also provided, e.g. logistics, banking, insurance, clearing and forwarding.
Revenue generation
International trade provides revenue for exporters as it gives them the opportunity of expanding their revenue base by selling in foreign markets. Besides, the government generates tax revenue from taxes imposed on imports and exports. Direct taxes in form personal income taxes and profits taxes are also realised by the government.
Competition
Importation allows foreign suppliers to compete with domestic suppliers. Competition will promote efficiency because domestic suppliers will work to be price competitive and responsive to the wants of the consumers by investing more in research and development. Competition can also prevent exploitation of consumers by domestic monopolies.
Wide range of products
Consumers have access to a wide range of products from suppliers across the world. These goods will be available at reduced prices because of increased supply. The standard of living of a country’s citizens will improve since they can afford various products.
Economies of scale
International trade makes products to be offered beyond a single country. Firms produce on a large scale in order to meet demand in both domestic and foreign markets. Large scale production enables them to enjoy benefits which lead to lower unit cost, e.g. bulk purchases and opportunity to spread costs over large output.
Economic growth
Exportation encourages production of more goods and raises an economy’s output. The rise in output is known as economic growth. A growing economy generates employment and incomes. In addition, there will be reduction in budget deficit or national debt because a lot of revenue is generated from both direct and indirect taxes.
Redistribution of natural resources
Trade ensures that countries benefit from the natural resources possessed by other countries. Countries without crude oil, for instance, can buy from a country that has it.
Promotes international relations
Trading promotes friendly relations among trading partners. It reduces the likelihood of war and promotes peace in the world. Peace promotes tourism, cultural interaction and economic activities.
Costs of international trade
Current account deficit
A rise in imports at the expense of exports can lead to a current account deficit. There is a deficit if money outflows exceed money inflows from the current account.
Dumping stifles infant industries
Developed countries may sell their goods at a price lower than domestic cost of production in developing countries. This will stifle infant industries found in developing countries. They may have to fold up because of the inability to compete with the more established industries found in developed countries.
Dangerous products
International trade may result in trade in goods that are harmful to the health of the citizens, e.g. cigarettes and alcohol. Over-consumption of these products will put pressure on the healthcare system and reduce the productivity of the workforce.
Developed countries gain more
The developed countries tend to benefit more as they get better prices for their exports, which are mainly manufactured goods. Demand for manufactured products rises considerably when incomes increase. Developing countries that specialise in primary products are often paid lower prices for their exports. Primary products sales do not rise significantly when consumers earn more income.
Over-reliance
International trade may encourage too much reliance on imported products. Over-reliance on cheap imported products prevents industrialisation of the economy and discourages the setting up of import-substitution industries.
Unemployment
Locally made products may not be able to compete with cheaper imported goods. Fall in demand for locally produced goods may lead to revenue loss for firms. Consequently, firms will downsize and lay off a lot of workers.
Principle of absolute advantage
The concept was developed by Adam Smith, a Scottish economist, in the 18th century. Absolute advantage exists when a country can produce a product with lesser resources than another country. In other words, one country can produce more units of one product than another using the same amount of resources. Every country should specialise in the production of good in which they have absolute advantage and then exchange with each other. In the end each country will get more of each good than if there was no specialisation. The ratio of exchange should be between the opportunity cost ratios for the countries involved. Opportunity cost ratio is the amount of one product that will be given up in order to produce a unit of another product. In Table 1 below, Japan has to give up 3 units of electronics in order to produce each unit of car (3,000/1,000). The opportunity cost ratio, therefore, is 1 car to 3 electronics.
Let us assume there are two countries, Japan and Germany, that use half of their resources to produce each of two goods, cars and electronics. Japan can produce 1,000 units of cars and 3,000 units of electronics. Germany, on the other hand, can produce 2,000 units of cars and 1,000 units of electronics (see Table 1 below). Japan can produce more electronics than Germany while Germany can make more cars than Japan. It means that Japan has absolute advantage over Germany in electronics production. But Germany has absolute advantage in car production. It can also be said that Japan has absolute disadvantage in car production since it produces fewer cars than Germany. Likewise, Germany has an absolute disadvantage in electronics production because it produces lesser electronics.
These countries can mutually benefit from trade because each country has a product it can produce more than the other. They should specialise and exchange. In this case, Japan should produce only electronics while Germany should concentrate on car production. After specialisation, If Japan will double its output to 6000 units of electronics because all its resources are now used to produce only electronics (Table 1 below). In the same manner, Germany will produce 4,000 cars instead of 2,000. The total output of the two goods has increased following specialisation. car production gained 1,000 while electronics gained 2,000.
Table 1: A numerical example of absolute advantage
| Before specialisation | After specialisation | Gains | ||||
| Cars | Electronics | Cars | Electronics | Cars | Electronics | |
| Japan | 1,000 | 3,000 | 0 | 6,000 | -1,000 | 3,000 |
| Germany | 2,000 | 1,000 | 4,000 | 0 | 2,000 | -1,000 |
| Total | 3,000 | 4,000 | 4,000 | 6,000 | 1,000 | 2,000 |
Principle of comparative advantage
It was propounded by David Ricardo, a British economist, in 1817. According to this principle, a country has a comparative advantage if it can produce a good at a lower opportunity cost than another country, i.e., it sacrifices fewer units of another good in order to produce it. This implies that it is cheaper for the country to produce the good. Even if a country does not have an absolute advantage in any good, trade can still be mutually beneficial it if can produce one of the goods at a lower opportunity cost than the other country.
Table 2: A numerical example of comparative advantage
| Before specialisation | After specialisation | Gains | ||||
| Crude oil (barrels | Cocoa (tonnes) | Crude oil (barrels | Cocoa (tonnes) | Crude oil (barrels | Cocoa (tonnes) | |
| Nigeria | 10,000 | 6,000 | 20,000 | 0 | 10,000 | -6,000 |
| Ghana | 7,000 | 5,000 | 0 | 10,000 | -7,000 | 5,000 |
| Total | 17,000 | 11,000 | 20,000 | 10,000 | 3,000 | 1,000 |
Table 2 above shows the production possibilities for Nigeria and Ghana. Nigeria, for example, can produce 10,000 barrels of crude oil and 6,000 tonnes of cocoa by using half of its resources for each of them. Nigeria has absolute advantage in the production of the two goods because it can produce a higher quantity of each good than Ghana. Ghana cannot be discarded because it is possible that Ghana can produce one of the goods at a lower opportunity cost than Nigeria. Trade can still be mutually beneficial if each party has a cost advantage in production of one good. The opportunity cost is calculated for both countries as follows:
Opportunity cost for Nigeria
The opportunity cost of 1 barrel of crude oil is 0.6 tonne of cocoa given up (6,000/10,000).
The opportunity cost of 1 tonne of cocoa is 1.67 barrels of crude oil sacrificed (10,000/6,000)
Opportunity cost for Ghana
The opportunity cost of 1 barrel of crude oil is 0.71 tonne of cocoa foregone (5,000/7,000).
The opportunity cost of 1 tonne of cocoa is 1.4 barrels of crude oil (7,000/5,000).
Nigeria has a comparative advantage in crude production because it has a lower opportunity cost (0.6 tonne of cocoa). Ghana has a comparative advantage in the production of cocoa with a lower opportunity cost of 1.4 barrels of crude oil compared to Nigeria’s 1.67 barrels of crude oil. Nigeria has a comparative disadvantage in cocoa production while Ghana has a comparative disadvantage in crude oil production. Therefore, Nigeria should produce only crude oil; Ghana should concentrate all its resources on cocoa production. After specialisation, Nigeria can produce 20,000 barrels of crude because it uses all (not half) of its resources in its production. Ghana can now produce 10,000 tonnes of cocoa compared to 5,000 it produces before specialisation. The exchange rate for 1 barrel of crude oil has to be between the opportunity cost for the two countries, i.e. between 0.6 and 0.71 tonne of cocoa. The countries could agree an exchange rate of 1 barrel of crude oil to 0.68 tonne of cocoa. Nigeria will get more cocoa than it could produce without specialisation and Ghana will get more crude oil than it could produce if it has not specialised.
Limitations of the principle of comparative advantage
There are more than two countries producing different goods
There are more two countries in the world. And two countries may not produce the same two goods.
Transport cost is ignored
Transport cost add to the cost of the good in reality. Transport cost can make a product not price competitive even if it is produced at a lower cost in a particular country.
There are no trade barriers
It is assumed that there are no barriers to trade such as tariffs. Many countries restrict trade using barriers to protect domestic businesses, prevent job loss or raise revenue.
Barter system has been abolished
According to the principle, the countries involved in trade exchange with each other after specialisation. This direct system of exchanging goods for goods is no longer adopted in the world. Money is now being used as a measure of the value of goods and a medium of exchange.
Constant opportunity cost
Costs are different because scale of production are not the same. Some countries have a lower cost due to economies of scale.
Trade agreements
Countries do have trade agreements with one another. A country may buy from a particular country even though there are others with lower cost because of the existence of agreements. An example is economic union where members buy from each other and impose tarriffs on goods from external countries.
Perfect knowledge
The theory assumes that there is perfect knowledge among buyers and sellers. In reality, countries find it difficult to ascertain the country with the lowest priced products.