Why Does International Trade Occur?
International trade occurs because one country enjoys a comparative advantage in the production of a certain good or service, specifically if the opportunity cost of producing that good or service is lower for that country than any other country. If a country opts not to trade with other countries, it is considered to be an autarky.
If we consider a two-country model, both countries can gain from specialization and trade. Specialization and trade will allow each country to produce the product they possess a comparative advantage in and then trade, and ultimately consume more of both goods. Therefore, there are gains from trade.
Sources of Comparative Advantage
1. International differences in climate
International differences in climate play a significant role in international trade – for example, tropical countries export products like coffee and sugar. In contrast, countries in more temperate areas export wheat or corn. Trade is also driven by differences in seasons and geography.
2. Differences in factor endowments
Differences in factor endowments imply that some countries are more resource-rich than others in land, labor, capital, and human capital. According to the Heckscher-Ohlin model, a country enjoys a comparative advantage in production if the resources are abundantly available within the country; for example, Canada exhibits a comparative advantage in the forestry industry. It is primarily driven because the opportunity cost is lower for a country rich in the related resource.
3. Differences in technology
Differences in technology are most commonly observed in superior production processes seen in different countries. For example, consider Japan in the 1970s – a country that is not overly resource-rich yet enjoys a comparative advantage in automobile manufacturing. The Japanese are able to produce more output with a given input than any other country, and it comes down to superior Japanese technology.
Examples of International Trade Policies
Most economists favor free trade agreements because of the potential for gains from trade and comparative advantage. This is because these economists believe that government intervention will reduce the efficiency of the markets. Yet, many governments introduce protectionist policies to protect domestic producers from foreign producers. There are two major protectionist policies:
1. Tariffs
A tariff is an excise that is paid on the sale of imported goods. Tariffs are put in place to discourage imports and protect domestic producers and are a source of government revenue.
A tariff raises the price received by domestic producers and the price paid by domestic consumers. Tariffs generate deadweight losses because they increase inefficiencies, as some mutually beneficial trades go unexecuted, and an economy’s resources are wasted on inefficient production.
2. Import quotas
An import quota refers to a legal limit on the quantity of a good that can be imported within a country. Generally, import quotas are administered through licensing agreements. An import quota leads to a similar result as a tariff; however, instead of generating tax revenue, the fees are paid to the license holder as quota rent.
Arguments for a Protectionist Trade Policy
The three major arguments for a protectionist trade policy are:
- National security
- Job creation
- Protection of infant industries
Generally, tariffs or import quotas lead to gains for producers and losses for consumers. Therefore, the imposition of tariffs or import quotas is generally created from the political influence of the producers.
Additional Resources
Thank you for reading CFI’s guide to International Trade. To keep advancing your career, the additional CFI resources below will be useful:
If you can walk into a supermarket and find Costa Rican bananas, Brazilian coffee, and a bottle of South African wine, you're experiencing the impacts of international trade.
International trade is the purchase and sale of goods and services by companies in different countries. Consumer goods, raw materials, food, and machinery all are bought and sold in the international marketplace.
International trade allows countries to expand their markets and access goods and services that otherwise may not have been available domestically. As a result of international trade, the market is more competitive. This ultimately results in more competitive pricing and brings a cheaper product home to the consumer.
- Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available in their own countries, or more expensive domestically.
- The importance of international trade was recognized early on by political economists such as Adam Smith and David Ricardo.
- Still, some argue that international trade can actually be bad for smaller nations, putting them at a greater disadvantage on the world stage.
International trade was key to the rise of the global economy. In the global economy, supply and demand—and thus prices—both impact and are impacted by global events.
Political change in Asia, for example, could result in an increase in the cost of labor. This could increase the manufacturing costs for an American sneaker company that is based in Malaysia, which would then result in an increase in the price charged for a pair of sneakers that an American consumer might purchase at their local mall.
A product that is sold to the global market is called an export, and a product that is bought from the global market is an import. Imports and exports are accounted for in the current account section of a country's balance of payments.
Global trade allows wealthy countries to use their resources—for example, labor, technology, or capital—more efficiently. Different countries are endowed with different assets and natural resources: land, labor, capital, technology, etc.
This allows some countries to produce the same good more efficiently; in other words, more quickly and at a lower cost. Therefore, they may sell it more cheaply than other countries. If a country cannot efficiently produce an item, it can obtain it by trading with another country that can. This is known as specialization in international trade.
For example, England and Portugal have historically been used, as far back as in Adam Smith's The Wealth of Nations, to illustrate how two countries can mutually benefit by specializing and trading according to their own comparative advantages. In such examples, Portugal is said to have plentiful vineyards and can make wine at a low cost, while England is able to more cheaply manufacture cloth given its pastures are full of sheep.
According to the theory of comparative advantage, each country would eventually recognize these facts and stop attempting to make the product that was more costly to generate domestically in favor of engaging in trade. Indeed, over time, England would likely stop producing wine, and Portugal stop manufacturing cloth. Both countries would realize that it was to their advantage to redirect their efforts at producing what they were relatively better at domestically and, instead, to trade with each other in order to acquire the other.
These two countries realized that they could produce more by focusing on those products for which they have a comparative advantage. In such a case, the Portuguese would begin to produce only wine, and the English only cotton.
Each country can now create a specialized output of 20 units per year and trade equal proportions of both products. As such, each country now has access to both products at lower costs. We can see then that for both countries, the opportunity cost of producing both products is greater than the cost of specializing.
Comparative advantage can contrast with absolute advantage. Absolute advantage leads to unambiguous gains from specialization and trade only in cases wherein each producer has an absolute advantage in producing some good.
If a producer lacked any absolute advantage, then they would never export anything. But we do see that countries without any clear absolute advantage do gain from trade because they have a comparative advantage.
According to international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization.
The theory of comparative advantage has been attributed to the English political economist David Ricardo. Comparative advantage is discussed in Ricardo's book On the Principles of Political Economy and Taxation, published in 1817, although it has been suggested that Ricardo's mentor, James Mill, likely originated the analysis and slipped it into Ricardo's book on the sly.
Comparative advantage, as we have shown above, famously showed how England and Portugal both benefit by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these facts and stop attempting to make the product that was more costly to generate.
A more contemporary example of comparative advantage is China’s comparative advantage over the United States in the form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost.
The comparative advantage for the U.S. is in specialized, capital-intensive labor. American workers produce sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefit each country.
The theory of comparative advantage helps to explain why protectionism has been traditionally unsuccessful. If a country removes itself from an international trade agreement, or if a government imposes tariffs, it may produce an immediate local benefit in the form of new jobs; however, this is rarely a long-term solution to a trade problem.
Eventually, that country will grow to be at a disadvantage relative to its neighbors: countries that were already better able to produce these items at a lower opportunity cost.
The U.S. international trade deficit in May 2022 was $85.5 billion, meaning imports exceed exports.
Why doesn't the world have open trading between countries? When there is free trade, why do some countries remain poor at the expense of others? There are many reasons, but the most influential is something that economists call rent seeking. Rent seeking occurs when one group organizes and lobbies the government to protect its interests.
Say, for example, the producers of American shoes understand and agree with the free-trade argument but also know that cheaper foreign shoes would negatively impact their narrow interests. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose their job or see profits decrease in the short run.
This desire could lead the shoemakers to lobby for special tax breaks for their products or extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound—even though, in the long run, American laborers would be relatively less productive and American consumers relatively poorer as a result of such protectionist tactics.
International trade not only results in increased efficiency but also allows countries to participate in a global economy, encouraging the opportunity for foreign direct investment (FDI). In theory, economies can thus grow more efficiently and become competitive economic participants more easily.
For the receiving government, FDI is a means by which foreign currency and expertise can enter the country. It raises employment levels and, theoretically, leads to a growth in the gross domestic product (GDP). For the investor, FDI offers company expansion and growth, which means higher revenues.
As with all theories, there are opposing views. International trade has two contrasting views regarding the level of control placed on trade between countries.
Free trade is the simpler of the two theories. This approach is also sometimes referred to as laissez-faire economics. With a laissez-faire approach, there are no restrictions on trade. The main idea is that supply and demand factors, operating on a global scale, will ensure that production happens efficiently. Therefore, nothing must be done to protect or promote trade and growth because market forces will do this automatically.
Protectionism holds that regulation of international trade is important to ensure that markets function properly. Advocates of this theory believe that market inefficiencies may hamper the benefits of international trade, and they aim to guide the market accordingly.
Protectionism exists in many different forms, but the most common are tariffs, subsidies, and quotas. These strategies attempt to correct any inefficiency in the international market.
As international trade opens up the opportunity for specialization, and thus more efficient use of resources, it has the potential to maximize a country's capacity to produce and acquire goods. Opponents of global free trade have argued, however, that international trade still allows for inefficiencies that leave developing nations compromised. What is certain is that the global economy is in a state of continual change. Thus, as it develops, so too must its participants.
The benefits of international trade for a business are a larger potential customer base, meaning more profits and revenues, possibly less competition in a foreign market that hasn't been accessed as yet, diversification, and possible benefits through foreign exchange rates.
International trade arises from the differences in certain areas of each nation. Typically, differences in technology, education, demand, government policies, labor laws, natural resources, wages, and financing opportunities spur international trade.
The barriers to international trade are policies that governments implement to prevent international trade and protect domestic markets. These include subsidies, tariffs, quotas, import and export licenses, and standardization.
The world economies have become more intertwined through globalization and international trade is a major part of most economies. It provides consumers with a variety of options and increases competition so that businesses must produce cost-efficient and high-quality goods, benefiting these consumers.
Nations also benefit through international trade, focusing on producing the goods they have a comparative advantage in. Though some countries limit international trade through tariffs and quotas to protect domestic businesses, international trade has shown to benefit economies as a whole.