Chapter 4 International Trade & Trade Theories

If you walk into a supermarket and can buy South American bananas, Brazilian coffee and a bottle of South African wine,
you are experiencing the effects of international trade.

International trade allows us to expand our markets for both goods and services that otherwise may not have been
available to us. It is the reason why you can pick between a Japanese, German or American car. As a result of
international trade, the market contains greater competition and therefore more competitive prices, which brings a
cheaper product home to the consumer.

What Is International Trade?

International trade is the exchange of goods and services between countries. This type of trade gives rise to a world
economy, in which prices, or supply and demand, affect and are affected by global events. Political change in Asia, for
example, could result in an increase in the cost of labor, thereby increasing the manufacturing costs for an American
sneaker company based in Malaysia, which would then result in an increase in the price that you have to pay to buy the
tennis shoes at your local mall. A decrease in the cost of labor, on the other hand, would result in you having to pay less for
your new shoes.

Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available in their
own countries. Almost every kind of product can be found on the international market: food, clothes, spare parts, oil, jewelry,
wine, stocks, currencies, and water. Services are also traded: tourism, banking, consulting and transportation. A product that
is sold to the global market is an export, and a product that is bought from the global market is an import. Imports and
exports are accounted for in a country's current account in the balance of payments.

International Trade- buying and selling of goods and services across country borders
Exports: selling of goods and services to buyers outside the country
Imports: buying of goods from sellers outside the country

Benefits of Trade
• Voluntary trade is mutually beneficial (the growth of imports and exports occurs because it benefits both parties to the
transaction)

Lower prices - there will be global division of labor; there is more output for less resources. The main gain from trade
is the ability to buy goods and services at a lower price than the domestic one. Consumers are able to buy less
expensive products and producers are able to purchase less expensive raw materials and semi-manufactured goods.
This is the main reason for trade.

Taking advantage of different factor endowments - premise is that no two countries share exactly the same
resource base. Different countries possess different resources. There are some resources that a country may need,
but quite simply does not have. For example, many countries do not possess copper, diamonds, or oil naturally.
However, they may need them in order to produce other products and so have no option but to import the
commodities they lack. To do this, they will need to export goods or services, in order to earn foreign currency and so
buy the required resources.

Economies of scale - gains come from large scale production and would not likely occur if it were limited to the
domestic market. When producing for an international market, as well as for a domestic one, the size of the market,
and thus demand, will increase. This means that the level of production and the size of production units will also
increase.

Increased Variety - you can have same goods made by different countries thus providing different levels of
satisfaction brought to consumers. International trade enables consumers to have a greater choice of products. They
now have access not just to domestically produced products, but also to products that come from a number of
different countries.

Acquisition of needed resources - Some countries lack critical goods to improve their standard of living. In some
cases, production of a needed good is simply impossible. Trade is the only way to get it. This need can range from a
vital natural resource like natural gas for heating, to the need to import capital goods that might improve industry or
agriculture. Adding these imported goods can improve production or improve everyday life for buyers.
Competition improves efficiency - “competitive incentive”. International trade may lead to increased competition, as
domestic firms compete with foreign firms. This should lead to greater efficiency and may mean that consumers gain
by being offered less expensive goods and services. It is also likely that the quality and variety of goods available to
consumers will increase, with increased competition.

Political benefits - trade and integration have consistently encouraged compromise and resolution over conflict and
 antagonism. Indeed, trade requires relationships and attachments. Merchants want predictable supply of their
imported resources and hope to maintain steady and reliable output to customers abroad. They abhor disruptions to
everyday business and future planning. This, economists believe, helps keep the peace. This idea has been
popularized by Thomas Friedman in The Lexus and the Olive Tree as ‘the golden arches theory of conflict resolution’,
which holds that no two countries with a McDonald’s have ever fought a war.

Understanding the benefits of trade using Production Possibilities

Key Points

• The production possibilities curve shows the maximum possible production level of one commodity for any
production level of another, given the existing levels of the factors of production and the state of technology.
• Points outside the production possibilities curve are unattainable with existing resources and technology if trade
does not occur with an external producer.
• Without trade, each country consumes only what it produces. However, because of specialization and trade, the
absolute quantity of goods available for consumption is higher than the quantity that would be available under
national economic self-sufficiency.

Key Terms

• Production possibilities frontier: A graph that shows the combinations of two commodities that could be
produced using the same total amount of each of the factors of production.

In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that
could be produced using the same total amount of the factors of production. It shows the maximum possible production
level of one commodity for any production level of another, given the existing levels of the factors of production and the
state of technology.

PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An
economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of
one good without decreasing the production of the other good. For example, if an economy that produces only guns and
butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter. If
production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest,
C if more butter is needed, or D if an equal mix of butter and guns is required.

Production Possibilities Frontier: If production is

efficient, the economy can choose between
combinations on the PPF. Point X, however, is
unattainable with existing resources and technology if
trade does not occur.
Laissez-Faire Versus Interventionist Approaches to
Exports and Imports
Once countries set economic and political objectives, officials enact
policies—including trade policies—to achieve desired results. This
influences which countries can produce given products more efficiently and
whether countries will permit imports to compete against their domestically
produced goods and services. Some nations take a more laissez-faire
approach, one that allows market forces to determine trading relations.
Free-trade theories (absolute advantage and comparative advantage) take a complete laissez-faire approach because they
prescribe that governments should not intervene directly to affect trade. At the other extreme are mercantilism and
neomercantilism, which prescribe a great deal of government intervention in trade. Whether taking a laissez-faire or
interventionist approach, countries rely on trade theories to guide policy development.

Trade Theories And Business

Table 5.1 summarizes the major trade theories and their emphases. These different theories expand our understanding of
how government trade policies might affect business competitiveness. For instance, they provide insights on favorable
locales and products for exports, thereby helping companies determine where to locate their production facilities when
governments do or do not impose trade restrictions.

Interventionist Theories
Let’s begin with mercantilism because it is the oldest trade theory, out of which neomercantilism has more recently emerged.
These theories are based on some of the reasons for governmental intervention, but there are other reasons as well that we
discuss in the next chapter.

Mercantilism

Mercantilism holds that a country’s wealth is measured by its holdings of “treasure,” which usually means its gold. According to
this theory, which formed the foundation of economic thought from about 1500 to 1800,2 countries should export more than they
import and, if successful, receive gold from countries that run deficits. Nation-states were emerging during this period, and gold
empowered central governments to raise armies and invest in national institutions so as to solidify the people’s primary
allegiance to the new nations.

Governmental Policies To export more than they imported, governments restricted imports and subsidized production that
otherwise could not compete in domestic or export markets. Some countries used their colonies to support this trade objective
by having the colonies supply commodities that the colonial powers would otherwise have to purchase from non-associated
countries and by running trade surpluses as an additional way to obtain gold. They did this not only by monopolizing colonial
trade but also by forcing their colonies to export less highly valued raw materials to them and import more highly valued
manufactured products from them.

As the influence of the mercantilist philosophy weakened after 1800, the governments of colonial powers seldom directly intended
to limit the development of industrial capabilities within their colonies. However, their home-based companies had technological
leadership, ownership of raw material production abroad, and usually some degree of protection from foreign competition—a
combination that continued to make colonies dependent on raw material production and tie their trade to their industrialized mother
countries. We still see vestiges of these relationships, which we discuss in the next chapter.

The Concept of Balance of Trade Some terminology of the mercantilist era has endured. For example, a favorable balance of
trade (also called a trade surplus) still indicates that a country is exporting more than it imports. An unfavorable balance of trade
(also known as a trade deficit) indicates the opposite. Many of these terms are misnomers. For example, the word favorable
implies “benefit,” and the word unfavorable suggests “disadvantage.” In fact, it is not necessarily beneficial to run a trade surplus
or detrimental to run a trade deficit. A country with a favorable balance of trade is, for the time being, supplying people in foreign
countries with more than it receives from them. In the mercantilist period, the difference was made up by a transfer of gold;
today it is made up by granting credit to the deficit country by holding its currency or investments denominated in that currency.
If that credit cannot eventually buy sufficient goods and services, the so-called favorable trade balance actually may turn out to
be disadvantageous for the country with the surplus.

Neomercantilism

The term neomercantilism describes the approach of countries that try to run favorable balances of trade in an attempt to achieve
some social or political objective. A country may aim for increased employment by setting economic policies that encourage its
companies to produce in excess of the demand at home and send the surplus abroad. Or it may attempt to

maintain political influence in an area by sending more merchandise there than it receives from it, such as a government
granting aid or loans to a foreign government to use to purchase the granting country’s excess production.

Free-Trade Theories
Why do countries need to trade at all? Why do some countries not contented with the goods and services it produces? In fact,
many countries following mercantilist policy tried to become as self-sufficient as possible. In this section, we discuss two theories
supporting free trade: absolute advantage and comparative advantage. Both theories hold that nations should neither artificially
limit imports nor promote exports. The market will determine which producers survive as consumers buy those products that best
serve their needs. Both free trade theories imply specialization. Just as individuals and families produce some things that they
exchange for things that others produce, national specialization means producing some things for domestic consumption and
export while using the export earnings to buy imports of products and services produced abroad.

Absolute Advantage Versus Comparative Advantage

Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller
quantity inputs to produce a good is said to have an absolute advantage in producing that good.

Theory of Absolute Advantage

In 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the real wealth of a country consists of the goods
and services available to its citizens rather than its holdings of gold. This theory of absolute advantage holds that different countries
produce some goods more efficiently than others, and questions why the citizens of any country should have to buy domestically
produced goods when they can buy them more cheaply from abroad. Smith reasoned that unrestricted trade would lead a country
to specialize in those products that gave it a competitive advantage. Its resources would shift to the efficient industries because
it could not compete in the inefficient ones. Through specialization, it could increase its efficiency for three reasons:

1. Labor could become more skilled by repeating the same tasks.

2. Labor would not lose time in switching production from one kind of product to another.
3. Long production runs would provide incentives for developing more effective working methods.

The country could then use its excess specialized production to buy more imports than it otherwise could have produced. But
in what products should a country specialize? Although Smith believed the marketplace would make the determination, he
thought that a country’s advantage would be either natural or acquired.

Natural Advantage A country’s natural advantage in creating a product or service comes from climatic conditions, access to
certain natural resources, or availability of certain labor forces.

Variations among countries in natural advantages also help explain where certain manufactured or processed items might best
be produced, particularly if a company can reduce transportation costs by processing an agricultural commodity or natural
resource prior to exporting. Processing coffee beans into instant coffee reduces bulk and is likely to reduce transport costs on
coffee exports; producing canned latte could add weight, lessening the industry’s internationally competitive edge.

Acquired Advantage Most of today’s world trade is of manufactured goods rather than agricultural goods and natural resources.
Countries that are competitive in manufactured goods have an acquired advantage, usually in either product or process
technology. An advantage of product technology is that it enables a country to produce a unique product or one that is easily
distinguished from those of competitors. For example, Denmark exports silver tableware, not because there are rich Danish
silver mines but because Danish companies have developed distinctive products.

An advantage in process technology is a country’s ability to efficiently produce a homogeneous product (one not easily
distinguished from that of competitors). Japan has exported steel despite having to import iron and coal to produce it because its
steel mills have encompassed new labor- and material-saving processes. Thus, countries that develop distinctive or less
expensive products have acquired advantages, at least until producers in another country emulate them successfully.

The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time. Country A
uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit,
and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage
in making both food and clothing.
Absolute Advantage: Country A has an absolute advantage in making both food and clothing, but a comparative advantage
only in food.

Theory of Comparative Advantage

We have just described absolute advantage, which is often confused with comparative advantage. In 1817, David Ricardo
examined the question, “What happens when one country can produce all products at an absolute advantage?” His resulting
theory of comparative advantage says that global efficiency gains may still result from trade if a country specializes in what it
can produce most efficiently—regardless of other countries’ absolute advantage.

Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of
both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation
having more and/or better resources or discovering improved production techniques.

Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than
another. Even if one country has an absolute advantage in producing all goods, different countries could still have different
comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading
because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative
advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which
leads to increased productivity.

For example, consider again Country A and Country B in. The opportunity cost of producing 1 unit of clothing is 2 units of food
in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than
in Country A, Country B has a comparative advantage in clothing.

Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B
specializes clothing. The countries will then trade, and each will gain.

Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.

Don’t Confuse Comparative and Absolute Advantage Most economists accept the comparative advantage theory and its
influence in promoting policies for freer trade.

Nevertheless, many government policymakers, journalists, managers, and workers confuse comparative advantage with absolute
advantage and do not understand how a country can simultaneously have a comparative advantage and absolute disadvantage
in the production of a given product.
Comparative advantage matrix: output model

Table 20.2 shows the output possible for each product

and each country, if each produced only that good. For
Example, if Country C produced only TVs, it could
produce 10 TVs and no smartphones. If Country J
produced 15 smartphones, it could not make any TVs. If
either country wanted to produce more of one, it would
need to sacrifice some of its production of the other. In
this regard, Table 20.2 represents the countries’
production possibilities.

Based on their output, it is rather easy to determine who

has the absolute advantage. Which country produces
more efficiently? Country J produces more TVs, as well
as more smartphones. Therefore, Country J has the
absolute advantage in both industries. Like Lawyer J,
Country J is better at both tasks. However, Country J may
still benefit from trade with the clearly inferior producer,
Country C.

We can now place opportunity cost values inside the matrix to clarify the choices. Table 20.3 shows the trade-offs for
making one good, in terms of another. For Country C, to produce 1 TV would require the sacrifice of 0.5 of a smartphone.
For Country C to make 1 smartphone, it would lose 2 TVs. For Country J, making 1 TV would require the sacrifice of 0.75 of
a smartphone. Making 1 smartphone would require the sacrifice of 1.33 TVs.
Comparative advantage matrix: input model

Calculations and determinations of comparative advantage can also be made using factor inputs, rather than market
production or output. This measure of efficiency is demonstrated by how relatively few inputs go into the production of one
unit of the good.

In this type of matrix, high numbers reflect inefficiency, as more resources are being used; low numbers show efficiency,
with fewer inputs per unit of output.

Specialize and trade

With comparative advantage determined, it is rational for each country to specialize in the production of the good that has the
lowest opportunity cost. This maximizes production between the two countries, which then trade goods with each other.
Although this is a simplification of real-world realities (only two products per country), it reflects the potential benefit a country
gets if it can incur lower opportunity costs to get the same or greater levels of output. After specializing, each country sells the
good at some barter price between its own opportunity cost and the opportunity cost of the other country.

Therefore, Country Z trades butter at a price somewhere between 0.5 and 0.6 units of iron per unit of butter. Accordingly,
Country A trades iron at a price somewhere between 1.67 and 2 units of butter per unit of iron. Country Z must get a price
better than its domestic opportunity cost for butter (0.5 iron units) and Country A must get a price better than its domestic
opportunity cost for iron (1.67 butter units). Assuming they both negotiate and trade, each is better off.

Absolute and comparative advantage with production possibilities curves

The concepts of absolute and comparative advantage can also be demonstrated using production possibilities curves
(PPCs). Because simple PPCs assume the production of two goods, and show the trade-offs between those goods, we
can deduce the relative
opportunity costs.

Figure 20.2 demonstrates the concept of absolute

advantage for Country U and Country S. For the sake of
simplicity, the trade-offs in each case are assumed to be
constant. Thus, opportunity costs are constant, and the
slope of the PPC line is a straight line. With a fixed set of
resources, Country U produces 15 units of wheat while
Country S produces only 5 units. Country U has the
absolute advantage in wheat. In the market for oil,
however, Country S produces 30 units, compared to the
Country U’s 3 units. Thus, Country S has the absolute
advantage in oil

It is less obvious when one country is more productive in each area. Figure 20.3 shows the same information as Table 20.2.
The PPC demonstrates Country J’s possession of absolute advantage in both industries by having a PPC beyond Country
C’s in every direction. If we did not have the values to give us specific information, the slope of lines would give us a clue to
the relative trade-offs for each country. Country C’s line is steeper, suggesting that it probably gives up TVs more rapidly as
it tries to increase its production of smartphones. We could then infer that Country J had the lower opportunity cost of
smartphones. Logically, Country C would then have the better opportunity cost of TVs.

Sources of Comparative Advantage

What, then should a country produce? Where, in reality, do its comparative advantages lie?

Resource endowments play a large role.

- A country that possesses most of the farmable land in the region is likely to have a comparative advantage in
agriculture.
- One that has vast quantities of untapped fossil fuel or other natural resources may have a potential comparative
advantage there.

- Other countries may have little natural resources or land, but have highly skilled workforces that provide
financial, merchant, and other services to the world.

Whether a country’s possession of particular resources gives it a comparative advantage rests on two factors. First, the
relative abundance of the resource. Second, the value of the good produced from the resource to the world market. An
abundant resource that is highly valued is an obvious source of comparative advantage. Production will be efficient and
opportunity costs low.

Perils of extreme specialization (potential downsides to specialization):

This overspecialization is just one of the risks of comparative advantage. A long-term concern is whether a country will be
trapped in a certain type of production, thus limiting its potential for full development.

• Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better
imports. For example, firms in United States may see demand for their products fall due to cheaper imports from
China. This may lead to structural unemployment.
• Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service
produced by a country. For example, the global demand for rubber has fallen due the availability of synthetic
substitutes. Countries may experience high levels of persistent structural unemployment and low GPD because
demand for their products has fallen.
• Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that
country. Political or economic changes in the second country may impact the supply of goods or services
available to the first.
Many countries may find themselves with a comparative advantage in agricultural goods, in part because the developed world
has already developed efficiencies in the making of many services and manufactured goods. With the rich world already in
possession of this head start, poor agricultural economies are left producing commodities of relatively low market value while
obeying the law of comparative advantage. Were they to strictly follow the law, the kind of structural change that is believed
to be necessary for development might never happen. The country, in other words, might never develop industry or service
sectors, and be relegated to a low standard of living and relative dependency.

Heckscher-Ohlin Model

The Heckscher-Ohlin model is a theory in economics explaining that countries export what they can most efficiently and
plentifully produce. This model is used to evaluate trade and, more specifically, the equilibrium of trade between two
countries that have varying specialties and natural resources. The model places emphasis on the exportation of goods
requiring factors of production that a country has in abundance and the importation of goods that a nation cannot produce
as efficiently.

Examples of the Heckscher-Ohlin Model

Certain countries have extensive oil reserves but have very little iron ore. Meanwhile, other countries can easily access and
store precious metals but have little in the way of agriculture. The Heckscher-Ohlin model is not limited to tradable
commodities, as it also incorporates other production factors such as labor. The costs of labor vary from one country to
another, so countries with cheap labor forces, according to the model, should focus primarily on producing labor
intensive goods.

The model emphasizes the benefits of international trade, more specifically, the global benefits to all when each country puts
the most effort into exporting resources that are domestically naturally abundant. All countries benefit when each country
imports the resources it naturally lacks. Because a country does not have to rely solely on internal markets, it can take
advantage of elastic demand. Considering the example of labor, as more countries and emerging markets develop, the cost
of labor increases and marginal productivity declines. Trading internationally allows countries to adjust to capital
intensive goods production, which would not be possible if the country only sold goods internally.
Evidence of the Heckscher-Ohlin Model

While the Heckscher-Ohlin model appears reasonable, most economists have difficulty finding evidence to support the model.
A variety of other models have been used to explain why industrialized and developed countries traditionally lean toward
trading with one another and rely less heavily on trade with developing markets. This Linder hypothesis outlines and explains
this theory.

History of the Heckscher-Ohlin Model

The primary work behind the Heckscher-Ohlin model was presented in a 1919 Swedish paper written by Eli Heckscher and
was later bolstered by his student, Bertil Ohlin, in 1933. Some years later, economist Paul Samuelson expanded the original
model — largely through articles written in 1949 and 1953. This is why some refer to it as the Heckscher-Ohlin-Samuelson
model.

The World Trade Organization (WTO)

The World Trade Organization (WTO) advertises itself as the ‘only international organization dealing with the global rules of
trade between nations. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible.’ The
WTO originated from negotiations on trade that followed World War II. It was generally thought that a wave of protectionism
in the 1930s drew countries closer to the war that followed. Thus, in 1948, 23 countries signed the General Agreement on
Tariffs and Trade (GATT).

During the same negotiations, held in Bretton Woods, New Hampshire USA, the International Monetary Fund (IMF), the
World Bank, and the Bretton Woods exchange rate system were also established with the aim of creating stability and order
to world trade and income flows. In time, the GATT developed from an agreement to a forum for future negotiations, and
eventually an organization in its own right.
Aims of the WTO

The WTO seeks to expand international trade by lowering trade barriers and improving the flow of trade. It has specific
objectives (in bold, below) that enhance this overall goal.
• Trade without discrimination. WTO members are all asked to subscribe to Most Favoured Nation status. This means
that goods from all WTO member countries are treated equally. A tariff applied to one is applied to all, and there are thus no
real favorites. At the same time, foreign goods should be treated the same as domestic goods.

• Freer trade through negotiation. The success of each trade round is attributed to the combined efforts of continuous
negotiation. This ensures that changes to trade policy are done by direct dealing, and also that they are done gradually. .
This allows affected countries to prepare for the adjustments that will probably be enacted when the new agreement comes
into force..

• Predictability through binding and transparency. Binding refers to the commitment among members to keep tariffs at
or below certain rates. This allows importers to assess markets more accurately and make better decisions about trade.
Openness about trade rules also encourages more trade.

• Promoting fair competition. While devoted to free trade, the WTO also claims to seek trade that is more fair. Rules
against dumping and intellectual property theft, for example, are aimed at increasing fair competition. More generally, the
creation of a system of trade rules promotes fair play by establishing some fundamental guidelines for most trade.

• Encouraging development. Nearly two-thirds of WTO members are developing countries. These countries are granted
special trade concessions because it is assumed that their industries need time and space to grow to a level of direct
global competition.