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Course Title: International Trade & Development

Course Instructor: Mr. Fayyaz Ghafoor

National College of Business

Administration & Economics

What is International Trade? How does it work?

International trade allows countries to expand their markets for both goods and services that
otherwise may not have been available domestically. 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.

KEY TAKEAWAYS

 International trade is the exchange of goods and services between countries.

 Trading globally gives consumers and countries the opportunity to be exposed to goods
and services not available in their own countries, or which would be more expensive
domestically.
 The importance of international trade was recognized early on by political economists
like Adam Smith and David Ricardo.
 Still, some argue that international trade actually can be bad for smaller nations, putting
them at a greater disadvantage on the world stage

How International Trade Works

International trade gives rise to a world economy, in which supply and demand, and therefore
prices, both 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 charged at your local mall. A decrease in the cost of labor, on the other hand, would
likely result in you having to pay less for your new shoes.

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 a country's current
account in the balance of payments.

Comparative Advantage: Increased Efficiency of Trading Globally

Global trade allows wealthy countries to use their resources—whether labor, technology
or capital—more efficiently. Because countries are endowed with different assets and natural
resources (land, labor, capital, and technology), some countries may produce the same good
more efficiently and therefore sell it more cheaply than other countries. If a country cannot
efficiently produce an item, it can obtain the it by trading with another country that can. This
is known as specialization in international trade.

Let's take a simple example. Country A and Country B both produce cotton sweaters and
mango juice. Country A produces ten sweaters and six bottles of mango juice a year while
Country B produces six sweaters and ten bottles of mango juice a year. Both can produce a
total of 16 units. Country A, however, takes three hours to produce the ten sweaters and two
hours to produce the six bottles of mango juice (total of five hours). Country B, on the other
hand, takes one hour to produce ten sweaters and three hours to produce six bottles of mango
juice (a total of four hours).

But these two countries realize that they could produce more by focusing on those products
with which they have a comparative advantage. Country A then begins to produce only mango
juice, and Country B produces only cotton sweaters. 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 20 units of both products.

We can see then that for both countries, the opportunity cost of producing both products is
greater than the cost of specializing. More specifically, for each country, the opportunity cost
of producing 16 units of both sweaters and mango juice is 20 units of both products (after
trading). Specialization reduces their opportunity cost and therefore maximizes their efficiency
in acquiring the goods they need. With the greater supply, the price of each product would
decrease, thus giving an advantage to the end consumer as well.

Note that, in the example above, Country B could produce both mango juice and cotton more
efficiently than Country A (less time). This is called an absolute advantage, and Country B may
have it because of a higher level of technology.

Important

According to the international trade theory, even if a country has an absolute advantage over
another, it can still benefit from specialization.

Origins of Comparative Advantage

The law of comparative advantage is popularly attributed to English political economist David
Ricardo. It's discussed in his 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.

David Ricardo 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.
Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing
cloth. Both countries saw that it was to their advantage to stop their efforts at producing these
items at home and, instead, to trade with each other.

A contemporary example is China’s comparative advantage with the United States in the form
of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity
cost. The United States’ comparative advantage is in specialized, capital-intensive labor.
American workers produce sophisticated goods or investment opportunities at lower
opportunity costs. Specializing and trading along these lines benefits each.

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
and industry. However, this is often not 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.

Criticisms of Comparative Advantage

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 they also know that their narrow interests would be negatively impacted by
cheaper foreign shoes. Even if laborers would be most productive by switching from making
shoes to making computers, nobody in the shoe industry wants to lose his or her job or
see profits decrease in the short run.

This desire could lead the shoemakers to lobby for special tax breaks for their products and/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 made relatively less productive and American consumers relatively poorer
by such protectionist tactics.

Other Possible Benefits of Trading Globally

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), which is the amount of money that individuals invest into foreign companies
and assets. In theory, economies can therefore grow more efficiently and can more easily
become competitive economic participants.

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 gross
domestic product. For the investor, FDI offers company expansion and growth, which means
higher revenues.

Free Trade Vs. Protectionism

As with all theories, there are opposing views. International trade has two contrasting views
regarding the level of control placed on trade: free trade and protectionism. Free trade is the
simpler of the two theories: a laissez-faire approach, with 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 needs to be done to protect or promote trade and
growth, because market forces will do so automatically.

In contrast, 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 it opens up the opportunity for specialization, and therefore more efficient use of resources,
international trade 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, and, as it develops, so too must its participants.