Before we begin a discussion about why nations trade, it would be helpful to take a moment to consider the character and evolution of trade. It is important to keep in mind, first, that although we frequently talk about trade “between nations,” the vast majority of international transactions today take place between private individuals and private enterprises based in different countries. Governments sometimes sell things to each other, or individuals or corporations in other countries, but these comprise only a small percentage of world trade.
Trade is not a modern invention. International trade today is not qualitatively different from the exchange of goods and services that people have been conducting for thousands of years. Before the widespread adoption of currency, people exchanged goods and some services through bartering—trading a certain quantity of one good or service for another good or service with the same estimated value. With the emergence of money, the exchange of goods and services became more efficient.
Developments in transportation and communication revolutionized economic exchange, not only increasing its volume but also widening its geographical range. As trade expanded in geographic scope, diversity, and quantity, the channels of trade also became more complex. Individuals conducted the earliest transactions in face-to-face encounters. Many domestic transactions, and some international ones, still follow that pattern. However, over time, the producers and the buyers of goods and services became more remote from each other.
A wide variety of market actors, individuals and firms, emerged to play supportive roles in commercial transactions. These “middlemen,” wholesalers, providers of transportation services, providers of market information, and others, facilitate transactions that would be too complex, distant, time-consuming, or broad for individuals to conduct face-to-face efficiently.
International trade today differs from economic exchange conducted centuries ago in its speed, volume, geographic reach, complexity, and diversity. However, it has been going on for centuries, and its fundamental character, the exchange of goods and services for other goods and services or money, remains unchanged.
That brings us to the question of why nations trade. Nations trade a lot, but it is not quite as obvious why they do so. Put differently, why do private individuals and firms take the trouble of conducting business with people who live far away, speak different languages, and operate under different legal and economic systems, when they can trade with fellow citizens without having to overcome any of those obstacles?
It seems evident that if one country is better at producing one good and another country is better at producing a different good (assuming both countries demand both goods) that they should trade. What happens if one country is better at producing both goods? Should the two countries still trade? This question brings into play the theory of comparative advantage and opportunity costs.
The everyday choices that we make are, without exception, made at the expense of pursuing one or several other choices. When you decide what to wear, what to eat for dinner, or what to do on Saturday night, you are making a choice that denies you the opportunity to explore other options.
The same holds for individuals or companies producing goods and services. In economic terms, the amount of the good or service that is sacrificed to produce another good or service is known as opportunity cost. For example, suppose Switzerland can produce either one pound of cheese or two pounds of chocolate in an hour. If it chooses to produce a pound of cheese in a given hour, it forgoes the opportunity to produce two pounds of chocolate. The two pounds of chocolate, therefore, is the opportunity cost of producing the pound of cheese. They sacrificed two pounds of chocolate to make one pound of cheese.
A country is said to have a comparative advantage in whichever good has the lowest opportunity cost. That is, it has a comparative advantage in whichever good it sacrifices the least to produce. In the example above, Switzerland has a comparative advantage in the production of chocolate. By spending one hour producing two pounds of chocolate, it gives up producing one pound of cheese, whereas, if it spends that hour producing cheese, it gives up two pounds of chocolate.
Thus, the good in which comparative advantage is held is the good that the country produces most efficiently (for Switzerland, it is chocolate). Therefore, if given a choice between producing two goods (or services), a country will make the most efficient use of its resources by producing the good with the lowest opportunity cost, the good for which it holds the comparative advantage. The country can trade with other countries to get the goods it did not produce (Switzerland can buy cheese from someone else).
The concepts of opportunity cost and comparative advantage are tricky and best studied by example: consider a world in which only two countries exist (Italy and China) and only two goods exist (shirts and bicycles). The Chinese are very efficient in producing both goods. They can produce a shirt in one hour and a bicycle in two hours. The Italians, on the other hand, are not very productive at manufacturing either good. It takes three hours to produce one shirt and five hours to produce one bicycle.
The Chinese have a comparative advantage in shirt manufacturing, as they have the lowest opportunity cost (1/2 bicycle) in that good. Likewise, the Italians have a comparative advantage in bicycle manufacturing as they have the lowest opportunity cost (5/3 shirts) in that good. It follows, then, that the Chinese should specialize in the production of shirts and the Italians should specialize in the production of bicycles, as these are the goods that both are most efficient at producing. The two countries should then trade their surplus products for goods that they cannot produce as efficiently.
A comparative advantage not only affects the production decisions of trading nations, but it also affects the prices of the goods involved. After the trade, the world market price (the price an international consumer must pay to purchase a good) of both goods will fall between the opportunity costs of both countries. For example, the world price of a bicycle will be between 5/3 shirt and two shirts, thereby decreasing the price the Italians pay for a shirt while allowing the Italians to profit. The Chinese will pay less for a bicycle and the Italians less for a shirt than they would pay if the two countries were manufacturing both goods for themselves.
In reality, of course, trade specialization does not work precisely the way the theory of comparative advantage might suggest, for several reasons:
- No country specializes exclusively in the production and export of a single product or service.
- All countries produce at least some goods and services that other countries can produce more efficiently.
- A lower income country might, in theory, be able to produce a particular product more efficiently than the United States can but still not be able to identify American buyers or transport the item cheaply to the United States. As a result, U.S. firms continue to manufacture the product.
Generally, countries with a relative abundance of low-skilled labor will tend to specialize in the production and export of items for which low-skilled labor is the predominant cost component. Countries with a relative abundance of capital will tend to specialize in the production and export of items for which capital is the predominant component of cost.
Many American citizens do not fully support specialization and trade. They contend that imports inevitably replace domestically produced goods and services, thereby threatening the jobs of those involved in their production.
Imports can indeed undermine the employment of domestic workers. We will return to this subject a little later. From what you have just read, you can see that imports supply products that are either 1) unavailable in the domestic economy or 2) that domestic enterprises and workers would be better off not making so that they can focus on the specialization of another good or service.
Finally, international trade brings several other benefits to the average consumer. Competition from imports can enhance the efficiency and quality of domestically produced goods and services. Also, competition from imports has historically tended to restrain increases in domestic prices.
- Name a product/business where labor would be the comparative advantage for a developing country.
- Name a product/business where capital would be the comparative advantage for a rich country.
- Name a product/business where natural resources would be a comparative advantage.
Global Interdependence
The tremendous growth of international trade over the past several decades has been both a primary cause and effect of globalization. The volume of world trade increased twenty-seven-fold from $296 billion in 1950 to $8 trillion in 2005. Although international trade experienced a contraction of 12.2 percent in 2009, the steepest decline since World War II, trade is again on the upswing.
As a result of international trade, consumers around the world enjoy a broader selection of products than they would if they only had access to domestically made products. Also, in response to the ever-growing flow of goods, services, and capital, a whole host of U.S. government agencies and international institutions have been established to help manage these rapidly developing trends.
Although increased international trade has spurred tremendous economic growth across the globe, raising incomes, creating jobs, reducing prices, and increasing workers’ earning power, trade can also bring about economic, political, and social disruption.
Since the global economy is so interconnected, when large economies suffer recessions, the effects are felt around the world. One of the hallmark characteristics of the global economy is the concept of interdependence. When trade decreases, jobs, and businesses are lost. In the same way that globalization can be a boon for international trade; it can also have devastating effects. Activities such as the choice of clothes you buy have a direct impact on the lives of people working in the nations that produce
There are several elements that are responsible for the expansion of the global economy during the past several decades: new information technologies, reduction of transportation costs, the formation of economic blocs such as the North American Free Trade Association (NAFTA), and the reforms implemented by states and financial organizations in the 1980s aimed at liberalizing the world economy.
Trade liberalization, or deregulation, has become a ‘hot button’ issue in world affairs. Many countries have seen great prosperity thanks to the disintegration of trade regulations that had otherwise been considered a harbinger of free trade in the recent past. The controversy surrounding the issue, however, stems from enormous inequality and social injustices that sometimes comes with reducing trade regulations in the name of a bustling global economy.
Given the dislocations and controversies, some people question the importance of efforts to liberalize trade and wonder whether the economic benefits are outweighed by other unquantifiable negative factors such as labor exploitation.
With globalization, competition occurs between nations having different standards for worker pay, health insurance, and labor regulations. Corporations benefit from lower labor costs found in developing regions, thanks to free-trade agreements and a new international division of labor. A worker in a high-wage country is thus increasingly struggling in the face of competition from workers in low-wage countries. Entire sectors of employment in developed countries are now subject to this growing international competition, and unemployment has crippled many localities.
The outcome has been an international division of labor in all sectors of the economy. In particular, manufacturing is increasingly being contracted out to lower- cost locations, which are often found in developing countries with no minimum wage and few environmental regulations.
An excellent example of international division of labor can be found in the clothes-making industry. What was once a staple industry in most developed Western economies has now been relocated to developing countries in Central America, Eastern Europe, North Africa, Asia, and elsewhere.
International Development Models
Self-Efficiency Model of Development
There are two models of economic development that play off each other as a way to. The first model is called the Self-Efficiency Model of Development, which encourages domestic development of goods and resources and discourages foreign influence and investment. Between 1990 to 2000, this was the primary form of economic development until globalization became the dominant force. What makes this model of development competitive to international trade models is that governments create barriers through the form of tariffs on imports, which makes them more expensive and less economically competitive with their local businesses. New businesses are nurtured until they and economically sustainable and competitive enough to compete with businesses abroad.
This model of development prides itself in an equal distribution of resources to a nation’s people and businesses over foreign entities and investments. But there are several critics of this form of development because they argue that this model protects inefficient businesses and does not reward competitive and highly efficient ones, requires a sizeable bureaucratic government to administer this model of development and limit abuse and corruption, and does not receive the benefits of rewarding foreign corporations that could provide goods and services to countries with limited resources.
Modernization Model of Development
The other model for economic development is through international trade. W.W. Rostow proposed in the 1950s the idea of a five-stage model of development that competes with the self-sufficiency model. In a report by Peter Kasanda, Rostow’s Modernization Theory of Development implies that nations should use local resources and industries to sell scarce or needed resources globally through international trade. The money that comes back to the country would increase the nation’s GDP, which could then be used to improve the development of infrastructure, invest in education and healthcare, and ultimately improve a country’s standard of living. The following is the 5-stage model of how progress and development might occur for a country:
- Traditional Society – This primary sector is determined for societies that have little economic development and a high percentage of people active in family-scale subsistence agriculture. Most of the money for development goes toward religious or military activities.
- Economic Growth – Key investments in core structures of an existing economy to expand its development. Structured invests in mining and large-scale agriculture and with technology to enhance the efficiency of existing infrastructure. The goal is to invest in the overall structure of the nation’s economy, so the production of goods can begin to occur.
- Economic Takeoff – Investment and development lead to expanded, but limited activity in mining, textile, and food production along with continued improvements and investment in modern technology. A key indicator of the “takeoff” stage is when the people in the country become more driven by economic development rather than traditional activities. Is should also be noted that this is often when concerning issues of slavery and sweatshops begin to surface if not appropriately handled.
- Drive to Economic Maturity – During this period, society is driven by modern technological advances over most other areas of the economy. Technology drives production and efficiency throughout all parts of the economy. It is at this time when a local economy becomes an international economic player. This stage is often said to be an extension of the “takeoff” stage, but more expansive than limited in scope.
- Age of Mass Consumption – This final stage of economic development occurs when an economy shifts from a secondary sector of manufacturing toward the tertiary sector of services. The economic status of the nation’s society also becomes driven by mass consumption of disposable goods.
The theory of international trade has become the preferred way to improve economic development. The reason is that most nations cannot produce all the goods and resources they require. So if nations can focus on specific goods and services to export, they can return the purchase of the goods and services they need.
In 1995, the World Trade Organization (WTO) was created to represent 97 percent of the world-trading establishment. It is through the WTO that nations can negotiate with each other international trade restrictions, governmental subsidies, and tariffs on exports. The WTO also has the power to act as an international court to enforce international agreements.
Liberals and conservatives have highly attacked the WTO. Liberals believe that too many actions or rulings are done undemocratically and behind closed doors. They also believe the organization focuses more on the rights of corporations rather than poorer nations. Conservatives believe that no international organization has the right to dictate the choices of sovereign nations. Learn more about the World Trade Organization.