Exploring the Importance of International Trade: Functions and Advantages

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Exploring the Importance of International Trade: Functions and Advantages

Business Essentials · Chapter 3: International Business and Global MarketsSection 3.1 · lesson 14 of 10515 min · free with a free account

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In this lesson

Why both sides can gain, and why not everyone does.

  • Explain why countries and firms trade
  • Distinguish absolute from comparative advantage
  • Trace where the gains from trade come from
  • State the case for and against protection fairly

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International Business and Global Markets

International Trade: Functions and Advantages

Look at the labels on the things around you, and you'll find goods made in many different countries. Nobody forced anyone to buy them from abroad. So why does international trade happen at all? This section supplies the theory behind the rest of chapter three. We'll separate absolute advantage from comparative advantage, the most important and least intuitive idea in trade. We'll work through a two-country example, and see exactly where the gains from trade come from. Then we'll face the harder truth, that the gains are shared unevenly, and weigh the arguments for protection fairly. And we'll finish with a manufacturer whose biggest customers just found a cheaper import.

Why Trade Occurs

Both Sides Expect to Gain

Start with the basic question. Why does trade happen? No one is compelled to buy from abroad. Every firm that sells across a border could, in principle, have sold at home. The answer is that trade, the voluntary exchange of goods and services, happens because both sides expect to gain. A buyer purchases from a foreign seller because the good is cheaper, better, or simply unavailable at home. A seller exports because the foreign market pays more, or is larger, or lets it use capacity the home market can't absorb. International trade is just trade in which the parties are in different countries. It differs from domestic trade mainly in its obstacles. Distance, currencies, borders, and differing laws. Its underlying logic is the same. The rest of chapter three is about measuring, crossing, and managing those obstacles. This section explains why crossing them can be worth it.

Two Kinds of Advantage

Absolute Versus Comparative

The most obvious reason to buy from another country is that it's simply better at making the thing. A country has an absolute advantage in a good if, with the same quantity of resources, it can produce more of it than another country. If the same land, labor, and equipment yield more grain in one country than another, the first has an absolute advantage in grain. That's intuitive. But it can't be the whole story. It seems to imply something odd. A country better at everything would gain nothing from trading with a country worse at everything. The central insight of trade theory is that this implication is false. Comparative advantage is different. A country has it in a good when it can produce that good at a lower opportunity cost, compared with another country. Opportunity cost is the value of the next best alternative given up. Here, it's how much of another good must be sacrificed to make one more unit. What matters isn't who is better in absolute terms. It's where each is relatively better. An everyday parallel helps. A senior partner at a law firm types faster than her assistant, and drafts contracts far better too. Yet she sensibly hires the assistant to type. Every hour she spends typing is an hour not spent on legal work, which is worth far more. The assistant's opportunity cost of typing is small, and hers is large. Both are better off if each does the task with the lower opportunity cost.

Norvale and Estmark

Better at Both, Yet Still Gaining

Now let's make the argument exact, with two fictional countries and made-up figures. Norvale and Estmark each have one hundred workers, and each can produce only grain and cloth. In a year, a Norvale worker can produce either six tons of grain, or twelve bolts of cloth. An Estmark worker can produce either four tons of grain, or four bolts of cloth. Norvale is better at both. It has the absolute advantage in grain, and in cloth. Now count opportunity costs. For Norvale, one ton of grain costs two bolts of cloth, since a worker who makes six tons could have made twelve bolts. For Estmark, one ton of grain costs just one bolt, since four tons could have been four bolts. So Estmark gives up less cloth to make grain. Estmark has the comparative advantage in grain. Flip it around for cloth. Norvale gives up half a ton of grain per bolt. Estmark gives up a full ton. So Norvale has the comparative advantage in cloth. The country that's worse at everything still has something it's relatively better at. That's the whole key.

Table 3.1.1

Specialize, Then Trade

Specialization means concentrating resources on the goods where you hold a comparative advantage. It's the mechanism that turns the advantage into a gain. Before trade, each country splits its workers equally, and consumes what it makes. Norvale makes three hundred tons of grain and six hundred bolts of cloth. Estmark makes two hundred of each. Together, that's five hundred tons and eight hundred bolts. Now specialize. Estmark puts all its workers into grain. Norvale moves eighty workers to cloth, and keeps twenty on grain. World output rises to five hundred twenty tons of grain, and nine hundred sixty bolts of cloth. More of both goods, from the same workers. That extra output is the source of the gain. Trade is how it gets divided. Suppose they trade at one ton of grain for one and a half bolts of cloth. Estmark sends two hundred tons of grain, and receives three hundred bolts. Norvale ends up with twenty more tons of grain and sixty more bolts than before trade. Estmark keeps its grain, and gains a hundred bolts of cloth. Both are better off, even though Norvale is better at producing both goods. So what sets the price? Estmark will accept anything above one bolt per ton, since that's what grain costs it at home. Norvale will accept anything below two bolts per ton, its own cost of making grain. One and a half sits between those limits, so both gain. A price near one bolt would give most of the gain to Norvale. A price near two would give most to Estmark. The theory doesn't say which will prevail.

Sources

Where Comparative Advantage Comes From

Comparative advantage comes from differences among countries, and five sources are commonly identified. Natural resources, including climate, soil, minerals, and location, make some goods cheaper to produce in some places. Labor cost and skill matter too. Economies differ in how abundant labor is relative to capital, and in the skills their workforces have built. So a labor-abundant economy tends to have a comparative advantage in labor-intensive goods. Be precise about what that means. It's a statement about the relative quantities of factors, and the resulting costs. It is not a claim about the capability or effort of any group of people. Capital, meaning machinery, infrastructure, and the financing to build them, favors capital-intensive production. Technology matters. A country holding a better method for a good can produce it more cheaply. And scale. Where producing more lowers the cost per unit, whoever reaches large volume first can hold an advantage that persists because of its size. Several of these sources can be created rather than inherited. That's why comparative advantage changes over time.

Gains From Trade

What the Gains Look Like

Beyond the arithmetic, the gains from trade show up in specific ways. Consumers get lower prices, because goods made where the opportunity cost is lower cost less to buy. They also get wider choice, because imports add varieties domestic producers don't make. Firms gain access to inputs unavailable at home, such as minerals, or components no domestic supplier makes. They also gain larger markets for their own goods, which lets them spread fixed costs over more sales. And competition from abroad creates pressure to raise productivity. A firm that must compete with imports has a stronger reason to improve its methods. These effects are real. But they aren't the whole account. The theory shows an aggregate gain, meaning the total a country can consume rises. It does not show that everyone gains.

Figure 3.1.1

A Wide Gain, a Narrow Loss

When a country opens its market to a product, the industry that made it at higher cost may shrink. Its workers, owners, and dependent communities bear a concentrated loss. Meanwhile, the benefit is spread thinly across a very large number of consumers and users. Picture it as two shapes. The gain is wide and shallow, touching many people a little. The loss is tall and narrow, falling heavily on a few. The gain is larger in total. But the people who lose know exactly who they are, and the people who gain often don't notice. That's why trade is contested politically, even where economists accept the aggregate case. The theory says nothing about how gains are distributed, or whether winners might compensate losers. In practice, they rarely do so automatically. And adjustment for workers and regions can be slow and painful. The United States has had programs of adjustment assistance for those affected by import competition. Whether one is in force now, and on what terms, should be verified. Here the empirical and normative parts of the debate separate. How large are the gains? How lasting are the losses, and how quickly do people adjust? Those can be studied, though the findings are disputed. How much weight should a concentrated loss carry against a diffuse gain, and what is owed to those who lose? Those questions are normative. So two people can accept the same evidence, and still disagree about policy.

Arguments for Protection

Four Cases, Four Counters

Protection is the use of government measures to shield domestic producers from foreign competition. Four arguments for it carry real force, and each meets a counter of equal weight. The infant industry argument says a new industry can't compete at first, because it lacks the scale and skills of established rivals. Temporary protection lets it grow. The counter: governments are poor at picking winners, protection tends to become permanent once a lobby forms, and the protected firm loses the pressure to improve. The national security argument says a country shouldn't depend on foreign suppliers for defense essentials, because supply could be cut off in a crisis. The counter: the label stretches easily to loosely connected industries, and narrower tools, like stockpiles or targeted subsidies, can do the job more cheaply. The employment argument says protection preserves jobs in exposed sectors. That matters, because job loss is concentrated and hard to reverse. The counter: jobs saved are visible, while jobs lost elsewhere aren't. Higher prices hurt users of the protected product, and partners may retaliate against exporters. So the cost per job saved can be high. The standards argument says imports made under weaker labor, safety, or environmental rules have an unfair cost advantage, and may drag standards down everywhere. The counter: standards partly reflect differences in income, can disguise protection, and excluding the goods may harm the very workers the standards should help. Each argument mixes an empirical claim about consequences with a normative claim about which consequences matter.

Instruments

How Governments Protect

Governments protect through four categories of instrument. A tariff is a tax on imported goods. It raises the domestic price, cuts imports, protects domestic producers, and raises revenue for the government. A quota limits the quantity that may be imported. It also raises the domestic price, and shields domestic producers. But the extra revenue goes to whoever holds the right to import, not to the government, unless the licenses are auctioned. A subsidy is support given to domestic producers. It lowers their costs, so they can sell cheaper or expand, and the cost falls on taxpayers rather than consumers. Non-tariff barriers are everything else that makes imports harder to sell. Product standards, licensing requirements, slow customs procedures. Depending on their purpose, they can be legitimate regulation, or protection in disguise. Trade is also governed by agreements and organizations. The World Trade Organization, established in nineteen ninety-five, administers rules among its members, and provides a way to settle disputes. Regional agreements, like the United States-Mexico-Canada Agreement and the European Union's single market, set terms among their participants.

For the Firm

Three Things Trade Changes

For an individual business, trade changes three things. It changes costs. Imported inputs may be cheaper or better, and tariffs and currency movements raise or lower what they cost. It changes competition. A firm may face foreign rivals at home, and may compete abroad itself. And it changes the market, which can be larger, but is also less familiar, and more varied. No firm can assume these effects are all favorable, or all unfavorable. The same trade opening can be a threat to one firm, and an opportunity to its neighbor. The closing case shows exactly that.

Case Vignette

One Import, Three Effects

Our closing case is a composite, built for instruction. Rosa owns a furniture-frame manufacturer with about sixty employees. A lower-cost imported frame appears, and her two largest customers, both upholstery firms, start buying it. It costs noticeably less, at comparable quality. Rosa's sales fall. She can cut her prices, move into more specialized frames, or start importing components herself. One import has three different effects. For Rosa and her employees, it's a concentrated loss that threatens the business. For the upholstery firms, it's a gain. Their costs fall, and their own prices to retailers can fall too. For consumers buying the finished furniture, it's a small gain, spread across many households who'll never know its source. None of these facts is in dispute. They show why the aggregate case for trade and Rosa's position can both be true. Now her options. Cutting price would match the import only with margins her costs can't sustain. Specializing in custom frames keeps her employees' skills in use, and moves her away from price competition, at the cost of smaller volumes. Importing components lowers her costs, but reduces the work done at home. She treats the import not as an outrage, or as a benefit, but as a change in the opportunity costs she faces. And she chooses the option in which her existing capabilities keep the highest value. Next, we move from the theory of trade to its mechanics, starting with imports, exports, and the balance of payments.

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FAQ

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About Exploring the Importance of International Trade: Functions and Advantages

What is the difference between absolute and comparative advantage?
A country has an absolute advantage in a good if it can produce more of it with the same resources, and a comparative advantage if it can produce it at a lower opportunity cost than another country. Adam Smith emphasized absolute advantage in 1776, and David Ricardo set out comparative advantage in 1817. Comparative advantage explains why even a country that is better at producing everything can gain from trade.
How do you calculate comparative advantage?
Calculate comparative advantage by comparing each country's opportunity cost, meaning how much of one good it gives up to make one more unit of the other. If a Norvale worker makes 6 tons of grain or 12 bolts of cloth, a ton of grain costs 2 bolts. If an Estmark worker makes 4 tons or 4 bolts, a ton costs 1 bolt. So Estmark has the comparative advantage in grain, and Norvale in cloth.
Who benefits and who loses from international trade?
Trade raises a country's total consumption, but its gains and losses are spread unevenly. Consumers gain lower prices and wider choice, and firms gain cheaper inputs and larger markets, yet these gains are spread thinly across many people. Workers, owners, and communities in industries that shrink under import competition bear concentrated losses, and adjustment can be slow. Winners rarely compensate losers automatically, which is why trade is politically contested.
What is the difference between a tariff and an import quota?
A tariff is a tax on imported goods, while a quota is a limit on the quantity that may be imported. Both raise the domestic price and shield domestic producers, but tariff revenue goes to the government, while a quota's extra revenue goes to whoever holds the right to import, unless the licenses are auctioned. Subsidies to domestic producers and non-tariff barriers, such as standards or slow customs procedures, are other forms of protection.

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