International trade is the exchange of goods and services across international boundaries or territories. Industrialization, improvement in transportation, globalization, multinational corporations, advancement in technology and outsourcing have all had a major impact on the international trade system. In international trade, countries import or purchase from foreign countries the products which they cannot produce and export or sell products which they can produce.
Theories of Trade
Adam Smith Theory of Absolute Advantage
A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example, if one unit of labour in Jamaica can produce 90 units of shoes or 40 units of slippers, while in Aruba one unit of labour makes 50 units of shoes or 70 units of slippers, then Jamaica has an absolute advantage in producing shoes and Aruba has an absolute advantage in producing slippers. Jamaica can get more slippers with its labour by specializing in shoes and trading the shoes for Aruba’s slippers, while Aruba can benefit by trading slippers for shoes as can be seen in the following table.
Specializing in the production of that product which each country has an absolute advantage of can result in more output than without specialization. Without specialization and trade, total output in shoes was 140 units while total output of slippers was 110 units. Now if Jamaica specializes in the production of shoes and Aruba specializes in the production of slippers, the production of both shoes and slippers will now increase. With specialization, shoe production will increase from 140 units to 180 units while slipper production will increase from 110 slippers to 140 slippers as seen in the following table.
Ricardian Comparative Advantage Theory of Trade
The principle of comparative advantage shows that even if a country has no absolute advantage in any product, the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production. In a Ricardian model, countries specialize in producing what they produce best.
Suppose we have two countries of equal size, France and Germany that both produce and consume two goods, Milk and Butter. The productive capacities and efficiencies of the countries are such as in the following table.
Germany has an absolute advantage over France in the production of Milk while France has an absolute advantage in the production of Butter. There seems to be no mutual benefit in trade between France and Germany. The opportunity costs shows otherwise. France’s opportunity cost of producing 1 unit of Milk is two units of Butter and Germany’s opportunity cost of producing the same 1 unit of Milk is 0.5 units of Butter. In terms of the production of Butter, France’s opportunity cost of 1 unit of Butter is 0.5 units of Milk and Germany’s opportunity cost of producing the same 1 unit of Butter is 2 units of Milk as can be seen in the following table.
Therefore, Germany has a comparative advantage in Milk production (with a small opportunity cost of 0.5 units of Butter which is less than the opportunity cost for France for the production of the same 1 unit of Milk which is 2 units of Butter). Also, France has a comparative advantage over Germany in the production of Butter (0.5 units of Milk as compared to 2 units of Milk for the case of Germany).
Gains or Benefits from Trade
The following are some of the gains from trade:
Producers – local producers gain from trade when their goods and services are purchased by foreigners.
Consumers – consumers may have access to goods and services which they may not have had otherwise.
Innovation - countries that have reduced trade barriers and increased the share of imports and exports in their economies tend to be among the fastest-growing nations and possess more technical innovation.
Foreign Exchange – an economy earns increased amounts of foreign exchange through international trade. This facilitates for growth and development of countries. This increase in foreign exchange allows citizens of countries to afford more and venture overseas.
Trade Protection and Promotion Measures
Governments can implement several measures in order to protect and promote trade in their country. Some of these measures are as follows:
Tariffs - are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would increase to the extent of the tariff. The increased prices will reduce the demand for imported goods and, at the same time, induce domestic producers to produce more of import substitutes.
Quotas – with a quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the trade deficit is reduced and the balance of payments position is improved.
Import Substitution – a country may resort to import substitution to reduce the volume of imports and make it self-reliant. Governments identify those products that account for the bulk of its import bill and can focus attention on these in an effort to produce these locally in an attempt to reduce the country’s import bill.
Arguments in favour of Tariffs
Some of these advantages are as follows:
Infant-industry protection - by protecting new domestic industries from established foreign competitors, a tariff can give a struggling industry time to become an effective competitor.
Job protection argument - supporters, especially unions, say that tariffs should be used to keep foreign labour from taking away local jobs.
To Raise Revenue for the Government - Tariffs can also have the added advantage of raising revenues for the government.
Lower or prevent balance of payment deficits - tariffs are used in order to assist in reducing imports relative to exports in order to bring equilibrium in the country’s balance of payments.
To prevent dumping – dumping occurs when manufacturers export a product to another country at a price either below the price charged in its home market or below its cost of production. The imposition of a tariff can assist in making the prices of these cheap foreign goods equal to the prices or even more expensive than the local goods.