International Trade - Introduction & Overview

What is Trade?

Trade is the exchange of products between countries
When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards.
One way of expressing the gains from trade in goods and services is to distinguish between static gainsfrom trade (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur over time from improved product quality, increased choice and faster innovative behaviour).

Gains from Trade – Understanding Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower
Countries will generally specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed.
If each country specializes, then total output can be increased leading to an improvement in allocative efficiency and welfare.
Because production costs are lower, providing that a good market price can be found from international buyers, specialisation should focus on those goods and services that provide the best value
In highly developed countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.
Example of comparative advantage
Usually we take a standard two-country + two-product example to illustrate comparative advantage

• Consider two countries producing two products – digital cameras and vacuum cleaners
• With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

OUTPUT BEFORE SPECIALISATION	Digital Cameras	Vacuum Cleaners
UK	600	600
United States	2400	1000
Total	3000	1600

Working out the comparative advantage

• To identify who should specialise in a particular product,  consider the internal opportunity costs
• Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television
• For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners
• If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
• USA has comparative advantage in producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

	Digital Cameras	Vacuum Cleaners
UK	0 (-600)	1200 (+600)
United States	3360 (+960)	600 (-400)
Total	3000 3360	1600 1800

• The UK specializes totally in producing vacuum cleaners – doubling its output  - now1200
• The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
• As a result of specialisation output of both products has increased - a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows:

• The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
• The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

	Digital Cameras	Vacuum Cleaners
UK	840	780
United States	2520	1020
Total	3360	1800

Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods

Key assumptions behind trade theory

This theory of trade based on comparative advantage depends on a number of assumptions:
Occupational mobility of factors of production (land, labour, capital) -this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment
Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output.
No externalities arising from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerationsarising from increased production and trade between countries.
The standard model of trade focuses on trade between countries. In reality, most trade takes place between businesses across national boundaries – i.e. intra-industry trade. In the last twenty years we have seen huge changes in both the pattern of trade between developed and developing countries. And also the complexity of manufacturing supply chains around the world. Typically for example, a tablet computer or a smartphone will be manufactured in one or two centers but the components will have come from dozens of other countries.

Sources of Comparative Advantage

Comparative advantage is a dynamic concept meaning that it changes over time.

For a country, the following factors are important in determining the relative unit costs of production:

The quantity and quality of factors of production available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage.

Different proportions of factors of production – some countries have abundant low-cost labour suitable for volume production of manufacturing products.

Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage.

Investment in research & development which can drive innovation and invention

Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country's domestic producers.

The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals.

Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows.

Comparative advantage is often a self-reinforcing process.

• Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets
• Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on
• The expansion of an industry leads to external economies of scale.
  

Wider Benefits of International Trade

Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991.

Prior to joining the WTO, Indian trade as a share of GDP was low by global standards at just 15%. That figure has doubled in the last twenty years

Some of the broader gains from trade are:

Welfare gains: Supporters of trade believe that trade is a ‘positive-sum game’ – all counties engaged in open trade and exchange stand to gain

Economies of scale – trade and increased market size allows firms to exploit scale economies leading to lower average costs of production that might be passed onto consumers

Competition / market contestability – trade promotes increased competition particularly for domestic monopolies that would otherwise face little competition. Trade is a spur for higher productivity – a stimulus to higher business efficiency across many industries.

Dynamic efficiency gains from innovation - trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living

Access to new technology and inflows of new knowledge: trade, like investment, is a mechanism by which countries can have access to new technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital. Openness to trade allows imports of capital equipment at lower prices.

Rising living standards and a reduction in poverty - a growing body of evidence shows that countries that are more open to trade grow faster over the long run and have higher per capita income than those that remain closed. Growth through trade directly benefits the world's poor although free trade is not necessarily equitable

The UNDP believe that greater openness in trade can be a major factor behind reducing extreme poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010.

Some quotes on the value of trade

“According to a recent study, one iPhone has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries”

Pascal Lamy, Director-General of the World Trade Organisation

“The case for free trade is robust. It extends not only to overall prosperity or gross national product (GNP), but also to distributional outcomes, which makes the free trade argument morally compelling as well”

“The dramatic upturn in GDP growth rates in India and China after they turned strongly towards dismantling trade barriers in the late 1980s and early 1990s is compelling.

“In India, the shift to accelerated growth after reforms that included trade liberalization has pulled nearly 200 million people out of poverty. In China, which grew faster, it is estimated that more than 300 million people have moved above the poverty line since the start of reforms.”

Professor Jagdish Bhagwati