This article introduces reasons for international trade and benefits of free trade. It also explains the theories of Absolute Advantage and Comparative Advantage using numerical examples.
Reasons for international trade
There are a number of reasons why international trade is conducted:
- Availability of products. Some goods can only be produced in certain countries, e.g. oil, diamonds, coffee, tea and bananas.
- Product differentiation. Provides more choice for consumers. Imagine, if only German cars were sold in Germany, or American computer software only in the US!
- Price. Some countries can produce goods relatively cheaper than others. See below for the theories of Absolute Advantage and Comparative Advantage.
Benefits of international trade
There are numerous benefits resulting from international trade, including the following:
- More choice and lower prices. As stated above, consumers have more choice, and greater competition results in cheaper prices, better quality and a more efficient use of resources.
- Innovation. Fairer prices are not the only advantage created by competition – new products, services and delivery methods will be created as companies battle in order to remain competitive.
- Specialization. International trade allows a country to focus on producing what it is best at, and then trade surpluses for other goods, as explained below in the theories of Absolute Advantage and Comparative Advantage. Again this can lead to a more efficient use of scarce resources.
- Economies of scale. Specializing creates efficiency and can increase any Comparative Advantage a country has.
- Peace and political stability. As trade and political relationships between countries become more and more important, they become less likely to waste resources on warfare.
Free trade
Free trade is when economies are able to move goods and services between each other without restrictions.
The biggest example in the world of a working free trade agreement is European Union (EU). International trade is very complex because it has many factors affecting it such as politics, culture and national development of each country that can affect efficiency and costs.
There are two models which simplify international trade including Absolute Advantage and Comparative Advantage. In their most basic form, both of these ideas simplify international trade by comparing two countries which produce the same two products.
A. Absolute Advantage
An Absolute Advantage means that a country is able to produce a product more efficiently than another country – more products, better quality products and more cheaply than another country.
Countries A and Country B produce TVs and Clothes respectively, with 50% of each country’s resources allocated to the production of each product. Each country makes the following amounts of each product:
| Product | Country A | Country B | Total global: |
|---|---|---|---|
| TV | 10 Absolute Advantage | 6 | = 16 |
| CLOTHES | 3 | 5 Absolute Advantage | = 8 |
Country A has an Absolute Advantage in the production of TVs. Therefore, Country A should specialize in the production of TVs.
Country B has an Absolute Advantage in the production of clothes. Therefore, Country B should specialize in the production of clothes.
If each country specializes in their Absolute Advantages, they could produce the following:
| Product | Country A | Country B | Total global: |
|---|---|---|---|
| TV | 20 | 0 | = 20 |
| CLOTHES | 0 | 10 | = 10 |
Both countries have gained through international trade by specializing in their Absolute Advantages and using resources more efficiently.
Comparing the original chart before trade with the final trade chart after specialization, total output of TVs has risen by 4 units from 16 to 20 units, and total output of clothes has risen by 2 units as well from 8 to 10 units. Hence, global output of both TV and clothes has risen from 24 to 30 units.
B. Comparative advantage
A comparative advantage means that a country is able to produce a product at a lower opportunity cost than the same product in another country.
This theory shows that even though a country does not have an Absolute Advantage in one or more industries, yet trade may still be beneficial for this country. It should specialize and trade using its Comparative Advantages.
Country A and Country B produce food and cars, with 50% of each country’s resources allocated to the production of each product. Each country makes the following amounts of each product:
| Product | Country A | Country B | Total global: |
|---|---|---|---|
| FOOD | 12 Absolute Advantage | 6 | = 18 |
| CARS | 16 Absolute Advantage | 4 | = 20 |
As we can see, country A has an Absolute Advantage in the production of both food and cars. This may imply that country A does not need to trade. However, if we look at the opportunity cost of each country’s industries, we can discover the Comparative Advantage for each of those countries:
| Product | Country A | Country B |
|---|---|---|
| FOOD | 16 / 12 = 1.33 | 4 / 6 = 0.66 Comparative Advantage |
| CARS | 12 / 16 = 0.75 Comparative Advantage | 6 / 4 = 1.5 |
Opportunity Cost = 2nd best choice / 1st choice
In Country A, the opportunity cost of producing 1 unit of food is 1.33 units of cars. That means for every unit of food produced, Country A loses the ability to produce 1.33 units of cars.
In Country B, the opportunity cost of producing 1 unit of cars is 1.5 units of food. That means for every unit of car produced, Country B loses the ability to produce 1.5 units of food.
To summarize country A:
If country A produces 1 unit of food, it loses the opportunity to produce 1.33 units of cars. If country A produces 1 unit of cars, it loses the opportunity to produce 0.75 units of food. Country A has a Comparative Advantage in the production of cars because the opportunity cost of car production is less than for that of country B. Country A loses 0.75 units of food when making cars, but Country B loses 1.5 units of food.
Therefore, Country A should specialize in the production of cars.
To summarize country B:
If country B produces 1 unit of food, it loses 0.66 units of cars. If country B produces 1 unit of cars, it loses 1.5 units of food. Country B has a comparative advantage in the production of food because the opportunity cost of food production in less than that of country A. Country B loses 0.66 units of cars when making food, but Country A loses 1.33 units of cars.
Therefore, Country B should specialize in the production of food.
Following up on this information about Comparative Advantages in those two different countries, imagine that Country A devotes 25% of resources to food and 75% to cars, while Country B allocates 100% to food.
| Product | Country A | Country B | Total global: |
|---|---|---|---|
| FOOD | 6 | 12 | = 18 |
| CARS | 24 | 0 | = 24 |
Both countries have gained through international trade by specializing in their Comparative Advantages and using resources more efficiently.
Comparing the original chart with the final trade chart, production of food has remained at the same level of 18 units, though production of cars has increased from 20 to 24 units. Hence, global output of both food and cars has risen from 38 units to 42 units.
Summary
The reasons for international trade include specialization, economies of scale, and beneficial competition increasing choice and promoting innovation.
Specialization allows countries to gain Absolute Advantages and/or Comparative Advantages, increasing efficiency and creating trade incentives.
