If you can walk into a supermarket and find South American bananas, Brazilian coffee and a bottle of South African wine, you're experiencing the effects of international trade.

International trade allows countries to expand their markets for both goods and services that otherwise may not have been available domestically. As a result of international trade, the market contains greater competition, and therefore more competitive prices, which brings a cheaper product home to the consumer.

Key Takeaways

  • International trade is the exchange of goods and services between countries.
  • Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available in their own countries, or which would be more expensive domestically.
  • The importance of international trade was recognized early on by political economists like Adam Smith and David Ricardo.
  • Still, some argue that international trade actually can be bad for smaller nations, putting them at a greater disadvantage on the world stage.

How International Trade Works

International trade gives rise to a world economy, in which supply and demand, and therefore prices, both affect and are affected by global events. Political change in Asia, for example, could result in an increase in the cost of labor, thereby increasing the manufacturing costs for an American sneaker company based in Malaysia, which would then result in an increase in the price charged at your local mall. A decrease in the cost of labor, on the other hand, would likely result in you having to pay less for your new shoes.

A product that is sold to the global market is called an export, and a product that is bought from the global market is an import. Imports and exports are accounted for in a country's current account in the balance of payments.

Comparative Advantage: Increased Efficiency of Trading Globally

Global trade allows wealthy countries to use their resources—whether labor, technology or capital—more efficiently. Because countries are endowed with different assets and natural resources (land, labor, capital, and technology), some countries may produce the same good more efficiently and therefore sell it more cheaply than other countries. If a country cannot efficiently produce an item, it can obtain the it by trading with another country that can. This is known as specialization in international trade.

Let's take a simple example. Country A and Country B both produce cotton sweaters and wine. Country A produces ten sweaters and six bottles of wine a year while Country B produces six sweaters and ten bottles of wine a year. Both can produce a total of 16 units. Country A, however, takes three hours to produce the ten sweaters and two hours to produce the six bottles of wine (total of five hours). Country B, on the other hand, takes one hour to produce ten sweaters and three hours to produce six bottles of wine (a total of four hours).

But these two countries realize that they could produce more by focusing on those products with which they have a comparative advantage. Country A then begins to produce only wine, and Country B produces only cotton sweaters. Each country can now create a specialized output of 20 units per year and trade equal proportions of both products. As such, each country now has access to 20 units of both products.

We can see then that for both countries, the opportunity cost of producing both products is greater than the cost of specializing. More specifically, for each country, the opportunity cost of producing 16 units of both sweaters and wine is 20 units of both products (after trading). Specialization reduces their opportunity cost and therefore maximizes their efficiency in acquiring the goods they need. With the greater supply, the price of each product would decrease, thus giving an advantage to the end consumer as well.

Note that, in the example above, Country B could produce both wine and cotton more efficiently than Country A (less time). This is called an absolute advantage, and Country B may have it because of a higher level of technology.

Important

According to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization.

Origins of Comparative Advantage

The law of comparative advantage is popularly attributed to English political economist David Ricardo. It's discussed in his book “On the Principles of Political Economy and Taxation” published in 1817, although it has been suggested that Ricardo's mentor, James Mill, likely originated the analysis.

David Ricardo famously showed how England and Portugal both benefit by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these facts and stop attempting to make the product that was more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing cloth. Both countries saw that it was to their advantage to stop their efforts at producing these items at home and, instead, to trade with each other.

Some scholars have recently argued that Ricardo did not actually come up with comparative advantage. Instead, the idea may have been inserted by his editor, the political economist and moral philosopher James Mill.

A contemporary example is China’s comparative advantage with the United States in the form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost. The United States’ comparative advantage is in specialized, capital-intensive labor. American workers produce sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefits each.

The theory of comparative advantage helps to explain why protectionism has been traditionally unsuccessful. If a country removes itself from an international trade agreement, or if a government imposes tariffs, it may produce an immediate local benefit in the form of new jobs and industry. However, this is often not a long-term solution to a trade problem. Eventually, that country will grow to be at a disadvantage relative to its neighbors: countries that were already better able to produce these items at a lower opportunity cost.

Criticisms of Comparative Advantage

Why doesn't the world have open trading between countries? When there is free trade, why do some countries remain poor at the expense of others? There are many reasons, but the most influential is something that economists call rent-seeking. Rent-seeking occurs when one group organizes and lobbies the government to protect its interests.

Say, for example, the producers of American shoes understand and agree with the free-trade argument—but they also know that their narrow interests would be negatively impacted by cheaper foreign shoes. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose his or her job or see profits decrease in the short run.

This desire could lead the shoemakers to lobby for special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound—even though, in the long run, American laborers would be made relatively less productive and American consumers relatively poorer by such protectionist tactics.

Other Possible Benefits of Trading Globally 

International trade not only results in increased efficiency but also allows countries to participate in a global economy, encouraging the opportunity for foreign direct investment (FDI), which is the amount of money that individuals invest into foreign companies and assets. In theory, economies can therefore grow more efficiently and can more easily become competitive economic participants.

For the receiving government, FDI is a means by which foreign currency and expertise can enter the country. It raises employment levels, and theoretically, leads to a growth in gross domestic product. For the investor, FDI offers company expansion and growth, which means higher revenues.

Free Trade Vs. Protectionism

As with all theories, there are opposing views. International trade has two contrasting views regarding the level of control placed on trade: free trade and protectionism. Free trade is the simpler of the two theories: a laissez-faire approach, with no restrictions on trade. The main idea is that supply and demand factors, operating on a global scale, will ensure that production happens efficiently. Therefore, nothing needs to be done to protect or promote trade and growth, because market forces will do so automatically.

In contrast, protectionism holds that regulation of international trade is important to ensure that markets function properly. Advocates of this theory believe that market inefficiencies may hamper the benefits of international trade, and they aim to guide the market accordingly. Protectionism exists in many different forms, but the most common are tariffs, subsidies, and quotas. These strategies attempt to correct any inefficiency in the international market.

As it opens up the opportunity for specialization, and therefore more efficient use of resources, international trade has the potential to maximize a country's capacity to produce and acquire goods. Opponents of global free trade have argued, however, that international trade still allows for inefficiencies that leave developing nations compromised. What is certain is that the global economy is in a state of continual change, and, as it develops, so too must its participants.