What Is Trade?
Trade is a basic economic concept involving the buying and selling of goods and services, with compensation paid by a buyer to a seller, or the exchange of goods or services between parties. Trade can take place within an economy between producers and consumers. International trade allows countries to expand markets for both goods and services that otherwise may not have been available to it. It is the reason why an American consumer can pick between a Japanese, German or American car. 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.
In financial markets, trading refers to the buying and selling of securities, such as the purchase of stock on the floor of the New York Stock Exchange (NYSE). For more on this kind of trade, please see the entry on 'what is an order?'
How Trade Works
Trade broadly refers to transactions ranging in complexity from the exchange of baseball cards between collectors to multinational policies setting protocols for imports and exports between countries. Regardless of the complexity of the transaction, trading is facilitated through three primary types of exchanges.
Trading globally between nations gives consumers and countries the opportunity to be exposed to goods and services not available in their own countries. Almost every kind of product can be found on the international market: food, clothes, spare parts, oil, jewelry, wine, stocks, currencies, and water. Services are also traded: tourism, banking, consulting and transportation. A product that is sold to the global market is 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.
International trade not only results in increased efficiency but also allows countries to participate in a global economy, encouraging the opportunity of foreign direct investment (FDI), which is the amount of money that individuals invest into foreign companies and other 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. These raise employment levels, and, theoretically, lead to a growth in the gross domestic product. For the investor, FDI offers company expansion and growth, which means higher revenues.
A trade deficit is a situation where a country spends more on aggregate imports from abroad than it earns from its aggregate exports. A trade deficit represents an outflow of domestic currency to foreign markets. This may also be referred to as a negative balance of trade (BOT).
- Trade broadly refers to exchanging goods and services, most often in return for money.
- Trade may take place within a country, or between trading nations. For international trade, the theory of comparative advantage predicts that trade is beneficial to all parties, although critics argue that in reality it leads to stratification among countries.
- Economists advocate for free trade between nations, but protectionism such as tariffs may present themselves due to political motives, for instance with 'trade wars'.
Comparative Advantage: Increased Efficiency of Trading Globally
Global trade, in theory, 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 item 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. However, according to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization.
The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “On the Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James Mill 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 in order to acquire them.
A contemporary example: China’s comparative advantage with the United States is 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 benefit each.
The theory of comparative advantage helps to explain why protectionism is typically unsuccessful. Adherents to this analytical approach believe that countries engaged in international trade will have already worked toward finding partners with comparative advantages. If a country removes itself from an international trade agreement, if a government imposes tariffs, and so on, it may produce a local benefit in the form of new jobs and industry. However, this is not a long-term solution to a trade problem. Eventually, that country will 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? Perhaps comparative advantage does not work as suggested. There are many reasons this could be the case, 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 leads the shoemakers to lobby for, say, 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.
Free Trade Vs. Protectionism
As with other 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 demandfactors, 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.
Currency as a Medium of Exchange Facilitating Trade
Money, which also functions as a unit of account and a store of value, is the most common medium of exchange, providing a variety of methods for fund transfers between buyers and sellers, including cash, ACH transfers, credit cards and wired funds. Money’s attribute as a store of value also provides assurance that funds received by sellers as payment for goods or services can be used to make purchases of equivalent value in the future.
Cashless trades involving the exchange of goods or services between parties are referred to as barter transactions. While barter is often associated with primitive or undeveloped societies, these transactions are also used by large corporations and individuals as a means of gaining goods in exchange for excess, underutilized or unwanted assets. For example, in the 1970s, PepsiCo Inc. set up a barter agreement with the Russian government to trade cola syrup for Stolichnaya vodka. In 1990, the deal was expanded to $3 billion dollars and included 10 Russian-built ships, which PepsiCo leased or sold in the years following the agreement.