The Reasons for Trade

Learning Objectives

1. Learn the five reasons why trade between countries may occur.
2. Recognize that separate models of trade incorporate different motivations for trade.
The first theory section of this course develops models that provide different explanations or reasons why trade takes place between countries. The five basic reasons why trade may take place are summarized below. The purpose of each model is to establish a basis for trade and then to use that model to identify the expected effects of trade on prices, profits, incomes, and individual welfare.

The reading “Why We Trade” focuses on the underlying mechanisms and theories explaining trade between countries. It aims to teach learners about five fundamental reasons that fuel international trade and how the principle of comparative advantage when paired with trade, enhances the welfare of individuals across nations. The theory of comparative advantage is emphasized as a cornerstone concept in international trade, often misunderstood but validated by experts like Nobel laureate Paul Samuelson as significant and nontrivial in economics. The course further explores how these trade models impact prices, profits, incomes, and overall individual well-being.

Differences in Technology

Reason for Trade #1: Differences in Technology

Advantageous trade can occur between countries if the countries differ in their technological abilities to produce goods and services. Technology refers to the techniques used to turn resources (labor, capital, land) into outputs (goods and services). The basis for trade in the Ricardian model of comparative advantage in is differences in technology. The difference in technology is explained in the Ricardian model of comparative advantage

Reason for Trade #2: Differences in Resource Endowments

Advantageous trade can occur between countries if the countries differ in their endowments of resources. Resource endowments refer to the skills and abilities of a country’s workforce, the natural resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital stock (machinery, infrastructure, communications systems).
The Pure Exchange Model and The Heckscher-Ohlin model explain the difference in resource endowments.

Reason for Trade #3: Differences in Demand

Advantageous trade can occur between countries if demands or preferences differ between countries. Individuals in different countries may have different preferences or demands for various products. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Canadians may demand more beer, the Dutch more wooden shoes, and the Japanese more fish than Americans would, even if they all faced the same prices—the monopolistic competition model.

Reason for Trade #4: Existence of Economies of Scale in Production

The existence of economies of scale in production is sufficient to generate advantageous trade between two countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as “increasing returns to scale.”

Reason for Trade #5: Existence of Government Policies

Government tax and subsidy programs alter the prices charged for goods and services. These changes can be sufficient to generate advantages in production of certain products. In these circumstances, advantageous trade may arise solely due to differences in government policies across countries. The following provide examples in which domestic tax or subsidy policies can induce international trade:
“Domestic Policies and International Trade”,  “Production Subsidies as a Reason for Trade” and “Consumption Taxes as a Reason for Trade”

Summary
There are very few models of trade that include all five reasons for trade simultaneously. The reason is that such a model is too complicated to work with. Economists simplify the world by choosing a model that generally contains just one reason. This does not mean that economists believe that one reason, or one model, is sufficient to explain all outcomes. Instead, one must try to understand the world by looking at what a collection of different models tells us about the same phenomenon.

For example, the Ricardian model of trade, which incorporates differences in technologies between countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which incorporates endowment differences, concludes that there will be winners and losers from trade. Change the basis for trade and you may change the outcomes from trade.

In the real world, trade takes place because of a combination of all these different reasons. Each single model provides only a glimpse of some of the effects that might arise. Consequently, we should expect that a combination of the different outcomes that are presented in different models is the true characterization of the real world. Unfortunately, because of this, understanding the complexities of the real world is still more of an art than a science.

Key Takeaways

• The five main reasons international trade takes place are differences in technology, differences in resource endowments, differences in demand, the presence of economies of scale, and the presence of government policies.
• Each model of trade generally includes just one motivation for trade.

Exercises

1. List the five reasons why international trade takes place.
2. Identify which model incorporates
1. Differences in technology,
2. presence of economies of scale,
3. Differences in demand,
4. Differences in endowments.

Competitive Advantage

Comparative Advantage and Trade. Authored by: Linda Williams. Provided by: Tidewater Community College.
Located at: http://www.tcc.edu/. Project: Z Degree Program. License: CC BY: Attribution

Competitive advantage is defined as the strategic advantage one business entity has over its rival entities within its competitive industry.

KEY Points

• A country is said to have a comparative advantage in the production of a good (say cloth) if it can produce cloth at a lower opportunity cost than another country.
• Competitive advantage seeks to address some of the criticisms of comparative advantage.
• Competitive advantage occurs when an organization acquires or develops an attribute or combination of attributes that allows it to outperform its competitors.

Terms

• Comparative advantage: The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.
• Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Examples

• Opportunity cost – The opportunity cost of cloth production is defined as the amount of wine for example, that must be given up in order to produce one more unit of cloth.

Competitive advantage is defined as the strategic advantage one business entity has over its rival entities within its competitive industry. Achieving competitive advantage strengthens and positions a business better within the business environment.

Competitive advantage seeks to address some of the criticisms of comparative advantage. A country is said to have a comparative advantage in the production of a good (say cloth) if it can produce cloth at a lower opportunity cost than another country. The opportunity cost of cloth production is defined as the amount of wine that must be given up in order to produce one more unit of cloth. Thus, England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give up to produce another unit of cloth.

Competitive Advantage

The 640GB drive has a competitive advantage over the 500GB drive in terms of both cost and value.

Michael Porter proposed the theory of competitive advantage in 1985. The competitive advantage theory suggests that states and businesses should pursue policies that create high-quality goods to sell at high prices in the market. Porter emphasizes productivity growth as the focus of national strategies. This theory rests on the notion that cheap labor is ubiquitous and natural resources are unnecessary for a good economy. The other theory, comparative advantage, can lead countries to specialize in exporting primary goods and raw materials that trap countries in low-wage economies due to terms of trade. The competitive advantage theory attempts to correct for this issue by stressing maximizing scale economies in goods and services that garner premium prices.

Competitive advantage occurs when an organization acquires or develops an attribute or combination of attributes that allows it to outperform its competitors. These attributes can include access to natural resources, such as high-grade ores or inexpensive power or access to highly trained and skilled personnel human resources. New technologies, such as robotics and information technology, are either to be included as a part of the product or to assist making it. Information technology has become such a prominent part of the modern business world that it can also contribute to competitive advantage by outperforming competitors with regard to Internet presence. From the very beginning (i.e., Adam Smith’s Wealth of Nations), the central problem of information transmittal, leading to the rise of middlemen in the marketplace, has been a significant impediment in gaining competitive advantage. By using the Internet as the middle man, the purveyor of information to the final consumer, businesses can gain a competitive advantage through creation of an effective website, which in the past required extensive effort finding the right middle man and cultivating the relationship.

GLOSSARY

Business environment:

The system within which companies exist.

Consumer

Someone who acquires goods or services for direct use or ownership rather than for resale or use in production and manufacturing. The consumer is the one who pays to consume the goods and services produced. As such, consumers play a vital role in the economic system of a nation. In the absence of their effective demand, the producers would lack a key motivation to produce, which is to sell to consumers.

Economy

Collective focus of the study of money, currency and trade, and the efficient use of resources. The system of production and distribution and consumption. The overall measure of a currency system; as the national economy.

Exporting

The act of selling to a foreign country the sale of capital, goods, and services across international borders or territories.

Good

An object produced for market.

Industry

The sector of the economy consisting of large-scale enterprises.

Lead

Potential opportunity for a sale or transaction, a potential customer.

Leading

To conduct or direct with authority the management function of determining what must be done in a situation and getting others to do it.

Market

A group of potential customers for one’s product. One of the many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange.

Premium

Bonus paid in addition to normal payments. The price above par value at which a security is sold. Something offered at a reduced price as an inducement to buy something else. The amount a policy-holder or his sponsor must pay to a health plan to purchase health coverage.

Price

The price is the amount a customer pays for the product. The quantity of payment or compensation given by one party to another in return for goods or services. The cost required to gain possession of something.

Product

Any tangible or intangible good or service that is a result of a process and that is intended for delivery to a customer or end user. Anything, either tangible or intangible, offered by the firm as a solution to the needs and wants of the consumer; something that is profitable or potentially profitable; goods or a service that meets the requirements of the various governing offices or society.

Absolute Advantage

Boundless Business. Authored by: Boundless. Provided by: Boundless. Located at: https://www.boundless.com/business/. License: CC BY-SA: Attribution-ShareAlike

GOALS

By the end of this section, you will be able to:
• Discuss globalization of markets, economies, and jobs.
• Explain international trade, foreign direct investments, and global monetary systems.

Absolute advantage and balance of trade are two important aspects of international trade that affect countries and organizations.

KEY Points

• Absolute advantage: In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources.
• Net exports: The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports.
• Advantageous trade: Advantageous trade is based on comparative advantage and covers a larger set of circumstances while still including the case of absolute advantage and hence is a more general theory.

Terms

• Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.
• Advantageous: Being of advantage; conferring advantage; gainful; profitable; useful; beneficial; as, an advantageous position.

In the drive for international trade, it is important to understand how trade affects countries positively and negatively—both how a country’s imports and exports affect its economy and how effectively the country’s ability to create and export vital goods effects the businesses within that country. Absolute advantage and balance of trade are two important aspects of international trade that affect countries and organizations .

European Free Trade Agreement

The European Free Trade Agreement has helped countries international trade without worrying about absolute advantage and increases net exports.

Absolute Advantage

In economics, the principle of absolute advantage refers to the ability of a party (an individual, a firm, or a country) to produce more of a good or service than competitors while using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input. Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party. It can be contrasted with the concept of comparative advantage, which refers to the ability to produce a particular good at a lower opportunity cost.

Balance of Trade

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports in an economy over a certain period. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance.

GLOSSARY

Balance of trade
The difference between the monetary value of exports and imports in an economy over a certain period of time.
Comparative advantage
The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.
Economy
Collective focus of the study of money, currency and trade, and the efficient use of resources. The system of production and distribution and consumption. The overall measure of a currency system; as the national economy.
Export
To sell (goods) to a foreign country. Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.
Exporting
The act of selling to a foreign country the sale of capital, goods, and services across international borders or territories.
Good
An object produced for market.
Input
Something fed into a process with the intention of it shaping or affecting the outputs of that process. Each participant’s contributions that are viewed as entitling him/her to rewards or costs. Examples include time, effort, and loyalty.
Opportunity cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative. The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen). The value forfeited by taking a particular route.
Output
Production; quantity produced, created, or completed. data sent out of the computer, as to output device such as a monitor or printer.
Productivity
Productivity is a measure of the efficiency of production and is defined as total output per one unit of a total input. The rate at which goods or services are produced by a standard population of workers. A ratio of production output to what is required to produce it (inputs). The state of being productive, fertile, or efficient. The rate at which products and services are produced relative to a particular workforce.
Resource
Something that one uses to achieve an objective, e.g. raw materials or personnel.
Services
That which is produced, then traded, bought or sold, then finally consumed and consists of an action or work.
Trade deficit
A negative balance of trade.
Trade surplus
A positive balance of trade.
Value
The degree of importance given to something. A value is extremely absolute or relative ethical value, the assumption of which can be the basis for ethical action. A customer’s perception of relative price (the cost to own and use) and performance (quality)
Values
A collection of guiding principles; what one deems to be correct and desirable in life, especially regarding personal conduct.