What Is International Trade?

International trade is the exchange of goods and services between countries. This type
of trade gives rise to a world economy, in which prices, or supply and demand, 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 that you have to pay to buy the tennis shoes at your local mall. A decrease
in the cost of labor, on the other hand, would result in you having to pay less for your
new shoes.

Trading globally 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. (Heakal, 2018)

The Importance of International Trade1

International trade between different countries is an important factor in raising living

standards, providing employment and enabling consumers to enjoy a greater variety of
goods.

International trade has occurred since the earliest civilizations began trading, but in
recent years international trade has become increasingly important with a larger share
of GDP devoted to exports and imports.

1
(Pettinger, 2017)
World Bank stats show how world exports as a % of GDP have increased from 12% in
1960 to around 30% in 2015.

With an increased importance of trade, there have also been growing concerns about
the potential negative effects of trade – in particular, the unbalanced benefits with some
losing out, despite overall net gains.
World exports of goods and services have increased to $2.34 trillion ($23,400 billion) in
2016.
Importance of trade

Make use of abundant raw materials

Some countries are naturally abundant in raw materials – oil (Qatar), metals, fish
(Iceland), Congo (diamonds) Butter (New Zealand). Without trade, these countries
would not benefit from the natural endowments of raw materials.

A theoretical model for this was developed by Eli Heckscher and Bertil Ohlin. Known as
the Heckscher–Ohlin model (H–O model) it states countries will specialise in producing
and exports goods which use abundant local factor endowments. Countries will import
those goods, where resources are scarce.

Comparative advantage

The theory of comparative advantage states that countries should specialise in those
goods where they have a relatively lower opportunity cost. Even if one country can
produce two goods at a lower absolute cost – doesn’t mean they should produce
everything. India, with lower labour costs, may have a comparative advantage in labour
intensive production (e.g. call centres, clothing manufacture). Therefore, it would be
efficient for India to export these services and goods. While an economy like the UK
may have a comparative advantage in education and video game production. Trade
allows countries to specialise. More details on how comparative advantage can
increase economic welfare. The theory of comparative advantage has limitations, but it
explains at least some aspects of international trade.

Greater choice

New trade theory places less emphasis on comparative advantage and relative input
costs. New trade theory states that in the real world, a driving factor behind the trade is
giving consumers greater choice of differentiated products. We import BMW cars from
Germany, not because they are the cheapest but because of the quality and brand
image. Regarding music and film, trade enables the widest choice of music and film to
appeal to different tastes. When the Beatles went on tour to the US in the 1960s, it was
exporting British music. Relative labour costs were unimportant.

Perhaps the best example is with goods like clothing. Some clothing (e.g. value clothes
from Primark – price is very important and they are likely to be imported from low-labour
cost countries like Bangladesh. However, we also import fashion labels Gucci (Italy)
Chanel (France). Here consumers are benefitting from choice, rather than the lowest
price. Economists argue that international trade often fits the model of monopolistic
competition. IN this model, the important aspect is brand differentiation. For many
goods, we want to buy goods with strong brands and reputations. e.g. popularity of
Coca-Cola, Nike, Addidas, McDonalds e.t.c.

Specialisation and economies of scale

Another aspect of new trade theory is that it doesn’t really matter what countries
specialise in, the important thing is to pursue specialisation and this enables companies
to benefit from economies of scale which outweigh most other factors. Sometimes,
countries may specialise in particular industries for no over-riding reason – it may just
be historical accident. But, that specialisation enables improved efficiency. For high
value added products, multinationals often split production process into a global
production system. For example, Apple design their computers in the US but contract
the production to Asian factories. Trade enables a product to have multiple country
sources. With car production, the productive process is often even more global with
engines, tyres, design and marketing all potentially coming from different countries.

Service sector trade

Trade tends to conjure images of physical goods import bananas, export cars. But,
increasingly the service sector economy means more trade is of invisibles – services,
such as insurance, IT services and banking. Even in making this website, I sometimes
outsource IT services to developers in other countries. It may be for jobs as small as
$50. Furthermore, I may export a revision guide for £9.50 to countries all around the
world. A global economy with modern communications enables many micro trades,
which wouldn’t have been as possible in a pre-internet age.

Trading blocks
Gravity theory states trade is more likely between similar countries of close
geographical proximity. Therefore, this provides added incentive to create geographical
blocks, such as NAFTA and EU, which enable reduction of non-tariff barriers to create
more free trade.

Problems arising from free trade

Given importance of free trade to an economy, it is unsurprising that people are

concerned at the potential negative impacts

Infant industry argument. The fear is that ‘free trade’ can cause countries to specialise
in primary products – goods which have volatile prices and low-income elasticity of
demand. To develop, economies may need to restrict imports and diversify the
economy. This isn’t an argument against trade per se, but an awareness trade may
need to be ‘managed’ rather than just rely on free markets. See more at Infant Industry
Argument.

Trade can lead to cultural homogenisation. Some fear trade gives an advantage to
multinational brands and this can negatively impact local produce and traditions.
Supporters argue that if local products are good, they should be able to create a niche
than global brands cannot.

Displacement effects. Free trade can cause uncompetitive domestic industries to

close down, leading to structural unemployment. The problem with free trade is that
there are many winners, but the losers do not gain any compensation. However, free
market economists may counter that some degree of creative destruction is inevitable in
an economy and we can’t turn back to a static closed economy. On the upside, if the
uncompetitive firms close down, ultimately new jobs will be created in different
industries.

International vs domestic trade

International trade refers to trade between two different countries

(such as India and Bangladesh) or one country and the rest of the
world (e.g., India and Great Britain, Germany, U.S.A., etc.). The
former is called bilateral trade and the latter multilateral trade.

Domestic trade or internal trade is the trade which takes places

between the different regions of the same country (e.g., the trade
between Calcutta and Mumbai or Calcutta and Chennai, etc.). It is to
be noted that there are some points of similarities between these two
kinds of trade.
All trade, whether domestic or international, arises from
specialisation. As one region of a country brings the goods from other
regions to make up the deficiencies, one country tries to bring goods
and services, in which it has deficiencies, from other countries.

Land, labour and the other resources used in production are not
distributed equally among the nations of the world. Minerals, for
example, such as coal, iron and gold are found only in certain areas.
Similarly, the climatic conditions essential for the growth of particular
commodities (such as cane sugar, rice and tropical fruit) are found
only in certain regions of the world.

Thus countries are dependent upon one another for supplying their
deficiencies in foods, raw materials and other products. But, countries
cannot buy the products they need from each other without selling
certain things in exchange. Thus, they are dependent upon one
another for markets. But there are some points of distinctions between
these two kinds of trade; these call for a separate theory for
international trade.

Trading between countries differ from domestic (internal) trade, i.e.,

trade within a country in different.

The sources of international trade in goods

Trade in goods and services is defined as change in ownership of material resources and services
between one economy and another. The indicator comprises sales of goods and services as well as
barter transactions or goods exchanged as part of gifts or grants between residents and non-
residents. It is measured in million USD and percentage of GDP for net trade and also annual growth
for exports and imports.
Protectionism2

Protectionism refers to government actions and policies that restrict or restrain

international trade, often with the intent of protecting local businesses and jobs from
foreign competition.

Breaking down 'protectionism'

The merits of protectionism are the subject of fierce debate. Critics argue that over the
long term, protectionism often hurts the people it is intended to protect by slowing
economic growth and pushing up prices, making free trade a better alternative.
Proponents of protectionism argue that the policies provide competitive advantages and
create jobs. Protectionist policies can be implemented in four main ways: tariffs, import
quotas, product standards and government subsidies.

Tariffs
There are three types of tariffs, also referred to as import duties, that can be
implemented for protective measures. All forms of tariff are charged and collected by
governments to raise the price of imports to equal or exceed local prices. Scientific
tariffs are imposed to raise the prices of products to end users. Peril point tariffs are
implemented when less-efficient industries are in jeopardy of closure due to an inability
to compete on pricing. Retaliatory tariffs can be used as a response to excessive tariffs
being charged by trading partners.

Import Quotas
Trade quotas are non-tariff barriers that are put in place to limit the number of products
that can be imported over a set period of time. The purpose of quotas is to limit the
supply of specified products, which typically raises prices and allows local businesses to
capitalize on unmet demand. Quotas are also put in place to prevent dumping, which
occurs when foreign producers export products at prices lower than production
costs. An embargo, in which the importation of designated products is forbidden, is the
most severe type of quota.

Product Standards
Limitations based on product standards are implemented for a variety of reasons,
including concerns over product safety, sub-standard materials or labeling. Whether
these concerns are valid or exaggerated, limiting imports benefits local producers. For

2
(Protectionisim: Investopedia, 2018)
 example, French cheeses made with raw, instead of pasteurized, milk must be aged at
least 60 days prior to being imported to the U.S. Because the process for producing
young cheeses is often 50 days or fewer, some of the most popular French cheeses are
banned, providing local producers the opportunity to compete with pasteurized versions.

Government Subsidies
Governments can help domestic businesses compete by providing subsidies, which
lower the cost of production and enable the generation of profits at lower price levels.
Examples include U.S. agricultural subsidies and subsidies paid by the Chinese
government to help grow the country's automotive industry

Trade Barrier3

Trade barriers are government policies which place restrictions on international trade.
Trade barriers can either make trade more difficult and expensive (tariff barriers) or
prevent trade completely (e.g. trade embargo)

Examples of Trade Barriers

 Tariff Barriers. These are taxes on certain imports. They raise the price of goods making
imports less competitive.
 Non-Tariff Barriers. These involve rules and regulations which make trade more difficult. For
example, if foreign companies have to adhere to complex manufacturing laws it can be difficult
to trade.
 Quotas. A limit placed on the number of imports
 Voluntary Export Restraint (VER). Similar to quotas, this is where countries agree to limit the
number of imports. This was used by US for imports of Japanese cars.
 Subsidies. A domestic subsidy from government can give the local firm a competitive
advantage.
 Embargo. A complete ban on imports from a certain country. E.g. US embargo with Cuba.

Real world examples of trade barriers

Chinese import tariffs. This link shows that China is reducing its import tariffs on
luxury foreign goods such as Scottish Whiskey from 10% to 5%. It is a sign Chinese
government want to encourage consumer spending. BBC – China cuts import tariffs

50% tariff on imports of washing machines. The US Trade body has recommended
tariffs of 50% on imports of washing machines – especially from South Korean
manufacturers IG and Samsung. The Trade body is concerned IG are selling washing

3
(Pettinger, Trade Barriers: Economics Help, 2017)
machines below cost and dumping surplus supply on the US market. US manufacturer
Whirlpool brought the case.

Custom duties post-Brexit. If the UK leaves the Single Market as part of Brexit
process there will be custom forms and regulations to meet on exports and imports.
These rules and regulations provide a significant barrier to trade.

Quotas on low-tariff food. The EU has a quota for allowing a certain number of food
items to enter without attracting tariffs.

VER. In 1981, the US implemented a 1981 voluntary restraint agreement limited the
Japanese to exporting 1.68 million cars to the U.S. per year. This limited the import of
cars, though ironically made it more profitable for Japanese exporters. With a limit on
the quantity, they could increase prices. Another consequence of this is that Japanese
firms began assembling cars in the US and entering into partnerships with American car
companies to get around the export restrictions.

Subsidies. The EU gives €39 billion to farmers in direct subsidies. Indirectly, this makes
EU agricultural exports more competitive and gives EU farmers an advantage in trade.

Embargoes are usually implemented for political reasons. After Fidel Castro came to
power, the US imposed a trade embargo on Cuba, which was strictly enforced.

EU tariffs

Source: WTO World Tariff rates

Economic Cost of Tariff

The effect of tariffs on consumers

Tariffs increase the cost of imports, leading to higher prices (P1 to P2) for consumers
and a decline in consumer surplus. For example, UK consumers have lost out from EU
wide tariffs on agricultural products. Many agricultural goods are more expensive
because of the high tariffs placed to protect EU farmers.

It is hard to think of any benefits from tariffs for consumers. Maybe in the long run
consumers benefit from the protection of domestic industries if these industries use the
tariffs to improve.

The effect of tariffs on producers

Domestic producers will benefit from the introduction of tariffs. This is because it makes
their domestic production relatively more competitive compared to imports. Agricultural
tariffs have benefited European farmers as they have been protected from cheaper
competition.

However, it is argued that the restriction of competition encourages inefficient firms.

Therefore, in the long run, domestic firms may not make the necessary improvements
that they would have done without tariffs.
 Also, the introduction of tariffs usually leads to retaliation. Therefore, other countries will
place tariffs on UK exports. Therefore, some exporting firms will lose out and sell fewer
exports.

The effect of tariffs on government

Tariffs will increase government revenue. However, it will be a small percentage of total
tax revenue. If the tariff is too high then the UK may no longer import the good, so the
government will not get any tariff revenue.

Also, there will be other effects. Tariffs lead to a decline in disposable income and a net
loss of economic welfare – this will lead to less noticeable falls in tax revenue elsewhere
in the economy.

Also, import tariffs may lead to retaliation, meaning UK export firms will face higher
tariffs, and they could suffer falling demand. This will lead to lower corporation tax
revenue.

The effect of tariffs on employment

It is often argued that tariffs can help protect jobs. If the US government place high
tariffs on car imports, this can make US car industry more competitive – safeguarding
jobs in US car industry.

However, whilst these jobs are quite obvious and visible. Less visible is the harmful
effect on employment elsewhere in the economy.

 Consumers face higher prices for cars, leaving less disposable income for buying other goods.
Therefore, other domestic industries may see a fall in demand – leading to less employment
 If the US place tariffs on car imports. Other countries – Japan, EU may retaliate and place tariffs
on US exports – leading to less employment in export industries which are internationally
competitive.
 Diagram to show the effect of tariffs on consumers and producers

 The tariff equals P2-P1. This causes a higher price for consumers, and demand falls from Q4 to
Q3. The net loss of consumer surplus is areas 1+2+3+4
 Domestic produces see sales rise from Q1 to Q2. Therefore, producer surplus rises by area 1
 The government receive tariff revenue of area 3.
 The net welfare gain is 1+4 – (1+2+3+4). So areas 2 + 4 are the net loss to the UK economy.
 However, we should remember foreign firms will also lose out from a decline in imports.
 Also, consumers will be relatively worse off so they will buy fewer goods elsewhere in the
economy.
 Also, exporting firms may be hit by retaliatory tariffs.

Evaluation
 The effect of tariffs depends on the elasticity of demand. If demand is inelastic, there will be
smaller welfare loss. If demand is price elastic, there will be a bigger decline in welfare and fall
in consumer consumption of the good.
 There are other issues from economies of scale. Tariffs may cause production to shift to smaller
firms with fewer economies of scale.
 There is also the issue of retaliation. If one country places tariffs on imports, then other
countries are likely to retaliate – causing a decline in exports.
 Some jobs may be saved in domestic industry (industries protected by tariffs). But, other jobs in
(export) industries will be lost.
 Also with less disposable income, consumer spending will fall and there will be some decline in
output in other sectors. (Pettinger, Benefits and Cost of Tariffs: Economics Help, 2017)
Balance of Payments

The balance-of-payments accounts of a country record the payments and

receipts of the residents of the country in their transactions with residents of
other countries. If all transactions are included, the payments and receipts of
each country are, and must be, equal. Any apparent inequality simply leaves
one country acquiring assets in the others. For example, if Americans buy
automobiles from JAPAN, and have no other transactions with Japan, the
Japanese must end up holding dollars, which they may hold in the form of bank
deposits in the United States or in some other U.S. INVESTMENT. The
payments Americans make to Japan for automobiles are balanced by the
payments Japanese make to U.S. individuals and institutions, including banks,
for the acquisition of dollar assets. Put another way, Japan sold the United
States automobiles, and the United States sold Japan dollars or dollar-
denominated assets such as treasury bills and New York office buildings.

Although the totals of payments and receipts are necessarily equal, there will
be inequalities—excesses of payments or receipts, called deficits or
surpluses—in particular kinds of transactions. Thus, there can be a deficit or
surplus in any of the following: merchandise trade (goods), services trade,
foreign investment income, unilateral transfers (FOREIGN AID), private
investment, the flow of gold and money between central banks and treasuries,
or any combination of these or other international transactions. The statement
that a country has a deficit or surplus in its “balance of payments” must refer
to some particular class of transactions. As Table 1shows, in 2004 the United
States had a deficit in goods of $665.4 billion but a surplus in services of $48.8
billion.

Many different definitions of the balance-of-payments deficit or surplus have

been used in the past. Each definition has different implications and purposes.
Until about 1973 attention was focused on a definition of the balance of
payments intended to measure a country’s ability to meet its obligation to
exchange its currency for other currencies or for gold at fixed exchange rates.
To meet this obligation, countries maintained a stock of official reserves, in the
form of gold or foreign currencies, that they could use to support their own
currencies. A decline in this stock was considered an important balance-of-
payments deficit because it threatened the ability of the country to meet its
obligations. But that particular kind of deficit, by itself, was never a good
indicator of the country’s financial position. The reason is that it ignored the
likelihood that the country would be called on to meet its obligation and the
willingness of foreign or international monetary institutions to provide support.

After 1973, interest in official reserve positions as a measure of balance of

payments greatly diminished as the major countries gave up their commitment
to convert their currencies at fixed exchange rates. This reduced the need for
reserves and lessened concern about changes in the size of reserves. Since
1973, discussions of “the” balance-of-payments deficit or surplus usually refer
to what is called the current account. This account contains trade in goods and
services, investment income earned abroad, and unilateral transfers. It excludes
the capital account, which includes the acquisition or sale of securities or other
property.

Because the current account and the capital account add up to the total account,
which is necessarily balanced, a deficit in the current account is always
accompanied by an equal surplus in the capital account, and vice versa. A
deficit or surplus in the current account cannot be explained or evaluated
without simultaneous explanation and evaluation of an equal surplus or deficit
in the capital account. (Stein, 2018)