CETS Reading-1

Basics of International Trade

 Chapter One: Basics of International Trade

1.1 Background of International Trade

International trade is the system by which countries exchange goods and services. Countries
trade with each other to obtain things that are better quality, less expensive or simply different
from goods and services produced at home. The goods and services that a country buys from
other countries are called imports, and goods and services that are sold to other countries are
called exports. Importers and exporters are the core parties in international trade. In terms of
international trade, the responsibility of exporter (seller) is to send the goods and that of importer
is to send/make payments.
International trade occurs because there are things that are produced in a particular country that
individuals, businesses and governments in other countries want to buy. Trade provides people
with a greater selection of goods and services to choose from, often at lower costs than at home.
In order to become wealthier, countries want to use their resources––labor, land and capital––as
efficiently as possible. However, there are large differences in the quantity, quality and cost of
different countries' resources. Some countries have natural advantages, such as abundant
minerals or a climate suited to agriculture. Others have a well-trained workforce or highly
developed infrastructure, like good roads, advanced telecommunications systems and reliable
electric utilities, which help the production and distribution of goods and services. Instead of
trying to produce everything by themselves, which would be inefficient, countries often
concentrate on producing those things that they can produce best, and then trade for other goods
and services. By doing so both the country and the world become wealthier.

1.2 Gains from Trade

International trade brings mutual gains by redistributing product in such a way that both parties
end up holding a combination of goods which is better suited to their preferences than the goods
they held before. When nation exports, producers are better off and when nation imports
consumers’ surplus is enhanced.
1.2.1 International Trade and the Exporting Country: Trade gain from Export (with
example on Steel):

If the world price of steel is higher than the domestic price, the country will become an exporter
of steel when trade is permitted. Domestic producers of steel will like to increase their output
because the domestic price moves to the world price. As a result, domestic consumers will have
to buy steel at the higher world price. How trade affects welfare in exporting country is shown in
the following graphs:

* Domestic producers of the goods are better off, and domestic consumers of the goods are
worse off.

* Trade raises the economic well-being of the nation as a whole (D).

1.2.2 International Trade and the Importing Country: Trade Gain from Import(with
example on Steel) :

If the world price of steel is lower than the domestic price, the country will become an importer
of steel when trade is permitted. Domestic consumers will want to buy steel at the lower world
price. Domestic producers of steel will have to lower their output because the domestic price
moves to the world price. How trade affects welfare in importing country is shown in the
following graphs:
 * Domestic producers of the goods are worse off, and domestic consumers of the goods
are better off.

* Trade raises the economic well-being of the nation as a whole because the gains of
consumers exceed the losses of producers (D).

1.3 Trade Theories

1.3.1 Trade Theories: Mercantilists view on Trade:

The economic philosophy known as Mercantilism (from 16th to mid-18th century) maintained
that the most important way for a nation to become rich and powerful was to export more than it
imported. The difference would be settled by an inflow of precious metal mostly gold. The more
gold a nation had, the richer and more powerful it was. Thus mercantilists advocated that the
government should stimulate exports and restrict imports. Since not all nations could have an
export surplus simultaneously and the amount of gold in existence was fixed at any one time, a
nation could only gain at the expense of the other nations.

1.3.2 Adam Smith: Absolute Advantage:

In 1776, Adam Smith published his famous book. The Wealth of Nations, in which he attacked
the mercantilist view on trade and advocated instead free trade as the best policy for the nations
of the world. Smith argued that with free trade, each nation could specialize in the production of
those commodities in which it had an absolute advantage (or could produce more efficiently than
other nations) and import those commodities in which it had an absolute disadvantage (or could
produce less efficiently). This international specialization of factors in production would result in
an increase in world output which would be shared by the trading nations. Thus a nation need not
gain at the expenses of other nations – all nations could gain simultaneously.

Example: Table 1 shows that the U.S has an absolute advantage over the U.K in the production
of wheat and the U.K. has an absolute advantage in the production of cloth . If the U.S
specializes in the production of wheat and the U.K in the production of cloth, the combined
output of wheat and cloth of the U.S and the U.K would be greater and both the U.S and the U.K
would share in this increase through (voluntary) exchange.

Table 1: Example of Absolute Advantage

U.S U.K

Wheat (bushels/labor-hour) 6 1

Cloth (yards/labor-hour) 1 2

Smith explained that if each nation specialized in (or produced more than it wanted to consume
domestically of) the commodity in which it was more efficient, and exchanged this excess for the
commodity in which it was less efficient, the output of all commodities entering trade would
increase. This increase would be shared by all nations that voluntarily engaged in trade. Thus, the
gains form trade would arise from specialization in production and trade. These gains would be
maximized when the government interfered as little as possible with the operation of the
domestic economy (laissez faire) and with international trade (free trade).

1.3.3 David Ricardo: Comparative Advantage

Ricardo writing after 40 years than Smith, stated that even if a nation has an absolute
disadvantage in the production of both commodities with respect to the other nation, mutually
advantageous trade could still take place. The less efficient nation should specialize in the
production of and export of the commodity in which its absolute disadvantage is less. This is the
commodity in which the nation has a comparative advantage. On the other hand, the nation
should import the commodity in which its absolute disadvantage is greater. This is the area of its
comparative disadvantage. This is known as the Law of comparative advantage – one of the most
famous and still unchallenged laws of economics.

Example:

Table 2 shows that the U.K has an absolute disadvantage with respect to the U.S in the
production of both wheat and cloth. However, its disadvantage is less in cloth than in wheat.
Thus the U.K has a comparative advantage with respect to the U.S in cloth and a comparative
disadvantage in wheat. For the U.S, the opposite is true. That is, the U.S has an absolute
advantage over the UK in both commodities, but this advantage is greater in wheat (6:1) than in
cloth (3:2). Thus the U.S has a comparative advantage over the U.K in wheat and a comparative
disadvantage in cloth. Mutually advantageous trade could take place with the U.S exchanging
wheat (W) for cloth (C) with the U.K.

Table 3: Example of Comparative Advantage

U.S U.K

Wheat (bushels/labor-hour) 6 1

Cloth (yards/labor-hour) 3 2

With reference to Table 2, we see that if the U.S could exchange 6W for 6C with the U.K, the
U.S. would gain 3C (since the U.S can only exchange 6W for 3C domestically). To produce 6W
itself, the U.K would require 6 hours of labor. Instead, the U.K can use the 6 labor-hours to
produce 12C exchange 6 of these 12 C for 6W from the U.S and end up with 6C more for itself.
Thus by exchanging 6W for 6C, the U.S would gain 3C and the U.K 6C. There are many other
ratios of exchange of W for C (besides 6W for 6C) that would be advantageous to both nations.
The rate at which exchange actually takes place determines how the gains from trade are shared
by the two nations. [What that rate itself will be, depends also on demand conditions in each
nation.
The difference in pre-trade relative commodity prices (comparative advantage) between the two
nations is based on a difference in factor endowments, technology, or tastes between the two
nations. However, even if two nations have exactly the same factor endowments and technology
a difference in tastes can be the basis for mutually beneficial trade.

1.4 Trade Barriers

International trade increases the number of goods that domestic consumers can choose from,
decreases the cost of those goods through increased competition. It allows domestic industries to
ship their products abroad. While all of these seem beneficial, free trade isn't widely accepted as
completely beneficial to all parties. Here comes the concept of trade barriers. These barriers are
measures that governments or public authorities introduce to make imported goods or services
less competitive than locally produced goods and services. The most common barriers to trade
are tariffs, quotas, and nontariff barriers. A tariff is a tax on imports, which is collected by the
government and which raises the price of the good to the consumer. A quota is a limit on the
amount of a certain type of goods that may be imported into the country. A quota can be either
voluntary or legally enforced. While tariffs and quotas are traditional tools for the purpose
mainly to protect domestic industries, there are other barriers which have become more
important in the world of today. These trade barriers are seen as ‘the tools of new protectionism’.
The tools of new protectionism are Voluntary export restraints, Technical, administrative, and
other regulations, International cartels, Dumping, Export Subsidies etc.

1.5 Role of Banks in Trade Facilitation

In the international trade, traders have to decide how to settle the transaction and, thereby, how
to manage the associated risk. And in many cases traders need financing assistance. To support
these needs arisen in trade transaction, banks play a vital role. Banks are important facilitators of
international trade. Banks act as the intermediary agent between exporter and importer. Its role in
international trade is to facilitate payment; and to provide finance to exporter and importer.
Banks also offer risk management services. Globally four international trade payment methods
are used. These are: Cash in Advance; Open Account; Documentary Collection; and
Documentary Credit. In cash in advance and open account payment methods, banks role is not
mandatory. They only facilitate the payment by transferring fund from importers account to
exporter’s account as per the importer’s instruction. But in documentary collection and
documentary credit banks play an active role. Under documentary collection banks act as an
agent of exporter to collect payment from importer against delivery of documents. Here bank has
no payment obligation. But in documentary credit bank provide irrevocable undertaking to pay
against complying presentation. Here bank holds the primary liability to pay. Besides offering
payment facility, banks also provide finance to both importer and exporter. Finance or credit
provided to the exporters is known as export finance which is generally offered at pre-shipment
and post-shipment stage. Importers are provided financing facilities at pre-import and post
import stage. Banks shoulder risks for their clients in the process of the facilitation of trade
payments and financing services. Moreover, banks offer some foreign exchange and commodity
derivatives to minimize different risks associated with international trade transactions.

Reference:

Salvatore, D., & Raymond, A. (2001). International economics (7th ed.). New York
;Chichester:Wiley,MLA