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Why do nations trade with each other? Are there any disadvantages for international trade?

International trade is the exchange of goods and services between two (or more) countries. When goods (services) are brought in, it is called import and when goods are carried out its called export.

International trade is necessary, because the scare resources are distributed unevenly between different countries and thus some countries are better producing some products than other. For example Zimbabwe has virtually all the world's chrome resources, so it has an advantage of extracting it while the workforce in Germany can produce chrome tapes (because they have the capital and technology). Without international trade the chrome tape production would not be possible (and thus the quality of sound suffers) etc. Furthermore, the Zimbabwe itself would have no remarkable benefits from its chrome resources as the domestic market for tapes is probably very small and the building of tape factories is expensive.

Another, not so obvious and maybe arguable, uneven allocation is the allocation of education for labour. As the possibilities for getting education in "west" are much greater, the services sector (or tertiary sector) is much more developed (e.g. workers in banking sector have to be trained for long time). In the developing countries the educational standards are lower, thus they have developed manufacturing and extraction (primary and secondary) industries, which require much not so educated labour.

The international trade helps to make the distribution of resources more even. The countries can specialise to work that they are best at. It also helps countries to obtain the products they otherwise might not get. Also, it increases the variety of goods. E.g. UK can produce cheese, but with international trade English are also able to enjoy French cheese etc.

If we take 2 countries, e.g. A and B, and assume that their economies produce only 2 things, food and cars, then, without international trade, both sectors would involve 50% of the resources and output might be:









From here it is seen that A is better in producing F and C, but the opportunity cost for 1F=2C, whereas the opportunity cost for F in B is 1F=1/2C. The international trade is beneficial and possible always when the 2 goods have different opportunity costs in different countries. When one country is absolutely better of producing one good and the other country another, then it is called an absolute advantage, but as in example above when one country is relatively (in terms of opportunity costs) better of producing one good it is called a comparative advantage. So A has absolute comparative advantage of producing C and B has comparative advantage of producing F. In this case (and in real life) the specialisation is never complete. That means that B will not give up all production of C if it wants to increase both the quantities of F and C, and vice-versa. A diagram can be draw from this data showing the production possibility curves for both of the countries and finding the optimum allocation of resources.

There is also one thing that needs to be considered - the exchange rate. A would trade with B if it would get anything more than 1/2 of F for its C, the same way B would trade if it could get more than 1/2 of C for its F, so any exchange rate between 1/2F=C and 2F=C would be beneficial, let us assume that the exchange rate will be F=C. Also let us assume that countries want to exchange 25 units. Note, that the production possibility curve cannot be straight line, because if A would produce only C (so 800), the it cannot exchange all of them to F, because B is not able to produce 800 F. So these production possibility curves apply only if 25 units is exchanged, any other quantity would have different possibility curves.

Country A(dotted line is before specialisation)                        Country B

If the countries would decide to produce more what they are best at (B produces F and A, C) then (- is import, + export, the sum is country's actual production):



Gain form trade









Both countries have gained and there was a gain in welfare of 30 units.

Specialisation can lead to economies of scale, so the production possibility curve is not always a straight line, but sometimes convex, thus e.g. B if it would produce only F could produce it 220 units.

Also the prices of factors of production can be equalised if the trade takes place. It reduces inequalities between different people in a country, but can also lead to unemployment in the sector whose prices are lowered.

The trade is beneficial even if the countries can produce the same amount of goods, but the tastes differ. Let us assume that A and B both produce same amount of F and C, but A likes C and hates F, thus the price of F is very low, and B likes F, but hates C, so the price of F is expensive. Now if the trade takes place the prices of F in A and C in B will increase and the people that produce them, will get higher income. This example is actually an extension to previous one (factor price equalisation).

Further gains in welfare might be due to increased competition that usually makes the firms more effective and reduces the X-inefficiency factor.

Anyway, there are also numerous disadvantages arising from international trade. In my example the exchange rate was F=C, but if A would be a very powerful country, it might force B to trade with ratio 29/20F=C. Although this exchange rate is beneficial to both A & B, but A benefits much more. This increases the inequalities between 2 countries and is nowadays serious problem when considering the trade between developed and developing countries.

Instead of economies of scale there might be diseconomies of scale and the curve might look like concave instead of convex.

There are also transport costs involved in international trade, which decrease the efficiency and increase production costs. They are especially important when two countries are not neighbours (e.g. USA and any European country).

Some might argue that the wages in developing countries are very low, thus it is unfair for the home country to trade. Anyway not trading at all will worsen the situation and create unemployment in the developing country.

Extending the previous point, the monopolies abroad might find the elasticities of different countries different and can price discriminate. If the elasticity in home country is high they might lower the price below production costs to sell a lot. This is called dumping and protectionism is usually considered against it in the home country.

The countries might have obstacles to trade (tariffs and quotas, political differences, different currencies, some disguised barriers (safety)). These increase the cost, decrease the welfare and international trade. But the tariffs imposed in one country will bring revenue to this country and losses to the other. And if the other country imposes tariffs the situation is opposite, thus in the whole world revenue is not increased with imposition of taxes, only welfare is decreased.

The specialisation itself can create disadvantages for trade. If a country is too dependant of one industry and the prices fall in that industry, then massive unemployment will occur. This was the case in many developing countries and might also apply to UK West-Midlands that is too dependant of car-industry. This phenomenon is called factor immobility and refers to the fact that factors of productions cannot easily be moved from one location to another. E.g. if after international trade B would decrease the production of C, then the labour producing C cannot easily be moved and retrained to produce extra F, thus unemployment will occur.

International trade can also damage infant industries in home country, because their production costs are high at the beginning. Over specialisation might have devastating effects if the war starts and import-export ceases. Thus the countries never specialise completely because of the strategic reasons. Also if the import is much greater than export, balance of payments would be negative, which will damage the economy in home country and might lead to devaluation of the currency.

Despite all these disadvantages, only few are valid in the long-run (labour can be trained in the long-run etc.), and most of the economists think that free trade is beneficial and increases welfare and should be supported.

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