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II. How Economies Function

International Trade: Commerce among Nations

Nations are almost always better off when they buy and sell from one another

Brad McDonald

If there is a point on which most economists agree, it is that trade among nations makes the world better off. Yet international trade can be a contentious political issue, both domestically and between governments.

When a firm or an individual buys a good or a service produced more cheaply abroad, living standards in both countries rise. There are other reasons consumers and firms buy abroad that also make them better off—the product may better fit their needs than similar domestic offerings or it may not be available domestically. The foreign producer also benefits from more sales than it could make solely in its own market and by earning foreign exchange (currency) for purchases of foreign-made products.

Still, not every individual or company is better off. When a firm buys a foreign product because it is cheaper, it benefits—but the (more costly) domestic producer loses a sale. Usually, however, the buyer gains more than the domestic seller loses. Except when the costs of production do not include such social costs as pollution, the world is better off when countries import things that are produced more efficiently abroad.

Those who perceive themselves to be harmed by foreign competition have long opposed international trade. Soon after economists such as Adam Smith and David Ricardo established the economic basis for free trade, British historian Thomas B. Macaulay observed the practical problems governments face: “Free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular.”

Two centuries later trade debates still resonate.

Why countries trade

Ricardo observed that trade was driven by comparative rather than absolute costs (of producing a good). One country may be more productive than others in all goods, in the sense that it can produce any good using fewer inputs (such as capital and labor) than other countries require to produce the same good. Ricardo’s insight was that such a country would still benefit from trading according to its comparative advantage—exporting products in which its absolute advantage was greatest, and importing products in which its absolute advantage was comparatively less (even if still positive).

A country may be twice as productive as its trading partners in making clothing, but if it is three times as productive in making steel or building airplanes, it will benefit from making and exporting these products and importing clothes. Its partner will gain by exporting clothes—in which it has a comparative but not absolute advantage—in exchange for these other products (see box). The notion extends beyond physical goods to trade in services—such as writing computer code or providing financial products.

Because of comparative advantage, trade raises the living standards of both countries.

Differences in comparative advantage may arise for several reasons. In the early 20th century, Swedish economists Eli Heckscher and Bertil Ohlin identified the role of labor and capital, so-called factor endowments, as a determinant. The Heckscher-Ohlin proposition maintains that countries tend to export goods whose production uses intensively the factor of production that is relatively abundant in the country. Countries well endowed with capital—such as factories and machinery—should export capital-intensive products; those well endowed with labor should export labor-intensive products. Economists today think that there are also other important influences on trade patterns (Baldwin 2008).

Recent research finds that episodes of trade opening are followed by adjustment not only across industries, but within them as well. Greater competition from foreign firms puts pressure on profits, forcing less efficient firms to contract and making room for more efficient firms. Expansion and new entry bring better technologies and new product varieties. Likely most important, trade enables greater selection across different types of goods (say refrigerators). This explains why there is a lot of intra-industry trade (for example, countries that export household refrigerators may import industrial coolers), which the factor endowment approach ignores.

There are clear efficiency benefits from trade that results in more products—not only more of the same products, but greater product variety. For example, the United States imports four times as many varieties (such as different types of cars) as it did in the 1970s, while the number of countries supplying each good has doubled. Even more beneficial may be the more efficient investment spending when firms have access to a wider variety and quality of intermediate and capital inputs (think industrial optical lenses rather than cars). By enhancing overall investment and facilitating innovation, trade can bring sustained higher growth.

Economic models that assess the impact of trade typically neglect technology transfer and pro-competitive forces such as greater product variety because these are difficult to model, and results that do incorporate them are subject to greater uncertainty. Where this has been done, however, researchers have concluded that the benefits of trade reforms—such as reducing tariffs and other nontariff barriers to trade—are much larger than suggested by conventional models.

Why trade reform is difficult

Trade contributes to global efficiency. When a country opens up to trade, capital and labor shift toward industries in which they are used more efficiently, and society benefits. But there is more to the story.

Trade also brings dislocation to those firms and industries that cannot cut it. Such firms often seek barriers such as import taxes (called tariffs) and quotas to raise the price or limit the availability of imports. Processors may try to restrict the exportation of raw materials to depress artificially the price of their own inputs. The benefits of trade, though, are not always recognized by those who are helped, and opponents often argue more effectively.

Reforms since World War II have reduced government-imposed trade barriers. But policies to protect domestic industries vary. Tariffs are much higher in certain sectors (such as agriculture and clothing) and among certain country groups (such as less developed countries) than in others. Many countries discourage trade in services in areas such as transportation, communications, and, often, the financial sector; others welcome foreign competition.

Moreover, trade barriers affect some countries more than others. Often hardest hit are less developed countries, whose exports are concentrated in low-skill, labor-intensive products that industrialized countries often protect. The United States, for example, is reported to collect about 15 cents in tariffs for each $1 of imports from Bangladesh (Elliott 2009), but only 1 cent for each $1 of imports from some major western European countries. Yet imports of a particular product from Bangladesh face the same or lower tariffs than similarly classified products imported from western Europe. Although the tariffs on Bangladesh items in the United States may be a dramatic example, World Bank economists calculated that exporters from low-income countries face barriers on average 50 percent higher than those on exports from major industrialized countries (Kee, Nicita, and Olarreaga 2006).

The World Trade Organization (WTO) referees international trade. Agreements since 1948 by its 153 members (of the WTO and its predecessor General Agreement on Trade and Tariffs) promote nondiscrimination and facilitate further liberalization in nearly all areas of commerce, including tariffs, subsidies, customs valuation and procedures, trade and investment in service sectors, and intellectual property (IMF, World Bank, and WTO 2017). These agreements are enforced through a powerful and carefully crafted dispute settlement process.

Under the WTO rules-based international trading system, trade policies are more stable, more transparent, and more open. And the WTO is a key reason why the global financial crisis did not spark widespread protectionism. Restrictive and discriminatory trade policies remain common. Addressing them could yield hundreds of billions of dollars in annual global benefits. But narrow interests seek to delay and dilute further reform. A focus on the greater good and on helping those few who will be harmed can help deliver a fairer and more sensible trading system.