3.2 Why Nations Trade

International trade shapes the global economy, with countries leveraging their strengths for mutual benefit. Absolute advantage allows nations to produce goods efficiently, while comparative advantage drives specialization and trade based on opportunity costs.

Globalization and free trade have far-reaching impacts, offering benefits like economic growth and consumer choice. However, they also present challenges such as job displacement and environmental concerns. Policymakers must balance these factors when crafting international economic strategies.

International Trade and Comparative Advantage

Concept of absolute advantage

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• Ability to produce a good or service more efficiently than another country
• Efficiency measured by quantity of resources (labor, capital, land) required to produce the good or service
• Country with absolute advantage can produce good or service using fewer resources than other countries
• Examples:
  • China has absolute advantage in manufacturing due to large, low-cost labor force and advanced infrastructure
  • Saudi Arabia has absolute advantage in oil production due to vast oil reserves and well-developed extraction infrastructure
  • United States has absolute advantage in technology and innovation due to highly skilled workforce and robust research and development capabilities

Comparative advantage in trade

• Ability to produce a good or service at a lower opportunity cost than another country
  • Opportunity cost is value of next best alternative foregone when making a decision
• Country has comparative advantage when it can produce good or service at lower opportunity cost than other countries, even without absolute advantage
• Comparative advantage influences trade decisions by encouraging countries to specialize in production of goods and services for which they have comparative advantage
  • Countries trade with one another to obtain goods and services they do not produce themselves
  • Specialization and trade leads to increased efficiency, lower prices, and greater variety of goods and services available to consumers
• Example:
  • Country A can produce either 10 units of wheat or 5 units of cloth with its resources
  • Country B can produce either 8 units of wheat or 2 units of cloth
  • Country A has comparative advantage in producing cloth (opportunity cost: 2 units of wheat per unit of cloth) compared to Country B (opportunity cost: 4 units of wheat per unit of cloth)
  • Country B has comparative advantage in producing wheat (opportunity cost: 0.25 units of cloth per unit of wheat) compared to Country A (opportunity cost: 0.5 units of cloth per unit of wheat)
  • Both countries benefit from specializing in good for which they have comparative advantage and trading with each other

Globalization and Free Trade

Globalization and free trade impacts

• Benefits:
  • Increased economic growth and efficiency due to specialization and trade based on comparative advantage
  • Lower prices for consumers due to increased competition and economies of scale
  • Greater variety of goods and services available to consumers
  • Increased foreign direct investment and technology transfer between countries
  • Improved international relations and cultural exchange
• Drawbacks:
  • Potential job losses in certain industries due to increased competition from foreign producers
  • Widening income inequality within countries as some workers benefit more from globalization than others
  • Environmental concerns due to increased transportation of goods and potential exploitation of natural resources
  • Loss of national sovereignty and control over economic policies as countries become more interdependent
  • Cultural homogenization as local traditions and practices may be replaced by global norms and values
• Policymakers must carefully consider potential benefits and drawbacks when designing international economic policies
  • Trade agreements (WTO, regional trade blocs) can help regulate international trade and address potential drawbacks
  • Domestic policies (education and training programs, social safety nets, environmental regulations) can help mitigate negative impacts on affected communities and industries
  • Governments may implement trade barriers (such as tariffs or quotas) to protect domestic industries or address trade imbalances

International Economic Factors

Balance of Trade and Exchange Rates

• Balance of trade refers to the difference between a country's exports and imports
  • A trade surplus occurs when exports exceed imports
  • A trade deficit occurs when imports exceed exports
• Exchange rates play a crucial role in international trade by determining the relative value of currencies
  • Fluctuations in exchange rates can impact the competitiveness of a country's exports and the cost of imports

International Monetary System and Economic Interdependence

• The international monetary system facilitates global trade and financial transactions
  • It includes institutions, agreements, and mechanisms for currency exchange and international payments
• Economic interdependence among nations has increased due to globalization
  • Countries rely on each other for resources, goods, services, and financial markets
  • This interconnectedness can lead to both opportunities and vulnerabilities in the global economy