Hi, from this post we begin a series of posts covering the subject of International Trade. In due course we will cover topics like GDP and GNP, benefits and costs of international trade, international trading restrictions and their types, balance of payments and currency exchange rates. Today, we will start with an introduction to the subject of International trade… let’s begin…
Gross Domestic Product and Gross National product
Gross domestic product and Gross National product are two concepts closely related to international trade. So before we delve into the various aspects of international trade let us understand these concepts more clearly.
Gross domestic product or GDP as we know it is the total value of goods and services produced within a country during a given product. The goods and services may have been produced either by citizens of the country or foreigners. Gross National Product (GNP), on the other hand, is the total value of goods and services produced by the citizens of a country, either within the country or on foreign soil.
The income earned and capital invested by foreigners within a country is included in the country’s GDP but not in its GNP. The income earned or capital invested abroad by a country’s citizens is included in the GNP of a country but not in its GDP.
Benefits and costs of International trade
Benefits of international trade accrue to importing countries in the form of lower cost goods when the importing country’s currency is stronger than the exporting country’s currency. The exporting country benefits from international trade in the form of higher demand for its products and therefore higher profits, increase in employment opportunities for its citizens and increase in wages.
However there are also costs associated with international trade which mainly affect the importing countries. The domestic producers of importing nations have to compete with low cost imports, which results in losses, shutdowns and loss of jobs. The displaced workers have to re-skill themselves to do the other jobs that are available.
Economics, however tells us that the benefits of international trade far outweigh its costs and the gainers can more than compensate the losers and still be better off.
Comparative advantage and absolute advantage of international trade
A country is said to have an absolute advantage over another country in the production of a good if it can produce it at a lower cost than the other country. A country is said to have comparative advantage if its opportunity cost of producing a good is lower than that of the other country.
Opportunity cost is the cost of having to forgo production of a good A for producing a good B due to availability of limited resources. Opportunity cost is the revenue lost from not producing good A. If the opportunity cost for a country from not producing good A is higher than that of another country it can import that good from the other country for whom the opportunity cost of that good is low.
Production costs per unit
From the above table you can see that India has an absolute advantage over U.S. in both the products. However the India has a comparative advantage over U.S. in only liquor. The U.S. can trade micro chips with India for liquor. U.S. would get liquor for 120 instead of producing it at 140. India would get micro chips for 90 instead of producing it for 100.
The baseline is that as long the opportunity costs are different in different countries there are possible gains from international trade.
Heckscher – Ohlin model of international trade
According to the Heckscher – Ohlin model there are only two factors of production, capital and labor and the comparative advantage that a country has over another depends upon the amount of each factor of production that each country possesses. Continuing with our above example, lets assume U.S. has more capital than India and India has more labor than U.S. Lets further assume that production of micro chips is more capital intensive and liquor production is labor intensive. Therefore U.S. which has more capital will produce more capital intensive goods and trade them for less capital intensive goods with India which has more labor and less capital.
The good that a country imports will fall in price in that country and the price of the good that it exports will rise in price. This is easy to understand. A country will import a good only if it can get it a lower price than what it would take to produce it. When a country imports a good the supply of that good in the country at lower prices increases due to which the domestic producers face competition and are forced to lower their prices too. When a country exports a good, its availability in the domestic market is reduced and its price is pushed upwards.
Thus the capital intensive good gains in price in U.S. but is still cheap for India to import due to less availability of capital in India (making capital more expensive for India). Similarly, the price of labor rises in India but labor intensive goods are still cheap for U.S. to import due to the dearth of labor in the U.S (making labor more expensive for U.S). Therefore there is a redistribution of wealth within each country between capital and labor due to international trade. In U.S. capital earns more income at the expense of labor and in India the price of labor rises at the expense of owner’s of capital.
And that brings us to the end of part 1 of the discussion on International trade…. Thanks for reading….….if you think something more needs to be included let me know via comments…also don’t forget to share or pin the post if you liked it….
p.s. if you want the next post and more amazing posts like these in your inbox use the SUBSCRIBE options on the page and follow me by email…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
This post contains affiliate links. Please see the disclosure policy for more information.