Why do countries trade?
Countries trade with each other when, on their own, they do not have the resources, or capacity to satisfy their own needs and wants. By developing and exploiting their domestic scarce resources, countries can produce a surplus, and trade this for the resources they need.
Clear evidence of trading over long distances dates back at least 9,000 years, though long distance trade probably goes back much further to the domestication of pack animals and the invention of ships. Today, international trade is at the heart of the global economy and is responsible for much of the development and prosperity of the modern industrialised world.
Goods and services are likely to be imported from abroad for several reasons. Imports may be cheaper, or of better quality. They may also be more easily available or simply more appealing than locally produced goods. In many instances, no local alternatives exist, and importing is essential. This is highlighted today in the case of Japan, which has no oil reserves of its own, yet it is the world’s fourth largest consumer of oil, and must import all it requires.
The production of goods and services in countries that need to trade is based on two fundamental principles, first analysed by Adam Smith in the late 18th Century (in The Wealth of Nations, 1776), these being the division of labour and specialisation.
Division of labour
In its strictest sense, a division of labour means breaking down production into small, interconnected tasks, and then allocating these tasks to different workers based on their suitability to undertake the task efficiently. When applied internationally, a division of labour means that countries produce just a small range of goods or services, and may contribute only a small part to finished products sold in global markets. For example, a bar of chocolate is likely to contain many ingredients from numerous countries, with each country contributing, perhaps, just one ingredient to the final product.
Specialisation is the second fundamental principle associated with trade, and results from the division of labour. Given that each worker, or each producer, is given a specialist role, they are likely to become efficient contributors to the overall process of production, and to the finished product. Hence, specialisation can generate further benefits in terms of efficiency and productivity.
Specialisation can be applied to individuals, firms, machinery and technology, and to whole countries. International specialisation is increased when countries use their scarce resources to produce just a small range of products in high volume. Mass production allows a surplus of good to be produced, which can then be exported. This means that goods and resources must be imported from other countries that have also specialised, and produced surpluses of their own.
When countries specialise they are likely to become more efficient over time. This is partly because a country's producers will become larger and exploit economies of scale. Faced by large global markets, firms may be encouraged to adopt mass production, and apply new technology. This can provide a country with a price and non-price advantage over less specialised countries, making it increasingly competitive and improving its chances of exporting in the future.
The advantages of trade
International trade brings a number of valuable benefits to a country, including:
The exploitation of a country's comparative advantage, which means that trade encourages a country to specialise in producing only those goods and services which it can produce more effectively and efficiently, and at the lowest opportunity cost.
Producing a narrow range of goods and services for the domestic and export market means that a country can produce in at higher volumes, which provides further cost benefits in terms of economies of scale.
Trade also breaks down domestic monopolies, which face competition from more efficient foreign firms.
The quality of goods and services is likely to increases as competition encourages innovation, design and the application of new technologies. Trade will also encourage the transfer of technology between countries.
Trade is also likely to increase employment, given that employment is closely related to production. Trade means that more will be employed in the export sector and, through the multiplier process, more jobs will be created across the whole economy.
The disadvantages of trade
Despite the benefits, trade can also bring some disadvantages, including:
Trade can lead to over-specialisation, with workers at risk of losing their jobs should world demand fall or when goods for domestic consumption can be produced more cheaply abroad. Jobs lost through such changes cause severe structural unemployment. The recent credit crunch has exposed the inherent dangers in over-specialisation for the UK, with its reliance on its financial services sector.
Certain industries do not get a chance to grow because they face competition from more established foreign firms, such as new infant industries which may find it difficult to establish themselves.
Local producers, who may supply a unique product tailored to meet the needs of the domestic market, may suffer because cheaper imports may destroy their market. Over time, the diversity of output in an economy may diminish as local producers leave the market.
Go to comparative advantage