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Why people R
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Topics:
 International Trade through Ages
 Why do nations trade?
 Classical Theories of International Trade
 Modern Theories of International Trade
 Why do nations import?
 Why do nations export?
 Trade Barriers

Objectives:
After studying this chapter, you should:
 Explain the nature and history of international trade, and be able to identify key
characteristics of and players in international trade today.
 Compare and contrast the types of economic decisions made by individuals and
governments and their differing impacts.
 Discuss the theories of comparative and absolute advantage and their role in economic
decision-making.
 Demonstrate an understanding of the roles that efficiency, specialization, and
opportunity costs play in defining comparative advantage.

T he tremendous growth of international trade over the past several decades has
been both a primary cause and effect of globalization. The volume of world trade increased
twenty-seven fold from $296 billion in 1950 to $8 trillion in 2005 (WTO, 2007). In recent years
world trade has declined in volume and was down in 2012 and is expected to remain sluggish
through 2013. This is a result of the struggling economies of Europe and doubt over the Euro
(WTO, 2013). The continued decline of world trade was evidenced by a decrease of 0.3 percent
in May, with forecasters cutting their prediction for global growth (Hannon, 2013).

In recent years China has experienced an economic

slowdown along with the rest of the world, but many worry that
because of its position in the world market, any
downturn will have a global impact. In the years
leading up to the global recession China was
growing at an unprecedented pace. However, the
Beijing government recently predicted a rate of seven
percent growth, for the next year, a
slowdown for the previously hot Chinese economy (Kurlantzick,
2013). China maintains the world’s largest reserves of US treasuries, which makes it vital in
determining the amount of trade that occurs in the world market
Part of the reason for the economic slowdown in China is rising labor costs which is
causing manufacturing jobs to move to poorer countries and other parts of China (Coonan,
2013). Fortunately, even if China’s economy does experience its projected slowdown, it should
not negatively impact the global economy as many fear, China’s large trade surplus means it
does not represent the biggest driver of demand, which typically drives growth. On the
contrary, if China’s economic rebalance causes it import more, this will boost other economies
(Pettis, 2013)

World merchandise exports and imports by level of development, 2012Q1-2019Q2

As a
result
of

international trade, consumers around the world enjoy a broader selection of products than
they would if they only had access to domestically made products. Also, in response to the
ever-growing flow of goods, services and capital, a whole host of U.S. government agencies and
international institutions has been established to help manage these rapidly-developing trends.
Although increased international trade has spurred tremendous economic growth
across the globe —- raising incomes, creating jobs, reducing prices, and increasing workers’
earning power — trade can also bring about economic, political, and social disruption.
Since the global economy is so interconnected, when large economies suffer recessions,
the effects are felt around the world. When trade decreases, jobs and businesses are lost. In the
same way that globalization can be a boon for international trade; it can also have devastating
effects.

A Snapshot of Philippines Trade

At independence in 1946, the Philippines was an agricultural nation tied closely to its
erstwhile colonizer, the United States. This was most clearly observed in trade relations
between the two countries. In 1950 the value of the Philippines' ten principal exports--all but
one being agricultural or mineral products in raw or minimally processed form—addedup to 85
percent of the country's exports. For the first twenty-five years of independence, the structure
of export trade remained relatively constant.
The direction of trade,
however, did not remain constant.
In 1949, 80 percent of total
Philippine trade was with the United
States. Thereafter, the United States
portion declined as that of Japan
rose. In 1970 the two countries'
share was approximately 40 percent
each, the United States slightly
more, and Japan slightly less. The
pattern of import trade was similar,
if not as concentrated. The United States share of Philippine imports declined more rapidly than
Japan's share rose, so that by 1970 the two countries accounted for about 60 percent of total
Philippine imports. After 1970 Philippine exporters began to find new markets, and on the
import side the dramatic increases in petroleum prices shifted shares in value terms, if not in
volume. In 1988 the United States accounted for 27 percent of total Philippine trade, Japan for
19 percent.
In 1990 weaker world prices for Philippine exports, higher production costs, and a
slowdown in the economies of the Philippines' major trading partners restrained export growth
to only slightly more than 4 percent. Increasing petroleum prices and heavy importation of
capital goods, including power-generating equipment, helped push imports up almost 17
percent, resulting in a 50 percent jump in the trade deficit to more than US$4 billion. Reducing
the drain on foreign exchange has become a major government priority.
The World Bank and the IMF as well as many Philippine economists had long advocated
reduction of the level of tariff protection and elimination of import controls. Those in the
business community who were engaged in import-substitution manufacturing activities,
however, opposed reductions. They feared that they could not successfully compete if tariff
barriers were lowered.
In the early 1980s, the Philippine government reached agreement with the World Bank
to reduce tariffs by about one-third and to lift import restrictions on some 3,000 items over a
five- to six-year period. The bank, in turn, provided the Philippines with a financial sector loan
of US$150 million and a structural adjustment loan for US$200 million, to provide balance-of-
payments relief while the tariff wall was reduced. Approximately two-thirds of the changes had
been enacted when the program ground to a halt in the wake of the economic and political
crisis that followed the August 1983 assassination of former Senator Benigno `Aquino.
In an October 1986 accord with the IMF, the Aquino government agreed to liberalize
import controls and to eliminate quantitative barriers on 1,232 products by the end of 1 986.
The target was accomplished for all but 303 products, of which 180 were intermediate and
capital goods. Agreement was reached to extend the deadline until May 1988 on those
products. The liberalizing impact was reduced in some cases, however, by tariffs being erected
as quantitative controls came down.
A tariff revision scheme was put forth again in June 1990 by Secretary of Finance Jesus
Estanislao. After an intracabinet struggle, Aquino signed Executive Order 413 on July 19, 1990,
implementing the policy. The tariff structure was to be simplified by reducing the number of
rates to four, ranging from 3 percent to 30 percent. However, in August 1990, business groups
successfully persuaded Aquino to delay the tariff reform package for six months.

INTERNATIONAL TRADE THROUGH AGES

Trade is not a modern invention. International trade today is not qualitatively different
from the exchange of goods and services that people have been conducting for thousands of
years.
Before the widespread adoption of currency, people exchanged goods and some services
through bartering—trading a certain quantity of one good or service for another good or
service with the same estimated value. With the emergence of money, the exchange of goods
and services became more efficient.
Centuries before the
Industrial Revolution, which Developments in transportation and
witnessed the advent of powered communication revolutionized economic exchange,
ships, trains, and gas-powered not only increasing its volume but also widening its
vehicles, merchants braved the geographical range. As trade expanded in
hazards of land and sea travel to geographic scope, diversity, and quantity, the
bring their goods to buyers in distant channels of trade also became more complex. The
lands. But Industrial Era transport earliest transactions were conducted by individuals
and communications made the in face-to-face encounters. Many domestic
exchange of large quantities of transactions, and some international ones, still
goods at great distances a safer, and
thus increasingly common part of
economic life.
follow that pattern. But over time, the producers and the buyers of goods and services became
more remote from each other.

A wide variety of market actors–individuals and firms–emerged to play supportive roles

in commercial transactions. These “middlemen”–
The Rise of the Middleman
wholesalers, providers of transportation services,
providers of market information, and others– It would have been very difficult, for
facilitate transactions that would be too complex, example, for an English blacksmith
distant, time-consuming, or large for individuals to to sell hand-made metal tools
conduct face-to-face in an efficient manner. directly to craftsmen in France. But
an English or French firm that
International trade today differs from
specialized in the purchase and sale
economic exchange conducted centuries ago in its
of tools could serve as an
speed, volume, geographic reach, complexity, and
intermediary between the
diversity. However, it has been going on for
blacksmith and the craftsman,
centuries, and its fundamental character–the
enabling both to engage indirectly in
exchange of goods and services for other goods
international trade.
and services or for money–remains unchanged.

WHY DO NATIONS TRADE?

The basic reason for different nations entering into trade is that no
nation has the capacity to produce by itself all the
commodities and services that are required by its people. There
has been an unequal distribution of productive resources by the
nature on the surface of the earth. Countries differ in respect of
climatic conditions, availability of cultivable land, forests, mines,
mineral products, labour, capital, technological capabilities and managerial
and entrepreneurial skills.

Given these diversities, no country has the potential to produce all the commodities in
the most efficient manner or at the least cost. For instance, India can produce textiles at the
lower cost while Japan can produce electronic goods and automobiles cheaply. Just as there is
division of labor in the case of individuals, the countries also adopt this principle at the
international level.
WHY DO NATIONS EXPORT?
The term “export” is derived from the conceptual meaning as to ship the goods and
services out of the port of a country. The seller of such goods and services is referred to as an
“exporter” who is based in the country of export whereas the overseas based buyer is referred
to as an “importer”.

In International Trade, “exports” refers to selling goods and services produced in home
country to other markets.

Important factors to consider in successful exporting:

sufficient
production capacity a good marketing
an effective
and capability, information and effective market
national export
product superiority communication research
and competitive policy
system
pricing
Selection of Exporting Method

Clearly the nature, size and structure of the market will be significant in determining the
method adopted.

Many other factors will affect the cost/benefit analysis of maintaining the company’s
own staff in foreign markets, such as whether the market is likely to be attractive in the long
term as well as the short term and whether the high cost of installing a member of the firm’s
own staff will be offset by the improvements in the quality of contacts, market expertise and
communications. The alternative, and usually the first stage in exporting, is to appoint an agent
or distributor.

Agents

Agents provide the most common form of low cost direct involvement in foreign
markets and are independent individuals or firms who are contracted to act on behalf of
exporters to obtain orders on a commission basis. They typically represent a number of
manufacturers and will handle non-competitive ranges. As part of their contract they would be
expected to agree sales targets and contribute substantially to the preparation of forecasts,
development of strategies and tactics using their knowledge of the local market.

The selection of suitable agents or distributors can be a problematic process. The selection
criteria might include:

 The financial strength of the agents.

 Their contacts with potential customers.
 The nature and extent of their responsibilities to other organizations.
 Their premises, equipment and resources, including sales representatives

Distributors

Agents do not take ownership of the goods but work instead on Direct Marketing
commission, sometimes as low as 2-3 per cent on large volume and orders.
Distributors buy the product from the manufacturer and so take the market risk
on unsold products as well as the profit. For this reason, they usually expect to take
a higher percentage to cover their costs and risk.

Distributors usually seek exclusive rights for a specific Distributor

sales territory and generally represent the manufacturer in all
aspects of sales and servicing in that area. The exclusivity, therefore, is
in return for the substantial capital investment that may be required in handling and selling
the products. The capital investment can be particularly high if the product requires special
handling equipment or transport and storage equipment in the case of perishable goods,
chemicals, materials or components.

Direct Marketing

Direct marketing is concerned with marketing and selling activities which do not depend
for success on direct face-to-face contact and include mail order, telephone marketing,
television marketing, media marketing, direct mail and electronic commerce using the Internet.
The critical success factors for direct marketing are in the standardisation of the product
coupled with the personalisation of the communication.International direct marketing,
therefore, poses considerable challenges, such as the need to build and maintain upto-date
databases, use sophisticated multilingual data processing and personalisation software
programs, develop reliable credit control and secure payment systems.
Reasons for exports

At least since the beginning of the industrial era almost three centuries ago, countries exported
goods and services because:
 Individuals and firms have been able to produce more goods and services than can be
consumed at home. This prompted a search for foreign opportunities to sell the
“excess” production;
 Individuals and firms have been able to sell goods or services to other countries at prices
higher than the prices they can obtain domestically.

In today’s global economy, exporting serves somewhat different purposes for developing and
industrial countries.

Developing Countries
Although the economies of developing countries
are typically not as productive as the economies of
industrial countries, developing countries nonetheless
produce some goods and services in amounts they are
unable to use or consume at home. This is called a
production surplus.
For example, some developing countries produce
vast quantities of agricultural products, like cocoa in Cote
d’Ivoire and coffee in Latin America, which their own
populations are not large enough to consume. Other
developing countries produce quantities of industrially
valuable minerals, like oil or iron ore, that their own economies are too small or not yet
industrialized enough to use.
For many developing countries, exports also serve the
purpose of earning foreign currency with which they can buy
essential imports—foreign products that they are not able to
manufacture, mine, or grow at home. Developing countries, in
other words, sell exports, in part, so that they can import.
Exporting goods and services can also further advance
developing nations’ domestic economies.

Industrial Countries
Exports are also more than just an outlet for “excess” production for industrial
countries. Because their economies are more diverse, industrial countries tend to:

 Export a much wider variety of products than do developing countries; and

 Export a larger proportion of their total production of goods and services.
Export sales help maintain high employment levels for the work force of the United States and
many other industrial countries.
Currencies and Exchange Rates
The exchange rate is determined by the ratio of sum A—an amount of domestic
currency compared to a sum of B—an equivalent amount of foreign currency. For example, the
ratio of the domestic prices for a basket of goods and the foreign prices for the same basket of
goods is a good approximation for the exchange rate of the domestic currency and foreign
currency.
 Another example: in 2009 one U.S. dollar had the buying power of roughly 31.5 rubles in
Russia. Imagine that in the United States, a can of soda from in a vending machine costs one
U.S. dollar. In Russia, if you are thirsty and want to purchase a can of soda from a vending
machine, how much should you have? Since we are comparing the same thing from the basket
of goods both countries have, you should have the equivalent of one U.S. dollar in Russia’s
currency, or 31.5 rubles.
This difference in price is due to the fact that exchange rates reflect both the local
market conditions and the calculations of currency traders about the overall prospects of an
economy. For example, when currency traders predict that a nation is going to undergo a bout
of inflation in the near future, making their currency less valuable, they are likely to sell their
holdings of that currency, just like any other commodity. (The term commodity usually refers to
basic goods that are generally easily substitutable for any other of its kind. Metals, such as gold
or aluminum, or basic foods, such as oranges or cattle, are considered commodities.)
Because exchange rates are comprised of these two factors, economists sometimes
measure the value of a currency according to the Purchasing Power Parity (PPP) Index. Put most
simply, the PPP rate of a currency can be calculated by comparing the cost of a basket of goods
in one country to the cost of that same basket of goods in another country.

The Economist magazine each

year famously publishes what it calls
the “Big Mac Index,” which measures
the price of a Big Mac hamburger sold
at McDonald’s restaurants around the
world, and then compares those prices
to the exchange rate of other
currencies. Many observers find that
their index proves to be a surprisingly
accurate predictor of exchange rate
changes.

The exchange rate is a key determinant of international trade. When a company in one
country wants to import goods from a company in another country, it typically must pay for the
exporting either in that country’s currency or in the currency of one of the world’s major
economies. These currencies– the United States dollar, the European euro, the British pound
sterling, the Japanese yen, and the Swiss franc–are collectively known as hard currencies. Most
countries do not use a hard currency in their domestic economy; you could not use them to buy
a Big Mac in Thailand or a soda in Russia. In order to participate in the international economy,
however, countries must have some stock of a hard currency.
WHY DO NATIONS IMPORT?
The motivation for a country to import goods and services
from other countries is perhaps less obvious than its motivation
for selling exports (making a profit on goods not consumed by the
domestic market). As with exports, the purposes served by
imports vary from country to country. Let’s explore these various
purposes by starting with asking why a country like the United
States, with its massive and extraordinarily diverse economy,
would need to import anything from other countries.
In fact, there are only a handful of goods or services that the United States absolutely
must import from other countries. With a land area spanning several climatic zones, immense
natural resources, and a dynamic workforce, the United States is able to produce, mine, or
grow almost every item its citizens need to lead reasonably prosperous lives.
 Yet no country today, including the United States, can be totally self-sufficient without
suffering a high cost. All countries need to—or choose to—import at least some goods and
services for the following reasons:
 Goods or services that are essential to economic well-being
 Goods or services that are highly attractive to consumers but are not available in the
domestic market
Goods or services that satisfy domestic needs or wants can be produced more
inexpensively or efficiently by other countries, and therefore sold at lower prices.

The United States cannot meet its oil consumption needs exclusively through domestically
produced oil; in 2012 the US consumption of oil dropped to a 16 year low, a total of 18.56 million bpd, as
a result of a weak economy (Reuters, 2013). Meanwhile, the domestic production of oil rose sharply in
2012, with 6.4 million bpd being produced in the U.S. (Fowler, 2013). This means that the U.S. will need
to import less and steadily become more self-reliant, with projections stating that U.S. output will
overtake Saudi Arabia by 2020, making it the largest producer for about five years (Nguyen, 2012).

The United States could, in theory, abandon foreign oil imports, but it would be a costly
decision because:

1. It is not clear that domestic reserves of oil, both those that are known and those that
have yet to be discovered, could satisfy current domestic demand.
2. Even if U.S. oil reserves were adequate, generating the extra oil necessary to fill the gap
now filled by imported oil would be extremely costly. Many foreign countries are able to
produce oil much more cheaply. Besides, accessing the additional U.S. reserves would
require many years of research and development.
3. Other energy sources—for example, coal, nuclear power, or hydro-electric power—
could conceivably be substituted for oil imports, but complying with the respective
environmental regulations, along with the cost of producing additional energy from
these sources, would be very expensive.
Of course, energy conservation measures could also reduce the need for oil imports by
decreasing the energy consumption of the average American citizen. Energy conservation
would be prudent, regardless of which energy supply the United States favors in the future;
however, foreign producers would still be able to produce the oil more cheaply, regardless of
the level of production. In addition, the scale of energy-saving measures needed to
substantially reduce U.S. imports of oil would require dramatic changes in economic activity
and lifestyles and have thus far have not been politically viable.
Electricity produced by hydropower plants built
into dams is another example of an essential resource
that the United States does not produce in sufficient
quantity to meet its consumption needs. The United
States imports large quantities of hydropower from
Canada.

The same logic applies to any resource or product whose domestic supply is limited
although the domestic demand is high. The United States—-though not most other countries—-
can often find ways to increase the production of a commodity, reduce domestic consumption,
or identify domestic substitutes. These alternatives often prove more costly than continuing to
import from other countries, though.
It is worth noting that the country where a good is produced need not be the same as
the country where the corporation that manufactures and sells the good is established. Several
American clothing companies, such as The Gap, manufacture most of their clothes in
developing countries.
Trade Specialization
 Two broad categories of goods
and services 

Economically essential goods Goods and services from abroad

and services that are either not that may be similar in function
available at home or unavailable and price to those available at
at a reasonable cost home, but which differ in quality
or features

A large number of other goods and services imported by the United States and many
other countries would probably fit into two additional categories:

Two additional categories of goods

and services 

Goods and services that can be produced

Goods and services that native more cheaply domestically, but which
companies, farms, and individuals native companies, farms, and individuals
can produce, but which foreign have chosen not to produce in favor of
countries can produce more cheaply. producing more sophisticated (and hence
more expensive) goods and services.

CLASSICAL THEORIES OF INTERNATIONAL TRADE

 Theory of Mercantilism (1500-1700)

Mercantilism became popular in the late seventeenth and early eighteenth centuries in
Western Europe and was based on the notion that governments (not individuals who were
deemed untrustworthy) should become involved in the transfer of goods between nations in
order to increase the wealth of each national entity. Wealth was defined, however, as an
accumulation of previous metals, especially gold.

The concept of mercantilism incorporates two fallacies. The first was the incorrect belief
that old or precious metals have intrinsic value, when actually they cannot be used for either
production or consumption. Thus, nations subscribing the mercantilism notion exchanged the
products of their manufacturing or agricultural capacity for this non-productive wealth. The
second fallacy is that the theory of mercantilism ignores the concept of production efficiency
through specialisation. Instead of emphasizing cost-effective production of goods, mercantilism
emphasises sheet amassing of wealth with acquisition of power.
  Theory of Economic Development
The trade structure is also sought to be explained in terms of scale economies.
According to this theory, there is a relationship between the size of the internal market and
average unit cost of production and export competitiveness. A firm operating in a country
where the domestic market is large will be able to reach a high output level thereby reaping the
advantage of largescale production. The lower cost of production will increase its
competitiveness enabling the firm to make an easy entry to the export market. While prima-
facie this logic appears to be valid, this hypothesis cannot be generalized because it is possible
that the pull of the domestic market will be so strong that the export would not be promoted,
as is the case with India in certain products.

 Rostow’s Stages of Economic Growth Theory

The Age of
Mass
The Drive to Consumption
Maturity
Takeoff
Preconditions
for takeoff
Traditional
Society

 The Theory of Comparative Advantage

David Ricardo, one of the famous classical

economists, developed the theory or law of
comparative advantage.

Countries Rice Calculator

Japan 120 days 10 days
Philippines 90 days 15 days

The above illustration shows that Japan

has comparative advantage in calculator while the Philippines in rice. Following the theory it
would be better for Japan to produce calculator and just buy rice from the Philippines. In the
case of our country, it would be more economical not to produce anymore calculator. Just
import from Japan, and concentrate in rice production.
 The classical economists, like Ricardo, equated the value of a product with the cost of
labor that went into its production. Thus, a product which takes more hours or days in
producing has a higher price or value than a product with lesser hours of producing it. For
example, if it takes 4 hours to catch a wild rooster and only 2 hours to catch a big fish, then the
price of the rooster is twice that of the fish. In the aforementioned illustration, it is cheaper for
Japan to buy the rice than to produce it.
The theory of comparative advantage is being practiced international trade. Agricultural
countries export raw materials and import finished products from the industrial countries. The
problem is that the prices of raw materials and other agricultural products are very low in the
world markets. And yet the prices of finished products are very high. The industrial countries
control the operations of the world markets, and they can manipulate prices if goods to the
disadvantage of the less developed countries which are basically agricultural economies.

Comparative Advantage versus Absolute Advantage

As you can see from the example above, a country can have a comparative advantage in
producing a good even if it is absolutely less efficient at producing that good. To understand
this more clearly, think of an example of a doctor in private practice:

A young doctor opens her own practice, working by herself, and within a few months
has developed a substantial clientele. At first, she was performing all her clerical work—filing,
typing and answering the phone—by herself. With an ever-busier schedule, however, she
realizes that she could spend more time seeing patients, and thus see a greater number of
patients, if she hired an assistant.

As it turns out, the young professional is not only a brilliant doctor, but is also lightning-
fast at typing and filing. She is, in fact, better at doing both jobs than the clerical assistant she
hires. In other words, she has an absolute advantage at both tasks: medical diagnosis and
clerical work.
Does it make sense then for the doctor and her assistant to share both tasks, each
spending part of the day diagnosing patients and doing clerical work? The answer is no. By
having the assistant perform all the clerical work, the doctor is able to maximize her
specialization and see more patients. The patients are undoubtedly better off too.

In other words, even though the assistant is worse at performing both tasks, an
economist would say that he nonetheless has a comparative advantage at clerical work. As you
can see, by working together – trading their services – the doctor and the assistant are able to
maximize their skills, making both better off.
As these examples show, trade allows countries to specialize in the production of what
they do best and make the most efficient use of their resources, thereby decreasing the price of
both goods. No matter how inefficiently a country produces every kind of good, it can always be
said to have a comparative advantage in at least one of those goods.

That is the theory of comparative and absolute advantage. It helps explain what
happens in the real world of international trade, and it offers broad guidance to countries as
they decide which goods and services to produce and subsequently export, and which, in turn,
to import.

 Factor Endowment Theory

The Eli Heckscher and Bertil Ohlin theory of factor endowment addressed the question
of the basis of cost differentials in the production of trading nations. They posited that each
country allocates its production according to the relative allocates proportions of all its
production factor endowments – land, labour and capital on a basic level, and, on a more
complex level, such factors as management and technological skills, specialized production
facilities, and established distribution networks.
 Thus, the range of products made or grown for export would depend on the relative
availability of different factors in each country.

Agricultural production or cattle grazing would be emphasized in such countries as Canada, and
Australia, which are generously endowed with land. Conversely, in small land mass countries with high
populations, export products would center or labor-intensive articles. Similarly, rich nations might center
their export base on capital-intensive production.

In this way, countries would be expected to produce goods that require large amounts
of the factors they hold in relative abundance. Because of the availability and low costs of these
factors, each country should also be able to sell its products on foreign markets at less than
international price levels. Although this theory holds in general, it does not explain export
production that arises from taste differences rather than factor differentials. Some of these
situations can be seen in sales of luxury-imported goods, such as Italian leather products,
deluxe automobiles and French wine, which are values for their quality, prestige, or panache.
Like Classical theory, the Heckscher-Ohlin theory does not account for transportation costs in its
computation, nor does it account for differences among nations in the availability of
technology.
Economist Paul Samuelson extended the factor endowment theory to look at the effect
of trade upon national welfare and the prices of production factors: Samuelson posited that the
effect of free trade among nations would be to increase overall welfare by equalizing not only
the prices of the goods exchanged in trade, but also of all involved factors. Thus, according to
his theory, the returns generated by use of the factors would be the same in all countries.
 Trade in Theory and Practice
In reality, of course, trade specialization does not work precisely the way the theory of
comparative advantage might suggest, for a number of reasons:

No country specializes All countries produce at A lower income country

exclusively in the least some goods and might, in theory, be able
production and export services that other to produce a particular
of a single product or countries can produce product more efficiently
service. more efficiently. than the United States

Generally, countries with a relative abundance of low-skilled labor will tend to specialize
in the production and export of items for which low-skilled labor is the predominant cost
component. Countries with a relative abundance of capital will tend to specialize in the
production and export of items for which capital is the predominant component of cost.
Finally, international trade brings several other benefits to the average consumer.
Competition from imports can enhance the efficiency and quality of domestically produced
goods and services. In addition, competition from imports has historically tended to restrain
increases in domestic prices.
Modern Theories of International Trade
 Human Capital Approach Theory
This theory, which is also sometimes known as Skills Theory of International Trade, has
been advocated by a number of economists, especially Becker, Kennen and Kessing. Whereas
the Factor Proportions Theory considers labor as a homogenous factor, however, it is not so in
the real world. In fact, for export of manufactured goods, the skill level of labor is very
important determinant. Labor can be basically divided into skilled and unskilled labor. On the
basis of empirical testing Kessing concluded that patterns of international trade and location
were predetermined for a broad group of manufacturers by the relative abundance of skilled
and unskilled labor.

 Identical Preferences Theory

 This theory is based on the role of demand as an explanatory variable used by Linder. A
domestic industry can flourish and reach commercially optimal level of production if the
domestic demand is large enough. It is also found that countries at similar levels of economic
development have similar demand characteristics. It is, therefore, postulated that trade
opportunities are more among counties at similar stage of development with similar demand
structure.

USA and Japan are highly industrialized; both have similar demand characteristics viz. computers,
software, air-conditioners, internet, fashion garments etc. Firms in both the countries are highly export
competitive because they have already grown big by first catering to the domestic demand that is why
the trade between the USA and Japan is so substantial. This theory explains how an industrialized
country grows rapidly in its economic growth.

The theory also assumed that each country had as its objective full production efficiency. It
neglected such other motives as traditional employment and production history, self-sufficiency
or political objectives.
In addition, the theory is overly simplistic in that it deals only with two commodities and
two countries. In reality, given the full range of production by many countries and interplay of
many motives and factors, the trade situation is actually an ongoing dynamic process in which
there is interplay of forces and products. The largest area of weakness in classical theory is that
while we considered all resource units used in production, the only costs considered by classical
economists were those associated with labor. The theorists did not account for other resources
used in the production of commodity or manufactured goods for export such as transportation
cost, the use of land, and capital. This failing was addressed by subsequent trade theories,
which in modern theories include all factors of production in looking at theories of comparative
advantage.

 Strategic Trade Theory

In the last two decades, a new set of models has come into being, using the perspectives of
game theory and theories of industrial organisation. While there is no one overarching model,
this broad collection of theories and ideas has come to be known as “strategic trade theories”.

Most of the models of strategic trade are motivated by the attempt to relax (and explore
systematically the implications of) the seemingly restrictive assumptions of the Ricardian and H-
O models, such as those relating to perfectly competitive markets, constant or decreasing
returns to scale, product homogeneity, per factor mobility, no externalities or spillover effects,
and so forth.

The essence of almost all the new models of trade is the recognition that industries are
characterized by any or all of the following features: scale, economies (both dynamic and
static), product differentiation, imperfect competition, externalities and spillover and, in cases,
irreversible investments. Some of the main insights from this literature are as follows:

1. Increasing returns to scale provide a justification for trade for reasons other than
comparative advantage, since firms will have the incentive to produce and export in
order to lower costs by attaining greater scale economies; an example of a industry
where this is an important issue is the commercial airframes industry.
2. Product differentiation can result in intra industry trade, since, within the same
industry, the same product can have different brand identities; for example, the US will
export certain types of automobiles (Ford Escort) and it will import other types of
automobiles (BMWs).
3. Imperfect competition creates rents, and trade policy could shift rents from the foreign
country to the home country. For example, the imposition of quotas will increase
domestic prices and thus can create rents for foreign producers; the home-country
government may Notes try to counterbalance it with a subsidy to domestic producers,
so as to put price pressure on foreign producers.
 4. Externalities and spillover effects (particularly in innovation and R & D) may sometimes
provide a justification for industry protection for reasons other than industry infancy or
national security.
5. Irreversible investments induce an asymmetry between entry and exit costs, and can
therefore lead to “hysteretic” responses to price or quantity shifts.

 Modern Investment Theory

Other theories explain investing overseas by firms, as a response to the availability of
opportunities not shared by their competitors, that is, to take advantage of imperfections in
markets and only enter foreign spheres of production when their comparative advantages
outweigh the costs of going overseas. These advantages may be production, brand awareness,
product identification, economies of scale, or access to favorable capital markets. These firms
may make horizontal investments, producing the same goods abroad as they do at home, or
they make vertical investments, in order to take advantage of sources of supplies or inputs.
Going a step further, some believe that firms within an oligopoly enter foreign markets
merely as a competitive response to the actions of an industry leader and to equalize relative
advantages. Oligopolies are those market situations in which there are few sellers of a product
that is usually mass merchandised.
In oligopolistic situations, no firm can profit by cutting prices because competitors
quickly respond in kind. Consequently, prices for oligopolistic products are practically
identical, and are set through industry agreement (either openly or tacitly).

Thus, the impetus for a firm to go abroad may come from a wish to expand for internal
reasons to use existing competitive advantages in additional spheres of operations, to take
advantage of technology, or to use raw materials available in other locations. Alternatively, the
motive might arise from external forces, such as competitive actions, customer requests or
government incentives. The final determinant however, is based in a cost benefit analysis. The
firm will move abroad if it can use its own particular advantages to provide benefits that
outweigh the costs of exporting or production abroad and provide a profit.

 International Product Life Cycle Theory

The international product life cycle theory puts forth a different explanation for the
fundamental motivations for trade between and among nations. It relies primarily on the
traditional marketing theory regarding the development progress, and life span of products in
markets. This theory looks at the potential export possibilities of a product in four discrete
stages in its life cycle.
The life cycle begins when a developed country having a new product to satisfy consumer
needs wants to exploit its technological breakthrough by selling abroad. Other advanced
nations soon start up their own production facilities and before long LDCs do the same?
Efficiency/comparative advantage shifts from developed countries to the developing nations.
Finally, advanced nations that are no longer cost-effective, import products from their former
customers.
Stages and Characteristics
The Trade Balance
The trade balance for any country is the difference between the total values of its
exports and imports in a given year. When a country’s total annual exports exceed its total
annual imports, it is said to have a trade surplus.
When imports exceed exports, a country has a trade deficit.

A trade deficit also occurs when companies manufacture goods in other countries. The raw materials for
manufacturing that are shipped overseas for factory production count as an export. The finished
manufactured goods are counted as imports when they're shipped back to the country. The imports are
subtracted from the country's gross domestic product  even though the earnings may benefit
the company's stock price, and the taxes may increase  the country's revenue stream.

Causes
Effect

Initially, a trade deficit is not necessarily a bad thing. It can raise a country's  standard of living because
residents can access a wider variety of goods and services for a more competitive price. It can also
reduce the threat of inflation since it creates lower prices.
Over time, a trade deficit  can cause more outsourcing of jobs  to other countries. As a country imports
more goods than it buys domestically, then the home country may create fewer jobs in certain industries.
At the same time, foreign companies will likely hire new workers to keep up with the  demand for their
exports.
They believe that trade deficits are harmful for a number of reasons:
 Trade deficits are often interpreted as a sign of a nation’s economic weakness. They are
said to reflect an excessive reliance on products made by others, and to result from
deficiencies in the home country’s economic output. In the eyes of many labor
supporters, an excess of imports over exports comes at the expense of domestic
production and jobs.

 Trade deficits represent a sacrifice of future growth. Because a nation with a trade
deficit is purchasing more than it produces, investment in future growth is being traded
for consumption in the present.
What is the impact of the coronavirus pandemic on global trade?

In the beginning of 2020, the world was impacted by the spread of the COVID-19 virus, also
known as Coronavirus. While the initial impact has been primarily in China, the virus later
spread worldwide. International Trade was impacted in several ways:

 Manufacturing companies closed down due to an imposed lockdown (for health

reasons), and were unable to deliver goods to their clients. An immediate impact was
felt worldwide in industries that relied on manufacturing in China, for example
electronics.
 Companies worldwide faced declining sales across many
industries, as a result of reduced household spending and the
temporary shutdown of many businesses. Consequently,
companies also reduced their purchases, including their imports.
 The capacity of logistics operations has also been under pressure
due to imposed lockdown.

Enrichment
Closet Check
Activity 1
Grab a pen and paper and go to your closet. Take out the items that you wear the most
and see what percentage is made in the Philippines and in other countries. How imports affect
our economic progress?

Activity 2 Trading Through the Ages Scenarios

Determine the chronological order of the history of trading using the information below.
Rewrite the sentences and use Period 1 to indicate the order.

 The growth over the last century opened up new opportunities for trade, by creating
new markets for new materials from new sources. This city was at the center of this
growth. The need for coal and iron to build trains, rails, and ships attracted investment
from this city’s banking industry. Cattle and corn from the center of the continent
passed through great port cities to feed the city and its neighbors. The city used
phosphate mined on distant island countries to support its weapons factories. Tea and
coffee were popular beverages, although grown in the far reaches of the globe. Cotton
from hundreds of miles away made residents more comfortable, just as furs from the
north made them more stylish. Advances in communication, such as the telegraph,
made it easier to meet schedules and make deals from across the country and across
the ocean.
 This community was the capital of a colonial settlement. Its residents consumed food
they grew nearby and used locally cut wood for fuel. Most of the tools, clothing, and
other necessities were provided by community craftsmen. More expensive products and
luxury items were procured from the home country over the ocean, as the
transportation and banking systems favored close trade relations with the colonists’
original land. The community participated in a plantation economy, purchasing slaves
from overseas and providing tobacco and processed rum in exchange.
 This was the leading city in a desert land, and was arguably one of the most important
cities along a trade route which stretched from one continent to another. This powerful
merchant community participated in a complex trading network, as merchants from
East and West would meet in its markets and trade for items unavailable in their own
countries. Silk and paper, the secret of whose production was kept for centuries by
Eastern traders, was traded for exquisite rugs and carpets produced near the market
city. In turn, these products were traded for gold (and other precious metals), raw
materials, and fine items made or mined in the West. Although this city was supplied
with its basic necessities from nearby river valleys, it rose to become one of the greatest
commercial centers the world has seen.
 The explosive expansion of the world economy over the preceding three centuries
dramatically affected this community. Most of this community’s residents were only
slightly aware of the level of internationalism of the trade that brought them so much.
The plastic materials in computers, cars, clothing and entertainment devices were
formulated from petroleum purchased from dozens of sources. The community
consumes coffee, soda, fruit, meat, and vegetables as likely to come from the other side
of the world as from their own country, but least likely to come from their own
neighborhood. The strong flow of raw materials from resource-rich countries to their
community was matched by the flow outwards of new products, intangibles like
information and communication and services, that comprised an ever-increasing portion
of the world economy. The necessities and luxuries that made up the daily life of the
residents were rarely made in the community, and items made or services provided by
the community were just as likely to be in demand in other countries.
 In this small, isolated village a community maintained a stable yet precarious existence,
with little change in population over the centuries. Food was provided through
agriculture and supplemented by hunting and gathering. Almost all clothing and tools
were made by community members from natural sources near the village. Every year
members of the village met with members of nearby villages and trade for a few
 precious products, such as religious items or perhaps new and unique weapons or tools.
In return, they provided raw minerals or salt from sources near their community.
 The members of this community practiced agriculture in the deserts and river valleys of
their homeland. They grew corn and beans to support their small communities. An
extensive network of villages and roads in a peaceful environment increased trade
opportunity. They used quetzal feathers from lands over 1,500 miles to the south in
their religious ceremonies, and traded for minerals and other items from across the
continental landscape.

Activity 3 Theory of Comparative Advantage

A Tale of Two Tribes

On an island, there lived two isolated tribes, Engia and Portigia. In order to survive, they
needed to catch fish from the sea and collect wood from the forest. There were 20 workers in
each tribe. The workers of Engia could collect 80 units of wood or catch 120 units of fish in one
day while the workers of Portigia could collect 200 units of wood or 160 units of fish. Initially,
the chief of each tribe assigned 10 workers to collect wood and the other 10 to catch fish. All of
them were satisfied with this arrangement.
One day, David, an adventurer, arrived. He discovered these tribes and was surprised to
find that their production arrangements were so inefficient. Based on his training in economics,
he was confident that he could improve their living standards by changing the production
arrangements. He urged the chiefs to discuss this issue.

Based on my knowledge in I don't think the Portigia will cooperate

international trade, specialization with our tribe because they are superior
would increase output. Trade to us and more productive. Why would
they do that without any benefit to
would improve living standards.
themselves?
Why don't you do so?
We can collect more wood and
catch more fish than they can with
the same number of workers. We
Let me tell you
may suffer if we trade with them. I
my plan. can't see any reason for
cooperation.

Instruction: Using your knowledge in the theory of comparative advantage, work out your own
plan to increase the efficiency of the production of fish and wood of the tribes.

Activity 3 Theory of Comparative Advantage

Compare your own plan with one suggested by David in the following conversations.
David turned to the Chief of Engia.
David: You, the chief of Engia, should ask all your workers to catch fish and collect no wood...
Interrupted by the Chief of Engia.
Chief of Engia : No, we will die of cold if we don't have wood to burn at night.
David: Don't worry, Portigia will provide your tribe with wood if you give fish to them.
He then turned to the Chief of Portigia.
David: Since you are more productive in both tasks, I don't advice you to limit yourselves to only
one. I suggest that you should send 15 workers to collect wood and 5 workers to catch fish.
Also, don't worry about the fish; you can get them from Engia. I guarantee that both of you can
get more fish and wood than before if you follow my suggestion.

After the conversation, both chiefs still hesitated to follow David's plan.
Essay Writing Rubric