International trade is the system by which countries exchange goods and services. Countries trade with each other to obtain things that are better quality, less expensive or simply different from goods and services produced at home. The goods and services that a country buys from other countries are called imports, and goods and services that are sold to other countries are called exports. Importers and exporters are the core parties in international trade. In terms of international trade, the responsibility of exporter (seller) is to send the goods and that of importer is to send/make payments.
International trade occurs because there are things that are produced in a particular country that individuals, businesses and governments in other countries want to buy. Trade provides people with a greater selection of goods and services to choose from, often at lower costs than at home. In order to become wealthier, countries want to use their resources-labor, land and capital -as efficiently as possible. However, there are large differences in quantity, quality and cost of different countries’ resources. Some countries have natural advantages, such as abundant minerals or a climate suited to agriculture.
Others have a well-trained workforce or highly developed infrastructure, like good roads, advanced telecommunications systems and reliable electric utilities, which help the production and distribution of goods and services. Instead of trying to produce everything by themselves, which would be inefficient, countries often concentrate on producing those things that they can produce best, and then trade for other goods and services. By doing so both countries and the world become wealthier.
International Trade Theories
The most important way for a nation to become rich and powerful is to export more than it imports. This economic philosophy is known as/ Mercantilism. The difference would be settled by an inflow of precious metal mostly gold. The more gold a nation had the richer and more powerful it was. Thus mercantilism advocated that the government should stimulate exports and restrict imports. Since not all nations could have an export surplus simultaneously and the amount of gold in existence was fixed at one time, a nation could only gain at the expense of the other nations.
But in 1776, Adam Smith published his famous book. The Wealth of Nations, in which he attacked the mercantilism view on trade and advocated instead free trade as the best policy for the nations of the world. Smith argued that with free trade, each nation could specialize in the production of those commodities in which it had an absolute advantage (or could produce more efficiently than other nations) and imports those commodities in which it had an absolute disadvantage (or could produce less efficiently).
This international specialization of factors in production would result in an increase in world output which would be shared by the trading nations. Thus a nation need not gain at the expenses of other nations – all nations could gain simultaneously.
Smith explained that if each nation specialized in (or produced more than it wanted to consume domestically of) the commodity in which it was more efficient, and exchanged this excess for the commodity in which it was less efficient, the output of all commodities entering trade would increase. This increase would be shared by all nations that voluntarily engaged in trade. Thus, the gains from trade would arise from specialization in production and trade.
These gains would be maximized when the government interfered as little as possible with the operation of the domestic economy and with international trade (free trade).
Ricardo writing after 40 years than Smith stated that even if a nation has an absolute disadvantage in the production of both commodities with respect to the other nation, mutually advantageous trade could still take place. The less efficient nation should specialize in the production of and export of the commodity in which its absolute disadvantage is less. This is the commodity in which the nation has a comparative advantage. On the other hand, the nation should import the commodity in which its absolute disadvantage is greater. This is the area of its comparative disadvantage.
This is known as the Law of comparative advantage one of the most famous and still unchallenged laws of economics. The difference in pre-trade relative commodity prices (comparative advantage) between the two nations is based on a difference in factor endowments, technology, or tastes between the two nations. However, even if two nations have exactly the same factor endowments and technology a difference in tastes can be the basis for mutually beneficial trade.