Why Countries Trade, and What Each Side Gains

Reasons to buy foreign products

By trading, two countries can gain one more kilogram of steel. Number one shows how. Number seven: why would anyone buy something made in another country? When a firm or a person buys something produced more cheaply abroad, living standards in both countries rise.

The product may also fit their needs better, or may not be available at home at all. The foreign producer benefits too, from more sales than it could make in its own market alone. It also earns foreign currency to buy products made abroad. If most economists agree on 1, it is that trade makes the world better off.

The world is better off when countries import what others make more efficiently, unless costs like pollution go uncounted. Buying abroad covers services too, such as writing computer code or providing financial products. Import rules and taxes are not the same everywhere. But what if one country is better at making everything?

Subscribe for the next parts of this series: every source here is the IMF or the World Trade Organization, linked below.

Benefits of trading with less efficient country

Number six: why trade with a country that is worse at making everything? The World Trade Organization calls comparative advantage arguably the single most powerful insight in economics. In its example, if country A is better at cars and country B at bread, both gain by specializing and trading. That is a case of absolute advantage.

Comparative advantage says both countries still gain even if country A is better than country B at making everything. If country A is far better at cars and only slightly better at bread, it should still focus on cars and export them. Country B should still make bread and export it to country A, even if country B is not as efficient as country A. A country does not have to be best at anything to gain from trade, the page says.

The idea is one of the most widely accepted among economists, it adds, and one of the most misunderstood among non-economists. Because of comparative advantage, trade raises the living standards of both countries, the IMF article says. How trade is organized depends on the country. Next, what gives a country an edge in the first place?

Source of comparative advantage

Number five: where does a country's comparative advantage come from? It is often claimed that some countries have no comparative advantage in anything, and the World Trade Organization calls that virtually impossible. All countries have assets they can use to produce goods and services, it notes. Those assets are human, industrial, natural and financial.

Economics tells us that we can benefit when these goods and services are traded. Countries prosper first by concentrating on what they produce best, then by trading for what others produce best. Labor and capital matter too, the IMF article explains. Countries well endowed with capital, such as factories and machinery, tend to export products that use a lot of capital.

Those well endowed with labor tend to export products that use a lot of labor. Economists today think other important influences shape trade as well. Experience shows that competitiveness can also shift between whole countries, the World Trade Organization says. With an open economy, a country can move on to become competitive in other goods or services, usually step by step.

What a place produces best depends on its own industries and resources. Next, a puzzle: a country can sell and buy products from the same industry.

Why countries exchange similar products

Number four: why do countries buy and sell the same kinds of products to each other? Trade enables greater selection across types of goods, such as refrigerators, the IMF back-to-basics article says. That is why a country that exports household refrigerators may import industrial coolers. Recent research finds that trade opening is followed by adjustment within industries, not only across them.

Competition from foreign firms makes less efficient firms shrink and makes room for more efficient ones. Expansion and new entry bring better technologies and new product varieties. Where researchers count variety and technology transfer, the benefits of trade reforms come out much larger than conventional models suggest, with greater uncertainty. Lower trade barriers got a greater variety of goods to households at lower prices, a twenty sixteen IMF article says.

Given the chance to export, or faced with import competition, businesses may innovate to upgrade how they produce, it adds. Exporters can also learn better techniques abroad and raise efficiency and quality. Policies that allow the unrestricted flow of goods and services sharpen competition and motivate innovation, the World Trade Organization says. They multiply the rewards of producing the best products, with the best design, at the best price.

Product standards vary from one market to another. That's four of the seven: buying abroad, comparative advantage, where it comes from, and variety. Next, the effect the twenty sixteen IMF article calls even more important.

Trade impact on economic growth

Number three: how does trade help a whole economy grow? Trade has powerful positive effects on productivity, meaning how efficiently resources are used to make goods, the twenty sixteen IMF article says. The main reason is comparative advantage. Trade always raises the productivity of every country that allows it, the article says.

In the classic theory, trade is like a new, better technology that becomes available to every country that opens its borders. Postwar trade opening delivered growth in advanced economies and helped incomes per person catch up across a significant part of the developing world. Firms also get a wider variety of production inputs, which lets them produce at lower cost. Better machinery and parts also make investment more efficient, the back-to-basics article says.

When a country opens up to trade, capital and labor shift toward industries where they are used more efficiently, and society benefits. By enhancing investment and innovation, trade can bring sustained higher growth. The World Trade Organization points to a definite statistical link between freer trade and economic growth. Tariffs on industrial products have fallen steeply, and its guide puts their average in industrial countries at less than 5%.

In the first twenty-five years after the Second World War, world growth averaged about 5% a year. World trade grew even faster, averaging about 8%. By our count, world trade growing 8% a year would double in about nine years. The five and 8% are world averages, so growth where you live can differ.

In one breath: buying abroad lifts both sides, comparative advantage guides who makes what, and variety and competition raise productivity. If you want to see how rising prices affect your money, the video on protecting your money from inflation is linked on screen. Next, a limit the sources state plainly.

Who benefits from international trade

Number two: does everyone gain when countries trade? Most people gain from trade, the twenty sixteen IMF article says. Still, not every person or company is better off, the back-to-basics article says. When a firm buys a cheaper foreign product, it benefits, but the domestic producer loses a sale.

Usually, however, the buyer gains more than the domestic seller loses. The gains can be divided unevenly, so the twenty sixteen article calls for policies that share them more widely. Policies that help people adjust include education, infrastructure, health and easier entry for new businesses, it adds. Such policies have the added benefit of also supporting growth.

How gains are shared varies between economies. Before number one, a guess: in the IMF's shirts-and-steel example, how much extra steel does trade create?

Container of shirts benefits two economies

Number one: how can one container of shirts at the port leave two countries better off? In the IMF's example, one hour of work in country A makes three kilograms of steel or two shirts. In country B, one hour makes one kilogram of steel or one shirt, so country A is better at both. Country B offers country A two shirts in exchange for two and a half kilograms of steel.

To make them, country B moves two hours from steel to shirts, and country A moves one hour from shirts to steel. Country A makes three more kilograms of steel, and country B makes two fewer. The world makes the same number of shirts, but one more kilogram of steel. That extra kilogram is a measure of the gains from trade, the article says.

By our count, after the swap, each country ends up half a kilogram of steel ahead. By our count, country A gets two shirts for two and a half kilograms of steel, when making them itself would cost three kilograms. By our count, country B gives up two kilograms of steel to make the shirts and gets two and a half back. Real trade is messier than this example: it involves many goods, many countries and many firms.

Real-world prices and trade rules vary by place. And that is why countries trade: each makes what it does comparatively best, and both sides can end up with more. So, seven ideas, starting with buying abroad, comparative advantage, where it comes from and variety. Then trade and growth, who gains, and one example where two countries both come out ahead.

Today, you can open the IMF's back-to-basics article on international trade, linked below. Which of the seven surprised you most? Tell us the number in the comments. Results vary, rules differ where you live, and this is information only, not financial advice.

This is Wealth Filings. If you want to see part seventeen, subscribe now: it shows how supply and demand set the prices you pay. Next on Wealth Filings, How Money Really Works, part seventeen: how supply and demand set prices.