Economic Benefits of International Trade

Adam Smith noted long ago that specialization of labor allows each worker to become efficient at his particular job. Some companies are also more efficient than others, which makes them more successful. Market competition forces producers to be efficient; otherwise they will be driven out of business. Efficiency depends on not only the skill of the workers, but also on the availability and the cost of resources, which varies by country.

If the division of labor within the country increases the economic wealth of that country, then international trade should be able to increase it further, because it allows the most efficient producers on a worldwide scale to compete, providing the lowest prices, which benefits everyone.

Industrialized countries can provide capital, 3rd world countries can provide cheap labor, modern economies can provide intellectual capital, and agricultural products can be produced most cheaply in countries that have a lot of land and the right climate. These differences in resources gives countries both an absolute and comparative advantage in producing specific products, but the world can only benefit if there is international trade. Countries benefit from international trade because they can import what they cannot efficiently produce domestically and export those products and services where it has an absolute or comparative advantage.

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A country has a comparative advantage in producing a product when it has the lowest opportunity cost for producing that product. For instance, the wages in 3rd world countries are much lower than in industrialized countries, so they are able to produce labor-intensive goods cheaply, which is why many items are manufactured in countries that have low wages, such as China and Mexico. Other products require a lot of land, such as agricultural products. Therefore, these land-intensive products can usually be produced more cheaply in countries with a lot of land, especially those with a good climate for the product. Valuable geological resources, such as oil and lithium, can only be economically extracted in a few countries. Sometimes, comparative advantage is artificial —those countries that have better legal systems and less corruption will be able to produce most products more efficiently than countries where corruption is rampant.

World Price

International goods and services have a world price, which is the price that prevails throughout the world for that particular product or service. If domestic producers cannot produce their product for less than or equal to the world price, then they will be unable to compete in the market. This leaves only those producers in those countries where they have the greatest comparative advantage in producing the product or service.

To analyze whether a country can profit from either importing or exporting a product, the domestic market of the country must first be analyzed in isolation.

Graph #1: If the domestic suppliers can supply the product for less than the world price then they will be able to sell their product worldwide at the world price. The domestic supply increases until equilibrium is reached with the world price. Since the world price is higher than the domestic price, producers will continue to sell in the worldwide market rather than the domestic market until the domestic price increases to the world price; thus, domestic demand will decline. However, the country benefits because the producer surplus is increased by the higher price which compensates for the loss of consumer surplus to the domestic buyers. There is an additional gain of producer surplus that is not offset by a loss of consumer surplus by selling on the world market. Hence, total surplus is maximized by exporting in the world market.

Graph #2: The opposite occurs when the domestic producers cannot supply the product at or below the world price. In this case, the wealth of the economy is maximized by allowing the importation of the good or service. This increases consumer surplus at the expense of producer surplus, but there is an additional consumer surplus that results from more people buying the product because of its lower price. Hence, allowing international trade makes everyone better off, which is one of the guiding objectives of economics.

The Economics Of Tariffs

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A tariff is a tax on imported goods, usually assessed to protect domestic suppliers. Tariffs are only effective, however, if the domestic suppliers cannot produce their product for less than the world price; otherwise, buyers would buy the domestic product rather than the import, so no tariffs would be collected.

Tariffs raise the prices of imports, reducing their quantity, and moving the market for that good or service closer to what the domestic market equilibrium would be without international trade.

Domestic buyers must pay a higher price, which benefits both sellers and the government. Sellers benefit because they can charge a higher price for their product and, thus, enjoy increased producer surplus. The government benefits by collecting the revenue which a tariff generates when people buy the imported products.

However, as with most taxes, there is a deadweight loss that results from assessing a tariff. This deadweight loss lowers the total surplus of the domestic economy by reducing the consumer surplus that buyers enjoy by paying lower prices.

The deadweight loss of a tariff equals the total loss of consumer surplus that is not compensated by an increase in the producer surplus of those domestic producers who can now sell at the higher price or by the tax revenue generated by the tariff.

When a tariff is imposed, the quantity demanded decreases from the quantity demanded at the world price to the quantity demanded at the world price plus the tariff. At the same time, the quantity produced by domestic suppliers increases from the quantity supplied at the world price to the quantity supplied at the higher price.

People who buy a product either increase producer surplus by buying from domestic producers or increase government revenues by buying the imported product and paying the tariff. The deadweight losses that result from a tariff arise entirely from people who do not buy the product because of its higher price.

Note that when the government imposes a tariff, it has decided to reward a few producers at the expense of the many buyers.

Import Quotas

Sometimes the government will impose an import quota rather than levy a tariff. Governments generally set import quotas by selling licenses to specific importers, allowing them to import a specified quantity. The license fee has the same economic effect as a tariff, lowering consumer surplus for the buyers and causing a deadweight loss by eliminating some buyers from the market.

Advantages of International Trade

Although there are some cogent arguments restricting for trade, the advantages of international trade are that a greater variety of goods and services can be provided to the world market at lower prices because of differences in people's knowledge and skills, differences in available resources and their costs, and simply because many more people compete to create products for the market. Moreover, a larger market provides more possibilities through economies of scale, which may not be realized by selling only to a domestic market. Increased world competition may also limit monopolies or oligopolies.

Moreover, world peace will be easier to maintain when the world's economies are intertwined, where each economy will be dependent on all of the others.