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International trade exists for several reasons. First, differences in demand underlie trade. Certain products we want are not produced in our country but are only available in other countries, so we have to import them.
Another key reason why international trade exists is the difference in technology and factor endowment. Both explain why a country produces products cheaper than other countries.
For example, the Ricardian trade model explains how countries have different comparative advantages associated with technological differences. These differences ultimately affect product prices and give rise to international trade because we are trying to get it cheaper than producing it ourselves.
What is international trade?
When discussing international trade, we discuss exports and imports. Export means we sell domestic products to foreigners in overseas markets. Import means we buy products from abroad and ship them to the domestic market.
Because it involves different currencies, international trade affects exchange rates. For example, suppose we are in the eurozone, and the partner country is the United States. Exports encourage the euro to appreciate as buyers in the United States increase demand for the euro to pay for the products they buy. An increase in demand makes the euro price more expensive (more valuable) against the US dollar as per the law of demand, ceteris paribus.
In contrast, imports depreciate the euro as demand for the US dollar increases. This is because we have to exchange euros to get US dollars to pay for the imported goods.
Almost all countries trade with other countries and do export-import. In fact, some countries – which we consider closed – like North Korea, are also involved in international trade. At least, they were transacting with their allies. For example, North Korea imported $491 million in goods from China and Russia and $41 million in 2020. In addition, the country also exported $44.1 million to China that year.
Trading with other countries allows a country to receive several benefits. For example, some goods may not be produced domestically, so we have to import them from other countries. Or we may have a production surplus for a particular good. So, after meeting domestic demand, we export it to other countries to earn income.
What are the reasons why international trade exists?
Several reasons explain why international trade exists, including:
- Difference in demand
- Differences in economic resources
- Technology difference
- Economies of scale in production
Difference in demand
Consumer needs and wants vary greatly between countries. Some Southeast Asian countries, for example, consume far more rice than Americans or Europeans. In contrast, Europeans consume more wheat than Asians. This difference in consumption patterns is a fundamental reason why international trade exists.
However, not all countries in Asia, America, and Europe have sufficient land or resources to produce both rice and wheat efficiently. This is where international trade comes in. It allows countries to address these differences in consumer needs and resource endowments. Countries can import goods that they don’t produce enough of or cannot produce efficiently, and export goods that they have a surplus of or can produce more efficiently. This mutually beneficial exchange is the foundation of international trade.
For example, some Asians may also like wheat, so they have to buy it from farmers in America and Europe. But, on the other hand, some Europeans may also like rice. So, because they are not producing enough for the domestic market, they must buy it abroad.
In other cases, some products may be similar but differ in quality and other attributes. And some people may prefer certain goods imported from abroad over similar goods produced domestically. For example, Japan imports Mercedes-Benz even though the country is known as a car manufacturer with various leading brands such as Toyota, Honda, Isuzu, and Mazda.
Differences in economic resources
The uneven distribution of resources (factors of production) across countries is another reason why international trade exists. Resources (factors of production) are available differently in some countries. For example, some developing countries are rich in natural resources but poor in capital and entrepreneurship. In contrast, developed countries such as South Korea are poor in natural resources. Still, they have a productive workforce and entrepreneurial supply.
When a particular resource is abundant in a country, it represents a factor endowment. As a result, the country specializes in and produces goods and services based on it. Thus, specialization allows the country to have a comparative advantage. On the other hand, for other products, the country imports them from other countries.
For example, countries with abundant capital will use it intensively to specialize in capital-intensive industries, such as electronics, enabling them to produce cheaper products. On the other hand, countries with abundant labor supply focus on labor-intensive industries, such as garments, because they can make more inexpensive products. They then traded for more affordable goods with each other.
Wheat production is another example. Countries in Southeast Asia have abundant land areas, but the climate is not conducive to growing wheat. On the other hand, their land is suitable for growing rice. So they focus on producing rice and selling it to the international market. Meanwhile, to meet the demand for wheat, they import it from wheat-producing countries such as China, India, and Russia.
These factor endowments underlie the Heckscher–Ohlin model. So, even though they have similar production techniques and technologies, some countries can produce goods cheaper than others because they are superior in comparative costs due to the factor endowment.
The Heckscher-Ohlin model
The Heckscher-Ohlin model, developed by economists Eli Heckscher and Bertil Ohlin, dives deeper into explaining why international trade exists even when countries have similar production techniques and technologies. It focuses on the concept of factor endowments, which are the resources a country has access to, such as:
- Labor: Skilled vs. unskilled labor abundance
- Capital: Availability of physical and financial capital
- Land: Natural resources and arable land
The model suggests that countries will tend to export goods that utilize their abundant and relatively cheap factors of production. Conversely, they will import goods that rely on factors that are scarce and expensive domestically.
This creates a situation where countries develop a comparative advantage in producing certain goods. Even if a country could technically produce everything it needs, it becomes more efficient to specialize in goods where they have a comparative advantage and trade for others. This specialization and trade lead to increased overall production and consumption for all participating countries.
The Heckscher-Ohlin model is a simplified representation of the complex world of international trade, but it provides a valuable framework for understanding why international trade exists and how factor endowments influence these exchanges.
Technology difference
Differences in technology are another reason why international trade exists. The Ricardian model explains comparative advantage based on it. Technological differences cause some countries to be more efficient in utilizing resources (labor, capital, and land) to produce output than other countries.
For example, a country has superior technology to produce smartphones more efficiently. Therefore, they specialize in these products and sell them at low prices to the international market.
In contrast, some other countries have technological limitations. Therefore, producing smartphones will cost more to produce than if they bought them from other countries. So, instead of making smartphones, they should focus on the items where they have the best technology. Thus, they can produce the product at a lower opportunity cost than in other countries and sell it cheaper.
Economies of scale in production
Without engaging in international trade, the size of the domestic market limits economies of scale. For example, a country with a small population will also have low demand, making it impossible to increase economies of scale.
In contrast, engaging in international trade allows a country to increase its demand and, therefore, its economies of scale. This is because the foreign market is more significant than the domestic market. As a result, producers can achieve higher economies of scale when selling their products to the international market than domestic ones.
Huge demand allows manufacturers to operate at a significant scale. Finally, they can lower unit costs by spreading high fixed costs over more output and selling the product at a lower price.
Long story short, economies of scale underlie international trade. Countries trade with each other to increase their economies of scale and produce cheaper products.
Samsung Electronics is a good example. The company has become a leading player in several businesses, such as semiconductors, mobile phones, and LCDs, by selling products to international markets instead of relying on demand in South Korea.
