Like every Friday, from Raj Nallari  and Breda Griffith's lecture notes.
Although there exists a near-consensus among economists that trade liberalization strongly promotes growth and reduces poverty, concern about its ill effects has not abated among policymakers and the general public. Against this backdrop, in upcoming weeks we will review the links between openness, growth, and poverty reduction after first presenting the rationale for trade.
The Rationale for Trade
Trade is motivated by the expectation of economic gain. Indeed the theory of absolute advantage states that nations gain by producing goods that require fewer domestic resources and exchanging their surplus for goods produced abroad with fewer resources. Each country can benefit from specialized production, which encourages trade. The theory of absolute advantage is incomplete, however, because it ignores the gains available through trade even when one party has an absolute advantage in the production of all goods. Those gains are explained by the theory of comparative advantage. The theory of comparative advantage holds that mutually beneficial trade is always possible between nations whose pre-trade relative costs and prices differ. According to the theory, international trade is the result of the exploration of benefits to two countries arising from trade. When trading countries concentrate on producing goods and services in which they have a comparative advantage, they benefit, and world output of goods and services is maximized. Differences in endowments of natural resources, human resources, and capital give rise to comparative advantage.
- The theory of comparative advantage assumes free trade across countries. It assumes access by participating countries to markets of member countries.
- The theory assumes fair trade among countries.
- Policies can be trade-creating, such as outward-oriented policies, which encourage production for export.
- Policies can also be trade diverting. Trade diversion occurs when policies are inward oriented and do not encourage production for export.
By engaging in trade, most countries expect to increase incomes for their producers and reduce costs of goods for their citizens. The global value of income and output is maximized if the opportunity costs of producing everything in every country are minimized. Trade, therefore, makes various contributions to different sectors of the economy.
- Trade is a source of revenue for government from licenses and trade taxes.
- Through exports, trade also is a source of foreign exchange.
- Imports and exports are exchanges of goods and services, which can encourage better relationships between countries. Countries that trade with each other are more likely to seek a peaceful solution to conflicts in order to avoid disrupting trade.
- Whole communities are dependent on trade for a livelihood. From producers to retailers, to importers and exporters, trade is often the only source of revenue that enables people to make a living. Efficient trading patterns permit people everywhere to enjoy higher living standards.
A number of factors ensure positive gains from trade at the international level.
Specialization. Specialization gains arise from producing and selling goods in which a country enjoys a comparative advantage and buying other goods from countries that can produce them at a lower cost. Access to export markets widens the scope for specialization gains, while simultaneously giving producers access to goods at lower opportunity costs than if they had to rely solely on domestic production.
Uniqueness. In some regions, local sources of certain goods do not exist. Technology gaps, for example, may affect a country’s capacity to produce a good or exploit a resource. Uniqueness gains arise from trading for goods that are not locally available.
Scale. Specialization gains may be limited by market size. Moving into the international market permits expanded production. Gains from scale occur when access to export markets stimulates production of larger amounts of goods at lower average costs.
Dynamic. Dynamic gains occur when trade accelerates economic growth and development. by spreading technology, accelerating capital formation, or encouraging innovation in the anticipation of succeeding in lucrative export markets.
Political stability. Political gains from trade arise when economic interdependency facilitates international political stability. Mutually beneficial trade is a powerful incentive for countries to avoid conflict by engaging in peaceful negotiations. The interdependency created by trade reduces the likelihood of war.
Next week: Trade Barriers