The basis of international trade, International Economics, Assignment Help

International Economics - The basis of international trade, International Economics,

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The basis of international trade

The basic question in the study of international economics is 'why do nations trade?' or in other words, 'what is the basis of international trade?' The basis of all economic activities, including international trade, is essential human desire to improve its standards of living, i.e., to consume more and more of superior goods and services. It is· this desire which creates a process of specializa­tion and division of labour between the individuals, between the regions and be­tween the nations, which forms ultimately the basis of trade between the individu­als, between the regions and between the nations.

In order to elaborate on this point, let us look into the basis of trade between the individuals. Needless to mention that individuals differ in their resource endowments, i.e., their overall capability to produce.

Individuals differ with respect to both their material means of production (i.e., land and capital) and human resources and their physical and mental capabilities. While some persons possess more of physical means of production, others possess more of human faculties. While some possess greater physical capability, others have greater mental ability. Given these broad categories of resource endowment differentials, innumerable finer distinctions can be made to show a wider range of differentials in the' resource endowment of the people. But one thing which is common to all is that they all try to maximize their earnings from their resources. Consequently, people tend to employ their resources in trade and occupations which maximize their income. This leads to specialization in occupation or what is also known as division of labour. Internal division of labour then becomes the basis of internal trade.

The basis of trade between the nations is essentially the same as the basis of trade between individuals. Countries differ in their resource endowments. While some countries are better endowed with natural resources like vast fertile and cul­tivable land, large mineral deposits, water and forest resources, better climatic con­ditions, etc., some have larger human resources, and some others are better equipped with technology. Most countries have some kind of resource imbalance. For ex­ample, India has a large supply of manpower but she lacks in capital and technol­ogy, minerals and other raw materials. Arab countries are rich in oil, but they are deficient in technology and manpower. Japan is highly advanced in automobile technology, but she lacks in iron ore and coal, etc. With highly advanced technol­ogy and huge capital the USA is deficient in manpower. The USSR with the largest area and highly advanced technology lacks in agricultural potentiality. The most important feature of distribution of world resources is irregularity and imbalance. Possibly no country can claim self-sufficiency in its resource requirements or a perfectly balanced supply of resource is the uneven distribution of resources is the basis of foreign trade. For, owing to resource endowment differences, the produc­tion potentials, i.e., production capacity arid efficiency, vary from country to country. While a country may be having a vast potential in the production of some com­modities, it may be severely handicapped in the production of others (Most coun­tries therefore tend to specialise in the production of commodities which they can produce more efficiently (i.e., at a lower cost) than the others. This leads to inter­national division of labour and, thereby, to international trade)

Another and a more important factor that forms the basis of international trade and its growth is that international trade is gainful to the trading countries. The ultimate gains of international trade are: (a) a larger supply of goods and services, and (b) availability of goods and services at a lower price. This adds to the eco­nomic welfare of the country to the extent it depends on the material goods and services. This point will be discussed in detail in the forthcoming chapters. Here,

Introduction 3 this point can be explained with a simple two-country and one commodity model. Suppose there are two countries, A and B. Both of them produce and consume commodity X. Their demand and supply conditions are presented in Fig. 1.1. The right side and the left side of the diagram present the demand and supply curves of countries A and B in respect of commodity X, respectively. Note that the demand and supply conditions for commodity X are different in the two countries. In the absence of trade between them, industry X in country A will be in equilibrium at point EA as shown in the right half of the diagram. It means that country A will produce and consume PAEA of commodity X at price PA. On the other hand, indus­try X in country B will be in equilibrium at point EB in left half of the diagram. It means that country B will produce PBEB of commodity X at price PB.

Note that price of commodity X in country A, (i.e., PA) is much higher than that in country B (i.e., PB). The difference in the prices equals PBPA. This price differ­ence is a sufficient reason for country A to import commodity X from country B, provided there is no trade barrier. Let us now see what happens when the two countries begin to trade commodity X. 

When country A decides to import X from country B, its supply curve SA begins to shift rightward. As a result, price of commodity X begins to decrease in the domestic market of country A. As shown by the downward arrow.

What happens in country B? Country B is in equilibrium at point EB where its domestic supply equals its domestic demand. There is no exportable surplus. There­fore, country B will have to increase its production of X in order to generate exportable surplus. Given its  supply curve, SB, when country B increases production of X, its cost of production begins to increase. This increases the supply price, as shown by the upward arrow. But, it is advantageous for country B to produce more and export to country A so long as cost of production is lower than that in country A.

The process of decrease and increase in price of X in country A and country B will continue until the price differential (P ~) is completely eliminated and price of X is settled at P. At price P, both countries attain equilibrium with respect to industry X. At price P, country A reaches a new equilibrium at point K where de­mand curve (D) intersects the new supply curve, SA which is composed of both domestic supply and imports. In country A,  

Total supply of X = PK = PJ + JK

where PJ = domestic supply and JK = imports

Country B reaches its new equilibrium at point Q where its supply curve (SB) intersects total demand curve, DB. The total demand curve (DB) represents both domestic demand PR plus foreign demand, RQ. Note that RQ equals country B's export to country A and RQ = JK = A's imports. It means that in equilibrium posi­tion, B s exports are exactly equal to A s imports.

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