Scientific innovation and invention in technology, communication, and transport networks has facilitated integration among countries; one major element of globalisation is international trade. International trade is trade among countries; it operates on two main paradigms, importation and exportation of factors of production and finished commodities.
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International trade prevails because of economic, resource and wealth differences among countries, which results to comparative and absolute advantage; with international trade, countries stand to benefit (Taylor 78). This report discusses the economic concept of free trade; it will use international policies to explain the advantages likely to be derived from free trade.
One advantage and one limitation of International Trade
Free trade is attained when countries remove trade and non-trade barriers among themselves and allow free flow of goods and factors of production; government intervention in free trade is minimal.
One advantage that countries stand to benefit from international trade is a large market base for raw materials and finished commodities. International trade brings the world into one market thus, traders, suppliers get a place where they can sell their commodities.
The increased market and large base of suppliers lead to innovativeness in efficient resource management as companies, countries and firms try to be competitive in international market, the result is a country with well-utilized resources. The world three largest economies, the United States, China and Japan have maintained their leadership because of the benefit they get from international trade; they are net exporters.
As countries trade among each other, some stands to lose whereas some gain; one disadvantage that international trade has lead to is dependency among countries, there are some countries that have become net consumers. When a country becomes a net consumer, it means that its local companies cannot produce goods to compete in the international arena they remain sycophants of other countries. Examples of countries that have become net consumers include Zimbabwe and Swaziland.
Absolute and comparative advantages of international trade
Both absolute and comparative advantages concepts explain why international trade prevail; they support free trade among countries;
Adam smith, an economist in late 18th century and early 19th century, developed this concept of absolute advantage, the concept behind the theory is that countries should produce what they can effectively and cheaply produce and import those commodities that it has limited capacity to produce effectively.
The concept is similar to household resource management; whereby households tend to produce what they can produce more cheaply and opt to buy those that they cannot produce effectively.
The concept broadly states that it is rational that if a country can import goods and services more cheaply than it can produce, then there is no point of producing such commodities. It goes further and states that a country should only produce what it can make efficiently then export to those countries that cannot have the commodities produced effectively. The proceeds gotten from the export is then used to pay for imports.
The net effect of the trading partners is that country A will have products produced form country B at a lower cost and country B will get commodity form country A at lower costs; consumers will benefit reduced prices. If we consider two countries, a country has an absolute advantage if it can produce some products at a low cost than another country.
David Ricardo developed the concept of comparative advantage in 1817; the main argument of the concept is that a country has a comparative advantage if its marginal production cost is lower than marginal production of the other country.
If we have two trading countries, country A and country B, country A has a comparative advantage than country B if it has a marginal superiority in production of certain product. Abundance of factors of production differs among countries; rational countries will generally tend to produce those products that utilize the most abundant (cheap) factor of production.
According to this concept, if each country specializes in those products and service that it can produce more efficiently, then production can increase and maximum and efficient resource utilization realized. The concept argues that trade allow each country (trading partner) to specialize in those goods and service that it can have a lower marginal production cost.
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However, the concept assumes that factors of mobility has are perfectly mobile; this means that a country can exchange a factor of production for another without affecting the level of efficiency of the factor. Secondly, it assumes that input-output ratio is constant. This is not true because of the effects of diminishing return and the effects of specialization (O’Sullivan and Sheffrin 23-67)
How Absolute and Comparative advantage are used
Let take a hypothetical example of two countries, country A and country B, they have different potentials. Country A can produce 300milligrams of wheat by using 300 units of factors of production, and can produce 500 milligrams of maize using 300 units of factors of production.
Country B can produce the 300 milligrams wheat using 200 units of factors of production, and 200milligrams of maize using 200 units of factors of production, then country B has an absolute advantage in wheat production than country A and country A has absolute advantage in maize than country B. In such a situation assuming that there are no barriers to trade, then country A should import wheat from country B and country B import maize from country A, both countries stand to benefit.
Let us consider two countries; county 1 and country 2, trading on only two products; wheat and television sets, using similar factors of production as an example;
Pre-specialization (before free trade)
Let analyze the opportunity costs of the two countries: where county 2 shifts more resources into making of television set, the opportunity cost of one television is one wheat milligram.
If county 1 was to put more resources into manufacture of more television sets, then the opportunity cost of one television is 2.4 wheat milligrams. Therefore county 2 has a lower marginal opportunity cost than county 1 in the production of television sets. On the other hand, for county 1 to produce television it is going to give a higher opportunity cost.
Post-specialization (after adopting free trade)
|county 2||(300-300)= 0||(300+300)= 600|
|county 1||(1200+ 200*2.4)= 1680||(500-200)= 300|
Looking at the above trading after specialization, then we find that if countries specialize in the area that they have a comparative advantage, then world’s production will increase.
From the analysis above, free trade among countries has an advantage over protectionism policies and lack of international trade; both countries to a trade stand to benefit. As nations, trade among themselves the citizens’ benefit. They enjoy a wide variety of goods and services, increased employment opportunities and improvements in health and standards of living.
In a period of about twenty years, a big number of countries have entered into global economies leading to a reduction in the number of people living in poverty. When borders are opened and there are no trade and non-trade barriers, new developed industries will have access to a large market. When the market is large then chances of their success is higher.
There will be demand of products and services in other countries that results to investment pull. Investment pull is whereby due to an increased market in a certain region, a country manufacturing the products on demand relocates/ opens a branch in the country of demand (Lipsey 16)
Factors affecting foreign exchange rates
In international trade, foreign currencies are required to effect a transaction; a country can peg its currency on an internationally known currency like Dollar or pound. After making an exportation, payments in the form of foreign currency forms a credit in foreign exchange and an importation there is a debit in the foreign currency account.
Two exchange rates are used in the financial market; the fixed exchange rate and floating exchange rate. The forces of demand and supply in the international market determine a floating exchange rate.
Exchange rate is determined by the demand of foreign currency at a certain particular time, if the demand is high, then the currency rate of exchange will be higher, when the rate of demand is low then the rate of exchange is low. Balance of trade exists when a country foreign currency from imports equals the expense of exportation.
When a country is a net importer, then it has a negative balance of trade and its exchange rate to foreign currency is higher (its currency is said to have devalued), when a country is a net exporter then it has a low exchange rate; it has a strong currency.
The international monetary fund (IMF) is an international organization that supervises the international financial market by examining the macroeconomic policies of member countries. The objective of IMF is to stabilize foreign exchange rates and enforce liberalized economic policies in countries for loan purposes (Parkin 23).
Lipsey, Richard, and Courant. Paul. Economics: Social and Environmental Regulation. New York: HarperCollins Publishers Inc, 1996.Print.
O’Sullivan, Arthur, and Sheffrin, Steven. Economics: Principles in Action. Upper Saddle River: New Jersey, 2003. Print.
Parkin, Michael. Economics. Massachusetts: Pearson Addison-Wesley, 2008.Print.
Taylor, John. Principles of Microeconomics. New York: Cengage Learning, 2006.Print.