Why do Countries Trade?

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Why do Countries Trade?

In the topic called 'Aggregate demand and aggregate supply', we looked at a model of the economy called the circular flow of income. To begin with, the model was kept simple. It was assumed that the economy was closed, meaning that it was 'closed' to the foreign sector. Of course, in the real world, we know that trade between countries is common place. The value of world exports was only around $200 billion in the 50s. Even by the late 60s it had only risen to about $300 billion. Since then world trade has risen exponentially. The value of world exports is already more than $5,000 billion (that's $5 trillion!) and rising.

So one must assume that trade is a good thing. But why is that? Surely there is more security in being a self-sufficient country? Here are some of the reasons that countries trade with each other.

There will be much discussion of the pros and cons of trade in the rest of this topic. Before we go down that road, it is important to understand the fundamental reason why countries trade. Each country has a different allocation of natural and human resources. A given country will be well suited to the production of some goods (or the provision of certain services) and totally unsuited to the production of others. Particularly in the field of agriculture, the differences in climate can be immense; it is simply impossible to grow certain agricultural products in certain countries.

The consequence of this is that some countries will go without some essential goods unless they trade with other countries. It doesn't matter how good a given country is at making desirable, but non-essential, goods. If it doesn't have the right resources then it may not be able to survive due to a lack of, say, essential foodstuffs; trade will be essential.

The next few points highlight why free trade is good rather than why it is absolutely necessary. Perfect competition is considered to be the most efficient market structure because it is the most competitive. Competition puts pressure on firms to keep their prices, and therefore their costs, down.

In the same way, the more open to foreign imports a country is, the more competition the home producers will face and the more efficient they will have to be. This is not only good in an economic sense (greater efficiency) but domestic consumers enjoy lower prices and, therefore, increased consumer surplus.

Given what we said earlier about the unequal distribution of the world's resources, it is likely that countries will not be able to produce all the goods that consumers will desire. By definition, therefore, consumers will have a greater choice if the country trades internationally.

Once a firm in a given product market is subject to international competition, often the only way to survive is through growth and economies of scale. The resulting reduction in their cost per unit produced will enable them to become more price competitive in the global marketplace. Obviously this will be good for consumers.

As you will see in the next Learn-It, it can be shown that all countries benefit from free trade, however well (or poorly) endowed with natural and human resources they are. Even if a poorly endowed country is worse at making everything than another country, they will still be relatively better at making something. See the next Learn-It for details.