What is international trade

International trade is the purchase and sale of goods and services by companies in different countries. Consumer goods,
raw materials, food, and machinery all are bought and sold in the international marketplace.

International trade allows countries to expand their markets and access goods and services that otherwise may not have
been available domestically. As a result of international trade, the market is more competitive. This ultimately results in
more competitive pricing and brings a cheaper product home to the consumer.

Understanding International Trade

International trade was key to the rise of the global economy. In the global economy, supply and demand—and thus prices
—both impact and are impacted by global events.

Political change in Asia, for example, could result in an increase in the cost of labor. This could increase the manufacturing
costs for an American sneaker company that is based in Malaysia, which would then result in an increase in the price
charged for a pair of sneakers that an American consumer might purchase at their local mall.

Imports and Exports

A product that is sold to the global market is called an export, and a product that is bought from the global market is an
import. Imports and exports are accounted for in the current account section of a country's balance of payments.

Global trade allows wealthy countries to use their resources—for example, labor, technology, or capital—more efficiently.
Different countries are endowed with different assets and natural resources: land, labor, capital, technology, etc.

This allows some countries to produce the same good more efficiently; in other words, more quickly and at a lower cost.
Therefore, they may sell it more cheaply than other countries. If a country cannot efficiently produce an item, it can obtain
it by trading with another country that can. This is known as specialization in international trade.

Comparative Advantage

For example, England and Portugal have historically been used, as far back as in Adam Smith's The Wealth of Nations, to
illustrate how two countries can mutually benefit by specializing and trading according to their own comparative
advantages.

In such examples, Portugal is said to have plentiful vineyards and can make wine at a low cost, while England is able to
more cheaply manufacture cloth given its pastures are full of sheep.

According to the theory of comparative advantage, each country would eventually recognize these facts and stop
attempting to make the product that was more costly to generate domestically in favor of engaging in trade. Indeed, over
time, England would likely stop producing wine, and Portugal stop manufacturing cloth. Both countries would realize that it
was to their advantage to redirect their efforts at producing what they were relatively better at domestically and, instead,
to trade with each other in order to acquire the other.

These two countries realized that they could produce more by focusing on those products for which they have a
comparative advantage. In such a case, the Portuguese would begin to produce only wine, and the English only cotton.

Each country can now create a specialized output of 20 units per year and trade equal proportions of both products. As
such, each country now has access to both products at lower costs. We can see then that for both countries, the
opportunity cost of producing both products is greater than the cost of specializing.

Comparative advantage can contrast with absolute advantage. Absolute advantage leads to unambiguous gains from
specialization and trade only in cases wherein each producer has an absolute advantage in producing some good.

If a producer lacked any absolute advantage, then they would never export anything. But we do see that countries without
any clear absolute advantage do gain from trade because they have a comparative advantage.

Origins of Comparative Advantage

The theory of comparative advantage has been attributed to the English political economist David Ricardo. Comparative
advantage is discussed in Ricardo's book On the Principles of Political Economy and Taxation, published in 1817, although it
has been suggested that Ricardo's mentor, James Mill, likely originated the analysis and slipped it into Ricardo's book on
the sly.

Comparative advantage, as we have shown above, famously showed how England and Portugal both benefit by specializing
and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while
England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these
facts and stop attempting to make the product that was more costly to generate.

A more contemporary example of comparative advantage is China’s comparative advantage over the United States in the
form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost.

The comparative advantage for the U.S. is in specialized, capital-intensive labor. American workers produce sophisticated
goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefit each
country.

The theory of comparative advantage helps to explain why protectionism has been traditionally unsuccessful. If a country
removes itself from an international trade agreement, or if a government imposes tariffs, it may produce an immediate
local benefit in the form of new jobs; however, this is rarely a long-term solution to a trade problem.

Eventually, that country will grow to be at a disadvantage relative to its neighbors: countries that were already better able
to produce these items at a lower opportunity cost.

Criticisms of Comparative Advantage

Why doesn't the world have open trading between countries? When there is free trade, why do some countries remain
poor at the expense of others? There are many reasons, but the most influential is something that economists call rent
seeking. Rent seeking occurs when one group organizes and lobbies the government to protect its interests.

Say, for example, the producers of American shoes understand and agree with the free-trade argument but also know that
cheaper foreign shoes would negatively impact their narrow interests. Even if laborers would be most productive by
switching from making shoes to making computers, nobody in the shoe industry wants to lose their job or see profits
decrease in the short run.

This desire could lead the shoemakers to lobby for special tax breaks for their products or extra duties (or even outright
bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound—even
though, in the long run, American laborers would be relatively less productive and American consumers relatively poorer as
a result of such protectionist tactics.

Other Possible Benefits of Trading Globally

International trade not only results in increased efficiency but also allows countries to participate in a global economy,
encouraging the opportunity for foreign direct investment (FDI). In theory, economies can thus grow more efficiently and
become competitive economic participants more easily.

For the receiving government, FDI is a means by which foreign currency and expertise can enter the country. It raises
employment levels and, theoretically, leads to a growth in the gross domestic product (GDP). For the investor, FDI offers
company expansion and growth, which means higher revenues.

The Bottom Line

The world economies have become more intertwined through globalization and international trade is a major part of most
economies. It provides consumers with a variety of options and increases competition so that businesses must produce
cost-efficient and high-quality goods, benefiting these consumers.

Nations also benefit through international trade, focusing on producing the goods they have a comparative advantage in.
Though some countries limit international trade through tariffs and quotas to protect domestic businesses, international
trade has shown to benefit economies as a whole.

The theory of international trade

Comparative-advantage analysis
The British school of classical economics began in no small measure as a reaction against the inconsistencies of mercantilist
thought. Adam Smith was the 18th-century founder of this school; as mentioned above, his famous work, The Wealth of
Nations (1776), is in part an antimercantilist tract. In the book, Smith emphasized the importance of specialization as a
source of increased output, and he treated international trade as a particular instance of specialization: in a world where
productive resources are scarce and human wants cannot be completely satisfied, each nation should specialize in the
production of goods it is particularly well equipped to produce; it should export part of this production, taking in exchange
other goods that it cannot so readily turn out. Smith did not expand these ideas at much length, but another classical
economist, David Ricardo, developed them into the principle of comparative advantage, a principle still to be found, much
as Ricardo spelled it out, in contemporary textbooks on international trade.

Simplified theory of comparative advantage

For clarity of exposition, the theory of comparative advantage is usually first outlined as though only two countries and
only two commodities were involved, although the principles are by no means limited to such cases. Again for clarity, the
cost of production is usually measured only in terms of labour time and effort; the cost of a unit of cloth, for example,
might be given as two hours of work. The two countries will be called A and B; and the two commodities produced, wine
and cloth. The labour time required to produce a unit of either commodity in either country is as follows:

cost of production (labour

time)

country A country B

wine (1 unit) 1 hour 2 hours

cloth (1 unit) 2 hours 6 hours

As compared with country A, country B is productively inefficient. Its workers need more time to turn out a unit of wine or
a unit of cloth. This relative inefficiency may result from differences in climate, in worker training or skill, in the amount of
available tools and equipment, or from numerous other reasons. Ricardo took it for granted that such differences do exist,
and he was not concerned with their origins.

Country A is said to have an absolute advantage in the production of both wine and cloth because it is more efficient in the
production of both goods. Accordingly, A’s absolute advantage seemingly invites the conclusion that country B could not
possibly compete with country A, and indeed that if trade were to be opened up between them, country B would be
competitively overwhelmed. Ricardo, who focused chiefly on labour costs, insisted that this conclusion is false. The critical
factor is that country B’s disadvantage is less pronounced in wine production, in which its workers require only twice as
much time for a single unit as do the workers in A, than it is in cloth production, in which the required time is three times
as great. This means, Ricardo pointed out, that country B will have a comparative advantage in wine production. Both
countries will profit, in terms of the real income they enjoy, if country B specializes in wine production, exporting part of its
output to country A, and if country A specializes in cloth production, exporting part of its output to country B. Paradoxical
though it may seem, it is preferable for country A to leave wine production to country B, despite the fact that A’s workers
can produce wine of equal quality in half the time that B’s workers can do so.

The incentive to export and to import can be explained in price terms. In country A (before international trade), the price
of cloth ought to be twice that of wine, since a unit of cloth requires twice as much labour effort. If this price ratio is not
satisfied, one of the two commodities will be overpriced and the other underpriced. Labour will then move out of the
underpriced occupation and into the other, until the resulting shortage of the underpriced commodity drives up its price. In
country B (again, before trade), a cloth unit should cost three times as much as a wine unit, since a unit of cloth requires
three times as much labour effort. Hence, a typical before-trade price relationship, matching the underlying real cost ratio
in each country, might be as follows:

country
country A B

Price of wine per unit $5 £1

Price of cloth per unit $10 £3

The absolute levels of price do not matter. All that is necessary is that in each country the ratio of the two prices should
match the labour–cost ratio.

As soon as the opportunity for exchange between the two countries is opened up, the difference between the wine–cloth
price ratio in country A (namely, 5:10, or 1:2) and that in country B (which is 1:3) provides the opportunity of a trading
profit. Cloth will begin to move from A to B, and wine from B to A. As an illustration, a trader in A, starting with an initial
investment of $10, would buy a unit of cloth, sell it in B for £3, buy 3 units of B’s wine with the proceeds, and sell this in A
for $15. (This example assumes, for simplicity, that costs of transporting goods are negligible or zero. The introduction of
transport costs complicates the analysis somewhat, but it does not change the conclusions, unless these costs are so high
as to make trade impossible.)

So long as the ratio of prices in country A differs from that in country B, the flow of goods between the two countries will
steadily increase as traders become increasingly aware of the profit to be obtained by moving goods between the two
countries. Prices, however, will be affected by these changing flows of goods. The wine price in country A, for example, can
be expected to fall as larger and larger supplies of imported wine become available. Thus A’s wine–cloth price ratio of 1:2
will fall. For comparable reasons, B’s price ratio of 1:3 will rise. When the two ratios meet, at some intermediate level (in
the example earlier, at 1:21/2), the flow of goods will stabilize.

What Is a Nontariff Barrier?

A nontariff barrier is a way to restrict trade using trade barriers in a form other than a tariff. Nontariff barriers include
quotas, embargoes, sanctions, and levies. As part of their political or economic strategy, some countries frequently use
nontariff barriers to restrict the amount of trade they conduct with other countries.

How Nontariff Barriers Work

Countries commonly use nontariff barriers in international trade. Decisions about when to impose nontariff barriers are
influenced by the political alliances of a country and the overall availability of goods and services.

In general, any barrier to international trade–including tariffs and non-tariff barriers–influences the global economy
because it limits the functions of the free market. The lost revenue that some companies may experience from these
barriers to trade may be considered an economic loss, especially for proponents of laissez-faire capitalism. Advocates of
laissez-faire capitalism believe that governments should abstain from interfering in the workings of the free market.

Countries can use nontariff barriers in place of, or in conjunction with, conventional tariff barriers, which are taxes that an
exporting country pays to an importing country for goods or services. Tariffs are the most common type of trade barrier,
and they increase the cost of products and services in an importing country.

Often times countries pursue alternatives to standard tariffs because they release countries from paying added tax on
imported goods. Alternatives to standard tariffs can have a meaningful impact on the level of trade (while creating a
different monetary impact than standard tariffs).

Types of Nontariff Barriers

Licenses

Countries may use licenses to limit imported goods to specific businesses. If a business is granted a trade license, it is
permitted to import goods that would otherwise be restricted for trade in the country.

Quotas

Countries often issue quotas for importing and exporting both goods and services. With quotas, countries agree on
specified limits for products and services allowed for importation to a country. In most cases, there are no restrictions on
importing these goods and services until a country reaches its quota, which it can set for a specific timeframe. Additionally,
quotas are often used in international trade licensing agreements.

Embargoes

Embargoes are when a country–or several countries–officially ban the trade of specified goods and services with another
country. Governments may take this measure to support their specific political or economic goals.

Sanctions
Countries impose sanctions on other countries to limit their trade activity. Sanctions can include increased administrative
actions–or additional customs and trade procedures–that slow or limit a country’s ability to trade.

Voluntary Export Restraints

Exporting countries sometimes use voluntary export restraints. Voluntary export restraints set limits on the number of
goods and services a country can export to specified countries. These restraints are typically based on availability and
political alliances.

Example of Nontariff Barriers

In December 2017, the United Nations adopted a round of nontariff barriers against North Korea and the Kim Jong Un
regime. The nontariff barriers included sanctions that cut exports of gasoline, diesel, and other refined oil products to the
nation. They also prohibited the export of industrial equipment, machinery, transport vehicles, and industrial metals to
North Korea. The intention of these nontariff barriers was to put economic pressure on the nation to stop its nuclear arms
and military exercises.

Tariff

International trade increases the number of goods that domestic consumers can choose from, decreases the cost of those
goods through increased competition, and allows domestic industries to ship their products abroad. While all of these
effects seem beneficial, it has been argued that free trade isn't beneficial to all parties.

This article will examine how some countries react to a variety of factors that attempt to influence trade.

Who Collects a Tariff?

In simplest terms, a tariff is a tax. It adds to the cost borne by consumers of imported goods and is one of several trade
policies that a country can enact. Tariffs are paid to the customs authority of the country imposing the tariff.

Tariffs on imports coming into the United States, for example, are collected by Customs and Border Protection, acting on
behalf of the Commerce Department. In the U.K., it's HM Revenue & Customs (HMRC) that collects the money.

It is important to recognize that the taxes owed on imports are paid by domestic consumers and not imposed directly on
the foreign country's exports. The effect is nonetheless to make foreign products relatively more expensive for consumers,
but if manufacturers rely on imported components or other inputs in their production process, they will also pass the
increased cost on to consumers.

Often, goods from abroad are cheaper because they offer cheaper capital or labor costs; if those goods become more
expensive, then consumers will choose the relatively costlier domestic product. Overall, consumers tend to lose out with
tariffs, where the taxes are collected domestically.

Why Are Tariffs and Trade Barriers Used?

Tariffs are often created to protect infant industries and developing economies but are also used by more advanced
economies with developed industries. Here are five of the top reasons tariffs are used:

Common Types of Tariffs

There are several types of tariffs and barriers that a government can employ:

 Specific tariffs
 Ad valorem tariffs
 Licenses
 Import quotas
 Voluntary export restraints
 Local content requirements
 Specific Tariffs

A fixed fee levied on one unit of an imported good is referred to as a specific tariff. This tariff can vary according to the type
of goods imported. For example, a country could levy a $15 tariff on each pair of shoes imported, but levy a $300 tariff on
each computer imported.
Ad Valorem Tariffs

The phrase "ad valorem" is Latin for "according to value," and this type of tariff is levied on a good based on a percentage
of that good's value. An example of an ad valorem tariff would be a 15% tariff levied by Japan on U.S. automobiles.

The 15% is a price increase on the value of the automobile, so a $10,000 vehicle now costs $11,500 to Japanese consumers.
This price increase protects domestic producers from being undercut but also keeps prices artificially high for Japanese car
shoppers.

Non-Tariff Barriers to Trade

Licenses

A license is granted to a business by the government and allows the business to import a certain type of good into the
country. For example, there could be a restriction on imported cheese, and licenses would be granted to certain companies
allowing them to act as importers. This creates a restriction on competition and increases prices faced by consumers.

Import Quotas

An import quota is a restriction placed on the amount of a particular good that can be imported. This sort of barrier is often
associated with the issuance of licenses. For example, a country may place a quota on the volume of imported citrus fruit
that is allowed.

Voluntary Export Restraints (VER)

This type of trade barrier is "voluntary" in that it is created by the exporting country rather than the importing one. A
voluntary export restraint (VER) is usually levied at the behest of the importing country and could be accompanied by a
reciprocal VER.

For example, Brazil could place a VER on the exportation of sugar to Canada, based on a request by Canada. Canada could
then place a VER on the exportation of coal to Brazil. This increases the price of both coal and sugar but protects the
domestic industries.

Local Content Requirement

Instead of placing a quota on the number of goods that can be imported, the government can require that a certain
percentage of a good be made domestically. The restriction can be a percentage of the good itself or a percentage of the
value of the good.

For example, a restriction on the import of computers might say that 25% of the pieces used to make the computer are
made domestically, or can say that 15% of the value of the good must come from domestically produced components.

In the final section, we'll examine who benefits from tariffs and how they affect the price of goods.

What is the WTO?

The World Trade Organization (WTO) is the only global international organization dealing with the rules of trade between
nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified
i Created in 1995, the World Trade Organization (WTO) is an international institution that oversees the rules for global
trade among nations. It superseded the 1947 General Agreement on Tariffs and Trade (GATT) created in the wake of World
War II.

The WTO is based on agreements signed by a majority of the world’s trading nations. The main function of the organization
is to help producers of goods and services, as well as exporters and importers, protect and manage their businesses.

As of 2021, the WTO has 164 member countries, with Liberia and Afghanistan the most recent members, having joined in
July 2016, and 25 “observer” countries and governments.

1n their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business.

Understanding the World Trade Organization (WTO)

The WTO is essentially an alternative dispute or mediation entity that upholds the international rules of trade among
nations. The organization provides a platform that allows member governments to negotiate and resolve trade issues with
other members. The WTO’s main focus is to provide open lines of communication concerning trade among its members.
The WTO has lowered trade barriers and increased trade among member countries. It also has also maintained trade
barriers when it makes sense to do so in the global context. The WTO attempts to mediate between nations in order to
benefit the global economy.

Once negotiations are complete and an agreement is in place, the WTO offers to interpret the agreement in case of a
future dispute. All WTO agreements include a settlement process that allows it to conduct neutral conflict resolution

Advantages and Disadvantages of the WTO

The history of international trade has been a battle between protectionism and free trade, and the WTO has fueled
globalization, with both positive and adverse effects. The organization’s efforts have increased global trade expansion.
There are side effects to globalization, including a negative impact on local communities and human rights.

Proponents of the WTO, particularly multinational corporations, believe that the organization is beneficial to business,
seeing the stimulation of free trade and a decline in trade disputes as beneficial to the global economy.

Skeptics believe that the WTO undermines the principles of organic democracy and widens the international wealth gap.
They point to the decline in domestic industries and increasing foreign influence as negative impacts on the world
economy.

As part of his broader attempts to renegotiate U.S. international trade deals, when he was in office, then-President Donald
Trump threatened to withdraw from the WTO, calling it a “disaster.” A U.S. withdrawal from the WTO could have disrupted
trillions of dollars in global trade. However, he didn’t withdraw the U.S. from the WTO during his time in office.

Why Is the World Trade Organization Important?

The World Trade Organization (WTO) is the body that keeps global trade running smoothly. It oversees the rules and
mediates disputes among its member nations. It now has 164 member nations and 25 observer nations (out of a total 195
nations in the world).

What Is the International Monetary Fund (IMF)?

The International Monetary Fund (IMF) is an international organization that promotes global economic growth and
financial stability, encourages international trade, and reduces poverty.

Quotas of member countries are a key determinant of the voting power in IMF decisions. Votes comprise one vote per
100,000 special drawing rights (SDR) of quota plus basic votes. SDRs are an international type of monetary reserve currency
created by the IMF as a supplement to the existing money reserves of member countries.

KEY TAKEAWAYS

 The IMF's mission is to promote global economic growth and financial stability, encourage international trade,
and reduce poverty around the world.
 The IMF was originally created in 1945 as part of the Bretton Woods agreement, which attempted to encourage
international financial cooperation by introducing a system of convertible currencies at fixed exchange rates.
 The IMF collects massive amounts of data on national economies, international trade, and the global economy in
aggregate and provides economic forecasts.
 One of the IMF's most important functions is to make loans to countries that are experiencing economic distress
to prevent or mitigate financial crises.

Understanding the International Monetary Fund (IMF)

The International Monetary Fund (IMF) is based in Washington, D.C. The organization is currently composed of 190
member countries, each of which has representation on the IMF's executive board in proportion to its financial
importance. Quotas are a key determinant of the voting power in IMF decisions. Votes comprise one vote per SDR100,000
of quota plus basic votes (same for all members).

The IMF's website describes its mission as "to foster global monetary cooperation, secure financial stability, facilitate
international trade, promote high employment and sustainable economic growth, and reduce poverty around the world

History of the IMF

The IMF was originally created in 1945 as part of the Bretton Woods Agreement, which attempted to encourage
international financial cooperation by introducing a system of convertible currencies at fixed exchange rates. The dollar
was redeemable for gold at $35 per ounce at the time.

The IMF also acted as a gatekeeper: Countries were not eligible for membership in the International Bank for
Reconstruction and Development (IBRD)—a World Bank forerunner that the Bretton Woods agreement created in order to
fund the reconstruction of Europe after World War II—unless they were members of the IMF.

Since the Bretton Woods system collapsed in the 1970s, the IMF has promoted the system of floating exchange rates,
meaning that market forces determine the value of currencies relative to one another. This system remains in place today.

IMF Activities

The IMF's primary methods for achieving these goals are monitoring capacity building and lending.

Surveillance

The IMF collects massive amounts of data on national economies, international trade, and the global economy in
aggregate. The organization also provides regularly updated economic forecasts at the national and international levels.
These forecasts, published in the World Economic Outlook, are accompanied by lengthy discussions on the effect of fiscal,
monetary, and trade policies on growth prospects and financial stability.

Capacity Building

The IMF provides technical assistance, training, and policy advice to member countries through its capacity-building
programs. These programs include training in data collection and analysis, which feed into the IMF's project of monitoring
national and global economies.

Lending

The IMF makes loans to countries that are experiencing economic distress to prevent or mitigate financial crises. Members
contribute the funds for this lending to a pool based on a quota system. In 2019, loan resources in the amount of SDR 11.4
billion (SDR 0.4 billion above target) were secured to support the IMF’s concessional lending activities into the next decade.

IMF funds are often conditional on recipients making reforms to increase their growth potential and financial stability.
Structural adjustment programs, as these conditional loans are known, have attracted criticism for exacerbating poverty
and reproducing the colonialist structures.

Where Does the IMF Get Its Money?

The IMF gets its money through quotas and subscriptions from its member countries. These contributions are based on the
size of the country's economy, making the U.S., with the world's largest economy, the largest contributor.

How Much Are the IMF Grants?

IMF grants are given to charities in Washington D.C. and member countries. The grants are meant to foster economic
independence through education and economic development." The average grant size is $15,000.

What Is the Difference Between the International Monetary Fund and the World Bank?

The International Monetary Fund is primarily focused on the stability of the global monetary system and monitoring the
currencies of the world. The aim of the World Bank is to reduce poverty across the world and strengthen the low- to
middle-class populations.

The Bottom Line

The IMF works to help reduce poverty, encourage trade, and promote financial stability and economic growth around the
world. It accomplishes this by monitoring capacity building and providing loans. While the IMF is currently working on
these goals with its 190 member nations, the organization has still faced criticism for the possible negative impacts of its
structural adjustment programs.

What is globalization?
Globalization is the process by which ideas, knowledge, information, goods and services spread around the world. In
business, the term is used in an economic context to describe integrated economies marked by free trade, the free flow of
capital among countries and easy access to foreign resources, including labor markets, to maximize returns and benefit for
the common good.

Globalization, or globalisation as it is known in some parts of the world, is driven by the convergence of cultural and
economic systems. This convergence promotes -- and in some cases necessitates -- increased interaction, integration and
interdependence among nations. The more countries and regions of the world become intertwined politically, culturally
and economically, the more globalized the world becomes.

How globalization works

In a globalized economy, countries specialize in the products and services they have a competitive advantage in. This
generally means what they can produce and provide most efficiently, with the least amount of resources, at a lower cost
than competing nations. If all countries are specializing in what they do best, production should be more efficient
worldwide, prices should be lower, economic growth widespread and all countries should benefit -- in theory.

Policies that promote free trade, open borders and international cooperation all drive economic globalization. They enable
businesses to access lower priced raw materials and parts, take advantage of lower cost labor markets and access larger
and growing markets around the world in which to sell their goods and services.

Money, products, materials, information and people flow more swiftly across national boundaries today than ever.
Advances in technology have enabled and accelerated this flow and the resulting international interactions and
dependencies. These technological advances have been especially pronounced in transportation and telecommunications.

Among the recent technological changes that have played a role in globalization are the following:

Internet and internet communication. The internet has increased the sharing and flow of information and knowledge,
access to ideas and exchange of culture among people of different countries. It has contributed to closing the digital divide
between more and less advanced countries.

Communication technology. The introduction of 4G and 5G technologies has dramatically increased the speed and
responsiveness of mobile and wireless networks.

IoT and AI. These technologies are enabling the tracking of assets in transit and as they move across borders, making cross-
border product management more efficient.

Blockchain. This technology is enabling the development of decentralized databases and storage that support the tracking
of materials in the supply chain. Blockchain facilitates the secure access to data required in industries such as healthcare
and banking. For example, blockchain provides a transparent ledger that centrally records and vets transactions in a way
that prevents corruption and breaches.

Transportation. Advances in air and fast rail technology have facilitated the movement of people and products. And
changes in shipping logistics technology moves raw materials, parts and finished products around the globe more
efficiently.

Manufacturing. Advances such as automation and 3D printing have reduced geographic constraints in the manufacturing
industry. 3D printing enables digital designs to be sent anywhere and physically printed, making distributed, smaller-scale
production near the point of consumption easier. Automation speeds up processes and supply chains, giving workforces
more flexibility and improving output.

Why is globalization important?

Globalization changes the way nations, businesses and people interact. Specifically, it changes the nature of economic
activity among nations, expanding trade, opening global supply chains and providing access to natural resources and labor
markets.

Changing the way trade and financial exchange and interaction occurs among nations also promotes the cultural exchange
of ideas. It removes the barriers set by geographic constraints, political boundaries and political economies.
For example, globalization enables businesses in one nation to access another nation's resources. More open access
changes the way products are developed, supply chains are managed and organizations communicate. Businesses find
cheaper raw materials and parts, less expensive or more skilled labor and more efficient ways to develop products.

With fewer restrictions on trade, globalization creates opportunities to expand. Increased trade promotes international
competition. This, in turn, spurs innovation and, in some cases, the exchange of ideas and knowhow. In addition, people
coming from other nations to do business and work bring with them their own cultures, which influence and mix with
other cultures.

The many types of exchange that globalization facilitates can have positive and negative effects. For instance, the exchange
of people and goods across borders can bring fresh ideas and help business. However, this movement can also heighten
the spread of disease and promote ideas that might destabilize political economies.

ypes of globalization: Economic, political, cultural

There are three types of globalization.

Economic globalization. Here, the focus is on the integration of international financial markets and the coordination of
financial exchange. Free trade agreements, such the North American Free Trade Agreement and the Trans-Pacific
Partnership are examples of economic globalization. Multinational corporations, which operate in two or more countries,
play a large role in economic globalization.

Political globalization. This type covers the national policies that bring countries together politically, economically and
culturally. Organizations such as NATO and the UN are part of the political globalization effort.

Cultural globalization. This aspect of globalization focuses in a large part on the technological and societal factors that are
causing cultures to converge. These include increased ease of communication, the pervasiveness of social media and
access to faster and better transportation.

Factors influencing globalization

(1) Historical:

The trade routes were made over the years so that goods from one kingdom or country moved to another. The well known
silk-route from east to west is an example of historical factor.

(2) Economy:

The cost of goods and values to the end user determine the movement of goods and value addition. The overall economics
of a particular industry or trade is an important factor in globalisation.

(3) Resources and Markets:

The natural resources like minerals, coal, oil, gas, human resources, water, etc. make an important contribution in
globalisation. The mineral based industries like steel, aluminium, coal in Australia are examples. Few of these Australian
mining and metal companies are owned by European / Japanese / American companies.

Near distance to end user or consumer also is an important factor in globalisation. The large markets as consumer bases in
Asian countries have led many European, Korean to Japanese manufacturing conglomerates and shift their manufacturing
and trading bases in Asian countries.

That is going near the customer makes globalisation. The Table 16.1 gives the strengths and weakness of India in global
level. The details are based on expert survey on globalisation. As may be seen from the table low on scale is lack or shortfall
and hence, ranking is low.

(4) Production Issues:

Utilisation of built up capacities of production, sluggishness in domestic market and over production makes a
manufacturing company look outward and go global. The development of overseas markets and manufacturing plants in
autos, four wheelers and two wheelers is a classical example.

(5) Political:
The political issues of a country make globalisation channelised as per political bosses. The regional trade understandings
or agreements determine the scope of globalization. Trading in European Union and special agreement in the erstwhile
Soviet block and SAARC are examples.

(6) Industrial Organisation:

The technological development in the areas of production, product mix and firms are helping organisations to expand their
operations. The hiring of services and procurement of sub-assemblies and components have a strong influence in the
globalisation process.

The stage of technology in a particular field gives rise to import or export of products or services from or to the country.
European countries like England and Germany exported their chemical, electrical, mechanical plants in 50s and 60s and
exports high tech (then) goods to under developed countries. Today India is exporting computer / software related services
to advanced counties like UK, USA, etc.

Factors affecting Globalization:

1) Technology (communication): Globalization is in part where it is today due to the advancements that the world has
made in technology in general. Technology is one of the leading factors in the evolution of globalization. Information
technology is helping further develop globalization. The cost efficiency of many technologies is increasing, and these
technologies are beginning to impact everyday life. For example, the cell phone is becoming more and more available to
the average consumers who rely on it. Cell phones are used for anything from family conversations to business calls, but
for many they have become a way of life. Life might become impossible without the reliance on the cell phone. Another
example of information technology is the Internet, which has drastically changed since its big debut in the 1990’s.

2) Transportation: Faster and cheaper transportation systems allow multinational corporations to build manufacturing
facilities across the globe while maintaining scheduled, frequent deliveries of parts and finished products. For example,
advances in the aviation system allow businesses to substitute just-in-time deliveries from remote manufacturing plants in
place of large inventories.

3) Deregulations: From the 1980s ahead (starting within the UK) several rules and regulation in business were removed,
particularly rules concerning foreign possession. Privatization additionally materialized, and enormous areas of business
were currently receptive purchase or take over. This allowed businesses in one country to shop for those in another as an
example, several United Kingdom of Great Britain and Northern Ireland utilities, once and government businesses, square
measure owned by French and USA businesses.

4) Removal of capital exchange controls: The movement of cash from one country to a different was additionally
controlled, and these controls were raised over identical amount. This allowed businesses to maneuver cash from one
country to a different in an exceedingly seek for higher business returns; if investment in one’s own country looked
unattractive, a business may purchase businesses in another country. Throughout the 1990s large sums of cash, in the main
from the USA, have acquire the United Kingdom economy.

5) Free Trade: Several barriers to trade are removed a number of this has been done by regional groupings of nations like
the EU. Most of it’s been done by the WTO. This makes trade cheaper and thus additional engaging to business.

6) Consumer tastes have changed, and consumers are more willing to try foreign products: The arrival of world television,
as an example, has exposed shoppers to world advertising shoppers square measure additional awake to what’s out there
in alternative countries, and square measure keen to allow it a strive.

7) Emerging markets in developing countries: Indonesia, as an example, while still not significantly wealthy, has some 350
million shoppers. Both India and China square measure terribly poor countries, however there square measure little middle
categories United Nations agency do okay and have cash to pay. Though these teams square measure little within the
context of the country, the populations square measure thus large (over 1 billion) that a tiny low social class adds up to
several scores of shoppers.

What is Dumping & Non-dumping activities

Dumping occurs when a country's businesses lower the sales price of their exports to gain market share.

Definition and Examples of Dumping

With dumping, a country's businesses drop their product's price on the foreign market below what it would sell for at
home. They may even push the price below the actual cost to produce. Then they raise the price once they've destroyed
the other nation's competition.

For example, if France exported tires to the U.S. for less than their normal value, it could make it difficult for American tire
manufacturers to compete. A prolonged "dumping" of cheap tires could force American tire manufacturers out of business.
While this could also be costly to France, once it eliminated American competition for its tires, it could hike the price again
and recoup some of the lost revenue.

How Does Dumping Work?

Dumping works by eliminating foreign competition through artificially depressing a product's prices in that country. It's
often viewed as an unfair tactic that floods a market with products priced so cheaply that competitors can't keep up.

The country that is dumping the products may help its businesses with subsidies until the competition is destroyed and
prices resume normal levels.

For instance, if France was dumping tires cheaply in the U.S., its tire manufacturers could be losing money on the
production of the tires. The French government could subsidize its tire manufacturers until the American tire companies
were pushed out of the market. Then the French tire makers could resume pricing the tires at normal levels, at which point
their government subsidies could end.

Avoiding Dumping

A country prevents dumping through trade agreements. If both partners stick to the agreement, they can compete fairly
and avoid dumping.

The WTO and Dumping

Most countries are members of the WTO. Member countries adhere to the principles laid out during negotiations of the
General Agreement on Tariffs and Trade. That was a multilateral trade agreement that preceded the WTO. Countries agree
that they won't dump and that they won't enforce tariffs on any one industry or country. To install an anti-dumping duty,
WTO members must prove that dumping has occurred.

The WTO is specific in its definition of dumping. First, a country must prove that dumping harmed its local industry. It must
also show that the price of the dumped import is much lower than the exporter's domestic price. The WTO asks for three
calculations of this price:

1. The price in the exporter’s domestic market.

2. The price charged by the exporter in another country.
3. A calculation based on the exporter’s production costs, other expenses, and reasonable profit margins.

The disputing country must also be able to demonstrate what the normal price should be. When all these have been put in
place, then the disputing country can institute anti-dumping tariffs.

Advantages and Disadvantages of Dumping

Pros

 It increases market share for the dumping country's industry

 It temporarily lowers prices for consumers

Cons

 Expensive for dumping country to maintain

 The target country could retaliate and cause a trade war
 Censure by the WTO and EU

Pros Explained

Increases market share for the dumping country's industry: The main advantage of dumping is selling at an unfairly
competitive lower price. A country subsidizes the exporting businesses to enable them to sell below cost. The nation's
leaders want to increase market share in that industry. It may want to create jobs for its residents. It often uses dumping as
an attack on its trading partner's industry. It hopes to put that country's producers out of business and become the
industry leader.

Temporarily lowers prices for consumers: There is also a temporary advantage to consumers in the country being dumped
upon. As long as the subsidy continues, they pay lower prices for that commodity.

Cons Explained

Expensive for dumping country to maintain: The problem with dumping is that it's expensive to keep up. It can take years
of exporting cheap goods to put the competitors out of business. Meanwhile, the cost of subsidies can add to the export
country's sovereign debt.

The target country could retaliate and cause a trade war: The second disadvantage is retaliation by the trading partner.
Countries may impose trade restrictions and tariffs to counteract dumping. That could lead to a trade war.

Censure by the WTO and EU: The third disadvantage of dumping is the possibility of censure by international trade
organizations. These include the World Trade Organization and the European Union. Censure is a formal disapproval by
member nations, and it can affect trade relations with those countries.

Anti Dumping

In the United States, an independent government agency called the International Trade Commission (ITC) enforces anti
dumping duties. These are based on examinations and recommendations from the Department of Commerce. Duties often
surpass 100% of the value of the products.

Anti dumping duties are often imposed when a foreign brand is selling a product significantly below the price at which it’s
being created. Part of the rationality behind anti dumping duties is to save domestic jobs. They’re also often used to give
higher prices for domestic customers and to lessen the international competition of local companies selling similar items.

To promote and protect local businesses and markets, many companies enforce anti dumping laws and duties on products
they believe are being dumped in their market.

So, if you’ve been wondering ‘what are anti dumping measures?’, now you know.

Role of the WTO in Regulating Anti-Dumping Measures

The World Trade Organization (WTO) plays a critical role in the regulation of anti-dumping measures. As an international
organization, the WTO does not regulate firms accused of engaging in dumping activities, but it possesses the power to
regulate how governments react to dumping activities in their territories.

Some government sometimes react harshly to foreign companies engaging in dumping activities by introducing punitive
anti-dumping duties on foreign imports, and the WTO may come in to determine if the actions are genuine, or if they go
against the WTO free-market principle.

According to the WTO Anti-Dumping Agreement, dumping is legal unless it threatens to cause material injury in the
importing country domestic market. Also, the organization prohibits dumping when the action causes material retardation
in the domestic market.

Where dumping occurs, the WTO allows the government of the affected country to take legal action against the dumping
country as long as there is evidence of genuine material injury to industries in the domestic market. The government must
show that dumping took place, the extent of the dumping in terms of costs, and the injury or threat to cause injury to the
domestic market.

Calculating the Anti-Dumping Duty

The WTO Anti-Dumping Agreement allows governments to act in a way that does not discriminate between trading
partners and honors the DATT 1994 principle when calculating the duty. The GATT 1994 principle provides a number of
guidelines to govern trade between members of the WTO. It requires that imported goods not to be subjected to internal
taxes in excess of the costs imposed on domestic goods.

Also, it requires that imported goods be treated the same way as domestic goods under domestic laws and regulations.
However, it allows the government to impose a duty on foreign imports if they exceed the bound rates and threaten to
cause injury to the domestic market.
There are several ways of determining whether an imported product has been dumped lightly or heavily, and the amount
of duty to be applied. The first method is to calculate the anti-dumping duty based on the normal price of the product.

The second alternative is to use the price charged on the same product but in a different country. The last alternative is to
calculate the duty based on the total product costs, expenses, and the manufacturer’s profit margins.

Examples of Dumping Cases in the United States

Recently, there’s been an increase in the number of anti-dumping cases initiated by American businesses. Local businesses
rely on anti-dumping laws to limit unfair competition from below-market-value imports manufactured abroad. The
International Trade Commission (ITC) imposes the anti-dumping duties based on the recommendations of the U.S.
Department of Commerce.

1. Flat Panel Display Screens Dumping by Japanese Companies in 1991

Following complaints by American businesses on the dumping of flat panel display (FPD) screens by Japanese companies,
the Commerce Department ruled that Japanese companies were liable for the dumping of the FPD screens in the U.S.
market. Consequently, the ITC initiated an investigation in early 1991, and the agency found that Japanese companies
dumped FPD screens, causing material damage to American businesses. The ITC recommended a 62.5% anti-dumping duty
on FPD screens imported from Japan.

2. Dumping of Steel by Chinese Companies in 2015

Large American steel producers filed complaints with the U.S. Department of Commerce on the dumping of steel by
Chinese companies in U.S. markets. The American businesses complained that the large imports of steel resulted in unfair
competition since the imports were unfairly low in price.

The ITC investigated the allegations on the recommendation of the Commerce Department to find out if there was injury or
threat to injury on the domestic market. The agency found the Chinese companies guilty of dumping steel products, and
that it caused material damage to the American businesses. The ITC imposed a 500% import duty on select steel imports
from China to protect the domestic steel industry.

What Is a Portfolio Investment?

A portfolio investment is ownership of a stock, bond, or other financial asset with the expectation that it will earn a return
or grow in value over time, or both. It entails passive or hands-off ownership of assets as opposed to direct investment,
which would involve an active management role.

Portfolio investment may be divided into two main categories:

 Strategic investment involves buying financial assets for their long-term growth potential or their income yield, or
both, with the intention of holding onto those assets for a long time.
 The tactical approach requires active buying and selling activity in hopes of achieving short-term gains.

There also are physical investments such as real estate, commodities, art, land, timber, and gold.

In fact, a portfolio investment can be any possession that is purchased for the purpose of generating a return in the short
or long term.

Making Choices

The composition of investments in a portfolio depends on a number of factors. The most important are the investor’s
tolerance for risk and investment horizon. Is the investor a young professional with children, a mature person looking
forward to retirement, or a retiree looking for a reliable income supplement?

Those with a greater risk tolerance may favor investments in growth stocks, real estate, international securities, and
options, while more conservative investors may opt for government bonds and blue-chip stocks.

On a larger scale, mutual funds and institutional investors are in the business of making portfolio investments. For the
largest institutional investors such as pension funds and sovereign funds, this may include infrastructure assets like bridges
and toll roads.

Components of a Portfolio
The assets that are included in a portfolio are called asset classes. The investor or financial advisor needs to make sure that
there is a good mix of assets in order that balance is maintained, which helps foster capital growth with limited or
controlled risk. A portfolio may contain the following:

1. Stocks

Stocks are the most common component of an investment portfolio. They refer to a portion or share of a company. It
means that the owner of the stocks is a part owner of the company. The size of the ownership stake depends on the
number of shares he owns.

Stocks are a source of income because as a company makes profits, it shares a portion of the profits through dividends to
its stockholders. Also, as shares are bought, they can also be sold at a higher price, depending on the performance of the
company.

2. Bonds

When an investor buys bonds, he is loaning money to the bond issuer, such as the government, a company, or an agency. A
bond comes with a maturity date, which means the date the principal amount used to buy the bond is to be returned with
interest. Compared to stocks, bonds don’t pose as much risk, but offer lower potential rewards.

3. Alternative Investments

Alternative investments can also be included in an investment portfolio. They may be assets whose value can grow and
multiply, such as gold, oil, and real estate. Alternative investments are commonly less widely traded than traditional
investments such as stocks and bonds.

Portfolio investments by institutional investors generally are held for the long term and are relatively conservative. Pension
funds and college endowment funds are not invested in speculative stocks.

Types of Portfolios

Portfolios come in various types, according to their strategies for investment.

1. Growth portfolio

From the name itself, a growth portfolio’s aim is to promote growth by taking greater risks, including investing in growing
industries. Portfolios focused on growth investments typically offer both higher potential rewards and concurrent higher
potential risk. Growth investing often involves investments in younger companies that have more potential for growth as
compared to larger, well-established firms.

2. Income portfolio

Generally speaking, an income portfolio is more focused on securing regular income from investments as opposed to
focusing on potential capital gains. An example is buying stocks based on the stock’s dividends rather than on a history of
share price appreciation.

3. Value portfolio

For value portfolios, an investor takes advantage of buying cheap assets by valuation. They are especially useful during
difficult economic times when many businesses and investments struggle to survive and stay afloat. Investors, then, search
for companies with profit potential but that are currently priced below what analysis deems their fair market value to be.
In short, value investing focuses on finding bargains in the market.

Steps in Building an Investment Portfolio

To create a good investment portfolio, an investor or financial manager should take note of the following steps.

1. Determine the objective of the portfolio

Investors should answer the question of what the portfolio is for to get direction on what investments are to be taken.

2. Minimize investment turnover

Some investors like to be continually buying and then selling stocks within a very short period of time. They need to
remember that this increases transaction costs. Also, some investments simply take time before they finally pay off.
 3. Don’t spend too much on an asset

The higher the price for acquiring an asset, the higher the break-even point to meet. So, the lower the price of the asset,
the higher the possible profits.

4. Never rely on a single investment

As the old adage goes, “Don’t put all your eggs in one basket.” The key to a successful portfolio is diversifying investments.
When some investments are in decline, others may be on the rise. Holding a broad range of investments helps to lower the
overall risk for an investor.

What Is a Foreign Direct Investment (FDI)?

Foreign direct investment (FDI) is an ownership stake in a foreign company or project made by an investor, company, or
government from another country.

Generally, the term is used to describe a business decision to acquire a substantial stake in a foreign business or to buy it
outright to expand operations to a new region. The term is usually not used to describe a stock investment in a foreign
company alone. FDI is a key element in international economic integration because it creates stable and long-lasting links
between economies.

How Does Foreign Direct Investment (FDI) Work?

Companies or governments considering a foreign direct investment (FDI) generally consider target firms or projects in open
economies that offer a skilled workforce and above-average growth prospects for the investor. Light government
regulation also tends to be prized. FDI frequently goes beyond mere capital investment. It may include the provision of
management, technology, and equipment as well. A key feature of foreign direct investment is that it establishes effective
control of the foreign business or at least substantial influence over its decision making.

The net amounts of money involved with FDI are substantial, with more than $1.8 trillion of foreign direct investments
made in 2021. In that year, the United States was the top FDI destination worldwide, followed by China, Canada, Brazil, and
India. In terms of FDI outflows, the U.S. was also the leader, followed by Germany, Japan, China, and the United Kingdom.

FDI inflows as a percentage of gross domestic product (GDP) is a good indicator of a nation’s appeal as a long-term
investment destination. The Chinese economy is currently smaller than the U.S. economy in nominal terms, but FDI as a
percentage of GDP was 1.7% for China as of 2020, compared with 1.0% for the U.S. For smaller, dynamic economies, FDI as
a percentage of GDP is often significantly higher: e.g., 110% for the Cayman Islands, 109% for Hungary, and 34% for Hong
Kong (also for 2020).

Special Considerations

Foreign direct investments can be made in a variety of ways, including opening a subsidiary or associate company in a
foreign country, acquiring a controlling interest in an existing foreign company, or by means of a merger or joint venture
with a foreign company.

The threshold for an FDI that establishes a controlling interest, per guidelines established by the Organisation for Economic
Co-operation and Development (OECD), is a minimum 10% ownership stake in a foreign-based company. That definition is
flexible. There are instances in which effective controlling interest in a firm can be established by acquiring less than 10% of
the company’s voting shares.

Types of Foreign Direct Investment

Foreign direct investments are commonly categorized as horizontal, vertical, or conglomerate.

 With a horizontal FDI, a company establishes the same type of business operation in a foreign country as it
operates in its home country. A U.S.-based cellphone provider buying a chain of phone stores in China is an
example.
 In a vertical FDI, a business acquires a complementary business in another country. For example, a U.S.
manufacturer might acquire an interest in a foreign company that supplies it with the raw materials it needs.
 In a conglomerate FDI, a company invests in a foreign business that is unrelated to its core business. Because the
investing company has no prior experience in the foreign company’s area of expertise, this often takes the form
of a joint venture.

Examples of Foreign Direct Investment

Foreign direct investments may involve mergers, acquisitions, or partnerships in retail, services, logistics, or manufacturing.
They indicate a multinational strategy for company growth.

They also can run into regulatory concerns. For instance, in 2020, U.S. company Nvidia announced its planned acquisition
of ARM, a U.K.-based chip designer. In August 2021, the U.K.’s competition watchdog announced an investigation into
whether the $40 billion deal would reduce competition in industries reliant on semiconductor chips. The deal was called off
in February 2022.

What are the advantages and disadvantages of FDI?

FDI can foster and maintain economic growth, in both the recipient country and the country making the investment. On
one hand, developing countries have encouraged FDI as a means of financing the construction of new infrastructure and
the creation of jobs for their local workers. On the other hand, multinational companies benefit from FDI as a means of
expanding their footprints into international markets. A disadvantage of FDI, however, is that it involves the regulation and
oversight of multiple governments, leading to a higher level of political risk.

The Bottom Line

FDI involves the direct investment by companies or governments into foreign firms or projects. This accounts for nearly $2
trillion in cash flows around the world, with the U.S. and China leading in the FDI inflow statistics. For smaller and
developing countries, FDI funds can be a substantial part of overall GDP. Foreign portfolio investment (FPI) is related to FDI
but instead involves owning the securities issued by firms (e.g., stock in foreign companies) rather than direct capital
investments.

What Is Absolute Advantage?

Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or
service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of
time using a lesser quantity of inputs, than its competitors.

Absolute advantage can be accomplished by creating the good or service at a lower absolute cost per unit using a smaller
number of inputs, or by a more efficient process.

Introduction

The concept of absolute advantage was developed by 18th-century economist Adam Smith in his book The Wealth of
Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can
produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing
and selling a specific good or service and use the generated funds to purchase goods and services from other countries.

Smith argued that specializing in the products that they each have an absolute advantage in and then trading the products
can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage
over other nations.

Absolute advantage explains why it makes sense for individuals, businesses, and countries to trade with each other. Since
each has advantages in producing certain goods and services, both entities can benefit from the exchange.

This mutual gain from trade forms the basis of Smith’s argument that specialization, the division of labor, and subsequent
trade lead to an overall increase in prosperity from which all can benefit. This, Smith believed, was the root source of the
eponymous "Wealth of Nations."

Absolute Advantage vs. Comparative Advantage

Absolute advantage can be contrasted with comparative advantage, which is when a producer has a lower opportunity cost
to produce a good or service than another producer. An opportunity cost is the potential benefits an individual, investor, or
business misses out on when choosing one alternative over another.

Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an
absolute advantage in producing some good. If a producer lacks any absolute advantage, then Adam Smith’s argument
would not necessarily apply.

However, the producer and its trading partners might still be able to realize gains from trade if they can specialize based on
their respective comparative advantages instead. In his book On the Principles of Political Economy and Taxation, David
Ricardo argued that even if a country has an absolute advantage over trading many kinds of goods, it can still benefit by
trading with other countries if that have different comparative advantages.

Assumptions of the Theory of Absolute Advantage

Both Smith's theory of absolute advantage, and Ricardo's theory of comparative advantage, rely on certain assumptions
and simplifications in order to explain the benefits of trade. Both theories assume that there are no barriers to trade: they
do not account for any costs of shipping or additional tariffs that a country might raise on another's imported goods.

Another is that the factors of production are immobile: In these models, workers and businesses do not relocate in search
of better opportunities. This assumption was realistic in the 1700s, but globalization has now made it easy for companies to
move their factories abroad.

More crucially, these theories both assume that a country's absolute advantage is constant, and scales equally. In other
words, it assumes that producing a small number of goods has the same per-unit cost as a larger number and that
countries are unable to change their absolute advantages. In reality, countries often make strategic investments to create
greater advantages in certain industries.

Pros and Cons of Absolute Advantage

One advantage of the theory of absolute advantage is its simplicity: The theory provides an elegant explanation of the
benefits of trade, showing how countries can benefit by focusing on their absolute advantages.

However, the theory of comparative advantage does not fully explain why nations benefit from trade. This explanation
would later fall to Ricardo's theory of comparative advantage: Even if one country has an absolute advantage in both types
of goods, it will still be better off through trade. In other words, if one country can produce all goods more cheaply than its
trading partners, it will still benefit by trading with other countries.

Also, as explained earlier, the theory also assumes that absolute advantages are static—a country cannot change its
absolute advantages, and they do not become more efficient with scale. Actual experience has shown this to be untrue:
Many countries have successfully created an absolute advantage by investing in strategic industries.

In fact, the theory has been used to justify exploitative economic policies in the postcolonial era. Reasoning that all
countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing
countries to focus on agricultural exports, rather than industrialization. As a result, many of these countries remain at a low
level of economic development.

Example of Absolute Advantage

Consider two hypothetical countries, Atlantica and Pacifica, with equivalent populations and resource endowments, with
each producing two products: guns and bacon. Each year, Atlantica can produce either 12 tubs of butter or six slabs of
bacon, while Pacifica can produce either six tubs of butter or 12 slabs of bacon.

Each country needs a minimum of four tubs of butter and four slabs of bacon to survive. In a state of autarky, producing
solely on their own for their own needs, Atlantica can spend one-third of the year making butter and two-thirds of the year
making bacon, for a total of four tubs of butter and four slabs of bacon.

Pacifica can spend one-third of the year making bacon and two-thirds making butter to produce the same: four tubs of
butter and four slabs of bacon. This leaves each country at the brink of survival, with barely enough butter and bacon to go
around. However, note that Atlantica has an absolute advantage in producing butter and Pacifica has an absolute
advantage in producing bacon.

If each country were to specialize in their absolute advantage, Atlantica could make 12 tubs of butter and no bacon in a
year, while Pacifica makes no butter and 12 slabs of bacon. By specializing, the two countries divide the tasks of their labor
between them.

If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each. Both countries would
now be better off than before, because each would have six tubs of butter and six slabs of bacon, as opposed to four of
each good which they could produce on their own.

The Bottom Line

The theory of absolute advantage represents Adam Smith's explanation of why countries benefit from trade, by exporting
goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple
illustration of the benefits of trade, it did not fully explain the benefits of international trade. That would later fall to David
Ricardo's theory of comparative advantages.