Trade Research Paper

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Trade is the exchange of goods between locations. For example, bananas from Honduras exchange for automobiles from the United States. International trade between locations in different nations receives far more attention than does domestic trade because nations discriminate against foreigners with international policies that are contested. For example, in 2005, the U.S. Congress ratified a Central American Free Trade Agreement in a hotly contested vote.

Trade also means the exchange of services of factors of production such as labor and capital. For example, Bangalore call centers provide telemarketing labor to U.S. marketers, while U.S. computer engineers maintain hardware and software in Bangalore. Trade in services is quantitatively important, but the distinction between trade in services and trade in goods is often not important. For many purposes, the distinction between international and intranational trade is similarly irrelevant. This essay uses the term trade to mean international trade in goods, but much of its content also applies to intranational trade in goods and services. The distinction is crucial when international trade policy—discrimination against foreigners— is important. (Domestic trade is affected by domestic policy, but seldom controversially.)

The key questions are: What explains the pattern of trade? Is liberal trade policy a good thing? The householder’s answer to the first question is that nations import goods that are unavailable domestically or are cheaper than potential domestic substitutes and export goods that are unavailable or more expensive abroad. There are gains from this exchange, to answer the second question—voluntary transactions must be beneficial or they would not be made, once familiarity acquaints participants with exchange.

Economic analysis embeds the householder’s insight in an equilibrium system. Crucially, householders take prices as given in their decisions. When all households together react to a new market opportunity, they will necessarily have an impact on prices. International trade theory provides an answer to what makes a nation’s goods cheaper or more expensive in a world where the act of trade changes prices. It also provides an analysis of the gains from trade in complex, many-household production economies. Since all prices normally will change, some households will gain (for example, owners of property or specific skills in the expanding export sector of the economy) while others will lose (for example, owners of property or specific skills in the contracting import sector). Trade theory shows that the gains to the gainers must ordinarily be larger than the losses to the losers. The answers convince the vast majority of economists about the desirability of trade, provided some compensation for losers from trade is made. But the explanation of how international trade affects the overall well-being of society is also subtle and sometimes misunderstood by a portion of the general population that tends to oppose liberal trade. Opposition to trade liberalization may also arise from well-informed opponents, including lobbies representing workers and firms that might be harmed by liberalization, as well as persons sympathetic to those workers and firms who are skeptical that fair compensation will be provided.

The Pattern Of Trade

Imports are goods and services purchased by domestic households and firms from firms located in foreign countries. Exports are goods and services sold to foreign households and firms by domestic firms. Imports must be paid for by exports, so the market for a nation’s imports is linked to the market for its exports. The price of imports cannot be isolated from the price of exports. Moreover, exports increase the demand for factors such as labor used to produce them, while imports reduce demand for factors used to produce import substitutes. Thus factor markets at home and abroad are linked through the mechanism of trade. (If exports pay for imports every year, trade is balanced. This simplification does no real harm to the analysis. Unbalanced trade has international borrowing or lending as a counterpart, and in this setting exports must pay for imports over time, in present discounted value terms.)

The balanced trade requirement implies that the relative price of exports, the terms of trade, is equal to the volume of imports divided by the volume of exports. Thus trade determines relative prices and, conversely, relative prices determine trade. The cause of trade must be sought in relative price differences between countries. Indeed, with frictionless trade (that is, international trade without tariffs, quotas, or other barriers to trade), these must be the price differences that would prevail in the absence of trade (autarky).

Compare the relative price (of, for example, wine in terms of cheese) at home to the same relative price abroad in a prior equilibrium with no trade (autarky) or restricted trade. The country with the lower relative price of wine is said to have a comparative advantage in wine, while the other country has, symmetrically, a comparative advantage in cheese. Trade theory predicts that countries will export the good in which they have the comparative advantage. Krugman and Obstfeld (2005) cite a recent study showing that Japan’s opening to trade in the 1850s reveals data consistent with the prediction.

Comparative-advantage differences between nations are explained in trade theory by differences between countries in either technology or factor supplies. Both are realistic— Canada exports grain because its large endowment of agricultural land makes land relatively cheap, but its better technology also provides an edge relative to landabundant Ukraine. Notice that the mechanism run by relative price differences implies that economy-wide forces (exchange-rate manipulations, environmental or labor standards) that tend to cause uniform (over goods) national differences in costs will tend to cancel out and have no effect on trade patterns.

Absolute, or “competitive,” advantage should be distinguished carefully from comparative advantage, as the former is the source of much fallacious reasoning. For example, suppose there are two countries considering whether they should trade with each other. Prior to the opening of trade, a naive observer would compare the domestic prices or production costs in the two countries good by good and predict that the country with the lower cost, having an absolute or “competitive” advantage, will export the good. But economic theory establishes that this method fails whenever one country could undersell the other for all goods, since the importer could not pay for the imports by exporting. Instead, prices of goods and factors must change so that in the trade equilibrium each country is competitive in its export industry, in which it has a comparative advantage. In equilibrium, prices must clear markets for all goods and factors in the world economy, and exports must pay for imports.

Differences between countries can arise endogenously from their economic interaction, in contrast to the differences which are given prior to trade in the preceding account of comparative advantage. Differences which arise as a result of trade lead to theories of trade that do not necessarily imply comparative advantage—difference in relative prices in the absence of trade. One theory is based on economies of scale, whereby the wider markets brought by trade will confer a cost advantage on one of the countries. Another theory is based on monopolistic competition, whereby the wider markets brought by trade increase product variety as buyers seek the special characteristics of foreign brands.

Gains From Trade

There are gains from trade in all these models. Each nation can act through trade policy to take more, leading to destructive trade wars with mutual losses. International institutions such as the World Trade Organization (WTO) act to restrain the destructive tendencies of unilateral action.

Within national economies, some members of a nation must lose from trade. For example, factors of production used intensively in export sectors of the economy tend to gain disproportionately when trade expands, while factors used intensively in import competing sectors tend to lose disproportionately. This gives insight into the widespread political resistance to trade that occasionally erupts into protectionism. National institutions act to redistribute some of the gains (U.S. Trade Adjustment Assistance) or provide temporary relief from losses due to trade (antidumping, escape-clause protection). In equilibrium the gains must outweigh the losses; there are gains from trade on average. On the way to equilibrium, it is theoretically possible that losses may temporarily exceed gains, justifying temporary relief measures. Extensive investigation of U.S. cases suggests that losses from trade are small and of short duration and are swamped by the gains from trade.

Most professional economists support liberal trade because there must be gains on average. The average is a “typical” household. Suppose that in autarky equilibrium, the home (domestic) typical householder is willing to swap 2 units of cheese for 1 unit of wine. That is, he would be indifferent to moving his consumption and production a small distance to offer the market 2 cheese for 1 wine or 1 wine for 2 cheese. Suppose that a typical foreign country household in the autarky equilibrium is willing to swap 2 wine for 1 cheese. Now allow frictionless trade, and suppose that the new equilibrium price is equal to 1. Each home household offers cheese to foreign households. Formerly it cost 2 cheese for 1 wine, but now the 2 cheese will procure 2 wine, a gain from trade. Similarly, each foreign household can obtain 2 cheese for 2 wine, where formerly this would procure only 1 wine. Both households gain from trade.

What if losers are not compensated? A person must decide for or against liberal trade by weighing individual gains and losses. Ethical considerations give more weight to the poor. The case for liberal trade is strengthened because the illiberal trade policies of rich countries hurt the poor disproportionately, as documented by Edward Gresser (2002). Poor countries have comparative advantage based on cheap low-skilled labor, hence discrimination against their exports harms the poor citizens of poor countries. At home in rich countries, protection makes food and clothing more expensive, a regressive tax on poor consumers. Among the poor, losers from protection surely outweigh gainers.

Much opposition to liberal trade is based on confusion and ignorance. The confusion of absolute advantage with a valid theory of trade sows fear that a nation must protect itself from overwhelming competition. Ignorance of the harm done to the world’s poor by protection persuades many who favor income redistribution in rich countries to support protection of rich country importcompeting workers, who tend to be relatively poor.


  1. Gresser, Edward. 2002. Toughest on the Poor: America’s Flawed Tariff System. Foreign Affairs (November/December): 9–14.
  2. Krugman, Paul, and Maurice Obstfeld. 2005. International Economics. 7th ed. Boston: Addison Wesley Longman.

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