This residency difference of international trade, however, leads to a couple of considerations.

• First, because different nations use different domestic currencies, international trade inevitably involves an exchange of currencies. Currency exchange, which takes places through the foreign exchange market, is central to the study of international finance.


• Second, because different nations are ruled by different governments, which are inclined to look after their different national interests, international trade inevitably involves government trade policies. These trade policies typically promote exports from a nation while restricting imports to the nation.

Two Views of Trade

• The Domestic View: With this view, the focus is on foreign trade, the flow of trade between the domestic economy and the foreign sector. The domestic economy includes activity that occurs within the political boundaries of a particular nation. The foreign sector is then any and all activity that takes place beyond those political boundaries, activity that takes place in other nations. This view inevitably creates an "us" versus "them" perspective. This is the perspective a dedicated sports fan might take when rooting for the "home" team. Use of the term foreign trade reveals the domestic/foreign, us/them perspective.


• The Global View: A broader view looks at every nation as but one among many players in the game of international trade, the flow of trade among nations. With this view each nation operates its own domestic economy and is simultaneously part of the foreign sector for every other nation. This is the perspective that an unbiased, objective umpire or referee should take when officiating a sporting event. Use of the term international trade emphasizes this notion of trade among nations.

Trading Flows: Exports and Imports

• Imports are goods (or services) produced by the foreign sector and purchased by the domestic economy. These are goods (or services) that flow into the domestic economy.


• Exports are goods (or services) produced by the domestic economy and purchased by the foreign sector. These are goods that flow out of the domestic economy.

• Net exports are the difference between exports and imports. This is the difference between goods flowing out of the domestic economy and goods flowing into the domestic economy.

Gains from Trades

• From the Buying Side: First, buyers are willing to purchase goods and services because doing so satisfies wants and needs. The maximum price buyers are willing to pay -- the demand price -- reflects this satisfaction. If the price is too high, then buyers opt for another good. However, should the price paid be less than the demand price, then buyers receive what is termed consumer surplus. The buyers gain from trade.


• From the Selling Side: Second, sellers are willing to produce goods and services if doing so covers the cost of production. The minimum price that sellers are willing to accept -- the supply price -- reflects this cost of production. If the price is too low, then sellers opt to produce another good. However, should the price received be greater than the supply price, then sellers receive what is termed producer surplus. The sellers gain from trade.

The only difference between regular market trades and international trades is the location of the buyers and sellers. If buyers live in one nation and sellers live in another, then the previous market exchange example is also an international trade. But the gains from trade still occur.

While the buyers of one nation gain from consumer surplus and the sellers of another gain from producer surplus, not everyone in both nations win from international trade. International trade has both winners and losers.

• Winners: The winners in an international trade are the consumers in the buying (or importing) nation and the producers in the selling (or exporting) nation. The buyers receive consumer surplus and the sellers acquire producer surplus.


• Losers: However, the losers in an international trade are the producers in the buying (or importing) nation and the consumers in the selling (or exporting) nation. The producers in the buying nation face greater competition for their products, which inevitably means lower prices and profits. The consumers in the selling nation also face greater competition for this domestic production, which is bound to cause higher prices.

The Law of the Comparative Advantage

How does this law work? First consider two related concepts.

• Absolute Advantage: A country is said to have an absolute advantage if it can, in general, produce more goods using fewer resources. An absolute advantage arises when a country is technically efficient or technologically superior.


• Comparative Advantage: A country is said to have a comparative advantage if it can produce one good at a relatively lower opportunity cost than other goods, compared to the production in another country.

In contrast, a technologically superior nation, one that is particularly efficient at the production of a good, gives up a lot more production and incurs a relatively high opportunity cost when it produces another good.

The law of comparative advantage works because EVERY nation has at least one good that it can produce at a relatively lower opportunity cost than that incurred by another nation. This is the key to international trade, because it also means that other nations can benefit by importing that good rather than producing it domestically. It's a win-win for exporters and importers.

The law of comparative advantage also applies to other activities, especially labor. That is, a person who is highly skilled and talented in the production of several goods is likely to purchase goods from others who are less skilled and talented, but who have comparative advantages because they have lower opportunity costs. For example, a skilled medical doctor, who also has carpentry skills, is likely to purchase a house produced by someone else.

The Balance of Trade

The balance of trade is essentially another term for net exports, the difference between exports and imports. However, whereas the net exports phrase surfaces in most theoretical analyses of the macroeconomy, the balance of trade term tends to be more common in the official measurement of foreign trade.

In fact, the balance of trade is actually one component of a more extensive set of international financial accounts termed the balance of payments. The balance of payments is the difference between all payments coming into a country and all payments going out of the country. Many of these payments are for exports and imports, but other payments are for capital assets or simply gifts between foreign and domestic citizens.

In the same way that net exports can be either positive or negative, meaning exports exceed imports or imports exceed exports, the balance of trade can have either a surplus or deficit.

• Balance of Trade Surplus: A surplus in the balance of trade arises if the value of exports exceeds the value of imports. In terms of "payments," this indicates that the domestic economy is receiving a net inflow of payments from the foreign sector. More payments coming in than going out means the domestic economy has more income that enhances the living standards of domestic residents. For this reason, a balance of trade surplus is also commonly termed a favorable balance of trade.


• Balance of Trade Deficit: A deficit in the balance of trade arises if the value of imports exceeds the value of exports. In terms of "payments," this indicates that the domestic economy has a net outflow of payments to the foreign sector. Fewer payments coming in than going out means the domestic economy has less income and thus lower living standards. For this reason, a balance of trade deficit is also commonly termed a unfavorable balance of trade.

Although most people likely think of the exporting and importing of tangible, physical goods when thoughts turn to foreign trade, the exchange of services is also extremely important. For example, a foreign student who enters the domestic economy in pursuit of an education, paying tuition in the process, is actually exporting services to the foreign sector. Alternatively, a domestic citizen who visits a foreign land to soak up a bit of vacation sunshine, paying for local hotel accommodations in the process, is importing services from the foreign sector.

Protecting the Home Country

• Tariffs: One common trade policy is the imposition of tariffs on imports. Tariffs are simply taxes placed on imports. Tariffs work like any other taxes. A tariff or tax is added to the price of the imported good. Suppose, for example, that the price of an imported good is $10. A tariff of $1 would then force importers to sell each good for $11. Domestic producers are usually thrilled with a tariff because the higher price of imports is bound to reduce the quantity of imports sold. This means more domestic production is likely to be purchased. Moreover, domestic producers can also raise the price they charge for their goods.


• Quotas: An alternative to tariffs is to simply restrict the quantity of imports coming in a country. The technical term for this is an import quota. Quotas are simply restrictions on the quantities of goods imported. In this case, the government stipulates that foreign producers can sell a specific number of imports in domestic economy. While domestic producers would likely prefer setting an import quota at zero, preventing all foreign imports, any restriction is appreciated. With fewer imports entering the domestic economy, more domestic production is sold, and in all likelihood, at higher prices.


• Subsidies: A third policy is for the domestic government to subsidize a domestic industry facing competition from imports. That is, the government pays domestic producers for each good produced. Subsidies are simply payments from the government to individuals or businesses without any expectations of receiving any production in exchange. Domestic producers usually promote the use of government subsidies as a way to be "competitive" with "lower cost" foreign imports. A subsidy gives domestic producers the ability to produce more goods at a lower price and presumably reduce the number of imports into the country.

• Domestic Employment: A primary argument is to promote or protect domestic employment. If fewer goods are imported, then more goods are produced domestically and more domestic citizens have jobs . However, while imports could be, in principle, produced by domestic workers, eliminating imports is no guarantee that the domestic industry will pick up the employment slack.


• Low Foreign Wages: A second argument is to combat the low levels of wages paid to foreign workers. Export subsidies or import tariffs would then allow domestic producers to compete. However, low foreign wages are really just an indication that the foreign producers have a comparative advantage.


• Infant Industry: Another common argument is to protect an infant industry, an industry is in its early stages of development that is presumably unable to compete with more mature foreign industries. However, trade protection might actually create a "crutch" that prevents the domestic industry from maturing and improving efficiency.


• Unfair Trade: Foreign competitors also might be benefitting from unfair trade practices, especially selling imports below production cost, including subsidies from their governments. As such, domestic producers need comparable assistance to remain competitive. However, this foreign government/producer package can be considered as a part of the overall comparative advantage that enables foreign trade.


• National Security: Lastly, imports might need to be restricted to ensure a strong national defense and to keep the country secure. Relying on foreign imports for a critical product might make the country vulnerable. However, while a number of key national defense and security goods (military aircraft, energy supplies, weapons, etc.) are justifiably protected to ensure that a country can protect itself, other goods fall beyond the boundaries of this argument.

Making Payment: International Finance

The trading of currency is captured in what is termed the foreign exchange market. When one nation buys goods produced by another it also needs a bit of the currency of the other nation to make the payment. It "buys" this currency through the foreign exchange market. However, when it "buys" the currency of another nation, it simultaneously "sells" its own currency. In other words, one currency is exchanged for another.

While international trade is a primary reason that nations exchange currency it is not the only reason. Currency is also exchanged when one nation investments in the physical or financial assets of another. Or when the government of one nation provides aid or assistance to another nation. Comparable to the balance of trade, an accounting of the assorted currency flows from one nation to others is termed the balance of payments.

The Global Players

• World Trade Organization: The World Trade Organization (WTO), established in 1995, is at the top of the list of international organizations. The WTO includes about 150 member countries. By comparison, the United Nations has 191 members. Members of the WTO account for over 95 percent of international trade. The WTO, operating out of Geneva, Switzerland, effectively sets the rules of the international trading game.


• General Agreement on Tariffs and Trade: The World Trade Organization was actually preceded by, and was an outgrowth of, the General Agreement on Tariffs and Trade (GATT). GATT launched the modern era of expanded international trade when it was established in 1947. While the GATT is still technically in force, the Uruguay Round in 1993 effectively created its replacement, the World Trade Organization.


• North American Free Trade Association: The North American Free Trade Association (NAFTA) includes Canada, the United States, and Mexico. NAFTA was established in 1994 to reduce trade restrictions and promote international trade between the United States and its neighbors to the north and south, Canada and Mexico.


• European Union: The European Union (EU) is the economical and political integration of European nations created by the Maastricht Treaty signed in 1992. The twelve original members of the European Union were Belgium, Denmark, Greece, Germany, Spain, France, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Great Britain. Additional nations have joined the original dozen, bringing the total to 25.


• International Monetary Fund: The International Monetary Fund (IMF), which includes over 180 countries, is an agency of the United Nations established in 1945 to monitor and stabilize foreign exchange markets. The IMF was created to prevent countries from manipulating exchange rates in such a way that they gained a competitive trading advantage over others.


• A Few Others: While these are the primary international trade and finance organizations, other organizations that play a part on the international stage in various ways include the United Nations, World Bank, and Group of Seven (G-7). A number of countries have formed free trade organizations like NAFTA with their nearby neighbors, including the Association of Southeast Asian Nations (ASEAN), Andean Community (of South America), Economic Commission for Latin America (ECLA), and Caribbean Community (CARICOM).