What Everybody Should Know about International Trade

Economics Corner: What Everybody Should Know about International Trade


  1. Trade theory
  2. Trade barriers
  3. Theory vs. the real world
  4. Trade agreements (NAFTA and TPP)

  5. The Theory of Trade According to Econ 101

    The “real world” aspects of international trade are different from the theoretical aspects. Still, the talking points are often based on theoretical aspects. It starts with theory. Here, in layman’s terms as much as possible, are the main points of trade theory.

    1. Every country has a unique set of resources available for productive use. Resources are generally categorized as land, labor, and capital.
    2. When a resource is being used to produce something, it isn’t available for producing something else.
    3. Production of anything requires some combination of resources. Certain combinations are more efficient than other combinations in terms of production capability vs. cost, and in terms of revenue potential vs. cost.
    4. Supply and demand will determine which goods get produced, and how many of each good gets produced. This will determine where the resources throughout the country get allocated.
    5. Because resources are used in combination with other resources, and because supply and demand determine where the resources are used, some individual resources will end up being used more efficiently than others.
    6. Some industries will end up being more efficient than other industries.
    7. Since each country has a unique set of resources, the efficiency of different uses of resources and the efficiency of different industries will vary from country to country.
    8. All of the above is based on domestic economies, without international trade. If we add trade to the mix, then consumer demand can be met with each country only producing the goods it is most efficient at producing.
    9. Resources from inefficient industries will be freed up for use in efficient industries.
    10. With overall production in each country being more efficient, more total production is possible.
    11. Consumer demand can be met, even for goods that each country no longer produces, through imports and exports between countries.
    12. With more overall production capability for the same quantity of resources, each country’s standard of living can increase. People in each country will have more stuff.
    13. Some industries will lose jobs, but only because jobs will be moved into more efficient industries. With consumers getting more things which are being produced more efficiently, their purchasing power will increase, and overall consumer demand will increase. The net result will be more jobs within each country.
    14. It doesn’t matter if one country is much larger than its trading partners. It doesn’t matter if one country is richer than other countries. It doesn’t matter if one country has the capacity to produce more of everything than other countries. The only thing that matters is that each country’s resources move from less-efficient uses to more-efficient uses.

    For more information about trade theory, see the Economics Online Tutor page ”Specialization and Trade”.

    Trade Barriers

    Free trade is the elimination of trade barriers. Econ 101 textbooks list some of these trade barriers:

    1. Tariffs
    2. Import quotas
    3. Embargoes
    4. Subsidies
    5. Purchase restrictions
    6. Product standards
    7. Voluntary export restrictions
    8. Anti-dumping laws

    For a brief description of each type of trade barrier, see the Economics Online Tutor page ”Trade Restrictions”.

    Why do trade barriers exist?

    Some reasons countries restrict trade:

    1. National security
    2. Infant industry
    3. Retaliation
    4. Protecting jobs
    5. Low foreign wages
    6. Politics

    For a brief description of each of these reasons, see the Economics Online Tutor page ”Trade Restrictions”.

    Free Trade and the Real World

    Free trade does not exist in the real world.

    Economic models and theories, including the theory of trade, work because they include numerous explicit and implicit assumptions that make them work. Economic models and theories are simplified versions of an extremely complex world. Theories work as long as the assumptions hold true. Once you get out in the real world, many assumptions are no longer true.

    Does this mean that economic models and theories, including trade theory, are useless in the real world? Not necessarily. They are designed to highlight specific relationships within a more complex world. Often, basic concepts which do hold true regardless of real world conditions are revealed through economic theory and modeling. But these basic truths are often hidden among ideas which only work because unrealistic assumptions make them work. The logic behind theories falls apart whenever unrealistic assumptions are taken out. But conclusions from theory, at least some of the conclusions, could still hold true if they are based on basic truths. Since factors unrelated to any particular theory are always at work in the real world, mathematical “facts” regarding conclusions are usually impossible. Statistical analysis of actual results is the best way to test conclusions based on theory. Trade theory tends to point to the advantages of international trade. For this reason, supporters of trade tend to cite theory whenever statistical data is unavailable or inconclusive. Opponents of trade tend to focus on cherry-picked data and anecdotal evidence which point to negative results of trade.

    In terms of international trade, a full discussion of the differences between the economic theory of trade and real-world conditions is far beyond the scope of this essay. I have picked out a few points which I believe everybody should be aware of:

    1. The theoretical advantages of free trade require that resources move from less-efficient uses to more-efficient uses. An underlying assumption behind this is that all resource prices in each country are market-value prices under identical economic systems. An extreme example which explains why this is a problem would be trade between a capitalist nation and a socialist nation. In a socialist system, the government “owns” all or some of the resources. Resource prices are either free or set by the government. There is no market for determining these prices, so how can we tell which industries are more efficient than others?
    2. While capitalism vs. socialism is a classic example, the same problems exist to some extent with trade between any two countries. Any policy or law which affects economic outcomes – whether it be a decision on infrastructure, taxation, government spending, job safety, product safety, wage protection, healthcare – really, just about any government policy at all – will affect the relative pricing of resources throughout a country. Any change in policy will change the structure of the pricing system. Every country has a unique set of policies and laws, so accurate comparisons of relative costs can be impossible.
    3. Some policies and laws are based on social values which aren’t necessarily universal. Some policies and laws might make more sense for an industrial nation than for a country with a third-world or emerging economy.
    4. A subsidy is a trade barrier. If a country subsidizes an industry, the effective relative costs for that industry will be lower than if the industry were not subsidized. This makes that particular industry more efficient simply because of the subsidy. Since efficiency within a country is relative, a subsidy makes non-subsidized industries less efficient.
    5. One country might want to subsidize an “infant industry” – an industry which is currently not efficient – with the expectation that it could become both efficient and a vital part of the economy with some help in its growth stages. Another country would consider such a subsidy as being “unfair”, and retaliate by imposing a steep tariff on imports from that country. From the point of view of each country, it is the other country which is obstructing free trade.
    6. One country’s laws might be based on favoritism to certain segments of the economy. Perhaps one segment is allowed to help write laws which effect overall resource prices and relative economic efficiency between segments of the economy.
    7. One country’s laws might be based on concern for the environment; a concern not shared by other countries.
    8. Trade means that jobs and resources get reallocated within a country. Some industries lose jobs, and some industries gain jobs. It is often easier to connect job losses than job gains to a specific trade agreement.
    9. It can be shown that trade creates more job gains than job losses. But the wages of jobs gained could be lower than the wages of jobs lost. “Lower relative resource costs” might be nothing more than slave wages which other countries would not tolerate.

    10. Trade Agreements including the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP)

      Trade agreements such as NAFTA and the proposed TPP are, by nature, complex. Evaluating their overall effects is complicated by the fact that other factors in the economy and other policies are also affecting the same outcomes. Understanding the impact of such agreements is further complicated by the fact that advocates for each side point to different pieces of evidence while providing different interpretations of the same data.

      What we know about NAFTA is that it has had a redistributive effect in the United States. There have been winners, and there have been losers. This is within expectations, and fully within the theory of trade described above. Some people claim that they personally benefitted from NAFTA. Some people claim that they personally were hurt by NAFTA. People on both sides can be correct in these personal assessments. Having both winners and losers is one effect of trade. One way to assess a trade agreement is to do a cost/benefit analysis of the overall picture. Put those who have been helped in the plus column, and those who have been hurt in the minus column. Beyond that, we can take a look at the overall effects on the economy – all of the effects, not just cherry-picked ones – and put them into the relevant plus/minus column.

      What about the overall effect on jobs, wages, the trade balance, and productivity? We have data, but there are reasons to believe that the numbers can be explained, at least partially, by other factors. Supporters of NAFTA tend to credit the trade agreement with items in the plus column, but blame unrelated factors for items in the minus column. Opponents tend to do the opposite – credit unrelated factors for items in the plus column while blaming NAFTA for items in the minus column.

      The truth is complex. NAFTA is clearly a factor in the economic data, but there are other factors. Here is what we know from the data. How much of it is due to NAFTA is open to interpretation.

      1. The total number of jobs in the United States increased following each phase-in of NAFTA’s provisions. This is true of other trade agreements as well. The only exception has been during the Great Recession.
      2. Trade among the United States, Mexico, and Canada has increased significantly.
      3. There has been an increase in the number of businesses which rely on exports for revenue.
      4. Agricultural exports have increased.
      5. There has been an increase in the rate at which manufacturing jobs have moved to Mexico.
      6. Individual states appear to be “winners” and “losers”. “Winners” include agricultural states and “losers” include states whose economies rely heavily on manufacturing.
      7. Wages do not appear to be affected to any significant degree. Wages were relatively flat before NAFTA, and they have continued along the same trend.
      8. GDP and productivity have increased, but it is not clear if their rates of increase are related to NAFTA.
      9. Both imports and exports increased significantly for several years following NAFTA, but the rate of increase for each has slowed in recent years. The trade balance goes up some years and down some years, with no clear trend.

      10. The net “good” or “bad” of NAFTA is difficult to analyze. In the real world, there are too many other factors involved in the results. The real world doesn’t have the benefit of ceteris paribus (everything else being equal) which is used as an assumption in economic theory. Still, a thorough cost/benefit analysis using what is known about the results – even if assumptions have to be made about the degree to which NAFTA has contributed to the results – is perhaps the best approach to take in judging whether NAFTA has been good or bad for the United States. It’s certainly a more rational approach than cherry-picking results in order to lead to a predetermined conclusion.

        For a proposed trade agreement such as TPP, we don’t have the luxury of historical data to judge the net cost/benefit of its overall effects. Proposals and new agreements would have to be judged based on expected future results. But whether looking at expected future results or actual historical data, such an analysis should be thorough, not cherry-picked. For TPP, no such thorough analysis is possible at this point in time. There is no agreement to judge; there are only ongoing negotiations. Once an agreement is reached, if at all, it will be sent to Congress, and there will be a period of time to debate its pros and cons. Those who have already judged TPP as either good or bad are cherry-picking points of contention based on what they expect to be in such an agreement – which is not a thorough approach.

        So far, I have discussed an analysis of international trade agreements based on actual or expected results. This is a “before vs. after” approach. Such an approach is incomplete and can be misleading. A correct approach would include “what will happen if we implement this agreement” vs. “what will happen if we don’t”. There is an important distinction between these two approaches. International trade will go on regardless of which role the United States chooses to play. We have shown that trade agreements increase trade among parties to each agreement, often by a significant amount. Countries which choose not to be included in an agreement can lose out on the increased trade. Nations looking for trading partners might look elsewhere for trading partners. One argument being presented in favor of TPP is that if we don’t make an agreement, we could lose business to China. Whether or not this is true is a point of contention. But these types of possibilities should be included in the analysis.

        We are not all economists, so why does the news media keep bombarding us with economic statistics and terminology we don’t understand? Should the average American even care about such news stories? When politicians talk about the economy, how do we separate the relevant from the rhetorical? More to the point, you might be asking yourself, “How does this affect me?”

        Perhaps talk about the economy sounds like a bunch of gibberish to you. But if you had a basic understanding of the terminology being used – not the dictionary definitions, but what the words in their context should mean to a layman – free of misleading political implications, then such talk would mean more to you than just gibberish. The good news is that you don’t have to be an economist or even a student of economics in order to understand the terminology.

        “Economics Corner: What Everybody Should Know About…” series is designed as a layman-friendly explanation of important economics terms and concepts. Created by Jerry Wyant.

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Jerry Wyant