INTERNATIONAL TRADE

Engineering Economics Project Report

Made By :Ali Khalid BE-EL-14 Daniyal bin Aamir BE-EL-22 Umer Rana BE-EL-73 Fahad Athar BE-EL-56 Alamgir BE-EL-409

In the name of ALLAH, the most beneficent and merciful

AcknowledgementsWe would like to thank our worthy instructor Mr. Muhammad Yousaf for providing us with the opportunity to explore such a vast and important topic necessary for an engineer and also the opportunity to present in to further improve our understanding.

DedicationWe would like to dedicate this report to our parents who are responsible for our present achievements in life

Table Of ContentsIncreased Efficiency of Trading Globally ....................................................................................................... 8 Globalization and International Trade: ......................................................................................................... 9 1. The Flows of Globalization .................................................................................................................... 9 2. Trade Facilitation ................................................................................................................................ 11 Distribution-based ...................................................................................................................... 11 Regulation-based ........................................................................................................................ 11 Transaction-based. ...................................................................................................................... 11 Integration processes.................................................................................................................. 11 Standardization ........................................................................................................................... 12 Production systems ..................................................................................................................... 12 Transport efficiency .................................................................................................................... 12 Transactional efficiency .............................................................................................................. 12

Adam Smith Model ..................................................................................................................................... 13 Ricardian model .......................................................................................................................................... 15 Heckscher-Ohlin model............................................................................................................................... 15 Regulation of international trade ............................................................................................................... 22 Risk in international trade .......................................................................................................................... 23 Absolute advantage .................................................................................................................................... 23 Origin of the theory ................................................................................................................................ 24 Examples ................................................................................................................................................ 24 Example 1 ......................................................................................................................................... 24 Example 2 ......................................................................................................................................... 24 Example 3 ......................................................................................................................................... 25 Comparative advantage .............................................................................................................................. 25 Origins of the theory ............................................................................................................................. 26 Effect of trade costs ............................................................................................................................... 27 Effects on the economy ......................................................................................................................... 28 Considerations ..................................................................................................................................... 28 Development economics .................................................................................................................... 28

Free mobility of capital in a globalized world ................................................................................ 29 Balance of trade .......................................................................................................................................... 30 Definition ................................................................................................................................................ 31 Views on economic impact ..................................................................................................................... 33 Conditions where trade imbalances may be problematic .................................................................. 33 Conditions where trade imbalances may not be problematic ........................................................... 34 Adam Smith on trade deficits ............................................................................................................. 34 Frdric Bastiat on the fallacy of trade deficits .................................................................................. 35 John Maynard Keynes on the balance of trade .................................................................................. 35 Milton Friedman on trade deficits ...................................................................................................... 36 Warren Buffett on trade deficits......................................................................................................... 38 Physical balance of trade ........................................................................................................................ 38 Free trade.................................................................................................................................................... 38 Features of free trade ............................................................................................................................. 39 Current status ......................................................................................................................................... 39 Protectionism .............................................................................................................................................. 40 Arguments for protectionism ................................................................................................................. 40 Comparative advantage has lost its legitimacy .................................................................................. 40 Domestic tax policies can favor foreign goods ................................................................................... 41 Infant industry argument .................................................................................................................... 41 Unrestricted trade undercuts domestic policies for social good ........................................................ 41 Arguments against protectionism........................................................................................................... 42 Current world trends .............................................................................................................................. 43 Protectionism after the 2008 financial crisis ....................................................................................... 43 International trade law ............................................................................................................................... 44 Overview ................................................................................................................................................. 44 World Trade Organization....................................................................................................................... 45 Trade in goods......................................................................................................................................... 45 Trade and Intellectual Property .............................................................................................................. 45 Dispute settlement ................................................................................................................................. 45 Trade bloc ................................................................................................................................................... 46 Description .............................................................................................................................................. 47

Free Trade Vs. Protectionism ...................................................................................................................... 47

If you walk into a supermarket and are able to buy South American bananas, Brazilian coffee and a bottle of South African wine, you are experiencing the effects of international trade. International trade allows us to expand our markets for both goods and services that otherwise may not have been available to us. It is the reason why you can pick between a Japanese, German or American car. As a result of international trade, the market contains greater competition and therefore more competitive prices, which brings a cheaper product home to the consumer.

What Is International Trade?International trade is the exchange of goods and services between countries. This type of trade gives rise to a world economy, in which prices, or supply and demand, affect and are affected by global events. Political change in Asia, for example, could result in an increase in the cost of labor, thereby increasing the manufacturing costs for an American sneaker company based in Malaysia, which would then result in an increase in the price that you have to pay to buy the tennis shoes at your local mall. A decrease in the cost of labor, on the other hand, would result in you having to pay less for your new shoes. Trading globally gives consumers and countries the opportunity to be exposed to goods and services not available in their own countries. Almost every kind of product can be found on the international market: food, clothes, spare parts, oil, jewelry, wine, stocks, currencies and water. Services are also traded: tourism, banking, consulting and transportation. A product that is sold to the global market is an export, and a product that is bought from the global market is an import. Imports and exports are accounted for in a country's current account in the balance of payments. International trade uses a variety of currencies, the most important of which are held as foreign reserves by governments and central banks. Here the percentage of global cumulative reserves held for each currency between 1995 and 2005 are shown: the US dollar is the most sought-after currency, with the Euro in strong demand as well. International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing

international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders. International trade is, in principle, not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or culture. Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Trade in goods and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it. An example is the import of labor-intensive goods by the United States from China. Instead of importing Chinese labor, the United States imports goods that were produced with Chinese labor. One report in 2010 suggested that international trade was increased when a country hosted a network of immigrants, but the trade effect was weakened when the immigrants became assimilated into their new country. International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics.

Increased Efficiency of Trading GloballyGlobal trade allows wealthy countries to use their resources - whether labor, technology or capital - more efficiently. Because countries are endowed with different assets and natural resources (land, labor, capital and technology), some countries may produce the same good more efficiently and therefore sell it more cheaply than other countries. If a country cannot efficiently produce an item, it can obtain the item by trading with another country that can. This is known as specialization in international trade. Let's take a simple example. Country A and Country B both produce cotton sweaters and wine. Country A produces 10 sweaters and six bottles of wine a year while Country B produces six sweaters and 10 bottles of wine a year. Both can produce a total of 16 units. Country A, however, takes three hours to produce the 10 sweaters and two hours to produce the six bottles of wine (total of five hours). Country B, on the other hand, takes one hour to produce 10 sweaters and three hours to produce six bottles of wine (total of four hours).

But these two countries realize that they could produce more by focusing on those products with which they have a comparative advantage. Country A then begins to produce only wine and Country B produces only cotton sweaters. 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 20 units of both products. We can see then that for both countries, the opportunity cost of producing both products is greater than the cost of specializing. More specifically, for each country, the opportunity cost of producing 16 units of both sweaters and wine is 20 units of both products (after trading). Specialization reduces their opportunity cost and therefore maximizes their efficiency in acquiring the goods they need. With the greater supply, the price of each product would decrease, thus giving an advantage to the end consumer as well. Note that, in the example above, Country B could produce both wine and cotton more efficiently than Country A (less time). This is called an absolute advantage, and Country B may have it because of a higher level of technology. However, according to the international trade theory, even if a country has an absolute advantage over another, it can still benefit from specialization.

Other Possible Benefits of Trading GloballyInternational trade not only results in increased efficiency but also allows countries to participate in a global economy, encouraging the opportunity of foreign direct investment (FDI), which is the amount of money that individuals invest into foreign companies and other assets. In theory, economies can therefore grow more efficiently and can more easily become competitive economic participants. For the receiving government, FDI is a means by which foreign currency and expertise can enter the country. These raise employment levels, and, theoretically, lead to a growth in the gross domestic product. For the investor, FDI offers company expansion and growth, which means higher revenues.

Globalization and International Trade:

1. The Flows of Globalization"Courtesy of ongoing trade liberalization, in conjunction with sharply declining communication and transportation costs, there has been a sharp increase in the tradable goods portion of world output over the past 15 years. At the same time, a veritable explosion in e-based connectivity since 1995, together with the emergence of an entirely new global IT outsourcing industry, has led to the networking of service providers around the world. As a result, rapidly expanding trade in both goods and services has become an increasingly powerful engine in driving the global growth dynamic." Stephen Roach, Morgan Stanley, July 18, 2005.

In a global economy, no nation is self-sufficient. Each is involved at different levels in trade to sell what it produces, to acquire what it lacks and also to produce more efficiently in some economic sectors than its trade partners. As supported by conventional economic theory, trade promotes economic efficiency by providing a wider variety of goods, often at lower costs, notably because of specialization, economies of scale and the related comparative advantages. International trade is also subject to much contention since it can at time be a disruptive economic and social force as it changes the conditions wealth is distributed within a national economy, particularly due to changes in prices and wages. The globalization of production is concomitant to the globalization of trade as one cannot function without the other. Even if international trade has taken place centuries before the modern era, as ancient trade routes such as the Silk Road can testify, trade occurred at an ever increasing scale over the last 600 years to play an even more active part in the economic life of nations and regions. This process has been facilitated by significant technical changes in the transport sector. The scale, volume and efficiency of international trade have all continued to increase since the 1970s. As such, space / time convergence was an ongoing process that implied a wider market coverage could be accessed with a lower amount of time. It has become increasingly possible to trade between parts of the world that previously had limited access to international transportation systems. Further, the division and the fragmentation of production that went along with these processes also expanded trade. Trade thus contributes to lower manufacturing costs. Without international trade, few nations could maintain an adequate standard of living. With only domestic resources being available, each country could only produce a limited number of products and shortages would be prevalent. Global trade allows for an enormous variety of resources from Persian Gulf oil, Brazilian coffee to Chinese labor to be made more widely accessible. It also facilitates the distribution of many different manufactured goods that are produced in different parts of the world to what can be labeled as the global market. Wealth becomes increasingly derived through the regional specialization of economic activities. This way, production costs are lowered, productivity rises and surpluses are generated, which can be transferred or traded for commodities that would be too expensive to produce domestically or would simply not be available. As a result, international trade decreases the overall costs of production worldwide. Consumers can buy more goods from the wages they earn, and standards of living should, in theory, increase. International trade consequently demonstrates the extent of globalization with increased spatial interdependencies between elements of the global economy and their level of integration. These interdependencies imply numerous relationships where flows of capital, goods, raw materials and services are established between regions of the world. As of the beginning of the 21st century, the flows of globalization have been shaped by four salient trends:

An ongoing growth of international trade, both in absolute terms and in relation to global national income. From 1970 to 2010 the value of exports has grown by a factor of 48

times if measured in current dollars, while GDP increased 22 times and population increased 1.8 times. A substantial level of containerization, often complete, of commercial flows. Containerization tends to grow at a rate faster than trade and GDP growth. A higher relative growth of trade in Pacific Asia as many economies developed an export-orienteddevelopment strategy that has been associated with imbalances in commercial relations. The growing role of multinational corporations as vectors for international trade, particularly in terms of the share of international trade taking place within corporations.

2. Trade FacilitationThe volume of exchanged goods and services between nations is taking a growing share of the generation of wealth, mainly by offering economic growth opportunities in new regions and by reducing the costs of a wide array of manufacturing goods. By 2007, international trade surpassed for the first time 50% of global GDP, a twofold increase in its share since 1950. The facilitation of trade involves how the procedures regulating the international movements of goods can be improved. It depends on the reduction of the general costs of trade, which considers transaction, tariff, transport and time costs, often labeled as the "Four Ts" of international trade. United nations estimates have underlined that for developing countries a 10% reduction in transportation cost could be accompanied with a growth of about 20% in international and domestic trade. Thus, the ability to compete in a global economy is dependent on the transport system as well as a trade facilitation framework with activities including:

Distribution-based. A multimodal and intermodal freight transport system composed of

modes, infrastructures and terminals that spans across the globe. It insures a physical capacity to support trade and its underlying supply chains. Regulation-based. Customs procedures, tariffs, regulations and handling of documentation. They insure that trade flows abide to the rules and regulations of the jurisdictions they cross. Cross-border clearance, particularly in developing countries, can be a notable trade impediment with border delays, bottlenecks and long customer clearance times. Transaction-based. Banking, finance, legal and insurance activities where accounts can be settled and risk mitigated. They insure that the sellers of goods and services are receiving an agreed upon compensation and that the purchasers have a legal recourse if the outcome of the transaction is judged unsatisfactory or is insured if a partial or full loss incurs.

The quality, cost, and efficiency of these services influence the trading environment as well as the overall costs linked with the international trade of goods. Many factors have been conductive to trade facilitation in recent decades, including integration processes, standardization, production systems, transport efficiency and transactional efficiency:

Integration processes, such as the emergence of economic blocks and the decrease of

tariffs at a global scale through agreements, promoted trade as regulatory regimes were harmonized. One straightforward measure of integration relates to custom delays, which

can be a significant trade impediment since it adds uncertainty in supply chain management. The higher the level of economic integration, the more likely the concerned elements are to trade. International trade has consequently been facilitated by a set of factors linked with growing levels of economic integration, the outcome of processes such as the European Union or the North American Free Trade Agreement. The transactional capacity is consequently facilitated with the development of transportation networks and the adjustment of trade flows that follows increased integration. Integration processes have also taken place at the local scale with the creation of free trade zones where an area is given a different governance structure in order to promote trade, particularly export oriented activities. In this case, the integration process is not uniform as only a portion of a territory is involved. China is a salient example of the far-reaching impacts of the setting of special economic zones operating under a different regulatory regime. Standardization concerns the setting of a common and ubiquitous frame of reference over information and physical flows. Standards facilitate trade since those abiding by them benefit from reliable, interoperable and compatible goods and services which often results in lower production, distribution and maintenance costs. Measurement units were among the first globally accepted standards (metric system) and the development of information technologies eventually led to common operating and telecommunication systems. It is however the container that is considered to be the most significant international standard for trade facilitation. By offering a load unit that can be handled by any mode and terminal with the proper equipment, access to international trade is improved. Production systems are more flexible and embedded (see concept 3). It is effectively productive to maintain a network of geographically diversified inputs, which favors exchanges of commodities, parts and services. Information technologies have played a role by facilitating transactions and the management of complex business operations. Foreign direct investments are commonly linked with the globalization of production as corporations invest abroad in search of lower production costs and new markets. China is a leading example of such a process, which went on par with a growing availability of goods and services that can be traded on the global market. Transport efficiency has increased significantly because of innovations and improvements in the modes and infrastructures in terms of their capacity and throughput. Ports are particularly important in such a context since they are gateways to international trade through maritime shipping networks. As a result, the transferability of commodities, parts and finished goods has improved. Decreasing transport costs does more than increasing trade; it can also help change the location of economic activities. Yet, transborder transportation issues remain to be better addressed in terms of capacity, efficiency and security. Transactional efficiency. The financial sector also played a significant role in integrating global trade, namely by providing investment capital and credit for international commercial transactions. For instance, a letter of credit may be issued based upon an export contract. An exporter can thus receive a payment guarantee from a bank until its customer finalizes the transaction upon delivery. This is particularly important since the delivery of international trade transactions can take several weeks due to the long distances involved. During the transfer, it is also common that the cargo is insured in the

event of damage, theft or delays, a function supported by insurance companies. Also, global financial systems permit to convert currencies according to exchange rates that are commonly set by market forces, while some currencies, such as the Chinese Yuan, are set by policy. Monetary policy can thus be a tool, albeit contentious, used to influence trade.

Adam Smith ModelAdam Smith displays trade taking place on the basis of countries exercising absolute cost advantage over one another. One of the major aims of Smith's Wealth of Nations was to demonstrate the falsity of the rather extensive set of ideas now called mercantilismabout 25 percent of his book is devoted to an examination of mercantilist doctrine and practice. Some mercantilists argued that government regulation of foreign trade was necessary in order for a country to have a so-called favorable balance of tradeexports greater than importsand, therefore, an increase in the quantity of bullion, as other countries paid in precious metals for the home country's excess of exports over imports. Interestingly, we still use the term "favorable balance of trade" to describe a situation in which a country gives others more goods than it gets in exchange, the difference being settled through payments of gold or IOUs. A favorable balance of trade, however, is favorable only if one incorrectly believes that the wealth of a nation depends upon its holdings of precious metals. Smith, on the contrary, argued for unregulated foreign trade, reasoning that if England can produce a good, e.g., wool, at lower costs than France, and if France can produce another good, e.g., wine, at lower costs than England, then it is beneficial to both parties to exchange these goods, with each trading the good it produces at lower costs for the good it produces at higher costs. In the language of economics, this became known as the absolute advantage argument for foreign trade. This argument, moreover, is not limited to international trade. It applies to trade within a country as well. Embedded in Smith's analysis of how markets develop dynamically over time, one finds another argument for free international trade. Although Smith never fully developed this argument, later economists were able to infer it from the Wealth of Nations. We have already seen that Smith held that a key determinant of the wealth of nations was the productivity of labor and that labor productivity depended primarily upon the division of labor. As labor becomes more divided and specialized, he pointed out, its productivity increases dramatically. Smith held that differences in individual abilities, and hence productivity, were largely the effects of the division of labor, not its cause. At birth, Smith asserted, we are all similarly talented; it is only after we begin to specialize in various activities that we become more proficient relative to others who do not so specialize. We learn by doing, becoming progressively able to produce our goods more cheaply as we get more efficient in our specialized tasks. In the language of modern economics, there are increasing returns (decreasing costs) as labor

becomes more and more specialized. Part of Smith's argument for the advantages of foreign trade was broadly based on this dynamic notion of increasing returns. He realized that if two individuals are equally talented at birth and their talents remain unchanged, it follows that there are no advantages to either of them if they specialize and trade their goods. (The nationality of the individuals makes no difference to these argumentsi.e., whether one person is English and the other French.) If, however, two individuals become more proficient by labor specialization, the costs of producing both their products decrease and both benefit by specializing and trading. Out of this insight of Smith's arose the recognition, pivotal for the development of free trade, that dynamically over time any nation might achieve absolute cost advantages in the production of certain goods through specialization and division of labor, and that all nations could gain from the resulting international trade. Smith, who was very policy-oriented in his analysis of international trade, criticized, in particular, mercantilist policies that had restricted the quantity of trade, concluding that those policies erroneously assessed the wealth of a nation as consisting of the bullion the nation held, rather than correctly defining a nation's wealth as a flow of goods. The proper governmental policy toward international trade, Smith held, should be the same as that toward domestic tradeone of letting voluntary exchanges take place in free-unregulated markets. A policy of laissez faire, he believed, would lead to ever higher levels of well-being in all countries. Modern economics, in assessing the dominant ideas of this period, has discovered another difference between the classicals and the mercantilists that significantly influenced their views concerning the relative importance of free markets versus government regulation. These differences, though never fully articulated in either Smithian or subsequent classical economics, are fundamental to classical views on the consequences of economic activity and remain fundamental even today. They have to do with the fact that if one holds that the total quantity of resources on our planet is fixed, then a process of exchange between two individuals or nations must require that one gain and the other lose. In the language of some modern economists, an economic exchange is a "zero-sum game," in which there is a winner and a loser. Thus, when Britain trades with France, if one gains by this exchange, the other must lose. An opposing perspective holds that economic exchanges are not zero-sum games, that both parties can benefit from the exchange. To rigorously prove that all countries can benefit from foreign trade, one must show that there are more goods in the world after the exchange than there were before. While this sort of book is not the place to demonstrate such a proof, some introductory economics texts do show how foreign trade benefits both parties and that the total amount of goods in the world is greater after the exchange. This insight of Smith and other classical writers that, contrary to the beliefs of many mercantilists, all parties might gain from trading provided a tremendously powerful argument for voluntary exchanges, whether between individuals within a country or between different

countries. An aspect of foreign trade that did not interest Smithno doubt partly because his forte was economic policy, not theorybut that bears on this discussion is the question of the price at which exchange occurs and, therefore, of what determines how the gains from trade are divided between the traders. We will address these issues when we examine David Ricardo and John Stuart Mill.

Ricardian modelThe Ricardian model focuses on comparative advantage, perhaps the most important concept in international trade theory. In a Ricardian model, countries specialize in producing what they produce best, and trade occurs due to technological differences between countries. Unlike other models, the Ricardian framework predicts that countries will fully specialize instead of producing a broad array of goods. Also, the Ricardian model does not directly consider factor endowments, such as the relative amounts of labor and capital within a country. The main merit of Ricardian model is that it assumes technological differences between countries.Technological gap is easily included in the Ricardian and Ricardo-Sraffa model (See the Ricardian theory (modern development)). The Ricardian model makes the following assumptions: Labor is the only primary input to production (labor is considered to be the ultimate source of value). Constant Marginal Product of Labor (MPL) (Labor productivity is constant, constant returns to scale, and simple technology.) Limited amount of labor in the economy Labor is perfectly mobile among sectors but not internationally. Perfect competition (price-takers). The Ricardian model applies in the short run, so that technology may vary internationally. This supports the fact that countries follow their comparative advantage and allows for specialization.

Heckscher-Ohlin modelIn the early 1900s an international trade theory called factor proportions theory was developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is therefore called the Heckscher-Ohlin theory (H-O theory). The H-O theory stresses that countries should produce and export goods that require resources (factors) that are abundant and import goods that require

resources in short supply. It differs from the theories of comparative advantage and absolute advantage since those theories focus on the productivity of the production process for a particular good. On the contrary, the Heckscher-Ohlin theory states that a country should specialize in producing and exporting products that use the factors that are most abundant, and thus are the cheapest to produce. The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic comparative advantage. Despite its greater complexity it did not prove much more accurate in its predictions. However from a theoretical point of view it did provide an elegant method of incorporating the neoclassical price mechanism into international trade theory. The theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce. Empirical problems with the H-O model, such as the Leontief paradox, were exposed in empirical tests by Wassily Leontief who found that the United States tended to export laborintensive goods despite having an abundance of capital. The H-O model makes the following core assumptions: Labor and capital flow freely between sectors The amount of labor and capital in two countries differ (difference in endowments) Free trade Technology is the same among countries (a long-term assumption) Tastes are the same. The problem with the H-O theory is that it excludes the trade of capital goods (including materials and fuels). In the H-O theory, labor and capital are fixed entities endowed to each country. In a modern economy, capital goods are traded internationally. Gains from trade of intermediate goods are considerable, as emphasized by Samuelson (2001). Reality and Applicability of the Heckscher-Ohlin Model Many economists prefer the Heckscher-Ohlin theory to the Ricardian theory, because H-O makes fewer simplifying assumptions.In 1953, Wassily Leontief published a study in which he tested the validity of the Heckscher-Ohlin theory. The study showed that the U.S was more abundant in capital compared to other countries, therefore the U.S would export capital-intensive goods and import labor-intensive goods. Leontief found out that the U.S's exports were less capital intensive than its imports.

After the appearance of Leontief's paradox, many researchers tried to save the Heckscher-Ohlin theory, either by new methods of measurement, or either by new interpretations. Leamer emphasized that Leontief did not interpret H-O theory properly and claimed that with a right interpretation, the paradox did not occur. Brecher and Choudri found that, if Leamer was right, the American workers' consumption per head should be lower than the workers' world average consumption. Many other trials followed but most of them failed. Many textbook writers, including Krugman and Obstfeld and Bowen, Hollander and Viane, are negative about the validity of H-O model. After examining the long history of empirical research, Bowen, Hollander and Viane concluded: "Recent tests of the factor abundance theory [H-O theory and its developed form into manycommodity and many-factor case] that directly examine the H-O-V equations also indicate the rejection of the theory.":321 Heckscher-Ohlin theory is not well adapted to the analyze South-North trade problems. The assumptions of H-O are less realistic with respect to N-S than N-N (or S-S) trade. Income differences between North and South is the assumption that third world cares about most. There is not much evidence of factor price equalization [a consequence of H-O theory. The H-O model assumes identical production functions among countries, although this is highly unrealistic. Technological gaps between developed and developing countries are the main reason why the latter are poor.

Specific factors modelIn the specific factors model, labor mobility among industries is possible while capital is assumed to be immobile in the short run. Thus, this model can be interpreted as a short-run version of the Heckscher-Ohlin model. The "specific factors" name refers to the assumption that in the short run, specific factors of production such as physical capital are not easily transferable between industries. The theory suggests that if there is an increase in the price of a good, the owners of the factor of production specific to that good will profit in real terms. Additionally, owners of opposing specific factors of production (i.e., labor and capital) are likely to have opposing agendas when lobbying for controls over immigration of labor. Conversely, both owners of capital and labor profit in real terms from an increase in the capital endowment. This model is ideal for understanding income distribution but awkward for discussing the pattern of trade.

New Trade TheoryNew Trade Theory tries to explain empirical elements of trade that comparative advantage-based models above have difficulty with. These include the fact that most trade is between countries with similar factor endowment and productivity levels, and the large amount of multinational production (i.e. foreign direct investment) that exists. New Trade theories are often based on

assumptions such as monopolistic competition and increasing returns to scale. One result of these theories is the home-market effect, which asserts that, if an industry tends to cluster in one location because of returns to scale and if that industry faces high transportation costs, the industry will be located in the country with most of its demand, in order to minimize cost. Although new trade theory can explain the growing trend of trade volumes of intermediate goods, Krugman's explanation depends too much on the strict assumption that all firms are symmetrical, meaning that they all have the same production coefficients. Shiozawa, based on much more general model, succeeded in giving a new explanation on why the traded volume increases for intermediates goods when the transport cost decreases .

Gravity modelThe Gravity model of trade presents a more empirical analysis of trading patterns. The gravity model, in its basic form, predicts trade based on the distance between countries and the interaction of the countries' economic sizes. The model mimics the Newtonian law of gravity which also considers distance and physical size between two objects. The model has been proven to be empirically strong through econometric analysis. The model has been an empirical success[further explanation needed], but the theoretical justifications for the model are the subject of some dispute. The model clearly has a relationship with a geographic view of trade, but other theoretical justifications for the model have also been proposed. The gravity model estimates the pattern of international trade. While the models basic form consists of factors that have more to do with geography and spatiality, the gravity model has been used to test hypotheses rooted in purer economic theories of trade as well. One such theory predicts that trade will be based on relative factor abundances. One of the common relative factor abundance models is the Heckscher-Ohlin model. This theory would predict that trade patterns would be based on relative factor abundance. Those countries with a relative abundance of one factor would be expected to produce goods that require a relatively large amount of that factor in their production. While a generally accepted theory of trade, comparative advantage has suffered empirical problems. Investigations into real world trading patterns have produced a number of results that do not match the expectations of comparative advantage theories. Notably, a study byWassily Leontief found that the United States, the most capital endowed country in the world, actually exports more in labor intensive industries. Comparative advantage in factor endowments would suggest the opposite would occur. Other theories of trade and explanations for this relationship were proposed in order to explain the discrepancy between Leontiefs empirical findings and economic theory. The problem has become known as the Leontief paradox. An alternative theory, first proposed by Staffan Linder, predicts that patterns of trade will be determined by the aggregated preferences for goods within countries. Those countries with similar preferences would be expected to develop similar industries. With continued similar demand, these countries would continue to trade back and forth in differentiated but similar goods since both demand and produce similar products. For instance, both Germany and

the United States are industrialized countries with a high preference for automobiles. Both countries have automobile industries, and both trade cars. The empirical validity of the Linder hypothesis is somewhat unclear. Several studies have found a significant impact of the Linder effect, but others have had weaker results. Studies that do not support Linder have only counted countries that actually trade; they do not input zero values for the dyads where trade could happen but does not. This has been cited as a possible explanation for their findings. Also, Linder never presented a formal model for his theory, so different studies have tested his hypothesis in different ways. Elhanan Helpman and Paul Krugman asserted that the theory behind comparative advantage does not predict the relationships in the gravity model. Using the gravity model, countries with similar levels of income have been shown to trade more. Helpman and Krugman see this as evidence that these countries are trading in differentiated goods because of their similarities. This casts some doubt about the impact Heckscher-Ohlin has on the real world. Jeffrey Frankel sees the Helpman-Krugman setup here as distinct from Linders proposal. However, he does say Helpman-Krugman is different from the usual interpretation of Linder, but, since Linder made no clear model, the association between the two should not be completely discounted. Alan Deardorff adds the possibility, that, while not immediately apparent, the basic gravity model can be derived from Heckscher-Ohlin as well as the Linder and Helpman-Krugman hypotheses. Deardorff concludes that, considering how many models can be tied to the gravity model equation, it is not useful for evaluating the empirical validity of theories. Bridging economic theory with empirical tests, James Anderson and Jeffrey Bergstrand develop econometric models, grounded in the theories of differentiated goods, which measure the gains from trade liberalizations and the magnitude of the border barriers on trade (see McCallum Border puzzle). Adding to the problem of bridging economic theory with empirical results, some economists have pointed to the possibility of intra-industry trade not as the result of differentiated goods, but because of reciprocal dumping. In these models, the countries involved are said to have imperfect competition and segmented markets in homogeneous goods, which leads to intraindustry trade as firms in imperfect competition seek to expand their markets to other countries and trade goods that are not differentiated yet for which they do not have a comparative advantage, since there is no specialization. This model of trade is consistent with the gravity model as it would predict that trade depends on country size. The reciprocal dumping model has held up to some empirical testing, suggesting that the specialization and differentiated goods models for the gravity equation might not fully explain the gravity equation. Feenstra, Markusen, and Rose (2001) provided evidence for reciprocal dumping by assessing the home market effect in separate gravity equations for differentiated and homogeneous goods. The home market effect showed a relationship in the gravity estimation for differentiated goods, but showed the inverse relationship for homogeneous goods. The authors show that this result matches the theoretical predictions of reciprocal dumping playing a role in homogeneous markets. Past research using the gravity model has also sought to evaluate the impact of various variables in addition to the basic gravity equation. Among these, price level and exchange rate variables have been shown to have a relationship in the gravity model that accounts for a significant

amount of the variance not explained by the basic gravity equation. According to empirical results on price level, the effect of price level varies according the relationship being examined. For instance, if exports are being examined, a relatively high price level on the part of the importer would be expected to increase trade with that country. A non-linear system of equations are used by Anderson and van Wincoop (2003) to account for the endogenous change in these price terms from trade liberalization. A more simple method is to use a first order loglinearization of this system of equations (Baier and Bergstrand (2009)), or exporter-country-year and importer-country-year dummy variables. For counterfactual analysis, however, one would still need to account for the change in world prices.

Ricardian theory of international trade (modern development)The Ricardian theory of comparative advantage became a basic constituent of neoclassical trade theory. Any undergraduate course in trade theory includes a presentation of Ricardo's example of a two-commodity, two-country model. A common representation of this model is made using an Edgeworth Box. This model has been expanded to many-country and many-commodity cases. Major general results were obtained by McKenzie and Jones, including his famous formula. It is a theorem about the possible trade pattern for N-country N-commodity cases.

Contemporary theoriesRicardo's idea was even expanded to the case of continuum of goods by Dornbusch, Fischer, and Samuelson This formulation is employed for example by Matsuyama and others. These theories use a special property that is applicable only for the two-country case.

Neo-Ricardian trade theoryInspired by Piero Sraffa, a new strand of trade theory emerged and was named neo-Ricardian trade theory. The main contributors include Ian Steedman (1941-) and Stanley Metcalfe (1946-). They have criticized neoclassical international trade theory, namely the Heckscher-Ohlin model on the basis that the notion of capital as primary factor has no method of measuring it before the determination of profit rate (thus trapped in a logical vicious circle). This was a second round of the Cambridge capital controversy, this time in the field of international trade. The merit of neo-Ricardian trade theory is that input goods are explicitly included. This is in accordance with Sraffa's idea that any commodity is a product made by means of commodities. The limitation of their theory is that the analysis is restricted to small-country cases.

Traded intermediate goodsRicardian trade theory ordinarily assumes that the labor is the unique input. This is a great deficiency as trade theory, for intermediate goods occupy the major part of the world international trade. Yeats found that 30% of world trade in manufacturing involves intermediate inputs. Bardhan and Jafee found that intermediate inputs occupy 37 to 38% of U.S. imports for the years 1992 and 1997, whereas the percentage of intrafirm trade grew from 43% in 1992 to 52% in 1997. McKenzie and Jones emphasized the necessity to expand the Ricardian theory to the cases of traded inputs. In a famous comment McKenzie (1954, p. 179) pointed that "A moment's consideration will convince one that Lancashire would be unlikely to produce cotton cloth if the cotton had to be grown in England." Paul Samuelson coined a term Sraffa bonus to name the gains from trade of inputs.

Ricardo-Sraffa trade theoryJohn Chipman observed in his survey that McKenzie stumbled upon the questions of intermediate products and discovered that "introduction of trade in intermediate product necessitates a fundamental alteration in classical analysis." It took many years until Y. Shiozawa succeeded in removing this deficiency. The Ricardian trade theory was now constructed in a form to include intermediate input trade for the most general case of many countries and many goods. This new theory is called Ricardo-Sraffa trade theory. The Ricardian trade theory now provides a general theory that includes trade of intermediates such as fuel, machine tools, machinery parts and processed materials. The traded intermediate goods are then used as inputs to production in the importing country. Capital goods are nothing other than inputs to the production. Thus, in the Ricardo-Sraffa trade theory, capital goods move freely from country to country. Labor is the unique factor of production that remains immobile in its country of origin. In a blog post of April 28, 2007, Gregory Mankiw compared Ricardian theory and HeckscherOhlin theory and stood by the Ricardian side. Mankiw argued that Ricardian theory is more realistic than the Heckscher-Ohlin theory as the latter assumes that capital does not move from country to country. Mankiw's argument contains a logical slip, for the traditional Ricardian trade theory does not admit any inputs. Shiozawa's result saves Mankiw from his slip. The neoclassical Heckscher-Ohlin-Samuelson theory only assumes productive factors and finished goods. It has no concept of intermediate goods. Therefore, it is the Ricardo-Sraffa trade theory that provides theoretical bases for ideas such as outsourcing, fragmentation and intra-firm trade.

Regulation of international trade

Current members of the World Trade Organisation. Traditionally trade was regulated through bilateral treaties between two nations. For centuries under the belief in mercantilismmost nations had high tariffs and many restrictions on international trade. In the 19th century, especially in the United Kingdom, a belief in free trade became paramount. This belief became the dominant thinking among western nations since then. In the years since the Second World War, controversial multilateral treaties like the General Agreement on Tariffs and Trade(GATT) and World Trade Organization have attempted to promote free trade while creating a globally regulated trade structure. These trade agreements have often resulted in discontent and protest with claims of unfair trade that is not beneficial todeveloping countries. Free trade is usually most strongly supported by the most economically powerful nations, though they often engage in selectiveprotectionism for those industries which are strategically important such as the protective tariffs applied to agriculture by the United States and Europe. The Netherlands and the United Kingdom were both strong advocates of free trade when they were economically dominant, today the United States, the United Kingdom, Australia and Japan are its greatest proponents. However, many other countries (such as India, China and Russia) are increasingly becoming advocates of free trade as they become more economically powerful themselves. As tariff levels fall there is also an increasing willingness to negotiate non tariff measures, including foreign direct investment, procurement andtrade facilitation.The latter looks at the transaction cost associated with meeting trade and customs procedures. Traditionally agricultural interests are usually in favour of free trade while manufacturing sectors often support protectionism. This has changed somewhat in recent years, however. In fact, agricultural lobbies, particularly in the United States, Europe and Japan, are chiefly responsible for particular rules in the major international trade treaties which allow for more protectionist measures in agriculture than for most other goods and services. During recessions there is often strong domestic pressure to increase tariffs to protect domestic industries. This occurred around the world during the Great Depression. Many economists have attempted to portray tariffs as the underlining reason behind the collapse in world trade that many believe seriously deepened the depression.

The regulation of international trade is done through the World Trade Organization at the global level, and through several other regional arrangements such as MERCOSUR in South America, theNorth American Free Trade Agreement (NAFTA) between the United States, Canada and Mexico, and the European Union between 27 independent states. The 2005 Buenos Aires talks on the planned establishment of the Free Trade Area of the Americas (FTAA) failed largely because of opposition from the populations of Latin American nations. Similar agreements such as theMultilateral Agreement on Investment (MAI) have also failed in recent years.

Risk in international tradeWhile trade barriers and unfair practices take many forms, the most common examples are listed below: Intellectual property infringement - including copyright, patent and trademarks. Lack of competitive bidding for foreign government tenders. Competition from unfairly traded (i.e., dumped or foreign government subsidized) imports. Unfair and trade distortive subsidies provided by foreign governments to overseas competitors. Foreign trade remedy investigations conducted inconsistent with international obligations. Burdensome certification and testing requirements that are not required by domestic manufacturers. Increasing imports and unfair competition. Concerns over other foreign trade barriers to export or investment.

Absolute advantageIn economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input. Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything; in that case, according to the theory of absolute advantage, no trade will occur with the other party. It can be contrasted with the concept of comparative advantage which refers to the ability to produce a particular good at a loweropportunity cost.

Origin of the theoryThe main concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he counteredmercantilist ideas. Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nations import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage. Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.

ExamplesExample 1

Party B has the absolute advantage.

Party A can produce 5 widgets per hour with 3 employees. Party B can produce 10 widgets per hour with 3 employees.

Assuming that the employees of both parties are paid equally, Party B has an absolute advantage over Party A in producing widgets per hour. This is because Party B can produce twice as many widgets as Party A can with the same number of employees.Example 2

Country C has the absolute advantage.

Country A can produce 1000 parts per hour with 200 workers. Country B can produce 2500 parts per hour with 200 workers. Country C can produce 10000 parts per hour with 200 workers.

Considering that labor and material costs are all equivalent, Country C has the absolute advantage over both Country B and Country A because it can produce the most parts per hour at the same cost as other nations. Country B has an absolute advantage over Country A because it can produce more parts per hour with the same number of employees. Country A has no absolute advantage because it can't produce more goods than either Country B or Country C given the same input.Example 3

You and your friends decided to help with fundraising for a local charity group by printing tshirts and making birdhouses.

Scenario 1: One of your friends, Gina, can print 5 t-shirts or build 3 birdhouses an hour. Your other friend, Mike, can print 3 t-shirts an hour or build 2 birdhouses an hour. Because your friend Gina is more productive at printing t-shirts and building birdhouses compared to Mike, she has an absolute advantage in both printing t-shirts and building birdhouses.

Scenario 2: Suppose Gina wasn't as agile with the hammer and could only make 1 birdhouse an hour, but she took a sewing class and could print 10 t-shirts an hour. Mike on the other hand takes woodworking and so he can build 5 birdhouses an hour, but he doesn't know the first thing about making t-shirts so he can only print 2 t-shirts an hour. While Gina would have the absolute advantage in printing shirts, Mike would have an absolute advantage in building birdhouses.

Comparative advantageIn economics, the theory of comparative advantage refers to the ability of a person or a country to produce a particular good or service at a lower marginaland opportunity cost over another. Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in

an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its opportunity cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 tradeoff). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs. The net benefits to each country are called the gains from trade.

Origins of the theoryComparative advantage was first described by David Ricardo who explained it in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less labor than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good where it has comparative advantage, and trading that good for the other. However, it is also worth mentioning that R. Torrens was an actual pioneer in the field of theoretical basis for the theory of comparative advantage. In 1815 he published 'An Essay on the External Corn Trade' which involved critical elements of the law of comparative advantage.

Effect of trade costsTrade costs, particularly transportation, reduce and may eliminate the benefits from trade, including comparative advantage. Paul Krugman gives the following example.

Using Ricardo's classic example: Unit labor costs

Cloth

Wine

Britain

100

110

Portugal

90

80

In the absence of transportation costs, it is efficient for Britain to produce cloth, and Portugal to produce wine, as, assuming that these trade at equal price (1 unit of cloth for 1 unit of wine) Britain can then obtain wine at a cost of 100 labor units by producing cloth and trading, rather than 110 units by producing the wine itself, and Portugal can obtain cloth at a cost of 80 units by trade rather than 90 by production. However, in the presence of trade costs of 15 units of labor to import a good (alternatively a mix of export labor costs and import labor costs, such as 5 units to export and 10 units to import), it then costs Britain 115 units of labor to obtain wine by trade 100 units for producing the cloth, 15 units for importing the wine, which is more expensive than producing the wine locally, and likewise for Portugal. Thus, if trade costs exceed the production advantage, it is not advantageous to trade. Krugman proceeds to argue more speculatively that changes in the cost of trade (particularly transportation) relative to the cost of production may be a factor in changes in global patterns of trade: if trade costs decrease, such as on the advent of steam-powered shipping, trade should be

expected to increase, as more comparative advantages in production can be realized. Conversely, if trade costs increase, or if production costs decrease faster than trade costs (such as via electrification of factories), then trade should be expected to decrease, as trade costs become a more significant barrier.

Effects on the economyConditions that maximize comparative advantage do not automatically resolve trade deficits. In fact, many real world examples where comparative advantage is attainable may require a trade deficit. For example, the amount of goods produced can be maximized, yet it may involve a net transfer of wealth from one country to the other, often because economic agents have widely different rates of saving. As the markets change over time, the ratio of goods produced by one country versus another variously changes while maintaining the benefits of comparative advantage. This can cause national currencies to accumulate into bank deposits in foreign countries where a separate currency is used. Macroeconomic monetary policy is often adapted to address the depletion of a nation's currency from domestic hands by the issuance of more money, leading to a wide range of historical successes and failures.

Considerations

Development economicsThe theory of comparative advantage, and the corollary that nations should specialize, is criticized on pragmatic grounds within the import substitution industrialization theory of development economics, on empirical grounds by the SingerPrebisch thesis which states that terms of trade between primary producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry and Keynesian economics. In older economic terms, comparative advantage has been opposed by mercantilism and economic nationalism. These argue instead that while a country may initially be comparatively disadvantaged in a given industry (such as Japanese cars in the 1950s), countries should shelter and invest in industries until they become globally competitive. Further, they argue that comparative advantage, as stated, is a static theory it does not account for the possibility of advantage changing through investment or economic development, and thus does not provide guidance for long-term economic development.

Much has been written since Ricardo as commerce has evolved and cross-border trade has become more complicated. Today trade policy tends to focus more on "competitive advantage" as opposed to "comparative advantage". One of the most indepth research undertakings on "competitive advantage" was conducted in the 1980s as part of the Reagan administration's Project Socrates to establish the foundation for a technology-based competitive strategy development system that could be used for guiding international trade policy.

Free mobility of capital in a globalized worldRicardo explicitly bases his argument on an assumed immobility of capital: " ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labor price of commodities, than the additional quantity of labor required to convey them to the various markets where they were to be sold." He explains why, from his point of view, (anno 1817) this is a reasonable assumption: "Experience, however, shows, that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and entrust himself with all his habits fixed, to a strange government and new laws, checks the emigration of capital." Some scholars, notably Herman Daly, an American ecological economist and professor at the School of Public Policy of the University of Maryland, have voiced concern over the applicability of Ricardo's theory of comparative advantage in light of a perceived increase in the mobility of capital: "International trade (governed by comparative advantage) becomes, with the introduction of free capital mobility, interregional trade (governed by Absolute advantage)." Adam Smith developed the principle of absolute advantage. The economist Paul Craig Roberts notes that the comparative advantage principles developed by David Ricardo do not hold where the factors of production are internationally mobile. Limitations to the theory may exist if there is a single kind of utility. Yet the human need for food and shelter already indicates that multiple utilities are present in human desire. The moment the model expands from one good to multiple goods, the absolute may turn to a comparative advantage. The opportunity cost of a forgone tax base may outweigh perceived gains, especially where the presence of artificial currency pegs and manipulations distort trade. Global labor arbitrage, where one country exploits the cheap labor of another, would be a case of absolute advantage that is not mutually beneficial.

Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may have helped developed countries maintain relatively advanced technology and industry compared to developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed countries, including the United States and United Kingdom, used interventionist, protectionist economic policies in order to get rich and then tried to forbid other countries from doing the same. For example, according to the comparative advantage principle, developing countries with a comparative advantage in agriculture should continue to specialize in agriculture and import high-technology widgits from developed countries with a comparative advantage in high technology. In the long run, developing countries would lag behind developed countries, and polarization of wealth would set in. Chang asserts that premature free trade has been one of the fundamental obstacles to the alleviation of poverty in the developing world. Recently, Asian countries such as South Korea, Japan and China have utilized protectionist economic policies in their economic development.

Balance of trade

Cumulative Current Account Balance 19802008 based on the International Monetary Fund data.

Cumulative Current Account Balance per capita 19802008 based onInternational Monetary Fund data. The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value ofexports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports.[dead link] A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance. Early understanding of the functioning of balance of trade informed the economic policies of Early Modern Europe that are grouped under the heading mercantilism. An early statement appeared in Discourse of the Common Wealth of this Realm of England, 1549: "We must always take heed that we buy no more from strangers than we sell them, for so should we impoverish ourselves and enrich them." Similarly a systematic and coherent explanation of balance of trade was made public through Thomas Mun's c1630 "England's treasure by forraign trade, or, The balance of our forraign trade is the rule of our treasure"

DefinitionThe balance of trade forms part of the current account, which includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position. The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by almost 1%; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debitin the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely. Factors that can affect the balance of trade include:

The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis--vis those in the importing economy; The cost and availability of raw materials, intermediate goods and other inputs; Exchange rate movements; Multilateral, bilateral and unilateral taxes or restrictions on trade; Non-tariff barriers such as environmental, health or safety standards; The availability of adequate foreign exchange with which to pay for imports; and Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle. Since the mid 1980s, the United States has had a growing deficit in tradeable goods, especially with Asian nations (China and Japan) which now hold large sums of U.S debt that has funded the consumption. The U.S. has a trade surplus with nations such as Australia. The issue of trade deficits can be complex. Trade deficits generated in tradeable goods such as manufactured goods or software may impact domestic employment to different degrees than trade deficits in raw materials. Economies such as Canada, Japan, and Germany which have savings surpluses, typically run trade surpluses. China, a high growth economy, has tended to run trade surpluses. A higher savings rate generally corresponds to a trade surplus. Correspondingly, the U.S. with its lower savings rate has tended to run high trade deficits, especially with Asian nations.

Views on economic impactConditions where trade imbalances may be problematic

Those who ignore the effects of long run trade deficits may be confusing David Ricardo's principle of comparative advantage with Adam Smith's principle of absolute advantage, specifically ignoring the latter. The economist Paul Craig Roberts notes that the comparative advantage principles developed by David Ricardo do not hold where the factors of production are internationally mobile.Global labor arbitrage, a phenomenon described by economist Stephen S. Roach, where one country exploits the cheap labor of another, would be a case of absolute advantage that is not mutually beneficial. Since the stagflation of the 1970s, the U.S. economy has been characterized by slower GDP growth. In 1985, the U.S. began its growing trade deficit with China. Over the long run, nations with trade surpluses tend also to have a savings surplus. The U.S. generally has lower savings rates than its trading partners, which tend to have trade surpluses. Germany, France, Japan, and Canada have maintained higher savings rates than the U.S. over the long run. Few economists believe that GDP and employment can be dragged down by an over-large deficit over the long run. Others believe that trade deficits are good for the economy. Theopportunity cost of a forgone tax base may outweigh perceived gains, especially where artificial currency pegs and manipulations are present to distort trade. Wealth-producing primary sector jobs in the U.S. such as those in manufacturing and computer software have often been replaced by much lower paying wealth-consuming jobs such as those in retail and government in the service sector when the economy recovered from recessions. Some economists contend that the U.S. is borrowing to fund consumption of imports while accumulating unsustainable amounts of debt. In 2006, the primary economic concerns focused on: high national debt ($9 trillion), high nonbank corporate debt ($9 trillion), high mortgage debt ($9 trillion), high financial institution debt ($12 trillion), high unfunded Medicare liability ($30 trillion), high unfunded Social Security liability ($12 trillion), high external debt (amount owed to foreign lenders) and a serious deterioration in the United States net international investment position (NIIP) (-24% of GDP), high trade deficits, and a rise in illegal immigration. These issues have raised concerns among economists and unfunded liabilities were mentioned as a serious problem facing the United States in the President's 2006 State of the Union address. On June 26, 2009, Jeff Immelt, the CEO of General Electric, called for the U.S. to increase its manufacturing base employment to 20% of the workforce, commenting that the U.S. has

outsourced too much in some areas and can no longer rely on the financial sector and consumer spending to drive demand.Conditions where trade imbalances may not be problematic

Small trade deficits are generally not considered to be harmful to either the importing or exporting economy. However, when a national trade imbalance expands beyond prudence (generally thought to be several[clarification needed] percent of GDP, for several years), adjustments tend to occur. While unsustainable imbalances may persist for long periods (cf, Singapore and New Zealands surpluses and deficits, respectively), the distortions likely to be caused by large flows of wealth out of one economy and into another tend to become intolerable. In simple terms, trade deficits are paid for out of foreign exchange reserves, and may continue until such reserves are depleted. At such a point, the importer can no longer continue to purchase more than is sold abroad. This is likely to have exchange rate implications: a sharp loss of value in the deficit economys exchange rate with the surplus economys currency will change the relative price of tradable goods, and facilitate a return to balance or (more likely) an overshooting into surplus the other direction. More complexly, an economy may be unable to export enough goods to pay for its imports, but is able to find funds elsewhere. Service exports, for example, are more than sufficient to pay forHong Kongs domestic goods export shortfall. In poorer countries, foreign aid may fill the gap while in rapidly developing economies a capital account surplus often off-sets a currentaccountdeficit. There are some economies where transfers from nationals working abroad contribute significantly to paying for imports. The Philippines, Bangladesh and Mexico are examples of transfer-rich economies. Finally, a country may partially rebalance by use of quantitative easing at home. This involves a central bank buying back long term government bonds from other domestic financial institutions without reference to the interest rate (which is typically low when QE is called for), seriously increasing the money supply. This debases the local currency but also reduces the debt owed to foreign creditors - effectively "exporting inflation".Adam Smith on trade deficits

"In the foregoing part of this chapter I have endeavoured to show, even upon the principles of the commercial system, how unnecessary it is to lay extraordinary restraints upon the importation of goods from those countries with which the balance of trade is supposed to be disadvantageous. Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon which, not only these restraints, but almost all the other regulations of commerce are founded.

When two places trade with one another, this [absurd] doctrine supposes that, if the balance be even, neither of them either loses or gains; but if it leans in any degree to one side, that one of them loses and the other gains in proportion to its declension from the exact equilibrium." (Smith, 1776, book IV, ch. iii, part ii)Frdric Bastiat on the fallacy of trade deficits

The 19th century economist and philosopher Frdric Bastiat expressed the idea that trade deficits actually were a manifestation of profit, rather than a loss. He proposed as an example to suppose that he, a Frenchman, exported French wine and imported British coal, turning a profit. He supposed he was in France, and sent a cask of wine which was worth 50 francs to England. The customhouse would record an export of 50 francs. If, in England, the wine sold for 70 francs (or the pound equivalent), which he then used to buy coal, which he imported into France, and was found to be worth 90 francs in France, he would have made a profit of 40 francs. But the customhouse would say that the value of imports exceeded that of exports and was trade deficit against the ledger of France. By reductio ad absurdum, Bastiat argued that the national trade deficit was an indicator of a successful economy, rather than a failing one. Bastiat predicted that a successful, growing economy would result in greater trade deficits, and an unsuccessful, shrinking economy would result in lower trade deficits. This was later, in the 20th century, affirmed by economist Milton Friedman.John Maynard Keynes on the balance of trade

In the last few years of his life, John Maynard Keynes was much preoccupied with the question of balance in international trade. He was the leader of the British delegation to the United Nations Monetary and Financial Conference in 1944 that established the Bretton Woods system of international currency management. He was the principal author of a proposal the so-called Keynes Plan for an International Clearing Union. The two governing principles of the plan were that the problem of settling outstanding balances should be solved by 'creating' additional 'international money', and that debtor and creditor should be treated almost alike as disturbers of equilibrium. In the event, though, the plans were rejected, in part because "American opinion was naturally reluctant to accept the principle of equality of treatment so novel in debtor-creditor relationships". His view, supported by many economists and commentators at the time, was that creditor nations may be just as responsible as debtor nations for disequilibrium in exchanges and that both should be under an obligation to bring trade back into a state of balance. Failure for them to do so could

have serious consequences. In the words of Geoffrey Crowther, then editor of The Economist, "If the economic relationships between nations are not, by one means or another, brought fairly close to balance, then there is no set of financial arrangements that can rescue the world from the impoverishing results of chaos." These ideas were informed by events prior to the Great Depression when in the opinion of Keynes and others international lending, primarily by the U.S., exceeded the capacity of sound investment and so got diverted into non-productive and speculative uses, which in turn invited default and a sudden stop to the process of lending. Influenced by Keynes, economics texts in the immediate post-war period put a significant emphasis on balance in trade. For example, the second edition of the popular introductory textbook, An Outline of Money, devoted the last three of its ten chapters to questions of foreign exchange management and in particular the 'problem of balance'. However, in more recent years, since the end of the Bretton Woods system in 1971, with the increasing influence of Monetarist schools of thought in the 1980s, and particularly in the face of large sustained trade imbalances, these concerns and particularly concerns about the destabilising effects of large trade surpluses have largely disappeared from mainstream economics discourse and Keynes' insights have slipped from view. They are receiving some attention again in the wake of the Financial crisis of 20072010.Milton Friedman on trade deficits

In the 1980s, Milton Friedman, the Nobel Prize-winning economist and father of Monetarism, contended that some of the concerns of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting industries. Prof. Friedman argued that trade deficits are not necessarily as important as high exports raise the value of the currency, reducing aforementioned exports, and vice versa for imports, thus naturally removing trade deficits not due to investment. Since 1971, when the Nixon administration decided to abolish fixed exchange rates, America's Current Account accumulated trade deficits have totaled $7.75 Trillion as of 2010. This deficit exists as it is matched by investment coming in to the United States- purely by the definition of the balance of payments, any current account deficit that exists is matched by an inflow of foreign investment. In the late 1970s and early 1980s, the U.S. had experienced high inflation and Friedman's policy positions tended to defend the stronger dollar at that time. He stated his belief that these trade deficits were not necessarily harmful to the economy at the time since the currency comes back to the country (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). However, it may be in one form or another

including the possible tradeoff of foreign control of assets. In his view, the "worst case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging them for pieces of cheaply-made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation. This posi