International Trade: Factors, Principles, and Capital Accounts
Principles of International Trade
This document explores the factors that influence international trade.
Our country represents 0.2% of the global population. Countries engage in international trade because it offers mutual benefits, often due to several key factors:
- Variations in production conditions across different regions.
- Differences in individual tastes and consumption patterns.
- Leveraging existing economies of scale.
- Variations in Production Conditions: Production conditions, including climate, natural resources, physical and human capital, and technology, often vary significantly between countries. In these circumstances, trade arises logically from the diverse production possibilities of different nations. Products generated by one country may be needed in another that lacks the conditions for their production.
- Differences in Tastes: Even if production conditions were similar across countries, differences in consumer preferences can justify international trade. A good produced domestically might not appeal to local consumers as much as a similar good produced elsewhere.
- Economies of Scale: In industries with economies of scale, international trade allows for mass production, leading to significant cost reductions. Specialization becomes a key tool for managing surplus production.
Basic Principles of International Trade
Beyond the three reasons mentioned above, a fundamental principle underlies all trade: comparative advantage. According to this principle, countries tend to specialize in producing and exporting goods where they have a comparative advantage over other countries. This specialization increases global production and, consequently, the ability to satisfy consumer demand, compared to a scenario where each country strives for self-sufficiency.
1. Principle of Absolute Advantage
A country has an absolute advantage over others in producing a good if it can produce more of that good with the same resources as its neighbors. Each country tends to specialize in producing goods where it has an absolute advantage to maximize resource efficiency and exchange surplus goods for those it needs but doesn’t produce.
Product Chile Colombia 1 Unit of Food 1 Hour of Work 2 Hours of Work 1 Unit of Manufacturing 2 Hours of Work 1 Hour of Work 2. Principle of Comparative Advantage
This principle states that countries specialize in producing goods they can manufacture at a lower opportunity cost. This specialization increases global production and the ability to satisfy consumer demand compared to a scenario where each country strives for self-sufficiency. In essence, the principle of comparative advantage indicates that a country will trade with others even if it is absolutely more efficient or inefficient in producing all goods.
Product Chile Colombia 1 Unit of Food 1 Hour of Work 3 Hours of Work 1 Unit of Manufacturing 2 Hours of Work 3 Hours of Work
Factors Determining Price Elasticity of Demand
Price elasticity of demand measures the percentage change in the quantity demanded of an item per unit of time resulting from a given percentage change in price. Price and quantity have an inverse relationship. The price elasticity coefficient is negative; to avoid handling negative numbers, we omit the minus sign in its calculation.
The following ranges are relevant in interpreting the coefficient:
Relevant Range
e > 1: Elastic Demand. The price change significantly impacts the amount consumers are willing to spend.
0 < e < 1: Inelastic Demand. The quantity demanded changes very little with price changes (e.g., prescription drugs).
e = 0: Perfectly Inelastic Demand. The quantity demanded doesn’t change with price (e.g., essential goods like salt).
Capital Account
All international transactions included in the current account are settled without further involvement. However, this isn’t the case if, for example, a foreign bank grants a loan to a national company. This amount is considered income in that year but also represents a national debt for subsequent years, requiring interest payments and principal repayment.
The capital account includes all public or private capital movements reflected in the balance of payments, whether long-term, short-term, or changes in foreign exchange reserves.
The long-term capital balance includes investments, credits, and loans (both public and private) made by foreigners in the country (income) or by nationals abroad (payments) with a term exceeding one year.
The short-term capital balance accounts for similar transactions with a term of less than one year.
Capital Account Deficit and Surplus
The capital account balance can be expressed as:
Capital Account Balance = Revenue from Asset Sales to Foreign Entities – Expenditure on Purchasing Assets Abroad
A country has a capital account surplus when it receives more revenue from selling assets to the rest of the world than it spends buying assets abroad. This represents a net inflow of capital. Conversely, a capital account deficit occurs when a country buys more assets abroad than foreigners buy from it, resulting in a net outflow of capital.
Balance of Payments
The balance of payments is an accounting document that systematically records all economic transactions between a country and the rest of the world during a specific period (usually a year). These transactions fall into two categories:
- Current Account: This includes buying and selling goods and services and unilateral current transfers. Current account transactions generate income in our country (exports) or abroad (imports) or, without generating revenue, affect disposable income for expenditures (current transfers). It comprises the trade balance, service balance, and balance of transfers.
- Trade Balance: This accounts for all goods exchanged with other countries. Goods bought from abroad are imports, and goods sold to other countries are exports.
- Balance of Services: Countries also buy and sell services. The service balance is linked to tourism, import needs, technology export possibilities, and income from investments abroad or within the country. Activities involving payment as compensation for a service are service imports. Service exports encompass similar activities but involve charges by domestic economic agents.
