What is International Trade? Need, Theories, Reasons, Methods, Trend

What is International Trade?

International trade allows different countries to exchange products and services that are not accessible in their home country. There are several factors that have contributed in the growth of international trade, such as liberalisation, transportation, technology, comparison of prices, and so on. Introduction of debit, credit, and master cards have made transactions faster and easier.

Millions of dollars are exchanged every day virtually at no cost. Liberalisation and change in political environment has also played a major role in making global trade popular.

International trade includes commercial transactions that comprises of sales, investments, and shipment. These transactions are carried out between two or more different countries for political and profit motives. All the transactions that are executed across border forms the part of international trade or business.

There are various reasons that have given rise to international trade which are as follows:

• Technological expansion
• Free cross-border trade and movement of resources
• Advancement of services that facilitates international business
• Increased pressure from customers
• Growing competition
• Continuously changing political scenarios

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Need for International Trade

In this highly competitive world, the role of international trade is very crucial in the economic development of a country and its people. It allows the countries involved in international trade to enjoy the mutual benefits and comparative advantages offered.

The need for international trade is explained in the following points:

• It acts as a platform for manufacturers and distributors to seek out products, services, and components produced in foreign countries.
  
  
• It is an important part of development strategy and can be an effective tool of economic growth, employment generation, and poverty alleviation.
  
  
• It provides the opportunity to companies for learning new technologies that further helps in increasing production as well as productivity, reducing cost, and increasing quality
  
  
• It enables firms to acquire resources that are not available within the country.
  
  
• It gives customers an increased number of options to select from

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Reasons for International Trade

Export and import play a crucial role not only in the growth of a nation’s economy, but also in improving global economy as well. Every country irrespective of its economic and social development has something unique to offer. Thus, it creates a demand for products or services that are offered to the host country by the home country.

Let us now discuss in details the reasons behind international trade:

Cheap Resources

It can be considered as the primary reason for the promotion of international trade. The country that has surplus of certain commodity of product can offer it internationally at cheaper prices. It provides mutual benefit to both the countries trading in balancing their demand and supply graph. Moreover, it helps the exporting country in obtaining foreign currency that further helps in strengthening its economy.

Access to New Technology

International trade helps in bridging the gap for inaccessible or limited skills and technology needed. For example, let us assume that country X is unable to produce a particular raw material A because of lack of resources and the country Y has surplus amount of raw material A. In this case, international trade helps in solving the problem as country X can import the raw material A from country Y.

Diversification of Risk

Global trade facilitates in export and import of products and services. Thus, it helps in boosting the confidence of domestic market by making it independent and not relying on the only sources available for certain products and services. Hence proved, that it helps in limiting the scope of risk for the domestic market and providing it with competitive edge over others.

Government Regulations

The rules and regulations imposed by the government also boost the confidence of traders. These regulations help to protect the interests of the marketers and impose strict restrictions on import and export of certain products.

Non-availability in Domestic Market

International trade also helps in overcoming scarcity of certain products and services. This further helps the nation to fulfil its need for the given commodity at cheaper price.

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Methods of International Trade

International Trade can be defined as a process in which exchange of goods and services take place across the borders. There are various methods for carrying out trade internationally, which are mentioned below:

Exporting

It refers to the process in which goods and services are sold and shipped from one country to another. It is of two types namely direct exporting and indirect exporting. Direct exporting is the basic form of export that is most suitable for small companies while indirect exporting is done through intermediaries and has no control over the goods exported in the international market.

Licensing

It refers to an agreement that allows foreign organisations to manufacture owner’s product either exclusively or nonexclusively for a specified time period in a particular market. In this process, the licensee is given limited rights and resources for his or her home country by the licensor. It can be of various types, such as managerial skills, trademarks, technology, patents and so on.

Licensing offers various benefits, which are enlisted below:

• Helps in gaining additional income for developing technology.
  
  
• Facilitates in reaching new unexplored markets that show potential for export.
  
  
• Allows quick expansion plan by eliminating risk and need for large capital investment.
  
  
• Opens the market for future investment.
  
  
• Retains the interests of established domestic market by imposing trade restriction on new entrants from international market.

However, it has some disadvantages also that are given below:

• Results in loss of control of the licensee manufacture and marketing operating and practices that further cause loss of quality.
  
  
• Incompetent partner can risk and ruin the trademark and brand reputation.
  
  
• Foreign partner might end up becoming the competitor of the parent company by selling its own production.

Franchising

According to T.W. Zimmerer “A system in which semi-independent business owners (franchisees) pay fees and royalties to a parent company (franchiser) in return for the right to become identified with its trademark, to sell its products or services, and often to use its business format and system.” In comparison to licensing, these agreements are for longer period of time and wide number of rights and resources are provided to the franchisee by the franchisor.

It offers various advantages that are enlisted below:

• Minimises political risk.
  
  
• Allows continuous and simultaneous expansion globally
  
  
• Encourages partners to bring financial investments and develop managerial capabilities.

Disadvantages of franchising are given below:

• Franchisees may end up becoming future competitors.
  
  
• Leads in selection of wrong franchisor as there is rare demand of franchisor after starting franchising for the company.
  
  
• Selection of wrong franchisee may result in loss of company’s name, reputation, and brand image in the market.
  
  
• Requires larger investment when compared with other methods of international trade, such as export or licensing.

Turnkey Projects

A project in which contractor is paid by the client for designing and constructing new facilities as well as training personnel is called turnkey project. It is basically constructed by the client for selling it the buyer as a complete and finished product. This is a method being frequently used by foreign companies for exporting their technology and process in other countries.

It is done by designing and establishing their plant in the host country. It is generally used by those companies that specialises in complex production technology and are in entry stage. The main benefit offered by turnkey project is that it requires only limited Foreign Direct Investment (FDI) but still can earn profits from the plant established in the foreign country.

Wholly Owned Subsidiaries

These are of two types, namely Greenfield Investment and Acquisitions, which are explained in detail below:

Greenfield Investment

It refers to the establishment of wholly owned new subsidiary and generally it is considered to be a complex and costly process. It helps in providing total control to the organisation as well as provides above average returns. When physical and capital intensive plants are designed then it is preferred option.

The main issue with this method is that it is highly expensive and time consuming process. In this, a third party such as a consultant or business partner is roped in for acquiring knowledge and expertise. Thus, it becomes really time consuming process as it requires time in learning and implementing marketing strategies.

Brownfield Investment or Acquisition

It refers to a popular method for entering global market as it provides quick access of the market. Under this type of investment the organisation acquires (i.e. it purchases) an already established production facility or business in the foreign country. It also helps in increasing the market share of the organisation.

so many MNCs are interested in applying acquisition strategy to increase their market share and power. It provides competitive edge to an organisation as it acquires the technical know-how, financial capabilities, and management capabilities of the acquired organisation.

Joint Venture

It can be arranged as a partnership firm, corporation, or any other form of business organisation as selected by the participating firms. Under the Indian Companies Act, 1956, a joint venture can be incorporated or established as a private or public company.

It has five common objectives that are explained as follows:

• Entry in new market
• Sharing of risk and reward
• Sharing technological know-how
• Joint Product Development
• Adherence to government regulations

It also helps in gaining political connections and accessing new distribution channels. This strategy is suitable only when below mentioned conditions are met:

• When the strategic goals of the partners are same and united, while their competitive goals diversify.
  
  
• The size, market power, and resources of the partner are smaller in comparison to the competitor.
  
  
• Partners are ready to learn from each other while providing limited access to their own propriety skills.

There are certain factors that need to be taken care of in joint venture, namely ownership, control, length of agreement, pricing, access to technology, local firm capabilities and resources, and government intentions.

Problems that can be faced in joint venture are mentioned hereunder:

• Conflicts relating to new investments
• Mistrust over sharing of propriety knowledge
• Performance ambiguity
• Lack of support from parent firm
• Cultural diversification may lead to clashes

Strategic Alliance

It refers to a cooperative agreement that is signed between different firms for the purpose of shared research, formal joint ventures, or minority equity participation. The advantages of this alliance are technological exchange, healthy global competition, industry convergence, economies of scale, and alliance becoming an alternative to merger.

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Theories of International Trade

International trade theories help in understanding its importance and concept. Trade has seen big change from barter system to international trade. In barter system, goods and services are directly exchanged for other goods and services instead of cash. While in international trade, goods and services are exchanged for cash across international border. Now let us discuss different theories of international trade.

Theory of Absolute Advantage

The Theory of Absolute Advantage was propounded by Adam Smith in 1776. According to this theory, any country can be more efficient in producing a certain kind of product in comparison to other countries. This condition will be beneficial for all countries to engage in trade. The other countries can benefit from their respective specialisations and consequently increase productivity. The Theory of Absolute Advantage is subjective in nature.

An example can be used to prove this theory. Suppose there are two countries A and B, which produce tea and coffee with equal amount of resources that is 200 labourers. Country A uses 10 labourers to produce 1 ton of tea and 20 labourers to produce 1 ton of coffee. Country B uses 25 units of labourers to produce tea and 5 units of labourers to produce 1 ton of coffee.

This is shown in Table:

	Country A	Country B
Tea	10	25
Coffee	20	5

It can be seen from Table 1.1 that country A has absolute advantage in producing tea as it can produce 1 ton of tea by using less labourers as compared to country B. On the other hand, country B has absolute advantage in producing coffee as it can produce 1 ton of coffee by employing less labourers in comparison to country A.

Now, if there is no trade between these countries and resources (in this case there are total 200 labourers) are being used equally to produce tea and coffee, country A would produce 10 tons of tea and 5 tons of coffee and country B would produce 4 tons of tea and 20 tons of coffee. Thus, total production without trade is 39 tons (14 tons of tea and 25 tons of coffee).

Table shows the production without the trade between country A and country B:

	Country A (in tons)	Country B (in tons)
Tea	20	0
Coffee	0	40

Without specialisation, total production of countries was 39 tons, which becomes 60 tons after specialisation. Therefore, the theory of absolute advantages shows that trade would be beneficial for both the countries.

Theory of Comparative Advantage

This theory states that two countries can engage in mutual trade, even if one country possesses an absolute advantage in producing all commodities. This theory considers the concept of opportunity cost and states that one country has a greater opportunity cost of manufacturing particular goods while the other country has a greater opportunity cost of manufacturing other goods; even if the first country has an absolute advantage in manufacturing both kinds of goods, they can still involve in trade. Corresponding to theory of absolute advantage, this theory too has practical limitations due to inherent assumptions.

Trade does not work precisely the way the theory of comparative advantage might suggest, for a number of reasons:

• No country specialises exclusively in the production and export of a single product or service.
  
  
• All countries produce at least some goods and services that other countries can produce more efficiently.

According to this theory, a third world country can produce any product more efficiently than a developed country. However, they cannot identify their end customers residing in developed countries or transport their inexpensive products to them. As a result, developed nations continue with the manufacturing of products.

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Product Life Cycle Theory

Product Life Cycle (PLC) theory was given by Raymond Vermon, which is an economic theory. It takes into consideration two important factors that were ignored by the other theories:

• New products are developed as a result of technological innovations.
  
  
• Trade patterns depend on the market structure and the phase in a new product’s life.

According to this theory, rich and developed countries can carry forward the Research and Development (R&D) for producing new products as they have stable patent protection system and people have money to buy or at least try new products.

Figure helps in understanding the different stage in PLC

Introduction

Any new product is first innovated, produced, and sold in the domestic (innovating) country. Generally in the first stage standardisation of the products is not done, which requires more labour oriented production processes. Since, the product is new so the introductory prices are higher in the initial stage.

Growth

As the demand of the product or service grows, competition also increases in the market. This further leads to a steep rise in foreign demand for the product, competition, and exports.

Maturity

The global demand of the product start reaching to peak, the manufacturer follows standardised production process and due to tough global price competition, production site is relocated to lower cost developing countries.

Decline

With the increase in competition, cost issues, and other market factors all production processes are relocated to developing countries.

Theory of Market Imperfection

The previous theories consider market in ideal situations, which does not exist in reality. The deviations from perfect condition are known as market imperfection. This imperfect competition results in high volume of intra industry trade between similarly endowed countries.

It results in emergence of cross-country technology gaps and helps to identify the determinants of dynamic comparative advantage. The explorations of trade with imperfect competition have also deepened substantially our understanding of the costs and benefits of trade policy.

Heckscher and Ohlin Theory: Modern Theory of International Trade

In contrast to absolute advantage and comparative advantage theories that are based on the differences existing between two nations, in

the relative efficiencies of manufacturing goods. This theory assumes similar levels of efficiency but classifies goods into two kinds, namely labour intensive and capital intensive. A labour rich country could lead in producing labour intensive goods where as a capital rich country can take lead in capital intensive goods. When these two types of countries engage in mutual trade, they can then reap the benefits of international trade.

Heckscher and Ohlin theory, given by Swedish Economists Eli Hecksher and Bertil Ohlin, is an extension of theory of comparative advantage. This theory introduces a second factor of production that is capital. Heckscher and Ohlin theory states that comparative advantage occurs from differences in factor endowments between the countries. Factor endowment refers to the amount of resources, such as land, labour, and capital available to a country.

Every country has different factor endowments, thus the costs of these factors differ depending upon their availability. For example, if a country has abundant labour, then the cost of labour would be low in that country. According to Heckscher and Ohlin theory, a country would export products, which it produces by using the abundant factor of production. However, it would import goods, which require use of scarce resources.

Countries trade with each other because they have different factor endowments. For instance, some countries may have more labour and less machinery and some may have more machinery and less labour. In such a case, the country with more labour would specialise in labour-intensive products and export those products to other country.

The assumptions of Heckscher and Ohlin theory are as follows:

• Needs of citizens of the two countries are same.
• Transportation cost between the countries is zero.
• Factors of production in both the countries are immobile.
• Factors of production in both the countries are not available in same proportion

The Heckscher and Ohlin theory shows relationship among various variables. The prices of the factors are determined by their availability, which further determines the price of the product. Cost advantage and specialisation occurs as a result of difference of factor prices and product price.

Theory of Imitation

This theory states that international trade can take place between two countries having similar factor endowments and consumer tastes.Trade starts between two countries as a result of gap between innovation of products and their imitations present in other countries.

There are two limitations in this theory:

• Demand lag is the time gap that exists between the introduction of a new product in one country and the demand for the product by the consumer living in different country.
  
  
• Trade occurs between the two countries when demand lag is shorter than imitation lag.

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International Trade Barrier

Trade barriers can be explained as the restrictions or limitations that are imposed by the government on exchange of goods and services among countries. Government has introduced various trade barriers that include tariffs, foreign exchange restrictions, trade agreements, and trading blocs to name a few. Trade barriers have two broad categories, which are tariff barriers or fiscal controls and non-tariff barriers or quantitative restrictions.

Trade barriers are imposed with different objectives under different situations as under:

• To protect home industries from foreign competition: In most of the developing countries, a major part of basic and heavy industries are still in the initial stage. They have high cost of production and low quality of output. Therefore, such industries need protection from outside competitors.
  
  
• To promote new industries and R&D: Developed countries are enriched with technologies that developing countries are still researching and innovating. Thus, it becomes really important to protect these potential developments from any kind of foreign competition.
  
  
• To conserve foreign exchange reserves: When a country indulges in surplus import then it impacts the foreign currency of the nation, hence government uses certain measures, such as quotas and tariffs for ensuring the proper balance of foreign exchange reserve.
  
  
• To maintain favourable balance of payments: As the name suggests the Balance of Payment (BOP) denotes the gap between inflow and outflow of foreign currency in the economy. When a country has favourable amount of BOP, then it attracts goodwill and more foreign investment for its economic development. Trade barriers imposed by the government plays an important role in import reduction and improving BOP of the nation.
  
  
• To protect national economy from dumping: When an MNC sells its products at price, which is lower than its production cost then it is known as dumping. As an outcome, the domestic manufacturers fail to beat the competition and they withdraw their products and presence from the market. For controlling such situations government may increase tariffs on the dumped goods.
  
  
• To make economy self-reliant: During the beginning stage, budding industries need protection from government. Slowly these protected industries gain strength and stands against the foreign competitors by continuously improving their quality.

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Types of Trade Barriers

Tariffs

Tariffs can be explained as customs duty or tax levied on products that cross the border of a country. It is one of the most effective trade barriers. Tariffs’ are imposed by the government in the form of custom duties and taxes for reducing the imports of certain commodities. Tariffs are basically imposed for maintaining BOP and discouraging the consumption of imported goods. All this is done by increasing the prices of the goods.

Tariff can be classified in several ways based on direction, purpose, length, rate, and distribution point, which are explained as follows:

• Direction: Tariffs are levied on the basis of the direction of product movement; it could be import or export. The export tariffs are mostly applied to an exporting country’s resources or raw materials.
  
  
• Purpose: Tariffs can be classified as protective tariffs and revenue tariffs. As the name suggests, protective tariffs are levied to protect home industry, agriculture, and labour against foreign competitors, its main purpose is to keep foreign goods out of the country. For instance, the South American markets have high import duties to curb the import of fully built cars. On other hand, revenue tariffs are imposed to generate revenues for the government rather than protecting the interests of the domestic industry.
  
  
• Distribution Point: There are few taxes that are collected at a particular point of distribution or during the time of purchases and consumption. Such indirect taxes are of four kinds, namely single-stage, value-added, cascade, and excise. Single-stage sales tax is collected at one point in the manufacturing and distribution chain.
  
  The single-stage sales tax is collected only after selling the product to the final consumers. A value-added tax (VAT) is a multistage tax that is charged on consumption of goods. In simple words, it is a tax levied when a product moves from one hand to another. Excise tax is a one-time charge levied on the sales of specified products. Alcoholic beverages and cigarettes are good examples.

Countervailing Duties

These duties are levied on the subsidised goods that are imported by the home country. Its main purpose is to reduce the advantage that the exporting country enjoys on trading the subsidised goods. A government can provide export subsidy by rebating certain taxes on exported goods.

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Trends in International Trade

International trade plays a vital role in the economic development of any nation. Statistics reveal that the year 2004 saw historic growth in the world of merchandise trade. It touched the milestone of 21%, which has been one of the highest growth rates in 25 years, amounting to nearly USD 8.9 trillion.

The merchandise world expanded 9% in 2004 and the growth rate of merchandise trade is moving rapidly than global Gross Domestic Product (GDP) rate.For example, the growth rate of world trade was 6% on an average in 1994-2004, whereas global GDP at market exchange rates grew less than 3% in the same period.

Some of the major trends are enlisted as follows:

Trade in Agricultural and Manufactured Goods

In the past two decades, world merchandise trade has observed above average growth rate in the manufactured goods sector, which does not include mining products. As a result, they accounted for around three-quarters of world merchandise trade in 2003. In contrast, the share of agricultural goods trade remained at around 9% in the three preceding years, which represented approximately 2% below the average level in the 1990s. Now the demand of processed agriculture goods is high in demand among agriculture goods over the past decade. One can notice this changing trend across the countries.

Trade Between Partners of Regional Trade Agreements (RTAs)

Due to increase in the registration of new RTAs, the trade between them has witnessed a quantum jump. It is predicted that the numbers will increase over a period of time because of present negotiations.

Developing Countries’ Trade

The merchandise trade pertaining to developing countries has increased significantly over the past years with shares jumping to 31%. More and more products are being exported to developed nations with predictions that it will continue to increase in the near future.

South-South Trade

The countries in southern hemisphere are accounting for about 13% of the world merchandise trade with an annual increase of 11%. Lion’s share of export of the developing countries is channelised to the other developing countries. The trade among Asian countries has increased in present time since the growth of East Asian economies.

Air or Express Cargo

Although the share of the air or cargo in world trade is miniscule but still it is growing at a healthy 10% growth rate annually and it is expected to rise in near future. Globalisation accompanied by real time supply and distribution is a primary reason for the explosive growth. The air cargo is considered to be the fastest mode of transfer of goods. However, the rising fuel price has impacted the cost of the product by making it expensive.

Global Production Network

Global production of manufactured goods has increased in recent times, followed by the trade between different countries located across the globe. All the exported goods comprise of the import of intermediate goods. It has helped to enhance the quality of the product by many notches.

Intra-Firm Trade

Intra- firm trade comprise of 30% of the total world trade. Trading in developed countries consists of supply of goods from the manufacturing units to the distributors. Subsidiary of the parent companies located in the middle income nations often produce goods destined for the developed countries. It has gone a long way in providing impeccable results to the organisations so that they can boost their efficiency by many notches.

E-commerce

Electronic commerce is an electronic form of business that has proved to be a vital component of the international trade and business unlike the conventional trade that is still popular all over the world. Internet has been a dominant factor in bringing the suppliers and customers together so that transactions of goods can take place in an effective manner. Rather than straining oneself to visit the neighbourhood store, people can shop online for products offering fabulous deals. It has reduced the cost of the business in a significant manner.

Just-in-Time System

Just-in time system has been immensely successful in meeting the demands of the consumers because there is negligible time lag between the manufactured goods and their eventual delivery to the intended destination. Supply chain is an important tool that helps to eliminate the discrepancy in ensuring the supply of materials, components, and the distribution of manufactured goods to the customers who would be delighted by the offered quality.