4.1: Why Do Nations Trade?

Globalization refers to the economic and social integration between countries and the increased flow of goods, services, and people across borders.

The globalization of business is bound to affect you. Not only will you buy products manufactured overseas, but it’s likely that you’ll meet and work with individuals from various countries and cultures as customers, suppliers, colleagues, employees, or employers. The bottom line is that the globalization of world commerce has an impact on all of us, as evidenced in Figure 4.1: The Expanded Circular Flow Model. Therefore, it makes sense to learn more about how globalization works.

Nations trade to capitalize on their unique advantages and to foster economic growth, enhance living standards, and build relationships with other countries. Trade allows countries to access products and services they cannot produce efficiently or lack altogether, enhancing consumer choice and quality of life. Tropical fruits are imported by colder countries like Canada because they cannot be grown domestically. By producing for export, businesses can achieve economies of scale, lowering production costs and making goods more affordable domestically and abroad. Automotive manufacturers in Germany produce vehicles on a large scale, selling them globally. Trade fosters innovation and the spread of new technologies, ideas, and practices, driving development and competitive advantage. Collaboration in international technology markets has accelerated advancements in renewable energy. Trade builds interdependence, reducing the likelihood of conflicts and fostering diplomatic relations. For example, the European Union promotes trade among its member states to strengthen regional stability and cooperation. Exporting goods and services generates income, creates jobs, and boosts the national gross domestic product (GDP). The export of oil and gas has been a significant contributor to Canada’s economic growth.

Why does Canada import automobiles, steel, digital phones, and apparel from other countries? Why don’t we just make them ourselves? Why do other countries buy wheat, chemicals, machinery, and lumber products from us? This is because no national economy produces all the goods and services that its people need. Countries are importers when they buy goods and services from other countries; when they sell products to other nations, they’re exporters. In 2023, the total value of world trade in merchandise and commercial services was $30.5 trillion, a 2% decrease from the previous year. This was due to a 5% decline in the value of goods trade, while the value of services trade increased by 9%. ^[1]

Factors that have impacted trade in recent years include:^[2]

• The war in Ukraine
• High inflation
• Tightening monetary policy in major economies
• High energy prices
• Rising interest rates
• Geopolitical tensions
• Food and energy insecurity
• Increased risk of financial instability
• High levels of external debt

Absolute and Comparative Advantage

To understand why certain countries import or export specific products, you need to realize that every country (or region) cannot produce the same products. The cost of labour, the availability of natural resources, and the level of know-how vary greatly around the world. Most economists use the concepts of absolute advantage and comparative advantage to explain why countries import some products and export others.

Absolute Advantage

A nation has an absolute advantage if (1) it’s the only source of a particular product, or (2) it can make more of a product using fewer resources than other countries. Because of climate and soil conditions, for example, France had an absolute advantage in wine making until its dominance of worldwide wine production was challenged by the growing wine industries in Italy, Spain, the United States, and, more recently, Canada. Unless an absolute advantage is based on some limited natural resource, it seldom lasts. That’s why there are few, if any, examples of absolute advantage in the world today.

Comparative Advantage

When a country decides to specialize in a particular product, it must sacrifice the production of another product (opportunity costs). Countries benefit from specialization—focusing on what they do best, and trading the output to other countries for what those countries do best. Canada’s top export destinations are the United States, China, and the United Kingdom. In 2023, the United States was the destination for 76% of Canada’s exports.^[3]

Canada’s energy exports make up 22% of its total exports. In 2023, the top exports in this category were mineral fuels, oils, and distillation products. Cars and parts are one of Canada’s biggest exports, making up 19% of its total exports. In 2023, the top exports in this category were vehicles other than railway and tramway. Consumer goods make up 12% of Canada’s total exports. Canada exports a variety of minerals, including potash, metallurgical coal, and diamonds. In 2022, Canada was the world’s biggest exporter of potash. Canada also exports machinery, nuclear reactors, boilers, pearls, precious stones, metals, and coins.^[4]

The United States, for instance, is increasingly an exporter of knowledge-based products, such as software, movies, music, and professional services (management consulting, financial services, and so forth). America’s colleges and universities, therefore, are a source of comparative advantage, and students from all over the world come to the United States for the world’s best higher-education system. France and Italy are centers for fashion and luxury goods and are leading exporters of wine, perfume, and designer clothing. Japan’s engineering expertise has given it an edge in such fields as automobiles and consumer electronics. And with large numbers of highly skilled graduates in technology, India has become the world’s leader in low-cost, computer-software engineering.

How can we predict, for any given country, which products will be made and sold at home, which will be imported, and which will be exported? This question can be answered by looking at the concept of comparative advantage, which exists when a country can produce a product at a lower opportunity cost compared to another nation. But what’s an opportunity cost?

Opportunity Costs

Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that is desired. A fundamental principle of economics is that every choice has an opportunity cost.

• If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss.
• If you spend your income on video games, you cannot spend it on movies.
• If you choose to marry one person, you give up the opportunity to marry anyone else.

In short, opportunity costs are all around us. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else; in short, opportunity cost is the value of the next best alternative. Since people and businesses must choose, they inevitably face trade-offs in which they must give up things they desire to get other things they desire more.

Opportunity Cost and Individual Decisions

In some cases, recognizing the opportunity cost can alter personal behaviour. Imagine, for example, that you spend $10 on lunch every day at work. You may know perfectly well that bringing lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $7 each day (that is, the $10 that buying lunch costs minus the $3 your lunch from home would cost). Seven dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 workdays a year × $7 per day equals $1,750—it is the cost, perhaps, of a decent vacation. If the opportunity cost were described as “a nice vacation” instead of “$7 a day,” you might make different choices.

Opportunity Cost and Societal Decisions

Opportunity cost also comes into play with societal decisions. These trade-offs also arise with government policies. For example, after the terrorist plane hijackings on September 11, 2001, many proposals, such as the following, were made to improve air travel safety in the United States:

• The federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year.
• Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million.
• Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face-recognition software, would cost another $2 billion.

Lost time can be a significant component of opportunity cost.

However, the single biggest cost of greater airline security does not involve money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation, more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travellers are relatively highly paid business people, conservative estimates set the average “price of time” for air travellers at $20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as substantial as costs involving direct spending.

Media Attributions

“Figure 4.1: The Expanded Circular Flow: Firms, Government, Households, Financial Markets, Rest of the World” is adapted from Chapter 4: Business in a Global Environment in Introduction to Canadian Business, © Business Faculty from Ontario Colleges and eCampusOntario Program Managers, licensed under CC BY-NC-SA.

Image descriptions

Figure 4.1

A flowchart depicting economic interactions between different sectors: Rest of the World is at the centre top; on the middle level is Households, Government, and Firms; Financial Markets is at the centre bottom of chart.

Each entity is represented by a colored box with grey arrows illustrating the flow of economic activities between each entity.

“Households” interacts with “Government” through “Taxes” and receive back “Wages, Interest & Transfer Payments,” Households also interact with “Firms” via “Expenditures on Goods and Services”

“Firms” deal with “Government” via “Business Taxes” and receive back “Purchases of Goods & Services,” “Firms” also deal with “Households” by “Payment of Wages, Rent, Interest, and Profit.”

“Financial Markets” interact with “Households” through “Saving” and provide “Payment of Wages, Rent, Interest, and Profit” to “Government” and “Borrowing for investment” to “Firms.”

The “Rest of the World” receives through “Expenditures by Domestic Households on Imports” from Households and sends “Expenditures by Foreign Households on Domestic Goods and Services (Exports)” to “Firms.”

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