Diversification of world trade in manufactured goods has been both a cause and a result of significant changes in how businesses enter foreign markets. Many years ago the term international trade, as measured by exports and imports, was synonymous with international business and international marketing. Today, more and more firms are choosing foreign market investment through licensing, joint ventures, and wholly owned foreign production facilities.
The Law of Comparative Advantage. It should be apparent that a basic motivation of any exchange is that each party hopes to gain more from trading than from not trading. This is the principle upon which the law or doctrine of comparative advantage is based. If a country's climate is not well suited to growing wheat, then it can make better use of its resources by growing something else and trading that for the wheat it wants. If each country specialized in producing products in which it was most efficient, and then traded them for products which it did not make as efficiently, the whole world would have a higher standard of living. Each country would be able to have more variety of goods and more of each kind. These are the principles of the doctrine of comparative advantage:
1. Every region (country or firm) should specialize in producing the goods in which it has the largest comparative advantage
2. Every region (country or firm) should then trade those goods for products in which it has a comparative disadvantage.
3. A trade price will naturally evolve that will benefit both parties and motivate them to engage in trade.
4. All regions will have, as a result, higher standards of living.
What happens if one country produces everything more efficiently than another? Is there no motivation to trade if one party has an absolute advantage in production over another one? The answer is that it depends on the products of comparative advantage that each country has. An example should illustrate this subtlety of the doctrine of comparative advantage.
Let's contrast Mexico and Canada. Mexico has low-cost labor, land that must be irrigated for agriculture, high capital costs and inflation, and a large unskilled and semiskilled labor force. Canada, on the other hand, has comparatively lower inflation and capital costs, a highly educated and skilled labor force, and large amounts of arable land. Mexico's resources are most efficiently used in producing labor-intensive products that do not require a sophisticated labor force. Canada's resources are best used in capital-intensive production and processing of more complex products. It is likely that Mexicans can produce the same quality of shoes cheaper than Canadians because shoe manufacturing requires a lot of semiskilled labor. On the other hand, Canadians can assemble automotive parts of a desired quality at a lower price than Mexicans because their labor force is better trained for that type of precise engineering. Let's further assume (unrealistically) that Canadians and Mexicans are each able to produce and consume only shoes and automotive parts – a two-commodity economy in each country.
Mexico's most efficient use of resources is in shoe production; auto parts are therefore more expensive than in Canada. Canada is more efficient in producing auto parts than shoes; auto parts are cheaper.
The example used to illustrate the law of comparative advantage was unrealistically simple: Each country could produce only two products, there were no economies or diseconomies of scale, nor were there tariffs or transportation costs. These types of refinements are made by economists and politicians when determining the effects of international trade on the domestic economy and when they are developing trade regulations. However, the basic point remains: Specialization and trade can benefit all parties. Trade theory also can be used to explain and predict differences in wage rates among countries (due to relative productivities of labor forces) and differences in monetary values (due to differing amounts of resources and efficiency in use of resources).
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