Objectives:
- Introduce concepts of international trade as the basis for international finance
- Set out the basic theories underpinning international trade
- Highlight the elements that constitute international financial environment
We introduce the concept of international finance by first looking at the international trade which gives rise to the need for international finance. International trade arises because of differences in the demand for and the supply of goods between countries. Some countries may be unable to produce certain goods they require, or to produce them in sufficient quantities or in a cost-effective manner -for example, the USA is a net importer of oil. Conversely, on the supply side production of certain commodities, or the presence of certain commodities and resources, is unevenly distributed throughout the world -for example, oil in the Middle East. Such commodities/resources are often restricted to an area, and are relatively immobile between one country and another (especially natural resources and labour), but may be sold to those with a demand for the resource concerned. Countries thus tend to specialize in those areas in which they enjoy the greatest comparative advantage.
Absolute and Comparative Advantage
It is easy to see why foreign trade is advantageous when a country cannot, perhaps for reasons of climate or natural resources, produce particular goods which it desires but can purchase them from another country which can provide them. For example, the UK has no diamond reserves but has oil, whilst South Africa has no oil but has diamonds -thus both nations can benefit by exchanging one for the other. However, even countries such as France and Germany, which have many similar natural resources, still benefit from trading. This can be explained by the theory of absolute advantage.
Absolute advantage
A country which is able to produce a good using less labour and capital than another country is said to have absolute advantage in the production of that good. Thus, we might consider that Germany has the absolute advantage over France in the production of high-performance cars (such as Porsche and Mercedes), but France has the absolute advantage in the production of inexpensive cars (such as Citroen). This means that due to the concentration of skilled labour and production facilities it is more efficient in terms of the usage of resources (minimizing the capital and labour required) to produce Porsches and Mercedes in Germany and Citroens in France, and to import/export cars to meet the needs of the populations of the two nations. Such trade, by utilizing the more efficient production methods, means that more goods will be produced from the fixed level of natural resources.
Comparative advantage
In certain trading relationships (e.g. the USA and India) it can be shown that one of the countries has the absolute advantage in the production of all goods (the USA has a higher output per unit of labour and per unit of capital than India). However, specialization of production and trade between countries can still be advantageous toboth countries if each has a comparative cost advantage in the production of a good, and concentrates on the production of that good. Remember that when economists refer to comparative costs they are considering opportunity costs and not absolute costs -i.e. the production of other goods foregone by producing X rather than Y will differ between countries.
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