Different nations arise largely because of historical, political, and geographical factors. In practical  terms,  however,  nations  are  identified with  their  governments, which  take actions that affect the domestic and global economies. This level of decision-making is one feature that distinguishes the study of international trade from the study of traditional economics. Our usual presumption is that governments act in order to maximize the overall income and welfare of the economy. As we will see, however, this presumption is often untrue. International economics can be divided conveniently into two parts: real analysis or trade theory, and monetary analysis or international finance. Real analysis studies the reasons that trade takes place, the implications for commodity and factor price of changes in real variables (such as the stock of capital and the supply of labor), the benefits that accrue from  international  trade,  and  the  effect  of  trade  restrictions  on  the  welfare  of  the economy. Because its focus is equilibrium determination of real trade flows and welfare, trade theory generally analyzes barter exchange expressed in terms of a numeraire good. It ignores macroeconomic disequilibrium problems by assuming the existence of full employment and  aggregate trade  balance.  

Monetary analysis,  on  the  other  hand,  is concerned with such issues as the determination of exchange rates and the international transmission of unemployment and inflation. Often the two branches of international economics use different methodologies, with trade theory using market-clearing microeconomic equilibrium processes and international finance using macroeconomic concepts such as a single aggregate output and price level, in which there can be short- run  fluctuations. However, this  distinction can  easily be overdrawn. In  recent years economists have made great strides in integrating the two approaches by  modelling aspects of international finance, such as the existence of an aggregate trade deficit, as the result of microeconomic equilibrium processes in which agents trade goods both across borders and over time. 

The subject matter of this discourse concerns the trade in commodities and factors that takes place among nations. One question naturally arises: why is it necessary to distinguish trade  between  nations  from  trade  between  regions,  and  even  from  trade  between individual  consumers?  The  basic  motivations  for  all  such  exchanges  are  similar, including differences in tastes and factor endowments. However, there are some unique features of international trade. First, though it is reasonable to assume that labor is completely mobile within a country, labor mobility among countries is severely restricted because of government regulation and differences in such things as language, religion, and social customs. Indeed, it is usually assumed in trade theory that labor is completely immobile among countries. Much of the theory of international trade also assumes capital to be immobile among countries, though we thoroughly analyze the implications of capital mobility later in the course of discussion in this course material. 

Differences in the degree of factor mobility are important because they help govern the incentives for and the implications of trade in commodities. A second distinguishing feature of international trade is the govern-mental regulatory power that does not exist in individual or interregional trade. Countries impose tariffs and nontariff barriers against imports. They limit the free flow of factors of production among countries and even adjust domestic policies so as to change the pattern of international trade. Such activities are virtually unknown among regions within the same country and in  many  countries are  actually against  the  law.  For  example,  the  U.S.  Constitution reserves to Congress the right to regulate interstate commerce, implying that individual states cannot erect barriers against imports from other states. This dichotomy between interregional and international trade policies is quite interesting. Infact, it reflects a popular, though flawed, view that trade among agents within a country is beneficial while international trade may be costly.

People in wealthier nations often argue that trade with poorer nations is harmful because it invites competition from low-wage foreign labor, while people in poorer countries make the opposite case that trade with countries with high-level technologies is unfair. These two views are fundamentally mercantilist in nature, in that they see international trade as taking place within a fixed-sum game. The gains to one country are accompanied by losses to another country. This view is wrong because International exchange, like trade among domestic agents, tends to expand aggregate incomes in all countries. Indeed, a substantial point of inquiry will be to investigate the nature of the gains from trade, or the benefits from international commerce. To gain a basic understanding of this question, however, note that countries would be worse off if they were precluded from trading. For example, if Canada were not able to export commodities such as wheat and other grains and natural resources, Canadians could not enjoy their present standard of living. Japan imports raw materials and exports final  products; without  such  trade  the  real  incomes  of  workers  in  Japan  would  be significantly lower. Even large and diverse economies such as that of the United States depend on foreign trade to supply a significant proportion of essential commodities such as petroleum and automobiles. Attaining self-sufficiency at the national level is no more feasible than it would be for a single family to produce all the goods it must consume. 

Globally, international trade has grown considerably in recent decades. For example, over the period between 1963 and 1979, the rate of expansion of real merchandise exports (that is, the value of exports deflated by changes in export prices) in the world averaged 11.8 percent per year, a remarkably high growth rate by historical standards. Indeed, this figure  likely  underestimates the  true  growth  in  the  real  volume  of  exports  because available price data do not adequately account for the marked improvements in product quality in recent years. At the same time, global growth in real output, measured by gross domestic product (GDP) in each country, averaged 6.1 percent per year, also high by historical standards. Thus, during that period, the world experienced a rapidly rising effective integration among countries as they become more closely interrelated through international trade in goods. This trend continued after 1979, though economic activity grew at markedly slower rates. Over the period between 1979 and 1991, real export growth averaged 4.4 percent per year, while real output expansion averaged 2.9 percent per year. 

Canada is an excellence example of a nation that economists regard as open in the sense that international transactions represent a highly significant proportion of overall activity. For example, in Canada exports now tend to comprise a larger component of national demand than investment. The United States has slowly but steadily seen the importance of exports in GDP rise over time. Over seven percent of U.S. GDP in 1991 was produced for export, a figure that amounted to some $398 billion. While this is a substantial sum, the United States retains the lowest export-to-GDP ratio among the major industrialized nations. 

The primary reason for this is simply that the United States is such a large country that relatively little of its output needs to be produced for the foreign sector. Most of its output may be sold in the huge domestic market with its diversified tastes. The European Community (EC) provides a good example of a set of countries that are intimately interrelated through international transactions. The EC is an example of a customs union, in which the member countries erect no barriers to imports from the other members white adopting a common set of restrictions on imports from outside the union. This   structural  provides  a   strong  measure  of   economic  integration  among  the participating nations. 

Accordingly, over 22 percent of the total GDP in these economies is exported, much of it to other countries within the Community. Over time, each of the twelve countries has become more open in the sense considered hero, in large part because of the integration of their economies through trade. Spain, for example, joined the EC in 1986 and has seen its trade with other EC members rise rapidly. An  additional factor in  the  strength of  trade among the  EC  nations is simply their proximity to one another, which limits associated transport costs. This element is an equally strong consideration in the trade behavior of other Western European countries. Switzerland has long had a strong export-component in GDP, reflecting its close trading relationships with the EC and other Western European countries. 

Similarly, the marked growth in Turkey's export position reflects its proximity to Europe. In contrast, the relatively small ratio of exports to GDP in Japan reflects in some part the geographical isolation of that country from the other industrialized markets. Note that the world as a whole also experienced a marked rise  in the importance of exports relative to production, with the ratio rising from 10.1 percent to 15.4 percent between 1970 and 1991.  This  reaffirms  our   earlier  observation  that  the  globe  has  become  more economically interrelated in recent decades. Of course, exports are only one part of this story. Exports may not equal imports in a particular year for any country, reflecting the existence of merchandise trade deficits or surpluses. Of more interest here is that imports tend to rise along with exports over time as countries become more integrated. Thus, for example, if we were to compute for a given country the ratio of imports to GNP -a rough measure of the importance of foreign sources of consumption goods and intermediate products, we would likely find that it has risen in relationship to the risen in the exports-to-GDP ratio. In 1991 this ratio would have been 8.9 percent for the United States, 22.5 percent for Germany, and 6.4 percent for Japan.

Despite the fact that in some countries, such as the United States and Japan, trade is relatively less important than in others, international transactions still have an extremely important influence on the overall level of economic activity. This point was clearly emphasized by the mid-1970s energy crisis in the United States. Although at the time, less than five percent of the United States consumption of petroleum products originated in the OPEC countries, those countries' restrictions on supply and the resulting increases in energy prices brought about significant disruptions in the American economy. The impact was even more dramatic in Japan, where nearly all petroleum products must be imported. The oil price increases of the 1970s hastened Japan‘s shift into alternative energy sources, including nuclear power.

Levels of trade can be significant in particular sectors of the economy even if the overall trade ratios are modest. For instance, the United States imports all of its consumption of certain tropical products, such as cocoa. Looking at two major domestic sectors, in 1990 the United States exported over 45 percent of its agricultural production and imported over 43 percent of its consumption of motor vehicles and automobile parts. Clearly, changes in the international economy that affect these sectors bear potentially significant impacts on domestic prices, output, and employment. Further, such impacts can spill over into other portions of the economy through their effects on consumer demand and input purchases. A fundamental concept in international trade theory is comparative advantage. 

The gains from trade can be conveniently broken down into gains from two distinct sources: gains from exchange and gains from specialization. The gains from exchange refer to the fact that if individuals or countries are endowed with different amounts of goods or have different preferences, they can both gain by trading with each other. In  modern society no one is self- sufficient,  and  indeed,  most  people  engage  in  an  extremely  narrow  range  of  work activities in order to earn income to buy a wide range of goods and services. Everyone seems to grasp the idea that we would have a much lower standard of living if people all tried to grow their own food, make their own clothes, build their own houses, and so forth. Specialization in a narrow range of activities is efficient.

In economics, gains from trade refers to the net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade. Gains from trade are commonly described as resulting from specialization in production from  division  of  labor,  economies  of  scale,  scope,  and  agglomeration  and  relative availability of factor resources in types of output by farms, businesses, location and economies, a resulting increase in total  output possibilities, trade through markets from sale of one type of output for other, more highly valued goods. 

Market incentives, such as reflected in prices of outputs and inputs, are theorized to attract factors of production, including labor, into activities according to comparative advantage, that is, for which they each have a low opportunity cost. The factor owners then use their increased income from such specialization to buy more-valued goods of which they would otherwise be high-cost producers, hence their gains from trade. The concept may be applied to an entire economy for the alternatives of  autarky (no trade) or trade. A measure of total gains from trade is the sum of  consumer surplus and producer profits or, more roughly, the increased output from specialization in production with resulting trade. Gains from trade may also refer to net benefits to a country from lowering barriers to trade such as  tariffs on imports.

Factors affecting gains from trade
There are several factors which determine the gains from international trade: 

1. Differences in cost ratio: The gains from international trade depends upon the cost ratios of differences in comparative cost ratios in the two trading countries. The smaller the difference between exchange rate and cost of production the smaller the gains from trade and vice versa.

 2. Demand and supply: If a country has elastic demand and supply gains the gains from trade are higher than if demand and supply are inelastic. 

3. Factor availability: International trade is based on the specialization and a country specializes depending upon the availability of factors of production. It will increase the domestic cost ratios and thereby the gains from trade.

 4. Size of country: If a country is small in size it is relatively easy for them to specialize in the production of one commodity and export the surplus production to a large country and can get more gains from international trade. Whereas if a country is large in size then they have to specialize in more than one good because the excess production of only one commodity cannot be exported fully to a small sized country as the demand for good will reduce very frequently. So the smaller the size of the country, the larger the gain from trade. 

5. Terms of Trade: Gains from trade will depend upon the terms of trade. If the cost ratio and terms of trade are closer to each other more will be the gains from trade of the participating countries. 

6. Productive Efficiency: An increase in the productive efficiency of a country also determines its gains from trade as it lowers the cost of production and price of the goods. As a result, the country importing gains by importing cheap goods