- Explain what globalization is and how it is related to business
- Understand why absolute and comparative advantage make companies want to do business in foreign markets
- Understand the difference between balance of trade and balance of payments
- Understand the difference between trade deficits and trade surpluses
What Is Globalization?
You can view the transcript for “Globalization easily explained” (opens in new window) or the text alternative for “Globalization easily explained” (opens in new window).
Absolute and Comparative Advantage
The following video provides an excellent illustration of comparative and absolute advantage and explains why they are such important considerations in how countries decide to specialize and trade.
You can view the transcript for “Episode 34: Comparative Advantage & Trade” (opens in new window) or the text alternative for “Episode 34: Comparative Advantage & Trade” (opens in new window).
Balance of Trade
Balance of trade is the difference between the value of a country’s imports and its exports, as follows:
value of exports – value of imports = balance of trade
NOTE: It’s important to use this formula just as it’s presented, without altering the sequence of values.
Imagine Nation’s Balance of Trade
Let’s look at the balance of trade for “Imagine Nation.”
Imagine Nation is located in a region that lacks phosphate as a natural resource. However, it does have an abundance of sugarcane. As a result of its comparative advantages, Imagine Nation imports phosphate from Christmas Island (it’s a real place in Australia—look it up!) to fertilize the sugarcane it grows, and it uses the sugarcane to manufacture saltwater taffy, which it exports to Christmas Island.
The following table shows Imagine Nation’s imports and exports with Christmas Island in 2021.
| Year | Imports (phosphate) | Exports (taffy) |
|---|---|---|
| 2021 | $45,000,000 | $75,000,000 |
Using these figures, we can easily calculate Imagine Nation’s balance of trade in 2021:
$75,000,000 (exports) − $45,000,000 (imports) = $30,000,000
This means that Imagine Nation had a trade surplus of $30,000,00 with Christmas Island, since exports exceeded imports. We can also say that Imagine Nation was a “net exporter,” meaning it exported more than it imported.
However, the picture changed in 2022, when the Australian government closed the phosphate mine on Christmas Island. Imagine Nation had to import phosphate from Morocco, instead, and was not able to get the same favorable pricing as before. Consequently, sugarcane farmers paid more for fertilizer, the price of sugarcane went up, and Imagine Nation had to raise the price on its saltwater taffy. Sadly, the people of Morocco aren’t really big fans of saltwater taffy, so exports fell. The following table shows Imagine Nation’s imports and exports with Morocco in 2022.
| Year | Imports (phosphates) | Exports (taffy) |
|---|---|---|
| 2022 | $65,000,000 | $55,000,000 |
We can use the figures to calculate Imagine Nation’s balance of trade:
$55,000,000 (exports) − $65,000,000 (imports) = −$10,000,000
The negative number indicates a trade deficit of $10,000,000, showing that Imagine Nation imported more from Morocco than it exported. We would say that Imagine Nation became a “net importer”—importing more than it was exporting.
Obviously, this is a simple example. A country’s global business doesn’t amount to just trading phosphate and taffy or cell phones and blue jeans. It includes all kinds of financial transactions: goods and services imported and exported, foreign investments, loans, transfers, and so on. Tracking all these payments provides another way to measure the size of a country’s international trade: the balance of payments.
Balance of Payments
A country’s balance of payments is calculated as follows:
total money coming into a country (inflow) − total money going out (outflow) = balance of payments
NOTE: It’s important to use this formula just as it’s presented, without altering the sequence of values.
Imagine Nation’s Balance of Payments
Let’s examine Imagine Nation’s balance of payments in 2022. The following table shows all of its external transactions during the year.
| Year | Imports (phosphates) | Exports (taffy) | Foreign aid (loan) from Hooperland | Purchase of Wandaland assets |
|---|---|---|---|---|
| 2022 | $65,000,000 | $55,000,000 | $25,000,000 | $30,000,000 |
When we calculated Imagine Nation’s balance of trade in 2022, we did not take into account the following two transactions:
- Imagine Nation received foreign aid in the form of a loan from the government of Hooperland in the amount of $25,000,000. This inflow of funds will affect Imagine Nation’s balance of payments.
- Imagine Nation invested in a factory in Wandaland and purchased the factory from the government for $30,000,000. This outflow of funds will affect Imagine Nation’s balance of payments.
When we calculate Imagine Nation’s 2022 balance of payments, by taking the inflows (revenue from exports and foreign aid) and subtracting the outflows (payments for imports and purchase of foreign assets), the balance is negative, as shown below:
($55,000,000 + $25,000,000) (total inflow) – ($65,000,000 + $30,000,000) (total outflow) = −$15,000,000
What effect will this have on Imagine Nation? Well, when Imagine Nation’s leader is briefed by her council of international economic advisers, they will inform her that the country currently has an “unfavorable balance of payments.” That is, less money is coming into the country than is going out. If, on the other hand, the balance of payments were a positive number (inflow exceeded outflow), then Imagine Nation could say that it has a “favorable balance of payments.”