Why Should Nations Trade?

In order to understand why businesses want to operate in a complex global environment, we must first understand two fundamental concepts that drive almost all business decisions: absolute and comparative advantage. Countries and companies want to engage in global trade because they believe that they have an advantage over the competition that they can turn into profits. Not all countries have the same natural resources, infrastructure, labor force, or technology. These differences create advantages that can be exploited in global trade, to a country’s (or company’s) benefit.

absolute vs. comparative advantage

An entity (country, region, company, or individual) has an absolute advantage if it can produce a good or service at a lower cost than another or if it is the only one that can provide that product. An entity is considered to have a comparative advantage over another in producing a particular good or service if it can produce the good or service at a lower opportunity cost relative to the opportunity costs of a potential competitor.

Absolute Advantage

The countries that are members of OPEC (The Organization of the Petroleum Exporting Countries) such as Venezuela and Saudi Arabia, have an absolute advantage in producing oil. Because oil is an abundant natural resource in OPEC countries, they can produce it at a lower cost than other countries that may have to use expensive techniques such as offshore drilling in the ocean. 

Climate can also result in an absolute advantage. Countries such as Brazil and Vietnam have conditions where coffee can grow very well. Countries like Canada with colder climates would not be able to grow coffee without using expensive methods of climate control. It is more efficient for businesses in Canada to buy coffee from Brazil than to try and grow it themselves.

Comparative Advantage

Recall from the economic environment module that opportunity cost is the value of the next best alternative. Since countries and businesses have limited resources, they are forced to make choices about how they allocate those resources. For example, India and Vietnam have a comparative advantage in producing clothing because of lower labor costs. Japan has long held a comparative advantage in consumer electronics because of technological expertise. The United States has an advantage in computer software, airplanes, some agricultural products, heavy machinery, and jet engines. Each country should specialize in the products that it can produce most readily and cheaply and trade those products for goods that foreign countries can produce most readily and cheaply. This specialization ensures greater product availability and lower prices.