International Trade (Intl Trade) 101: International Trade Theories - Comparative Advantage, David Ricardo Opportunity Cost Gains from Trade Terms of Trade

What This Is

Comparative Advantage is a fundamental concept in international trade that explains why countries trade with each other despite having different production costs. It was first introduced by David Ricardo in 1817. Imagine a shipment of apples from the US to China. The US has a comparative advantage in producing apples due to its favorable climate and lower labor costs. China, on the other hand, has a comparative advantage in producing electronics. By trading with each other, both countries can benefit from specialization and gain from trade.

Key Terms & Rules

• Comparative Advantage: The ability of a country to produce a good or service at a lower opportunity cost than another country.
• Opportunity Cost: The value of the next best alternative that is given up when a choice is made.
• Gains from Trade: The benefits that countries receive from trading with each other, including increased efficiency and specialization.
• Terms of Trade: The ratio of the price of a country's exports to the price of its imports.
• Incoterms: A set of international trade terms that define the responsibilities of buyers and sellers in the delivery of goods.
• FOB (Free on Board): A trade term that indicates the seller is responsible for the goods until they are loaded onto the ship.
• CIF (Cost, Insurance, and Freight): A trade term that indicates the seller is responsible for the goods until they are delivered to the buyer's destination.
• UCP 600 (Uniform Customs and Practice for Documentary Credits): A set of rules that governs the use of letters of credit in international trade.
• LC (Letter of Credit): A financial instrument that guarantees payment to the seller upon presentation of compliant documents.
• Duty Calculation: The process of calculating the amount of customs duty owed on imported goods.

Step-by-Step Process

1. Identify Comparative Advantage: Determine which country has a comparative advantage in producing a particular good or service.
2. Calculate Opportunity Cost: Calculate the opportunity cost of producing a good or service in each country.
3. Determine Gains from Trade: Calculate the gains from trade that each country can expect to receive from trading with each other.
4. Negotiate Terms of Trade: Negotiate the terms of trade, including the price and quantity of goods to be traded.
5. Use Incoterms: Use Incoterms to define the responsibilities of buyers and sellers in the delivery of goods.
6. Establish LC: Establish a letter of credit to guarantee payment to the seller upon presentation of compliant documents.

Common Mistakes

• Mistake: Confusing CIF and CIP trade terms.
• Correction: CIF indicates the seller is responsible for the goods until they are delivered to the buyer's destination, while CIP indicates the seller is responsible for the goods until they are delivered to the buyer's destination, but the buyer is responsible for insurance.
• Mistake: Assuming "open account" is risk-free.
• Correction: Open account means the buyer pays the seller directly, without a letter of credit or other financial instrument, which can be risky for the seller.
• Mistake: Misusing "free on board" with air freight.
• Correction: FOB is typically used with sea or inland waterway transportation, not air freight.

Exam / Certification Tips

• FOB vs FCA: FOB indicates the seller is responsible for the goods until they are loaded onto the ship, while FCA indicates the seller is responsible for the goods until they are delivered to the buyer's destination.
• Confirmed vs Unconfirmed LC: A confirmed LC is guaranteed by a bank, while an unconfirmed LC is not guaranteed.
• DPU (Destination Port Unloaded) vs DAT (Destination Arrival Terminal): DPU indicates the seller is responsible for the goods until they are unloaded at the destination port, while DAT indicates the seller is responsible for the goods until they are delivered to the buyer's destination.

Quick Practice Scenario

A Chinese exporter sells goods to a US importer under FOB Shanghai. Who pays for the main carriage?

Answer: The buyer (US importer) pays for the main carriage.

Explanation: Under FOB Shanghai, the seller (Chinese exporter) is responsible for the goods until they are loaded onto the ship, but the buyer (US importer) is responsible for the main carriage.

Last-Minute Cram Sheet

• Comparative Advantage: The ability of a country to produce a good or service at a lower opportunity cost than another country.
• Opportunity Cost: The value of the next best alternative that is given up when a choice is made.
• Gains from Trade: The benefits that countries receive from trading with each other, including increased efficiency and specialization.
• Terms of Trade: The ratio of the price of a country's exports to the price of its imports.
• Incoterms: A set of international trade terms that define the responsibilities of buyers and sellers in the delivery of goods.
• FOB (Free on Board): A trade term that indicates the seller is responsible for the goods until they are loaded onto the ship.
• CIF (Cost, Insurance, and Freight): A trade term that indicates the seller is responsible for the goods until they are delivered to the buyer's destination.
• UCP 600 (Uniform Customs and Practice for Documentary Credits): A set of rules that governs the use of letters of credit in international trade.
• LC (Letter of Credit): A financial instrument that guarantees payment to the seller upon presentation of compliant documents.
• Duty Calculation: The process of calculating the amount of customs duty owed on imported goods.
• Under FOB, risk transfers when goods are on board the vessel – not at the port gate or on the dock.
• CIF indicates the seller is responsible for the goods until they are delivered to the buyer's destination, but the buyer is responsible for insurance.