Trade Definition in Finance: Benefits and How It Works (2024)

What Is Trade?

Trade is the voluntary exchange of goods or services between different economic actors. Since the parties are under no obligation to trade, a transaction will only occur if both parties consider it beneficial to their interests.

Trade can have more specific meanings in different contexts. In financial markets, trade refers to purchasing and selling securities, commodities, or derivatives. Free trade means international exchanges of products and services without obstruction by tariffs or other trade barriers.

How Trade Works

As a generic term, trade can refer to any voluntary exchange, from selling baseball cards between collectors to multimillion-dollar contracts between companies.

In macroeconomics, trade usually refers to international trade, the system of exports and imports that connects the global economy. A product sold to the global market is anexport, and a product bought from the global market is animport. Exports can account for a significant source of wealth for well-connected economies.

International trade results in increased efficiency and allows countries to benefit fromforeign direct investment(FDI) by businesses in other countries. FDI can bring foreign currency and expertise into a country, raising local employment and skill levels. For investors, FDI offers company expansion and growth, eventually leading to higher revenues.

A trade deficit is a situation where a country spends more on aggregateimportsfrom abroad than it earns from its aggregateexports. A trade deficit represents an outflow of domestic currency to foreign markets. This may also be referred to as a negativebalance of trade(BOT).

International Trade

International trade occurs when countries put goods and services on the international market and trade with each other. Without trade between different countries, many modern amenities people expect to have would not be available.

Comparative Advantage

Trade seems to be as old as civilization itself—ancient civilizations traded with each other for goods they could not produce for themselves due to climate, natural resources, or other inhibiting factors. The ability of two countries to produce items the other could not and mutually exchange them led to the principle of comparative advantage.

This principle, commonly known as the Law of Comparative Advantage, is popularly attributed to English political economistDavid Ricardoand his book On the Principles of Political Economy and Taxation in 1817. However, Ricardo's mentor James Mill likely originated the analysis.

Ricardo famously showed how England and Portugal benefited by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to manufacture cloth cheaply. By focusing on their comparative advantages, both countries could consume more goods through trade than they could in isolation.

The theory of comparative advantage helps to explain why protectionism is often counterproductive. While a country can use tariffs and other trade barriers to benefit specific industries or interest groups, these policies also prevent their consumers from enjoying the benefits of cheaper goods from abroad. Eventually, that country would be economically disadvantaged relative to countries that conduct trade.

Example of Comparative Advantage

Comparative advantage is one country's ability to produce something better and more efficiently than others. Whatever the item is, it becomes a powerful bargaining tool because it can be used as a trade incentive for trading partners.

When two countries trade, they can each have a comparative advantage and benefit each other. For instance, imagine a country that has limited natural resources. One day, a shepherd stumbled upon an abundant cheap and renewable energy source only occurring within that country's borders that could provide enough clean energy for its neighboring countries for centuries. As a result, this country would suddenly have a comparative advantage it could market to trading partners.

Imagine a neighboring country has a booming lumber trade and can manufacture building supplies much cheaper than the country with the new energy source, but it consumes a lot of energy to do so. The two countries have comparative advantages that can be traded beneficially for both.

Benefits of Trade

Because countries are endowed with different assets and natural resources, some may produce the same good more efficiently and sell it more cheaply than others. Countries that trade can take advantage of the lower prices available in other countries.

Here are some other benefits of trade:

• It increases a nation's global standing
• It raises a nation's profitability
• Creates jobs in import and export sectors
• Expands products variety
• Encourages investment in a country globally

Criticisms of Trade

While the law of comparative advantage is a regular feature of introductory economics, many countries try to shield local industries with tariffs, subsidies, or other trade barriers. One possible explanation comes from what economists callrent-seeking. Rent-seeking occurs when one group organizes andlobbiesthe government to protect its interests.

For example, business owners might pressure their country's government for tariffs to protect their industry from inexpensive foreign goods, which could cost the livelihoods of domestic workers. Even if the business owners understand trade benefits, they could be reluctant to sacrifice a lucrative income stream.

Moreover, there are strategic reasons for countries to avoid excessive reliance on free trade. For example, a country that relies on trade might become too dependent on the global market for critical goods.

Some development economists have argued for tariffs to help protect infant industries that cannot yet compete on the global market. As those industries grow and mature, they are expected to become a comparative advantage for their country.

The Bottom Line

Trade is the exchange of goods and services between parties for mutually beneficial purposes. People and countries trade to improve their circ*mstances and quality of life. It also develops relationships between governments and fosters friendship and trust.