GED Explains: Why More Foreign Trade Means More Growth

In our numerous GED studies on the consequences of international trade, we have always emphasised the positive effects of increased cross-border trade. This entry describes the underlying relationship between increased cross-border trade and economic growth.

Static effects: growth through increased trade

First of all, increased trade signals a decrease in trade barriers such as import duties and non-tariff trade barriers. One direct consequence of such a reduction is that the costs of cross-border trade are reduced, meaning that prices for internationally traded goods go down.

• If Germany levies a five percent import duty on a car imported from the US and this import duty is abolished, then the price German consumers pay for such a car is reduced by five percent.
• Also, non-tariff trade barriers (e.g. admission and control procedures for foreign goods) lead to higher costs. The Federal Ministry for Economic Development and Cooperation has calculated that for German companies’ exports to the USA, the administrative effort and costs for duplicate certifications, tests and admission procedures for exporting companies lead to additional costs of 10 to 20 percent on average. Consequently, reducing these trade barriers also reduces prices.

As a result, improving the conditions for trade between the two countries also allows prices for goods traded between these two countries to go down. This has a positive effect on economic growth and employment in both countries (see also Figure 1).

• First of all, consumers benefit from reduced prices for imported goods as the purchasing power of their income increases. This increased purchasing power usually leads to an increase in demand for consumer goods, so increasing domestic production.
• Domestic companies can obtain inputs from abroad required for their own production at a lower price. This lowers production costs and normally also prices. In turn, domestic consumers benefit from decreasing prices, triggering further increases in production and employment.
• Lower production costs improve international competitiveness for domestic companies, allowing them to increase their export sales to the rest of the world. In turn, the knock-on increase in production has a positive effect on employment.
• Reducing trade barriers generally makes exporting to trade partner countries easier, meaning that domestic companies increase their exports.
• Companies which do not export themselves, but supply inputs to exporting companies, also benefit. There is also an increase in production and employment for these companies.
• If domestic consumer demand grows, as well as exports, domestic companies have to increase production capacities, i.e. the number of machines and the necessary premises. Hence we see an increase in investment. This results in an increase in production and employment for companies which provide these production capacities.

Dynamic effects: growth through productivity gains

The growth effects described so far, which result from increased trade between two countries, arise mainly from an increase in cross-border trade volumes between those countries, resulting from a reduction in trade costs. Production technology remains unchanged.

In addition to this, economic integration leads to an increase in innovation and productivity and so to changes in production technology. The related reduction in production costs and prices lead to dynamic growth effects. There are two main effects arising from reduction of trade barriers which lead to productivity increases:

• On the one hand, reducing barriers to international trade allows companies to produce for a larger market. The resulting economies of scale lead to lower unit costs and lower prices and therefore, consumer purchasing power increases.
• On the other hand, increased trade between two countries increases competition. Companies are forced to react by reducing production costs through innovation and technological progress, so as to remain internationally competitive. A cost reduction through technological progress means an increase in productivity. This implies that the amount of goods which can be produced for a given amount of production factors increases and the economy grows. At the same time, prices decrease as a result of technological progress, which in turn increases domestic demand.

Summary

The connections described between increased international trade and economic development explain why trade between different countries increases growth in all participating countries. Static and dynamic growth effects which occur in countries with greater economic integration also mutually strengthen these stimuli for growth.

For example, if production and employment in Germany grows, it increases citizens’ demand for goods and services. This increase in demand also affects imported products, meaning that production, employment and income abroad go up. Furthermore, stronger economic growth abroad also triggers an increase in German exports into these countries (see Figure 2).

Conversely, this implies that any barriers to international trade reduce growth and therefore employment. Citizens have to pay for the negative growth effects connected with this:

• As consumers, they pay for flagging international trade through higher prices for goods and services. Thus their purchasing power decreases. This loss of purchasing power reduces their material prosperity.
• As employees, they pay for the restriction of international trade with fewer opportunities on the job market and therefore with lower wages and higher unemployment.
• As taxpayers, citizens suffer from foreign trade barriers because weaker economic growth means a reduction in government revenue. At the same time, government expenditure increases in order to combat unemployment. Therefore, citizens either have to pay higher taxes or accept a reduction in state benefits.

For more on the impact of trade see our study on the Effects of International Trade for the Manufacturing Sector!