Chapter: Free Trade and Trade Barriers

Hey everyone! Welcome to one of the most exciting topics in Economics. Ever wondered why your iPhone is designed in the US but made in China? Or why Hong Kong sells so many financial services to the world but imports most of its food? This chapter has the answers!

We're going to explore why countries trade with each other, how everyone can benefit from it (yes, really!), and what happens when governments put up walls, called trade barriers. This is super important for us in Hong Kong, a city built on trade!


Section 1: Why Do Countries Trade? The Magic of Advantage

Imagine you're great at writing essays, and your friend is a genius at solving math problems. You could both spend hours doing your own homework. But what if you helped your friend with their essay, and they helped you with your math? You'd both finish faster and do a better job! Countries trade for the exact same reason: specialization.

Absolute Advantage (AA)

This is the easy one. A country has an absolute advantage if it can produce a good using fewer resources (like time or workers) than another country.

Example: Let's look at Japan and the USA. In one day, one worker can produce:

Cars: Japan: 12 cars, USA: 10 cars
Computers: Japan: 6 computers, USA: 8 computers

- Who has the absolute advantage in cars? Japan (12 > 10).
- Who has the absolute advantage in computers? The USA (8 > 6).

It seems obvious they should trade, right? Japan makes cars, the USA makes computers. But what if one country is better at making EVERYTHING?

Comparative Advantage (CA) - The REALLY Important One!

Don't worry if this seems tricky at first, it's a game-changer! A country has a comparative advantage in producing a good if it can do so at a lower opportunity cost than another country.

Quick Review: Opportunity cost is the value of the next best alternative you give up. When producing something, the opportunity cost is what else you *could have* produced in that time.

How to find Opportunity Cost (The 'Give Up' Method):

Let's use a new example where the USA is better at producing both goods (has an absolute advantage in both).

In one day, one worker can produce:

Wheat: USA: 6 units, UK: 1 unit
Cloth: USA: 4 units, UK: 2 units

Step 1: Calculate the opportunity cost for the USA.

  • To produce 6 units of wheat, the USA gives up 4 units of cloth. So, the cost of 1 unit of wheat is (4/6) = 0.67 units of cloth.
  • To produce 4 units of cloth, the USA gives up 6 units of wheat. So, the cost of 1 unit of cloth is (6/4) = 1.5 units of wheat.

Step 2: Calculate the opportunity cost for the UK.

  • To produce 1 unit of wheat, the UK gives up 2 units of cloth. So, the cost of 1 unit of wheat is 2 units of cloth.
  • To produce 2 units of cloth, the UK gives up 1 unit of wheat. So, the cost of 1 unit of cloth is (1/2) = 0.5 units of wheat.

Step 3: Compare the opportunity costs.

  • Wheat: Who gives up less cloth to make wheat? The USA (0.67 < 2). So, the USA has a comparative advantage in wheat.
  • Cloth: Who gives up less wheat to make cloth? The UK (0.5 < 1.5). So, the UK has a comparative advantage in cloth, even though it has an absolute disadvantage!

This leads us to the super important Principle of Comparative Advantage: Total output increases when countries specialize in producing the goods in which they have a comparative advantage and trade with each other.

Key Takeaway for Section 1

Even if a country is better at producing everything (has absolute advantage in all goods), it can still benefit from trade by specializing in what it's *relatively* best at (its comparative advantage). This is because trade is based on opportunity cost, not absolute productivity.


Section 2: The Gains from Trade

So how does this specialization actually benefit everyone? Through trade, countries can consume more than they could produce on their own.

Condition for Mutually Beneficial Trade

For trade to be worthwhile for both sides, the terms of trade (the price of one good in terms of the other) must lie BETWEEN the two countries' opportunity costs.

From our USA/UK example:

  • Opportunity cost of 1 unit of cloth in the UK = 0.5 wheat
  • Opportunity cost of 1 unit of cloth in the USA = 1.5 wheat

So, a mutually beneficial terms of trade would be anything between 0.5 and 1.5 wheat for 1 unit of cloth. Let's say they agree on 1 unit of cloth for 1 unit of wheat.

Calculating the Gains from Trade

Let's see what happens if they specialize and trade at this price.

UK's perspective (specializing in cloth):
- The UK can make 1 unit of cloth by giving up 0.5 wheat.
- But by trading, it can "get" 1 unit of wheat for its 1 unit of cloth.
- This is a gain of 0.5 wheat for every unit of cloth it trades! (1 wheat from trade - 0.5 wheat it would have cost to make itself).

USA's perspective (specializing in wheat):
- To make 1 unit of cloth itself, it would cost the USA 1.5 wheat.
- But by trading, it only has to give up 1 unit of wheat to get 1 unit of cloth.
- This is a saving (gain) of 0.5 wheat for every unit of cloth it imports! (1.5 wheat it would have cost - 1 wheat it paid).

Everyone wins! By specializing and trading, both countries can get the other good more cheaply than if they made it themselves.

Key Takeaway for Section 2

Trade is not a zero-sum game where one person's gain is another's loss. As long as the terms of trade are between the opportunity costs of the trading partners, both countries can gain and achieve a higher level of consumption.


Section 3: Trade and Hong Kong - A Real-Life Story

Hong Kong is a perfect example of the Principle of Comparative Advantage in action.

Hong Kong's Comparative Advantage

What is HK good at? We don't have many natural resources. Instead, our advantage is in services.

  • Financial Services: We have a stable banking system, a strong legal framework, and a skilled workforce. Our opportunity cost of providing financial services is lower than in many other places.
  • Trading and Logistics: We have one of the world's busiest ports and airports, and expertise in managing global supply chains.
  • Tourism and Professional Services: We are a hub for business, law, and accounting in Asia.

So, Hong Kong specializes in these high-value services and exports them to the world.

Importance of Trade to Hong Kong

Because we specialize, we need to import almost everything else!

  • Wider Variety of Goods: We can enjoy food, electronics, and cars from all over the world that we could never produce ourselves.
    • - Lower Prices: We import goods from countries that can produce them most cheaply, which keeps prices low for consumers.
  • Economic Growth: Trade is the engine of our economy. Our service exports bring in income that fuels growth and creates jobs.

Did you know? The total value of goods and services traded by Hong Kong is often more than three times the size of our entire economy (GDP)! This shows how incredibly dependent we are on free trade.


Section 4: When Trade Isn't Free - Trade Barriers

If trade is so great, why do some governments try to restrict it? This is called protectionism. The main goal is to protect domestic industries from foreign competition. The tools they use are called trade barriers.

Types of Trade Barriers
  1. Tariff: A tax imposed on imported goods. This makes imported goods more expensive for consumers.
    Analogy: It's like the government adding a surcharge to your online shopping from overseas.
  2. Quota: A physical limit on the quantity of a good that can be imported.
    Analogy: It's like being told you can only bring back two tins of cookies from your holiday, no matter how cheap they are.
  3. Import Surcharge: A temporary, extra tariff often used to deal with a specific economic problem.
  4. Embargo: A complete ban on trading a particular good or with a particular country. This is usually for political reasons.

Section 5: Analysing the Effects of Tariffs and Quotas

Let's look at the economic effects of the two most common barriers for a small open economy. This means the country is a "price taker" - its buying decisions don't affect the world price (Pw).

Effects of a Tariff

Imagine the market for Japanese cars in a country.

  • Before Tariff: The price is the low world price (Pw). Domestic producers make a small amount, consumers buy a lot, and the rest is imported.
  • After a Tariff is Imposed:
    1. Price ↑: The domestic price of the cars increases to (Pw + Tariff).
    2. Domestic Output ↑: Local car makers, who can now sell at a higher price, produce more.
    3. Consumption Quantity ↓: Consumers, facing a higher price, buy fewer cars.
    4. Import Quantity ↓: The gap between what consumers want and what local firms produce shrinks. Imports fall.
    5. Government Revenue: The government collects tax revenue (Tariff amount × Quantity of imports).

Winners and Losers from a Tariff:

  • Winners: Domestic producers (sell more at a higher price), the government (gets tax revenue).
  • Losers: Consumers (pay a higher price for less quantity).
Effects of a Quota

Now, what if the government uses a quota instead of a tariff to limit car imports?

  • Before Quota: Same as before, price is Pw.
  • After a Quota is Imposed:
    1. Import Quantity ↓: The quantity of imported cars is physically restricted by the quota.
    2. Price ↑: With fewer cars available, a shortage is created at Pw. The price rises until the quantity demanded minus the quantity supplied by domestic firms equals the quota amount.
    3. Domestic Output ↑: Just like with a tariff, local producers respond to the higher price by producing more.
    4. Consumption Quantity ↓: Consumers buy fewer cars due to the higher price.

Winners and Losers from a Quota:

  • Winners: Domestic producers (sell more at a higher price), importers who hold the quota licenses (they can buy at Pw and sell at the higher domestic price, making a big profit).
  • Losers: Consumers (pay a higher price for less quantity).
Common Mistake Alert!

A tariff and a quota can have very similar effects on price and quantity. The key difference is who gets the extra money. With a tariff, the government gets the revenue. With a quota, the profit (called quota rent) goes to the firms that are lucky enough to get a license to import.


Section 6: Hong Kong's Fight for Free Trade

As a small, open economy, Hong Kong is a strong supporter of free trade and is vulnerable to protectionism from other countries.

How Hong Kong Overcomes Trade Barriers
  • Trade Promotion: Organizations like the Hong Kong Trade Development Council (HKTDC) help HK businesses find new markets and promote their products and services globally.
  • Role of the HKSAR Government: The government actively participates in international forums to advocate for free trade and negotiate agreements that reduce barriers for our businesses.
  • Role of International Institutions (e.g., WTO): Hong Kong is a founding member of the World Trade Organisation (WTO). The WTO is crucial because it:
    • Sets the rules for international trade.
    • Provides a forum for countries to negotiate lower trade barriers.
    • Offers a dispute settlement system to resolve trade conflicts peacefully.
    By supporting the WTO, Hong Kong helps maintain a stable, rules-based global trading system that is essential for our prosperity.
Key Takeaway for Sections 4, 5 & 6

Trade barriers like tariffs and quotas protect domestic producers but harm consumers by raising prices and reducing choice. For a small trading hub like Hong Kong, fighting protectionism and supporting free trade through organisations like the WTO is not just a policy, but a necessity for survival and success.