Welcome to the World of International Trade!

Hello future economist! This chapter, "Trade," is the bedrock of understanding how the global economy works. It explains why countries don't just produce everything they need domestically, and how opening borders to goods and services can make everyone better off (usually!). Don't worry if concepts like comparative advantage sound complicated—we'll break them down using simple examples. Let's get started!

Section 1: The Fundamental Reasons for Trade

1.1 Specialisation and the Concept of Advantage

Why do countries trade? The simple answer is
specialisation: focusing production on what they do best. This efficiency allows total global output to increase.

Absolute Advantage (AA)

A country has an Absolute Advantage (AA) if it can produce a good or service using
fewer resources (more efficiently) than another country.

  • Example: The USA can produce 100 cars or 50 tonnes of rice per day. Vietnam can produce 50 cars or 10 tonnes of rice per day. The USA has the absolute advantage in both goods because it uses fewer resources (time, labour) to produce both.
Comparative Advantage (CA) - The Key Concept!

This is the most important idea in trade theory. A country has a Comparative Advantage (CA) in the production of a good if it can produce that good at a
lower opportunity cost than another country.

Don't worry if this seems tricky at first. CA is all about what you have to give up.

Step-by-step CA calculation (The 'Opportunity Cost' Method):

  1. Identify what is given up to produce one unit of the other good.
  2. Compare the opportunity costs between the two countries.
  3. The country with the lowest opportunity cost holds the comparative advantage.

Analogy: You are a great lawyer (AA in law) and also the fastest typist in the world (AA in typing). Should you type your own legal documents? No! Your opportunity cost of typing is very high (you give up high billable lawyer hours). You should hire a secretary (who has a CA in typing) and focus on law. Both of you are better off!

Gains from Specialisation and Trade

The model of comparative advantage demonstrates that if countries specialise and trade based on their CA, the total global output of goods and services will increase.

  • When total output increases, both countries can consume bundles of goods that were previously unattainable (outside their Production Possibility Frontier).
Other Economic Benefits of Trade

Trade does more than just increase output. It also offers:

1. Economies of Scale (EoS): Countries specialise and produce for a global market, not just a small domestic one. This larger scale production allows them to benefit from EoS, lowering average costs (e.g., bulk buying, better machinery).
2. Increased Competition: Domestic monopolies or inefficient firms face pressure from foreign competitors. This forces them to innovate, improve quality, and keep prices down, benefiting consumers.
3. Increased Variety: Consumers get access to a wider range of goods and services (e.g., exotic foods, foreign cars, imported fashion).

Key Takeaway: Comparative advantage, based on opportunity cost, is the primary reason why countries trade, leading to increased output and lower costs.

Section 2: Dynamics of Trade and Costs

2.1 Causes and Changing Patterns of Comparative Advantage

Why does a country have a CA? It usually comes down to its Factor Endowments (the resources it has):

  • Natural Resources: Saudi Arabia has CA in oil due to its geology; Brazil has CA in coffee due to its climate.
  • Labour Supply: Countries with large, low-skilled populations might have CA in basic manufacturing.
  • Capital and Technology: Countries with high levels of R&D and advanced machinery (like Germany or Japan) have CA in high-tech products (e.g., robotics).

Comparative advantage is not fixed. It changes over time due to:

  • Investment: Investing in education (improving human capital) or infrastructure can shift CA.
  • Discovery: Finding new resources (e.g., gas fields).
  • Technology: New production methods can destroy old comparative advantages (e.g., automation reducing the CA of cheap labour).

2.2 Costs of International Trade

Trade isn't without downsides. Key costs include:

  • Structural Unemployment: When a country specialises, industries where it lacks CA shrink, leading to job losses in those sectors (e.g., manufacturing jobs in developed nations moving to lower-cost countries).
  • Environmental Costs: Increased global shipping and production lead to higher pollution and carbon emissions.
  • Dependency: Over-reliance on a single industry (e.g., relying only on exporting one commodity like oil) makes the economy vulnerable to global price fluctuations.
  • Erosion of Culture/Local Industries: Local industries struggle to compete against cheap, mass-produced imports.

2.3 Terms of Trade (ToT)

The Terms of Trade (ToT) measure the ratio of a country's average export prices to its average import prices. It tells us how many imports we can buy for a given quantity of exports.

Calculation:

Terms of Trade = \( \frac{\text{Index of Export Prices}}{\text{Index of Import Prices}} \times 100 \)

Memory Aid: ToT is always 'Export over Import'.

Changes in Terms of Trade

If the index increases (e.g., from 100 to 110), the ToT has improved: export prices have risen faster than import prices. We can now buy more imports for the same volume of exports—a gain in economic welfare.
If the index decreases, the ToT has deteriorated.

Causes of Changes in ToT:

  1. Changes in Demand/Supply of Exports/Imports: If global demand for your key export rises (e.g., a country exporting rare minerals), your export price index rises, improving ToT.
  2. Inflation: Higher domestic inflation relative to trading partners will usually increase export prices, improving ToT (though perhaps harming competitiveness).
  3. Exchange Rates: An appreciation of the currency makes exports more expensive and imports cheaper, leading to an improved ToT.
  4. Productivity: An increase in productivity might lower export prices, leading to a deteriorating ToT, but increasing competitiveness.

Did you know? Many Less Economically Developed Countries (LEDCs) suffer from long-term deteriorating terms of trade because they rely heavily on exporting primary commodities, whose prices often fall relative to manufactured goods.

Key Takeaway: Comparative advantage is dynamic. While trade has benefits, it creates structural adjustment costs. ToT measures the relative purchasing power of a country's exports.

Section 3: Restricting Trade – Protectionism

3.1 Protectionist Policies

Protectionism refers to policies designed to restrict or restrain international trade, typically with the intent of protecting domestic industries from foreign competition.

Types of Protectionist Measures
  • Tariffs: A tax placed on imported goods. This raises the price of the import, making the domestic product relatively more competitive. (This is the most common tool).
  • Quotas: A physical limit on the quantity of a good that can be imported. This directly restricts supply, raising the price of the import.
  • Export Subsidies: Government payments to domestic firms that produce goods for export. This lowers the firm's costs, allowing them to sell exports at a lower price and be more competitive globally.
  • Non-Tariff Barriers (NTBs): These include complex health and safety regulations, strict product standards, or complex customs procedures that make importing difficult and costly.

3.2 Arguments FOR Protectionism (Reasons for adopting these policies)

Even though free trade theoretically increases welfare, governments often impose barriers for specific reasons:

  1. Protecting Infant Industries: This argues that new domestic industries cannot compete with large, established foreign rivals and need temporary protection (tariffs/subsidies) until they grow large enough to achieve economies of scale and become globally competitive.
  2. Preventing Dumping: Dumping occurs when a foreign firm sells goods in the domestic market at a price below its cost of production. This is often done to destroy local competition. Protectionist measures fight against this unfair practice.
  3. Protecting Domestic Jobs: Tariffs raise the cost of imports, encouraging consumers to buy local, thus safeguarding employment in threatened industries.
  4. Correction of Balance of Payments Deficit: Imposing tariffs or quotas reduces imports, which can help improve a persistent deficit on the current account (an expenditure-switching policy).
  5. National Security/Self-Sufficiency: Certain key industries (like agriculture or defence production) are sometimes protected so a country is not reliant on foreign supply during conflicts or crises.

3.3 Consequences of Protectionism

While protectionism helps some domestic groups, it has negative consequences overall:

  • Higher Prices for Consumers: Tariffs are a tax paid by the consumer/importer, and quotas restrict supply. Both lead to higher domestic prices.
  • Reduced Competition: Domestic firms become lazy and inefficient without foreign competition. This leads to X-inefficiency.
  • Retaliation: If Country A imposes a tariff on Country B's steel, Country B will likely respond with its own tariff on Country A's wheat, leading to a "trade war" that shrinks global trade.
  • Distorted Comparative Advantage: Protection forces the country to produce goods inefficiently (i.e., goods where it does not have a CA).

*Note:* You should be able to use simple demand and supply diagrams to illustrate the effects of tariffs and quotas (e.g., showing higher price, reduced quantity, and welfare loss/deadweight loss).

Key Takeaway: Protectionism uses tools like tariffs and quotas to shield local industries. While arguments exist (like protecting infant industries), the overall consensus is that protectionism reduces consumer welfare and global efficiency.

Section 4: Global Cooperation in Trade

4.1 Trading Blocs

A Trading Bloc is a group of countries that agree to reduce or eliminate trade barriers among themselves, creating preferential trade conditions.

They range in their level of integration:

  • Free Trade Area (FTA): Members eliminate tariffs and quotas among themselves, but retain the right to set their own tariffs against non-member countries. (Example: NAFTA/USMCA)
  • Customs Union (CU): Members eliminate internal barriers AND adopt a common external tariff (CET) against non-members. This means all members charge the same tariff rate to the rest of the world.
  • Common Market: A Customs Union that also allows for the free movement of
    factors of production (labour and capital) between member states.
  • Monetary Union: A Common Market that adopts a single common currency and a shared monetary policy (e.g., the Eurozone).

4.2 Role of the World Trade Organisation (WTO)

The WTO is a global institution founded to supervise and liberalise international trade.

Primary Roles:

  1. Forum for Negotiations: It provides a platform for member governments to negotiate trade agreements to lower tariffs and other barriers.
  2. Administrator of Trade Agreements: It oversees the application and monitoring of existing agreements.
  3. Dispute Settlement: It acts as an arbitrator to resolve trade disputes between countries (e.g., if one country believes another has unfairly subsidised an industry).

The core principle of the WTO is Non-discrimination—trade policies should be applied equally to all trading partners (known as Most-Favoured Nation status).

Quick Review: Trading blocs integrate economies at various levels, from simple free trade to full monetary union. The WTO works globally to promote free and fair trade.