Economics | Trade and the global economy

Welcome to the World of Global Trade!

Hello future economist! This chapter, Trade and the Global Economy, is one of the most exciting and relevant sections of your course. It explains why countries don't produce everything they need and how international trade makes us all richer (usually!).

Don't worry if concepts like 'Comparative Advantage' seem tricky at first. We will break them down using simple examples and handy memory tricks. Understanding these principles is essential for grasping how the modern global economy operates. Let's get started!

Section 1: The Economic Basis for Trade

1.1 Absolute and Comparative Advantage

The foundation of international trade lies in the concept that countries benefit from specialisation.

Absolute Advantage (AA)

Definition: A country has an Absolute Advantage in the production of a good if it can produce more of that good than another country, using the same amount of resources (or the same amount of output using fewer resources).

• Example: If Country A can produce 100 cars in a year with 1,000 workers, and Country B can only produce 50 cars with those same 1,000 workers, Country A has the Absolute Advantage in cars.

Comparative Advantage (CA) - The Key Concept

Comparative Advantage is the *true* reason why trade occurs, even if one country has an absolute advantage in everything! It focuses on Opportunity Cost.

Definition: A country has a Comparative Advantage in the production of a good if it can produce that good at a lower Opportunity Cost than another country.

Quick Review: Opportunity Cost

• Opportunity Cost is what you must give up to get something else.

Step-by-Step: Finding Comparative Advantage

Imagine two countries, UK and Germany, producing either Cheese or Cars in one day.

Country	Max Cheese (kg)	Max Cars
UK	100	20
Germany	150	60

Step 1: Calculate the Opportunity Cost (OC) for 1 Car:

• UK: To make 1 Car, the UK gives up 100 kg of Cheese / 20 Cars = 5 kg Cheese.
• Germany: To make 1 Car, Germany gives up 150 kg of Cheese / 60 Cars = 2.5 kg Cheese.

Step 2: Compare the Opportunity Costs:

• Germany gives up less Cheese (2.5 kg) to make 1 Car than the UK (5 kg).
• Therefore, Germany has the Comparative Advantage in Cars.

Step 3: Determine the other advantage (Cheese):

• If Germany specialises in Cars, the UK must specialise in Cheese (the thing it is 'least bad' at).
• (Check the maths: OC of 1 kg Cheese is 1/5 Car for UK, and 1/2.5 = 0.4 Car for Germany. 1/5 = 0.2, which is lower than 0.4. So, UK has the Comparative Advantage in Cheese).

Key Takeaway: Trade is mutually beneficial if each country specialises in the good for which it has the lowest opportunity cost. This leads to specialisation and increased global output (gains from trade).

1.2 Factors Influencing the Pattern of Trade

Why do certain countries export certain goods?

• Natural Resources (Factor Endowments): Countries rich in oil (e.g., Saudi Arabia) will specialise in oil. Countries with good climate (e.g., Brazil) specialise in agriculture.
• Differences in Costs/Technology: Countries with cheap labour or highly advanced production methods (often known as the Heckscher-Ohlin model factor) can produce goods more cheaply.
• Exchange Rates: A weak currency makes a country's exports cheaper abroad, increasing trade.
• Protectionism: Tariffs or quotas imposed by importing countries restrict where trade flows.
• Historical Factors: Established trading relationships, often linking former colonial powers to their dependencies.

Section 2: Protectionism and Trade Barriers

Protectionism refers to government actions and policies that restrict or restrain international trade, often with the intent of protecting domestic industries.

2.1 Methods of Protectionism

Governments use several tools to limit imports:

1. Tariffs (Customs Duties):
   • A tax imposed on imported goods or services.
   • Impact: Increases the price of the import, making domestic goods more competitive and generating tax revenue for the government.
2. Quotas:
   • A physical limit on the volume or value of a good that can be imported over a specific time period.
   • Impact: Restricts supply, driving up the price and protecting domestic producers.
3. Subsidies to Domestic Producers:
   • Financial aid or grants given by the government to local firms.
   • Impact: Lowers the production costs for domestic firms, allowing them to compete with cheaper imports without raising the price for consumers.
4. Non-Tariff Barriers (NTBs):
   • Rules, regulations, or standards that restrict imports indirectly.
   • Examples: Strict health and safety standards, complex bureaucratic procedures, or 'Buy National' campaigns.

2.2 Arguments for and Against Protectionism

Governments often feel pressured to restrict trade, but these policies always come with economic costs.

Arguments FOR Protectionism

• The Infant Industry Argument: New, small domestic industries cannot compete with large, established foreign rivals. Protection (like a tariff) gives them time to grow and achieve economies of scale. (This is temporary protection.)
• Protecting Domestic Employment: By restricting imports, demand is shifted towards domestic products, theoretically saving jobs in competing industries.
• Strategic Industries: Protecting industries vital for national security (e.g., defence, certain food supplies).
• Anti-Dumping: Dumping occurs when a foreign firm sells goods abroad at a price below their cost of production. Protectionist measures fight this unfair practice.
• Correcting a Balance of Payments (BoP) Deficit: Reducing imports helps improve the current account balance (covered in Section 4).

Common Mistake to Avoid: Tariffs save jobs in *import-competing* industries, but destroy jobs in *export* industries due to retaliation from other countries.

Arguments AGAINST Protectionism (The Costs)

• Higher Prices for Consumers: Tariffs increase the cost of imports, forcing consumers to pay more.
• Reduced Competition and Inefficiency: Domestic firms protected from foreign competition lack the incentive to innovate or minimise costs.
• Limited Consumer Choice: Fewer products are available in the market.
• Risk of Retaliation: If Country A imposes a tariff on Country B’s goods, Country B will likely retaliate with its own tariff, leading to a 'trade war' that harms both countries.

Section 3: Trade Blocs and Global Integration

3.1 Types of Economic Integration (Trade Blocs)

Countries often form Trade Blocs (or regional economic integration agreements) to reduce internal trade barriers, but they differ in how deeply integrated they become.

The Hierarchy of Integration (from loosest to tightest):

1. Free Trade Area (FTA):
   • Members eliminate tariffs and quotas among themselves.
   • BUT, each member maintains its own independent trade policies (tariffs) towards non-members.
   • Example: NAFTA/USMCA.
2. Customs Union:
   • Achieves FTA goals (no internal barriers).
   • PLUS, members adopt a Common External Tariff (CET) against non-member countries.
   • Example: Mercosur (South America).
3. Common Market (Single Market):
   • Achieves Customs Union goals.
   • PLUS, allows for the free movement of factors of production (labour and capital) among member states.
   • Example: The EU (before Brexit).
4. Monetary Union:
   • Achieves Common Market goals.
   • PLUS, adopts a single currency and a common monetary policy, managed by a central bank.
   • Example: The Eurozone (subset of the EU).

3.2 Effects of Trade Blocs

Trade blocs have two major, often conflicting, effects:

• Trade Creation (GOOD): Occurs when trade shifts from a high-cost producer (in the domestic country) to a lower-cost producer within the trade bloc. This is a beneficial outcome, increasing efficiency and welfare.
• Trade Diversion (BAD): Occurs when trade shifts away from a lower-cost producer *outside* the bloc to a higher-cost producer *inside* the bloc. This happens because the high external tariff makes the non-member goods artificially expensive. Trade diversion reduces global efficiency.

The overall net effect of a trade bloc is positive only if Trade Creation > Trade Diversion.

3.3 The Role of the World Trade Organization (WTO)

The WTO is the global international organisation dealing with the rules of trade between nations.

• Goal: To ensure that trade flows as smoothly, predictably, and freely as possible.
• Key Functions:
  • Administering trade agreements.
  • Acting as a forum for trade negotiations (e.g., the Doha rounds).
  • Handling trade disputes among member nations.

The WTO supports the principle of non-discrimination, particularly through the Most-Favoured-Nation (MFN) clause, which dictates that if a country grants a special trade favour to one country, it must grant the same favour to all other WTO members.

Section 4: Measuring Trade Performance

4.1 Terms of Trade (ToT)

The Terms of Trade (ToT) measure the relative price of a country's exports compared to its imports. Essentially, it tells us how many imports a country can get for a unit of its exports.

The ToT Formula:

\[ \text{Terms of Trade Index} = \frac{\text{Index of Export Prices}}{\text{Index of Import Prices}} \times 100 \]

What does a change mean?

• Improvement in ToT (The index rises): Export prices have risen faster than import prices (or import prices have fallen). The country can buy more imports for the same volume of exports—it is economically ‘richer.’
• Deterioration in ToT (The index falls): Export prices have fallen relative to import prices. The country has to export more goods just to buy the same quantity of imports—it is economically ‘poorer.’

Factors Causing Changes in ToT:

• Changes in Global Demand and Supply: If demand for a country’s key exports (e.g., oil) rises sharply, its export prices rise, improving the ToT.
• Inflation Rates: If a country experiences higher inflation than its trading partners, its export prices will rise (improving ToT).
• Exchange Rates: If a country's currency appreciates, its exports become more expensive in foreign currency, leading to an improvement in ToT.

4.2 The Balance of Payments (BoP)

The Balance of Payments (BoP) is a record of all financial transactions made between consumers, businesses, and the government of one country and the rest of the world over a specific time period (usually a year).

The BoP is recorded using the double-entry bookkeeping system, meaning the total of all accounts must always conceptually sum to zero (Credits = Debits).

The Three Main Accounts

The BoP is broken down into three main sections:

1. The Current Account (The most focused-on account)
2. The Capital Account
3. The Financial Account

Focus: The Current Account

This account records payments for the day-to-day flow of goods, services, and income.

Four Components of the Current Account:

1. Trade in Goods (Visible Balance): Exports and imports of physical goods (e.g., cars, machinery, food).
2. Trade in Services (Invisible Balance): Exports and imports of services (e.g., tourism, shipping, banking, insurance).
3. Primary Income (Net Investment Income): Income earned from assets owned abroad (e.g., profits, interest, dividends).
4. Secondary Income (Net Transfers): One-way financial transfers (e.g., foreign aid, remittances sent by immigrants to their home countries).

Current Account Deficits and Surpluses

• Current Account Deficit: Occurs when the value of imports (payments out) of goods, services, and income exceeds the value of exports (payments in).
• Current Account Surplus: Occurs when the value of exports of goods, services, and income exceeds the value of imports.

Impact of a Persistent Current Account Deficit:

• Increased Foreign Debt: A deficit must be financed by borrowing from abroad or selling domestic assets (recorded as a surplus in the Financial Account).
• Depreciation Pressure: Persistent deficits mean more national currency is being sold abroad to pay for imports, putting downward pressure on the exchange rate.
• Loss of Confidence: International investors may lose confidence in the country’s economic health.