International Trade Theory

Why countries Trade and reasons for trade restriction

Reasons for trade
• Reasons for trade
• Specialisation and division of labour
• 1. Different goods require dfferent proportions of factor inputs in their
production
• 2. Economic resources are unevenly distributed throughout the world
• 3. Internation mobility of resources is extremely limited
• Since it is difficult to move resources between nations, the goods which
embody the resources must move
• 4. Intenational trade expands a nations consumption possibilties- essence
of trade
Effects of trade
Y

X
Reasons for trade
• 5. Vent for surplus

• A. International trade involves exchange among different nations-

should we discriminate- protection
• B. Use of different currencies
Absolute advantage theory
• Adam Smith 1776
• He justifies trade on the basis of differences in effeciency in
production- trade maxim
• Absolute advantage- when a country can produce more of a good
with a given amount of resources than another country.
• Example: Two countries- Botswana and SA; two commodites: beef
and rice.
• No transport costs and trade barriers- easy transfer of resources from
one industry to another within the country and between countries.
Absolute Advantage

Country BEEF RICE

Botswana 20 100
South Africa 10 150
Total 30 250
Absolute Advantage
• Botswana – absolute advantage in production of beef
• South Africa- absolute advantage in production of rice
• Botswana should specialise in production of beef
• South Africa should specialise in the production of rice
Specialisation
• More production than before- total output is greater with
specialisation.

Country Beef Rice

Botswana 40 0
South Africa 0 300
Total 40 300
Comparative Advantage
• What if Botswana has an absolute advantage in both lines? Is there
no basis for trade?
• David Ricardo- comparative advantage or comparative costs- relates
to the opportunity costs of producing the goods
• A country should specialise and produce goods to which it has a
relatively low production costs and import the one it has a relatively
high production costs.
Comparative Advantage
• Botswana has an absolute advanatge in both lines of production.
• Does that mean there can therefore be no trade? NO

Country Beef Rice

Botswana 20 200
South Africa 10 150
Total 30 350
Comparative Advantage Calculations
• Botswana: cost of 1 beef= 10 tons of rice
• Producing 1 beef you forgoe 10 tonnes of rice
• South Africa: Cost of 1 beef =15 tonnes of rice
• Botswana has a comparative advantage in beef as shown by lower CA
• Rice
• Botswana: Cost of a tonne of rice = 1/10 of beef
• South Africa: Cost of a tonne of rice = 1/15 of beef
• Rice is cheaper in South Africa than in Botswana and therefore South Africa
has a comparitive advantage in production of rice.
• Conclusion: Each country should produce and export goods in which is has
a CA.
Conclusion
• There should be free trade and that will benefit both countries
• Does the law apply in practice?
• 1. Free trade does not always exist- domestic industry protection and
imports discouragement
• 2. High transport costs
• Differentiation of products. Eg cars- make the product competitive in
any part of the world.
Advantages of Free Trade
• Vent for surplus- deficit country
• International trade increases competition among suppliers in the
world market
• Some firm’s can benefit from economies of scale- extension of the
market- reduction in price
• `Political advantages- trading links provide a foundation for closer
political links
Case for Protection
• Preserve output and employment domestically- avoid cheap goods
that compete with highly priced domestically produced goods-
dumping
• a) don’t imports create jobs?
• b)fallacy of composition- all nations cannot simultaneously succeed in
restricting imports while maintaining their exports- beggar thy
neighbour principle
• Possibility of retaliation- trade barrier war
• Long run feedbacks- reallocation of resources to inefficient
domestically protected industries.
Case for Protection
• Infant industry argument- cant compete internationally because
they are not yet fully developed.
• Problems
• a)They may never grow
• b)Difficult to identify which industries are infants
• Diversification for stability argument
• Protect to allow for greater industrial diversification-avoid
dependence on exports of one or two products
• Problems- may diversify into ineffecient industries
Case for Protection
• Strategic trade policy
• Reduce the risk of investing in product development by domestic
firms
• Protected firms can grow and eventually dominate the market
because of their lower costs
• Industries may be strategic for a particular economy. Eg national
defense, agriculture, etc.
• Problems
• May invite rataliation-countries come with tariffs of their own
Case for Protection
• Protection against dumping
• Selling of excess goods in the foreign market at prices below costs
• Reasons
• Establish monopoly- drive down competition
• Price discrimination
• Anti dumping laws can be abused- protect ineffecient domestic
industries
Case for Protection
• Cheap foreign labour
• Protect from competition with foreign goods from low wage countries
• If no protection-domestic wages fall leading to lower domestic living
standards
• Will countries benefit without trade then? No! Reallocationof
resources to ineffecient industries
• Deal with balance of payment problem
• Restrict imports and encourage exports
Case against Protection
• Deters growth
• Invites rataliation- every country becomes worse off
• Lose gains from greater competition and economies of scale
• Protection creates political ill will
Alternative Means
• Use indirect measures to reduce costs and make them more
competitive, eg hidden subsidies, devaluation of currency
• Can also fund industrial training and educational policies- increase
domestic productivity
Trade barriers and impact
• Tariffs- taxes on imports
• Revenue tariff-applied to a product not produced domestically
• Potective tariff-designed to shield domestic producers from foreign
competition
• Import quota- quantitative restrictions
• Non tariff barriers- licencing requirements that specify standards on
quality and safety
• Trade embargoes- total ban on imports- normally done for political
reasons
Impact of Tariff
Impact of Tariff

•Imports decrease
•High domestic production
•Consumptions decreases
•Tariff revenue
End Result
• Domestic consumers buy fewer units
• Domestic producers supply more to the market
• Foreign suppliers provide less to the market
• Government earns tax revenue (Qw-Qd)X T
• Benefits governmnet and producers but hurts consumers
• If demand and supply are price inelastic, the tariff will have small
effect on output volumes
Import Quota
• Both domestic amd foreign suppliers enjoy a higher price
• Domestic producers supply more
• Fewer imports (in volumes)
• Consumers buy less and pay more
• Government collects no revenue
Embagoes and Hidden subsidies
• Embargoes are total ban on imports
• Done for political reasons usually- hurts consumers
• Hidden subsidies and import restrictions
• Government subsidies to assist exports and deterrent against imports
Terms of Trade
• Rate at which one nations goods exchange against those of the other

!"#$% &' ( )*+,$-

• X 100
!"#$% &' . )*+,$-

• Fall in Terms of Trade- unfavourable ToT

• Means you are getting less from the same resources than before.
• Can be caused by changes in relative prices or by changes in exchange
rates.
Balance of Payment
• Statistical accounting record of a country’s international trade transactions and
capital transacations
• 2 major accounts: Current account and Capital Account
• 1. Current account
• Visible trade- X-M
• Invisible trade- trade in services
• Balance of trade
• Capital account
• Financial assets- movement of finance- inflow and ouflow of capital, foreign
investment
• Official Reserves Account- records reserves and financing of deficit
• BoP always balances. But it can be in deficit or surplus
Ways to deal with BOP deficit
• Depreciation of currency
• Trade restrictions- M falls
• Continous BOP deficit – deplete reserves ultimately
• Exports- exports credit guarantees; govt financial help- make unit costs
lower
• Imports- complex import regulations and documentations or special safety
standards demanded from imported goods
• Devaluation- e falls- imports becomes more expensive, cut down volumes.
• But this depends on the price elasticity of demand
• J curve effect