33- 1

Chapter 33

INTERNATIONAL
TRADE
33- 2

Questions in our mind

• Do imports of goods made with cheap

foreign labour destroy jobs at home?
• Is globalization making the rich richer and
the poor poorer?
• Should our government subsidize our
domestic industries to help them compete
internationally?
33- 3 Learning Outcomes
• Basis of interpersonal, interregional and international
trade
• Gains from trade result from comparative advantage,
which arises whenever there are differences in
opportunity costs of production.
• Terms of trade determine how the gains from trade
are distributed
• Free trade tends to maximize world income.
• Protectionism may make one country better off, but
the world as a whole tends to be made worse off by
protection.
• The World Trade Organization polices world trade
rules and the commercial policies of member
governments.
33- 4

Sources of the gains from Trade

• Open economy vs. closed economy

• Free trade vs. autarky
• The advantages realized from trade are
called gains from trade.
• Interpersonal, interregional and
international trade.
33- 5

Interpersonal, interregional and

international trade
• Trade between individuals allow people to
specialize in those areas they can do relatively
well and to buy from others the goods that they
themselves can not easily produce. Ex. A doctor
and carpenter.
• With trade between regions, each regions are
forced to specialized in those goods in which
they have some natural or acquired advantages.
Ex. Plain regions, mountain regions, cold
regions.
33- 6

Interpersonal, interregional and

international trade
• International trade is necessary to achieve
the gains that international specialization
makes possible. Trade allows each
individual, regions and nations to
specialize and concentrate on producing
those goods that is produced relatively
efficiently while trading to obtain goods
and services that it would produces less
efficiently than others.
33- 7

Sources of International Trade

• Diversity in conditions of production
endowed with natural resources, supply of petroleum, large
amount of fertile land etc.
• Deceasing Costs
manufacturing units enjoy a economies of scale; they tend to
lower average cost of production when the scale of production
increases.
Differences in Tastes: The countries may find that
the conditions are same but still have trade due to taste
differences.
33- 8

Gains from Trade

• Absolute advantage: Adam Smith’s
powerful illustration of the basis and gains
from trade is the principle of absolute
advantage.
• Based on the principle, trade is possible
and profitable when both the nation should
have “absolute advantage” in producing
any of the trade goods.
33- 9

Absolute Advantage

US UK
Wheat(bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 5

With an exchange rate of 6W = 6C,

US has absolute advantage in Wheat : Export
UK has absolute advantage in Cloth : Export
US export W and import C
UK export C and import W
33- 10

Gains from Trade

• For US, domestically they can get 4 C for 6W
(6W = 4C)
• In trade, they have 6W = 6C
• So, US gains 2C
• For UK, they requires 6 man labour hour to
produce 6 W.
• Those 6 man hour can produce 30 C.
• So, they export 6C to get 6W and can save 24 C
• So the total gain is 2C and 24C
33- 11

Comparative Advantage
• It is obvious that when one country is
having absolute advantage in one line and
other is having in other line, trade is
possible.
• But, what if one country is more productive
than another country in all lines of
production?
• Is trade possible in the above case?
• David Ricardo answer YES.
33- 12

Comparative Advantage
• Even if one nation is less efficient compared to other
nation in both the lines of production, still there is
possibility of mutual advantageous trade between the
nations.
• If a lawyer earns Rs.1000 per hour but can also type
twice faster than her typist who earn Rs.100 per hour,
does it pay the lawyer to do her typing?
• No
• So, even is the nation has absolute disadvantage in the
production of both the commodities with respect to other
nation, mutual advantageous trade is still possible.
33- 13

Comparative Advantage
• The less efficient nation should specialize in the
production of that good in which the absolute
disadvantage is less – the good in which it has
comparative advantage.
• So, they will specialize in the production of that
good and export.
• On the other, the country should import the good
in which the absolute disadvantage is greater –
comparative disadvantage.
33- 14

Law of Comparative Advantage

• Absolute disadvantage is smaller –
comparative advantage – production –
Export.
• Absolute disadvantage is more –
comparative disadvantage – Import
• Absolute advantage is greater –
comparative – Export
33- 15

Illustration of Comparative Advantage

US UK
-------------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
-----------------------------------------------------------
US has absolute advantage in both W and C
UK has absolute disadvantage in both W and C.
However, UK’s disadvantage is smaller in Cloth. (2:4 > 1:6)
For US, 6:1 > 4:2. (comparative advantage in wheat)
33- 16

Law of Comparative Advantage

• In two-two model, once it is determined that one
nation has comparative advantage in one
commodity, then other nation must have
comparative advantage in other commodity.

• In the above case,

UK should Export Cloth and Import Wheat
US should Export Wheat and Import Cloth.
33- 17

Gains from Trade

• US would be indifferent if they receive only 4C in
exchange for 6W.
• UK will not be in trade if they have to sacrifice more
than 2C for 1W.
• The range of mutually advantageous trade
4C < 6W < 12C
• If the exchange rate is 6W = 6C
• US gains 2C : ½ man labour hour
• UK gains 6C : 3 man labour hours
• The spread between 4C and 12C is 8C; represents
the total gains from trade.
33- 18

Gains from Trade

• The closer the exchange rate to 4C = 6W, the lesser
will be the gains shared by U.S.
• The closer the exchange rate to 12C = 6W, less is the
share of gain to UK relative to US.
• If the exchange rate is 6 W = 10 C;
US gains 6 C and
UK gains 2C
• If the exchange rate is 6 W = 8 C;
US gains 4 C and
UK gains 4 C
33- 19
Comparative Advantage and
Opportunity Cost
• The opportunity cost theory: The cost of a commodity is the
amount of a second commodity that must be given up to
release just enough resources to produce one extra unit of
the first commodity.
• Without trade, US must give up 2/3 rd amount of cloth to
release just enough resources to produce one extra unit of
wheat.
• US, the opportunity cost of 1W = 2/3 C
• UK the opportunity cost of 1W = 2 C
(the amount of cloth that must be given up)
US has less opportunity cost of producing wheat –
comparative advantage and produce and export.
In the two-two model, once it is determined that one nation
has comparative advantage in one commodity, then other
nation must have comparative advantage in other
commodity
33- 20

The production possibility frontier with

constant cost
US UK
W C W C
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
33- 21
The production possibility frontier with constant cost

U.S. U.K.

C C

120 120

A
60 B
40

90 180 40 60 W
W
33- 22

PPF
• The transformation curve (PPF/PPC) shows the
alternative combinations of two commodities that
a nation can produce by fully utilizing his
resources fully with best technology available to
it.
• In US, 30W = 20C or 1W = 2/3C (constant)
• In UK, 10W = 20C or 1W = 2C (constant)
• So, we have constant opportunity cost
33- 23 Gains From Trade With Constant Opportunity Costs

U.S. D
U.K.
120

120 50 E’

Cloth
Cloth

E B
70 40
A
60

C
0
40 60 70
0 90 110 180 Wheat
Wheat
US UK
33- 24

The Gains from Trade

• In autarky, the nation’s PPF become its
consumption frontier.
• With trade, each nation specializes
production of the commodity of
comparative advantage and exchange a
part of it for commodity of its comparative
disadvantage.
• In absence of trade, the US is at point A
and UK is at B.
33- 25
The Gains from Trade
• So, in absence of trade:
US is at A (90 W, 60 C)
UK is at B (40 W, 40 C)
• With trade and specialization;
U S is at C (180 W and 0 C)
U K is at D (0 W and 120 C)
• If US exchange 70W for 70C with UK;
U S is at E (110 W and 70 C)
U K is at E’ (70 W and 50 C)
• Compare the situation with trade and autarky;
We find US gains 20 W and 10 C
UK gains 30 W and 10 C
33- 26

The Terms of Trade

• The terms of trade refer to the ratio of the prices
of goods exported to those imported, which
determines the quantity of imports that can be
obtained per unit of exports.
• The terms of trade determine how the gains from
trade are shared.
• A favourable change in the terms of trade - that
is, a rise in export prices relative to import prices
- means a country can acquire more imports per
unit of exports.
33- 27

Case for free trade:

• Maximization of world production
• Each consumer in the world
consumes more goods than without
free trade.
• Maximization of world welfare.
33- 28

Case against Free trade

1) National objectives other than national income
2) To increase country’s national income.

National objectives other than national income

• Non-economic advantages of diversification
• National defense

To increase country’s national income.

• To protect infant industries
• To encourage learning by doing
• To alter terms of trade.
33- 29 Gains From Trade With Constant Opportunity Costs
 International trade leads to specialization in production and
increased consumption possibilities.
 The blue lines in in parts (i) and (ii) represent the production-
possibility boundary for the United States and the EU,
respectively. In the absence of international trade these also
represent each country’s consumption possibilities.
 The difference in the slopes of the production-possibility
boundaries reflects differences in comparative advantage (as
shown in the table). In each part the opportunity cost of
increasing production of wheat by the same amount (measured
by the distance ba) is the amount by which the production of
cloth must be reduced (measured by the distance bc).
 The relatively steep production-possibility boundary for the
United States thus indicates that the opportunity cost of
producing wheat in the United States is less than that in the
European Union.
33- 30 Gains From Trade With Constant Opportunity Costs

 If trade is possible at some terms of trade between the

two countries’ opportunity costs of production, each
country will specialize in the production of the good in
which it has comparative advantage.
 In each part of the figure production occurs at U; the
United States produces only wheat, and the EU produces
only cloth.
 Consumption possibilities are given by the red line that
passes through U and has a slope equal to the terms of
trade.
 Consumption possibilities are increased in both countries;
consumption may occur at some point such as d that
involves a combination of wheat and cloth that was not
obtainable in the absence of trade.
33- 31 Methods of Protecting Domestic Producers

Price D S

pd
1 2
4 T
pw

0 q0 q3 q2 q1

Quantity
[ii].Free
[i]. Restricted
trade trade
33- 32 Methods of Protecting Domestic Producers
 The same reduction in imports can be achieved by using
either a tariff or a quantity restriction.
 In both parts of the figure D and S are the domestic demand
and supply curves, respectively, and pw is the world price
 Part (i) of the figure shows the situation under free trade.
Domestic consumption is q1, domestic production is q0, and
imports are q0 - q1.
 Part (ii) show what happens when protectionist policies
restrict imports to the amount q2 - q3. When this is done by
levying a tariff of T per unit, the price in the domestic market
rises by the full amount of the tariff to pd.
 Consumers reduce consumption from q1 to q2 and pay an
extra amount, shown by the areas 1,2, and 4 for the q2 that
they now purchase.
 Domestic production rises from q0 to q3.
33- 33 Methods of Protecting Domestic Producers

 Since domestic producers receive the domestic price, their

receipts rise by the areas, labelled 1,2 and 3. Area 3 is
revenue that was earned by foreign producers under free
trade, while areas 1 and 2 are paid by domestic consumers
because of the higher prices they now face.
 Foreign suppliers of the imported good continue to receive
the world price, so the government receives as tariff revenue
the extra amount paid by consumers for the q3 - q2 units that
are still imported (area 4).
 When the same result is accomplished by a quantity
restriction, the government - through either a quota or a
voluntary export agreement (VER) - reduces imports to q2 -
q3.
33- 34 Methods of Protecting Domestic Producers

 This drives the domestic market price up to pd and has the

same effect on domestic producers and consumers as the
tariff.
 Since the government has merely restricted the quantity of
imports, both foreign and domestic suppliers get the higher
price in the domestic market. Thus foreign suppliers now
receive the extra amount paid by domestic consumers (area
4) for the units that are still imported.
33- 35 Global Commercial Policy
• GATT: General Agreement on Tariffs and Trade. The
principles of the GATT is that each member country
agrees not to make unilateral tariff increase. This
prevents the outbreak of tariff war.
• There have been 8 rounds of global trade talks since
1948.
• Three most recent rounds of talk completed are
Kennedy round (1967), Tokyo round (1979) and Uruguay
round (1993)
• Results: reduction of world tariff by 1/3rd and 40%
• Uruguay round created a new body, the world trade
organization (WTO) which superseded GATT in 1995.
• Under this new structure, all members are having equal
rights and obligations.
• In the first three years, WTO dealt with 132 complaints
whereas, GATT dealt with 300 cases in 40 years.
33- 36 Global Commercial Policy: Types of
Regional agreement
• Regional agreement seek to liberalise trade over a much
smaller set of countries than the WTO membership
• The forms are: Free trade areas (FTA), Custom union, and
Common markets.
• Regional trade-liberalising agreements such as free-trade areas
and common markets bring efficiently gains through trade
creation and efficiency losses through trade diversion.
• Free trade areas: allows for tariff free trade among the member
countries and leaves the the country to put restrictions of non-
member countries.
• Custom Union: free trade areas + common barriers to others
• Common Market: is a custom union that allows free movement
of labour and capital among its member countries.
• The North American Free Trade Agreement [NAFTA] is the
world’s largest and most successful free-trade area, while the
European Union is the world’s largest and most successful
common market [now called a single market].
33- 37 CHAPTER 33: INTERNATIONAL TRADE
Sources of the Gains from Trade
• Potential gains from trade exist when one country, region, firm, or
individual has a comparative advantage in the production of some good or
service.
• Comparative advantage occurs whenever countries have different
opportunity costs of producing particular goods.
• World production of all products can be increased if each country transfers
resources into the production of the products in which it has a comparative
advantage, which means those in which it has the lower opportunity cost.
• The most important proposition in the theory of the gains from trade is that
trade allows countries to obtain the goods in which they do not have a
comparative advantage at a lower opportunity cost than they would face if
they were to produce all products for themselves; this allows all countries
to have more of all products than they could have if they tried to be self-
sufficient.
33- 38 CHAPTER 33: INTERNATIONAL TRADE
• As well as gaining the advantages of specialisation arising from
comparative advantage, a nation that engages in trade and
specialisation may realise the benefits of the economies of large
scale production and of learning by doing.
• Classical theory regarded comparative advantage as being
determined largely by natural resource endowments, and thus as
difficult to change.
• Economists now believe that some comparative advantages are
acquired and thus can be changed.
• A country may, in this view, influence its role in world production
and trade.
• Successful intervention leads to a country acquiring a comparative
advantage; unsuccessful intervention fails to develop such an
advantage.
33- 39 CHAPTER 33: INTERNATIONAL TRADE

The Terms of Trade

• The terms of trade refer to the ratio of the prices of goods
exported to those imported, which determines the quantity
of imports that can be obtained per unit of exports.
• The terms of trade determine how the gains from trade
are shared.
• A favourable change in the terms of trade - that is, a rise
in export prices relative to import prices - means a country
can acquire more imports per unit of exports.
33- 40 CHAPTER 33: INTERNATIONAL TRADE
The Theory of Commercial Policy
• Protection can be a means to ends other than maximising
world living standards.
• It is also sometimes justified on the grounds that it may
lead to higher living standards for the protectionist country
than a policy of free trade would.
• Such a result might come about by developing a dynamic
comparative advantage allowing inexperienced or
uneconomically small industries to become efficient
enough to compete with foreign industries.
• A recent argument for protection is to operate a strategic
trade policy whereby a country attracts firms in
oligopolistic industries that, because of scale economies,
can earn large profits even in equilibrium.
33- 41 CHAPTER 33: INTERNATIONAL TRADE
• Domestic industries may be protected from foreign competition by
tariffs, which affect the prices of imports, or by non-tariffs which
affect the quantities of imports.
• Some fallacious free-trade arguments are that [a] because free
trade maximises world income, it will maximise the income of every
individual country; and [b] because infant industries seldom admit to
growing up and thus try to retain their protection indefinitely, the
whole country necessarily loses by protecting its infant industries.
• Some fallacious protectionist arguments are that [a] mutually
advantageous trade is impossible because one trader’s gain must
always be the other’s loss; [b] our high-paid workers must be
protected against the competition from low-paid foreign workers; [c]
imports are to be discouraged because they lower national income
and cause unemployment.
33- 42 CHAPTER 33: INTERNATIONAL TRADE
Global Commercial Policy
• The World Trade Organisation [WTO] has taken over from
GATT the role of policing world trade rules relating to
government commercial policies and providing a forum for
further international co-operation in evolving the global trade
regime.
• Regional trade-liberalising agreements such as free-trade
areas and common markets bring efficiently gains through
trade creation and efficiency losses through trade diversion.
• The North American Free Trade Agreement [NAFTA] is the
world’s largest and most successful free-trade area, while the
European Union is the world’s largest and most successful
common market [now called a single market].
33- 43

Monetary and Fiscal Policy

Monetary Policy: The behavior of the central bank
concerning the nation’s money supply.
• Fiscal Policy: Changes in taxes or spending that are
result of deliberate changes in government policy.
• The instruments of the monetary policy are:
Changes in Money supply through changes in bank
money, changes in required reserve ratio, open
market operation, discount rate and interest rate.
• The instruments of Fiscal policy are: Changes in
Government spending and changes in the tax rates.
33- 44

The Nuts and Bolts of Monetary Policy

• Open market operations: buying and

selling government bonds
• Discount rate policy: setting the interest
rate, called the discount rate, at which
member banks can borrow reserves from
central bank.
• Reserve requirement policy: changing the
legal reserve ratio requirement of banks
33- 45

Nuts and bolts of Fiscal policy

• Public expenditure: government purchases
– purchases of tanks, construction of
roads, schools, hospitals etc.
Government transfer payments – old age
benefits, sickness benefits, unemployment
benefits etc.
Taxation: taxation reduces income and
taxes affecting prices of goods.