Chapter 4

INTERNATIONAL TRADE
(CORE)
Kalaiyarasi Danabalan
A’ level (economics)
Topic covered

 Principles of absolute and comparative advantage

 Arguments for free trade and motives for protection
 Types of protection
 Types of economic integration
 Terms of trade
 Components of the balance of payments
The Principle of International Trade

 Refer to as multinational trade.

 Their principles of absolute and, particularly, of comparative advantage have modern relevance in the
objectives of the World Trade Organization (WTO), which exists to promote free trade amongst all of its
member countries.
 Trade will take place when countries have a clear-cut or absolute advantage over other countries in they
produce.
 Trade can also be beneficial where a country may not / comparative advantage in the production of a
particular good over another country, trade can produce gains for both partners.
INTERNATIONAL TRADE

Free trade - system of trade policy that allows traders to trade across national boundaries without interference
from the respective governments.
There are 2 reasons of free trade
 Domestic Non-availability: A nation trades because it lacks the raw materials, climate, specialist labour,
capital or technology needed to manufacture a particular good. Trade allows a greater variety of goods and
services.
 Cost effectiveness: It is cheaper to buy from other countries rather than producing themselves.
 Reciprocal absolute advantage- one country is better at producing one product, the other is superior in the
production of the other.
 Comparative advantage – trade between two countries should still take place and be mutually beneficial
provided the domestic opportunity cost of production differ.
Benefits of Free Trade

 Lower prices for consumers

 Greater choice for consumers
 benefit from economies of scale
 acquire needed resources
 efficient allocation of resources
 Increased competition
 Source of foreign exchange
FREE TRADE DIAGRAM

http://www.youtube.com/watch?v=65UcSx_LrZI#t=62
EXPORTS & IMPORTS / VISIBLE TRADE
AND INVISIBLE TRADE

 EXPORTS (X)- the movement of goods / commodities out of the country.

 IMPORTS (M) – the movement of goods / commodities into the country.
 VISIBLE TRADE – involves trading of goods which can be touched & weighed. Examples include trade in
goods such as oil, machinery, foods, clothes etc.
 Visible exports- selling of tangible goods which can be touched & weighed to other countries.
 Visible imports - buying of tangible goods which can be touched and weighed from other countries.
 INVISIBLE TRADE – involves the M &X of services rather than goods. Ex :- banking, tourism, education.
 Balance of trade - It is the difference between the value of visible exports and value of visible imports of a
country.
X>M - the country will have a Surplus balance of trade.
M>X - the country will have an Unfavourable balance of trade.
ABSOLUTE ADVANTAGE

 A country has an absolute advantage over another in producing a good, if it can produce that good using
fewer resources than another country.
 if one unit of labor in Australia can produce 80 units of wool or 20 units of wine; while in France one unit of
labor makes 50 units of wool or 75 units of wine, then Australia has an absolute advantage in producing
wool and France has an absolute advantage in producing wine.
 Australia can get more wine with its labor by specializing in wool and trading the wool for French wine,
while France can benefit by trading wine for wool.
COMPARATIVE ADVANTAGE

 A country should specialize in the production of good or service in which it has lower opportunity cost and it
should import commodities which have a higher opportunity cost of production.
 A country enjoys a comparative advantage in the production of a good when that good can be produced at a
lower cost in terms of other goods.

Example
Northland and Southland produce and consume two goods, Food and Clothes. The productive capacities and
efficiencies of the countries are such that if both countries devoted all their resources to Food production, output
would be as follows:
 Northland: 100 tonnes
 Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
 Northland: 100 tonnes
 Southland: 100 tonnes
 each has constant opportunity costs of production between the two products and both economies have full
employment at all times. All factors of production are mobile within the countries between clothing and food
industries, but are immobile between the countries. The price mechanism must be working to provide perfect
competition.
 Southland has an absolute advantage over Northland in the production of Food. Both countries are equally
efficient in the production of clothes. There seems to be no mutual benefit in trade between the economies.
 The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne
of Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The
opportunity cost of one tonne of Clothes is 2 tonnes of Food.
 Southland has a comparative advantage in food production, because of its lower opportunity cost of production
with respect to Northland. Northland has a comparative advantage over Southland in the production of clothes,
the opportunity cost of which is higher in Southland with respect to Food than in Northland.
To show these different opportunity costs lead to mutual benefit if the countries
specialize production and trade, consider the countries produce and consume
only domestically. The volumes are:

Foods Cloths
Northland 50 50

Southland 100 50

World total 150 100

Production & consumption before trade

 he exchange price will be somewhere between the two. The remainder of the example works with an
international trading price of one tonne of Food for 2/3 tonne of Clothes.
 If both specialize in the goods in which they have comparative advantage, their outputs will be

Food Clothes
Northland 0 100
Southland 200 0
World total 200 100
Production & Consumption after Trade

 World production of food increased. Clothing production remained the same. Using the exchange rate of one
tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level
of consumption :
 Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points
outside their production possibility frontiers.

Food Clothes

Northland 75 50

Southland 125 50

World total 200 100

Limitations of Theory of Absolute Advantage

The theory is based on unrealistic assumptions:

 Factors of production are immobile and fixed
 Technology is fixed
 There is perfect competition
 Resources are fully employed
 Imports and exports balance each other
 There is free trade
Cost of Transportation has been ignored
http://www.youtube.com/watch?v=RpfV0Oerfr8
Summary of the Principles of Absolute and
Comparative Advantage

 There are just two countries involved in trade.

 Each can produce just two products.
 Productivity differs between them, so varying quantities of each are produced.
 Production costs and opportunity costs are constant for each product.
PRINCIPLES OF INTERNATIONAL TRADE

 The production possibility frontiers are linear.

 The exchange rate operating for international transactions must be between respective domestic opportunity
cost ratios.
 No transport cost are charged.
 The two country, two-product assumption is again a long way from reality in the 21 st century.
 Production cost are most unlikely to be constant.
 There are no restrictions on free trade between those countries which possess absolute and comparative
advantage.
Other explanation & determinants of trade
flows

 Competitive advantage- focuses on the actual production cost and how in reality, firms are continuously
striving to reduce their unit costs.
 Factor endowment – this model of trade stresses the importance of the quantity and quality of the production
factors.
 Government policy – a government may decide that it does not wish to over-specialize & that its best
strategy is to diversify production so that it has a range of products available in the event of any dislocation /
supplies interruption.
Protectionism

 Policy of protecting domestic industries against foreign competition by means of tariffs, subsidies, import
quotas, or other handicaps placed on imports.
 Government-levied tariffs, raise the price of imported articles, making them less attractive to consumers than
cheaper domestic products.
 Import quotas, which limit the quantities of goods that can be imported, are another protectionist device.
 Tariff (tax on imports)

 tax on foreign goods upon importation. Tariff rates vary according to the type of goods imported. Import
tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus
lowering the quantity of goods imported.
Impacts of Tariffs

 Tariffs lead to higher prices for imports and thus Imports fall
 Domestic consumers have to pay higher prices and buy less.
 Domestic producers gain, as they get higher prices and sell larger quantities. As we can see in the
diagram domestic production increases from 0Q1 to 0Q2. Moreover their revenue increases from
PwQ1 to Pw+TQ2
 Higher domestic production leads to increased domestic employment.
 Government now gains from tariff revenues, which can be represented by ‘e’ in the diagram
 Tariffs are regressive in nature and thus worsen income distribution.
 Exporting countries lose due to fall in exports.
 Quotas (restriction on the maximum import
quantity)

 Import quotas - sets a physical limit on the quantity of a good that can be imported into a country in a given period of
time. This leads to a reduction in the quantity imported and therefore increases the market price of imported goods.
Effects of Quotas
 Domestic production increases from 0Q1 to 0Q1+Q3Q4.
 Domestic consumption fall from 0Q2 to 0Q4
 Imports fall from Q1Q2 to Q1Q3
 Consumers end up paying more. Before quota was imposed they were paying Pw, but now they are paying
Pw+Quota
 Domestic producers gain as they sell more at higher prices (Pw+Quota)
 Domestic employment increases as domestic production rises.
 Government gets quota revenues
 Domestic society is worse off due to decrease in consumption and production by less efficient producers
 Exporting countries lose revenue
 Quotas result in global misallocation of resources as goods are being produced by inefficient producers.
 J and K represents the dead weight loss of welfare to the society, as J represents production by inefficient
producers and K represents the loss of consumer surplus.
Subsidies

 government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms
that cannot compete well against foreign imports.
Effects of Subsidies

 Consumption of the good is not affected. Consumption remains at Q3.

 Taxpayers lose as the tax revenue collected is being used for subsidies
 Domestic producers gain as the production increases from 0Q1 to 0Q3.
 Employment increases as more is being produced domestically.
 Exporting countries are worse off
 Global misallocation of resources as inefficient producers are now producing goods.
Other protection policy

 Administrative Barriers
Countries are sometimes accused of using their various administrative rules (eg. regarding food safety,
environmental standards, electrical safety, etc.) as a way to introduce barriers to imports.
 Embargo
An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it and to put its
government into a difficult internal situation, given that the effects of the embargo are often able to make its
economy suffer from the initiative.
 Anti-dumping legislation
Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods that would cause
local firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on
foreign exporters.
ECONOMIC INTEGRATION

 Trade unification between different states by the partial or full abolishing of customs tariffs on
trade taking place within the borders of each state.
 This is meant in turn to lead to lower prices for distributors and consumers (as no customs duties
are paid within the integrated area) and the goal is to increase trade.
 Trade agreement – A contract/agreement/pact between two or more nations that outlines how they
will work together to ensure mutual benefit in the field of trade and investment. Trade agreements
are either bilateral, involving only two countries, or multilateral, involving more than two
countries.
 Trade bloc - a type of intergovernmental agreement, where regional barriers to trade, (tariffs and
non-tariff barriers) are reduced or eliminated among the participating states.
 Types of Trade Blocs

 Preferential Trade agreement – A trading bloc that gives preferential access to certain products from the
participating countries. This is done by reducing tariffs but not by abolishing them completely. A PTA can be
established through a trade pact. It is the first stage of economic integration.
 Free Trade Areas - A trade bloc whose member countries have signed a free-trade agreement (FTA), which
eliminates tariffs, import quotas, and preferences on most (if not all) goods and services traded between
them.
 Customs Union- An agreement among countries to have free trade among
themselves and to adopt common external barriers against any other
country interested in exporting to these countries.
 Common Market - A type of custom union where there are common
policies on product regulation, and free movement of goods and services,
capital and labour. All common markets and economic and monetary
unions are also customs unions
 Economic & Monetary Unions

 A common market with common currency

 Where more than two countries use the same currency.

Advantages of single currency

 Reduces the level of transaction cost.
 When trading among each other the countries need not worry about possible exchange rate fluctuations.
 It is easier to make price comparisons between countries.
 Greater FDI is attracted because of reduced transactions costs, reduced uncertainty and the large size of single currency market.

Disadvantages of single currency

 Individual countries lose the ability to set interest rates.
 Individual countries cannot depreciate or devalue its currency value.

The terms of Trade

 The exchange Rate operating for international transaction must be between the respective domestic
opportunity cost ratios.
 It measures the rate at which the goods of one country exchange for the goods of another.
 The consumption combinations possible through specialization and trade at these terms of trade are
represented by each country’s trading possibility curve (TPC).
 Trading possibilities exist that exceed domestic production possibilities. Countries can still do much better
through trade than trying to produce everything for themselves.
 The terms of trade are represented as an index of the ratio of export prices and import prices :-

Terms of Trade index = x 100