The terms of trade

The terms of trade

• The terms of trade is a measure of the ratio of export prices and import
prices.
• Terms of trade are defined as the ratio between the index of export prices
and the index of import prices. If the export prices increase more than the
import prices, a country has a positive terms of trade, as for the same
amount of exports, it can purchase more imports.
• The ratio is calculated from the average prices of many goods and
services that are traded internationally. The prices are weighted by
the relative importance of each product traded.
• If the index increases, this is described as a favourable movement or
an improvement in the terms of trade.
• It means that fewer exports have to be sold to buy any given quantity
of imports. An unfavourable movement or deterioration in the terms
of trade means that the index number has fallen. Now more exports
will have to be exchanged to gain the same quantity of imports.
Causes of changes in the terms of trade
• Factors that affect the terms of trade
• A fall in the exchange rate should reduce the terms of trade. This is
because a decline in the exchange rate will make exports cheaper. An
appreciation in the exchange rate should improve the terms of
trade because exports will rise in price and imports become cheaper.
Absolute and comparative advantage
Absolute advantage: used in the
context of international trade, a
situation where, for a given set
of resources, one country can
produce more of a particular
product than another country.
Comparative advantage: used in
the context of international
trade, a situation where a
country can produce a product
at a lower opportunity cost
than another country.
The theory of absolute advantage:
By Adam Smith
• Absolute advantage refers to the ability of one country to produce a good
using fewer resources than another country.
• A country has an absolute advantage in a good if with the same quantity of
resources it can produce more of the good than another country.
• According to the theory of absolute advantage, if countries specialise in and
export the good in which they have an absolute advantage (can produce with
fewer resources), the result is increased production and consumption in each
country.
Absolute
advantage
Absolute advantage: before and after
specialization
Absolute advantage and specialization
• If each country specialises in the product in which it has an absolute
advantage and then trades, based on opportunity cost ratios, total
output will rise and both countries will be able to consume more
products. Table 4.4 shows output before and after specialisation. In
this case, the opportunity cost of producing 1 tonne of rice in
Indonesia is two-fifths of a tonne of coffee while in Brazil it is 2.5
tonnes of coffee.
• An exchange rate of 1 tonne of rice for 1.5 tonnes of coffee lies
between the opportunity cost ratios and will benefit both countries.
Table 4.5 shows the countries’ positions aft er Indonesia has
exchanged 300 tonnes of rice for 450 tonnes of coffee.
Absolute advantage
Absolute advantage
Theory of comparative advantage:
By David Ricardo
• Comparative advantage theory shows how that countries can gain
from specialisation and trade even if one country has the absolute
advantage in both goods. In order for this surprising result to hold, it
is only necessary that countries have different opportunity costs for
their goods, so that the production of one good is relatively cheaper
in one country than in another, even if it is not absolutely cheaper.
• Comparative advantage refers to the situation where one country has
a lower opportunity cost (relative cost) in the production of a good
than another country.
Comparative
advantage
Comparative advantage: before and after
Comparative advantage and specialization:
• Bangladesh has the comparative advantage in making shirts as it can
make them at a lower opportunity cost. In Bangladesh for every shirt
produced, one-eighth of a coat has to be sacrifi ced, In contrast, in the
USA, the opportunity cost of producing a shirt is two-fi ft hs of a coat.
Table 4.6 shows how specialisation increases output by 1,000 units.
Comparative advantage
The benefits of free trade
• Free trade: international trade not restricted by tariffs and other
protectionist measures.
• List the differences between domestic trade and free trade.
• Free international trade is the exchange of goods and services across
national borders without any government restrictions.
• When free trade exists, firms are free to export and import what they
want in the quantities they want.
• No taxes or limits are imposed on exports and imports, no subsidies
are given to distort cost advantages and there is no unnecessary
paperwork involved.
The benefits of free trade
• Free trade allows an efficient allocation of resources with countries being able to
concentrate on producing those products that they have a comparative advantage.
• The competition that may arise from free trade can put pressure on firms to keep
their prices and costs down and raise the quality of their products
• consumers may enjoy lower prices and better products
• Firms may also be able to buy raw materials and capital goods at lower prices.
• Free trade may enable firms to produce a higher output and so take greater
advantage of economies of scale.
• Consumers may be able to buy a greater variety of products as they may have a
wider choice of products,
• Firms may also have a wider source of raw materials and capital goods.
Trading possibility curve: a diagram showing the effects
of a country specialising and trading.
Activity
• 1. How does specialisation allow countries to benefit from trade?
• 2. Explain how each of the following can benefit from trade: (a)
consumers, (b) producers, (c) the domestic economy and society, and
(d) the global economy and society.
• 3. Why has international trade been termed an ‘engine for growth’?
• 4. Explain the difference between (a) the terms ‘absolute advantage’
and ‘comparative advantage’, and (b) the theory of absolute
advantage and the theory of comparative advantage. (c) Which of the
two theories is amore powerful explanation of the benefits from
trade. Why?
Trading possibility curve
• Trading possibility curve: a diagram showing the effects of a country specialising
and trading.
• A trading possibility curve shows how an economy can benefit from specialising
and trading.
• For example, a country may be able to produce a maximum of 50 million units
of clothing or 100 million units of food. For every 1 unit of clothing it produces
it gives up the opportunity to produce 2 units of food.
• Engaging in international trade may enable the country to specialise in clothing
production and import three units of food for every unit of clothing it exports.
• Trading will increase the total quantity of products the country can consume.
Trade blocs
• Trade bloc: a regional group of countries that have entered into trade agreements.
• Trading blocs lead to trade liberalisation (the freeing of trade from protectionist measures)
and trade creation between members, since they are treated favourably in comparison to non-
members.
• EXAMPLES:
• European Union (EU) – a customs union, a single market and now with a single currency
• European Free Trade Area (EFTA)
• North American Free Trade Agreement (NAFTA) between the USA, Canada and Mexico
• Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela
• Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
• Common Market of Eastern and Southern Africa (COMESA)
• South Asian Free Trade Area (SAFTA) created in 2006 with countries such as India and Pakistan
• Pacific Alliance – 2013 – a regional trade agreement between Chile, Colombia, Mexico and Peru
Types of trading blocs:
1. Free trade areas
• Free trade area: a trade bloc where member governments agree to
remove trade restrictions among themselves.
• The members are allowed to determine their own external trade
policies towards non-members.
• An example of a free trade area is the North American Free Trade
Agreement (NAFTA). This consists of the USA, Canada and Mexico.
2. Customs unions
• Customs union: a trade bloc where there is free trade between member
countries and a common external tariff on imports from non-members.
• As well as removing trade restrictions between members, members of a
customs union agree to impose a common external tariff on trade with
non-members.
• Example: the Southern Africa Customs Union (SACU). Its members
include Botswana, Lesotho, Namibia, South Africa and Swaziland. These
countries impose the same tariff on goods being imported from outside
the trading bloc.
• The countries share tariff revenues and coordinate some trading policies.
3. Economic unions
• Economic union: a trade bloc where there is free trade between
member countries, a common external tariff and some common
economic policies, which may include a common currency.
• Example: The European Union (EU). It operates a single market and its
members have adopted the same policies on a number of labour
market and social issues. Most of the members have adopted the
same currency, the euro, and the European Central Bank operates a
single interest rate.
• Monetary union involves economies operating the same currency, as
the members of the euro area do.
Trade creation and trade diversionx
Trade creationx
• Trade creation occurs when the removal of tariffs allows members to
specialise in those products in which they have a comparative
advantage.
• Trade creation: where high-cost domestic production is replaced by
more efficiently produced imports from within the customs union.
• Trade creation allows consumers and producers in member countries
to enjoy the benefits of economies of scale.
Trade diversionx
• Trade diversion is a switch from a lower-cost foreign source/supplier outside of a
customs union towards a higher-cost supplier located inside the customs union.

• Trade diversion is a feature of a country deciding to join a customs union i.e. an area
where there is free trade within the customs union but also a common external tariff.
• When/ Before a country joins a customs union it might initially be trading freely with a
low cost supplier in a 3rd party nation.
• Once inside a customs union, the country must now adopt a common external tariff
which will then increase the cost of importing from the 3rd party nation.
• These higher prices might affect consumers directly e.g. higher prices for food.
• Or they might affect consumers indirectly because producers now have to pay more
for their imports from the 3rd party.
• Fig 4.45 p107
Table 4.8 Examples of trade blocs and their
membership p108
Chapter 26
Protectionism
Restrictions on free trade: trade
protection
• Protectionism: protecting domestic producers from foreign
competition.
Protectionism
Protectionism
• Protectionism involves protecting domestic industries from foreign
competition. It restricts free trade and the methods used often seek
to increase domestic industries’ relative price competitiveness.
• Is protectionism good or bad?
• Why do countries use protectionism?
• What is an example of protectionism?
• What are the pros and cons of protectionism?
Methods of protection and
their impact
Tariffs
• Tariff: a tax imposed on imports or exports.
• Revenue raising may also be the reason for taxing imports.
• The other motive is to discourage consumption of imports.
• A tariff can be specific, that is a fixed sum per unit, or ad valorem, which
is a percentage of the price.
• A tariff imposes an extra cost on the supplier which usually pushes up the
price.
• A tariff will be more effective in raising revenue if demand for imports is
price inelastic whereas it will be more effective in protecting the
domestic industry if demand for imports is price elastic.
The effect of imposing a tariff
• Figure shows that the
imposition of a tariff will benefit
domestic producers as their
output rises from Q to Q1.
• Domestic consumers lose out as
they have to pay a higher price
P1 and experience a reduction in
their consumption from Q3 to
Q2.
Effect of Tariffs on imports p. 383
• Diagram shows that under free trade, the
country accepts the world price Pw, at
which it produces quantity Q1 (giventhe
intersection of Sd with the world supply
curve), demands quantity Q4 (given by
the intersection of Dd , with the world
supply curve), and imports Q4 − Q1.
• Suppose a tariff is imposed on the
imported good. As a result, the price of
the imported good rises, to Pw + t,
causing the domestic price of the good
to rise above the world price by the
amount of the tariff, to Pw + t.
Quotas
• Quota: a limit on (value/ quantity) imports or exports.
• Restricting the supply of imports is likely to drive up their price.
• As a result, consumers end up paying higher prices and consuming
fewer products.
• Unlike tariffs, quotas usually do not raise revenue for the government.
Quotas
• For example, the US may limit the number of Japanese car imports to
2 million per year.
• Quotas will reduce imports, and help domestic suppliers.
• However, they will lead to higher prices for consumers, a decline in
economic welfare and could lead to retaliation with other countries
placing tariffs on our exports.
• Quotas will lead to lower sales for foreign companies, but it could
push up prices and make sales more profitable.
In this diagram, the quota is the difference between
S(domestic) and S(domestic) + quota
The effect of quotas (diagram)
Without quotas
• The market price is P world
• Quantity of imports is Q4-Q1
• World exporters make revenue
of areas A+B+C
Imposing quotas of (Q3-Q2)
• This leads to a fall in imports to just Q3-Q2
• Domestic suppliers gain more revenue. The price rises
to P quota and domestic suppliers, supply more Q1 to
Q2. It can create domestic jobs.
• Consumers pay a higher price and also total quantity
falls from Q4 to Q3.
• Governments are not affected directly, as there is no
income.
• There is a net welfare loss to society because the
increase in producer surplus is outweighed by the
decline in consumer surplus.
• World exporters will make less revenue – unless
demand is very inelastic, meaning increase in price is
greater than fall in quantity
Welfare loss of quotas
Quotas vs Tariffs

• Quotas tend to cause a bigger fall in economic welfare because the government don’t
gain any tax revenue, that you get with tariffs.
• Quotas allow the country to be certain on the number of imports coming in. Tariffs is
more unknown because it depends on the elasticity of demand and how consumers and
suppliers react to the tariff.
• Quotas may be harder to enforce if it is difficult to count the amount of the good coming
into the country.
• Quotas could be more unfair. Some export firms may do well if they get the quota
allowance, but others may lose out. It becomes a political issue on how to distribute the
quotas. Firms may also dislike the uncertainty of not knowing how many quotes to gain
Exchange control
• Exchange control: restrictions on the purchases of foreign currency.
• Foreign exchange controls are various forms of controls imposed by a government
on the purchase/sale of foreign currencies by residents, on the purchase/sale
of local currency by nonresidents, or the transfers of any currency across national
borders.
• These controls allow countries to better manage their economies by controlling
the inflow and outflow of currency, which may otherwise create exchange
rate volatility.
• Countries with weak and/or developing economies generally use foreign exchange
controls to limit speculation against their currencies.
• They may also introduce capital controls, which limit foreign investment in the
country
Export subsidies
• Subsidies may be given to both exporters and to those domestic firms
that compete with imports. In both cases domestic firms will, in effect,
experience a fall in costs.
• This will encourage them to increase their output and lower their price.
This may enable them to capture more of the markets at home and
abroad.
• The losers will be the foreign firms and domestic taxpayers. Domestic
producers will gain. Consumers will also benefit in the short run. In the
long run, however, they may lose if the more efficient foreign firms are
driven out of business and the subsidised domestic firms raise their
prices.
Embargoes
• An embargo is a complete ban either on the imports of a particular
product or on trade with a particular country.
• A government may want to ban the import of a product that it
regards as harmful, e.g., non-prescription drugs or weapons.
• A ban on trade with a particular country may arise from political
disputes.
Voluntary export restraints/ restrictions
• Voluntary export restraints are sometimes also called voluntary
export restrictions.
• They are an agreement by an exporting country to restrict the amount
of a product that it sells to the importing country.
Economic and administrative burdens (‘red tape’)
• A government may seek to discourage imports by requiring importers
to fill out time consuming forms. It may also set artificially high
product standards to restrict foreign competition. Such measures
restrict consumer choice.
Keeping the exchange rate below its market
value (Devaluation)
• A government may manipulate the country’s exchange rate in order
to give its producers a competitive advantage. This may lead to other
governments lowering their exchange rates.
The arguments in favour of protectionism 109
• To protect infant (sunrise) industries
• To protect declining (sunset)industries
• To protect strategic industries.
• To prevent dumping
• To improve the terms of trade
• To improve the balance of payments
• To provide protection from cheap labour
• Other reasons: revenue, retaliatory, discourage overspecialisation
To protect infant industries

https://
www.econo
micshelp.org
/blog/
glossary/
infant-
industry-
argument/
• Barriers to trade can be used to protect sunrise industries, also known
as infant industries, such as those involving new technologies. This
gives new firms the chance to develop, grow, and become globally
competitive.
To protect declining
industries
• If declining (also called sunset)
industries, which have lost their
comparative advantage, go out of
business quickly there may be a sudden
and large rise in unemployment.
• If the industry is granted protection and
that protection is gradually removed,
unemployment might be avoided.
• As the industry reduces its output,
some workers may retire and some
leave for jobs in other industries.
• Examples: Coal industry
To protect strategic industries
• Some governments seek to protect industries that produce products
they regard as strategic, such as weapons, fuel and food.
• They may not want to be dependent on foreign supplies of these
products. For example, a government may be worried that firms and
households in its country would be seriously disadvantaged if fuel was
cut off due to a trade dispute or a military conflict.
• As a result it may protect some home industries even if they are
relatively inefficient.
To prevent dumping
• Dumping involves selling products at below their cost price.
• In the short run, home consumers will benefit from dumping as they
will enjoy lower prices. In the long run, however, if the foreign fi rms
drive out the domestic firms, they may gain a monopoly and then
raise their prices.
• Indeed, foreign firms may engage in dumping with the specific
intention of gaining control of a market in another country by
destroying existing competition and preventing new domestic firms
from becoming established.
To improve the terms of trade
To improve the balance of payments
To provide protection from cheap labour
Other reasons