AS Economics (Macro)

Chapter 7: International Trade

Absolute vs comparative advantage in specialization: countries should specialize in the

goods in which they are good at. How do we know whether a country is good at producing
something or not? Through the theories of absolute advantage and comparative advantage.

Absolute advantage: this theory states that a country should specialize in that product in
which it is more efficient as compared to another country or if a country produces a product
at a lower average cost as compared to another country, it should specialize in that product.

1. Before specialization (diversification)

I Food Clothing
Country X 30 15
Country Y 10 20
World Output 40 35

Assuming both countries have 100 workers each and each country assigns 50 workers each
to production of both goods

2. After specialization
I Food Clothing
Country X 60 0
Country Y 0 40

Now as X has an absolute advantage in food and Y has absolute advantage in clothing.
X assigns all 100 workers to food and Y assigns all 100 workers to clothing

As countries specialize in those goods in which they have absolute advantage, there overall
output will increase as they are focusing on goods in which they are more efficient and
hence countries then trade with each after specialization for their mutual benefits

Comparative advantage: this theory states that a country should specialize in that product
in which its opportunity cost is less compared to another country.

Sometimes one country has an absolute advantage in both goods. If specialization of trade
takes place in such a case using the absolute advantage theory, 1 country will produce both
goods while the other will not produce anything. This will make both countries worse off. In
such a case, theory of comparative advantage is used, as shown in the e.g., below: -

I Tea Coffee Ratio

X 40 40 1:1
Y 30 10 3:1

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In this example X can produce either 40 units of tea or 40 units of coffee with all its 100
workers, while y can either produce either 30 tea or 10 coffees with all its resources.

The ratio column in the above tables shows opportunity cost of both countries of each good.
So, for X, if X produces 1 unit of extra tea, it will have to sacrifice 1 unit of coffee, due to
scarcity of tradeoff.
Similarly, if Y produces 1 extra unit of coffee, it will have to forgo 3 units of tea due to
scarcity

As opportunity cost for y < x, for this reason Y specializes in producing tea while as
opportunity cost (coffee) for X < Y, X should specialize in producing coffee

Now as Y specializes in tea and X specializes in coffee, they now decide to trade these
goods with each other to benefit.

At what price do they decide to trade? The price of trade, or how many units of should Y
export to X in return for how many units of coffee from X and vice versa, is known as

Terms of trade: how do countries decide on terms? For mutually beneficial trade, terms of
trade must always lie between the opportunity cost ratios of two countries of the same
product.

For this, or to calculate the range of opportunity costs of countries X and Y of tea and coffee
respectively, we draw a table in the terms of per unit tea and coffee produced for both
countries and their opportunity costs.

3. 0C Table 1T 1C
X 1C 1T
Y 1/3 C 3T

The table shows the opportunity cost of each unit of tea and coffee for each country. So, for
example, if X produces 1 tea, it sacrifices 1 coffee and if Y produces 1 tea, it sacrifices 1/3
units of coffee.

Now, as we defined terms of trade to be between the opportunity costs the 2 countries face
of each good, the arrows in the above table show us the range of the terms of trade.

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 4. L U
1/3 Coffee (Y) < 1 Tea < 1 Coffee (X)
1 Tea (X) < 1 Coffee < 3 Tea (Y)

These above are the two ranges that we have from our terms of trade. The terms of trade
between X and Y should lie between one of the two ranges. So, for example, we take the
lower range, and both countries agree that the terms of trade would be 1CX = 2TY, this
means that if X exports 1 unit of coffee it will import 2 tea from Y and country Y exports 2
tea for 1 coffee import.

Trading Possibilities Curve: it is a curve that shows that combination of two goods that a
country can consume after specialization and trade according to the terms of trade. It is
drawn by assuming that the country produces only that good in which it has a comparative
advantage, and then by assuming that the country exports all of that good and imports all of
the good that it isn t specializing in based on the terms of trade that have been determined.

Tea
^
In this example of country X, a PPC is first
drawn, which shows that it can produce
either 40 tea or 40 coffee respectively. Then so -

the TPC is drawn, where the x intercept of

the amount of coffee it can produce
remaining the same, but the y intercept
changes, as due to the ToT being 1C = 2T, if B
country X exports all 40 coffee, it will import 40 - - - - --
-

;•
80 tea, hence the y intercept is 80 tea. Ai TPC ×
Hence on any point on the TPC, it is clear
20
- - - - - - --
•!•
that X is better off after specialization and
trade than before it. Therefore trade makes I.PPC ✗

countries better off. Same will be the case I

with country Y
1 )
20

Note: no country can have comparative

40
Coffee
advantage in 2 goods as its opportunity cost
in both the goods cannot be lower than the
other country.

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 comparatiueA-dnantag.ee
countries have d- A ?
step ①ORMich
does AA work ? (no !)
Tea '
toffee
✗ 40 or qÉ÷¥÷
Y 30 Jor 10
throne

!÷±
"

A-A lies with ✗ in both

it becomes useless
.
Foods
so

Ratios
step② Finding → Oc

step③ which country has CA ?

CA in Tea Yasitsocis less
CA in
coffee ✗ asitsocieess
while Y
:O ✗
specializes in
coffee
specializes in Tea d they trade
-
Step④ Determination of Price of
Trade:-TermsifFrade(T
To T , it should
For mutually benefited
ratio the two
lie b/w the 20C of
intros for the same goods

¥¥¥E÷÷÷÷÷aC
.

Q answered
by TI
FEW
toy , how much T should

.IT#benefitialb-ode
?
✗
1¥ 1¥ :

Y tzc 3T K×=
This T T will
-
cause

L U
✗ & Y to benefit due
to trade
-

IT < 1C ①
43C <

④=
IT < 3T .
step⑤ Trading Possibilities Gone
(TPC) of⇐
.

Tenn
:
1C×=2
so -

B
Tpc
Go↳ =
So
I
4 -

go
- -
o -- -
- - - -

20 . - - - - - . .
.
!A
\ PPC
✗

:
>
2-
% coffee

% trade is mutually Hefted

A : -

beforetrade
Trade same C but
B after : -

:
T
-

more .

•
: ✗ is better
ff
One country have CA in
Note : -

Ocs
can never

both goods vary

as .
 Tea No Trade as 0C same
Some PPC related Trade scenarios
since PPC are parallel
(
slopes
are same )
1. Parallel PPC
(✗ has Aotinbothqooh)
NO trade will take place as both countries useless
PPCs are parallel, meaning their opportunity PPc× (
Atheoryisabo
costs are the same. Hence trade will not Ppcy
occur as there is no benefit in trade

coffee
AAinT=y
AAinC=✗
2. Intersecting PPCs PPCY
Trade will take place through the theory
of absolute advantage as country Y is
better at tea while country X is better at
coffee Ppcx

T Trade thru CA
3. Non-intersecting non parallel PPCs (Ocs will be different)
Trade will take place through the
theory of comparative advantage as
country X is better in both goods but PPG
their opportunity costs are clearly
different PPCY

T Oulyduetotradeis
possible
-

A-
4. When consumption point is •
A
above PPC
This will happen when a country is
involved in international trade, as
the country will be at its imaginary
PPC×
TPC

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 Protectionism and Trade

A country trades or not depends on its domestic price of a good relative to world D

price
p
St

If PD = PW then there will be no trade

as it will not benefit anyone PIPE

Dig
150
Pw ¥9M
; ,
Sw
PD < PW, then the gap between quantity '
I
,

demand and supplied (surplus) will be

100 PD '
1

|
exported " "

Local consumption I !
OQ ,
I 1 DD
i
esports i
.

Q, Q ,
-

0←⑧
Lc ←
a

✗
⑨
s
PD > PW then the gap between quantity supplied
and demanded (shortage) will be imported

PD
Sw
Pw -

Import (shortage) D
i
i.
⇐aim QD
>

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 Trade barriers / Protectionism
Indirect tones
.

1. Tariffs: these are the tariffs imposed increasing the price of imports.
-
s

Pre-tariff import =
Post-tariff import =
Goat PD
€
Tsizeoforuola .
TARIFFS = fall in imports Putin ,

freeloader i
-

toward Pw ; i
1. ! ;D
opetradevaouersv '

Q 's Q; Q; Q ;
2. Quotas: these are physical limits-imposed om quantity / volume or value of
M -1006b€
.

,
imports
Mz -4506m€ 3. Exchange controls: a limit on the amount of foreign exchange that can be
'

purchased by an individual over time.

4. Subsidies: give local producers and exporters incentive to produce more at
cheaper rates.
5. Embargoes: complete ban on imports
6. Voluntary export restraints (VER): an agreement between 2 countries where the
exporting country agrees to restrict the volume of its exports of a certain good to
another country
7. Red tapes: economic and administrative burden on export/imports.

barriers
/ disadvantages cftrade
-

The advantages of 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 wish .

- no taxes or limits are imposed on exports and Imports

- no subsidies are given to distort cost advantages
- there is no unnecessary paperwork involved.
trade
Benefits of free international include:
K

1. There is an increase in the world output and gains for the individual country as a
result of specialization and trade. This is because countries focus on goods in which
they are good at. Moreover, employment in such sectors also increases.→ Timeous

2. There is wider consumer choice. As a result of international trade, there is a greater

variety of goods and services to choose from. Consumers can choose commodities
that cannot be produced locally and those goods which are too expensive to be
produced locally.

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 3. International trade generates income and brings about higher economic growth and
hence, a higher standard of living. The expansion of output for export also creates
employment. entension to pt 1 .

4. International trade brings about the sharing of new knowledge and information.
New technology is acquired. Research and development programs from developed
I cost
countries through trade. + cheaper I better Fop →
in
push a- .

5. With international trade, there will be keen competition which forces firms to be
cost effective and efficient. They will have to produce at lower cost and they must
also improve on their production techniques as well as the quality of their products.
Inefficient firms will be forced to close down,

6. International trade improves countries relations with each other as it promotes

interdependence between countries.

7. It can allow local firms to expand into foreign markets, increasing market share,
customer base and hence profits.
trade
The arguments in favor of protectionism /Disadvantages of free
Despite the potential advantages of free trade, most countries impose import restrictions.
There are a number of arguments that may be put forward for doing this.

1. To protect infant Industries: Infant industries are new industries that have a low
output and a high average cost. Firms in a new industry may find it difficult to survive
when faced with competition from more established, larger foreign firms.
Protecting a new infant industry may give it time to grow and so benefit from
economies of scale and to gain a global reputation. If the infant (also called sunrise)
industry has the potential to develop into an efficient industry in line with
comparative advantage, then using trade restrictions may be justified.

2. 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. However, too much protection of sunset industries can lead to
inefficiency and wastage of resources.

3. 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. inefficient

4. To prevent dumping: There may be an economic justification for imposing trade

restrictions in the case of dumping as this practice may he regarded as unfair
competition. Dumping involves selling products at below their cost price.
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 In the short run, home consumers will benefit from dumping as they will enjoy lower
prices. In the long run, however, if the foreign firms drive out the domestic firms,
they may gain a monopoly and then raise their prices, destroying local firms in the
process.

5. To improve the balance of payments: A government may impose trade restrictions

in order to improve its current account position. For instance, imposing tariffs may
encourage consumers to switch from buying imports to buying domestic products.

This again, however, may provoke retaliation. If foreign governments do retaliate by

imposing their own trade restrictions, then, while the country's imports may fall, so
might its exports. International trade would decline and again global output would
fall. In addition, if the country's products are not internationally competitive because
of strategic problems, trade restrictions would only provide a short-term boost to
the current account.

6. To prevent the Imports of demerit goods: A country may want to ban or severely
curtail the importation of things such as drugs, pornographic literature cigarettes
and alcohol.

7. To raise revenue: Tariffs may be used to raise revenue. This will be successful if
demand for imports inelastic.

8. to try to persuade another government to reduce its trade protection: By

retaliating against, for instance, another government imposing a quota on its
exports, it may persuade the other government to remove its quota. There is,
however, a risk that a trade war will develop.

9. To avoid overspecialization: A government may seek to protect a range of

industries to avoid the risks attached to overspecialization. A highly specialized
economy - Zambia with copper, Cuba with sugar - will be highly susceptible to world
market fluctuations. Greater diversity and greater self-sufficiency. although may be
leading to less efficiency, can reduce these risks.
each
Memorize 4- 5 advantages of
.

Trade blocs or international economic integration

International economic integration or trade blocs means regional groupings of countries

that have preferential trade agreements between member countries.

The following are the different types of trade block agreements that countries are normally
a part of, and their characteristics:

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 Free trade area Custom union Economic and Full economic
Monetary union union
Free trade among
members
Common external
tariff with non-
members
Common currency
Free mobility of
resources
Common fiscal
policy
North America free 1. Mercosur is a In effect, the
trade agreement customs union is the south American different economies
(NAFTA). This south Africa custom trading bloc which become one
consists of USA, union(SACU). Its has Argentina, Brazil, economy. This
Examples Canada and Mexico. members include Paraguay, Uruguay, occurred when the
Botswana, Lesotho, and Venezuela as full 13 original states
Namibia, south members. formed the united
Africa and states of America.

za swaz-laud.ae
Switzerland. 2. The European
union (EU)

Consequences of formation of trade Block

Positive affect: Trade Creation

Trade creation occurs when high-cost domestic production is replaced by more efficiently
produced imports from within the trading partner. This happens when a country which was
not a member of a union initially becomes a member and hence tariffs on that country
goods are eliminated.

This gives the countries already in the union to specialize in goods in which they have a
current account in, and import those goods from the country which has just entered the
union at cheaper rates.

In this diagram, Germany which is a part of

the union produces Clothes at a higher price
Negative effects: Trade Diversion
(Pc) than turkey, which produces at (Pt).
however, as turkey is not a member, tariffs
are imposed on their goods, making them
expensive. (Pt+t)
But if turkey becomes a member and hence
tariffs are removed, Germany will import
more from turkey at cheaper Price, creating
mutually beneficial Trade. German consumers
also benefit as their consumer surplus rises.

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Negative eaffect: Trade diversion
Trade diversion means trade with low count cost production country outside of a union is
diverted to higher-cost production country from within the union. This is where the low-cost
production country is charged a higher tariff to make their goods artificially expensive which
means they are to import from a lesser efficient country within the union this makes the
country worse off.

In this diagram, Germany produces clothes

more expensively at Pc and thus it has 2
options, either to import from Denmark or non
union based New Zealand. Even though New
Zealand produces clothes cheaper than
Denmark , as NZ is not in the union , Germany

imports from Denmark , making its imports

more expensive than if they had imported from
NZ . thus, trade has been diverted away from
cheaper to expensive alternatives due to
existence of union. Consumer surplus of
Germany falls as well.

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