ECO0006

Economics for Managers

© 2022 Singapore Institute of Management Group Limited

 Lecture 12
International Trade

Ref:
Tan Khay Boon, Economics for Managers Module Book,
SIM Global Education, 2014
Session 12
 Learning Objectives
1. At the end of the lesson, students will be able to:
2. Identify the reasons why countries trade.
3. Discuss the theory of absolute and comparative
advantage.
4. Demonstrate the gains from specialization and trade.
5. Discuss the various reasons for protectionism.
6. Discuss the various reasons for free trade.
7. Analyze the economic impact of trade restrictions such as
tariff and quota.

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 Introduction
Definition:
The exchange of goods across national boundaries
i.e. it involves the exports and imports of goods
between nations.

i. Exports:Domestically produced goods purchased by

other countries.
ii. Imports: Foreign goods bought by the domestic
country.

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 Why is there a need for international
trade?
(i) Differences in Factor Endowments
Not only is there an uneven distribution of resources
among nations, but nations also differ in terms of the
types of resources available.

Example:
Singapore is resource scarce while Malaysia is relatively
rich in resources such as mineral and oil. Furthermore,
nations also experience different climatic conditions, and
are at different levels of skills and technological
advancement.
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 Why is there a need for international
trade?
(ii) Differences in Factor Proportion

• There are goods which can be produced at home but which

are imported because foreign producers can supply them
more cheaply than home producers.

• Differences in factor endowments of countries give rise to

differences in the relative prices of factors of production
between countries.

• Thus, countries that are relatively rich in land resources (such

as Australia) tend to specialize in the production of
agricultural products for trade, while those rich in capital
(such as U.K) tend to produce and export capital intensive
goods like industrial machinery.
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Why is there a need for international
trade?
(iii) Differences in Taste
• Two countries can have the same factor
endowments and the same factor productivities;
yet if the consumption pattern is different between
two countries, then the prices of the same good
will differ in the two countries.

• Price will be lower in the country that has lower

demand for the good and higher in the country that
favours the good. Hence trade, can take place.

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 Why is there a need for international
trade?
(iv) Economies of scale

• Domestic demand or market may be too small for

efficient production and producers would then not
be able to enjoy economies of scale.
• Thus such industries need to export to take
advantage of a larger market size and enjoy
economies of scale.
• For example, in Malaysia, palm oil production is
carried out on a large scale and is mostly exported.
• In Singapore, electronic components are assembled
on a large scale and mainly meant for exports.
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 Why is there a need for international
trade?
International trade

• nation specializes in the production of good that it

can produce best
(i.e. can produce goods more efficiently or at a
lower cost)
• use these goods to trade for those goods which it
cannot produce as efficiently
• countries that produces all it requires and does not
trade is said to be in autarky

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 Theory of Absolute Advantage

Theory of absolute advantage refers to the

ability of country to:

• produce more output given the same

amount of resources; or
• produce the same output with lesser
resources.

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 Theory of Absolute Advantage
Assumes a 2-nation, 2-good scenario whereby the only input
available is labour.
Country Food Clothing
A 6 4
B 3 6

• Country A – One worker can produce either 6 units of food or 4 units of clothing
• Country B – One worker can produce either 3 units of food or 6 units of clothing
• Country A can produce more food than Country B using the same resources
o Country A has absolute advantage over Country B in the production of food
• Country B can produce more clothing than Country A using the same resources
o Country B has absolute advantage over Country A in production of clothing

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 Theory of Absolute Advantage –
Gains from Trade
•A country with absolute advantage in producing a
good should
o specialise in the production of the good

o Export the good that it specialises in

o Import the good that it does not have absolute

advantage in

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 Theory of Absolute Advantage –
Gains from Trade
• Assume Country A & B each have 10 workers and
international trade is possible
• Without trade, each country uses half of its
resources to produce each product and consume its
own production
• With trade the terms of trade is 1 unit food: 1 unit
clothing
Country Before Trade After Trade
Production Consumption Production Consumption
A 30 F, 15C 30 F, 15C 60F 30F, 30C
B 20F, 30C 20F, 30C 60C 30F, 30C

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Theory of Comparative Advantage

• Comparative advantage is the ability of one

country to produce a good with a lower
opportunity cost

• Therefore gains from trade still take place

even when a country has absolute advantage
in producing all goods

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Theory of Comparative Advantage
Assume each country uses 1 worker per day to
produce either food or clothing in the following
manner:
Country Food Clothing
A 6 4
B 1 2

Country A:
• Gives up 4 unit of clothing to produce 6 units of
food
• The opportunity cost of producing 1 unit of food is
4/6 = 2/3 units of clothing
• The opportunity cost of producing 1 unit of
clothing is 6/4 = 3/2 units of food
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 Theory of Comparative Advantage
Country Food Clothing
A 6 4
B 1 2

Country B

•Gives up 2 unit of clothing to produce 1 unit of

food
•The opportunity cost of producing 1 unit of
food is 2/1 units of clothing
•The opportunity cost of producing 1 unit of
clothing is 1/2 units of food

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 Theory of Comparative Advantage

Country Food: Clothing Clothing : Food

A 1:2/3 1:3/2
B 1:2 1:1/2

• Country A gives up less clothing in the

production of 1 unit of food
o Incurs a lower opportunity cost in production
of food
o Has comparative advantage in the production
of food

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 Theory of Comparative Advantage
Country Food: Clothing Clothing : Food

A 1:2/3 1:3/2
B 1:2 1:1/2

• Country B gives up less food in the production of

1 unit of clothing
o Incurs a lower opportunity cost in the
production of 1 unit of clothing
o Has comparative advantage in the
production of clothing

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 Theory of Comparative Advantage –
Gains from trade
• Country A has absolute advantage in the production
of both food and clothing
• However Country A only has comparative advantage
in the production of food
• Country B has comparative advantage in the
production of clothing
• Therefore Country A should specialise in the
production of good and Country B in the production
of clothing

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 Theory of Comparative Advantage –
Gains from trade
Country A:
• Without trade it can exchange one unit of food for 2/3 unit of
clothing
• With trade it can exchange one unit of food for extra 1/3 unit
of clothing (assuming terms of trade is 1 unit of food: 1 unit of
clothing)
Country B:
• Without trade it can exchange 1 unit of food for 1/2 unit of
clothing internally
• With trade it can exchange 1 unit of food for extra 1/2 unit of
clothing
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Theory of Comparative Advantage –
Gains from Trade
To see gains from trade, assume that
• both countries have 10 units of labour
• A uses 9 units of labour to produce food and 1 unit
of labour to produce clothing
• B uses 8 units of labour to produce food and 2 units
of labour to produce clothing
• both countries exports 4 units of food and imports
4 units of clothing
Country Before Trade After Trade
Production Consumption Production Consumption
A 54 F, 4C 54 F, 4C 60F 56F, 4C
B 2F, 16C 2F, 16C 20C 4F, 16C 21
 Terms of Trade
• Current assumption for exchange of 1 unit of
Food:1 unit of clothing is not mutually beneficial
• Mutually beneficial terms of trade lie between the
two countries opportunity costs
• Opportunity cost for production of 1 unit of food is
o 2/3 unit of clothing for Country A
o 2 units of clothing for Country B
• Terms of trade for 1 unit of clothing is between 1/2
unit of food and 3/2 unit of food

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 Terms of Trade
• For export and import of more than one product:
Terms of trade = Average price of exports
Average price of imports
• Higher terms of trade is better as more can be earned
from higher value of exports
• Higher terms of trade is considered an improvement
• Lower terms of trade is considered a deterioration

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 Gains from Trade
Before trade production and consumption

Country A Country B
Food Food

100

50
40

20

30 50 Clothing 30 100 Clothing

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 Gains from Trade
• Opportunity cost of producing 1 unit of food is
o 1/2 unit of clothing for Country A
o 2 units of clothing for Country B

• Country A has comparative advantage in the

production of food
• Country B has comparative advantage in the
production of clothing
• Assume terms of trade of 1 unit of food for 1 unit
of clothing

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 Gains from Trade
Terms of trade line has a slope of -1

Country A Country B
Food Food
100
100

60 50
40 40

20

30 40 50 100 60 100 Clothing

Clothing
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 Free trade versus protectionism
• Theory of comparative advantage shows that free
trade increases consumption and hence welfare
• However in reality trade restrictions are commonly
used to protect the domestic economy
• A common reason is that while trade brings about
overall gains, there are winners and losers
• Exports occurs when foreigners pay a higher price
and imports takes place when locals can it at a
lower price

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 Free trade vs Protectionism

Exporting Country A Importing Country B

Price Price

D S

P
Export
P2
Import
P1

D
S

QA1 QA2 Quantity QA2 QB2 Quantity

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 Free trade vs protectionism

• If foreigners are willing to pay a higher price (for

imports), local consumers must match this higher
price to get the good
• If local consumers can get imports at lower prices,
local producers must reduce price and earn less
revenue
• Local producers that suffer will lobby for trade
restrictions

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 Arguments for Protectionism
• Infant industry argument
o This argument states that protection in the form of a tariff is
necessary to allow new domestic industries to establish
themselves
o The temporary protection offered to these ‘infant’ industries
will shield them from the competition of the more efficient
foreign firms and provides an opportunity for them to
become efficient producers in the future
o Protection should be temporary and removed once the
industry has ‘grown up’
o A subsidy to reduce production cost for ‘infant’ industries
may be a better alternative to trade restrictions

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 Arguments for Protectionism
• Protect Income and Jobs
o Reducing imports will divert spending to
domestic output. This will increase income
and jobs
o However, countries adversely affected by
trade barriers imposed upon them by other
countries are likely to retaliate, causing
further ‘trade war’ that will eventually lead
to a contraction of international trade,
leaving all countries worse off.
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 Arguments for Protectionism
• Sensitive Industry Argument
o Industries that are important to the survival
of the country need to exist even if there are
no comparative advantages
o Industries linked to national defence e.g.
weapon industry, steel, telecommunications
and banking
o Again subsidies may prove more effective
than trade restrictions
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 Arguments for Protectionism
• Declining Industry Argument
o Changes in taste or technology will lead to some
industries losing their comparative advantage
o Firms need time to change production methods and
workers to upgrade their skills
o Protection is needed during this period of transition
o Again a subsidy to aid the transition may be better
than trade restriction

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 Arguments for Protectionism
• Anti Dumping Argument
o To protect against predatory dumping – deliberate act of
foreign producers to sell product at a very low price or
below cost
o The objective of predatory dumping is to force domestic
producers out of business
o Foreign producers can then monopolise the market
o Difficult to prove predatory dumping and consumers again
o Again a subsidy to reduce local producer cost may be more
effective than dumping

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 Arguments for Protectionism
• To correct a balance of payments deficit
o A balance of payment deficit can be corrected by
imposing trade restrictions on imports
o However this is effective only if foreign countries do
not retaliate
o Other methods such as currency depreciation may
be a better alternative

Overall only infant industry argument is most convincing.

Subsidies are usually better than imposing trade
restrictions
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 Arguments for Free Trade
• Augmenting Domestic Consumption
o Specialisation and trade allows consumption to be above
PPC
o Standard of living is increased as country can consume
more than it can produce
• Large Scale Production promotes efficiency
o World market > Domestic market
o Trade allows larger output to enjoy greater economies of
scale
o Average total costs will fall, raising efficiency levels
o Consumers benefit from lower prices
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 Arguments for Free Trade

• Competition Promotes Efficiency

o Trade invites foreign competition and brings
more choices to domestic consumers
o Local producers are forced to be as efficient
(price & quality) in order to survive
o Less wastage and more efficient use of resources

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 Arguments for Free Trade
• Promoting Growth
o Trade makes net exports is possible for a small
country
o Promotes economic growth (net exports is a
component of GDP)
o Non economic advantages
o Trade fosters greater cooperative between
countries
o Political, social and cultural advantages

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 Tariffs
• A tariff is a tax imposed on imports.
• The government is tempted to impose a tariff for the
following reasons:
o By taxing imports, price of imports is raised but the
price of domestically produced goods remains
unchanged, a definite advantage.
o Source of revenue to the government

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Effects of a Tariff: Reduction in Welfare
Price of X

P1 + t f
Price after tariff
b c d e
P1 Price before tariff
a
D

0 Q1 Q3 Q4 Q2
Quantity (bushels)
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 Tariffs
Who gains and who loses from the imposition of tariff?

Gainers:
1. Domestic producers - both price & quantity supplied
has 
2. Government - government that imposed the tariff
has gained in terms of revenue collected.
Losers:
1. Domestic consumers - consuming less but paying
more
2. Foreign suppliers - now selling a smaller amount than
before
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 Quota
• A restriction on the quantity of imports
• Effective if the amount specified is less than the
amount imported under free trade
• A shortage of imported good will result and result in
an increase in price
• Consumers will switch to domestic goods that are
lower in price

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Effects of a Quota: Reduction in Welfare
Price of X

S
S + Quota

Quota
P2
c d e
P1
D

0 Q1 Q3 Q5 Q4 Q2
Quantity of X
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 Effects of Tariff Vs Quote
• Effect on quantity consumed, imported and
produced can be made to be the same
• Key difference is that with tariffs, the government
gains revenue
• Tariff allows more imports to enter as long as
consumer is willing to pay
• If government objective is to limit imports, quota
system is more direct

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 Discussion Question 1

A/An ________ in the tariff will tend to

__________

A. increase; decrease import

B. increase; increase import
C. decrease; increase export
D. decrease; decrease export

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 Discussion Question 2
Based on the information in the table, which one of the following
statements about trade between Nepal and Russia is true?
Country Wheat per unit labour (kg) Timber per unit labour (kg)
Nepal 5 2
Russia 10 15
A. Both countries will not trade because Russia has absolute
advantage in the production of both goods.
B. Russia will specialize in the production of wheat, while Nepal
will specialize in the production of timber and both countries
will trade.
C. Nepal will specialize in the production of wheat, while Russia
will specialize in the production of timber and both countries
will trade.
D. Russia will produce both wheat and timber, while Nepal will
only produce wheat and buy its timber needs from Russia.
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 Discussion Question 3
A country that has high inflation will have _____
exports and _____ imports.

A. lower; lower
B. lower; higher
C. higher; lower
D. higher; higher

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 Discussion Question 4
Which of the following is not a reason cited for trade
restriction?

A. To develop industry with potential

B. To protect job and income
C. To improve balance of payments position
D. To allow specialization of resources

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 Discussion Question 5
This graph describes the production possibilities on
the island of Genovia:
The opportunity cost of
producing one car in Genovia is
______

A.5,000 tons of agricultural

products.
B.500 tons of agricultural
products.
C.5 tons of agricultural
products.
D.50 tons of agricultural
products.
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 Discussion Question 6

Nancy and Bill are auto mechanics. Nancy takes 4 hours

to replace a clutch and 2 hours to replace a set of
brakes. Bill takes 6 hours to replace a clutch and 2
hours to replace a set of brakes.

a) Who has comparative advantage in clutch

replacement?
b) Who has comparative advantage in brake
replacement?

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 Discussion Question 7

“International trade makes a country better

off”. True or false? Explain.

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Thank you