International Trade

Chapter 4INTERNATIONAL 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 21st 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.

Huge cost involved such as physical changing, reprogramming computers, producing new price lists etc.

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