International trade, comparative advantage, protectionism and the terms of trade

Last time

Before we start: last time, in The current account, exchange rates and correcting imbalances, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Why countries trade

Even a country that can make everything more efficiently than another can gain from trade. That surprising result is comparative advantage. This lesson covers the gains from trade, protectionism, and the terms of trade.

Reasons for trade

Countries differ in resources, climate and skills, so they can produce different goods at different costs. Trade lets them specialise and exchange, giving more output, lower prices, more choice and economies of scale. It also spreads technology and increases competition.

Absolute and comparative advantage

Absolute advantage: a country can produce more of a good with the same resources than another. Comparative advantage: a country can produce a good at a lower opportunity cost than another. Trade benefits both countries if each specialises in its comparative advantage.

Comparative advantage, worked

Country A makes 10 wheat or 5 cloth per worker; Country B makes 6 wheat or 4 cloth. A has an absolute advantage in both. But one cloth costs A 2 wheat, and costs B only 1.5 wheat. So B has the comparative advantage in cloth, and A in wheat.

Limits of the theory

It assumes no transport costs, constant costs, and perfectly mobile factors within countries. In reality, transport costs, trade barriers and changing costs reduce the gains. And specialisation can make a country dependent on a few exports.

Protectionism

Tariffs: taxes on imports. Quotas: limits on the quantity of imports. Subsidies to domestic producers, embargoes, and administrative barriers such as strict standards. Each makes imports dearer or scarcer, protecting domestic firms.

Arguments for and against

For: protect infant industries, strategic industries and jobs; prevent dumping; correct a current account deficit; raise revenue. Against: higher prices and less choice for consumers, inefficiency in protected firms, retaliation, and a misallocation of resources. Judgement: protection may be justified for a limited time and purpose, but widespread protection reduces welfare.

The terms of trade

The terms of trade index is the index of export prices divided by the index of import prices, times 100. If export prices rise to 110 and import prices stay at 100, the terms of trade are 110: an improvement. Each export buys more imports. A fall in the index is a deterioration.

Is an improvement always good?

An improvement means each unit of exports buys more imports, which raises living standards. But if export prices rise because of high inflation, exports may become uncompetitive, and the volume sold falls. So the effect depends on the cause, and on price elasticities of demand for exports.

Mistakes that lose marks

Mistake one: confusing absolute and comparative advantage. Mistake two: calculating comparative advantage without opportunity costs. Mistake three: assuming an improvement in the terms of trade is always beneficial. The fix: opportunity costs, and evaluation of causes.

The full-marks tip

The full-marks tip: find comparative advantage by working out each country's opportunity cost. Evaluate protection and the terms of trade by cause, time period and elasticities.

On one card

So, on one card: international trade. Keep it for revision.