15International Trade

7/30/2019 15International Trade

1/10

International Trade

Objectives:

1) Identify the reasons for international trade.

2) Describe the theories of International trade; i.e. Absolute and Comparative Advantage

and how it may lead to Opportunity cost.

3) Identify the reasons for Free Trade (Trade Agreements).

4) Discuss the impact of free trade on Developed and Developing economies.

5) Discuss the arguments for and against Protectionism.

Introduction

International trade is very important both to individual countries and to the world economy as awhole. It is very rare for a country to be able to supply all of its own needs, it has to exchange

part of its national product for goods from other countries. International trade requires an

understanding of how two countries, each having its own currency, manage to buy and sell from

each other in a world in which there is no such thing as international money. It also requires a

very through understanding of the advantages and disadvantages for trade itself.

Trade involves the Buying and selling goods and services from other countries. The purchase of

goods and services from abroad leads to an outflow of currency from the importing country, i.e.

Imports (M). The sale of goods and services to buyers from other countries leads to an inflow

of currency, i.e. Exports (X).

Reasons for International Trade

In a modern economy, production is based on a high degree of specialization. Within a country

individuals specialize, factors specialize and whole regions specialize. Specialization increases

productivity and raises the standard of living. International trade extends the principle of the

division of labour and specialization to countries. In a modern economy, production is based on

a high degree of specialization. Within a country individuals specialize, factors specialize and

whole regions specialize. Specialization increases productivity and raises the standard of living.

International trade extends the principle of the division of labour and specialization to countries.Some reasons for international trade are:

1. Different goods require different proportions of factor inputs in their production.

2. Economic resources are unevenly distributed throughout the world.

3. The international mobility of resources is extremely limited.


2/10

4. Countries gain access to wider world markets

5. Economic benefits which can be subdivided into: economies of scale, division of labour

Gains from Trade:

Since it is difficult to move resources between nations, the goods which embody the

resources must move.

We are all aware of the importance of trade. It is trade that makes possible the division

and specialization of labour on which our productivity is so largely based. The

importance of trade in making possible specialization is so great that there is the need to

illustrate.

Countries could get goods which they otherwise have not been able to acquire.

Lower cost of goods due to specialization and economies of scale.

Prevents monopolies developing in countries due to worldwide competition.

It leads to better relationships between trading nations.

Specialisation and Trade

Different factor endowments mean some countries can produce goods and services more

efficiently than others and specialisation is therefore possible viaAbsolute or Comparative

Advantage.

Assumptions made in Absolute and Comparative Advantage:

1. There are only two countries.

2. Only two goods are produced.

3. There are no transport costs and no barriers to trade.

4. Each country has an equal quantity of resources and devotes half of its resources to the

production of each commodity.

5. Only one factor of production, labour was the main input. The value of a good is

determined by the contribution of labour used in production

6. Perfect competition exists and prices are a true reflection of demand and supply.

7. The model is static taste, technology and population are assumed constant.

8. Factors of production are internationally immobile.


3/10

Absolute advantage depends on theproductivity of the workers.

Absolute Advantage

Gains from Specialization

Before Specialization Wool town Cotton town

Wool production (kg) 5,000 2,000

Cotton production(kg) 10,000 20,000

After Specialization

Wool production (kg) 10,000 0

Cotton production(kg) 0 40,000


4/10

Now if we compare total production of the two towns we can see the gains from specialization.

Specialization followed by trade makes it possible for both towns to have more of both

commodities than before. However, if the world was divided into nations like Wool town and

Cotton town, each producing for trade only a single item in which it has a clear advantage overall others, international trade would be a simple matter to understand. However, this is not the

way international resources are distributed. Many nations do not have such an advantage in a

single product.

Comparative Advantage

Supaville is now a more efficient producer than Infraville in both cotton and wool, i.e. in terms

of resources used, the cost of production in both industries is lower in Supaville. If we consider

the opportunity costs, however, the picture is rather different. In Supaville, the cost to produce 1

kg of wool = 4 kg of cotton, i.e. in devoting resources to the production of one kg of wool in

Supaville there is a sacrifice in terms of 4 kg of cotton foregone, i.e. an opportunity cost. The

opportunity cost for Infraville to produce 1 kg of wool = 3.33 kg of cotton. Thus Infraville hasa comparative advantage in the production of woolas they have a lower opportunity cost in the

production of wool and should therefore specialize in the production of wool.

In Supaville, to produce one more kg of Cotton = .25 kg of wool whereas in Infraville to produce

one more kg of cotton = .3 kg of wool. ThusSupaville has a comparative advantage in the

Mixed Specialization Gains from Specialization

Wool production

(kg)

7,000 10,000

Wool Town

3,000

Cotton

production (kg)

30,000 40,000

Cotton Town

10,000

Supaville Infraville

Wool production (kg) 5,000 3,000

Cotton production kg) 20,000 10,000


5/10

production of cotton as they have a lower opportunity cost in the production of cotton and

should therefore specialize in the production of cotton.

Students should draw Production Possibility Curve to illustrate the above phenomena.

Despite the fact that Supaville is more productive in terms of output per man than Infraville inboth cotton and wool, it is relatively more productive in cotton than in wool, in the same way

Infraville is relatively more productive in wool. This kind of relative superiority is termed

comparative advantage.

A country will benefit from international trade, as the world as a whole would, if it concentrates

its productive resources in producing those goods and services in which it is (relatively) more

efficient. Since the opportunity cost ratios are different in the two countries, beneficial trade is

possible.

Students have to identify the gains from specialization.

Comparative advantage also gives us an important insight into the fundamental economic truth

opportunity cost. The real cost of wool in Supaville is the cotton that cannot be made because

men are engaged in wool production. Just as the real cost of cotton is the wool that have been

gone without. Therefore the basic reason for comparative advantage lies in the fact that

opportunity costs vary, so that it pays for different parties to engage in different activities.Opportunity cost differs from country to country because of climate, resources, skills,

transportation costs, capital scarcity.

The significance of the law of comparative advantage is that it provides a justification for the

belief that:

Countries should specialize in what they produce, even if they are less efficient (in

absolute terms) in producing every type of good. They should specialize in the goods

where they have a comparative advantage.

International trade should be allowed to take place without restrictions on imports or

exports; in other words, there should be free trade. Free trade plus specialization will

result in an increase in the worlds output, and all countries will share in the benefits.

Thus the Law of Comparative Advantage forms the basis for FREE TRADE.

Limitations to the Gains from Comparative Advantage:


6/10

Factor immobility where workers are unable to transfer their skills to another job or even

learn new skills.

The existence of unemployed resources

The increased output due to specialization may not be met with increased demand for allgoods and services.

There is movement of FOP between countries.

Arguments for Free Trade

The law of comparative advantage does apply in practice, and countries do specialize in

the production of certain goods. However, there are certain limitations or restrictions on

how it operates:

Free trade does not always exist. Some countries take action to protect domestic

industries.

Transport costs can be very high in international trade so that it is cheaper to produce

goods in the home country rather than to import them.

Countries might produce similar goods, but give them sufficiently unique

characteristic to make them competitive in any country of the world, e.g. cars.

The law of comparative advantage states perhaps the major advantage of encouraging

international trade.

Some countries have a surplus of raw materials to their needs and others have a deficit.

The surplus country can take advantage of its resources and export them.

International trade increases competition among suppliers in the worlds markets.

International trade creates larger markets for a firms output, and so some firms can

benefit from economies of scale by engaging in export activities.

There are political advantages of international trade, because the development of trading

links provides a foundation for closer political links.

Free trade is associated with free movement of goods and services. Another aspect of

international trade is the free movement of capital, e.g. EU

FREE TRADE however does not exist because of PROTECTIONISM.

Protectionist Measures


7/10

1. Tariffs or custom duties may lead to a price increase, leading to a fall in domestic

demand and a simultaneous increase in domestic supply. This results in reduced imports

and an increase in government revenue as consumer surplus is transferred to government

and producers thus leading to a loss in consumer welfare.

2. Import quotas or quantity restrictions

3. Embargoes

4. Hidden subsidies for exporters and domestic producers export subsidies.

5. Import restrictions red tape and technical regulations.

6. Voluntary export restraints (VER).

7. Exchange controls.

8. Protectionist measures by forming international cartels.

9. Government action to devalue the nations currency, ie to reduce its foreign exchange

value.

Protectionism can be viewed in terms of any policy that distorts market forces to give

competitive advantage to domestic industries.

Impact of an export subsidy:

Increase the supply of exports on the world market, thereby reducing prices below that

determined in a free market.

Foreign consumers will enjoy an increase in their economic welfare as price of the good

falls.

Employment in the domestic economy increases

Locals might enjoy higher wages and job security.

Taxpayers lose for they are paying for the subsidy.

Output diverted to the overseas market, supply may fall in domestic market, leading to

rising prices and reduce welfare of domestic consumers.


8/10

Protectionist policies are sometimes called expenditure switching policies because their aim is

clearly to switch expenditure, both domestic and foreign, to the output of goods and services of

the domestic economy.

Devaluation or depreciation of the currency

Assume 1 = $1.60 US. The USA exports to the UK or the UK imports from the USA.

Good X sells for $8,000 in USA and 5,000 in UK. The UK government reduces the interest

rates, which in effect weakens the value of the . The exchange rate changes to 1 = $1.50 US.

Good X sells for $8,000 in USA and 5,333 in the UK.

There is now a price increase of 333 to the UK consumer. Demand therefore falls. The extent of

the fall in imports will depend on the price elasticity of demand in the UK for USA good X.

Reasons for Protection

1. Maintain employment and preserve output in domestic production.

2. To protect industries that may be considered necessary for national security.

3. To assist new industries to become established.

4. To avoid the possibility of dumping.

5. To improve a Balance of Payments position.

6. In retaliation against measures taken by another country.

7. To help a country in the short term to deal with the problems of a declining industry.

8. Terms of trade argument

9. Formation of a Customs Union.

Arguments against Protection


9/10

1. Because protectionist measures taken by one country will most inevitably provoke

retaliation by others, protection will reduce the volume of international trade. This means

that the benefits from international trade will be reduced.

2. Because of retaliation by other countries, protectionist measures to reverse a balance of

trade deficit are unlikely to succeed. Imports might be reduced, but so too would exports.

3. It enables the inefficient firm to remain in operation.

4. Widespread protection will damage the prospects for economic growth amongst countries

of the world.

5. Protection creates political ill-will amongst countries of the world and so there are

political disadvantages in a policy of protection.

6. Once protectionist policies are used in the domestic market it is difficult to withdraw the

support they give to all firms.

Terms of Trade (T of T)

The terms of trade is the price index of exports divided by the price index of imports, it is 100%

in the base year. The Terms of Trade looks at the relationship between the price received for

exports and the amount of imports we are able to buy with that money.

Average Price of Exports

Terms of Trade = ----------------------------------------

Average Price of Imports

The fundamental factors that bring about changes in the terms of trade are the prices of exports

and imports. These are in turn influenced by the forces of demand and supply.

If the price index of exports is 120 and the price index of imports is 80, the terms of trade will be

150. If the T of T is more than a 100, it is said to be favourable. If it is below 100, it is

unfavourable. At 100 there is a balanced T of T.

The T of T measure implies that the foreign exchange generated from the export of 1 unit of a

good is 1.5 times the foreign exchange needed to buy 1 unit of imported good.


10/10

15International Trade

Documents

Transcript of 15International Trade