Unit 6

International economic issues (AS Level)

Chapter 25

The reasons for international trade

 explain the difference between absolute and comparative advantage

 explain the benefits of specialisation and free trade (trade liberalisation),

including the trading possibility curve

 explain how the terms of trade are measured

 analyse the causes and impact of changes in the terms of trade

 discuss the limitations of the theories of absolute and comparative advantage.

 Absolute advantage. A country has an absolute advantage in producing a product if it

can produce more of the product with the same quantity of resources than another
country .In other words if the country can produce at lower cost of production than
other country then it may have absolute advantage.

Figure (a)

For example, . Figure (a) shows simplified production possibilities for the two countries
where Indonesia has the absolute advantage in producing rice while Brazil has the
absolute advantage in producing coffee

Comparative advantage

Comparative advantage
 It is the ability to produce a good or service at a lower opportunity cost than other
countries such as a country has a comparative advantage in production of a good if it has
to forego the production of fewer other products in order to make it.

The USA has the comparative advantage in producing coats. It can make four times as
many coats as Bangladesh but only one and a quarter as many shirts. It can also
be seen that the USA has the comparative advantage
as its opportunity cost of producing coats (10,000/4,000) is lower than Bangladesh’s
(8,000/1,000).

Bangladesh has the comparative advantage in making shirts as it can make them at a
lower opportunity cost.
In Bangladesh for every shirt produced, one-eighth of a coat has to be sacrificed, In
contrast, in the USA, the opportunity cost of producing a shirt is two-fifths of a coat.

Assumptions of Comparative Advantage

The following are the assumptions of the Ricardian doctrine of comparative advantage:

1. There are only two countries, assume A and B.

2. Both of them produce the same two commodities, X and Y.

3. Labour is the only factor of production.

4. The supply of labour is unchanged.

5. All labour units are homogeneous.

6. Tastes are similar in both countries.

7. The labour cost determines the price of the two commodities

8. The production of commodities is done under the law of constant costs or returns.

The benefits of specialisation and free trade (trade liberalisation)

No government restriction:

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 want. No taxes or limits are imposed
on exports and imports, no subsidies are given to create cost advantages and there is
no unnecessary paperwork (‘red tape’) involved.

Efficient allocation of resources

Free trade allows an efficient allocation of resources with countries being able to
specialise on producing those products that they have a comparative advantage in.
Allowing countries to specialise in those products where their production is most
efficient should increase world output and employment and so should raise living
standards.

Availability of resources

Factor endowments (the availability and the quality of resources) differ between
countries. Free trade allows countries that have, for instance, fertile land and the
appropriate climate to specialise in growing oranges while allowing countries that
have financial institutions and appropriately educated workers to specialise in
banking.

Lower prices and better products

The competition that may arise from free trade can put pressure on firms to keep their
prices and costs down and raise the quality of their products. As a result, consumers
may enjoy lower prices and better products than would have been the case in the
absence of free trade. Firms may also be able to buy raw materials and capital goods
at lower prices.

Economies of scale.

Firms might produce a higher output if they are selling to an international market. The
higher output could enable firms to take greater advantage of economies of scale.
 Greater variety of products

Consumers may be able to buy a greater variety of products as they may have a wider
choice of products. Firms may also have a wider source of raw materials and capital
goods.

Trading possibility curve

A trading possibility curve shows how an economy can benefit from specialising
and trading. For example, Figure 1 shows a country that is able to produce a
maximum of 50 million units of clothing or 100 million units of food

Figure 1

 If the country had initially produced 40 million units of clothing, the maximum output
of food it could produce would be 20 million units. If it engages in international trade,
it can specialise in clothing production, making 50 million units of clothing. It can
export ten million units of clothing in exchange for 30 million units of imported food,
enabling it to move from point A to point B and enjoy more products. In this case,
trading will increase the total quantity of products the country can consume.

Limitations of the theory of absolute and comparative advantage

Despite their importance, absolute and comparative advantage do not provide a full
explanation of the pattern of international trade. There are a number of reasons for this:

 Some governments may want to avoid overspecialisation.

 High transport costs may offset the comparative advantage.

  The exchange rate may not lie between the opportunity cost ratios.

 Other governments may impose trade restrictions.

 The theory only considers labour costs and neglects all non-labour costs involved in
the production of the commodities.

 The theory considers all labour to be homogenous. However, in reality, labour is

heterogeneous due to different grades and kinds.

 The theory assumes similar tastes for all. However, the tastes differ with the growth of
economies and income brackets.

 The theory assumes that a fixed proportion of labour is used in the production of all
commodities. However, in reality, utilization of the proportion of labour depends on
the type of commodity being produced.

 The theory has an unrealistic assumption of constant costs. However, large-scale

productions lead to cost reduction and thereby increase the comparative advantage

 Transport costs play an essential role in determining the pattern of trade. But the
Ricardo theory neglects this independent factor of production.

The terms of trade

The terms of trade measures the volume of imports an economy can receive per unit of
exports. It is calculated by the index price of exports over the index price of imports.

NOTE:

Terms of trade above 100 are improving, whilst those below 100 are worsening.

An example calculation is:

- The index price of exports increases by 15%. The index price of imports increases by
20%.

The terms of trade are (115/120) x 100 = 95.83. This means that the terms of trade has
reduced, so the economy gets fewer imports per unit of exports.

Causes of changes in the terms of trade

A favourable movement in the terms of trade occurs when there is a rise in export prices
relative to import prices.

An increase in the demand for exports would increase their price and so cause a favourable
movement in the terms of trade.

A worsening (deterioration) of the terms of trade

Possible factors :

1.A depreciation / devaluation of the exchange rate

2.Low relative inflation rates

3.Higher relative productivity rates

4.Lower relative labour costs (wage and non-wage costs)

5.Higher relative levels of capital investment

6.Change in the price of commodities, e.g. oil (a rise in the price of commodities for net
importers, and a fall in the price of commodities for net exporters)

7.Primary product dependency may lead to a worsening of terms of trade over time

The Prebisch-Singer hypothesis suggests that the terms of trade tend to move against
countries that produce primary products. This is based on the view that demand for
manufactured goods and for services rises by more than demand for primary products when
income increases. In recent years, the relative prices of some agricultural products have fallen
but there has been more volatility (sudden changes) in commodity prices, with some years
witnessing significant rises in the price of, for instance, oil and copper.

8.Increased globalisation and the industrialisation of China, India and Latin American
countries
9.Increased competition in the markets of a country's main exports / reduced competition in
the markets of a country's main imports

10.Protectionist policies

The impact of changes in the terms of trade

Improving terms of trade mean the economy can import more goods for each unit of
export. This can help reduce the effects of cost-push inflation, since import prices are
falling relative to export prices. However, it can mean that the balance of payments
worsens, since there are fewer exports and more imports.

Worsening terms of trade means that for every import, the country has to export more.

A rise (favourable movement) in a country's terms of trade and impact on macroeconomic

objective .

Price of exports rises relative to price of imports.:

1.This would tend to worsen the economy's trade balance, failing to meet the objective of a
healthy balance of payments position

However, this depends on the PED for a country's imports and exports (may be extended to
a discussion of the Marshall-Lerner condition / 'J-curve' effect)

Although the current account on the balance of payments has two additional components,
which may move in the opposite direction

2.A worsening trade balance may constrain aggregate demand in the country, leading to
lower economic growth, and/or rising unemployment, particularly in export industries.

However ,relatively cheaper imports may lead to an increase in (SR)AS, offsetting the
negative effects on economic growth

Although changes in the other components of AD may more than compensate for this,
meaning that unemployment does not rise

3.Inflation in the economy is likely to fall, as both demand pull and cost push (imported
raw materials) inflationary pressures will reduce
However, this depends on the level of spare capacity in the economy, the size of the
multiplier effect, and all other things being equal

4. If there is rising unemployment, this is likely to have a negative effect on the

government budget balance, as transfer payments rise (automatic stabilisers) and tax
revenue falls

However, such a cyclical budget deficit may be less damaging to an economy than a
structural budget deficit. It depends on how long the terms of trade rise for, and how great
the rise is

5. Lower/negative rates of economic growth may have a positive effect on the environment,
as fewer non-renewable resources are used, and fewer negative productive externalities
occur

Howevr, for most developed countries, growth has a positive effect on the environment, as
improved green technology is developed, and energy intensity falls

6. Lower/negative rates of economic growth may have a positive effect on income

inequality in the economy, as less high returns accrue to the owners of the factors of
production

Chapter 26

Protectionism

LEARNING INTENTIONS
In this chapter you will learn how to:

 define the meaning of protectionism as it relates to international trade

 explain the different tools of protection: tariffs, import quotas, export subsidies,
embargoes and excessive administrative burdens (‘red tape’)
 analyse the impact of the different tools of protection
 discuss the arguments for and against protectionism.

What is Protectionism

Protectionism is the economic policy of restricting trade .

Tariffs

-A tariff is a rax on imports.

Note: Tariffs are taxes, usually on imports but they may also be imposed on exports. A tariff
can be:

 specific: a fixed sum per unit

 ad valorem: a percentage of the price.

Import tariffs

There are two key reasons why governments impose import tariffs: one is to
discourage consumption of imports; another is to raise tax revenue.
Figure A

A tariff imposes an extra cost on the supplier which usually pushes up the price.
Figure A shows that the imposition of a tariff will benefit domestic producers as
their output rises from Q to Q . Domestic consumers lose out as they have to pay
1
a higher price, P , and experience a reduction in their consumption from Q to
1 3
Q .
2

Evaluation1:

A tariff will be more effective in raising revenue if demand for imports is price
inelastic whereas it will be more effective in protecting the domestic industry if
demand for imports is price elastic.

2.There is the possibility that the imposition of a tariff may not make domestic
products more price competitive. This would be the case if the price of the
import plus the tariff is still below the domestic price or if firms selling the
imports absorb the tariff and do not raise their prices.

Note:

Export tariffs

1.A government may put a tax on exports to raise revenue. If demand for the
export is price inelastic, the imposition of an export tariff may not have much
impact on demand

2.Governments may impose a tariff on a product to ensure an adequate supply of

the product on the home market.

3.Export tariffs can also act as a form of protectionism. This is because if they
are placed on raw materials, they can protect the domestic industries that use
those raw materials. For example, if Australia were to impose an export tariff on
iron ore to Japan, it would increase the costs of Japan’s steel producers and
make them less internationally competitive.

Import quotas

Quotas are limits on imports. The limits are usually imposed on the quantity of
imports.

Evaluation:
1.Unlike tariffs, quotas usually do not raise revenue for the government

Note:It is also possible to impose quotas on exports. As with export tariffs, the
motive may to ensure an adequate supply on the home market or as a form of
protectionism.

Export subsidies /subsidies on import substitute industries.

Subsidies may be given to both exporters and to those domestic firms that
compete with imports. In both cases domestic firms will, in effect, experience a
fall in costs. This will encourage them to increase their output and lower their
price. This may enable them to capture more of the markets at home and
abroad.

The losers will be foreign firms and domestic taxpayers. Domestic producers will
gain. Consumers will also benefit in the short run.

Evaluation:

However, in the long run, they may lose if more efficient foreign firms are driven
out of business and subsidised domestic firms raise their prices.

Embargoes

An embargo is a complete ban either on the imports of a particular product or

on trade with a particular country.

Note:

A government may want to ban the import of a product that it regards as

harmful, such as non- prescription drugs or weapons. A ban on trade with a
particular country may arise from political disputes.

Voluntary export restraints

Voluntary export restraints are sometimes also called voluntary export

restrictions. They are an agreement by an exporting country to restrict the
amount of a product that it sells to the importing country. The exporting country
may be pressured into signing such an agreement or it may agree in return for
the importing country also agreeing to limit the exports it sells of another
product.

Excessive administrative burdens (‘red tape’)

A government may seek to discourage imports by requiring importers to fill out

lengthy forms that are time-consuming to complete (excessive administrative burdens
or ‘red tape’). It may also set artificially high product standards to restrict foreign
competition. Such measures restrict consumer choice.

Exchange control
A government may place limits on the amount of foreign exchange that can be
purchased in order to buy imports, travel abroad or invest abroad. This is known as
exchange control.

The arguments for protectionism

To protect infant industries

Firms in a new industry may find it difficult to survive when faced with
competition from more established, larger foreign firms. This may be
because the foreign firms are taking advantage of economies of scale
and/or benefiting from their names being well-known.

A new infant industry may be protected to give the industry time to grow
and so benefit from economies of scale and to gain an international
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.

However, it is difficult to identify which new industries will develop and

gain a comparative advantage. It is, for example, very difficult to estimate
the long-run average cost curves of firms in the industry.

There is also the risk that an infant industry may become dependent on
protection. Knowing that rival foreign products are being made
artificially expensive, it may not feel any pressure to lower its costs.

To protect declining industries

If declining (also called sunset) industries that have lost their comparative
advantage go out of business quickly, there may be a sudden and large
rise in unemployment. If the industry is given protection and the
protection is only gradually removed, unemployment might be avoided.
As the industry reduces its output, some workers may retire and some
leave for jobs in other industries.

To protect strategic industries

Some governments seek to protect industries that produce products

regarded as strategic, such as weapons, fuel and food. Governments may
not want to be dependent on foreign supplies of these products. For
example, a government may be worried that firms and households in its
country would be seriously disadvantaged if fuel was cut off due to a
trade dispute or a military conflict. As a result, it may protect some home
industries even if they are relatively inefficient.

To prevent dumping

There may be an economic justification for imposing trade restrictions in

the case of dumping as this practice may be regarded as unfair
 competition. Dumping involves selling products at below their cost price.
In the short run, home consumers will benefit from dumping as they will
enjoy lower prices.

However, in the long run, if foreign firms drive out domestic firms, they
may gain a monopoly and then raise their prices. Foreign firms may
engage in dumping with the specific objective of gaining control of a
market in another country by destroying existing competition and
preventing new domestic firms from becoming established.

Foreign firms may be able to engage in dumping by covering losses with

previous profits, by charging high prices in their home markets or
because they receive subsidies from their governments.

In practice, it can be difficult to determine if dumping is taking place or

whether the foreign firms have gained a comparative advantage.

To improve the terms of trade

If a country purchases a large proportion of another country or countries’ exports of a

product, it may be able to force down the product’s price. By imposing trade
restrictions, the country can lower demand for the product and, as its demand is
significant, this may lead to a lower price. This will improve the country’s terms of
trade and allow it to purchase more imports for the same quantity of exports.

Similarly, if a country accounts for a significant proportion of the world’s supply of a

product, quotas on its exports may improve its terms of trade. Restricting the supply
of exports will drive up their price and so increase the purchasing power of exports.

Obviously, such action distorts trade and is likely to reduce global output. It may also
result in retaliation.

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.

However, this may lead to retaliation. If foreign governments 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.

To provide protection from cheap labour

Some economists argue that trade restrictions should be imposed on products from
countries where wages are very low. The view is that, in order to compete, wages and
so living standards in the country would have to fall. This is not a very strong
 argument. Low wages do not always mean that a country will be able to produce
products more cheaply as labour productivity may be low and so labour costs may
actually be relatively high. If low wages are actually linked to low costs, it may
indicate that the countries have a comparative advantage.

There may be moral arguments for imposing trade restrictions on products produced
using slave or child labour. However, even here, other approaches may be more
appropriate as trade restrictions may drive down wages even further in low-income
countries.

Other reasons

There are a number of other reasons why a government may impose trade restrictions.
Tariffs may be used to raise revenue. This will be successful if demand for imports is
inelastic.

A government may impose trade restrictions to try to persuade another government to

reduce its trade protection. For instance, retaliating against another government
imposing a quota on imports from the country may persuade the other government to
remove its quota. However, there is a risk that a trade war will develop.

A government may be concerned that certain imports do not meet health and safety
standards. Governments may have different standards. For example, Zimbabwe
banned the importation of genetically modified food between 2008 and 2020 whereas
Canada did not.

In addition, a government may seek to protect a range of industries to avoid the risks
attached to overspecialisation.

The arguments against protectionism

 prevent countries from specialising in the products in which they have a

comparative advantage – this can lower global output and living standards

 reduce international competition and so increase prices and lower the quality of
products

 reduce the choice of products available to consumers

 lower the size of firms’ markets and so reduce their ability to take

advantage of economies of scale

 reduce firms’ choice of raw materials and capital goods which may increase costs
of production

 result in a trade war, with tariffs pushing up prices.