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 a whole. 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.

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 via Absolute 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.

Absolute advantage depends on the productivity of the workers.

Before Specialization Wool production (kg) Cotton production (kg) After Specialization Wool production (kg) Cotton production (kg)

Wool town 5,000 10,000

Cotton town 2,000 20,000

10,000 0

0 40,000

Absolute Advantage

Gains from Specialization

Mixed

Specialization

Gains from Specialization Infraville 3,000 3,000 10,000 10,000

Wool production 7,000 10,000 Supaville (kg) Wool productionWool (kg) Town 5,000 Cotton 30,000 40,000 20,000 Cotton production kg) production (kg) Cotton Town

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 over all 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 has a comparative advantage in the production of wool as 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. Thus Supaville has a comparative advantage in the

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 in both 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:

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 all goods 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

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.

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

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.