INTERNATIONAL TRADE

Define trade:
Movement of goods and services across boundaries in an economy

What results from growing economic interdependence between countries:

● Specialization: countries can focus on a specific production that they are good at
● Consumer choice: countries offer different goods and services with more variety, so with trade,
consumers have more choices
● Increased competition and greater production efficiency: As firms are exposed to competitive
markets in other countries, they are forced to become more efficient to keep costs low to attract
consumers.
● Lower prices for consumers: Increased competition and efficiency lead to lower costs.
● Acquiring needed resources: countries rely on natural resources or capital goods unavailable
domestically for domestic production.
● Sources of foreign exchange: countries engage in export and can acquire foreign
exchange/currencies (able to make payments to other countries for imports).
● Trade results in new ideas and technologies
● Trade makes countries interdependent, thereby reducing possibilities of hostility and violence:
trade links form the basis for economic relationships, reducing the possibility of war and
hostilities. (War becomes inconceivable with strong economic interdependence)
● Trade is an engine for growth

Free trade

Define free trade:

The absence of government intervention of any kind in international trade, so that trade takes place
without any restrictions (or barriers) between individuals or firms in different countries.

Outline the benefits of free trade:

● Increased competition
○ Import: domestic firms are exposed to competition
● Greater efficiency
○ Firms: forced to become more efficient (produce at the lowest cost possible)
○ Domestic consumers will prefer lower-priced imported products
○ Higher cost firms (stakeholder) will have lower sales (might run out of business)
● Lower prices for consumers
○ Trading: a larger variety of products and quality.
● Acquiring needed resources:
○ Allows countries to import inputs they need for domestic production.
■ Semi-finished products are used as inputs and capital goods for production
● Sources of foreign exchange:
○ Export: countries acquire source of foreign exchange (foreign currencies)
○ Use money gained to pay imports (increase in import ability)
● Access to larger markets
○ Absence of trade: limits output by the size of the domestic market
○ Trade: expansion in size of market and expansion of sales
● Economies of scale
 ○ The ability of firms to decrease the average cost of production → increase the quantity of
output produced.
○ Lower cost: more efficiency → sell output at lower price
○ Access to larger markets → firm can grow beyond national boundary
○ Export competitiveness
● Increase in domestic production and consumption as a result of specialization:
○ Trade allows countries to focus/concentrate their production
○ Specialization → produce more efficiently at lower cost → able to produce larger quantity
of output → does not waste its scarce resources on producing goods and services at a
high cost.
○ Able to increase consumption of goods and services → acquire larger quantity of goods
and services (comparative advantage)
● More efficient allocation of resources
○ Free trade = more efficient allocation of resources domestically and globally
○ Specialization → less waste of scarce resources and more efficient allocation of
resources
● Trade makes possible the flow of tech
○ Transfer of skills and technology
● Trade makes countries interdependent, reducing the possibility of hostilities and violence
○ Strong international trade → basis for economic relations
○ elimination of war and hostilities (become inconceivable)
● Trade as an "engine for growth"
Increase in domestic output → greater economic growth

Diagram an import for free trade:

Explain the diagram:

Labels: Sd: supply domestic; Dd: demand domestic; Pw: Price world; Sw: Supply word
Domestic quantity demanded (QDd) increases, as demand increases from Q1 to QDd, the price
decreases, as the law of demand states that as quantity demanded increases, price decreases, ceteris
paribus. As that occurs, there is a decrease in quantity supplied domestically (Qsd), considering only
some producers can sustain the new price. This results in QDd > QSd instilling a shortage. This shortage
is dealt with by imports, which gives access to other producers worldwide. The latter makes it so that the
supply of world (Sw) is perfectly elastic due to the inumerous producers and substitutes. Within the supply
world, some producers can sell at a lower price than the domestic price hence, Pw is below P1.

What are the two theories that explain how countries know what to produce and export:
 ● Theory of absolute advantage
● Theory of comparative advantage

Define the Theory of absolute advantage:

Suppose countries specialize in and export the goods in which they have an absolute advantage (can
produce with fewer resources). In that case, there results in an improvement in resource allocation and
increased production and consumption in each country.

Explain the theory of absolute advantage:

Specialisation & free trade → all countries are better off
Absolute advantage refers to the ability of one country to produce a good using fewer resources than
another. If a country has an absolute advantage in a good, with the same quantity of resources, it can
produce more of the good than another country

Draw the curve that illustrates the Theory of absolute advantage and explain:

Vietnam has conducive growing conditions for rice production (abundant rain), while Kuwait has
conducive conditions for oil production. In view of the fact that Vietnam utilizes fewer resources to
produce rice and Kuwait oil, according to the theory of absolute advantage, they should specialize their
production in these goods.

Explain how a production possibility curve can be used to illustrate absolute advantage.
Production possibility curve (PPC) - Illustrate absolute advantage.
If a country chooses to specialize in the good they have an absolute advantage → Both countries will be
producing somewhere on their PPC [done to specialization and trade, they can consume at a point
outside their PPC] & countries' better off → specialization leads to a global reallocation of resources
where production occurs by the most efficient (low-cost) producers.
Improvement in resource allocation → Produce at a point in PPC al consume at a point out of PPC
As long as the opp cost of two (or moves countries differ), all countries can gain from specialization trade.
Improved global allocation of resources → greater global output a consumption+ countries consume
outside PPC
Define the Theory of comparative advantage:
As long as opportunity costs in two (or more) countries differ, it is possible for all countries to gain from
specialization and trade according to their comparative advantage; this results in an improvement in the
global allocation of resources, resulting in greater global output and consumption. Is a more powerful
explanation of the gains from trade than the theory of absolute advantage.

Explain the Theory of comparative advantage:

Countries can gain from specialization & trade even if one country has an absolute advantage in both
goods. [Must: Given that countries have different opportunity costs for their goods → production of one
good is relatively cheaper to produce in one country than in another, even if not absolutely cheaper.
Comparative advantage refers to a situation where one country has a lower opportunity cost (relative
cost) in producing a good than another.

Draw the curve that illustrates the Theory of comparative advantage and explain:

Country B has a comparative advantage in producing both goods; to determine what country should
produce, a table with the maximum amount each individual country can make if it were to specialize
should be used.

Outline the benefits of comparative advantage:

● Comparative advantage allows countries to import products at a lower opportunity cost than it
would cost them domestically. It allows countries to specialize and results in opportunities that
allow for consumption opportunities beyond the production possibility curve.
● Allows countries to engage in the mutual benefit of trade - countries become more efficient
[concept]. It also leads to UN Goal #17: Partnership for the goals - Interdependence [concept] =
better allocation of resources.
● An increase in overseas markets = more jobs

Define opportunity cost:

The value of the following best alternative that must be given up or sacrificed in order to obtain something
else.
Define opportunity cost regarding comparative advantage:
A country has a comparative advantage in the production of the good that has a lower opp. cost (lower
relative cost)

Formula to calculate opportunity cost for comparative advantage:

𝑠𝑎𝑐𝑟𝑖𝑓𝑖𝑐𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑔𝑜𝑜𝑑

𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 = 𝑔𝑎𝑖𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑡ℎ𝑒𝑟𝑔𝑜𝑜𝑑

State the law of comparative advantage:

If countries specialize and trade according to their comparative advantage, global
production, $consumption will increase due to an improvement in the global allocation
of resources call countries involved= better off)

What happens in the case of parallel PPC + Diagram:

Country A = absolute comparative advantage in the production of both goods.

Parallel PPC: two countries (A & B) face identical opportunity costs for both goods.
If no country has a comparative advantage in production → not able to gain from specialization & trade →
no point

Diagram an export for free trade:

Export (product of comparative/absolute advantage): sell foreign for the increased price (higher than
domestic; P1<Pw)

Trade Protection

Define trade protection:

Government intervention in international trade through the imposition of trade restrictions (or barriers) to
prevent the free entry of imports into a country and protect the domestic economy from foreign
competition.

State the reasons for trade protection:

● (1) To protect domestic employment: It will keep local jobs safe and allow them to adjust to the
market.
● (2) To protect sunrise or infant industries: Shelter newly formed industries in less developed
countries until they are able to compete with more powerful economies & industries.
● (3) To prevent dumping foreign goods on domestic markets: dumping is when a country exports a
good for an average cost lower than in their nation.
● (4) Diversify the production base of developing countries, which ignores the benefits of
comparative advantage & dissuade diversification.
● (5) To enforce product standards: protect consumers from dangerous products & ensure quality
production (reputation) but increase the cost of factors of production.
● (6) To raise government revenue: custom duties serve as a source of money, especially in
countries where income tax compliance is low but distort the market & limits the importation of
essential resources
● (7) To protect against unfairly low labor costs, lower wages & reduced labor standards make it
impossible for domestic industries to pay a living wage & provide a safe work environment for
workers.
● (8) To protect strategic industries: protect industries that are important, especially for national
securities (industries that we want to exist when a crisis occurs) - Protect from foreign competition
(ensure domestic production)

State the types of protectionist policies:

● Tariffs
● Quotas
● Embargos
● Subsidies
○ Production subsidy
○ Export subsidy

Define tariff:
Taxes on imported goods; they are the most common form of trade restriction. Tariffs may serve two
purposes: to protect a domestic industry from foreign competition (a protective tariff); or to raise revenue
for the government (a revenue tariff).

Diagram tariff + Explain:

Determine who are the winners and losers of tariffs:

Winners Losers

Domestic producers (sell more, import Domestic consumer (price increases)

shrinks)

Domestic employment/workers Foreign produces (import decreases, sell

(protected, increased wages) less)

Government (government revenue) Domestic income distribution (proportion of

income, acts as a regressive tax)

Efficiency (welfare loss)

Global misallocation of resources

(domestically and globally)

Calculate the impact of a tariff (stakeholders):

Define quota:
A type of trade protection that involves setting a legal limit to the quantity of a good that can be imported
over a particular time period (typically a year). (More generally, a ‘quota’ is a limited or fixed number of
things.)

Diagram + Explain quota:

Calculate the impact of a quota (stakeholders):

Define subsidy:
An amount of money paid by the government to firms for a variety of reasons: to prevent an industry from
failing, to support producers' incomes, or as a form of protection against imports (due to the lower costs
and lower prices that arise from the subsidy). A subsidy given to a firm results in a higher level of output
and lower prices for consumers. May also be paid to consumers as financial assistance or for income
redistribution.

Diagram a production subsidy:

Production Subsidy: In the context of trade, production subsidies are payments per unit of output granted
by the gov. to domestic firms that compete with imports [Goal: allow domestic firms to be more
competitive with foreign producers & decrease imports]

How can you calculate from the graph the effect of production subsidy?
● Subsidy per unit: Vertical difference between two supply curves
Quantity of imports and imports expenditure: Imports bf - Imports after = Import quantity
● Import expenditure = decrease in imports x world price
● Domestic Consumer: not affected ⇒ pay same P(s) ⇒ purchase same Q
● Domestic Producers: increase in subsidy P/unit x increase in quantity produced = increase in
producer revenue
Gov expenditure and taxpayers: gov. expenditure = subsidy P/unit x quantity produces domestically after
subsidy is granted.
● Taxpayers are worse off by the same amount as gov. expenditure
Consumer and producer surplus: Consumer surplus = unchanged (same P(s) and Q)
● Producer Surplus =
● Welfare loss: area of triangle
Foreign producers: Exports of foreign producers fall by an amount = fall in country's imports also =
Increase in domestic Production
● Export revenue of foreign producers fall by an amount equal to the fall in quantity of imports x
world P(s)

Determine who are the winners and losers of production subsidies:

Winners Losers Neutral

Domestic producers: domestic Domestic workers Domestic Consumers: not

producers in the protected affected
industry receive Pw + S & consumption bf & after = Q2
domestic production expands price stays at Pw (Consumers
(Q1 → Q3) purchase more domestic goods
over imported)
 Domestic employment Exporting countries: foreign
increases: Increase in Q1 → Q3 producers export less of the
results in increased worker good - export rev. falls
need.

Gov. budget: gov. must spend

tax revenue spends: Pw + S -
Pw (Subsidy per unit) x Q3
(Quantity produced)

Income distribution

Increased inefficiency in
production: production of
efficient foreign producers ↓

Taxpayers: portion of tax rev. is

spent on production subsidy =
Increasing production of
inefficient producers. Doesn't
benefit taxpayers.

Global misallocation of
resources

Discuss the Welfare effects → Consumer and producer surplus in a production subsidy:
Production subsidies: domestic P(s) for producers = ↑ Q supplied = ↓ imports = protect producers &
domestic employment
Very large subsidy = (may) result in excess production = Q supplied > domestic demand = excess is
exported = Domestic & Global misallocation
● Welfare effects: effects of production subsidies on producer & consumer surplus
○ Consumer surplus = Not affected (both P(s) paid and Q bought = same)
○ Producers = Gain surplus (receive a higher P(s) and sell more extensive Q)
■ Gov = loses [Pw + s - Pw] x Q3 = a + b = Government spends to provide subsidy
○ Net loss
● Efficiency:
○ Subsidy > efficient than tariff and quota
○ Subsidies encourage inefficient production but (unlike tariffs and quotas) does not effect
consumption
○ only producer surplus is lost (↓ consumer surplus)

Define export subsidy:

A payment by the government to a producer or exporter per unit of the subsidized good, where the
subsidy is paid for each unit of the good that is exported.

Diagram export subsidy:

Determine who are the winners and losers of export subsidies:

Winners Losers

Producers: receive a higher Price (Pw+s) Consumers: pay higher price (Pw+s) and
and sell larger quantity (Q3 instead of Q2) consume less quantity
due to increased volume of exports

Domestic employment increases: Gov. budget: must fund subsidy

Increase in domestic production - need
more labor (EDP)

Taxpayers: pay indirectly for subsidy which

does not benefit them

Domestic Income distribution: consumers

must pay a higher P(s) = regressive - higher
fraction of lower incomes

Increased inefficiency: inefficient domestic

producers are protected by higher P(s)

Exporting countries: Foreign producers lose

a share of their global markets - export
revenue falls

Increased Global misallocation of

resources: Increased inefficiency of
resources

Discuss the Welfare effects → Consumer and producer surplus in a export subsidy:
● Consumer surplus: higher P and lower Q (Loss of surplus) both are worse
● Producers surplus: receive higher P and produce higher Q (gain of surplus)
● Gov: loses - pay / fund subsidy
● Net loss = gain of producers - (loss of consumer + government) [minus]
● Export subsidies = greater welfare loss than production subsidy
Calculate the impact of a subsidy (stakeholders):

EXCHANGE RATES AND THE BALANCE OF PAYMENTS

Exchange rate
Define exchange rates:
The rate at which one currency can be exchanged for another, or the number of units of foreign currency
that correspond to the domestic currency; can be thought of as the 'price' of a currency, which is
expressed in terms of another currency.

Define foreign exchange:

Refers to foreign national currencies, i.e. for any country, it refers to currencies other than its own.

Define foreign exchange market:

Market for currencies; open 24/7
Diagram currency:

Define appreciation (of currency):

An increase in the value of a currency in the context of a floating exchange rate system or managed
exchange rate system (compare with revaluation, which refers to an increase in currency value in the
context of a fixed or pegged exchange rate system).

Define depreciation/devaluation (of currency):

Refers to a decrease in the value of a currency in the context of a fixed or pegged exchange rate system
(to be compared with depreciation, which is a decrease in currency value in the context of a floating or
managed exchange rate system).

State the factors that effect currency demand vs. currency supply:

currency demand: currency supply:

State the causes of changes in the exchange rate:
Changes in demand and supply of currency → Fluctuation of exchange rate
● Interest rates
● Imports and exports
● Flow of remittances
● Foreign currency reserves
● Inflation
● Investment from abroad
● Change in income
● Speculation

What are factors that lead to a change in currency demand:

● Inflow of funds into a country
Export related:
● Foreign demand for exports of goods: increase in foreign demand for a product, the demand for
the product's currency increases. Demand curve shifts right = appreciation
 ● If demand falls → curve shifts left = depreciation
● Foreign demand for exports of services: Increase in export of services = demand more of
country's currency → currency appreciates
● If demand for service from abroad falls = depreciate
● Rate of inflation relative to other countries: lower rate of inflation → increase in demand for
exports = demand for country's currency increases & appreciate
● (dd shifts right)
● higher rate of inflation → foreign demand for its exports falls = demand for currency falls →
depreciates
● Relative growth rates: If a country's trading partner experiences economic growth → rise in
income = demand increase for exports of country trading → increase in demand for currency =
appreciation
● Conversely, low econ. growth = depreciation
Investment related:
● Inward foreign direct investment and portfolio investment: (foreigners - 2 types of investment)
● same impact
● Foreign direct investment: Investment by multinational corporations in production facilities
● Portfolio Investment: Financial Investment
● Inward investment: foreigners are bringing in funds from abroad by demanding (into country)
domestic currency = demand for currency shifts right = appreciation
● If foreigners decrease their investment = d (for currency) falls = depreciates
● Relative interest rate: higher interest rate = more attractive saving deposits and bonds = financial
Investment becomes more attractive = more financial capital flows in = demand for currency
increases = shifts (DD) right = currency appreciates
lower IR = less financial capital flow = depreciate
Others:
● Inward flow of remittances: remittances involve a transfer of money from one country to another
[most cases = foreign workers sending money home]. Increase in remittances into a country sent
from abroad → increase demand for currency = appreciation; Conversely, a fall in remittances =
depreciation
● Speculation that a currency will appreciate: Currency speculation involves buying and selling
currencies to make profit from changes in exchange rates. Buying and selling based on
expectation of future exchange rate changes. Speculator expects the currency to appreciate →,
buy it to sell later & profit = when purchase →, may cause it to appreciate.
● Central bank intervention to increase the value of a currency: Central Bank holds reserves of
foreign exchange currencies to increase the value of domestic currency = CB buys domestic
currency by selling foreign exchange currency (Shift D right) → appreciates

What are factors that lead to a change in currency supply:

● Outflow of funds from a country
Import related:
● Domestic demand for imports of goods: An increase in demand for imports → exchange rates
consumers demand more foreign g & s = country's importers must buy more foreign currency in
the exchange market → increase in supply of currency (shift right) = depreciation.
● If demand for foreign g & s falls → left shifts domestic currency appreciates
● Domestic demand for imports or services: Increase in demand for imports or services means the
service must travel abroad to foreign countries → sell domestic currency to buy foreign exchange
to use abroad. An increased number of individuals traveling abroad means that the currency of
 their country (home) will increase in supply and depreciate. Conversely, if the number of services
abroad falls → supply of (home) country currency will increase → appreciate
● Rate of inflation relative to other countries: lower IR → demand for imports decreases (bc they
are relatively more expensive than domestically produced goods → supply of domestic currency
decreases → appreciate
● high IR compared to other countries → increase in imports → increase in supply of domestic
currency → depreciate
● Relative growth rates: higher domestic growth w/ growth in income → increase in demand for
imports → Supply of domestic currency increases → appreciate
● lower growth rates = lower income growth → demand for imports decreases → domestic currency
supply decreases → appreciates
Investment related:
● Outward foreign direct investment (FDI) and portfolio investment
○ Investment outside the home country involves funds flowing out = Increase in supply of
domestic currency = depreciate
○ Decrease in investment abroad = decrease in supply of domestic currency = appreciate
● Relative interest rate: interest rates and exchange rates move together, ceteris paribus. If IR of a
country falls = more supply of currency = depreciate
● higher IR = supply of currency decreases = appreciation
Others:
● Outward flow of remittances: outward flow of money by foreigners who sent money home -
increase in supply of currency foreign workers reside in = depreciates.
● A decrease in remittances sent home = a fall in the currency supply = appreciation.
● Speculation that currency will depreciate: expectation by speculators that currency will depreciate
→ sells it = makes profit = when selling cause to depreciate (by increasing supply)
● Central bank intervention to decrease the value of currency: CB sells more (supplies) domestic
currency by buying foreign currency = increase supply = depreciates

What happens when both currency demand and supply change at the same time:
● Rate of inflation relative to other countries: lower rate of inflation relative to other countries →
increase in demand for exports → decrease in demand for imports → currency appreciation
● Interest rates relative to other countries: Increase IR → attracts financial capital → demand of
currency increases, supply of currency decreases → appreciation

Define floating exchange rate system:

An exchange rate system where exchange rates are determined entirely by market forces.

Define floating exchange rate:

An exchange rate determined entirely by market forces, or the forces of supply and demand. There is no
government intervention in the foreign exchange market to influence the value of the exchange rate.
Changes in demand for currency:
● Foreign demand for exports - increase in d. for exports → inc. d. for currency
● Foreign demand export of services (tourism) - to visit → buy / demand currency of country visiting
● Inflation relative to other countries - more demand for country with lower inflation
● Relative growth rate - A growth rate of another country - Better economy → more jobs → more
income → d. from abroad → d for currency from abroad increases
● Investments - Foreign Direct Investment + Investment in domestic currency → d. for domestic
currency increases
● Remittances - Send money from abroad home → more remittances → more demand for home
currency
● Speculation - Speculation that currency will value (appreciate) → demand increases → (hope to
sell after to make a profit) → in the process of purchasing currency, causes it to appreciate

Changes in supply for currency:

● Domestic demand for import of goods - increase in d. for import of goods → increase s. currency
domestic
● Domestic demand for import of services (tourism) - when tourism → change currency to foreign
currency → increase supply of domestic currency (devaluations)
● Rate of inflation relative to other countries - high domestic inflation → increase in s. of domestic
currency, as people reside to Other currency
● Relative growth rates - Economy doing well -> supply of domestic currency increases as
individuals demand imports
● Outward flows of investment - to invest abroad -> increase s. of domestic currency → trade to
currency abroad
● Relative interest rates - high I.R. → pay more to keep money in savings a/c country - Transfer
money to a country with high i.r. → long foreign currency → increase s. of domestic currency
● Outward flow of remittances - Send money home (abroad) → increase s. domestic currency
● Speculation on depreciation - Sell money → increase supply
● Central bank intervention - foreign exchange reserve → exchanging large amounts to support
own currency → sell foreign currencies to appreciate domestic currency