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The Benefits Of Trade

International trade – buying and selling of goods/services across international boundaries.
Imports – goods and services that a country buys from other countries
Exports – goods and services that a country sells to other countries.

BENEFITS OF TRADE
Increases in domestic production and consumption due to specialization
Specialization – when one concentrates production on a few goods and services that it can
produce efficiently. Countries that don’t trade can’t specialize because they need to make more
resources.
Factor endowments – factors of production a country possesses.
Countries can make use of the differences in quantities and qualities of the factors of production
to increase consumption and production.
Economies of scale in production
EoS – ability of firms to decrease costs of production by becoming larger and increasing the
quantity of output.
Without trade, the size of the market is limited and it’s hard to take advantage of economies of
scale.
Greater choice for consumers
Countries can have a larger variety of goods and services.
Increased competition and greater efficiency in production
Domestic firms gain extra competition which forces them to be more efficient
Lower prices for consumers
Increased efficiency results in lower costs
Acquiring needed resources
Countries are able to import the necessary inputs for domestic production thanks to trade.
Free trade and a more efficient allocation of resources
Free trade means there is no government intervention with restrictions
Source of foreign exchange
Allows countries to make payments to other countries
Flow of new ideas and technology
Reduces hostilities and violence
Countries become interdependent and reduce the possibility of war.
“Engine for growth”
All of the above allow an increase in output which can cause economic growth.

Free Trade: Absolute And Comparative Advantage

FREE TRADE

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It is defined as the absence of government intervention in international trade, so that trade

takes place without any restrictions (or barriers) between individuals or firms in different
countries.

THE THEORY OF ABSOLUTE ADVANTAGE

The theory of absolute advantage states that increased production and consumption in each nation
is the outcome of countries focusing on and exporting the product in which they have an absolute
advantage (can produce with fewer resources).
PPC CURVE showing absolute advantage:

From the above table, we can conclude by saying that Coffenia has an absolute advantage in
coffee because it can produce 8 units of coffee compared to only 3 in Robotia. Similarly Robotia
has an absolute advantage in robotics since it can produce 6 robots compared to only 4 in
Coffenia.
Production and Consumption with no trade:
In the absence of trade (known as autarky), both the countries produce both robot and coffee, so
that they consume both (produces anywhere along their PPC).
Production and Consumption with trade:
Due to a “global” reallocation of resources in which production is carried out by the most cost-
effective producers, both nations can consume outside of their PPC because they engage in trade
and produce within it.

THE THEORY OF COMPETITIVE ADVANTAGE

It describes a circumstance in which one nation has a lower opportunity cost—also known as the
relative cost of producing a product—than another nation.
Graphical Explanation:
In the production of both goods, Microchippia has a clear advantage. As a result, its PPC is
significantly higher than that of Cottania.

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If PPC’s intersect: When one country has the absolute advantage in one or both the goods.
If PPC’s do not intersect: PPC of the country lying fully above has the absolute advantage in
both the goods.
When the opportunity cost (lower relative cost) of producing a good is lower, a nation has a
competitive advantage.

LAW OF COMPETITIVE ADVANTAGE

When a good can be produced at a lower opportunity cost than its trading partner, a nation has a
comparative advantage. All nations can benefit from specialization and trade based on their
comparative advantage, as long as opportunity costs in two or more countries differ. This is the
theory or law of comparative advantage. Countries can consume outside of their PPC as a result of
improved resource allocation, which increases global output and consumption.
A highly skilled and educated worker using more advanced technology adds more to the output.

UNREALISTIC ASSUMPTION OF THEORY OF COMPETITIVE ADVANTAGE

Factors of production are immobile.

Technology is fixed (new technologies are always introduced).
There exists a perfect competition (which is a rare scenario).
Imports and exports balance each other (in reality there exists several trade imbalances).
Ignore transportation costs.
It leads to excessive specialization.
Assumption of free trade is unrealistic (in reality there exists a lot of Government interference).

The World Trade Organization (WTO)

HISTORY

During the Great Depression, countries imposed tariffs to limit imports and resulted in tariff wars
which reduced trade without affecting output and employment.
29 countries formed the General Agreement on Tariffs and Trade (GATT) to prevent outbreak of
tariff wars in 1947.
Principles that the GATT was based on:
Non-discrimination
Elimination of non-tariff trade barriers
Consultations to resolve trade disputes
They would conduct rounds to achieve the objectives. In Jan 1995, the GATT was replaced by the
World Trade Organization (WTO).

FUNCTIONS & OBJECTIVES

Contains: 153 members and 31 “Observers”

Functions:
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Administers WTO trade agreements

Helps in implementation/admin of trade agreements
Provides forum for negotiations
Most important; allows members to discuss problems
Handles trade disputes
Monitors national trade policies
Conducts reviews of trade policies
offers training and technical assistance to developing nations
Facilitates cooperation with other international organizations
Such as the World Bank and International Monetary Funds

Principles:

Non-discrimination
Emphasis on equal treatment for all member countries (excluding trading blocs)
Free trade
Trade barriers should be lowered
Predictability
Firms, gov’ts, etc., should have confidence that barriers won’t be raised
Promotion of fair competition
Unfair practices are discouraged
Development and economic reform should be encouraged
Developing countries should be offered flexibility

Restrictions On Free Trade: Trade Protection

TRADE PROTECTION

Free trade – trade without government intervention so no restrictions take place; efficient global
allocation of resources and maximization of global output
Trade protection – Government intervention with trade barriers to prevent free entry of imports or
protect the economy from foreign competition.

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Under free trade, goods are exported when the global price is higher than the domestic price. The
product is imported if the international price is lower than the domestic price.

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The world price (Wp = Ws) curve is the perfectly elastic curve. Once a country opens up to
international trade, the domestic price (Pd) is no longer relevant.

TARIFFS

Tariffs (custom duties) are taxes on imported goods. They are used to protect a domestic industry
from competition (protective tariff) or to raise government revenue (revenue tariff).

Under free trade, the country will produce Q1, demand Q4, and import Q4 – Q1. The tariff will
increase the price to Pw+t.
Increase in Qs, decrease in Qd, decrease in imports
Qs to Q2, Qd to Q3, quantity of import to Q3 – Q2.
Domestic consumers worse off
Pay higher price at Pw+t and buy quantity Q3 instead of Q4
Domestic producers better off
Receive higher price Pw+t and sell quantity Q2 instead of Q1
Domestic employment increases
Producers sell more, so employment increases
Gov’t gains tariff revenues
Revenue gained: amount of tariff * quantity of imports. Orange shaded (E)
region.
Domestic income distribution worsens
Tariff is a regressive tax which burdens those with low incomes.
Increased inefficiency in production
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Increase in output increases production by inefficient producers which results in a waste of

resources.
Foreign producers worse off
Since there are fewer imports, the foreign exporters export less.
Global misallocation of resources
Decreased consumption, inefficient domestic producers
Welfare loss at purple shaded (D + F) region.
Effect of tariff on consumer and producer surplus

IMPORT QUOTAS

Quotas – legal limit to quantity that can be imported over a time period. Similar effects as tariffs,
but without gov’t revenue.
Under free trade: Q1 supplied and Q4 demanded; Q4 – Q1 imported.
With a quota, the quantity imported is limited to Q3 – Q2.
Governments issue a number of quota licenses that determine the legal limit on the quantity of
imports, and the license holders gain revenues.
Usually given to exporting countries.

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Increase in Qs, decrease in Qd and imports

Domestic consumers worse off
Pay higher for less
Domestic producers better off
Receive higher price and sell more
Domestic employment increases
Output increases, so employment increases
The government does not gain nor lose
Import license given to foreign gov’ts, so the domestic government budget isn’t affected
Domestic income distribution worsens
Higher price has the same regressive effect
Increased inefficiency
Increase in production by the inefficient domestic producers
Exporting countries better/worse off
Loss of export revenues but gain quota revenues
Global misallocation of resources
Decrease in consumption, shift of production to inefficiency, etc.
Effect of quotas on consumer and producer surplus

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SUBSIDIES

Production subsidies are government payments made to domestic businesses that compete with
imports.
Under free trade: produce Q1, demand Q2, and import Q2 – Q1.
Increase in Qs, decrease in imports
Qimports to Q2 – Q3 from Q2 – Q1
Consumption unaffected
Consumers buy more of the
domestic good and less of the imported, so it stays the same
Domestic producers better off
Receive more (Ps, or Pw + subsidy)
Government budget worse off
Must spend tax revenues on subsidies
Taxpayers worse off
Taxpayer funds could be spent elsewhere
Domestic employment increases
Output increases; employment increases

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Increased inefficiency
Domestic producers more inefficient compared to foreign producers
Exporting countries worse off
Global misallocation of resources
Economists prefer subsidies to tariffs or quotas because they don’t have negative effects on
consumption
Subsidies result in exports of the protected goods
If the subsidy is large enough, the country can become an exporter of the good even though it has
a comparative disadvantage in its production.
Effect of production subsidies

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Subsidy per unit = Vertical difference between two supply curves.

Quantity of imports = imports before subsidy ( 9 million units)
Imports after subsidy (4 million units)
Domestic consumers: Consumers are not affected. They pay the same price.
Domestic producers: The price received by producers increases by the amount of subsidy.
Government expenditure and tax payers: Government expenditure increases from zero to an
amount equal to the subsidy per unit.
Foreign producers: The decline in imports from a country equals the decline in exports from foreign
producers.

ADMINISTRATIVE BARRIERS

Administrative barriers are obstacles to imports.

Such as: custom procedures with inspections, valuations, and red-tape checks. These make it
harder to import and use up more time.
Health, safety, environmental standards also require time-consuming tests.
Believed to be an attempt to reduce imports sometimes

ARGUMENTS AGAINST TRADE PROTECTION

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Protection worsens the allocation of resources.

Trade protection benefits only workers and producers. Producer gain comes at the expense of
higher production costs and reduced efficiency.
Consumers lose in most cases
Higher cost and lower quantities available. (Consumer losses usually greater than producer
gains)
Income distribution worsens
Except with subsidies and barriers
Foreign producers worse off
Society as a whole / global resource allocation loss
Trade protection may have negative effects on a country’s export competitiveness.
Some protected domestic goods may be inputs to other exported goods.
Price of protected fertilizer increases, and agricultural products now have increased in price.
Lower competitiveness in export markets
Trade wars
Other countries can retaliate by imposing barriers should a country impose a barrier.
Potential for corruption
Bribery and smuggling can occur as a result of import restrictions.

ARGUMENTS FOR TRADE PROTECTION

Infant industries
Infant industry – new domestic industry that is unable to compete with other competitors as it
hasn’t reached economies of scale.
An industry might need protection before it can specialize in it.
Needs to be temporary, or governments may continue to protect it after maturity
Difficult for gov’t to decide what industries have potential.

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Industry may not have incentive to become efficient

Strategic trade policy
Strategic trade policy – argument in favor of protection that calls for high tech industries to help
developed countries achieve economies of scale.
Certain industries important to future economic growth.
Difficulties in identifying industries
Difficulties in selecting policies
National security
National defense industries should be protected so a country can produce them by themselves.
Used by industries that have indirect use in defense to gain protection.
Hard to draw a line between national defense and not national defense.
Health, safety, and environmental standards
Concern: hidden protection
Efforts of a developing country to diversify
Countries need to keep out imports of goods that they want to produce themselves.
Applies only to developing countries.

INCORRECT ARGUMENTS

Wage protection argument

Foreign countries can produce at lower costs because of low wages.
Low-wage countries probably have a comparative advantage in producing goods that make use of
the resources because they are cheaper.

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