This chapter will explain why trade can take place between nations. It will outline the advantages and disadvantages of trade as well as the barriers to it.
Comparative and Absolute Advantage
We know that specialisation occurs at all levels in the global economy; individual division of labour, firms, regions and countries).
If we assume there are only two counties in the world, England and France, and each has the same quantity of resources. The two countries only produce two goods, bread and jam. England and France devote half of their resources to the production of each of the goods.
We can see from the table below that with a year’s worth of labour in England can produce both more bread and jam than in France. England therefore has an absolute advantage in the production of bread and jam.
England is six times as efficient in jam production, but only 50% more efficient in bread production.
If France wishes to produce an extra unit of bread it has to give up half a unit of jam, however if England wishes to produce an extra unit of bread it must give up two units of jam. A country’s comparative advantage lies in the good that it can produce relatively cheaply, i.e. at a lower opportunity cost than its trading partner.
What is the opportunity cost of 1 unit of Jam for England?
What is the opportunity cost of 1 unit of Jam for France?
England (which has an absolute advantage in both commodities) therefore has a comparative advantage in jam production, whereas France has a comparative advantage in bread production.
If each country specialises completely in the good that they have a comparative advantage in, the production totals will be:
Compared to the earlier scenario without specialisation and trade, there has been a gain of 25 units of jam, but bread production has fallen by 5 units. It is impossible for us to say whether there has been a welfare gain because the amount of jam has fallen and we do not know what relative values consumers place on bread and jam.
For us to demonstrate a definite gain in welfare we must create a situation where the results from specialisation and trade are at least as much of one good and more of another good. We are able to obtain this result by allowing England to devote one sixth of its resources to bread production, giving production totals that are shown below.
There are a number of assumptions that we have to make with the comparative advantage model:
- There are no transport costs between England and France.
- Costs are constant; therefore there are no economies of scale.
- There are only two economies producing goods in the world.
- Goods are homogeneous in the different countries – is bread and jam the same in the UK and France?
- Factors of production are completely mobile – this assumes the country’s PPF is a straight line.
- There are no barriers to trade.
- There is perfect knowledge in both countries.
There are analogies in terms of individuals specialising in different tasks. Some lawyers may be better typists than their secretaries, but the secretaries do all of the typing. The lawyer has an absolute advantage in both practising law and typing, but the secretary has a comparative advantage in typing. This is because the opportunity cost of the lawyer doing an hour’s typing is far higher than that of the secretary, therefore it makes sense for the secretary to type and allow the lawyer to practice law.
Gains from trade
We can assume that the price of the two goods will be roughly equal to their opportunity cost. We can state that the exchange ratios for bread and jam will be:
- In England – 1 bread for 2 jam or 1 jam for 0.5 bread
- In France – 2 bread for 1 jam or 1 bread for 0.5 jam
We can state that both countries will benefit from trade if the exchange ratio is between 1:2 and 2:1. Let us examine what will happen if the exchange ratio is set at 1:1.
England will benefit from importing bread and exporting jam. When the exchange ratio is 1:1 England will only have to export 1 unit of jam to obtain 1 unit of bread, before the opportunity cost of the unit of bread was 2 units of jam.
Explain how France benefits from trading at an exchange ratio of 1:1.
Terms of Trade
The terms of trade are the ratio between export prices and import prices, it can be calculated as:
Average price of exports
Average price of imports
It is possible that you will see the terms of trade expressed as index numbers.
The UK’s terms of trade will improve if more imports are received for a fixed number of exports. This will occur if either the export prices rise or the costs of imports fall.
What will happen if the terms of trade for the UK worsen?
Patterns of Trade
The table below outlines the UK’s trade with various trading partners.
Outline the key points from the above table. Are there any countries where there is a difference between the percentage of imports and exports? Who are the UK’s main trading partners?
The table below shows the categories of goods traded by the UK in 2006.
Outline the key points from the above table.
The table below shows the categories of services traded by the UK in 2006.
Outline the key points from the above table.
Benefits of Trade
There are a number of benefits of international trade; the following is a summary of the key points:
- Comparative advantage – countries are able to specialise in the production of goods and services that they can produce at a lower opportunity cost. This will have the effect of raising world welfare levels.
- Employment – countries will see a rise in employment as exports rise.
- Economies of scale – selling to other countries will enable firms to reduce their average costs and become more productively efficient.
- Competition – increased competition will reduce prices and markets will become more allocatively efficient.
- Increased research and development – firm will strive to lower costs through advances in technology. They will become more dynamically efficient as they do this.
- Use of surplus factors of production – countries will be able to make better use of their factors of production and are more likely to be on the production possibility curve.
Free trade and the World Trade Organisation
The World Trade Organization (WTO) is the organisation responsible for the supervision and liberalisation of international trade. The WTO was formed on 1st January 1995 when it took over from the General Agreement on Tariffs and Trade (GATT), which was created in 1947. The WTO has 153 members, which represents more than 95% of total world trade. The member countries are highlighted on the map below.
The World Trade Organization deals with the rules of trade between nations; it is responsible for negotiating and implementing new trade agreements. The WTO is also in charge of policing member countries’ adherence to the WTO agreements.
The latest round of negotiations held by the WTO is called the Doha Round and they began in Qatar in November 2001. The agenda of the Doha round was particularly ambitious as its aim was to make globalisation more inclusive and help the world’s poor; this would be achieved by reducing barriers to trade and subsidies in farming. Agreement still has not been reached; the main disagreements are focused upon agriculture subsidies.
Import controls are barriers to the free movement of goods and service that distort the pattern of trade between countries. There are a number of different arguments in favour of protectionism:
- Protecting domestic jobs – whilst free trade creates jobs, there is no doubt it also destroys them as well. Protectionism can protect jobs whilst workers are retrained, although some countries continue to protect jobs long after any comparative advantage has been lost.
Why will domestic consumers lose out from such protectionism?
- National security – some industries may be vital due to national security and government would not want to lose them just to reduce costs.
- Infant industry argument – new industries can be given protection whilst they establish themselves and build up economies of scale. The protectionism should be removed after a period of time under the infant industry argument.
- Unfair competition argument – free trade only works if everyone plays by the rules! If other countries are using protectionism to gain a competitive advantage then it would only seem fair to do so as well.
What is the obvious solution to this scenario?
- Protection as a bargaining tool – the threat of protectionism can help to persuade other countries to remove their own barriers to trade.
There are a variety of import controls can be introduced.
A tariff is a tax on imports that is used to restrict imports and raise revenue for the government. We assume that producers from other countries can supply the good at a constant price of PW – their supply curve, SW, is perfectly elastic.
The domestic demand and domestic supply curves demonstrate the intentions of producers and consumers. At the market price of PW domestic producers are able to supply cheaper than the imported price, therefore domestic firms will supply up to output Q1. Demand from domestic consumers at PW is Q2. Beyond Q1 imports are cheaper than the domestic supply, therefore there will be Q1 to Q2 imported.
Placing a tariff on to all imports will raise their price to Pw+t. This will lead to demand falling to Q4. At the new price of Pw+t domestic supply will expand to Q3.
What effect has the tariff had on the volume of imports?
What effect has the tariff had on the quantity sold by domestic suppliers?
The impact of the tariff will depend upon the price elasticity of demand and the price elasticity of supply. The tariff will have a greater effect the more elastic the demand and supply. If the demand is inelastic then the imposition of a tariff will have little effect on the level of imports.
Explain how the tariff impacts the two different demand curves in the above diagram.
If one country introduces a tariff it will often be met by retaliation from other countries. This retaliation can lead to trade wars that are damaging to all nations involved.
After the tariff is imposed the consumers have to pay a higher price and consumer surplus will fall. Firms receive a higher price and their producer surplus will increase. The government receives extra revenue from tariff receipts.
Overall, imposing a tariff will have a cost to society. This is highlighted on the diagram below where:
- 1 +2 +3 + 4 = loss in consumer surplus
- 1 = gain in producer surplus
- 3 = gain in government revenue
Therefore areas 2 and 4 are a net loss.
An import quota places a limit on the quantity of a product that is allowed to be imported. The main beneficiaries of quotas are the domestic producers who face less competition.
This is where the government completely bans certain imports, for example, drugs or exports to certain countries, such as to enemies during a war.
Regulations may be designed in such a way to exclude imports, for example, in Germany imported lagers used to have to pass many purity tests and in Japan importers had to complete so much paperwork and satisfy so many safety tests that many were put off.
This is where governments favour domestic producers when purchasing equipment, such as defence equipment.
VOLUNTARY EXPORT RESTRAINT
A voluntary export restraint is similar to an import quota. With a voluntary export restraint, the exporting country voluntarily restricts the number of goods that it ships to its trading partner. Foreign exporters must purchase licences from its government and then it is able to exports its allotted amount.
An export subsidy is a payment to a domestic producer who exports a good abroad. They help domestic producers to compete in the global market more effectively as the subsidy will have the effect of reducing the price charged in foreign markets.