International trade

• International trade is the exchange of goods and services beyond national borders.

Free trade

• Free trade is defined as the exchange of goods and services between nations without restrictions.

What are the benefits of free trade?

• International trade can allow countries to gain access to resources they do not have. Many economies use international trade to gain access to raw materials not found in their own country.
• International trade leads to an increase in consumer choice. Due to the increased option of imports, consumers enjoy more choice.
• Industries that export can benefit from large economies of scale.
• International trade can allow for lower prices for consumers as other countries may be able to sell goods at a lower price level.
• International trade can also allow for more efficient allocation of resources (theory of comparative advantage).
• Benefits of increased competition (innovation and lower prices)
• Source of foreign exchange.

Why should free trade be avoided?

• Infant industries might not be able to grow due to foreign competition and the country might not be able to gain any comparative advantage.
• Government should protect declining industries from foreign trade in order to prevent mass unemployment in the economy.
• Protectionism methods such as tariffs can help raise government revenue.
• Balance of payments is maintained if free trade is avoided (imports will not surpass exports)
• Protects against certain methods like dumping (when the foreign competition has excess supply of a good and ‘dumps’ it in another economy at a very low cost, undercutting domestic producers and taking their revenue)

World Trade Organisation (WTO)

• WTO’s main objective is to promote trade liberalisation all over the world. This means reducing methods of protectionism such as embargoes, quotas, and tariffs.
• It also acts a forum for negotiation between different economies. It performs the role of a mediator.
• It also monitors national trade policies.
• It provides training and technical assistance to less economically developed countries.

Theory of absolute advantage (HL only)

• The absolute advantage theory states that a country has absolute advantage when it produces a greater quantity of a good than another country with the same amount of inputs.
• So, if two countries produce goods in which they have absolute advantage, more wants can be satisfied and the production of goods increases for both countries individually.

Theory of comparative advantage (HL only)

• The comparative advantage theory states that a country must specialise in the production of a good that bears the least opportunity cost.
• There are two main sources that provide a country with comparative advantage:
  • Factor endowments: this refers to the resources that the country owns. For example, India has large labor endowments. This can allow countries to reduce costs of production and therefore increase production with the same level of inputs.
  • Level of technology: this refers to the technology of the country. For example, Japan was able to take advantage of technology and have the biggest research and development budget in the whole world.
• If two countries produce goods that they have comparative advantage in and then trade, it can increase the total output from the combined resources of both countries.
• There is an increase in output so economic welfare is increased.
• It is important to note that this leads to a greater increase in output than if the economy was being self-sufficient.

Limitations of the theory of absolute and comparative advantage (HL only)

• The problem with both these theories is that both of them are fundamentally based on several assumptions.
• These assumptions are:
  • Countries must produce only two types of goods.
  • All resources must be used without wastage.
  • Quality of goods in both countries is the same.
  • There are no trade barriers.
  • Opportunity cost is constant and factors of production are fully interchangeable.

Trade protectionism

• When a country erects barriers to trade in order to protect a domestic economy from disadvantages of free trade.
• There are several forms of trade protectionism.

Tariff

• A tariff is an indirect tax on imports, and it is a form of protectionist measure.
• It increases the price of imports, thereby increasing the demand for domestic goods.

• A tariff has several effects on various stakeholders:
  • Domestic producers:
    • Benefit initially as the quantity of domestic goods supplied is more and the revenue earned is increased.
    • Producer surplus increases.
    • However, may lead to X-inefficiencies due to reduction in intensity of market competition.
    • Other domestic producers that utilise the import as a raw material will face higher costs of production due to higher prices.
  • Foreign suppliers:
    • Quantity of goods supplied reduces. Portion of revenue is taken due to tariff.
    • In the long run, may be able to shift production to other countries or regions where import tariffs are lower.
  • Domestic consumers:
    • Pay a higher price for the good. Therefore, consumer surplus falls.
    • Fall in real income as there is an increase in average price level leading to inflation.
    • Since tariffs are regressive taxes, they have a greater impact on the lower class, might create unequal distribution of income.
    • If the demand for the good is price inelastic, greater burden is placed on the consumers.
  • Government:
    • Earns revenue through the tariff.
    • AD increases as $(X-M)$ increases.
    • However, retaliation may occur in the long run, increasing costs of production for other industries and therefore leading to cost-push inflation.

Subsidy

• A subsidy is a form of financial assistance provided by the government in order to lower costs of production.
• In order to help domestic producers, the government can subsidise domestic firms, increasing their supply and reducing the supply of foreign producers.

• A subsidy has several effects on various stakeholders:
  • Domestic producers: produce at a higher quantity, resulting in higher revenue. Producer surplus increases.
  • Foreign producers: quantity traded falls for foreign competition.
  • Consumers: no change in welfare as they are still buying the same amount of good for the same price.
  • Government: Money invested in subsidy could lead to a budget deficit in the economy. Moreover, money could be used to invest in merit goods.

Quota

• A quote is a physical limit on the volume of goods and services allowed to be imported.
• A voluntary export restraint is when the exporter willingly limits the supply of exports.

• A quota can have several impacts on different stakeholders:
  • Domestic producers: they are able to produce more goods, and at a higher price. Therefore, they earn higher revenue. Producer surplus increases.
  • Foreign producers: quantity of goods being imported falls as a result of the quota.
  • Consumers: consumer expenditure increases as a result of the quota. Therefore, consumer surplus falls.
  • Government: no effect on the government directly. However, the government can earn money from issuing licenses to companies that do decide to import.

Administrative barriers

• The country may choose to protect their domestic market by applying non-tariff or administrative barriers.
• This can be in the form of making certain chemicals illegal in imported goods, occupational safety regulations and even using intellectual property rights to stop imports.