International Economics Flashcards
What is international trade?
International trade is the exchange of goods and services between countries.
What are the seven advantages of trade?
- Lower prices - Main aim of trade is to buy goods/services at a lower price. Consumers are able to buy less expensive products, whereas producers purchase raw materials/semi-manufactured goods at a cheaper price.
- Greater choice - It allows consumers to have a greater choice of products.
- Differences in resources - Some country simply doesn’t have specific resources which are required. Hence, they can export goods/services in order to earn foreign currency which can be used to buy the required resources.
I.E. Singapore - Low resources –> dependent on trade
- Economies of scale - Global market is greater than domestic. Hence, demand increases which means that level of production and size of production units increases.
- Increased competition - More firms –> more competition –> greater efficiency –> Cheaper prices/increased quality and variety of goods.
- Efficient allocation of resources - Free trade –> The countries best at producing goods/services produce them (i.e. production at lowest cost).
- Source of foreign exchange - trade acts a source of foreign currency which can then be used to buy other goods/services. Especially important for developing countries. I.e. Ghana sells cocoa –> receives euros –> import industrial machinery.
On a global market, what theory could we use to decide what country produces what product?
Comparative advantage theory
What is absolute advantage?
Absolute advantage means that an economy can produce a greater total of goods for the same quantity of inputs.
Example below
Absolute advantage is best used when comparing two countries that each have an absolute advantage in producing a product (Reciprocal absolute advantage).
What is a comparative advantage?
Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another.
Basically, country ‘A’ has to give up fewer units of other goods in order to produce X, than country ‘B’.
Comparative advantage is best used when 1 country has an absolute advantage in producing 2 goods in comparison to the other country.
The example below –> if both countries specialise using comparative advantage, the output of both textiles and books would increase (3–>4 / 7–>8)
In what situation would the theory of comparative advantage not work?
When both countries have the same opportunity cost then there is no point for trade to take place.
This is shown on a PPF curve by two parallel lines
What are the assumptions made in the comparative advantage theory?
- No transport cost is taken into account
- Only two goods are being produced
- Only two economies/countries
- Cost of production remains constant
- Both economies –> same resources –> they will not become depleted
- Free trade
- Goods are identical –> no difference in quality.
What diagram is used to show comparative advantage?
A PPF diagram can show the output of two goods between two countries.
What factors result in a country having a comparative advantage?
Highly dependent on the factors of the endowment.
i.e. A country with abundant unskilled labour can develop its comparative advantage in the production of labour intensive, low skilled, manufactured goods. Whereas, a country with well-educated labour will have a comparative advantage in the financial sector.
The abundance of a specific factor –> decrease in the price of a factor –> opportunity cost of goods/services using that factor lower.
What are the limitations of the theory of comparative advantage?
- It is assumed that producers/consumers have perfect knowledge –> aware of where the least expensive good may be purchased.
- Assumed no transport costs –> not the case –> in reality, decrease the comparative advantage as they are less competitive.
- External costs of trade. Exporting goods leads to increased pollution
- Diminishing returns/diseconomies of scale –> in some cases increasing output leads to diminishing returns.
- Assumed goods traded are identical –> Not the case for consumer durables –> i.e. Toshiba television is different from a Philips television.
- Assumed that there is perfect free trade –> trade barriers.
- Assumed that the factors of production remain in a country –> Not the case! –> Developed countries invest into producing goods in LDC’s.
What is the World Trade Organisation?
The WTO is an international trade organisation that sets rules for global trading and resolves disputes between member countries.
Members are supposed to grant “most favoured nation” status to one another –> trade concessions granted must be granted to all WTO members.
What are the aims/functions of the WTO?
Main aim –> Increase trade by lowering trade barriers and providing a forum for negotiation.
Functions are to…
- Administer WTO trade agreements
- Forum for trade negotiations
- Handle trade disputes
- Monitor national trade policies
- Provide technical assistance/training for developing countries.
- Cooperate with other international organizations
What are the advantages of the WTO?
- Lower prices for consumers. (Less tariffs –> cheaper imports)
- Free trade encourages greater competitiveness –> increased efficiency.
- The law of comparative advantage states that free trade will enable an increase in economic welfare. Cause, countries specialize where the Opp. Cost is low.
- Economies of scale. By encouraging free trade, firms can specialize and produce a higher quantity.
What are the successes of the WTO? (examples)
- WTO has over 160 members representing 98 percent of world trade –> large number involved.
- Increased number of trade disputes have been brought to the WTO, showing the WTO is a forum for helping to solve disputes.
- WTO regulations and co-operation helped avoid a major trade war; this was significant during 2008/09 global recession.
What are the disadvantages of the WTO?
- Unfavourable for developing countries –> Inhibits diversification –> developing countries need some trade protection to be able to develop new industries (infant industry argument)
- Most favoured nation principle –> unfair advantage to MNCs –> costs for local firms and the right of developing economies to favour their own emerging industries.
- Failure to reduce tariffs on agriculture –> US and EU still have high tariffs –> hurts developing country farmers who face the high tariffs.
- Diversification —> To diversify, LDCs might require tariffs to protect new industries.
- Environment. Free trade has often ignored environmental considerations –> WTO’s philosophy of maximising GDP no always useful.
- Free trade ignores cultural and social factors –> Free trade leads to MNCs reducing cultural diversity and tend to swamp local industries and firms.
- The WTO is criticised for being undemocratic –> richer countries get what they desire.
- Slow/difficult process to reach an agreement.
What is free trade?
Free trade means that countries can import and export goods without barriers to trade (Tariffs, quotas, etc)
What is protectionism?
Protectionism –> imposing restrictions on trade with the aim of protecting domestic businesses and industries from overseas competition.
Basically, preventing the outcome to solely result from the interplay of free market forces of supply and demand.
What are the arguments in favour of protectionism?
- Protecting domestic employment –> Gov. use protectionist measures in order to prevent unemployment of a declining industry due to foreign competition.
- Protecting from low-labour costs –> Some argue that the declining domestic industries are as a result of cheaper labour costs in foreign countries.
- Protecting infant industries —> Developing industries lack economies of scale –> less competitive –> Need protection until they are able to compete.
- Avoid the risk of overspecialisation –> Governments may want to limit overspecialisation –.> cause a small change in global market may have detrimental impacts.
- Strategic reasons –> Some industries need to be protected in case they needed for war (steel, agriculture, etc.)
- Prevent dumping –> This is when a country sells large quantities of a commodity at low prices in another country. Hence, damaging domestics firms.
- Protect product standards –> Country imposes safety, health or environmental standards on imported goods –> imports match domestic standards.
- Raise government revenue –> Developing countries –> difficult to collect taxes –> so they impose import taxes –> increase revenue
- Correct B.O.P deficit –> Used to reduce import expenditure.
What are the counter-arguments to the points in favour of protectionism
- Protecting domestic employment –> Industry will still decline –> Protectionist measures only prolong the process. Better idea? –> move resources to other expanding areas in the economy –> depends on extent of social cost of unemployment
- Protecting from low-labour costs –> Goes against the idea of comparative advantage –> domestic consumers pay more.
- Protecting infant industries —> Developed countries –> unjustified (large amount of financial capital) –> developing countries potentially applicable –> but do they have global political power?
- Avoid the risk of overspecialisation –> No-counter
- Strategic reasons –> Unlikely countries will go to war + if they do, it is unlikely they will be disconnected from supplies.
- Prevent dumping –> Difficult to prove dumping and aren’t subsidized industries supporting dumping.
- Protect product standards –> Valid only if concerns are true. Another issue –> Cost to meet standards, getting approval and documentation are high –> disadvantage for developing countries
- Raise government revenue –> No-counter –> its just imposing taxes on consumers that are buying.
- Correct B.O.P deficit –> Short term solution –> doesn’t tackle cause –> may lead to retaliation.
What are the arguments against protectionism?
Basically restating the benefits of trade.
- Protectionism leads to higher prices for producers and consumers.
- Protectionism leads to less choice.
- Protectionism leads to less competition which may result in inefficiency.
- Protectionism distorts comparative advantage –> inefficient use of worlds resources.
- Less specialisation –> reduction is global output.
- For the reasons listed above –> negative impact on economic growth.
What does a normal diagram look like without protectionist measures (tariffs, quotas, etc)?
If there was no foreign trade the domestic farmers would produce at the level Qe.
However, once the domestic market opens up to all other markets, the world supply is introduced (Perfectly elastic). Note–> S (Wolrd) must be below Qe otherwise there is no point in trading.
When world supply is introduced –> domestic suppliers will only produce at the level Q2. Thus, the excess demand is satisfied by foreign producers (Q2 —> Q1.
What are tariffs?
Tariff is a tax that is charged on imported goods.
Explain the tariff diagram?
The tariff will shift the world supply upwards (placed on foreign producers) –> this results in an increase in domestic producer surplus.
The upward shift of the World supply curve results in an increase in price P1 –> P2 . As a result, the total quantity demand falls (Q2 –> Q3) because the price has increased.
Furthermore, there is an increase in domestic supply (Q1 –> Q4) –> accompanied by an increase in revenue.
Foreign supply decreases (Q2 –> Q3) –> their revenue falls.
Show the changes in revenue for domestic/foreign suppliers and show the tariff revenue received by the government on a tariff diagram.
Domestic revenue increases –> increase in area from ‘g’ to ‘g+a+b+c+h’.
Foreign suppliers revenue decreases –> decrease in area from ‘h+I+j+k’ to ‘i+j’.
Government now receives tariff revenue –> d+e
On a tariff diagram what area represents a dead-weight loss?
There are two areas that correspond to a dead-weight loss.
- Loss of consumer surplus equivalent to ‘f’ –> this area represents the dead-weight loss of welfare.
- Inefficiency –> Foreign farmers produced Q1 –> Q3 for a min revenue of ‘h’ but domestic producers need a min revenue of ‘h+c’. Thus, C represents inefficiency of domestic producers/loss of world efficiency.
What are the impacts of the tariff on Domestic/foreign producers, consumers and the government?
Domestic producers
- Increased output –> increased revenue
- Less incentive to innovate.
Foreign producers
- Decreased output –> less revenue
- Increased efficiency –> in order to compete
Consumers
- Less choice
- More expensive products
Government
- Decreased unemployment
- Increased government revenue.
Explain what happens when a subsidy is applied to a trade diagram?
Subsidy used to make domestic producers more competitive –> outward shift in the domestic supply
Subsidy is represented by area –> e+f+g
Domestic production increases –> 0 –> Q3 –> increase in revenue from ‘a’ to ‘a+b+e+f+g’.
Foreign producers supply the rest which is a decrease from Q1–>Q2 to Q3 –> Q2 . Hence, their revenue falls from ‘b+c+d’ to ‘c+d’.
On a trade diagram + subsidy what area represents the deadweight loss?
With subsidy Q1 –> Q3 is produced inefficiently by domestic producers as opposed to more efficient foreign producers.
Foreign producers –> would produce for a min revenue of ‘b’.
Domestic producers –> would produce for a min revenue of ‘b+g’
Misallocation of the world’s resources.
On a trade diargam, do subsidies impact consumers?
Directly, No –> Price stays the same –> no drop in consumer surplus.
Indirectly they may be affected by higher taxes (to fund subsidy) as well as decreased government expenditure on other sectors (opportunity cost of subsidy)
What is a quota?
A quota is a physical limit on the numbers goods that can be imported into a country.
Explain the quota diagram.
Before…
0 —> Q1 is supplied domestically
Q1 —> Q2 are imports
Then..
The government imposes quota (limit) –> Q1 –> Q3
This results in a shortage (excess demand) Q3 –> Q2 as there is decreased supply –> upwards pressure on price.
Shortage pushes the price up —> domestic producers attracted by higher prices –> enter the market.
Eventually, price settles at Pquota –> demand = supply (Q4)
Now…
Domestic producers supply –> 0 to Q1 and Q3 to Q4
Foreign producers supply –> Q1 to Q3
How does the quota diagram impact revenue for domestic and foreign producers?
Domestic revenue increases –> from ‘a’ to ‘a+c+d+f+i+j’
Foreign revenue decreases –> from ‘b+c+d+e’ to ‘b+g+h’. Usually a decrease but not always.
What area represents the dead-weight loss on a quota diagram?
Two areas of deadweight loss.
- Area ‘k’ –> represent a decrease in consumer surplus which is a dead-weight loss.
- Area ‘J’ –> represents inefficiency of domestic producers and loss of world efficiency –> more of the worlds resources are used to produce wheat.
What are the two main types of administrative barriers?
- ‘Red Tape’
When goods are imported it involves an administrative process. If these processes are lengthy and complicated —> acts as a restriction on imports.
- Health/safety/ environmental standards
Restrictions on the type of good sold in the domestic market or on the method of manufacturing.
How can nationalistic campaigns be used to promote domestic goods rather than foreign?
Governments may run marketing campaigns to encourage people to buy domestic goods instead of foreign ones.
What is the definition of an exchange rate?
The exchange rate is the value of one currency in terms of another.
1€ : 4$
This means that 1€ can be exchanged for 4$
What are the three main types of exchange rate systems?
A country manages its exchange rate system (exchange rate regime)
- Fixed exchange rate
- Floating exchange rate
- Managed exchange rate.
What is a fixed exchange rate?
A fixed exchange rate is when the value of a currency is fixed, or pegged, to the value of another currency, to the average value of a selection of currencies or to the value of some other commodity, such as gold.
Value of the variable to which the currency is pegged changes –> value of the currency itself changes.
Raise in the value of a currency in a fixed exchange rate —> revaluation.
Decrease in the value of a currency in a fixed exchange rate —> devaluation.
How is a fixed exchange rate maintained?
A fixed exchange rate is maintained via government intervention in the foreign exchange rate market.
Example:
Barbadian $ fixed to US $
Two main methods of maintenance.
Situation 1 –> increase in the supply (outward shift) of Bbs $ due on foreign exchange market (F.E.M) due to Barbadians purchasing more imports.
No gov intervention? exchange rate falls
But the Barbadian government can buy up an excess supply of its own currency on the F.E.M using reserves of foreign currencies –> increase in demand –> balance out of effects.
Situation 2 –> Increased demand (outward shift) for the Bds$ due to increased tourism. Without gov intervention –> exchange rate would rise.
But to maintain the exchange rate –> Barbadian government sell its own currency on the foreign exchange market –> Outward shift in supply –> this increases Barbadian reserves of foreign currency.
What is a floating exchange rate?
A floating exchange rate is when the value of a currency is allowed to be determined by the interaction between demand and supply on the foreign exchange market.
Rise in the value of a floating exchange rate –> appreciation.
1$ : €0.80 —> 1$ : €0.85 –> dollar has appreciation
The decrease in the value of a floating exchange rate –> depreciation.
€1 : 1:25$ —> €1 : 1:18$ –> euro has depreciated
What demand factors influence the value of a currency in a floating exchange rate?
Example –> E.U and U.S
Demand
- Increase in demand for U.S good/services
- US inflation is lower –> cheaper products
- E.U income increases –> demand for all things increase
- Cange in taste - U.S investment prospects improve
- U.S interest rates increase –> more attractive to save in their banks
- Speculators think the U.S dollar will rise.
What supply factors influence the value of a currency in a floating exchange rate?
Example –> E.U and U.S
Increase in supply –> increase in supply of US $ on the foreign exchange market.
-
Increased demand for E.U goods/services –> more U.S dollars exchange for euros.
- U.S inflation rates are higher than E.U –> U.S goods/services are more expensive
- An increase in general income level –> overall increase in demand
- Change in taste - EU investment prospects improve
- EU interest rates increase –> making it more attractive to save money there
- Speculators think the value of the U.S dollar will fall –> so they sell it now and buy euros.
What is a managed exchange rate?
In reality –> no currency is ‘freely floating’ –> there is always some level of government intervention during periods of extreme fluctuations.
Hence, most exchange rates are managed –> currency is allowed to float between an upper and lower limit but there is some level of interference from the government when value surpasses U.L or falls below L.L.
Most common –> central bank sets upper and lower limits.
What are the advantages of a high exchange rate?
-
Downward pressure on inflation
- Price of finished imported goods will be relatively low –> force domestic producers to keep price low.
- Price of imported materials/components will reduce costs of production –> lower prices for consumers -
More imports can be bought
- Higher value of currency –> more foreign currency can be bought with a single unit of domestic currrency –> cheaper imports.
Benefits for both visible imports -> technology and invisible imports –> foreign travel.
-
High value of currency forces increased domestic efficiency
- High exchange rate will threaten international competitiveness –> forced to lower costs and increase efficiency.
What are the disadvantages of a high exchange rate?
Disadvantages
-
Damage to export industries
- High exchange rate –> difficulty selling goods/services abroad –> lead to unemployment/industry decline -
Damage to domestic industries
- More imports being purchased (relatively less expensive) –> increased competition leading to falling in domestic demand –> industry decline/unemployment.
What are the advantages of a low exchange rate?
Advantages of a low exchange rate
-
Greater employment in export industries
- Value of exchange rate is low –> value of exports relatively less –> more competitive –> increased employment in export industries -
Greater employment in domestic industries
- Low exchange rates make imports relatively more expensive –> encourages consumers to buy from domestic industries –> increased employment.
What are the disadvantages of a low exchange rate?
Disadvantages of low exchange rate
- Inflation –> Low value of the currency makes imported final goods/services, raw materials, components more expensive
These materials are required for producers which then raises costs of production –> higher prices –> inflation.
Summary of benefits/disadvantages of high/low exchange rates
- Appreciation/high value of the currency
- Imports are cheaper –> pushes down cost
- Exports are more expensive for foreign consumers –> discouraged
Hence —> Good to fight inflation but can create unemployment.
- Depreciation/low value of a currency
- Imports are more expensive –> Inflation (higher costs of production)
- Exports are now cheaper for international buyers –> increased demand.
Hence –> may result in inflation but can help solve unemployment problems.
Three things to consider when evaluating whether a change in exchange rate is detrimental or not.
- Businesses are held by contracts –> are the changes going to have an impact on them?
- Price is not the only factor –> quality of goods/services.
- Are the changes short or long term?
Why would a government intervene to influence the value of their currency?
They may wish to…
- Lower exchange rate in order to increase employment.
- Raise the exchange rate in order to fight inflation
- Maintain fixed exchange rate
- Avoid fluctuations in floating exchange rate
- Improve stability –> improve business confidence
- Improve a current account deficit
What is the J-Curve effect?
If an economy satisfied the Marshall Lerner condition then we would expect to see an improvement in the current account as the value of the currency depreciates.
However…. This is not the case.
The J-Curve effect explains why in the short run the current account deficit actually gets worse before it improves in the long run, even though it satisfies all the condition.
Explain the trade creation diagram?
It is basically the opposite of the tariff diagram.
Best explained using a example
Examining the change that takes before and after the UK enters the EU.
Uk has the comparative advantage in the production of lawnmowers.
Before entering –> The UK would export Q2 –> Q3 to the EU because of the tariff.
After entering –> The tariff is gone –> UK can export Q1 —> Q4 which is greater than before. Whereas, France domestic production dropped 0 –> Q1.
This might look unbeneficial for the E.U but one must remember that it is a two-way process.
Explain the welfare gained on the trade creation diagram?
There are two areas on the diagram that represent Welfare gains
- The Extra demand results in an increase in consumer surplus –> shaded triangle on the right.
- The movement from high-cost to low cost producers (increase in production from UK producers who are more productively efficient as they have a comparative advantage) –> fewer resources wasted –> area on the left –> world welfare gain.
Explain the trade diversion diagram?
Before joining the custums union (E.U), the U.K imported textiles from Thailand which had the comparative advantage –> S (Thai)
However, once the UK joined the E.U they had to impose tariffs which pushes the supply curve from S(Thai) –> S(Thai) + tariff.
Consequently, due to the increased price of textiles from thailand –> E.U firms become more competitive –> the U.K will import from other E.U countries (Q2 - Q3) instead.
Explain the dead-weight loss on the trade diversion diagram?
There are 2 areas that show a dead-weight loss
- Triangle Area on the right –> As there is an overall decrease in consumer surplus (Q4 –> Q3) –> there is a dead-weight loss.
- Triangle Area on the left –> As there is a movement from low cost (Thailand) to high-cost producers (E.U) –> world welfare loss as more resources are being used to produce the textiles.
