Trade Flashcards
What are the ideas of absolute and comparative advantage an applications of?
The ideas of absolute and comparative advantage are an application of ‘specialisation’ to international trade. The basic idea is that specialisation and international trade will increase global output.
What is absolute advantage?
Absolute Advantage (AA) is when a country can produce a good at a lower cost, in absolute (ie money) terms than another country.
If 2 countries have absolute advantage in 2 products they can both gain by specialising and trading what they have an absolute advantage in for what they don’t.
This can be shown on a PPF (Production Possibility Frontier). If two countries both split resources they produce a lot less than if both specialise and trade.
What is comparative advantage?
Comparative Advantage (CA) is when a country can produce a good at a lower cost, relative to the cost of other domestically produced goods (ie at a lower opportunity cost) than another country.
The theory of comparative advantage is that even if a country has an absolute advantage in all goods(ie can produce everything cheaper), it still benefits from trade. If a country can buy the good for cheaper than the opportunity cost of producing it itself, it is better off not making the product itself. This can happen even if it does have an absolute advantage.
The basic rule is that if the exchange rate is less than the opportunity cos of a product you should not make the product/should import it. If the exchange rate is greater than the opportunity cost you should make the products/should export it. Since a country cannot, mathematically, have a lower opportunity cost on both goods, so long as the exchange rate is between the 2 countries’ opportunity costs then they will both benefit from specialising in the product they have a low opportunity cost in and exchanging it. This means international trade must be a benefit to all countries!
This can also be shown on a PPF. The opportunity cost is the gradient of the curve, so as long as the exchange rate is between the 2 gradients, then both countries are better off.
Why does comparative advantage exist?
The initial theory was developed by David Ricardo in the early 1800s. He said CA existed because of different levels of productivity. This is basically true, although has been expanded to all factors of production.
CA exists because of different ‘labour, capital & land endowments’. That is some countries have a highly productive (& high paid!) labour force, they would then have a comparative advantage in industries which are capital intensive (capital would be relatively cheap compared to labour) and require high skill levels. Other countries may have low skilled (low wage) labour so would have a CA in labour-intensive industries. Some countries have natural resources, so they would have a comparative advantage in those areas etc etc.
Why do all countries produce a range of goods?
This may seem to contradict the theory, but I doesn’t! The key is to remember that a country will import a product if the exchange rate (E) is less than the opportunity cost (O) of producing itself. Also remember that the PPF is curved and opportunity cost is not constant. At low level of output of a good the opportunity cost is likely to be very low, so the country will make the product itself (E>O), but as output rises, so does the opportunity cost, until some point where E=O. Beyond that level of output E
What are the criticisms of the law of comparative advantage?(6)
There are a number of assumptions underlying CA which may be questioned:
- Is there demand? CA tells us what countries could produce, but not if there is an actual demand for that product? What happens if a country has a CA in a product where demand is falling? It would not make sense to specialise as no one would want to buy your output.
- Are factors of production perfectly mobile? By switching from ‘no trade’ to ‘free trade’ (or if demand changes, or if the areas of CA change) we are assuming labour will simply move from the old industry to the new, but geographical and occupational mobility might prevent this. The UK lost a CA it had in coal mining, and gained a CA in financial services, but coal miners from South Wales didn’t move to London to take financial service jobs. It could even mean less output, as the UK now has unemployed resources.
- Are there transport costs? This would mean it may not be worth trading even if the good was cheaper to produce.
- Is there perfect knowledge? Do we know exactly what each country’s CA is, what prices they will charge, quality of output etc.
- Are goods non-homogeneous? If so our decisions may not solely be based on price/costs, we have non-price factors as well.
- Are there artificial barriers to trade (tariffs etc.)?
What is free trade and what does it enable?
Free trade means that countries can import and export goods without any tariff barriers or other non-tariff barriers to trade.
Essentially, free trade enables lower prices for consumers, increased exports, benefits from economies of scale and a greater choice of goods.
What are the benefits of free trade?(8)
- Increased output/improved living standards
The theory of CA explains that by specialising in goods where countries have a lower opportunity cost, there can be an increase in economic welfare for all countries. Free trade enables countries to specialise in those goods where they have a comparative advantage. This can be shown using PPFs. - Reducing tariff barriers leads to trade creation
Trade creation occurs when consumption switches from high cost producers to low cost producers. This can be shown on a ‘tariff diagram’:
Normal demand curve (domestic demand)
Upwards sloping domestic supply curve
Perfectly elastic (horizontal) world supply curve
World supply + tariff above the world supply curve
The 4 areas in between the two world supply curves are marked from 1 to 4.
The removal if tariffs leads to:
Lower prices for consumers -> increase in consumer surplus of (1+2+3+4)
Imports increase from Q3-Q2 to Q4-Q1
The government will lose tax revenue of 3
Domestic firms producing this good will sell less and lose producer surplus 1
However overall there will be an increase in economic welfare of 2+4 [(1+2+3+4)-(1+3)]
The magnitude of this increase depends upon the elasticity of supply and demand. If demand is elastic, consumers will have a big increase in welfare.
Essentially, removing tariffs leads to lower prices for consumers - so the price of importer products will be cheaper. When the UK joined the EEC - the price of many imports from Europe fell. - Increased exports
As well as benefits for consumers importing goods, firms exporting goods where the UK has a comparative advantage will also see a big improvement in economic welfare. Lower tariffs on UK exports will enable a higher quantity of exports boosting AD and so both UK jobs and economic growth. This can be seem I’m the tariff diagram as well, if we imagine the diagram as foreign countries removing tariffs & so the UK exports (or from those countries’ point of view imports from the UK) rise. - Economies of scale
If countries can specialise in certain goods they can benefit from economies of scale and low average costs, this is especially true in industries with high fixed costs or that require high levels of investment. This is because they are now not just selling to the domestic market, but to the global market. The benefits of EoS will ultimately lead to lower prices for consumers and greater efficiency for exporting firms - Increased competition
With more trade, domestic firms will face more competition from abroad therefore there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices. - Trade is an engine of growth
World trade has increased by an average of 7% since the 1945, causing this to be one of the big contributors to economic growth. Within the UK income growth is relatively low, so given a set YED, demand for products grows slowly. However, many areas of the world have rapid growth (‘emerging economies’) and high YED for luxury/high quality goods, so the potential for growth is greater. - Make use of surplus raw materials
Middle Eastern countries such as Qatar are very rich in reserves of oil but without trade there would be not much benefit in having so much oil. Japan on the other hand has very few raw material without trade it would be very poor. - Tariffs may encourage inefficiency
If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs
What are the negatives of free trade/reasons for trade barriers? (9)
- Infant industry argument
If developing countries have industries that are relatively new, then at the moment these industries would struggle against international competition. However if they invested in the industry then in the future they may be able to gain Comparative Advantage. This shows that CA can change over time. Therefore protection would allow them to progress and gain experience to enable them to be able to compete in the future.
The Korean car industry is a good example. In 1962 the South Korean government launched a “5-Year Automobile Plan” to encourage domestic car manufacturers, insisted on foreign companies entering joint ventures with Korean firms and put large tariffs on imported cars. At the mid 1970’s the first Korean-designed car was built (the Hyundai Pony) and they began to export (at first to South America). Since then Korean car manufacturers have grown strongly (Hyundai are now the worlds’ 4th largest, ahead of Ford), although the Korean government only began to reduce tariffs on imported cars in 1987, and a 2011 agreement between the EU and Korea should see all tariffs removed. - The Senile industry argument
If industries are declining and inefficient they may require large investment to make them efficient again. Protection for these industries would act as an incentive for firms to invest and reinvent themselves. However protectionism could also be an excuse for protecting inefficient industries/firms. - To diversify the economy
Many developing countries rely on producing primary products in which they currently have a CA. However relying on agricultural products has several disadvantages:
- Prices can fluctuate due to environmental factors
- Goods have a low income elasticity of demand. Therefore with economic growth demand will only increase a little - Raise revenue for the government
Import taxes can be used to raise money for the government however this may only be a relatively small amount of money (for MEDCs it is a very small % of government income, although for LEDCs it is often larger)
5. Reduce imports/Protect domestic jobs Tariffs are (as the diagram shows) likely to reduce imports, helping the current account. This may be linked to infant or senile industry protection. Ultimately the aim is to protect jobs from foreign competition. However in the long term this is likely to lead to retaliation and also cause lower exports so it might soon prove counter-productive.
- Cultural identity
This is a political and cultural argument. Many countries wish to protect their countries from what they see as an Americanisation or commercialisation of their countries. - Protection against dumping
Dumping occurs when a country has excess stock and so it sells below cost on global markets causing other producers to become unprofitable. The EU sold a lot of its food surplus from the CAP at very low prices on the world market; this caused problems for world farmers because they saw a big fall in their market prices. Other examples include allegations that China has been dumping excess supply of steel on global markets causing other firms to go out of business. - Environmental
It is argued that free trade can harm the environment because LDC may use up natural reserves of raw materials to export. Also countries with strict pollution controls may find consumers import the goods from other countries where legislation is lax and pollution is allowed.
However supporters of free trade would argue that it is up to individual countries to create environmental legislation. - Retaliation
If another country introduces trade barriers against your exports then you may retaliate by putting protectionist measures up against their exports. The danger is that this can quickly escalate into a ‘trade war’
What is protectionism and what are different types of it(6)?
Protectionism is erecting a trade barrier of some type. This may include:
- Tariff: A tax on imports
- Quota: Physical limit on quantity that can be imported.
- Currency manipulation: Gov intervention to reduce the value of your currency. This could be done by QE/loose monetary policy, open market operations or by regulations on currency exchange.
- Subsidies or tax breaks for domestic firms
- Other gov help to domestic firms: Invest in infrastructure, help with R&D, help setting up a new business etc.
- Red tape & Regulation: This is becoming increasingly popular. For example the EU has strict regulations on the use of GM crops, which the US doesn’t , so this means US grown crops (with GM) can’t be sold in the EU - which is then a form of protectionism.
What are the stages of economic integration?(6)
- Preferential trading areas: where countries agree to reduce, even abolish, tariffs and trade barriers between them on some goods.
- “Free Trade Area”: where member countries agree to abolish trade barriers between themselves. However they may impose different tariffs/quotas on goods from non members.
- “Customs Union”: where member countries agree to abolish trade barriers between themselves and agree a common external tariff.
- “Single (or Common) Market”: like a custom union, but also free movement in the factor market - labour and capital.
- Economic and Monetary Union: a single currency, with a single central bank, a single monetary policy and some central control over fiscal policy.
- Complete economic integration/political union: as above, but some central government with significant control over spending and taxation.
Any of the above can count as a “trade bloc” (a bloc/group who trade with each other)
What is the EU?
The European Union is an example of a “trade bloc” - a group of countries which agree to reduce trade barriers between them.
The EU is a single/common market, with a core of countries in a monetary union.
How has the EU encouraged international trade?(8)
- Specialisation allows a greater total output - theory of CA. This is known as “trade creation”. With no barriers there is ‘nothong’ to stop the theory functioning. Around 50% of Uk exports and imports are to/from the EU.
- Removal of tariffs/non-tariff barriers between EU countries - similar to above, the removal of trade barriers has led to trade creation. A tariff diagram shows the benefits to consumers and (exporting) firms. Since most EU countries trade mainly with other EU countries this has a large impact. Even outside removing tariffs there are benefits, eg the removal of customs barriers mean 60 million customs clearance documents per year no longer need to be completed, cutting bureaucracy and reducing costs and delivery times.
- Economies of Scale - EU businesses now have access to a greater market - they are larger firms - they can achieve EoS/lower LR AC - they charge lower prices - there is more trade!
- Competition - With firms from all EU countries competing in the same market there should be more efficient firms - offer a wide range of choice - lower prices. All this should mean more trade.
- Increased FDI - The EU is one of the main recipients of FDI. A Japanese car manufacturer, for example, may want to avoid EU tariffs and so set up a factory within the EU. The huge size (population and incomes) of the EU market makes this more attractive than setting up in smaller markets/individual markets.
- Cheaper labour - An increased supply of labour should reduce wages - firms have lower costs - lower prices - more trade (cheap labour may be firms moving to low cost countries or labour moving).
- Greater labour mobility - This links to the point above, but also means skilled workers can move to areas where where they are needed/jobs available and so fully use their ‘human capital’. Note that it is not just the right to work in other countries, but also aspects such as EU-wide recognition of qualifications which help mobility.
- Greater access to capital - should make it easier for firms to invest/raise start up capital - more trade.
What are the problems with trade blocs/the EU?(6)
- “Trade diversion” - The EU may have changed trading patterns rather than created trade. For example UK used to buy butter from NZ. When the UK joined the EU it put tariffs on NZ butter, so sales fell, and started buying Irish/Danish butters.
- The existence of large EoS may lead to the creation of an oligopolistic market, so consumers may not benefit
- It may magnify regional differences - workers move from poor regions to richer ones, making the poorer areas poorer and the rich areas richer.
- Loss of control - Some of this is economic, for example when joining the euro a country losses control over monetary policy (which is controlled by the ECB). Some of this is ‘political’, for example the loss of control over migration.
- Bureaucracy - The EU is a large bureaucratic organisation and no doubt suffers from x-inefficiency. This means it has large running/administration costs, which are paid by member nations.
- Lack of labour mobility may limit the gains from CA.
Has the EU brought a net benefit?
A paper, Campos, Coricelli, and Moretti (2014) used the synthetic counterfactuals method (SCM). It showed that even more prosperous EU countries have benefited from higher GDP as a result of being in the EU.
On average a countries GDP has grown by 12% after joining the EU.
The EU may be seen as a “second best” solution in a world where there is protectionism. It creates a massive free trade area, but still puts barriers on trade from outside the EU.
