International Trade
• Countries can consume beyond their own PPF if they
trade each specialise in goods with comparative
advantage
• The rate of exchange will be somewhere between
their opportunity cost ratios)
• The rate of exchange is measured by the “terms of
trade” – an index of export prices divided by index of
import prices (the greater a quantity of imports a
country can acquire for a given quantity of exports,
the higher the “terms of trade”)
The Importance of International Trade
Bananas
Bananas
B
C
C
A
A
B
Wine
EU
Wine
USA
• Without trade, each produces at A
• With complete specialisation, each produces at B
• Trade occurs at an exchange rate somewhere between
opportunity costs (same slope for both countries) therefore both
can consume greater quantity of Bananas and Wine
Welfare Gain From Trade
S domestic
P domestic
P world
A
B
C
D domestic
Qs
Qd
domestic
domestic
Imports
Consumer surplus gain = A + B + C
Producer surplus loss = A
Total welfare gain = B + C
Welfare Loss from Trade?
• Assumes trade based on current comparative advantage
– may be too static & not flexible enough
• Looks at overall welfare, but not at individual winners &
losers (ie. unemp.)
• Infant industries… do newly emerging businesses and
industries have the chance to grow in global competition
– perhaps they should be protected until strong enough?
• Assumes all trade based on comparative adv. but lots
based on consumer preference for choice
• Free trade is corrosive to cultural practices – not taken
into account (an external cost)
Trade Protection Options
• Tariffs: taxes on imports
• Quotas: quantity restrictions on imports
• Subsidies: given to domestic firms to help
them compete in foreign markets
• Regulations: can make it very difficult or
expensive for foreign products to comply
Tariffs – A Loss of Welfare
S domestic
P tariff
P world
A
B
C
D
D domestic
Qs
Qs
Qd
Qd
free trade
with tariff
with tariff
free trade
Less Imports
Consumer surplus reduced by A + B + C + D
Producer surplus increased by A (domestic producers expand production at ↑ price)
Gov’t tax revenue = C
Total loss of welfare = B + D
Welfare loss from quota
SD1
Quota amount
decided, added to
domestic production
Loss in consumer
surplus is A+B+C+D
PW
+q
PW
Gain in producer
surplus is A
A
B
C
D
SW
D
QS1
QS2
QD2
QD1
Who receives C?
Generally importers,
so welfare loss is
B+C+D
If the government sold
licences to import,
welfare loss is
between B+D and
B+C+D
So tariffs are better
than quotas
Welfare loss from subsidy
SD1
New producer surplus
is A+B+C+D
SD2
SW
PW
A
S
PW S
Original producer
surplus is A
C
Gain in producer
surplus is B+C+D
Subsidy costs taxpayers
A+B+C+E
B
E
D
So loss from subsidy
is A+B+C+E minus
B+C+D
Which is A+E-D
D
QS1
QS
2
QD1
Since A is the same
as D the loss is E
Advantages of free trade
Advantages of free trade
• Specialisation leading to
increased output
• Trade allows economies of
scale (larger market to sell
to)
• Lower price and increased
choice
• Competition and innovation
Disadvantages of free trade
• Risk – interdependence,
over-reliance on trade, loss
of control
• Unemployment (perhaps)
• Income inequality
• Environmental impact
• Culture
Why have trade restrictions?
• If countries specialise according to
comparative advantage there are major gains
from trading
• Tariffs, quotas and other restrictions lead to
welfare loss, so why do some countries have
protectionist policies?
Outward Orientation
• Concentrating on exports – primarily from the
industrial sector
• Adam Smith, 1776 – ‘The Wealth of Nations’ was
limited by the ‘extent of the market’
• Especially relevant for smaller countries
• Could make income more unequal – relies on lowwages
• Puts country at mercy of world markets
• Loans for investment to industrialise may be hard to
repay
• MDC’s may make allegations of ‘dumping’
Inward Orientation
• Until early ’90’s, larger countries (China, India)
able to export less & replace imports with domestic
production
• Makes economy self-sufficient – can control every
aspect (necessary in communism)
• Avoids problem of international debt & vulnerability
to world mkts
• Country may lack resources to provide everything
• Consumers begin to demand access to
international goods & services
• Smaller countries cannot satisfy their needs
efficiently