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 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 Bananas Wine EUUSA A C B A C B

Welfare Gain From Trade S domestic D domestic P domestic P world ABC Q s domestic Q d 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 D domestic P tariff P world ABD Q s with tariff Q d with tariff Less Imports C 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 Q s free trade Q d free trade

Welfare loss from quota S D1 QS 1 SWSW PWPW D QD 1 QD 2 Loss in consumer surplus is A+B+C+D Quota amount decided, added to domestic production Gain in producer surplus is A Who receives C? Generally importers, so welfare loss is B+C+D QS 2 P W +q A 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 S D1 S D2 QS 1 SWSW PWPW P W - S A B C E D D QD 1 QS 2 Original producer surplus is A New producer surplus is A+B+C+D Gain in producer surplus is B+C+D Subsidy costs taxpayers A+B+C+E So loss from subsidy is A+B+C+E minus B+C+D Which is A+E-D Since A is the same as D the loss is E S

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 low- wages 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