International trade: Free trade

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The benefits of free trade

  • Countries are able to specialise in the production of goods and services that they are best at which means costs tend to be less. For instance, it is cheaper to grow tropical fruits in the warmer climates and import them than to try to grow them in the UK.

  • Consumers can purchase goods that would not be produced within their own country. In addition, firms can import products with their exact specifications due to the greater choice, which increases productivity and profitability.

  • Operating in international markets means that demand is likely to be higher and therefore firms can expand their output whilst benefitting from economies of scale. These cost savings by firms can then be passed onto the consumers as well.

  • Due to the increased competition, domestic firms are forced to improve the quality of their output and so more efficiently allocate resources. For instance, monopoly power tends to decline

  • The transfer of technology and ideas across borders becomes faster. This means that innovation in one country has benefits for many others as well.

Absolute and comparative advantages (HL)

Absolute advantage: when a country can produce more of a good and service than another country with the same amount of resources. This is a result of productivity a country may be more efficient at producing certain goods than others.

As shown in the diagram, country green has the absolute advantage in the production of good Y because the PPC cuts the axis higher than country grey. Whereas, country grey has the absolute advantage in the production of good X.

According to the theory of absolute advantage, if a country is absolutely more efficient in the production of both goods, then there is no reason for it to specialise and engage in trade. This would be illustrated if the PPCs did not intersect.

Comparative advantage:  when a country can produce a given amount of output at a lower opportunity cost than another country. Therefore, it gives up less resources than other countries in producing the concerned good or service.

As shown in the diagram, country green has the absolute advantage in the production of both goods. However, according to the theory of comparative advantage, trade is still worthwhile because there is a difference in opportunity cost. Country grey has the comparative advantage in the production of good X, whereas country green has the comparative advantage in the production of good Y.

Opportunity cost of producing the good on the horizontal = ΔY/ΔX

Comparative advantage is a result of a difference in factor endowments and technology. For instance, countries differ in the quality and quantity of factor of production, including stock of human, natural and physical capital. Technology is embodied in physical capital and therefore also has an effect on the productivity of country and its comparative advantage.

The exchange rate can also have an effect on the comparative advantage because an exchange rate that is appreciating will make exports less competitive, whereas a depreciating exchange rate will have the opposite effect.

Assumptions of comparative advantage:

  • Constant costs of production as the PPCs are linear – economies of scale and increasing returns to scale mean that costs tend to depend on output

  • Perfect mobility of factors of production within a country – in reality workers are often geographically and occupationally immobile

  • No transaction costs

  • Perfect competition in markets

  • Free trade without barriers

The World Trade Organisation was set up on 1995 to promote trade liberalization. It has 153 member who set trade rules and ensure that they are followed. The WTO is the arbitrator of trade-related disputes.

It has been criticised for being biased in favour of the US and EU, whilst being inconsiderate of the needs of developing countries. Therefore, it has tried to establish the following principles:

  • Non-discrimination

  • More open

  • Predictable and transparent

  • More competitive

  • Protect the environment

  • More beneficial for less developed countries

Trade protectionism

Trade protectionism: policies aimed at restricting the flow of imports into a country and creating an artificial advantage to exporting firms.

Tariff: tax on imports aimed at increase the costs of production for foreign firms. These raise the domestic price and domestic production, so that less in imported and consumed.

  • The domestic price increases from world price at Pw to the price with the tariff Pt.

  • Domestic production increases from Q1 to Q2.

  • Consumption decreases from Q2 to Q4.

  • Consumer surplus decreases by area a + b + c + d

  • Producer surplus increases by area a

  • Tariff revenues of area c are created

  • A production inefficiency equal to area b results

  • A consumption inefficiency equal to area d results

  • A welfare loss results of area b + d

Quota: a quantitative restriction on the volume of imports.

  • Increase the domestic price of the protected good from world price, Pw, to the quota price, Pq.

  • Increase in the domestic production of the good from Q1 to Q3.

  • The consumer surplus decreases by area a + b + c + d

  • The producer surplus increases by area a

  • Quota rents, which represent the money typically earned by foreign firms and can now export the product at a higher price, are equal to area c

  • There is a production inefficiency of area b

  • There is a consumption inefficiency of area d

  • The resulting welfare loss is equal to area b + d

Subsidy: lowers domestic firms’ production costs and increases their competitiveness, subsequently imports decrease and exports may increase.

  • There is no change in the domestic price, it remains at the world price, Pw

  • There is no change in the consumption of the good, it remains at Q2

  • Domestic production increases from Q1 to Q3

  • Imports fall from Q1Q2 to Q3Q2

  • There is a wasteful domestic production and resource misallocation

  • Government spending increases

  • Trade frictions emerge

Administrative barriers

Regulatory barriers include product, sanitary and pollution standards which are often aimed at protecting domestic producers and therefore have the effect of reducing imports.

Antidumping duties

Domestic firms may claim that foreign firms are dumping there goods in the domestic market. This means that the foreign firms are selling their products abroad at a price below the average unit price. Therefore, the domestic government puts in place a tariff to raise the foreign firms’ costs and prices.

Arguments for trade protectionism:

  • Protection of domestic jobs as small domestic firms may be put out of business when competeting with large multinational corporations.

  • National security may be at risk if countries become too relient on imports and trade, especially during times of war. For example, during the Second World War Germany was largely isolated and therefore could not rely as much on trade, so selfsufficiency through trade protectionsim became more important.

  • Protection of infant industries may be necessary in order to allow them to grow until they can make use of the economies of scale that large foreign firms already have access to.

  • Trade protectionism may maintain health, safety and environmental standards by regulating imports.

  • Tariffs may be used as anti-dumping measures against unfair competition which is due to foreign firms selling products below their average costs in other countries.

  • Overcoming a balance of payments deficit may be achieved through trade protectionism as expenditure on imports declines and exports may fall in price, due to subsidies, so that they become more attractive to foreigners.

  • Protectionism, particularly tariffs, can be a source of government revenue

Arguments against trade protectionism:

  • Government intervention tends to distort the market which leads to the misallocation of resources as less efficient industries become relient on government protection

  • Protectionism tends to anger other countires so they may retailiate by imposing their own trade barriers, in turn creating “trade wars”.

  • Companies are more incentivised to be seen as favourably by the government so bribes and corruption may increase. Also illegal smuggling may increase in order to permit consumers access to foreign goods that the government has tried to reduce the supply of.

  • Protected firms lack the incentives to innovate and improve due to the lack of competition. So productivity and efficiency may fall, creating increased costs of production.

  • Under protectionism, lower cost imports are more difficult to access and the prices set by domestic producers are likely to be higher, so domestic consumers must pay these higher prices.

  • The costs of imported factors of production increase so inflation may increase and domestic firms relying on these imported primary goods may be put out of business.

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