6.1 The Reasons for International Trade

Chapter 6.1: The Reasons for International Trade — Revision Notes

6.1 The Reasons for International Trade

International trade is the exchange of goods and services between countries. It exists because no country is self-sufficient in all resources, technologies, or products. Trade enables countries to specialise, increases efficiency, enhances consumer choice, and promotes global economic integration.

Key reasons for international trade include:

• Differences in factor endowments: Countries possess different quantities and qualities of factors of production such as land, labour, and capital.

• Technological advantages: Countries with better technology can produce certain goods more efficiently.

• Consumer preferences: Trade allows access to goods not produced domestically or not available in sufficient variety or quantity.

• Cost differences: Countries trade to benefit from differences in production costs.

• Economies of scale: Specialisation in production for international markets allows firms to lower costs through large-scale production.

6.1.1 Distinction Between Absolute and Comparative Advantage

Absolute Advantage

• A country has an absolute advantage if it can produce more of a good or service with the same amount of resources than another country.

• It reflects greater productivity.

• Example: If Country A can produce 10 units of cloth and Country B only 6 with the same resources, Country A has an absolute advantage in cloth.

Comparative Advantage

• A country has a comparative advantage if it can produce a good or service at a lower opportunity cost compared to another country.

• This forms the foundation for mutually beneficial trade, even when one country has an absolute advantage in all goods.

• Example: If Country A sacrifices fewer units of wheat to produce a unit of cloth than Country B does, it has a comparative advantage in cloth.

Summary of Key Differences:

6.1.2 Benefits of Specialisation and Free Trade

Specialisation

• Occurs when a country focuses on producing goods for which it has a comparative advantage.

• Leads to increased output, efficiency, and economic welfare.

• Encourages efficient use of resources and development of expertise.

Free Trade (Trade Liberalisation)

• Involves the reduction or removal of trade barriers such as tariffs, quotas, and subsidies.

• Benefits include:

• Greater competition: Encourages efficiency and innovation.

• Lower prices: Consumers gain access to cheaper goods.

• More choice: Access to a wider range of products.

• Higher growth: Export-led growth improves GDP.

Trading Possibility Curve (TPC)

• TPC represents the consumption possibilities of a country engaged in trade.

• It lies beyond the Production Possibility Frontier (PPF), reflecting the gains from trade.

• Trade allows countries to consume more than they could produce domestically.

6.1.3 Exports, Imports, and the Terms of Trade

Terms of Trade (TOT)

• The Terms of Trade measure the rate at which one country’s goods exchange for those of another.

• Formula:
  Terms of Trade = (Index of Export Prices / Index of Import Prices) × 100

• A TOT above 100 indicates export prices are higher relative to import prices, and vice versa.

Causes of Changes in the Terms of Trade

1. Changes in Global Demand and Supply:

• • Higher demand for a country’s exports improves TOT.

  • Supply shocks (e.g. oil shortages) may worsen TOT.

2. Inflation:

• Domestic inflation can raise export prices, improving TOT.

• However, exports may become less competitive.

3. Exchange Rates:

• A depreciation worsens TOT (exports become cheaper, imports more expensive).

• An appreciation improves TOT (exports become expensive, imports cheaper).

4. Changes in Trade Policy:

• Imposing tariffs or subsidies can influence TOT indirectly.

5. Technological Changes:

• Can affect costs and competitiveness, altering export/import prices.

Impact of Changes in Terms of Trade

• Improvement in TOT:

• More imports can be bought for the same volume of exports.

• Increases national purchasing power and may reduce cost-push inflation.

• May worsen trade balance if due to falling demand for exports.

• Worsening of TOT:

• Requires exporting more to purchase the same volume of imports.

• Reduces national income, especially in countries reliant on primary goods.

Marshall-Lerner Condition

• States that a depreciation will only improve the balance of payments if:

• The sum of the price elasticities of demand for exports and imports is greater than one.

• If not, the trade balance may deteriorate.

J-Curve Effect

• Following a currency depreciation:

• Short-term: Trade deficit worsens (inelastic demand).

• Long-term: Trade balance improves as demand becomes more elastic.

6.1.4 Limitations of the Theories of Absolute and Comparative Advantage

Though powerful in theory, both models have limitations in real-world application:

Unrealistic Assumptions:

1. No Transport Costs: In reality, transportation affects trade decisions.

2. Full Employment: Not all economies operate at full capacity.

3. Perfect Mobility of Resources: Labour and capital are not easily transferable across sectors.

4. No Trade Barriers: Tariffs, quotas, and regulations impact trade flow.

5. Homogeneous Products: Goods are often differentiated by branding and quality.

6. Static Technology and Preferences: These change over time and affect competitiveness.

7. Constant Returns to Scale: Economies of scale benefit large producers disproportionately.

Additional Criticisms:

• Distributional effects: Gains from trade may not be equally shared.

• Structural unemployment: Specialisation can lead to job losses in declining industries.

• Over-dependence: Reliance on certain sectors makes economies vulnerable to shocks.

• Environmental degradation: Focus on exports can lead to overuse of natural resources.

Prebisch-Singer Hypothesis:

• Suggests that over time, countries that export primary commodities experience a decline in their TOT relative to those exporting manufactured goods.

• Developing countries may suffer deteriorating terms and increasing poverty.