This document provides an overview of key concepts in international trade including: - The principles of absolute and comparative advantage which form the basis for beneficial trade between countries. - Arguments for free trade and reasons countries engage in protectionism such as tariffs or quotas. - Different levels of economic integration like free trade areas or customs unions. - How terms of trade measure the exchange rate between a country's exports and imports.

1. Chapter 4
INTERNATIONAL TRADE
(CORE)
Kalaiyarasi Danabalan
A’ level (economics)

2. Topic covered
 Principles of absolute and comparative advantage
 Arguments for free trade and motives for protection
 Types of protection
 Types of economic integration
 Terms of trade
 Components of the balance of payments

3. The Principle of International Trade
 Refer to as multinational trade.
 Their principles of absolute and, particularly, of comparative advantage have modern
relevance in the objectives of the World Trade Organization (WTO), which exists to
promote free trade amongst all of its member countries.
 Trade will take place when countries have a clear-cut or absolute advantage over other
countries in they produce.
 Trade can also be beneficial where a country may not / comparative advantage in the
production of a particular good over another country, trade can produce gains for both
partners.

4. INTERNATIONAL TRADE
Free trade - system of trade policy that allows traders to trade across national boundaries
without interference from the respective governments.
There are 2 reasons of free trade
 Domestic Non-availability: A nation trades because it lacks the raw materials, climate,
specialist labour, capital or technology needed to manufacture a particular good. Trade
allows a greater variety of goods and services.
 Cost effectiveness: It is cheaper to buy from other countries rather than producing
themselves.

5.  Reciprocal absolute advantage- one country is better at producing one product, the
other is superior in the production of the other.
 Comparative advantage – trade between two countries should still take place and be
mutually beneficial provided the domestic opportunity cost of production differ.

6. Benefits of Free Trade
 Lower prices for consumers
 Greater choice for consumers
 benefit from economies of scale
 acquire needed resources
 efficient allocation of resources
 Increased competition
 Source of foreign exchange

7. FREE TRADE DIAGRAM
http://www.youtube.com/watch?v=65UcSx_LrZI#t=62

8. EXPORTS & IMPORTS / VISIBLE TRADE AND
INVISIBLE TRADE
 EXPORTS (X)- the movement of goods / commodities out of the country.
 IMPORTS (M) – the movement of goods / commodities into the country.
 VISIBLE TRADE – involves trading of goods which can be touched & weighed. Examples
include trade in goods such as oil, machinery, foods, clothes etc.
 Visible exports- selling of tangible goods which can be touched & weighed to other
countries.
 Visible imports - buying of tangible goods which can be touched and weighed from other
countries.
 INVISIBLE TRADE – involves the M &X of services rather than goods. Ex :- banking, tourism,
education.
 Balance of trade - It is the difference between the value of visible exports and value of
visible imports of a country.
X>M - the country will have a Surplus balance of trade.
M>X - the country will have an Unfavourable balance of trade.

9. ABSOLUTE ADVANTAGE
 A country has an absolute advantage over another in producing a good, if it can
produce that good using fewer resources than another country.
 if one unit of labor in Australia can produce 80 units of wool or 20 units of wine; while in
France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has an
absolute advantage in producing wool and France has an absolute advantage in
producing wine.
 Australia can get more wine with its labor by specializing in wool and trading the wool for
French wine, while France can benefit by trading wine for wool.

10. COMPARATIVE ADVANTAGE
 A country should specialize in the production of good or service in which it has lower
opportunity cost and it should import commodities which have a higher opportunity cost
of production.
 A country enjoys a comparative advantage in the production of a good when that good
can be produced at a lower cost in terms of other goods.
Example
Northland and Southland produce and consume two goods, Food and Clothes. The
productive capacities and efficiencies of the countries are such that if both countries
devoted all their resources to Food production, output would be as follows:

11.  Northland: 100 tonnes
 Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would
be:
 Northland: 100 tonnes
 Southland: 100 tonnes

12.  each has constant opportunity costs of production between the two products and both
economies have full employment at all times. All factors of production are mobile within the
countries between clothing and food industries, but are immobile between the countries. The
price mechanism must be working to provide perfect competition.
 Southland has an absolute advantage over Northland in the production of Food. Both
countries are equally efficient in the production of clothes. There seems to be no mutual
benefit in trade between the economies.
 The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of
Food is one tonne of Clothes and vice versa. Southland's opportunity cost of one tonne of
Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food.
 Southland has a comparative advantage in food production, because of its lower opportunity
cost of production with respect to Northland. Northland has a comparative advantage over
Southland in the production of clothes, the opportunity cost of which is higher in Southland
with respect to Food than in Northland.

13. To show these different opportunity costs lead to mutual benefit if the
countries specialize production and trade, consider the countries
produce and consume only domestically. The volumes are:
Foods Cloths
Northland 50 50
Southland 100 50
World total 150 100

14. Production & consumption before trade
 he exchange price will be somewhere between the two. The remainder of the example
works with an international trading price of one tonne of Food for 2/3 tonne of Clothes.
 If both specialize in the goods in which they have comparative advantage, their outputs
will be
Food Clothes
Northland 0 100
Southland 200 0
World total 200 100

15. Production & Consumption after Trade
 World production of food increased. Clothing production remained the same. Using the
exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland
are able to trade to yield the following level of consumption :
 Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now
consume at points outside their production possibility frontiers.
Food Clothes
Northland 75 50
Southland 125 50
World total 200 100

16. Limitations of Theory of Absolute
Advantage
The theory is based on unrealistic assumptions:
 Factors of production are immobile and fixed
 Technology is fixed
 There is perfect competition
 Resources are fully employed
 Imports and exports balance each other
 There is free trade
Cost of Transportation has been ignored
http://www.youtube.com/watch?v=RpfV0Oerfr8

17. Summary of the Principles of Absolute and
Comparative Advantage
 There are just two countries involved in trade.
 Each can produce just two products.
 Productivity differs between them, so varying quantities of each are produced.
 Production costs and opportunity costs are constant for each product.

18. PRINCIPLES OF INTERNATIONAL TRADE
 The production possibility frontiers are linear.
 The exchange rate operating for international transactions must be between respective
domestic opportunity cost ratios.
 No transport cost are charged.
 The two country, two-product assumption is again a long way from reality in the 21st
century.
 Production cost are most unlikely to be constant.
 There are no restrictions on free trade between those countries which possess absolute
and comparative advantage.

19. Other explanation & determinants of trade
flows
 Competitive advantage- focuses on the actual production cost and how in reality, firms
are continuously striving to reduce their unit costs.
 Factor endowment – this model of trade stresses the importance of the quantity and
quality of the production factors.
 Government policy – a government may decide that it does not wish to over-specialize &
that its best strategy is to diversify production so that it has a range of products available in
the event of any dislocation / supplies interruption.

20. Protectionism
 Policy of protecting domestic industries against foreign competition by means of tariffs,
subsidies, import quotas, or other handicaps placed on imports.
 Government-levied tariffs, raise the price of imported articles, making them less attractive
to consumers than cheaper domestic products.
 Import quotas, which limit the quantities of goods that can be imported, are another
protectionist device.

21. Tariff (tax on imports)
 tax on foreign goods upon importation. Tariff rates vary according to the type of goods
imported. Import tariffs will increase the cost to importers, and increase the price of
imported goods in the local markets, thus lowering the quantity of goods imported.

22. Impacts of Tariffs
 Tariffs lead to higher prices for imports and thus Imports fall
 Domestic consumers have to pay higher prices and buy less.
 Domestic producers gain, as they get higher prices and sell larger quantities. As
we can see in the diagram domestic production increases from 0Q1 to 0Q2.
Moreover their revenue increases from PwQ1 to Pw+TQ2
 Higher domestic production leads to increased domestic employment.
 Government now gains from tariff revenues, which can be represented by ‘e’ in
the diagram
 Tariffs are regressive in nature and thus worsen income distribution.
 Exporting countries lose due to fall in exports.

23. Quotas (restriction on the maximum
import quantity)
 Import quotas - sets a physical limit on the quantity of a good that can be imported into a country
in a given period of time. This leads to a reduction in the quantity imported and therefore
increases the market price of imported goods.

24. Effects of Quotas
 Domestic production increases from 0Q1 to 0Q1+Q3Q4.
 Domestic consumption fall from 0Q2 to 0Q4
 Imports fall from Q1Q2 to Q1Q3
 Consumers end up paying more. Before quota was imposed they were paying Pw, but now
they are paying Pw+Quota
 Domestic producers gain as they sell more at higher prices (Pw+Quota)
 Domestic employment increases as domestic production rises.
 Government gets quota revenues
 Domestic society is worse off due to decrease in consumption and production by less efficient
producers
 Exporting countries lose revenue
 Quotas result in global misallocation of resources as goods are being produced by inefficient
producers.
 J and K represents the dead weight loss of welfare to the society, as J represents production by
inefficient producers and K represents the loss of consumer surplus.

25. Subsidies
 government subsidies (in the form of lump-sum payments or cheap loans) are sometimes
given to local firms that cannot compete well against foreign imports.

26. Effects of Subsidies
 Consumption of the good is not affected. Consumption remains at Q3.
 Taxpayers lose as the tax revenue collected is being used for subsidies
 Domestic producers gain as the production increases from 0Q1 to 0Q3.
 Employment increases as more is being produced domestically.
 Exporting countries are worse off
 Global misallocation of resources as inefficient producers are now producing
goods.

27. Other protection policy
 Administrative Barriers
Countries are sometimes accused of using their various administrative rules (eg. regarding
food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to
imports.
 Embargo
An embargo is the prohibition of commerce and trade with a certain country, in order to
isolate it and to put its government into a difficult internal situation, given that the effects of
the embargo are often able to make its economy suffer from the initiative.
 Anti-dumping legislation
Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign
goods that would cause local firms to close down. However, in practice, anti-dumping laws
are usually used to impose trade tariffs on foreign exporters.

28. ECONOMIC INTEGRATION
 Trade unification between different states by the partial or full abolishing of
customs tariffs on trade taking place within the borders of each state.
 This is meant in turn to lead to lower prices for distributors and consumers (as no
customs duties are paid within the integrated area) and the goal is to increase
trade.
 Trade agreement – A contract/agreement/pact between two or more nations
that outlines how they will work together to ensure mutual benefit in the field of
trade and investment. Trade agreements are either bilateral, involving only two
countries, or multilateral, involving more than two countries.
 Trade bloc - a type of intergovernmental agreement, where regional barriers to
trade, (tariffs and non-tariff barriers) are reduced or eliminated among the
participating states.

29. Types of Trade Blocs
 Preferential Trade agreement – A trading bloc that gives preferential access to certain
products from the participating countries. This is done by reducing tariffs but not by
abolishing them completely. A PTA can be established through a trade pact. It is the first
stage of economic integration.
 Free Trade Areas - A trade bloc whose member countries have signed a free-trade
agreement (FTA), which eliminates tariffs, import quotas, and preferences on most (if not
all) goods and services traded between them.

30.  Customs Union- An agreement among countries to have free
trade among themselves and to adopt common external
barriers against any other country interested in exporting to
these countries.
 Common Market - A type of custom union where there are
common policies on product regulation, and free movement
of goods and services, capital and labour. All common
markets and economic and monetary unions are also
customs unions

31. Economic & Monetary Unions
 A common market with common currency
 Where more than two countries use the same currency.
Advantages of single currency
 Reduces the level of transaction cost.
 When trading among each other the countries need not worry about possible exchange rate fluctuations.
 It is easier to make price comparisons between countries.
 Greater FDI is attracted because of reduced transactions costs, reduced uncertainty and the large size of single
currency market.
Disadvantages of single currency
 Individual countries lose the ability to set interest rates.
 Individual countries cannot depreciate or devalue its currency value.
 Huge cost involved such as physical changing, reprogramming computers, producing new price lists etc.

32. The terms of Trade
 The exchange Rate operating for international transaction must be between the
respective domestic opportunity cost ratios.
 It measures the rate at which the goods of one country exchange for the goods of
another.
 The consumption combinations possible through specialization and trade at these terms of
trade are represented by each country’s trading possibility curve (TPC).
 Trading possibilities exist that exceed domestic production possibilities. Countries can still
do much better through trade than trying to produce everything for themselves.
 The terms of trade are represented as an index of the ratio of export prices and import
prices :-
Terms of Trade index = 풊풏풅풆풙 풐풇 풆풙풑풐풓풕 풑풓풊풄풆풔
풊풏풅풆풙 풐풇 풊풎풑풐풓풕 풑풓풊풄풆풔
x 100