W 1006 Economics

Lesson 19 International Trade,

Free Trade and Protection
 Overview
• Basis of International Trade
• Theories of International Trade
• Terms of Trade
• Balance of Trade
• Free Trade
• Trade Protection
 International Trade
• International trade refers to the exchange
of goods and services between countries.

• International trade exist to make countries

better off by trading goods and services
with one another.
Basis of International Trade
• International trade arises because:
– Economic resources are not evenly distributed
in all the countries.
– Climatic conditions are different, favouring the
cultivation of different crops.
– The different goods produced require different
methods and resources used in different
proportions.
– Mobility of factors is limited.
 Theories of International
Trade
• Absolute Advantage
– When one country can produce a good
with less resources than another country.

• Comparative Advantage
– When one country can produce a good at a
lower opportunity cost (i.e. it has to forgo
less of the other good in order to produce
it).
 Principle of Absolute
Advantage
Country Rice Corn Opportunity cost Opportunity cost
for 1 unit of Rice for 1 unit of Corn
A 100 50 0.5 unit Corn 2.0 unit Rice

B 50 150 3 units Corn 0.33 unit Rice

A+B 150 200

– Country A is more efficient in producing Rice

while Country B is more efficient in producing
Corn.
 Principle of Absolute
Advantage
• With trade, each country will tend to specialize
in producing the good in which it is more
efficient.

• Total output will increase after specialization.

Country Rice Corn
A 200 0
B 0 300
A+B 200 300
 Principle of Comparative
Advantage
• Even when one country has an absolute
advantage in all products, Trade and
specialization can still benefit all countries, if
each has a comparative cost advantage.
• Gain from trade are realized, if countries
export those goods in which they are a
comparative advantage, and import goods
that they have a comparative disadvantage.
 Principle of Comparative
Advantage
• Example: Country A has absolute advantage
in both products

Country Rice Corn

A 150 100

B 60 80

A+B 210 180

 Principle of Comparative
Advantage
Opportunity cost for 1 Opportunity cost for 1
Country unit of Rice unit of Corn

A 0.67 unit Corn 1.5 units Rice

B 1.33 units Corn 0.75 unit Rice

 A has comparative advantage in Rice production

 B has comparative advantage in Corn production.
 Principle of Comparative
•
Advantage
If Country B were to specialize completely in Corn
production, and Country A specialize partially in Corn,
Total output will increase.
• After Specialization:

Country Rice Corn

A 255 30
B 0 160
A+B 255 190
Advantages of International
Trade
– Greater variety of goods.
– Efficient allocation and better utilisation of resources
since countries produce goods that they have a
comparative advantage.
– Promotes efficiency in production as countries adopt
better method of production to keep costs down.
– More employment could be generated as the market
for the countries’ goods widens through trade.
Advantages of International
Trade
– Increased size of a country’s market
– Increased standard of living
• By importing goods from elsewhere, the trading country’s
population has access to a greater range of goods and
services, which can have better quality than before. In
return, importing country exports its surpluses.
– Improved international relations
• Trade promotes more understanding and goodwill between
countries, through increased contacts.
 Disadvantages of
International Trade
– It could lead to a more rapid depletion of
exhaustible natural resources.
– A country could become heavily dependent on
other countries for goods.
– Domestic industries are exposed to foreign
competition.
– ‘Dumping’ of cheap foreign products may cause
unemployment if industries cannot compete with
cheaper imports.
 Terms of Trade
• The rate at which one country’s goods are
exchanged for those of other countries is referred to
as the terms of trade.

• It is computed as an index.

Terms of Trade = Index of Export Prices X 100

Index of Import Prices

• If Terms of Trade rise, they are said to have

improved as fewer Exports have to be sold to
purchase any given quantity of Imports.
 Balance of Trade
• Balance of trade refers to the difference
between the value of exports and imports.
Balance of trade = Value of exports
– Value of imports

• If value of exports > value of imports, the

balance of trade is favorable.

• If value of exports < value of imports, the

balance of trade is unfavorable.
Free Trade & Protection
• Theories of Free Trade
• Restrictions on Trade
• Arguments For Protection
• Arguments against Protection
 Free Trade
• Free trade occurs when countries do not
impose restrictions on the movements of
goods and services between them.
• It enhances their living standards and
results in better utilisation of their
resources.
 Free Trade
• However, it could result in over-
specialisation and dependence on a few
products.
• This would make a country vulnerable in
times of changes in world demand.
• As a result, most countries implement
some form of trade restrictions.
 Restrictions on
International Trade
• Tariffs
– This is the most common barrier to trade.
Tariffs may be ‘ad valorem’ or ‘specific’.
– They act by raising the price of imports
as they enter the country.
 Restrictions on
International Trade
• Subsidies
– Subsidies are grants or payments to
producer by the government. They
tend to lower the prices and encourage
consumption of local products in
preference to imported goods.
 Restrictions on
International Trade
• Quotas
– A quota is the most serious kind of
restriction. It places a physical
limitation on the quantity of inputs
allowed into a country.
 Restrictions on
International Trade
• Exchange Control
– A system of exchange control will limit the
amount of foreign currency people could
acquire.
– Importers require foreign currency to pay
for imports, the volume of imports could
be controlled by controlling the issue of
foreign currency.
 Arguments For Restrictions
on International Trade
• ‘Key Industry’ Argument
– Some industries e.g. iron and steel,
agriculture and scientific instruments are
regarded as strategic industries which
are essential in the event of a crisis.
– Such industries need protection to
reduce a country’s dependence on
imports of strategic materials.
Arguments For Restrictions
on International Trade
• ‘Infant Industry’ Argument
– In the early stage of development, certain
industries may not be able to compete with the
established industries of the industrialised
nations.

– Protection is needed to enable such industries

to reach a scale of production large enough to
allow their costs to fall to a more competitive
level.
Arguments For Restrictions
on International Trade
• ‘Employment’ Argument
– Workers would become unemployed in
industries which cannot compete with
cheaper imports.
– Tariffs are imposed to keep out or make
the ‘cheaper’ imports more expensive
when compared to the goods that are
locally produced.
 Arguments For Restrictions
on International Trade
• To Correct A Balance of Payment Deficit
– If a country persistently suffers from a balance of
payments deficit, it is losing gold and foreign
exchange and it might be heading towards
economic bankruptcy if the problem is not
checked.

– Protection is needed to keep out imports in

order to correct the deficit.
 Arguments For Restrictions
on International Trade
• ‘Diversification of Industry’ Argument
– A country should not depend on one or a few
industries because this could lead to mass
unemployment if foreign demand falls.

– In order to minimise these risks, it should produce

a variety of goods and protection is accorded to
them.
 Arguments against
Restrictions on International
Trade
• Causes retaliation by other countries
• Damages prospects of economic growth
• Creates ill-will among countries
• Defeat measures to reverse balance of trade
deficits
 Review Questions
• Explain the following theories of
international trade:
– Principle of Absolute Advantage
– Principle of Comparative Advantage

• Explain and evaluate the arguments

in favour of and against free trade
amongst nations.

• What are the various forms of import

control?
Thank You