Transcript Slide 1

International Trade
Why trade?
Why do countries trade?
There will be much discussion of the pros
and cons of trade in the rest of this topic.
Before we go down that road, it is
important to understand the fundamental
reason why countries trade

Differences in their resources

More competition and choice

Economies of scale
Differences in their resources


Each country has a different allocation of
natural and human resources. A given country
will be well suited to the production of some
goods (or the provision of certain services)
and totally unsuited to the production of
others. Particularly in the field of agriculture,
the differences in climate can be immense; it is
simply impossible to grow certain agricultural
products in certain countries.
The consequence of this is that some
countries will go without some essential goods
unless they trade with other countries.
More competition and choice
Perfect competition is considered to be the most
efficient market structure because it is the most
competitive. Competition puts pressure on firms to keep
their prices, and therefore their costs, down.
 In the same way, the more open to foreign imports a
country is, the more competition the home producers will
face and the more efficient they will have to be. This is not
only good in an economic sense (greater efficiency) but
domestic consumers enjoy lower prices and, therefore,
increased consumer surplus.
 Given what we said earlier about the unequal distribution
of the world's resources, it is likely that countries will not
be able to produce all the goods that consumers will
desire. By definition, therefore, consumers will have a
greater choice if the country trades internationally.

Economies of scale

Once a firm in a given product market is
subject to international competition,
often the only way to survive is through
growth and economies of scale. The
resulting reduction in their cost per unit
produced will enable them to become
more price competitive in the global
marketplace. Obviously this will be good
for consumers.
The case for free trade
Some definitions
Before we plough into the case for free trade, it is
important that we define a few terms.


Absolute advantage
A country has an absolute advantage over another
country in the production of a certain good if, for a
given amount of resources, it can produce more of
the good than its competitor. Another way of looking
at it is that the country with the absolute advantage
can make the same amount of the good with fewer
resources. Basically, it is when one country is better
at making a given good than another country. See
the next Learn-It for a numerical example.
Comparative advantage

The theory of comparative advantage takes
absolute advantage a stage further. Even if a
country is so bad at using a given set of
resources that it is worse at making all goods
than another country, it will still have a
comparative advantage in the production of at
least one good. This means that there will be
at least one product where it is relatively
better at producing, even though in absolute
terms it is the worst at making everything. This
might sound confusing, but all will be revealed
with a numerical example
The terms of trade

Put simply, the terms of trade are the
'terms' (or price) agreed when two
countries trade. You will see that it is
important to understand this concept
when we look at numerical example of
trade between countries below.
Trade barriers

It should be obvious that when an
economist refers to free trade he is
referring to international trade without
trade barriers (i.e. trade 'free' of
barriers). We will see later the most
prominent barriers that are used and the
reason why they are used.
Question

Why is free trade a good thing?
The World Trade Organisation
(WTO)

The WTO is the world policeman for matters associated with trade. It used
to be called the General Agreement on Tariffs and Trade (GATT). The
major industrialised countries signed this agreement straight after the war.
Its purpose, in particular, was to reduce the use of tariffs around the world.
Their ultimate objective was the elimination of all tariffs resulting in free
trade around the world. It was very successful, reducing tariffs (on average)
from around 40% after the war to fewer than 5% in the 1990s.

GATT consisted of a number of 'rounds' where ministers and civil servants
from all the important countries got together and thrashed out deals on tariff
reduction. The final round (the Uruguay round) that finished in 1993 (these
rounds could take a number of years to complete) was not only ambitious in
terms of the elimination of tariff and non-tariff barriers, it also created a new
body (the WTO) to take over from the occasional policeman that was the
GATT. The WTO was to be on going. Not only would it carry on the job of
setting up 'rounds' of discussions for further reductions in barriers (the
attempted introduction of the 'Seattle' round at the end of 1999 was not so
successful), but it would act as the adjudicator when countries had a trade
dispute.
The World Trade Organisation
(WTO)

A good recent example of one such 'dispute' was between the USA and the EU
(most of them are between these two huge economies) over the relatively
humble banana. The EU gave preferential treatment to banana growers in
African and Caribbean countries, partly due to historical colonial links, but also
because they are at a huge cost disadvantage compared with the large,
American owned, banana plants in Latin America. It would be no good for the EU
if the poorer banana growers went bust.

The USA complained to the WTO in 1996. The WTO agreed with the USA and
the EU was asked to change their banana regime. The proposed changes were
not enough to satisfy the USA. It was at this point, towards the end of 1998, that
the USA threatened to impose 100% tariffs on randomly selected EU products
(Scottish Whiskey and French cheese to name but two). Again the WTO agreed
and allowed the USA to go ahead with almost $200 million worth of retaliation.
The EU finally backed down in 1999 with changes that the USA accepted.

The long running nature of the dispute does highlight the difficulty in reaching
agreement and the trouble that the WTO has in getting countries to comply with
their judgements. It is a better system than the old GATT, though, which had to
rely on voluntary compliance by quarrelling member countries. At least the WTO
has a formal disputes procedure and can impose penalties on countries that are
judged to be in the wrong
The case for free trade -absolute
advantage


We are now going to look at a numerical example
that shows why it makes sense for two countries to
trade when each has an absolute advantage in one
of the two goods being traded.
The method used below is one based on the final
output of the goods in question assuming each
country has the same resources and that they are
distributed evenly to the production of each good.
Some textbooks prefer to illustrate the same concept
by comparing the relative costs in terms of resources
required to make one unit of the good in question.
The first method has been chosen mainly because a
diagram can be used to illustrate what is going on (in
terms of a production possibility frontier, or PPF)
as well as some numerical analysis.
The 'pre-specialisation' situation

Assume that two countries, Germany
and France, with similar amounts of
resources (which is more or less true in
the real world) both produce only two
goods, beer and wine (not so true in the
real world!). The table below gives the
production possibilities for a given year
assuming that they each split their
resources evenly between the
production of beer and wine.
The 'pre-specialisation' situation
Wine
Beer
(Millions of bottles)
(Millions of bottles)
Germany
150
300
France
200
200
This information can be illustrated on two PPFs, one for each country
Assumptions

As the resources have been split equally
between the productions of the two
goods, we see that each country is
producing at the mid-point on their
respective PPFs (points A and B).
Germany, for example, could produce
600 million bottles of beer if it
concentrated all of its resources on the
production of beer.
Assumptions

You can probably see that we have to
make a number of assumptions for this
model to be valid. First, each country is
on rather than within its PPF. We
assume, therefore, that each country is
using all of their resources and in the
most efficient way.
Assumptions

Secondly, the PPFs are straight lines. This
means we are assuming that all resources
used are equally good at making beer or
wine (a bit dubious - most PPFs are
convex to the origin). The straight line PPF
also means that we are assuming that
returns to scale are constant. If Germany
does decide to concentrate on the
production of beer, they do not experience
economies of scale (they probably would in
the real world).
Specialise and Trade

Looking back at the table, we have a
situation here where France has an
absolute advantage in the production of
wine and Germany has an absolute
advantage in the production of beer. In this
situation, it makes sense for each country
to specialise and produce the good that
they are best at making, and then trade.
So, Germany concentrates on beer
production and France concentrates on
wine production.
The situation after specialisation
Wine
Beer
(Millions of bottles)
(Millions of bottles)
Germany
0
600
France
400
0
Total
400
600
The Result


France is now producing at point C on its PPF and
Germany is producing at point D on its PPF. Notice
that total production of both goods has now risen
because each country is concentrating on the
production of the good in which they have an
absolute advantage. The question now is what will
be the terms of trade?
If France was still a closed economy, it could
produce an extra bottle of beer at the cost of exactly
one bottle of wine. Hence, France will not want to
trade a bottle of wine for anything less than one
bottle of beer. The domestic trade off is one bottle of
beer for one bottle of wine, so France would hope to
do better than that.



Similarly, if Germany was still a closed economy, it
could produce an extra bottle of beer at the cost of
only half a bottle of wine. Germany would hope to
get at least half a bottle of wine (from now on, W) for
each bottle of beer (from now on, B) that it trades
with France.
So the terms of trade (or the price) will be
somewhere between 1B for W (or 2B for 1W) and 1B
for 1W. France will hope the agreed price will be
nearer to 2B for 1W and Germany will hope that the
price is nearer 1B for 1W.
Let's say that they agree on 1½B for 1W, and decide
to trade 255 million bottles of beer for 170 million
bottles of wine.
The situation after specialisation
and trade
The final, post-trade, table will look like this:
Wine
Beer
(Millions of bottles)
(Millions of bottles)
Germany
170
345
France
230
255
Total
400
600
The Result

Both countries now have more beer and
wine than they had before they
specialised and traded. Germany has 20
million more bottles of wine and 45
million more bottles of beer. France has
30 million more bottles of wine and 55
million more bottles of beer. In a sense,
their PPFs have moved out as a result
of specialisation and trade.
The case for free trade comparative advantage
In the numerical example in the last
Learn-It, it was fairly obvious what the
two countries should do. One was better
at making wine, the other was better at
making beer, so they each specialised,
overall production rose and they were
both better off after trading.
 What should happen, though, if one of
the two countries is best at making both
the goods in question?

The 'pre-specialisation' situation

Assume that two countries, Germany
and France, with similar amounts of
resources (which is more or less true in
the real world) both produce only two
goods, wine and cheese (not so true in
the real world!). The table below gives
the production possibilities for a given
year assuming that they each split their
resources evenly between the
production of wine and cheese.
The Table
Wine
Cheese
(Millions of bottles)
(Millions of kilos)
Germany
150
100
France
200
200
Total
350
300
In this example, where we assume that both countries produce only
wine and cheese,
France has an absolute advantage in the production of both wine and
cheese.
It is better at making both goods. Here are the relevant PPFs.
As you can see, France's PPF is further to the right than
Germany's. They are better at making both goods, so why
bother trade with Germany?
This is where the theory of comparative advantage comes in.
This theory states that in the situation above, both countries
can still benefit from specialisation and trade. Germany must
specialise in the good at which it is 'least bad' at making, and
France should specialise in the product at which it is best (or
'most good') at making. We find out who should specialise in
what by finding, for each country, the opportunity cost of
making each good in terms of the other good. This is where the
PPFs come in handy. It is easier to see what the opportunity
costs are using a diagram.
Finding the value of the
opportunity costs

Let's look at France first. France is initially at
point A on its PPF, producing 200 million
bottles of wine (from now on, W) and 200
million kilograms of cheese (from now on, C).
If France was to make one more kilogram of
cheese, you can see from the diagram that a
bottle of wine would have to be sacrificed. So
the opportunity cost of making 1C is 1W. If
France were to make one more bottle of wine,
it would have to sacrifice a kilogram of cheese.
The opportunity cost of making 1W is 1C. The
gradient of the PPF (which is -1) determines
the size of the opportunity cost.
France

The calculation is a little more complicated for
Germany, currently at point B on its PPF. To
make one more kilogram of cheese you can
see from the steeper slope of the PPF that
Germany will have to give up more than one
bottle of wine. To be exact, the opportunity
cost of 1C is 1½W. Again the gradient of the
PPF (which is -1½) holds the key. To make
one more bottle of wine, you can see that
Germany will be giving up less than one
kilogram of cheese. To be exact, the
opportunity cost of 1W is 2C/3.
The table above has been reproduced below, but the
opportunity costs of making an extra unit of each product
has been added in the relevant boxes.
Wine
Cheese
(Millions of bottles)
(Millions of kilos)
Germany
150
100
(1W costs C)
(1C costs 1W)
France
200
(1W costs C)
(1C costs 1W)
Total
350
200
300
The Result

Now that we have the opportunity costs of
production, we can see which country is relatively
better at making each good. In other words, we can
see which country has a comparative advantage in
producing which good. Let's look at wine first. France
can make 1W at a cost of 1C, but Germany can
make wine relatively more cheaply. It can make 1W
for only 2C/3. Germany has a comparative
advantage in the production of wine. With cheese,
France can make 1C at a cost of 1W, but it is more
costly in Germany, where 1C costs 1½W. France has
a comparative advantage in the production of
cheese.
The situation after specialisation
So, Germany will specialise in wine and France will specialise in cheese.
This gives the following table:
Wine
Cheese
(millions of bottles)
(millions of kilos)
Germany
300
0
France
0
400
Total
300
400
Notice that, although overall production has risen (700 units is
bigger than 650 units), the extra 100 million kilograms of
cheese have been produced with a loss of 50 million bottles of
wine. This may seem like a bad deal if you particularly like
wine!
It is for this reason that the two countries in this situation are
unlikely to specialise 100% in the product for which they have a
comparative advantage.
The table below gives a more sensible degree of specialisation
which results in higher overall production of both goods.
Wine
Cheese
(millions of bottles)
(millions of kilos)
Germany
300
0
France
70
330
Total
370
330
Both wine and cheese lovers should be happy now! The two countries
together now produce 20 million more bottles of wine and 30 million more
kilograms of cheese. So now its time to trade. What will the terms of
trade be?


If France was still a closed economy, it could
produce an extra kilogram of cheese at the cost of
exactly one bottle of wine. Hence, France will not
want to trade a kilogram of cheese for anything less
than one bottle of wine. The domestic trade off is one
kilogram of cheese for one bottle of wine, so France
would hope to do better than that.
Similarly, if Germany was still a closed economy, it
could produce an extra bottle of wine at the cost of
only two-thirds of a kilogram of cheese. Germany
would hope to get at least two-thirds of a kilogram of
cheese for each bottle of wine that it trades with
France. 1W for 2C/3 is the same as 1C for 1½W.
The Terms of Trade
So the 'price' will be somewhere
between 1C for 1W and 1C for 1½W.
France would rather the price was as
close as possible to 1C for 1½W and
Germany will hope that the price is as
close as possible to 1C for 1W.
 Let's say that the two countries agree on
a price of 1C for 1¼W, and decide to
trade 112 million kilograms of cheese for
140 million bottles of wine.

The situation after specialisation and
trading
The final, post-trade, table will look like this:
Wine
Cheese
(millions of bottles)
(millions of kilos)
Germany
160
112
France
210
218
Total
370
330
Summary


Both countries now have more cheese and wine
than they had before they specialised and traded.
Germany has 10 million more bottles of wine and 12
million more kilograms of cheese. France has 10
million more bottles of wine and 18 million more
kilograms of cheese. In a sense, their PPFs have
moved out as a result of specialisation and trade.
As with the absolute advantage example, it should
be noted that we have assumed that there are no
transport costs for the delivery of the exports of each
product. Also, we have assumed that there are no
negative externalities in the production process, or
from the consumption of wine and cheese (which is
definitely not the case in the real world!).
The lawyer and his secretary



If the numerical example above doesn't make much
sense, think of the concept of comparative
advantage in terms of a lawyer and his secretary.
Assume that a lawyer can charge his services out at
100 pounds an hour (it is probably more nowadays!).
Also assume that he/she happens to be a very quick
typist, and can type 80 words a minute. His secretary
is fairly good, typing 60 words a minute. The
secretary is paid 12 pounds an hour.
The lawyer has an absolute advantage in being a
lawyer and being a secretary! But he is much better
at being a lawyer and only a little bit better at typing.
He has a comparative advantage in the law and the
secretary has a comparative advantage at typing.
The lawyer

If the lawyer decides to type a letter, or a
report, because he is a bit quicker than the
secretary, he would lose out overall. Let's
say that it takes him 15 minutes to type a
report. The secretary types 25% slower, so
it would take him/her 20 minutes. It costs
the lawyer four pounds to hire the secretary
for 20 minutes, but if he types the report,
he has wasted 15 minutes for which he
could have earned 25 pounds being a
lawyer!