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Why do countries import goods and services?
Availability: the particular good may only be available on the foreign market.
Price: the particular good may be cheaper on the foreign market.
Diversity: so the country can enjoy a wider selection of goods/better quality of goods.
What is free international trade?
The exchange of goods and services across national borders without government restrictions.
What are the benefits of free trade?
Resources will be more efficiently allocated (with the context of the world)
Countries can specialise
World Output increases
Wider consumer choice
Consumer satisfaction becomes higher.
Lower prices
Specialisation will increase the scale of production which will reduce costs of production. (Economies of scale)
Firms can purchase cheaper raw materials from foreign markets.
Quality of products improve
Due to competition. When there are foreign products, domestic firms are pressured to keep costs of productions low and innovate to improve quality.
Economic growth
Domestic firms have a wider consumer base. So firms are induced to produce more and earn more, potentially increasing GDP.
Spreading of technology can happen.
Trade can stimulate the local economy as there will be more products being made available.
Absolute vs comparative advantage.
Given the same set of resources, a country with absolute advantage will be able to produce more of the good than a country without absolute advantage.
Comparative advantage looks at opportunity cost. The country that has to give up less to produce a good is said to have the comparative advantage of that good.
What are the sources of comparative advantage?
Factor endowments (In the areas of land, labour, capital, and enterprise)
Which are the 2 models we can use to demonstrate comparative advantage? How do we do it?
We can use
1) The opportunity cost model
The country with the lower opportunity cost has the comparative advantage for the good (has to give up less)
2) Demand and supply model.
The country where the domestic price is lower than the world price has the comparative advantage.
When is it that it is beneficial for countries to specialise and trade?
When there is a difference in the opportunity cost of producing the good between the tow countries. i.e. when comparative advantage exists.
What is a trading possibility curve?
It is a form of PPC. Shows the production possibilities under the conditions of free trade.
What are the risks to excessive specialisation?
Countries that over specialise can be vulnerable to events that affect their exports that are outside of their control, as they have no alternative sources of income.
They could also become overly reliant on foreign goods.
What are the unrealistic assumptions in the absolute/comparative advantage analysis?
Unrealistic assumptions, namely:
that there is free trade (tariffs can negate comparative advantages)
fixed fop and technology (assume that there will not be any improvements.
no transport costs
exchange rates remain constant despite trading
full employment of fop on both sides
etc etc.
What are the limitations in the absolute/comparative advantage argument?
Unrealistic assumptions
Excessive specialisation carries its risks
If trade protection is needed, then the free trade required in the comparative advantage might not be suitable.
It is not a good idea for all countries to specialise in there CA(Esp developing countries)
What are some disadvantages for developing countries to follow the theory of comparative advantage?
Developing countries, according to the theory, should specialise in agricultural goods because they have abundant labour.
Not good because:
1) Agricultural goods are volatile in price in the short term, so they cannot plan ahead.
2) In the long term agri goods will continually drop in price, as tech improves faster than the demand.
2) Prevents them from developing economy as a whole, citizens will be low skilled.
What are the underlying assumptions in the opportunity cost model?
That there are only 2 countries
Only 2 goods to trade and consume
constant production and opportunity costs
Perfectly mobile FOP so they can shift resources from one good to the other
no transportation costs.
What is the terms of trade index? What is the formula and what does it imply?
Terms of trade index is given by:
Terms of trade Index = 100 x Export price index (XPI) / Import price index (MPI)
It can tell you how much you can import per unit of good exported (If ToT = 200, you can get 2 of a foreign good per 1 good exported.
Note that it is an index, reference to a BASE YEAR. Note the the exports and imports are also price indices and not revenue or quantity.
What is the export / import price index?
The average price of export / import referenced against a base year.
What is the difference between the terms of trade and the balance of trade?
Terms of trade is a price ratio, balance of trade is net exports.
What causes a change in the terms of trade in the short term?
Exchange rates. Because, depending on whether the country is an exporter or importer, will affect the “expensiveness” of imports/exports.
Relative inflation rates. Because they affect relative cost of goods.
Global supply and demand conditions. Strong/week supply and demand will affect export and import prices.
What causes a change in terms of trade in the long term
Productivity increase. Which can cause prices to drop due to increased supply. TOT decrease for exporters
Technological improvement. Which can cause prices to drop due to increased supply. TOT decrease for exporters.
Changes in income. Income change can affect domestic or foreign demand, but only if YED is elastic.
How do you calculate a suitable terms of trade between two countries?
Terms of trade is like the “exchange rate” for goods. How much should a good cost in terms of another. A suitable terms of trade will be a ratio that is in between the two country’s opportunity costs.
EG:
Say Country A has to forgo 2 oranges for 1 apple, whereas country B has to forgo 5 oranges for 1 apple. They will specialise, with A specialising in apples and B in oranges. When they trade, the terms should be between 2 oranges to 1 apple and 5 oranges and 1 apple.
3 oranges to 1 apple is suitable.
1 orange to 1 apple is not, because then country A is getting cheated (Apples are not selling for enough) and would rather that they produce their own oranges
6 oranges to 1 apple is not, because now country B is getting cheated (Apples are too expensive) and would rather that they produce their own apples
They will have to meet in the middle obviously.
What are the impacts of a change in terms of trade and balance of trade due to demand changes?
When demand increases:
Exporters: price of exports increase, XPI increases, TOT improves. Trade Balance improves
Importers: price of import increase, MPI increases, TOT deteriorates, Trade Balance deteriorates.
When demand decreases, opposite of above happens.
What are the impacts of a change in terms of trade and balance of trade due to supply changes?
When supply increases, PED matters!:
Same analysis thinking about changes in price, for exporter and importer.
Except for trade balance. If PED inelastic, the trade balance will move same direction as TOT. If PED elastic, trade balance will move in an opposite direction. Think about it. And slow down!
How do we illustrate the changes in societal benefit before / after trading?
Total output after trading should increase.
What are the impacts on TOT and trade balance when exchange rate changes?
They affect the prices of imports. Appreciating exchange rate makes imports cheaper, and depreciating exchange rates make imports more expensive
EV: trade balance will be in the opposite direction of TOT if the Marshal-Lerner condition holds, that
Export PED + Import PED > 1
Means when imports are very sensitive to price changes, and revenue increase a lot despite price drop (When imports get cheaper) or revenue rise very little despite price increase (when imports get more expensive)
Otherwise import will go down go up because price drop and rise.
What is a tariff and what are their functions? (Plus assumptions)
A tariff is a tax on imports. It raises the price of imported goods.
(In exams you should elaborate more, say what they do [raise import prices, protect local firms], give an example, [specific and ad valorem taxes.])
Assumptions:
That domestic goods are the same are foriegn goods (Perfectly substitutable)
That domestic producers will match the price of foreign goods
What are the 3 kinds of tariffs?
Ad Valorem Tax,
Specific Tax,
Value Added Tax, (Where tax is levied on the value added to the good at every stage of production)
How do you illustrate the impacts before and after tariffs?
Be careful on domestic and world!
Draw a domestic supply and demand curve with a horizontal world price line below domestic equilibrium. This is before.
raise the world price line so that it is higher than before but still less than domestic equilibrium. You can now examine changes in surplus and quantity imported
Where can you read the government revenue after tarrifs? Deadweight loss?
Area E (Quantity imported times tariff)
Area D and F
What are import quotas?
A limit on the amount of imports. Used to protect local firms
How to illustrate impacts of quotas on a graph?
Draw domestic supply and demand, with world price.
Draw a new supply with quota curve. Indicate new prices, quantity imported etc.
What are export subsidies?
Subsidies granted to exports, reducing their price making them more competitive in the international market.
How to illustrate the impacts of export subsidy?
Draw the normal domestic supply demand curves
Add the world price.
Shift a new supply curve to the right to represent supply after subsidy. Make sure that the new domestic equilibrium price is not lower than world price.
Price consumers pay is still world price, producers receive the market price plus subsidy per unit. Red rectangle is the cost of subsidy.
What is an embargo?
Embargo is zero quota. It is a total ban on imports,
What are some non-tariff barriers?
Red tape, or other regulations imposed on foreign goods.
What is protectionism?
A deliberate attempt by a country to restrict international trade, often to protect local businesses from competition.
What are some arguments for protectionist measures?
FOR:
Prevents dumping from happening. (A predatory pricing behaviour from other countries)
Protects local infant industries.
- Need reach certain economies of scale, need support to get familiar with the market.
Protects local sunset industries.
- because need to protect the workers. If all the workers are displaced you can get high levels of unemployment. To prevent an abrupt shutdown.
Protects strategic industries.
-eg: energy, IT, cybersecurity, country cannot be completely reliant on foreign industries.
Others:
-Diversifies industries
-improve current account deficit
-increase tax revenue from tarrifs.
What are some arguments against protectionism?
AGAINST:
Too much protection
-infant industries dont expand
-sunset industries dont die
-existing firms dont innovate and they get complacent. worse quality products
-export competitiveness decreases
Consumer impact
-typically worse off
-higher prices, reduced choice
-poverty can worsen
-lower SOL and overall well being
Exporter impact
-more difficult for exporters to enter market due to articificially depressed prices, perhaps due to other countries’ subsidy.
Others:
-Trade wars can happen
-overall innefficient allocation of resources
