No protection on goods from other nations (international trade) such as taxes, quotas, etc.
Benefits of Free Trade
1. Allows specialization of resources increasing output 2. Increases competition 3. Leads to greater efficiency 4. Leads to lower prices which benefit buyers and keep the cost of living lower 5. May induce domestic firms to grow and achieve Economies of Scale 6. Allows domestic firms to import exactly what they need 7. Enables technology and ideas to spread faster 8. Stimulates faster growth 9. Allows higher savings 10. Presents consumers with more options
Economies of Scale
the idea of obtaining larger production returns through the use of division of labor
A country has an absolute advantage in the production of a good if it can produce more of it with the same resources, or, equivalently, if it can produce a unit of it with fewer resources than another country
How to illustrate Absolute Advantage?
PPC with straight line crossing one another
If a country can produce the good at a lower opportunity cost (that is, by sacrificing fewer units of another good compared to another country
What does it mean if the PPCs are parallel?
There is no room for specialisation and mutually beneficial trade because the opportunity cost ratios are equal
Sources of Comparative Advantage
1. Differences in Factors of Production 2. Differences in the stock of human capital 3. Movements in the exchange rates 4. Export subsidies create an artificial comparative advantage
Assumptions of Comparative Advantage
1. Constant (average and marginal) costs of production reflected in the linear PPCs we draw 2. Perfect factor mobility within each country (but, immobility between countries) 3. No transport costs 4. Perfect competition in all markets 5. Free trade (no trade barriers)
Criticism of the principle of comparative advantage
1. Costs of production are not constant they always change 2. Labour suffers from occupational and geographical immobility so it may be costly to specialize 3. Transportation costs exist, limiting the scope for trade 4. Perfectly competitive conditions are rarely approximated 5. Trade barriers exist, limiting the scope for trade
Comparative Advantage the dynamic
Comparative advantage can be created, the country is not born with it
World Trade Organization (WTO)
153 member countries, it is an international institution which aims at promoting free trade by persuading countries to abolish import tariffs and other barriers
1. Biased in favour of Western civilizations - particularly US and European Union 2. Inconsiderate in the needs of the developing countries 3. Paying INSUFFICIENT attention to increasingly important issues such as child labour, health, the environment and workers' rights
Why trade protection?
1. Protect jobs from foreign competition 2. Correct trade deficit 3. Protect against dumping 4. Enhance government revenue 5. 'Infant Industry' argument 6. Strategic trade policy argument 7. Health and safety 8. Prevent income stagflation
In economics, an infant industry is a new industry,which in its early stages experiences relative difficulty or is absolutely incapable in competing with established competitors abroad.
Strategic Trade Policy
policy certain countries adopt in order to affect the outcome of strategic interactions between firms in an international oligopoly, an industry dominated by a small number of firms - The term 'strategic' in this context refers to the strategic interaction between firms
Why not trade protection?
1. Breeds inefficiency 2. Limits competition and increases monopoly power 3. Responsible for misallocation of scarce resources 4. It leads to higher prices for consumers 5. It increases the production costs of firms importing intermediate goods 6. Increases possibility of retaliation 7. Limits awareness of firms to technological progress embodied in imported capital goods 8. Responsible for directly unproductive profit (DUP) 9. Limits options to consumers and firms
Types of trade protection
Tariffs, Quotas, Subsidies
A tariff is defined as a tax imposed on imports aimed at restricting their flow into the country and protecting domestic producers
Effects of a Tariff
1. Increase the domestic price of the protected good 2. Increase domestic production of the good 3. Decrease consumption of the good 4. Decrease consumer surplus 5. Increase producer surplus 6. Tariff revenue 7. Production inefficiency 8. Welfare loss
A limit placed on the quantities of a product that can be imported
Effects of a Quota
1. Increase domestic price of good 2. Increase domestic production of good 3. Decrease consumption of the good 4. Create quota 'rents' which are typically pocketed by foreign firms (but government may also collect it-domestic) 5. Production inefficiency 6. Consumption inefficiency 7. Welfare loss
The economic rent received by the holder of the right (or license) to import under a quota. Equals the domestic price of the imported good, net of any tariff, minus the world price, times the quantity of imports.
Subsidies lower production costs of firms and therefore artificially increase their competitiveness
Effects of subsidies
1. Do not affect the domestic price 2. Do not affect the consumption of the good 3. Increase domestic production of the good 4. No not affect consumer welfare 5. Make domestic consumers better-off 6. Leads to wasteful domestic production and resource misallocation 7. Lead to increase government spending burdening tax payers 8. Creates trade friction
Administrative or Regulatory Barriers
Standards such as the fact the good needs to meet certain domestic standards in order to be traded with a nation
If a nation files a complaint for dumping then a tax is imposed on the nation which is dumping
Why do people want more protection?
The value of one currency expressed in the terms of another currency
Foreign Exchange Market
A market in which currencies are exchanged for other currencies
Foreign Exchange Market = Perfectly competitive
1. The 'good' is homogeneous as it makes no difference whether a dollar is bought in Frankfurt, or in Singapore, or in London 2. Very many buyers and sellers 3. No entry barrier into the market exists
Floating (flexible) exchange rate
If the currency is valued based on market forces alone, without government aid
Fixed Exchange Rate
Currency value set or maintained by the government or central bank
Managed Exchange Rate
No announced level or band but either the exchange rate is allowed to float within some implicit upper and lower bound or authorities intervene whenever they consider the direction or the speed of adjustment of the currency undesirable
The price (value) of a currency in a floating exchange rate system increases
The price (value) of a currency in a floating exchange rate system decreases
Official changes in the price of the currency in the fixed exchange rate system -- INCREASE
Official changes in the price of the currency in the fixed exchange rate system -- DECREASE
Who demands a currency in a foreign exchange market?
1. Individuals who demand goods from that currency's country 2. Individuals who want to make investments or buy bonds of that currency's country 3. Speculations about the possible appreciation of the currency
Who supplies a currency in a foreign exchange market?
1. The value of the imports of the goods and services (in the foreign currency) 2. Inflow of investments
Foreign Exchange Rate Diagram
Causes of Changes in the Exchange Rate
1. Speculation 2. Domestic demand for imports 3. Change in foreign demand for a country's exports 4. Interest Rates (HOT MONEY) 5. Investment prospects 6. Tourism to a limited extent 6. Rate of inflation
How do exchange rates appreciate? (reasons)
1. Foreign demand for a country's exports increases and/or demand for imports decreases 2. Creating a current account surplus 3. Domestic interest rates increase 4. Then it is expected that the country will continue to grow 5. Speculations
How do exchange rates depreciate? (reasons)
1. Domestic demand for imports increases and/or demand for imports decreases 2. Creating a current account deficit 3. Domestic inflation increases 4. Domestic interest rates decrease 5. Bad speculations
In a fixed exchange to revalue...
1. The central bank must start buying it using foreign exchange reserves 2. The central bank must increase interest rates to attract foreign capital inflows 3. The country must resort to official borrowing of foreign exchange 4. The government may restrict imports and access to foreign exchange
In a fixed exchange rate for it to devalue...
1. The central bank must start selling it to buy dollars 2. Central bank must decrease interest rates to create an outflow of current capital
Advantages of a floating exchange rate:
1. Policy makers can use monetary policy to achieve domestic goals 2. Trade imbalances are in principle automatically corrected 3. Exchange rate adjustments are smooth and continuous 4. Typically, less speculations exist 5. There is less need for the central bank to keep foreign exchange reserves
Disadvantages of a flexible exchange rate:
1. Increased uncertainty hurts trade and cross-border investment flows 2. A government may be more prone to adopt inflationary policies for short-term gains
Advantages of fixed exchange rate
1. Less uncertainty and exchange rate risk increases the volume of trade and cross border investments 2. Policy discipline on government as inflationary growth policy is not an option 3. They provide a policy option to curb high inflation
Disadvantages of fixed exchange rate
1. The government cannot use monetary policy to achieve domestic goals 2. The government is deprived of an exchange rate policy 3. The use of expansionary fiscal policy is restrained as financing a deficit may affect the money supply or interest rates 4. Exchange rate adjustments are abrupt and potentially disruptive 5. Trade deficits are not automatically corrected requiring use of painful contractionary fiscal policy 6. The central bank may maintain large foreign exchange reserves
Purchasing Power Parity (PPP)
An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.
The Balance of Payments
A record of all transaction of a country with the rest of the world over a period of time, usually a year
The balance of payments is composed of:
The current account, capital account, financial account
The sum of the current account, capital account and financial account =
The current account
1. Goods and services 2. Income 3. Transfers
1. Capital transfers 2. Non-financial assets
1. Foreign Direct Investment 2. Portfolio and other investments 3. Reserve assets (official reserves)
1. A country is consuming inside its production possibilities 2. Living standards are lower 3. Trade surplus causes retaliation from foreign countries 4. Not using comparative advantage 5. PUTS PRESSURE ON THE EXCHANGE RATE TO APPRECIATE 6. If country is keeping currency undervalued may encounter inflation
Marshall Lerner Condition
States that for devaluation or a sharp depreciation of a currency to improve, a current account deficit the sum of the PED for imports and the PED for exports must be (absolutely) greater than 1.
Why are PED for exports and PED for imports low in the short run?
Firms especially households may not even be aware of the new prices - access to new information is never instantaneous
The J- Curve
y axis: Net Exports x axis: Time
The J- Curve effect
With time people will know the change in the currency and thus the PED will rise and there will be greater exports and imports
Preferential Trade Agreement
Where a country agrees to give preferential access, e.g. reduced tariffs, to certain products from one or more trading partners.
Regional Trading blocks
The idea is: you have a group of countries who among themselves have free trade, but countries from the outside are blocked out
Free Trade Area
Members eliminate or agree o phase out trade barriers between them but each member country maintains its own external tariff to outside members
Free trade area members agree to adopt a common external tariff
Members of a customs union additionally agree to permit the free flow of factors of production
Members of a common market additionally harmonize certain macroeconomic and regulatory prices
Members of an economic union agree to adopt a common currency and establish a common central bank (Eurozone)
Advantages Monetary Union
1. Lower transaction costs as currency conversions are unnecessary 2. Greater price transparency, facilitating price comparisons 3. No exchange rate risks and associate uncertainty costs 4. Greater negotiating and bargaining power in world affairs
Disadvantages of Monetary Union
1. No independent monetary policy 2. No exchange rate policy 3. Limited room for independent fiscal policy 4. Loss of economic sovereignty
Terms of Trade Equation
(Index of export prices / index of import prices) x 100
Terms of Trade
Defined as the ratio of the average price of exports over the average price of imports expressed as index numbers times 100
Causes for a change in terms of trade:
1. Changes in world demand 2. Changes in world supply for a country's exports 3. Changes in exchange rate 4. Changes in relative interest rates 5. Imposing trade barriers improves terms of trade
Consequences of changes in terms of trade
1. Revenue may increase/decrease (of a nation) 2. Depending of elasticity it may increase or decrease revenue 3. Marshall Lerner Condition
IB Economics Section 4: International Economics55 terms