International Trade

Nations trade with each other, to consume things they cannot naturally produce but need. In the UK, we do not have as much raw materials such as steel that we have used, nor do we grow most fruits, but rely on services(much like the U.S) to sell to the world. Russia has the oil the world needs to make the world function.

Each nation specialises in what they produce best, in an attempt to attain their highest income they can and mutually benefit who they trade with. Here, we study International trade, and what largely defines it.

The Balance of Payments and Exchange Rates

In trade, countries import and export. The Balance of payments is an account of how much money goes in and out of the country for whatever reason, I will bring in the Forex rate later to explain the idea.

The BOP in theory always balances when the exchange rate is ‘floating'(I will explain).It is divided into the current account and the capital account. The current is the most important in the course to know.

The Current Account

This records the flow of money which is income in and out of the country due to importing and exporting. If we export Barratts sweets the the US, then this will be positive in CA, as we recieve an income flow for our good. Likewise, CA will be in deficit if we import more than we export as in exchange there is a net flow of income overseas.(This can affect ‘aggregate demand’, explained in a later area).

The account may be divided into income flows in which are an exchange for something and those which are not. When they’re in exchange for a good or service, then it is the visible section of CA. When income flows which is not in exchange(such as income channeled overseas to family) then its the invisible section.

The Capital Account

This is basically money flows that are not an exchange for goods and services. The main components are foreign direct investment, and portfolio deposits.

 FDI comes under overseas takeovers of firms aswell as paying the capital markets for a factory or an office, which stays there with you’re ownership.

Portfolio deposits is money management. All the overseas payments into bonds, hedge funds and mutuals, derivatives and of course bank accounts.

The Balance of Payments always balances with a Floating Exchange Rate

Lets use $U.S in my explanation. The BOP shows how much money flows in and out of a country. When it is balanced, the amount flowing in equals the amount flowing out.

How the Market Shows Flows..When money flows into the U.S, the Dollar is demanded as foreign exchange so it is useful. When money flows out of the U.S, it will be changed into the abroad currency, and the $ is supplied on the forex market.

Equilibrium Shows Balance: We need to know, that with a floating exchange rate, the price of a currency is defined by simple supply and demand for it, tending to equilibrium. For the Dollar, if there is greater demand than supply its forex rate will rise and vice versa.

If the forex market for $ tends to equilbrium, than the amount $ freed(supplied) = amount $ bought(demanded), and, as $ are freed when money escapes US, and bought to go into US, then money into US=money out of US. Hence balance.

Exchange Rate Changes on Current Account

Why change the exchange rate? A nation’s current account balance is an important part of its government’s focus, it finds a large deficit undesirable. If its consumers import too much, income flows out of the borders in volumes, depressing aggregate demand. Likewise too large a surplus may cause inflationary pressure.

The way a government may combat this is to revalue it’s exchange rate, to change the prices consumers at home face for overseas goods, and the cost of our produce for overseas markets. Due to crises in export demand, the recent recession saw a ‘race to the bottom’ of various currencies.

The J Curve Effect and Marshall Lerner Condition

Lets use the example of devaluation. The current account shows what economists call ‘a J curve’. When devalued, the balance will often worsen slightly, before improving, creating an overall surplus, making a J as shown.

Why Initial Worsening? Buyers and sellers are fairly fixed in their contracts in the short run, and hence the price elasticity of demand for imports and exports is inelastic. Devaluations make imports more expensive, hence more spending on imports when inelastic. Likewise, exports being cheaper mean less overseas spending for us.

Eventual Improvement: Over time, more costly imports will be switched away from and more of our cheaper exports will be in demand.

Why improvement? People are able to choose alternative suppliers and less will be spent on imports, more on exports, improving current account.

Marshall-Lerner Condition. This is the guarantee that current account improves with a devaluation. Imports and Exports need to be both price elastic, which they become after some time for adjustment. With this, we are assured more spending on exports and less on imports with devaluation.

Comparative Advantage Theory

Absolute Advantage: A country has absolute advantage over another when it can make more of one good than another with the same factor inputs(Land Labour Capital Enterprise). Lets assume countries A and B have the same factors, and Wheat and Maize are the two tradable goods. Here, A has Abs Ad over B in Maize, as it can produce more outright.

Comparative Advantage: The great classical Economist David Ricardo explains that nations, to improve living standards of it’s people, need to produce what they are best at by specialising, using his theory of comparative advantage.

Tell me about Comparative Advantage: A country has comparative advantage over another for a good if it need sacrifice less potential output of other goods to produce it.

Comparative Advantage does not always imply Absolute Advantage: The PPF shows this. Although(we are assuming same factors for A and B) country A has Absolute Adv for Wheat, Country B has Comparative Adv for wheat as it does not have to sacrifice so much Maize to make it. If country A exports Maize and B exports Wheat, both will be better off.

Assumptions and Risk of Complete Specialisation

Constant returns: With the model above, we assume the trade off between two goods in constant. Constant returns to scale are needed for total specialisation to be realised, as, diseconomies of scale would make the final stages of specialisation unrewarding and costly.

Demand Conditions are Similar: A country would hardly make life better for it’s citizens if it totally specialised in the production of a particlar good, only to find that an inventor has created a better prototype or a scientist reveals some medical problems with it. Demand must be stable before a country has confidence in following the theory.

Risk: So called monoculture and reliance on export markets for much of it’s income leaves the economy susceptible to total collapse if there is a world downturn, especially if there is a loss in confidence in their sector. Take Iceland, who were ranked 1st in world HDI indexes of welfare due to it’s banking sector. Then the recession came, which saw the collapse of Landsbanki and a huge downturn when what the economy lived on failed.

But Comparative Advantage is Sensible

Example: To make 5000 tonnes of Bananas in Costa Rica has little sacrifice as there is enough spare land and climate. But to do so in UK will have much greater sacrifice as spare land is scarce and that land could be used for what we do best, high rise offices for accountants and consultancy.

Waste of potential, and incomes: Just imagine how much of a waste it would seem having Banana fields in Central London. Due to the huge price of land and vast opportunity cost, bananas from the UK would be very expensive, and for this reason, little demand and output means domestic incomes will shrivel. Hence Costa has Comp Advantage for Bananas.


This is an approach a government takes to protect its own industries by limiting imports, switching demand to domestic firms to keep them trading.

Excessive restrictions are often frowned upon by the World Trade Organistion.

Types of Protectionism


What it is: A tariff is a tax on imports which the government imposes, which increases their price to the domestic consumer. The government successfully goads the consumer to boost domestic firms revenues whilst picking up extra tax reciepts.

Real world tariffs: It is normal, however, for countries to have these, often up to 5% mark up, but Cameroon has a 60% tariff(as of 2006, book I read, which is an obvious example of their extreme and often corrupt government)!

Tariffs can cause a loss in consumer surplus, and allows inefficient firms to enter a market. Also causes less to be traded worldwide, a deadweight welfare loss.

Illustrating the diagram: Lets call this the market for steel in the UK. The world can supply with perfect elasticity due to the sheer volume it trades. As their costs are cheaper, most world supply is chaper than domestic supply could be, so the consumer buys little steel from domestic firms.

If the government wants to protect UK steel, it will tariff imported steel so that import price is higher (S-tariff, shifted up). Now, we can see more domestic firms can now compete with the more expensive imports(mpore S-domestic). Domestic producers are ‘protected’.


What is a quota? Here, the government restricts the amount of imports into a countries, by setting a maximum number that can be imported per year. On market prices faced, it has the same effect as a tariff, less traded at a higher price.

How it protects domestic firms: Domestic firms are protected in a similar way. Instead of the government artificially marking up the price, it is left to the market mechanism through making the product scarcer. More expensive world supply means more home firms can compete again. Quotas can range from an outright ban to whatever number max.

Embargoes are complete bans on trade, be it for a certain good, or imports from a certain country. The latter only tends to occur when countries are at war, for which it is illegal to trade withy the enemy.

Criticisms of protecting from imports

Inefficiency: Due to an artificial mark up, inefficient firms who would not otherwise be in the market are trading. It does not encourage us to make what we do best, as if our consumers would rather buy certain goods from overseas than here, than they are obviously better than us at making those goods, and we are not maximising output and incomes with the rescources we have.

Loss in Consumer Surplus: It can be seen that consumers do not benefit from it either, as the prices of imports rise, causing also home produced goods to rise aswell as home firms often have to buy imports somewhere along the way to make what they make.

Loss In Export Demand and International Tensions. By restricting imports, we are restricting overseas firms from an export market, meaning that economies such as China, and any other economy which specialises are less willing and able to consume our exports.

Less able as much demand for their produce is restricted, reducing their incomes and consumption. Less willing due to political tensions it could create.

Benefits of Protectionism

Self Sufficiency: If we rely less on other economies, it becomes clear that our economy can produce everything domestic consumers need. In this case, we have little reliance on matters which are out of our own hands, and we become in control of our own fate.

Diversifying Risk: If an economy specialises, which it needs to with open barriers, then it puts it’s economy at risk of severe recession if demand or productive capacity collapses. Allowing other industries into a market avoids this risk.

More Stability When an economy is insulated from the rest of the world, it will not be susceptible to bouts of cost push inflation on imports. There will be no surge in structural unemployment because overseas can produce it better. GDP and inflation are likely to be much more stable.

Exploitation is Avoided. The economies which begin to specialise and open their barriers are likely to do this for development, implying they are less developed. Dependency and Strategic Trade theory suggests that any benefits of comparative advantage of such an economy may be eroded by unfair trade terms, which can result from an increasing reliance on imports and overseas demand.

Trade related theories: Nations rich and poor….

Strategic Trade Theory

Created by the currently active Paul Krugman. It argues that poor economies have little chance of building up their industries because the WTO will not allow them trade barriers, even though MDC’s benefitted from protectionism when they industrialised. The G8 economies have the biggest say in world trade, perhaps at the expense of the third world in the past.

Heckscher-Ohlin Theory:

About a century ago, this looked for trends between factors of production ratios and wealth of countries. It summed up that richer nations tend to use higher levels of capital per person, and poorer lower capital levels, to make their goods.

This was certainly true over the last 200 years, where the UK and US had their industrial revolutions and productive technology, whereas poorer nations were more labour intensive(farming, irrigation, fishing etc).

Recently, however, the richest have tended to labour intensive again, with our legal, financial(and more) personal services making most of our GDP.

Dependency Theory

That we have got the better end of the deal with poor countries in trade, as they are desperate for any income they can get for their goods, aswell as aid. This has caused the gap between richer and poorer nations to widen, as we ‘give them dishes for their platters'(using their often immense natural rescources).


One Response to International Trade

  1. Pingback: Thinktank « Zahablog's Economic Page

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