Trade & the Global Economy

Why do countries trade at all? The answer is comparative advantage. This sub-theme covers the theory of trade, the terms of trade, trading blocs, and the case for and against protectionism.

🎯 Learning objectives — by the end of 4.2 you can…

- distinguish absolute and comparative advantage and identify CA from data; - calculate the terms of trade and explain what shifts them; - explain trading blocs, trade creation and trade diversion; - analyse protectionism and draw a tariff diagram.

4.2.1 Comparative advantage

Spec: 4.2.1

Absolute advantage means a country can produce more of a good with the same resources. Comparative advantage means it can produce a good at a lower opportunity cost. The key insight: countries should specialise where they have a comparative advantage and trade — and both gain, even if one is better at making everything.

Worked example — finding comparative advantage

| Output per unit of resource | Wheat | Cloth | | --- | --- | --- | | Country A | 60 | 30 | | Country B | 20 | 40 |

Opportunity costs: In A, 1 wheat costs ½ cloth (and 1 cloth costs 2 wheat). In B, 1 wheat costs 2 cloth (and 1 cloth costs ½ wheat).

A's opportunity cost of wheat (½ cloth) is lower → A specialises in wheat. B's opportunity cost of cloth (½ wheat) is lower → B specialises in cloth. They then trade and both end up with more of both goods than they could alone.

Key terms

Assumptions & limitations

- Assumptions: two countries and two goods, no transport costs, constant returns to scale, factors mobile within a country, no trade barriers. - Limitations: transport costs, the assumptions are unrealistic, the risk of over-specialisation, and ignored externalities can all weaken the conclusion.

4.2.2 Patterns & terms of trade

Spec: 4.2.2

Patterns of world trade shift over time because of the rise of emerging economies, changes in comparative advantage, the growth of trading blocs and bilateral deals, changes in relative exchange rates, and changes in protectionism.

The terms of trade measure the rate at which a country's exports exchange for its imports:

$$\text{Terms of trade} = (\text{index of export prices} \div \text{index of import prices}) \times 100$$

Worked example

If the export price index is 110 and the import price index is 100, the terms of trade = (110 ÷ 100) × 100 = 110 — an improvement, because each unit of exports now buys more imports.

Key terms

What moves the terms of trade — and why it matters

- Influences: relative inflation rates, relative productivity, relative labour costs, the exchange rate, and import/export prices. - Impact: an improvement helps living standards (cheaper imports) but its effect on export revenue depends on PED — if export demand is elastic, dearer exports can cut total revenue and worsen the trade balance.

4.2.3 Trade liberalisation & trading blocs

Spec: 4.2.3

The World Trade Organization (WTO) promotes trade liberalisation — lowering barriers and settling disputes. Countries also form trading blocs, which deepen in stages:

Key terms

Trade creation vs trade diversion

- Trade creation (a gain): switching from a high-cost domestic producer to a lower-cost member producer once internal tariffs go. - Trade diversion (a loss): switching from a low-cost non-member to a higher-cost member, because the external tariff makes the efficient outsider dearer.

Blocs also bring economies of scale, lower transaction costs and free factor movement — but regional deals can conflict with the WTO's goal of global free trade.

4.2.4 Protectionism

Spec: 4.2.4

Governments restrict free trade to protect infant and geriatric (declining) industries, safeguard employment and national security, prevent dumping (foreign goods sold below cost), correct a current account deficit, or raise revenue. The main tools are tariffs (taxes on imports), quotas (quantity limits), non-tariff barriers (regulations/standards) and subsidies to domestic producers.

Evaluation — impact of protectionism

Consumers face higher prices and less choice; domestic producers are shielded but may become inefficient; governments gain tariff revenue. It can protect jobs short-term, but invites retaliation and lower global efficiency. Whether it is justified depends on whether the industry is genuinely infant (temporary) or just uncompetitive.

4.2 Recap — nail these

Comparative advantage = lowest opportunity cost; specialise & trade and both gain.
Terms of trade = (export prices ÷ import prices) × 100; effect on revenue depends on PED.
Blocs: free-trade area → customs union → common market → monetary union; trade creation vs diversion.
Protectionism (tariffs, quotas, subsidies) protects some but causes a deadweight loss and risks retaliation.