AS Level Economics 9708

6. International economic issues

Written by: Adhulan Rajkamal
Formatted by: Adhulan Rajkamal

Index

6.1 The reasons for international trade
6.2 Protectionism
6.3 Current account of the balance of payments
6.4 Exchange rates
6.5 Policies to correct imbalances in the current account of the balance of payments

6.1 The reasons for international trade

Different countries have difference factor endowments → affects the types, quality and quantity of products produced – also affects cost of production
Factor endowments → The availability and quality of capital, enterprise, land and labour

Absolute advantage

Definition: The ability of a country to produce more of a good using the same amount of resources
Focus: Productivity (who can produce the most)
Example: If Country A can produce 10 cars and Country B can produce 6 cars with the same resources, Country A has an absolute advantage in car production

Comparative advantage

Definition: The ability of a country to produce a good at a lower opportunity cost than another.
Focus: Opportunity Cost (what is given up to produce a good)

🔥 Calculating opportunity cost

$$\text{Opportunity cost of 1 Good X} = \frac{\text{loss of Good Y}}{\text{gain of Good X}}$$

This value tells us how much of Y has to be given up to produce 1 unit of X

Key Idea: Countries should specialize in the good where they have a comparative advantage and trade for the other.
Eg: Opportunity costs:
- Country A: 1 car = 2 computers.
- Country B: 1 car = 0.5 computers.
- Country B has a comparative advantage in cars because it gives up fewer computers (0.5 < 2)
Trade Principle: Specialize in the good with comparative advantage → Mutual Gains through trade and efficient resource allocation
- Increased world output and employment
- Raises standard of living globally

🔥 Steps to determine mutual benefit

Step 1: Calculate opportunity cost for both countries
Step 2: Identify the exchange rate
Step 3: Compare the exchange rate with opportunity costs
- Trade is beneficial if the exchange rate lies between their opportunity costs

Benefits of specialisation and free trade (trade liberalisation)

Free trade → Exchange of goods and services across national borders without any government restrictions
Free trade allows countries to specialize based on comparative advantage
Competition from free trade → pressure for firms to keep prices low, improve quality, and be highly efficient
- Firms will be able to buy capital goods and raw materials at lower costs (competition in those markets too)
Firms can produce larger output when they have access to international markets → economies of scale
Consumers will have greater variety of goods and services to choose from; firms have a wider source of raw materials and capital goods

Trading possibility curve

Definition → A diagram that shows the combination of two goods a country can consume after engaging in international trade, which lies beyond its PPC
Note: Trading possibility curve illustrates that while a country cannot produce outside its PPC, international trade can allow it to consume outside its PPC

Note: Elsewhere and Overthere are countries

Terms of trade

Measurements of the terms of trade

Terms of trade → Measure of the ratio of export and import prices

🔥 Calculating terms of trade index

$$\text{Terms of trade index} = \frac{\text{index of export prices}}{\text{index of import prices}} \times 100$$

Ratio calculated from the average prices of many goods and services that are traded internationally
The prices are weighted based on their relative importance

Terms of trade index increases → favourable movement/ improvement; fewer exports have to be sold to buy any given quantity of imports
Terms of trade index decreases → unfavourable movement/ deterioration

Causes of changes in the terms of trade

Favourable change → rise in exports prices relative to import prices
Causes of changes in price → demand for and supply of exports and imports
Increase in demand for exports (and/or) rise in relative inflation → rise in prices of exports → favourable change in terms of trade
Devaluing a currency → deliberate deterioration of terms of trade to make exports more internationally competitive

Impact of changes in terms of trade

Though rise in terms of trade → favourable movement; the impacts of a favourable movement may not always be beneficial
Effect of the movement will depend on its cause
- Due to rise in demand → beneficial as more products will be sold
- Due to higher relative inflation → lesser products will be sold (less competitive in the international market)
Unfavourable movement in terms of trade → may reduce current account deficit
- If demand for exports and imports are elastic, a relative fall in export prices will result in relative increase in export revenue to import expenditure
Note: Terms of trade is a measure of import and export price – do not confuse with balance of trade

Limitations of the theory of absolute and comparative advantage

They do not provide the full explanation for the pattern of international trade
- Some governments want to avoid overspecialisation
- High transport cost may offset the comparative advantage
- The exchange rate may not lie between the opportunity cost ratios
- Governments may impose trade restrictions
Theory of comparative advantage also assume that resources are mobile
Countries do not adapt to changes in comparative advantage
Difficult to determine where a country’s comparative advantage lies

6.2 Protectionism

Definition → Protecting domestic producers from foreign competition. It involves the restriction of free trade

Tools of protection

Tariffs

Tariffs (custom duties) → Taxes usually in imports; sometimes on exports
- Decreases consumption of the good, but increases domestic production
- Can be: specific → fixed sum per unit (or) ad valorem → % if the price
- Import tariffs used to discourage imports and raise tax revenue

Video to understand the graph → Protectionism

🔥 Evaluation points

Tariff will be more effective in raising revenue if demand for imports is price inelastic however it will be more effective in protecting domestic industry if PED of imports is elastic
A tariff may not boost domestic price competitiveness if it remains below domestic prices or if importers absorb the tariff without raising prices

Export tariffs
- May be imposed to raise revenue – if demand for export is inelastic, low effect on demand
- To ensure adequate supply of the product in domestic market
- Also acts as a form of protectionism if imposed on export of raw materials (raw materials are cheaper for local producers than international producer)

Import quotas

Limit on imports
Restricting the supply of imports → drive up prices
- Disadvantages consumer
- Sellers will receive the extra price
Do not raise revenue for government (usually) – however, government may sell licenses to firms for an allocation of the quota
Export quotas may also be imposed

Export subsidies

Subsidies given to both exporters and domestic firms that compete with imports
The losers will be foreign firms and domestic taxpayers
Domestic producers will gain
In the long run, more efficient firms may be driven out of business and subsidised firms will raise their prices

Other tools

Embargoes → Complete ban on the import of a particular good or on trade with a particular country
Voluntary export restraints → A limit placed on the imports reached with agreement of the supplying country
Red tape (Excessive administrative burdens) → Force importers to fill out long and lengthy forms; or set artificially high quality standards
Exchange control → Restrictions on the purchase of foreign currency
- Instead of limiting imports directly, the amount of foreign exchange that can be purchased is limited

The arguments for protectionism

To protect infant (sunrise) industries
- Trade restrictions may help new industries grow, achieve efficiency (economies of scale) and comparative advantage, but it’s hard to predict their success or cost structures
- Risks: Industries may become reliant on protection, reducing incentives to lower costs as foreign competition is artificially limited
To protect sunset industries
- If industries that have lost their comparative advantage go out of business quickly → sudden and large rise in unemployment
- Protection given and gradually removed – large rise in unemployment avoided
- Risk: Sunset industry may resist gradual reduction in protection. Can create inefficiency and harm other industries, e.g., tariffs to help steel industry raise car production costs

🔥 Examples (India)

Sunrise industries of India → Renewable energy, Electrical Vehicle (EV)
Sunset industries of India → Textiles and jute (excessive international competition from Bangladesh, China, and Vietnam), coal mining (transition towards renewables)

To protect strategic industries (Eg: Food, weapons, fuel, etc.)
To prevent dumping
- Selling products in a foreign market at below their cost of production
- In the short run – home consumers will benefit from dumping
- In the long run – foreign firms gain a monopoly, and may raise prices
To improve terms of trade
- If the home country is a major source of demand → imposing trade restrictions → reduces demand significantly → forcing prices down → favourable movement in terms of trade
- If home country is a major supplier → imposing export restrictions → prices rise → increases the purchasing power of exports
- However, such actions distort trade, reduce global output, and may provoke retaliation
To improve balance of payments
- Trade restrictions only provide a short-term boost to the current account
To provide protection from cheap labour

Arguments against protectionism

Lowers global output and therefore living standards
Reduced international competition → higher prices and reduced quality
Reduced choice of products for consumers
Lower market sizes for firms → cannot take advantage of economies of scale
Reduce firms’ choice of raw materials and capital goods → may increase cost of production

6.3 Current account of the balance of payments

Balance of payments → Record of all economic transactions between the residents of that country and residents in other countries
- Balance of payments account consists of → Current account, capital account, and the financial account
Money coming into the country → credit item → +ve sign
Money going out → debit item → -ve sign

Components of the current account of the balance of payments

Trade in goods: refers to the exports and imports (exports → credit item; imports → debit item)
Trade in services: Refers to the exports and imports of services (also known as invisibles); Eg: shipping, tourism, banking and insurance
Primary income: Includes income from profits, interest and dividends earned on direct investment abroad (credit item) and foreign earnings from investment in the home country (debit item)
- Also includes employees’ compensation → wages earned by the home country’s residents temporarily working in other countries
Secondary income: Includes payments and receipts for which there is no corresponding exchange of an actual good or service. It includes:
- Financial aid given or received
- Remittances (money sent back by individuals working in a foreign country permanently – more than a year – to their relatives in the home country)

Imbalance in the current account

Imbalance → debit items is not equal credit items
- Credit items (receipts) > debit items (payments) → Current account surplus (+ve balance)
- Debit items > credit items → Current account deficit (-ve balance)

🔥Fun fact

The sum of the current account balances of all countries will be equal to 0!

Current account balance calculation

Find the balance of trade in goods: Exports = $900m, Imports = $1200m → –$300m (deficit)
Find the balance of trade in services: Exports = $160m, Imports = $100m → +$60m (surplus).
Calculate the balance of trade in goods and services:
Add the balance of trade in goods and the balance of trade in services
–$300m + $60m = –$240m.
Calculate the current account balance:
Balance of primary income = +$70m
Balance of secondary income = +$45m
Combine the total trade balance, primary income, and secondary income
–$240m + $70m + $45m = –$125m

Causes of imbalances in the current account

A growing domestic economy: Demand for raw materials and capital equipment from abroad is high; output may be directed to the domestic market rather than the international market
- This current account deficit is only in the short-run
- Self-correcting
Declining economic activity in a country’s trading partners: The import expenditure of foreign countries will reduce
- Deficits occurring due to changes in economic cycles of foreign or domestic economy → cyclical deficit
- Short-term
Structural problems: Deficit lasting in the long run – dangerous
- Indicates that domestic firms are not internationally competitive
  - Overvalued exchange rate
  - High relative inflation rate
  - Low labour and capital productivity
- Not self correcting
Note: Consider the opposites for current account surplus

Consequences of imbalances in the current account

Current account deficit allows residents to consume more value of products than the country produces → this deficit has to be financed by borrowing or by attracting investment
Increased current account deficit → fall in AD → reduced economic growth and increased unemployment
Current account surplus means residents are not enjoying as high a living standard as possible
- Increased AD and money supply → inflationary pressure

6.4 Exchange rates

Exchange rate → the price of one country in terms of another currency
Floating exchange rate → Exchange rate that is determined by the market forces of demand and supply
- Currencies are bought and sold in the foreign exchange market → made up of financial institutions that buy and sell foreign currency on behalf of private and business customers
Reasons why currency traders buy domestic currency (opposite for sell):
- Purchase goods and services from the country
- Invest in the country
- Speculate on making a profit if the value of the currency should rise in the future
Depreciation → Fall in the international price of a currency caused by market forces
Note: Use demand-supply diagrams to show appreciation and depreciation

Causes of changes in a floating exchange rate

Changes in demand and supply of a currency
Demand increases if:
- High value of exports
- Improvement in country’s economic prospects → foreign investments in assets (eg: shares)
- Relatively high interest rates → foreigner would want to save in domestic banks (this short-term movement of money → hot money flows)
- Speculation about future interest rate and exchange rate
Note: Higher demand for one currency is simultaneous with higher supply of another

Impact of exchange rate changes on the domestic economy

Depreciation

Exports cheaper and imports more expensive → domestic firms can sell more at home and abroad → increased output → increased employment
Rise in net exports → increases AD → may result in a rise in national income

Higher AD → inflationary pressure
- Finished imported products that are still purchased → will count in the CPI
- Cost of production increases price of imported raw materials rise
Opposite for appreciation
- It will cause a fall in inflationary pressure (rate of inflation decreases) since AD decreases

Instead of AD1 the AD rises to AD2 due to appreciation leading to a fall in net exports

- Inflationary pressure also reduces to a right-ward shift in supply → imported raw materials become cheaper hence lower cost of production

6.5 Policies to correct imbalances in the current account

Governments seek balance of payments stability → money entering = money leaving
If export revenue = import expenditure → no international debt and good standard of living
In the short-run, deficit arising from high imports of raw materials and capital goods is healthy
Government may seek a surplus to pay off external debt
To judge the extent of imbalance → view surplus/ deficit as a % of GDP

Effect of fiscal policy

To correct deficit arising from excessive imports → contractionary fiscal policy
- Lowers domestic and import demand → firms are pressured to increase exports to sell stock
Fiscal policy measures → short-term solutions
- Once policy measures are stopped → back to old spending patterns
- Also have adverse side effects

Effect of monetary policy

Monetary policy to correct current account: Complex approach
Low inflation + current account deficit: Central bank may lower interest rates → Depreciates exchange rate → Boosts export competitiveness
Higher interest rates: Reduces consumer spending → Lowers import demand but may appreciate exchange rate, offsetting import reduction
Long-term ineffectiveness: Fails to address structural weaknesses (e.g., low productivity)
No impact on strengths: High innovation or ownership of scarce resources remains unaffected

Effect of supply side policy

May reduce deficit → domestic products more price competitive; domestic markets more attractive to invest in
Spending on education and subsidies→ more skilled labour force and better capital equipment → reduces relative price of domestic output and increases quality → increased exports
Trade union reform → Increases flexibility for domestic firms, improving responsiveness to demand changes; more appealing to MNCs
Long-term potential to reduce deficits but may not address short-term imbalances or surpluses effectively

Effect of protectionist policy

There must be close substitutes to imported goods produced locally
Tariffs against trading partners in a trade bloc → not possible
Imposing tariffs has 2 risks:
- Provoke retaliation
- Reduces pressure on domestic firms to become more efficient