Reasons / Benefits to trade
- To gain from international specialization (absolute/comparative advantage - discussed below)
- Increased output
- Lower prices
- Greater efficiency
- To gain from international economies of scale
- To gain from increased variety of goods and services
- To gain from increased globalization and communication
- Leads to research and development
- To reduce international tensions (vested interests)
- To increase export revenue / sell to larger markets
Entering world trade
When a country enters into trade with the world, it will find that its domestic prices may be different to prices on the world market.
Because the world market for most goods and services is so big, we draw it as being perfectly elastic. What this means is that we have no power over it and must accept the price that is offered by it.
Only a few countries have real market power over internationally traded goods, and for that reason we assume world supply to be perfectly elastic in most cases - whatever we do domestically does not influence the enormous international supply.
As a result, world price is the same as world supply (that is to say, if we increased supply - a shift downwards - we would thus reduce price)
Scenario 1: World Price is Lower than Domestic Price
If a country entered into trade and found that world price was lower than domestic price, then this would mean they cannot compete on the world market.
Consumers will now buy the cheaper foreign goods instead of the more expensive domestic goods.
As a result, the domestic producers will be forced into closing. Only those that can compete (the portion of the supply curve below world price) will stay in business.
However, at world price, demand exceeds domestic supply. To satisfy this demand the excess must be imported.
Scenario 2: World Price is Higher than Domestic Price
If a country entered into trade and found that world price was higherthan domestic price, then this would mean they have an advantage on the world market.
They thus have 2 choices: either they can satisfy all of the domestic demand at the current prices OR they can decide to increase their prices and sell on the world market.
Clearly, the second choice would create more revenue (dependant on elasticities) so they therefore raise prices to where world price is.
At this price some domestic consumers decide not to buy the product (contraction in demand) but there is an extension in supply. This excess supply is thus sold on the world market.
Regulating Trade:
The World Trade Organisation
Objectives:
Absolute Advantage
Comparative Advantage
Calculating Comparative Advantage
Types of Protectionism
1. Tariffs
These are the most common form of protectionism. They are essentially a tax on imported goods and services per unit.
Effects:
- Increase in price / fall in world supply
- Loss of consumer surplus
- Reduction in imports
- Increase in government revenue (if government is importing)
- Increase in domestic producer surplus
- Extension of domestic supply
2. Subsidies
If a government subsidizes domestic firms this makes their costs of production lower and thus they are able to produce more at a lower price. This has the effect of shifting the domestic Supply curve outwards.
Effects (considering it is a fairly small subsidy):
- No price change
- No change in consumer surplus
- Reduction in imports
- Loss of in government revenue (through subsidy) but gain through less imports
- Increase in domestic supply
3. Quotas
If a government decides to limit the physical amount of goods/services entering its country, this would be a quota.
If domestic price is higher than world price and a quota is imposed, the quota will act as a 'fake' domestic supply. For example, if Nigeria was importing 100 000 TVs from the USA at $100 per unit, and Nigeria put a quota of 50 000 TVs then the USA would have a choice. Either they could sell all of their TVs at $100 as before, or they could sell at the higher domestic price.
Clearly they would choose to do this (as they know all of their TVs will sell since there is excess demand for them). This decision makes the quota part of domestic supply, causing a new equilibrium to be found (lower than previous domestic equilibrium but higher than previous world equilibrium).
Effects:
- Higher prices for consumers
- Loss of consumer surplus
- Reduction in imports
- No change in government revenue
- No change in real domestic supply
4. VERs
If a government decides to voluntarily limit the physical amount of goods/services it is exporting this would be a voluntary export restraints. They have the same effect as a quota.
Effects:
- Higher prices for consumers
- Loss of consumer surplus
- Reduction in imports
- No change in government revenue
- No change in real domestic supply
Reasons for Protectionism
- To protect against dumping
- To protect 'infant industries'
- To protect 'sunset industries'
- To reduce the budget deficit
- To encourage self-sufficiency
- Political reasons
- To encourage diversification
- Strategic trade policy
- To boost domestic employment
Reasons against Protectionism
- Loss of consumer surplus in all cases (aside from subsidies)
- Encouragement of inefficiency
- Lack of choice for consumers
- Potential for retaliation
- Restriction to benefits of specialisation
- Worsening income inequalities
Reasons for Free Trade
These are essentially the benefits of international specialization
- Benefits of absolute and comparative advantage
- Increased output
- Lower prices through economies of scale
- Allocative efficiency
- Increased variety of goods and services
- Increased economic globalisation
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