Absolute and comparative advantage

Absolute advantage — a country can produce more of a good with the same resources (it is simply better at it).

Comparative advantage (David Ricardo, 1817) — a country can produce a good at a lower OPPORTUNITY COST than another. This is the one that matters. Its astonishing implication: even a country that is worse at producing everything still gains from specialising in whatever it is least bad at, and trading.

Assumptions (and hence criticisms): the model assumes no transport costs, constant returns to scale, perfect factor mobility within countries, free trade, and it ignores the huge adjustment costs borne by the workers in the losing industry. Over-specialisation also leaves a country dangerously exposed to a demand shock in its one export — the resource curse.

Your turn — opportunity cost

Your turn — the other side of the ledger

Comparative advantage

Terms of trade and competitiveness

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

• An IMPROVEMENT (the index rises) means export prices have risen relative to import prices: each unit of exports now buys more imports. That sounds good — and for a given volume of trade it is.
• But beware. If the improvement is caused by higher export prices, exports may become uncompetitive, and if demand is elastic the volume of exports falls enough to worsen the current account. An improvement in the terms of trade can therefore worsen the trade balance.

International competitiveness has two halves: price competitiveness (relative inflation, unit labour costs, productivity, the exchange rate) and non-price competitiveness (quality, design, reliability, branding, after-sales service, delivery times). Germany's export success rests overwhelmingly on the second — which is why a strong euro has not destroyed it.

Your turn — the terms of trade

Protectionism, trading blocs and the WTO

Protectionism is any policy restricting imports:

• Tariff — a tax on imports. It raises the domestic price, so quantity imported falls, domestic production rises, consumer surplus falls, producer surplus rises, and the government earns tariff revenue (= tariff per unit × the number of units still imported). There is a net welfare loss from the resources misallocated to inefficient domestic producers and the trades that no longer happen.
• Quota — a physical limit on the quantity imported. Same effect on price and quantity, but the extra revenue goes to whoever holds the import licences, not to the government.
• Subsidies to domestic producers, non-tariff barriers (standards, red tape, licensing), and embargoes.

Arguments FOR: the infant industry argument (a new industry needs temporary shelter to reach MES); protecting strategic industries (food, defence, steel); preventing dumping (selling below cost to destroy rivals); protecting jobs in a declining industry while it adjusts; correcting a persistent current account deficit; and retaliation.

Arguments AGAINST: higher prices and less choice for consumers (regressive — it hits the poor hardest); domestic firms shielded from competition become X-inefficient; it destroys the gains from comparative advantage; it invites retaliation and trade wars; and "temporary" protection is never removed — the infant industry never grows up.

Economic integration — the ladder:

• Free trade area — no internal tariffs, but each member keeps its own external tariff.
• Customs union — no internal tariffs plus a common external tariff (so members cannot negotiate their own trade deals).
• Single market — adds free movement of labour, capital and services and common regulation.
• Monetary union — a shared currency and a single central bank (the eurozone): members lose independent monetary policy and the ability to devalue, which is why an asymmetric shock is so painful for a member.
• Economic union — adds harmonised fiscal and economic policy.

Trade creation vs trade diversion. Joining a customs union creates trade when high-cost domestic production is replaced by cheaper production from a partner (a welfare gain). It diverts trade when imports switch from a low-cost non-member (now facing the common external tariff) to a higher-cost member (a welfare loss). Whether a bloc is beneficial depends on which effect dominates.

The World Trade Organisation (WTO) promotes free trade by hosting negotiating rounds, enforcing the most-favoured-nation principle (treat all members alike), and adjudicating disputes. Criticisms: its rounds have stalled for decades; its dispute mechanism has been paralysed; it is accused of serving rich countries' interests (rich countries still protect agriculture, precisely where poor countries have comparative advantage); and it has no power over the bilateral deals that have replaced it.

Your turn — tariff revenue

The effect of a tariff

Trade diversion

Exchange rates, Marshall-Lerner and the J-curve

An exchange rate is the price of one currency in terms of another. Under a floating system it is set by demand and supply of the currency: demand comes from exports, inward investment and speculation; supply from imports and outward investment. Under a fixed system the central bank maintains a rate by buying/selling reserves and adjusting interest rates.

• Appreciation (a floating currency rising) → SPICED: Strong Pound = Imports Cheaper, Exports Dearer. Net exports fall → AD falls; but imported inflation falls too.
• Depreciation → WPIDEC: Weak Pound = Imports Dearer, Exports Cheaper. Net exports rise → AD rises; but imported inflation rises (raw materials and components cost more), shifting SRAS left.

The Marshall-Lerner condition. A depreciation only improves the current account if:

Why? A depreciation raises the volume of exports but reduces the price received in foreign currency, and raises the price paid for imports. If demand is too inelastic, the higher import bill outweighs the extra export volume.

The J-curve. In the short run elasticities are LOW: contracts are already signed, buyers take time to switch suppliers, and firms cannot re-source overnight. So immediately after a depreciation the current account WORSENS (the import bill rises at once while export volumes have not yet responded). Over time, as demand becomes more elastic and Marshall-Lerner is satisfied, the balance improves — tracing a "J" shape.

Evaluation: a depreciation is no free lunch. It raises import costs and therefore cost-push inflation; it removes the pressure on firms to raise productivity and non-price competitiveness (a permanent devaluation strategy is a treadmill); and it makes the country poorer in real terms, because it must give up more exports for each import.

Your turn — an exchange rate conversion

The J-curve

Globalisation

Appreciation

Tariff, quota or non-tariff barrier?

Tap a measure, then tap the type of protection it is.

Match the exchange rate concept to its meaning

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered trade, exchange rates and globalisation from the OCR A-level Economics (H460) specification. Press Finish to see your score.