Calculate advantage
Use opportunity cost to distinguish absolute advantage from comparative advantage and identify the basis for specialisation.
International Trade and Protectionism
International trade allows countries to specialise, exchange goods and services and widen consumption possibilities. This chapter explains why trade can create gains, why those gains are not always distributed evenly, and why governments sometimes restrict trade to protect domestic producers.
Absolute advantageComparative advantageTerms of tradeFree tradeTariffs & quotasProtectionism
What this chapter prepares you to do
Explain gains from trade
Show how specialisation and exchange can allow consumption beyond a country's own production possibility curve.
Interpret terms of trade
Calculate a terms-of-trade index and explain why changes in relative export and import prices matter.
Evaluate protectionism
Analyse tariffs, quotas, embargoes, export subsidies and non-tariff barriers, including their effects on consumers, producers and welfare.
High-grade habit: when answering a trade question, separate the potential gain from specialisation from the question of who receives that gain. Comparative advantage can create scope for mutual benefit, but the terms of trade, market power and policy barriers affect the final outcome.
Chapter sections
12.1
The reasons for international trade
Countries trade because they differ in resources, climate, skills, technology and productive efficiency. Trade can widen consumer choice, open new markets for producers and allow countries to specialise in activities in which their relative efficiency is greatest.
Absolute advantage and comparative advantage
Absolute advantage
The ability to produce a good more efficiently than another producer, for example by using fewer resources or less labour time.
Comparative advantage
The ability to produce a good at a lower opportunity cost than another producer.
Law of comparative advantageTotal output can increase when individuals or countries specialise in goods and services in which they have a comparative advantage and then trade.
Worked example — opportunity cost:
Suppose Country A can produce either 40 units of wheat or 20 machines, while Country B can produce either 30 units of wheat or 30 machines.
- Country A gives up 2 wheat for each extra machine, so the opportunity cost of 1 machine is 2 wheat.
- Country B gives up 1 wheat for each extra machine, so the opportunity cost of 1 machine is 1 wheat.
- Country B therefore has the comparative advantage in machines.
- Country A gives up 0.5 machine for each wheat, compared with 1 machine in Country B, so Country A has the comparative advantage in wheat.
Absolute advantage is not the deciding test. The key question is which country has the lower opportunity cost.
Easy book example — Ali and Ayesha: Ali can make either 12 pots or 12 bracelets, while Ayesha can make either 18 pots or 36 bracelets. Ali's opportunity cost of 1 pot is 1 bracelet. Ayesha's opportunity cost of 1 pot is 2 bracelets. Ali therefore has the comparative advantage in pots, while Ayesha has the comparative advantage in bracelets, even though Ayesha has an absolute advantage in both. This is why comparative advantage, not absolute advantage, determines the potential gains from specialisation.
Exam warning: a country can have an absolute advantage in producing both goods and still gain from trade. What creates the basis for specialisation is a difference in comparative advantage.
Specialisation, trade and consumption possibilities
Without trade, a country is limited to consumption combinations on or inside its own PPC. With specialisation and mutually beneficial exchange, its consumption possibilities can extend beyond its domestic PPC.
Trading possibilities for Overthere and Elsewhere
The two countries have different opportunity costs, shown by the slopes of their PPCs. After specialising according to comparative advantage and trading at a mutually beneficial exchange ratio, consumption can take place beyond each country's own production possibility curve.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Conditions for mutual gain
For both countries to gain, the rate of exchange must lie between their opportunity-cost ratios. The exact exchange ratio determines how the gains from trade are shared.
Chain: different opportunity costs → comparative advantage → specialisation → higher combined output → trade → wider consumption possibilities.
Benefits — and risks — of specialisation
| Potential benefit | Why it may occur |
|---|---|
| Greater total output | Resources are concentrated where opportunity cost is relatively low. |
| Greater consumer choice | Imports make goods and services available that may not be produced domestically. |
| Access to larger markets | Exporters can sell beyond the domestic economy and may exploit economies of scale. |
| Competitive pressure | Exposure to foreign competition can encourage firms to improve quality and efficiency. |
Specialisation also creates risks. A country may become dependent on imports of strategically important goods, or overdependent on a small range of exports whose world prices can change sharply.
Terms of trade
The gains from trade depend partly on the prices at which exports exchange for imports. The terms of trade compare export prices with import prices.
Terms of trade indexExport price index ÷ Import price index × 100
Easy example — interpreting a terms-of-trade index: If the export-price index is 126 and the import-price index is 120, the terms of trade are 126 ÷ 120 × 100 = 105. Compared with a base of 100, export prices have risen relative to import prices. This means a given volume of exports can purchase a larger volume of imports than at the base date.
Worked calculation:
If the export price index is 126 and the import price index is 120:
Terms of trade = 126 ÷ 120 × 100 = 105.
Relative to the base period, the terms of trade have improved. The same volume of exports can purchase a greater volume of imports than before.
Improvement
Export prices rise relative to import prices. A given volume of exports can purchase more imports.
Deterioration
Import prices rise relative to export prices. A given volume of exports can purchase fewer imports.
Do not confuse: the terms of trade concern relative export and import prices. The balance of trade concerns the value of exports relative to imports.
The textbook also distinguishes the net barter terms of trade from the income terms of trade. The net barter measure uses relative prices only. The income terms of trade also reflect the value or volume of exports and therefore give a broader indication of the purchasing power of export earnings.
Important qualification: a deterioration in the price-based terms of trade does not automatically prove that a country is worse off. Export volumes may rise enough to offset less favourable relative prices.
Limitations of the theory of absolute and comparative advantage
The basic theory shows potential gains, but actual trading conditions are more complicated. The pattern of comparative advantage can be influenced by a country's relative factor endowments. A labour-abundant economy may initially have an advantage in labour-intensive production, while a capital-abundant economy may be better placed in capital-intensive production.
Short-run volatility of primary-product prices
Agricultural supply can change substantially because of weather and harvest conditions, while demand for many food products is relatively price inelastic. Small supply changes can therefore cause large price movements. For minerals and raw materials, demand may fluctuate with the economic cycle in importing economies. In both cases, export prices and export earnings can be unstable.
Volatility in supply
A poor harvest shifts supply left and can cause a large rise in the world price of a primary product when demand is relatively price inelastic. A good harvest does the reverse. This helps explain unstable export prices for countries dependent on agricultural commodities.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Volatility in demand
For minerals and raw materials, supply can be relatively stable while demand changes with the economic cycle in importing countries. Stronger demand raises both equilibrium price and quantity, while weaker demand can sharply reduce export prices and earnings.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Why export instability matters
If a country depends heavily on commodity exports, unstable prices make export earnings uncertain and can make development planning more difficult.
Long-run deterioration
Demand for many primary products may grow relatively slowly as world incomes rise. Demand for agricultural goods often has a low income elasticity, while artificial substitutes and more efficient technology can weaken demand for some raw materials. If supply also expands, relative prices may fall over time.
Long-term movements of demand and supply
If supply of primary products expands faster than demand over time, the equilibrium price can fall even while output rises. For a country dependent on these exports, this can contribute to a long-run deterioration in its terms of trade.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Market power and diversification
Small exporting economies may have little power over prices set in world commodity markets and may compete against experienced producers from high-income economies. This can weaken their ability to capture the gains from trade. Countries may therefore seek to diversify and develop new specialisms rather than remain dependent on a narrow range of primary exports.
Evaluation: comparative advantage is a powerful explanation of why trade can create gains, but it does not guarantee stable export earnings, favourable terms of trade or an equal distribution of those gains.
12.2
Protectionism
Protectionism means measures taken by a country to restrict international trade and shelter domestic producers from foreign competition. Governments may protect industries even though free trade can offer lower prices, wider choice, larger markets and stronger competitive pressure.
Tariffs
TariffA tax imposed on imported goods.
With free trade, an imported good may be available at the world price. A tariff raises the domestic price above the world price. Domestic demand falls, domestic supply rises and the quantity imported falls.
The effects of a tariff
A tariff raises the domestic price above the world price. Domestic production expands, domestic consumption contracts and imports fall. Domestic producers and the government gain some surplus or revenue, but consumers lose and the two welfare-loss triangles represent an overall efficiency cost to society.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
| Group | Likely effect of a tariff |
|---|---|
| Consumers | Pay a higher price, consume less and lose consumer surplus. |
| Domestic producers | Receive a higher price, sell more and gain producer surplus. |
| Government | Receives tariff revenue. |
| Society | Faces a net welfare loss because some mutually beneficial trade is prevented and inefficient domestic production is encouraged. |
Tariffs may also delay structural change and weaken incentives for protected firms to improve efficiency. Retaliation by trading partners can lead to a trade war in which the gains from trade are reduced for all sides.
Quotas
QuotaA quantitative restriction that limits the amount of a good that may be imported.
A quota reduces total supply available in the domestic market, pushes the domestic price above the unrestricted world price and reduces consumption. Domestic producers gain from the higher price. Unlike a tariff, however, the importing government does not automatically receive tariff revenue; the benefit created by the higher price on the permitted imports may accrue to foreign exporters.
The effects of a quota
A quota restricts the quantity of imports and raises the domestic market price. Domestic producers expand output and consumers buy less. Unlike a tariff, the extra return on the permitted imports can accrue to foreign exporters rather than to the home government.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Easy comparison — tariff versus quota: Both can reduce imports and raise the domestic price. With a tariff, the home government receives tax revenue on each imported unit. With a quota, the higher price on the restricted imports may instead create a gain for the foreign suppliers who are allowed to sell into the market. That difference is central when evaluating who gains and who loses.
Tariff vs quota: both restrict imports and tend to raise the domestic price, but the distribution of the financial gain differs. With a tariff, the government receives revenue; with a quota, quota rents may go to foreign producers.
Embargoes
An embargo prohibits trade in specified goods or with specified countries. It may be imposed because a product is considered undesirable or as part of political sanctions. A possible side effect is the encouragement of smuggling or other unofficial trade.
Export subsidies
A government may subsidise domestic producers so that they can expand output and compete more effectively with imports or in export markets. Domestic production rises and imports can fall, while consumers may still buy at the world price.
The effects of an export subsidy
A subsidy encourages domestic producers to expand output while consumers can still buy at the world price. Imports fall, but the subsidy must be financed by the government and can support production that would otherwise be uncompetitive.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Evaluation: the subsidy has to be financed from public funds. It may support inefficient production, distort resource allocation elsewhere in the economy and weaken incentives for firms to become genuinely competitive.
Non-tariff barriers
Non-tariff barrierAn obstacle to free trade other than a tariff, such as product standards, administrative rules or other regulations that make importing more difficult or costly.
Some regulations have legitimate purposes, such as protecting health or the environment. Others may function mainly as trade restrictions. Complex standards and administrative requirements can be particularly difficult for producers in less developed countries to meet.
Arguments used in favour of protection
Strategic industries
A country may want to preserve sectors considered essential for national security or self-sufficiency, such as food production.
Anti-dumping
Protection may be argued for where foreign firms sell at unfairly low prices, perhaps because they benefit from export subsidies.
Sunset industries
Temporary protection may reduce disruption and unemployment while workers move out of industries in long-term decline.
Infant industries
New industries may be protected temporarily while they gain experience, improve efficiency and become able to compete internationally.
DumpingA situation in which imported goods are sold at very low prices, for example below marginal cost or with support from export subsidies, placing domestic producers at a competitive disadvantage.
Central problem: temporary protection can become permanent. Infant industries may never become competitive, and sunset industries may remain dependent on government support rather than adjusting.
Overall impact of protectionism
| Area | Possible effect | Evaluation |
|---|---|---|
| Consumers | Higher prices, lower consumption and less choice | Consumer surplus generally falls. |
| Domestic producers | Higher sales and producer surplus | Protection may weaken efficiency incentives. |
| Government | Tariff revenue may rise; imports may fall | Other policies such as subsidies impose fiscal costs. |
| Balance of payments | Lower imports may improve the trade position | The effect depends on responses of domestic supply, demand and trading partners. |
| Living standards | Protection can preserve some jobs or strategic capacity | Higher prices and welfare losses can lower overall wellbeing. |
| Income distribution | Resources are redistributed toward protected producers | Consumers finance part of the gain through higher prices. |
Evaluation framework: ask whether the protection is temporary, whether the industry can actually become competitive, how elastic domestic supply is, how trading partners may respond, and whether the strategic or employment benefit is large enough to justify the consumer and welfare costs.
Why protection can become difficult to remove: The infant-industry argument assumes protection is temporary while firms learn and become competitive. The textbook's warning is that the “infant” may never grow up: once firms and workers benefit from protection, political pressure can make it difficult to withdraw, allowing inefficiency to persist.
Chapter 12 revision checklist
Define absolute advantage.
Define comparative advantage using opportunity cost.
Calculate opportunity-cost ratios from numerical data.
Explain the law of comparative advantage.
Explain how specialisation can raise combined output.
Explain why trade can expand consumption possibilities.
Explain why the exchange ratio matters for the distribution of gains.
Define trade liberalisation.
Calculate and interpret the terms-of-trade index.
Distinguish terms of trade from the balance of trade.
Distinguish net barter and income terms of trade.
Explain why primary-product prices may be volatile in the short run.
Explain possible long-run deterioration in primary-product terms of trade.
Explain why market power and diversification matter for LDCs.
Define protectionism.
Explain the effects of a tariff on price, output, imports and welfare.
Compare a quota with a tariff.
Explain embargoes, export subsidies and non-tariff barriers.
Explain strategic, dumping, sunset and infant-industry arguments.
Evaluate the overall effects of protectionism on economic welfare.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.