4.3.2 - Trade and the global economy

International specialisation means concentrating resources on goods and services a country can produce at relatively low opportunity cost, then trading for other output. When comparative costs differ, specialisation and exchange can raise total output and consumption possibilities.

A country can gain overall while particular workers, regions or firms lose. The size and distribution of the gain depend on factor mobility, adjustment support, market power, trade barriers and the prices at which exports exchange for imports.

Absolute advantage means producing more output with the same resources. Comparative advantage means producing at a lower opportunity cost. Trade gains depend on comparative, not absolute, advantage.

Country A has comparative advantage in wheat because 0.5 cloth is sacrificed rather than 1. Country B has comparative advantage in cloth because 1 wheat is sacrificed rather than 2. If the exchange rate lies between these opportunity-cost ratios, both can consume beyond their pre-trade possibilities.

The simple model assumes two countries and two goods, constant opportunity costs, fixed and fully employed resources, factors mobile within but not between countries, no transport costs or trade barriers, and homogeneous products.

A trade pattern describes who trades with whom and the product and service composition of those flows. The volume of world trade is the quantity traded; its value can also change because prices or exchange rates change.

The drivers interact. An emerging economy may gain comparative advantage through productivity growth, join an agreement that lowers barriers, and then become a larger supplier in regional value chains.

A trade flow is an export or import moving between particular countries. A useful explanation identifies the direction, partner, product or service, and whether the evidence measures value, volume or share.

A complete causal chain links the shock to relative cost or demand, then to competitiveness or market access, and finally to the value, volume, composition or destination of trade.

The terms of trade index compares the average price of a country's exports with the average price of its imports. It measures the import purchasing power of a unit of exports, not the quantities traded.

If the export-price index is 142.3 and the import-price index is 121.3, the terms of trade are $142.3/121.3\times100=117.3$ (1 d.p.). Relative to a base of 100, export prices have risen more than import prices, so the terms of trade have improved.

If both indices begin at 100 and export prices fall 4.8% while import prices fall 3.1%, the new index is $95.2/96.9\times100=98.25$: a deterioration even though both prices fell.

The terms of trade improve when export prices rise relative to import prices and worsen when import prices rise relative to export prices. Each factor matters through one or both price indices.

The effect is conditional on the trade basket, market power, contract currency, firms' pricing decisions and the duration of the change. For a commodity exporter, a world commodity-price movement may dominate domestic cost changes.

An improvement in the terms of trade means a given quantity of exports can purchase more imports; a deterioration means it can purchase fewer. The welfare and trade-balance effects are not automatic because quantities respond to prices.

A deterioration reverses the purchasing-power effect, but may make exports more price competitive. If export and import quantities respond strongly enough, higher net export volume can offset the less favourable price ratio.

The World Trade Organization (WTO) provides a multilateral framework in which member governments negotiate, apply and review rules intended to make international trade more open and predictable.

Liberalisation can be slow because agreements require negotiation among members with conflicting interests. Enforcement depends on members bringing cases and complying with outcomes; WTO membership does not eliminate protectionism.

Trading blocs differ by how much policy and factor-market integration members share. Each deeper form normally includes the central feature of the preceding form.

A common external tariff identifies a customs union; free movement of labour and capital identifies a common market; a shared currency and central monetary authority identify monetary union.

Trade creation occurs when removing an internal barrier replaces higher-cost domestic production with lower-cost imports from a member. Trade diversion occurs when preference shifts imports from a lower-cost non-member to a higher-cost member.

Net benefit depends on the size of internal barrier reductions, the common external barrier, cost differences, demand elasticities, distance, market competition, factor mobility and how adjustment gains and losses are distributed.

The WTO promotes multilateral, rules-based liberalisation, whereas a trading bloc gives preferential access to its members. Regional integration can support freer trade internally while discriminating against outsiders.

There is no necessary conflict: a regional agreement can remove substantial internal barriers, build support for wider liberalisation and operate within WTO conditions. The judgement depends on whether it creates new trade or mainly raises discrimination against non-members.

A reason explains the policy aim, not whether the restriction is efficient. Evaluation compares the targeted benefit with consumer costs, resource misallocation, administrative cost and the risk of foreign retaliation.

A protectionist policy changes the price, quantity, cost or administrative conditions of trade to favour domestic activity or limit imports.

A tariff fixes the tax rate while import quantity responds; a quota fixes the maximum quantity while the price and quota rent respond. A subsidy supports domestic supply but does not directly make the imported product pay a tax.

Protection changes prices, output, trade and income distribution. Its effects must be traced separately for consumers, producers and government before judging living standards or equality.

Across countries, widespread protection can distort comparative advantage, reduce specialisation and world output, raise prices and provoke retaliation. Domestic gains may therefore be transferred from consumers or foreign producers rather than created.