A country good at absolutely everything should still buy some things from a country good at nothing. That claim sounds wrong and it is the most important result in international economics. It explains why trade benefits both parties even when one is more productive across the board, and once you see why, most arguments for restricting trade start to look like arguments about who captures the gains rather than whether the gains exist.
Specialisation means concentrating on producing a narrower range of goods and obtaining the rest through exchange. It happens at every level: individuals specialise in occupations, firms in products, regions in industries and countries in exports. The gains come from producing more with the same resources, because specialists get better at what they repeat, because time is not lost switching between tasks, and because larger production runs allow economies of scale and justify investment in specialised equipment.
Countries specialise for reasons rooted in what they have. Climate and geography determine what can be grown or extracted, which is why bananas come from the tropics and iron ore from where the deposits are. The quantity and skill of the workforce matters, so labour-intensive manufacturing tends to locate where labour is plentiful and cheap. Capital and technology allow advanced manufacturing and services. Accumulated expertise and reputation matter too, which is why certain regions dominate industries long after the original reason has faded.
The advantages of international trade follow from specialisation. Consumers get a wider variety of goods, including those a country cannot produce at all, and lower prices from cheaper foreign producers. Firms access larger markets, which allows economies of scale and makes investment worthwhile. Competition from imports pressures domestic firms to improve quality and control costs. And countries obtain the raw materials and capital equipment they need for growth. Against that, trade brings dependence on other countries, exposes domestic industries to competition they may not survive, can encourage overspecialisation that leaves a country vulnerable if demand for its export collapses, and carries environmental costs from transport.
Free trade
International trade that takes place without restrictions such as tariffs, quotas or subsidies to domestic producers.
Globalisation
The process by which the economies of the world become increasingly connected through trade, investment, the movement of people and the spread of technology.
Globalisation has been driven by cheaper transport, especially container shipping and air freight, by the internet and faster communication, by agreements that have reduced trade barriers, and by the growth of multinational companies. A multinational company (MNC) is a firm that produces in more than one country, usually with its headquarters in one country and factories, offices or shops in others. It spreads production to wherever costs are lowest, to get closer to its customers, to secure raw materials, and to get round trade barriers by producing inside the markets it sells to.
For the host country, where the MNC sets up, the benefits are new jobs, training that raises workers' skills, investment the country could not fund itself, new technology and management methods, tax revenue, and more exports. The costs are that profits are sent back to the home country, local firms may be driven out by the competition, the best jobs often go to staff brought in from abroad, the firm may exploit weak rules on pay, safety or pollution, and it may leave suddenly if costs are lower elsewhere. For the home country, where the MNC is based, the benefits are the profits that return and cheaper imports; the cost is that jobs may move abroad.
Which is a disadvantage to a host country of a multinational company setting up there?
Protectionism
Government policies that restrict international trade in order to shield domestic industries from foreign competition.
The instruments are worth knowing precisely because questions ask you to distinguish them. A tariff is a tax on imports, which raises their price and generates revenue for the government. A quota is a physical limit on the quantity that may be imported, which raises price without any revenue, since the gain accrues to whoever holds the import licence. A subsidy to domestic producers lowers their costs so they can undercut imports, which costs the government money rather than raising it. Embargoes ban trade in a good or with a country entirely. And administrative barriers, such as demanding safety standards or paperwork designed to be onerous, restrict trade without appearing to.
The difference between a tariff and a quota is examined regularly and the discriminator is revenue. A tariff raises price and gives the government tax revenue. A quota raises price by restricting quantity, and that extra revenue goes to the importers or foreign producers holding the licences, not to the government. Both protect domestic producers and both raise prices for consumers; only one funds the treasury.
Who gains and who loses from a tariff
A country imports 50,000 tonnes of sugar a year at a world price of $400 per tonne. Domestic producers supply 20,000 tonnes. The government imposes a $100 per tonne tariff. Imports fall to 35,000 tonnes and domestic supply rises to 30,000 tonnes. Calculate the tariff revenue, the extra cost to consumers on the quantity still imported, and identify who gains and who loses.
Governments protect for reasons that are not all bad, and questions want the strongest version of each. The infant industry argument holds that a new industry needs temporary protection to reach the scale at which it can compete, after which protection is removed. Protecting employment in a declining industry buys time for workers to retrain rather than face sudden mass unemployment. Strategic industries such as food, energy and defence may be protected on security grounds, since dependence on imports is dangerous if supply is interrupted. Dumping, where a foreign producer sells below cost to drive out competitors, is met with anti-dumping duties. And protection may be a bargaining tool, imposed to obtain the removal of another country's barriers.
Several other reasons are given for restricting trade. Cutting imports can reduce a deficit on the current account of the balance of payments. Tariffs raise tax revenue for the government, which matters most in countries where other taxes are hard to collect. Restrictions can keep out harmful goods, such as drugs, weapons or unsafe products, in the same way that taxes discourage demerit goods at home. And they can promote environmental sustainability, for example by restricting imports of goods produced with heavy pollution or illegal logging. Against every reason stands the same set of costs: higher prices and less choice for consumers, less pressure on domestic firms to become efficient, and the risk that other countries retaliate, which harms the country's exporters.
A government replaces a tariff with a quota that restricts imports to the same quantity. Compared with the tariff, the quota means:
Which is the strongest economic objection to protecting a domestic industry indefinitely?
Draw a domestic demand and supply diagram for a good, with a horizontal world supply line below the domestic equilibrium price. Mark domestic production, total consumption and imports. Then raise the world supply line by the amount of a tariff and mark the new domestic production, consumption and imports, shading the government's tariff revenue.
Four quantities change and all four should be labelled: domestic output rises, consumption falls, imports are squeezed from both sides, and the government collects revenue on what still comes in. Candidates who mark only the price change miss most of the available marks, since the whole argument is about the quantities.