International trade, protectionism and globalisation
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Which is a disadvantage to a host country of a multinational company setting up there?
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?
A country's export price index rises from 100 to 120 while its import price index rises from 100 to 105. What happens to its terms of trade?
Country X can produce both wheat and cloth using fewer resources than Country Y. This means:
Worked problems
Show your working.
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.
Finding comparative advantage and a gainful terms of trade. With one unit of resources, Country A can produce 40 tonnes of wheat or 20 cars. Country B can produce 30 tonnes of wheat or 30 cars. Identify any absolute advantages, calculate opportunity costs, determine comparative advantage, and state a rate of exchange at which both countries gain.
Calculating a change in the terms of trade. In the base year both a country's export and import price indices are 100. Five years later its export price index is 110 and its import price index is 125. Calculate the terms of trade and explain what has happened.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why a tariff can reduce national welfare even though domestic producers gain
- A Consumers face the higher price on every unit they buy, whether domestic or imported, so consumer surplus falls.
- B Those additional units are produced using more resources than it would have cost to import them, so resources are being used inefficiently.
- C But two portions are transferred to nobody: the extra resource cost of the inefficient domestic production, and the surplus lost by consumers priced out of the market entirely.
- D Part of that lost consumer surplus is transferred to domestic producers as higher profit and part to the government as tariff revenue, and transfers are not net losses.
- E Domestic producers expand output, because production is now profitable at the higher price for firms that could not compete at the world price.
- F A tariff raises the domestic price of the imported good above the world price.
- G Those two triangles are the deadweight welfare loss, so national welfare falls even though a visible and vocal group of domestic producers has gained.
Diagrams
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.
Draw production possibility curves for two countries with different slopes, reflecting different opportunity cost ratios. Mark each country's pre-trade production and consumption point. Then show each specialising completely and draw the consumption possibility line each faces once trade takes place at an agreed rate.
Answers
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.
Protectionism: Government policies that restrict international trade in order to shield domestic industries from foreign competition.
Terms of trade: The rate at which a country's exports exchange for its imports, measured as an index of export prices relative to an index of import prices.
C. The other three are benefits to the host country. When profits are sent abroad to the MNC's owners, the host keeps less of the income created, which is why a country's GDP can rise faster than the income its residents actually receive.
B. Both measures restrict imports to the same level and raise the domestic price similarly, so consumers and domestic producers are affected much the same way. The difference is where the money goes: a tariff collects it as government revenue, while a quota transfers it to whoever holds the right to import.
B. Protection removes the competitive pressure that forces firms to improve, so costs stay high and consumers pay for it permanently. This is why even supporters of the infant industry argument insist protection must be temporary and withdrawn on a stated timetable.
B. (120 / 105) x 100 = 114.3. Export prices rose faster than import prices, so each unit of exports buys more imports: an improvement. Whether that is good for the country depends on whether export volumes hold up at the higher prices.
C. Absolute advantage in both goods does not preclude gains from trade. What matters is relative opportunity cost, and unless the ratios are identical each country has a comparative advantage in one good. Country X specialises where its margin of superiority is greatest and buys the other good from Y.
Step 1. Calculate the government's tariff revenue. Revenue = tariff per tonne x quantity imported after the tariff = $100 x 35,000 = $3,500,000.
Step 2. Calculate the extra cost to consumers on imports. Consumers now pay $500 rather than $400 on each of the 35,000 tonnes imported, which is $100 x 35,000 = $3,500,000 extra. This is exactly the tariff revenue, transferred from consumers to the government.
Step 3. Identify the effect on domestic producers. Domestic output rises from 20,000 to 30,000 tonnes and domestic producers now receive $500 rather than $400 per tonne. They gain both from selling more and from a higher price on every tonne, so producer surplus rises substantially.
Step 4. Identify the losers. Consumers lose twice: they pay $100 more on every tonne they still buy, whether imported or domestic, and total consumption falls from 70,000 to 65,000 tonnes because some buyers are priced out. Foreign producers lose 15,000 tonnes of sales.
Step 5. State the net effect. Part of the consumer loss is transferred to the government as revenue and part to domestic producers as higher profit, so those are transfers rather than losses to the economy. But the extra 10,000 tonnes are now produced domestically at a higher cost than the world price, and 5,000 tonnes of consumption have been given up entirely. Those two elements are pure welfare loss, benefiting nobody.
Step 5 is the analytical payoff. Transfers move value between groups; the welfare loss destroys it. A candidate who identifies which parts are which is doing economics rather than describing a policy.
Step 1. Identify absolute advantage. Country A produces more wheat (40 against 30), so it has an absolute advantage in wheat. Country B produces more cars (30 against 20), so it has an absolute advantage in cars. Neither is better at both here, but comparative advantage would still determine specialisation even if one were.
Step 2. Calculate Country A's opportunity costs. A gives up 20 cars to produce 40 wheat, so 1 wheat costs 20/40 = 0.5 cars. Conversely 1 car costs 40/20 = 2 wheat.
Step 3. Calculate Country B's opportunity costs. B gives up 30 cars to produce 30 wheat, so 1 wheat costs 1 car, and 1 car costs 1 wheat.
Step 4. Determine comparative advantage. Wheat costs A 0.5 cars and costs B 1 car, so A has the lower opportunity cost in wheat. Cars cost A 2 wheat and cost B 1 wheat, so B has the lower opportunity cost in cars. A should specialise in wheat and B in cars.
Step 5. Find the range of gainful terms of trade. A will only export wheat if it receives more than 0.5 cars per tonne, since that is what wheat costs it domestically. B will only import wheat if it pays less than 1 car per tonne. So any rate between 0.5 and 1 cars per tonne of wheat benefits both. A rate of 0.75 cars per tonne would split the gain roughly evenly.
Step 6. Confirm the gain. At 0.75, Country A gets 0.75 cars for a tonne of wheat that cost it only 0.5 cars to produce, gaining 0.25 cars. Country B obtains wheat for 0.75 cars when producing it itself would have cost 1 car, gaining 0.25 cars. Both consume beyond their own production possibility curves, which is the gain from trade.
Step 5 is the part most often omitted and it is where the marks concentrate. The terms of trade must lie between the two domestic opportunity cost ratios; outside that range one country would rather produce the good itself, and no trade occurs.
Step 1. Base year. (100 / 100) x 100 = 100.
Step 2. Five years later. (110 / 125) x 100 = 88.
Step 3. Interpret. The terms of trade have fallen by 12%, a deterioration. Export prices rose, but import prices rose faster, so each unit of exports now buys 12% fewer imports than before. The country must export more to buy the same quantity of imports.
F, E, B, A, D, C, G
- A tariff raises the domestic price of the imported good above the world price.
- Domestic producers expand output, because production is now profitable at the higher price for firms that could not compete at the world price.
- Those additional units are produced using more resources than it would have cost to import them, so resources are being used inefficiently.
- Consumers face the higher price on every unit they buy, whether domestic or imported, so consumer surplus falls.
- Part of that lost consumer surplus is transferred to domestic producers as higher profit and part to the government as tariff revenue, and transfers are not net losses.
- But two portions are transferred to nobody: the extra resource cost of the inefficient domestic production, and the surplus lost by consumers priced out of the market entirely.
- Those two triangles are the deadweight welfare loss, so national welfare falls even though a visible and vocal group of domestic producers has gained.
Step 7 explains the politics as well as the economics. The gains are concentrated on an identifiable industry that will lobby for them, while the losses are spread thinly across all consumers who mostly will not notice, which is why protection is politically durable despite the welfare arithmetic.
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.
The consumption possibility line lies outside the country's own PPC, and that gap is the entire gain from trade shown geometrically. The slope of that line is the terms of trade, and it must lie between the two countries' PPC slopes, which is the same condition derived arithmetically in the worked example.