International Trade: Advantages and Balance of Payments
International Trade
- If countries specialize in the production of certain goods and then trade with other countries, there will be an increase in economic welfare. Countries will specialize in those goods where they have a comparative advantage.
Absolute Advantage:
This occurs when one country can produce a good with fewer resources than another. For example, if the USA can produce cars at a lower cost than the UK, the USA has an absolute advantage in producing cars.
Comparative Advantage:
A country has a comparative advantage over another in the production of a good if it can produce it at a lower opportunity cost:
- i.e. it has to forgo less of other goods in order to produce it.
The Law of Comparative Advantage
This states that trade can benefit all countries if they specialize in the goods in which they have a comparative advantage.
UK Balance of Payments
The balance of payments consists of:
- Current Account: Trade in goods, services, investment incomes, and transfers.
- Capital Account / Financial Account: Capital and financial flows, net investment, and portfolio investment.
- Errors and omissions: It is hard to collect all data, so some is missed out.
In theory, there should be a balancing between the capital and current/financial accounts. If there is a current account deficit, there should be a surplus on the capital/financial account.
UK Current Account
Components of Current Account
- Trade in goods
- Trade in services
- Total income (e.g. investment income)
- Total current transfers
Reasons for a Current Account Deficit
1. Overvalued Exchange Rates: Countries in the Eurozone that became uncompetitive (e.g. Greece, Portugal, and Spain) experienced large current account deficits. This is because an overvalued exchange rate means exports are more expensive, but imports are cheaper. This encourages domestic consumers to buy imports. It also makes it hard for exporters because they are relatively uncompetitive. See: Competitiveness in the Euro.
2. High Consumer Spending: If there is rapid growth in consumer spending, then there tends to be an increase in imports, causing a deterioration in the current account. For example, in the 1980s boom, we saw a fall in the savings rate and a rise in UK consumer spending; this caused a record current account deficit. The recession of 1991 caused an improvement in the current account as import spending fell.
3. Unbalanced Economy: An economy focused on consumer spending rather than investment and exports will tend to have a bigger current account deficit.
4. Competitiveness: Related to the exchange rate is the general competitiveness of firms. If there is a decline in relative competitiveness, e.g. rising wage costs, industrial unrest, or poor quality goods, then it is harder to export, causing a deterioration in the current account.
Protectionism represents any attempt to impose restrictions on trade in goods and services. The aim is to cushion domestic businesses and industries from overseas competition.
- Tariffs – A tariff is a tax that raises the price of imported products and causes a contraction in domestic demand and an expansion in domestic supply. The net effect is that the volume of imports is reduced and the government receives some tax revenue from the tariff.
- Quotas – Quantitative limits on the level of imports allowed.
- Embargoes – A total ban on imported goods.
- Export Subsidies – A payment to encourage domestic production by lowering their costs. Soft loans can be used to fund the ‘dumping’ of products in overseas markets. Well-known subsidies include the Common Agricultural Policy in the EU, or cotton subsidies for US farmers.
- Domestic Subsidies – Government financial help for domestic businesses facing financial problems, e.g. subsidies for car manufacturers or loss-making airlines.