Trade theory and protectionism - Economics IB Study Notes

Absolute Advantage: A country can produce a good using fewer resources than another country. For example, if Kenya produces coffee more efficiently than the UK, Kenya has absolute advantage in coffee.

Comparative Advantage: The foundation of trade theory, stating countries should specialize in goods where they have the lowest opportunity cost. Even if Country A is more efficient at producing everything, trade still benefits both nations if each specializes based on comparative advantage.

Opportunity Cost Formula: Opportunity cost of Good X = Units of Good Y sacrificed / Units of Good X gained

Terms of Trade: The rate at which one good exchanges for another internationally. Formula: (Index of Export Prices / Index of Import Prices) × 100. Values >100 indicate improvement.

Protectionism: Government policies restricting international trade to protect domestic industries. Key instruments:

• Tariffs: Taxes on imports, raising prices and government revenue
• Quotas: Physical limits on import quantities
• Subsidies: Government payments to domestic producers, lowering their costs
• Non-tariff barriers: Regulations, standards, or administrative procedures that restrict trade

Trade Creation vs. Trade Diversion: Trade creation occurs when customs unions/free trade areas replace high-cost domestic production with lower-cost imports. Trade diversion happens when they replace low-cost external suppliers with higher-cost member suppliers.

Key Principle: Countries maximize welfare by specializing according to comparative advantage and trading, even when one country has absolute advantage in all goods. The gains from trade arise from differences in opportunity costs, not absolute efficiency.

The Logic of Comparative Advantage: Think of it like a hospital where the surgeon is also the fastest typist. Even though she's better at both surgery and typing, she should specialize in surgery (lower opportunity cost) while the receptionist handles typing. Similarly, China might produce both electronics and textiles more efficiently than Vietnam, but if China's opportunity cost for electronics is lower, both countries gain when China focuses on electronics and Vietnam on textiles.

Real-World Application - EU Sugar Market: The EU historically protected sugar beet farmers through quotas and high tariffs on cane sugar from developing nations. This cost EU consumers approximately €6 billion annually in higher prices while preventing efficient Caribbean producers from accessing markets. When quotas were removed in 2017, prices fell, demonstrating how protectionism creates deadweight loss—economic inefficiency where neither consumers nor producers capture the value.

Modern Protectionism Example: US-China trade tensions (2018-2020) saw tariffs imposed on $360 billion of Chinese goods. American consumers paid $46 billion more annually, while US industries using Chinese inputs (like manufacturers) faced higher costs. This illustrates the unintended consequences of protectionism: protecting one sector harms others.

Terms of Trade in Action: When oil prices collapsed in 2014-2016, oil-exporting nations like Venezuela saw their terms of trade deteriorate catastrophically—they needed to export far more oil to buy the same imports, destroying purchasing power. Conversely, oil importers like Japan benefited from improved terms of trade.

Analogy: Trade is like teamwork on a group project—everyone contributes what they do best relative to alternatives, making the whole group more productive than if everyone did everything independently.