World trade has grown rapidly over the past 40 years and is dominated by the developed
countries. Primary commodities are 25 per cent of world trade; the rest is trade in
manufactures.
Countries trade because they can buy goods more cheaply abroad. Differences in costs
reflect differences in technology and factor endowments. Scale economies also lead to
international specialization.
Countries make the goods in which they have a comparative advantage, or produce
relatively cheaply. By exploiting international differences in opportunity costs, trade leads to
a pure gain.
When technology diffuses quickly to other countries, relative factor endowments are the
main cause of different relative costs. Countries produce and export goods that use
intensively the factors with which the country is relatively well endowed.
Intra-industry trade occurs because of scale economies and consumer demand for
diversity. The gain from this trade is cost reduction and greater diversity of products.
If trade is to balance, and the forex market is to be in equilibrium, each country must have a
comparative advantage in at least one good. The level of the equilibrium exchange rate
offsets international differences in absolute advantage.
Although international trade can benefit the world as a whole, trade usually hurts some
groups of people, unless the gainers compensate the losers.
By raising the domestic price, a tariff reduces consumption but raises domestic output.
Hence imports fall.
A tariff leads to two distortions that are social costs: overproduction by domestic firms
whose marginal cost exceeds the world price, and underconsumption by consumers whose
marginal benefit exceeds the world price.
When a country affects the price of its imports, the world price is less than the social
marginal cost of importing. This is the case for the optimal tariff. Otherwise, arguments for
tariffs are usually second-best solutions. A production subsidy or consumption tax achieves
the aim at lower social cost.
Export subsidies raise domestic prices, reducing consumption but raising output and
exports. They involve waste. Goods are exported for less than society’s marginal production
cost and for less than the marginal benefit to domestic consumers.
Tariffs, and other non-tariff barriers fell a lot in the last 40 years.
Trade protection is usually costly to society. Yet governments often adopt it as an easy
option politically.
