Why countries trade
Trade lets each country specialise in what it does at the lowest opportunity cost, then exchange. The idea of comparative advantage says that a country should specialise in a good when its opportunity cost of producing it is lower than that of its trading partner. A country can have an absolute advantage (produce more per hour) in everything and still gain from trade.
Worked example
In one hour, Country A can make 6 shirts or 3 phones. Country B can make 2 shirts or 2 phones.
- A: 1 phone costs 6 ÷ 3 = 2 shirts; 1 shirt costs 0.5 phone.
- B: 1 phone costs 2 ÷ 2 = 1 shirt; 1 shirt costs 1 phone.
A is better at both goods (absolute advantage), yet B's opportunity cost of a phone (1 shirt) is lower than A's (2 shirts). So B has the comparative advantage in phones and A has it in shirts. If they trade at, say, 1.5 shirts per phone, both are better off than going without trade: A obtains a phone for 1.5 shirts instead of 2, and B obtains 1.5 shirts for a phone instead of 1.
Tariffs and quotas
A tariff is a tax on imports and a quota is a limit on their quantity. They protect domestic producers and raise prices for domestic buyers. Typically, the loss to consumers is greater than the gain to producers plus the government's revenue, leaving a net loss. Arguments for protection include defending new industries and national security. Economists debate how strong these are, and which workers and regions lose from trade also matters for policy.
Exchange rates
An exchange rate is the price of one currency in terms of another. If 1 US dollar buys 0.8 euros, then a European item priced at 40 euros costs 40 ÷ 0.8 = 50 dollars.
When a currency appreciates, it buys more foreign currency, making imports cheaper and exports dearer for foreign buyers. When it depreciates, the reverse holds. Rates are set by demand and supply for currencies in a floating system. Demand is raised by foreign demand for the country's goods and investments and by higher interest rates; inflation tends to depress a currency over time.
The balance of payments
The current account records trade in goods and services and income flows. The financial account records flows of investment. Roughly, they must offset: a country running a trade deficit is financed by net borrowing or selling assets to foreigners. A deficit is not in itself bad or good; what matters is what the borrowing is used for.