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Chapter 15

International Trade & Globalisation

College

No economy stands alone. Nations trade goods, services, capital and ideas across borders, and the theory explaining why — comparative advantage — is one of economics' deepest and most counter-intuitive results. This final chapter covers the gains from trade, exchange rates, and the debates that globalisation ignites.

At a glance
Core ideaCountries gain by specialising where their opportunity cost is lowest.
Key termComparative advantage — lowest opportunity cost, not absolute skill, wins.
You can…Work out who should make what from an output-per-worker table.
Watch outTrade grows the pie but creates losers — compensating them matters.
Theory

Comparative advantage and the balance of payments

Adam Smith noted a country should export what it makes with an absolute advantage (using fewer resources). But David Ricardo's greater insight is comparative advantage: a country gains by specialising in whatever it produces at the lowest opportunity cost — even if it is worse at everything in absolute terms. Mutually beneficial trade exists as long as opportunity costs differ.

Trade is beneficial whenever the domestic opportunity-cost ratios of two countries differ.

The terms of trade (the ratio at which exports exchange for imports) determine how the gains are split; trade benefits both sides as long as the ratio lies between their two internal opportunity costs.

A country records its transactions with the world in the balance of payments: the current account (trade in goods and services, plus income and transfers) and the financial/capital account (flows of investment and assets). They must, in principle, sum to zero — a current-account deficit is financed by a capital-account surplus (borrowing or selling assets).

The exchange rate is the price of one currency in another. Under a floating regime it is set by supply and demand for the currency (driven by trade, interest rates, and speculation); under a fixed regime the central bank pegs it. A currency depreciation makes exports cheaper and imports dearer.

Explanation

Why trade helps — and why it's still fought over

Comparative advantage shows the world's total output rises when each country specialises and trades — the pie grows. Free trade also brings lower prices, greater variety, economies of scale, and competition that spurs innovation. Yet nations routinely erect protectionism — tariffs (taxes on imports), quotas (quantity limits), subsidies to domestic firms, and regulatory barriers.

Why? Because the gains from trade, though larger in total, are unevenly distributed. Trade creates winners (exporters, consumers) and losers (workers in import-competing industries). The losses are concentrated and visible; the gains are diffuse. Arguments for protection include the infant-industry case (shelter a new sector until it matures), national security, and retaliation against unfair "dumping" — but each risks retaliation, inefficiency, and higher consumer prices.

S(dom) D Pw Pw+t Price Quantity tariff shrinks imports
A tariff lifts the domestic price from Pw to Pw+t: home output rises, consumption falls, imports shrink — with a net deadweight welfare loss.

Globalisation — the deepening integration of economies through trade, capital flows, technology and migration — has lifted hundreds of millions out of poverty and slashed the cost of goods, but is charged with widening inequality within rich countries, enabling a "race to the bottom" in wages and environmental standards, and increasing systemic contagion (a crisis in one region spreads fast). The economist's balanced verdict: trade grows the pie, but compensating the losers (retraining, transfers) is essential for it to be both efficient and just.

Practical

Worked example: computing comparative advantage

Two countries each have a fixed labour force. Output per worker per day:

CountryCloth (units)Wine (units)
Portugal612
England42
Step 1 — spot absolute advantagePortugal makes more of both goods (6>4 cloth, 12>2 wine). Naïvely, it seems Portugal should make everything — but that ignores opportunity cost.
Step 2 — opportunity costs in PortugalTo make 1 wine, Portugal gives up 6/12 = 0.5 cloth. To make 1 cloth, it gives up 12/6 = 2 wine.
Step 3 — opportunity costs in EnglandTo make 1 wine, England gives up 4/2 = 2 cloth. To make 1 cloth, it gives up 2/4 = 0.5 wine.
Step 4 — compare (lowest opportunity cost wins)Wine costs 0.5 cloth in Portugal vs 2 cloth in England → Portugal has the comparative advantage in wine. Cloth costs 0.5 wine in England vs 2 wine in Portugal → England has the comparative advantage in cloth.
Step 5 — specialise and tradePortugal makes wine, England makes cloth. A terms-of-trade of 1 cloth for 1 wine lies between the two internal ratios (0.5 and 2), so both gain: England gets wine for 1 cloth instead of 2; Portugal gets cloth for 1 wine instead of 2.
Step 6 — the lessonEven the country worse at everything (England) has something it gives up least to produce. Specialisation by comparative — not absolute — advantage raises world output. This is why trade is (almost) always mutually beneficial.
Q&A
Q1How can a country that is worse at producing everything still gain from trade?

Because gains depend on comparative, not absolute, advantage. However inefficient a country is in absolute terms, there is some good it sacrifices least to produce — its lowest-opportunity-cost good. By specialising there and trading, it obtains the other good more cheaply than making it itself. As long as the two countries' opportunity-cost ratios differ, both can consume beyond their own production frontiers.

Q2Who really pays a tariff on imported steel?

Mostly domestic buyers. The tariff raises the price of imported steel, so home consumers and steel-using industries (carmakers, builders) pay more — a transfer from them to protected domestic steel producers and to the government (tariff revenue). There is also a net deadweight loss: some efficient trade is prevented. Protection helps a visible, concentrated group at a larger, diffuse cost to everyone else — and invites foreign retaliation.

Q3A currency depreciates by 20%. What happens to the trade balance?

Exports become cheaper abroad and imports dearer at home, so it should improve the trade balance — but not immediately. In the short run, contracts are fixed and quantities respond slowly, so the higher import bill can worsen the balance first before it improves — the J-curve effect. Improvement requires that export and import demand are sufficiently price-elastic (the Marshall–Lerner condition: the elasticities must sum to more than 1).

Q4Is the "infant-industry" argument for protection valid?

It has theoretical merit: a new industry may need temporary shelter to reach the scale and experience where it can compete, after which protection is removed. But in practice it is risky: protected industries often never "grow up," lobbying keeps tariffs long past their justification, and consumers pay in the meantime. It can work with strict, time-limited, credibly-enforced support — but the record is mixed, so economists apply it cautiously.

Q5Does a persistent current-account deficit mean a country is "living beyond its means"?

Not necessarily. A current-account deficit is mirrored by a capital-account surplus — the country is a net recipient of foreign investment. If that capital funds productive investment that raises future output, the deficit is sustainable and even beneficial (as with fast-growing developing economies). It becomes a problem only if it funds consumption and mounting external debt with no rise in future capacity to repay. The composition matters more than the headline number.

← Prev: Fiscal & Monetary Policy ↑ Top Next: Microeconomic Theory →
Concept mind map

How the ideas connect

Every key idea in this chapter, branching from the core concept — use it to see the whole picture at a glance.

ComparativeadvantageGains from tradeExports andimportsExchange ratesTariffsFree trade vstariffsBalance ofpaymentsTrade & Globalisation
Infographic

The key facts, visualised

Comp. adv.
produce what you sacrifice least to make, then trade
Tariff
a tax on imports that raises their price
Exch. rate
the price of one currency in terms of another
Gains
trade lets both nations consume beyond their own PPF
Solved examples

Worked problems, step by step

Follow each solution line by line, then try to reproduce it on paper before moving on.

Example 1Country A gives up 2 wheat per cloth; Country B gives up 4 wheat per cloth. Who has comparative advantage in cloth?

  1. Comparative advantage goes to the lower opportunity cost producer.
  2. A sacrifices 2 wheat per cloth; B sacrifices 4.
  3. A gives up less wheat.

Example 2A US firm buys 100 euro of goods when 1 euro = $1.10. What is the dollar cost, and if the euro rises to $1.20?

  1. At $1.10: 100 x 1.10 = $110.
  2. At $1.20: 100 x 1.20 = $120.
  3. A stronger euro makes euro goods dearer for Americans.
Practice problem set

Now you try

Work each one out first, then tap to reveal the worked answer.

1What is comparative advantage?
The ability to produce a good at a lower opportunity cost than another producer, which drives beneficial trade.
2How can two countries both gain from trade?
By each specialising where its opportunity cost is lowest and trading, both consume more than in isolation.
3What does a tariff do to domestic consumers?
It raises the price of imports, so consumers pay more and buy less, though domestic producers gain.
4Why might a country protect an infant industry?
To let a new industry grow to efficient scale before facing full foreign competition.
5What happens to exports when a currency depreciates?
Exports become cheaper abroad, so foreign demand for them tends to rise.
6What is the current account of the balance of payments?
A record of a country's trade in goods and services plus income and transfers with the rest of the world.