Notes · EconomicsUK · A-Levels

The international economy

This chapter examines how economies interact through trade and finance. It covers globalisation and the pattern of world trade, the theory of comparative advantage and the gains from trade, protectionism and its effects, the balance of payments and exchange rates, and the economics of growth and development in poorer economies.

5 sections~21 min reading time4 competenciesLevel Standard 1 · Advanced 4

T·141414 / 14

Exam profile

AO1 · Define globalisation, comparative advantage, protectionism, the balance of payments and exchange ratesAO2 · Apply comparative advantage and exchange-rate analysis and calculate gains from trade and currency conversionsAO3 · Analyse the effects of trade, protectionism and exchange-rate changes on the economyAO4 · Evaluate the case for free trade and protectionism and the strategies for development

Operators:defineexplainanalysecalculateevaluateassessdraw a diagram to show

basic level

AS-Level requires globalisation, the gains from trade, protectionism, the balance of payments and exchange rates.

higher level

The full A-Level adds comparative-advantage calculation, tariff analysis, exchange-rate determination and the economics of development, with evaluation.

Depth

Text

Contents · 5 sections

The international economy

Globalisation and the pattern of world trade#

StandardAQA 7136 4.2.6DfE GCE Economics - globalisation

Globalisation is the increasing integration and interdependence of the world's economies - the growing flows of goods and services, capital, labour and technology across national borders, so that economies become more closely linked. Its characteristics include a rising share of trade in world output, the spread of multinational corporations organising production across countries (global supply chains), large flows of foreign direct investment and financial capital, and greater movement of people and rapid transmission of technology and ideas.

The causes of globalisation over recent decades are several and mutually reinforcing: falling transport costs (containerisation, cheaper air freight); the revolution in information and communications technology, which slashed the cost of coordinating activity across borders; the reduction of trade barriers through successive rounds of negotiation and the growth of trading blocs and the World Trade Organisation; the liberalisation of capital markets, allowing finance to flow freely; and the opening-up of large economies such as China and India to world trade and investment.

The consequences of globalisation are far-reaching and genuinely double-edged, which sets up the evaluation. The benefits include: access to larger markets and the gains from specialisation and trade (the next section); lower prices and wider choice for consumers; economies of scale for firms; the transfer of technology and investment to developing countries, lifting hundreds of millions out of absolute poverty; and faster growth. The costs and concerns include: the loss of jobs in industries that cannot compete with imports (structural unemployment); downward pressure on wages and conditions in some sectors; widening inequality within and between countries; the environmental cost of increased production and transport; the vulnerability of interconnected economies to shocks transmitted rapidly across borders (as in the 2008 crisis); and concerns about the power of multinationals and the erosion of national policy autonomy.

Whether globalisation is beneficial 'depends on' the perspective and the policies that accompany it: it has raised aggregate world output and cut absolute poverty dramatically, but its gains have been unevenly shared, and managing its costs (through retraining displaced workers, redistribution and environmental regulation) is essential if the benefits are to be widely felt. The pattern of world trade it has produced - with developing economies increasingly exporting manufactures and services rather than only primary products - reflects shifting comparative advantage, the concept the next section develops as the theoretical case for trade.

Worked example

Weighing a consequence of globalisation

A developed economy's manufacturers relocate production to a lower-wage country. Identify one gain and one cost for the developed economy.

Identify a gain
Consumers in the developed economy gain from lower-priced goods, and firms gain lower costs and higher profits, some of which may fund investment and higher-value activities at home.
Identify a cost
Workers in the relocated industry lose their jobs - structural unemployment - because their skills are tied to the declining sector and may not match the jobs available.
Reach a balanced view
The net effect depends on whether the displaced workers can be retrained and re-employed in growing sectors; without active policy, the gains (spread across consumers) may be offset by concentrated losses among affected workers.

Result: The developed economy gains cheaper goods and higher firm profits but suffers structural unemployment - the net effect depends on retraining and redistribution.

Typical mistakes

Presenting globalisation as wholly good or wholly bad - top answers weigh its gains (growth, lower poverty, cheaper goods) against its costs (inequality, structural unemployment, environmental damage).
Confusing globalisation (integration of economies) with trade liberalisation alone - it also involves capital, labour and technology flows.

Active revision

Evaluate the view that globalisation has benefited developing economies more than developed ones.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Comparative advantage and the gains from trade#

AdvancedAQA 7136 4.2.6DfE GCE Economics - the theory of comparative advantage

The gains from trade through specialisation

Fig. 1When each country specialises in the good in which it has the lower opportunity cost, total world output of BOTH goods rises (wheat 50 to 60, cloth 30 to 40) - the gains from trade. Illustrative.

The theoretical case for international trade rests on the theory of comparative advantage, developed by David Ricardo. First distinguish two ideas. Absolute advantage: a country has an absolute advantage in a good if it can produce more of it with the same resources (or the same amount with fewer resources) than another country. Comparative advantage: a country has a comparative advantage in a good if it can produce it at a lower OPPORTUNITY COST than another country - that is, by giving up less of the other good. Ricardo's insight was that mutually beneficial trade is driven by comparative, not absolute, advantage.

The principle of comparative advantage states that world output can be increased if each country specialises in producing the good in which it has the lower opportunity cost, and then trades for the other good. Remarkably, this holds EVEN IF one country has an absolute advantage in both goods: as long as the countries' opportunity costs differ, specialisation according to comparative advantage and trade makes both better off, because total world output rises and can be shared so that each country consumes more than it could alone. The opportunity cost of each good is found from the amounts producible, and the country giving up less of the other good has the comparative advantage.

For trade to benefit both countries, the terms of trade (the rate at which the goods exchange) must lie between the two countries' domestic opportunity-cost ratios. Within that range, each country can obtain the imported good more cheaply through trade than by producing it itself, so both gain. The gains from trade are the extra consumption made possible - shown as being able to consume at a point beyond the country's own production possibility frontier. This is the rigorous foundation for the benefits of trade and globalisation discussed in the previous section.

The theory is powerful but rests on assumptions that must be evaluated. It assumes no transport costs, constant returns to scale (constant opportunity costs), perfect mobility of factors between industries within a country, no trade barriers, and that comparative advantage is static. In reality: transport costs can offset the gains; opportunity costs usually rise with specialisation (so complete specialisation is rarely optimal); factors are not perfectly mobile, so the workers displaced by imports suffer structural unemployment; and comparative advantage shifts over time and can be created by investment (the 'infant industry' argument). Moreover, the gains, though real in aggregate, are unevenly distributed - trade produces losers as well as winners. So while comparative advantage is the core case FOR free trade, these qualifications are the basis for the protectionism debate that follows.

\text{Opportunity cost of good X} = \frac{\text{units of good Y forgone}}{\text{units of good X gained}}

Opportunity cost and comparative advantage

A country has a comparative advantage in the good with the lower opportunity cost. Specialisation according to comparative advantage raises total world output.

Worked example

Finding comparative advantage and the gains from trade

With one unit of labour, Country A can produce 30 wheat OR 10 cloth; Country B can produce 20 wheat OR 20 cloth. Each has 2 units of labour. Identify each country's comparative advantage and show the gain from specialisation.

Opportunity costs of wheat
A: 1 wheat costs 10/30 = 0.33 cloth. B: 1 wheat costs 20/20 = 1 cloth. A gives up less cloth per wheat, so A has the comparative advantage in WHEAT.
Opportunity costs of cloth
A: 1 cloth costs 30/10 = 3 wheat. B: 1 cloth costs 20/20 = 1 wheat. B gives up less wheat per cloth, so B has the comparative advantage in CLOTH.
Compare output
Without trade (each splits its 2 workers): A makes 30 wheat + 10 cloth, B makes 20 wheat + 20 cloth - world total 50 wheat, 30 cloth. With specialisation, A makes 60 wheat, B makes 40 cloth - world total 60 wheat, 40 cloth.

Result: A specialises in wheat, B in cloth; world output rises from 50 wheat and 30 cloth to 60 wheat and 40 cloth - a gain of 10 units of each good to be shared through trade.

Typical mistakes

Confusing absolute advantage (producing more) with comparative advantage (lower opportunity cost) - trade is driven by the latter.
Assuming a country with an absolute advantage in both goods gains nothing from trade - it still gains through comparative advantage.

Active revision

Two countries can each produce food and machines. Using opportunity-cost reasoning, explain how you would determine which country should specialise in which good, and one limitation of your conclusion.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Protectionism and trade policy#

AdvancedAQA 7136 4.2.6DfE GCE Economics - protectionism

The effect of a tariff on imports

Fig. 2A tariff raises the price from the world price (4) to the world price plus tariff (6): domestic supply rises from 2 to 4, consumption falls from 8 to 6, and imports shrink from 6 to 2. The government gains tariff revenue, but there is a net welfare loss.

Protectionism is the use of barriers to restrict international trade and shield domestic producers from foreign competition. The main instruments are: tariffs (taxes on imports, which raise their price); quotas (physical limits on the quantity of a good that may be imported); subsidies to domestic producers (which lower their costs relative to importers); and non-tariff barriers such as excessively strict product standards, complex customs procedures and outright bans. Each reduces the volume of imports and supports domestic producers, but at a cost to consumers and to the efficiency gains from trade.

The effect of a tariff is best shown on a diagram. At the free-trade world price, domestic consumers buy a large quantity, of which domestic firms supply only a little and the rest is imported. A tariff raises the price of imports to the world price plus the tariff: at this higher price, domestic production rises (domestic firms can now compete), domestic consumption falls, and so imports are squeezed from both ends. The government gains tariff revenue on the remaining imports. But there is a net welfare loss (deadweight loss): consumer surplus falls by more than the gain to producers and the government, because the tariff draws resources into relatively inefficient domestic production and prices some consumers out of the market.

The arguments FOR protectionism (and against free trade) are examinable and must be weighed. The infant-industry argument: new industries need temporary protection to grow to a size where they can compete (a dynamic comparative-advantage argument). Protecting employment in declining or strategic industries and easing the pain of structural change. Preventing dumping (foreign firms selling below cost to destroy domestic competitors). Correcting a balance-of-payments deficit. Raising government revenue (important for some developing countries). And protecting standards or national security. Each has some validity but also weaknesses - infant industries may never 'grow up', protected industries lose the incentive to become efficient, and revenue and employment could often be pursued by better means.

The case AGAINST protectionism, and for free trade, generally prevails in economic analysis. Protection sacrifices the gains from comparative advantage, raises prices and reduces choice for consumers, protects inefficiency and removes the spur of competition, and invites retaliation - a spiral of tit-for-tat barriers (a trade war) that shrinks world trade and harms everyone, as in the 1930s. Trading blocs (free-trade areas, customs unions, single markets) and the World Trade Organisation exist to promote and referee freer trade, though regional blocs can also divert trade from more efficient outside producers. The judgement 'depends on' the specific circumstances: temporary, targeted protection may be justified for a genuine infant industry or against dumping, but broad, permanent protectionism usually costs more than it gains - the balanced conclusion expected at the top band.

Worked example

Analysing a tariff

Domestic demand is P = 12 - Q and domestic supply is P = 2 + Q. The world price is 4. A tariff raises the price to 6. Find domestic production, consumption and imports before and after the tariff.

Free trade (price 4)
Domestic supply: 2 + Q = 4, so Qs = 2. Domestic demand: 12 - Q = 4, so Qd = 8. Imports = 8 - 2 = 6.
With the tariff (price 6)
Domestic supply: 2 + Q = 6, so Qs = 4. Domestic demand: 12 - Q = 6, so Qd = 6. Imports = 6 - 4 = 2.
Interpret
The tariff raises domestic production from 2 to 4 and cuts consumption from 8 to 6, so imports fall from 6 to 2. The government collects tariff revenue of 2 (the tariff) x 2 (imports) = 4, but consumers pay more and resources shift into less efficient domestic production - a net welfare loss.

Result: The tariff raises domestic output (2 to 4), cuts consumption (8 to 6) and imports (6 to 2), yielding tariff revenue of 4 but a net welfare loss.

Typical mistakes

Forgetting the net welfare (deadweight) loss of a tariff, or claiming a tariff benefits everyone in the importing country.
Treating the infant-industry argument as decisive - protected industries may never become efficient.

Active revision

Using a tariff diagram, evaluate the case for a government imposing tariffs to protect a domestic industry from cheaper imports.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

The balance of payments and exchange rates#

AdvancedAQA 7136 4.2.6DfE GCE Economics - the balance of payments and exchange rates

The foreign-exchange market: an appreciation

Fig. 3The exchange rate is set by the demand for and supply of the currency. A rise in demand for pounds (from D1 to D2) causes an appreciation, raising the exchange rate.

The balance of payments records all transactions between a country and the rest of the world. Its current account (introduced in the measurement chapter) records trade in goods and services, primary income (investment income) and secondary income (transfers). A current-account deficit means the country's outflows on these items exceed its inflows - importing more than it exports overall. The causes of a persistent deficit include a lack of international competitiveness (high relative costs or prices, low productivity), a strong exchange rate, strong domestic demand pulling in imports, and structural weakness in the traded-goods sector. A deficit is financed by surpluses on the financial account (inflows of investment and lending from abroad).

An exchange rate is the price of one currency in terms of another. Under a floating exchange rate, the rate is determined by the demand for and supply of the currency in the foreign-exchange market, like any price. The demand for pounds comes from foreigners wanting to buy UK exports, invest in the UK or hold sterling; the supply of pounds comes from UK residents wanting foreign currency to buy imports or invest abroad. A rise in the demand for pounds (or a fall in supply) causes an appreciation (the pound becomes worth more); a fall in demand (or rise in supply) causes a depreciation. Under a fixed exchange rate the government or central bank intervenes (buying or selling the currency, or adjusting interest rates) to hold the rate at a set level; a managed float lies between the two.

Exchange-rate changes affect the economy powerfully, and the effect on trade is captured by the phrase 'a lower pound makes exports cheaper and imports dearer'. A depreciation lowers the foreign-currency price of exports (raising their competitiveness and quantity demanded) and raises the domestic-currency price of imports (reducing them), which tends to improve the current account and raise AD - though it also raises the cost of imported inputs, adding to cost-push inflation. An appreciation does the reverse: it makes exports dearer and imports cheaper, tending to worsen the current account but easing inflation. (Whether a depreciation actually improves the current account depends on the elasticities of demand for exports and imports - the Marshall-Lerner condition - and effects may be delayed, the J-curve.)

The choice and the effects of exchange-rate policy are matters for evaluation. A floating rate adjusts automatically to shocks and frees monetary policy for domestic goals, but can be volatile and speculative; a fixed rate provides certainty for traders and investors and disciplines inflation, but requires large reserves to defend and surrenders monetary independence. A current-account deficit is not necessarily a problem - it may reflect strong investment or growth and can be sustained if foreigners are willing to finance it - but a large, persistent deficit driven by uncompetitiveness can signal a structural weakness, requiring supply-side measures to raise productivity and competitiveness rather than a quick fix. The judgement 'depends on' the cause and size of the imbalance, the exchange-rate regime, and the elasticities involved.

\text{Value in foreign currency} = \text{domestic price} \times \text{exchange rate}

Exchange-rate conversion

A depreciation lowers the exchange rate, making exports cheaper abroad and imports dearer at home; an appreciation does the reverse. The effect on the current account depends on the elasticities (Marshall-Lerner).

Worked example

Exchange-rate conversion and competitiveness

A UK car is priced at 20,000 pounds. Find its price to a US buyer when the exchange rate is 1 pound = 1.25 dollars, and then after the pound appreciates to 1 pound = 1.40 dollars. Comment on competitiveness.

Price at 1.25 dollars per pound
US price = 20,000 x 1.25 = 25,000 dollars.
Price at 1.40 dollars per pound
After the appreciation, US price = 20,000 x 1.40 = 28,000 dollars.
Interpret
The appreciation raises the car's dollar price from 25,000 to 28,000 dollars, making UK exports LESS competitive in the US, so the quantity of exports demanded is likely to fall - tending to worsen the current account (while making US imports cheaper for UK buyers).

Result: The appreciation raises the export price from 25,000 to 28,000 dollars, cutting UK competitiveness abroad - a depreciation would do the reverse and tend to improve the current account.

Typical mistakes

Getting the trade effect backwards - a DEPRECIATION (weaker currency) makes exports cheaper and imports dearer.
Assuming a current-account deficit is always harmful, or that a depreciation always improves it (it depends on the elasticities).

Active revision

Evaluate the likely effects of a large depreciation of a country's currency on its current account and its rate of inflation.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

Economic growth and development#

AdvancedAQA 7136 4.2.6DfE GCE Economics - growth and development

Strategies to promote development

Fig. 4Development strategies are broadly market-oriented or interventionist; successful development usually combines outward-looking trade with government investment in human and physical capital.

Economic growth (a rise in real GDP) must be distinguished from economic development, which is a broader concept concerning improvements in living standards and the quality of life - health, education, freedom and the reduction of poverty - not just the quantity of output. Growth is usually necessary for development but is not the same thing: a country can grow without the gains reaching most of its people. Development is measured by wider indicators than GDP, notably the Human Development Index (HDI), which combines real GDP (or gross national income) per capita, life expectancy and education into a single index, precisely because income alone is an incomplete measure of wellbeing.

Developing economies share certain characteristics that both reflect and reinforce their situation: low GDP per capita and high poverty; a large share of output and employment in low-productivity primary (agricultural) production; rapid population growth; low levels of human capital (health and education); poor infrastructure; and often weak institutions. Many are dependent on exporting a narrow range of primary commodities, whose prices are volatile and whose long-run terms of trade may decline (the Prebisch-Singer hypothesis), leaving them vulnerable.

The barriers to growth and development are several and interconnected. The savings gap (the Harrod-Domar idea): poor countries have low incomes, so low saving, so little finance for the investment needed to grow - a vicious circle of poverty. Lack of human capital (poor health and education limiting productivity); poor infrastructure (transport, power, water); the foreign-currency gap and debt burdens; weak institutions, corruption and insecure property rights; primary-product dependency and volatile export earnings; and, for some, geography, conflict and the effects of climate change. These barriers reinforce one another, which is why development is difficult.

Strategies to promote development are conventionally split, like supply-side policy, into market-oriented and interventionist, and each is evaluated by weighing its promise against its risks. Market-oriented strategies include trade liberalisation and export-led growth (using comparative advantage to grow through exports, as in East Asia), attracting foreign direct investment by multinationals (bringing capital, technology and jobs, but with concerns about profits repatriated and labour standards), promoting microfinance, and removing government-imposed distortions. Interventionist strategies include government investment in infrastructure, education and health (building the human and physical capital the market under-provides), development of the primary sector, protectionism for infant industries, managed exchange rates, and the use of foreign aid and debt relief. There is no single formula: the appropriate strategy 'depends on' a country's specific barriers, institutions and stage of development, and most successful cases (such as the East Asian economies) combined outward-looking, market-based trade with strong, capable government investment in human capital and infrastructure - a balanced conclusion that draws together the whole macroeconomics course.

Worked example

Choosing a development strategy

A developing country depends on exporting a single primary commodity whose price is volatile, and has low levels of education. Suggest a suitable strategy and explain one risk.

Diagnose the barriers
The country faces primary-product dependency (volatile export earnings and possibly declining terms of trade) and low human capital, which limits productivity and diversification.
Propose a strategy
A combined approach: interventionist investment in education and infrastructure (raising human capital and enabling diversification) alongside measures to develop and diversify exports beyond the single commodity, reducing vulnerability.
State a risk
The strategy requires funding that a poor government may lack (the savings and foreign-currency gaps), and it works only slowly; borrowing or aid to finance it carries the risk of a rising debt burden if the investment does not raise growth enough to repay it.

Result: Investing in human capital and diversifying exports addresses the country's specific barriers, but faces the constraints of limited finance, long time lags and the risk of rising debt.

Typical mistakes

Treating growth and development as the same - growth need not reduce poverty or improve health and education.
Advocating a single strategy for all countries - the right approach depends on the specific barriers and institutions.

Active revision

Evaluate the view that attracting foreign direct investment is the most effective strategy for promoting development in a poor economy.

Active recall

Recall the key points — then reveal.

Sources: GCE AS and A level subject content for economics (Department for Education) · AQA A-level Economics 7136 specification (AQA)

References & sources

Sources

Department for Education

GCE AS and A level subject content for economics

AQA

AQA A-level Economics 7136 specification

The international economy

5 sections~21 min reading time4 competenciesLevel Standard 1 · Advanced 4

The international economy

Key points

Weighing a consequence of globalisation

Key points

Finding comparative advantage and the gains from trade

Key points

Analysing a tariff

Key points

Exchange-rate conversion and competitiveness

Key points

Choosing a development strategy

Sources

The international economy

Key points

Weighing a consequence of globalisation

Key points

Finding comparative advantage and the gains from trade

Key points

Analysing a tariff

Key points

Exchange-rate conversion and competitiveness

Key points

Choosing a development strategy

Sources