International Trade, Exchange Rates, and Globalization
Core concepts
Comparative advantage explains gains from trade: a country should specialize where its opportunity cost is lowest, even if another country has an absolute advantage in everything. Absolute advantage means producing more with the same resources.
Trade balance: exports − imports. A trade deficit means imports exceed exports; it must be financed by capital inflows. Protectionism includes tariffs (taxes on imports), quotas (quantity limits), and subsidies; it raises domestic prices and reduces total surplus, though it may protect infant industries or strategic sectors.
Exchange rates: an appreciation makes exports dearer and imports cheaper; a depreciation does the reverse. Exchange rates are determined by supply and demand for currencies, influenced by interest rates, inflation, and expectations. Purchasing power parity is a long-run benchmark.
Globalization refers to growing integration of goods, capital, and labor markets; benefits include specialization and lower prices, costs include adjustment pressures and inequality concerns.
Common traps
- Confusing absolute and comparative advantage; comparative advantage is the basis for trade.
- Assuming a trade deficit is always harmful; it reflects capital flows and consumption choices.
- Mixing up currency appreciation with export competitiveness (appreciation hurts exports).
- Forgetting that tariffs raise domestic prices for consumers.
Worked example
Country A gives up 2 units of cloth to make 1 unit of steel; Country B gives up 4 units of cloth. A has the lower opportunity cost in steel, so A specializes in steel and B in cloth; both gain through trade even if B is larger overall.
Rule of thumb
Specialize where opportunity cost is lowest. Appreciation → cheaper imports, dearer exports. Tariffs raise prices and shrink total surplus.