Absolute Advantage: The ability to produce a good or service more efficiently than another country.
Comparative Advantage: The ability to produce a good or service at a lower opportunity cost than another country. This is the basis for trade.
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March 02, 2025 21:36
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International Trade Cheatsheet
A concise reference guide to the key concepts, theories, and policies governing international trade, covering comparative advantage, trade barriers, exchange rates, and trade agreements.
Foundations of International Trade
Core Principles
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Opportunity Cost: What is forgone when choosing one alternative over another. Crucial for determining comparative advantage. |
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Specialization: Countries should specialize in producing goods and services for which they have a comparative advantage. |
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Gains from Trade: Countries benefit from trade by consuming beyond their own production possibilities. |
Theories of Trade
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Mercantilism |
Advocates trade surpluses to accumulate national wealth (gold reserves). Largely discredited today. |
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Adam Smith |
Argued for free trade based on absolute advantage, promoting efficiency and wealth creation. |
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David Ricardo |
Developed the theory of comparative advantage, demonstrating that trade can be mutually beneficial even if one country is more efficient in producing everything. |
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Heckscher-Ohlin Model |
Countries export goods that use their abundant factors of production intensively (e.g., labor, capital). |
Trade and Welfare
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Consumer Surplus: The difference between what consumers are willing to pay and what they actually pay. |
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Producer Surplus: The difference between what producers receive and their cost of production. |
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Total Welfare: Sum of consumer and producer surplus. Trade generally increases total welfare, but can create winners and losers within a country. |
Trade Barriers and Policies
Types of Trade Barriers
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Tariffs |
Taxes on imported goods. Increase the price of imports, protecting domestic producers but harming consumers. |
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Quotas |
Quantitative limits on the amount of a good that can be imported. Similar effects to tariffs, but can lead to larger welfare losses. |
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Subsidies |
Government payments to domestic producers. Lower production costs, making them more competitive, but can distort global markets. |
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Non-Tariff Barriers (NTBs) |
Regulations, standards, and other policies that restrict trade without explicit tariffs or quotas (e.g., sanitary regulations, labeling requirements). |
Arguments for Trade Restrictions
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Infant Industry Argument: Protecting new industries until they are mature enough to compete internationally. |
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National Security Argument: Protecting industries vital for national defense. |
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Job Protection Argument: Shielding domestic jobs from foreign competition. |
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Unfair Competition Argument: Counteracting subsidies or other unfair practices by foreign firms. |
Effects of Tariffs
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Price Effect |
Tariffs increase the domestic price of imported goods. |
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Quantity Effect |
Tariffs reduce the quantity of imported goods. |
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Revenue Effect |
Tariffs generate revenue for the government. |
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Welfare Effect |
Tariffs create deadweight losses, reducing overall welfare. |
Exchange Rates and the Balance of Payments
Exchange Rate Systems
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Fixed Exchange Rate: The exchange rate is set and maintained by the government. |
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Floating Exchange Rate: The exchange rate is determined by market forces of supply and demand. |
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Managed Float: The exchange rate is primarily determined by market forces, but the government intervenes occasionally. |
Balance of Payments
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Current Account |
Measures the flow of goods, services, income, and unilateral transfers. |
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Capital Account |
Records the flow of investments in assets. |
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Financial Account |
Transactions that involve the purchase or sale of assets, including foreign direct investment (FDI). |
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Official Reserve Account |
A component of the balance of payments that reflects changes in a country’s official reserves of foreign currency. |
Factors Affecting Exchange Rates
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Relative Inflation Rates: Higher inflation in a country typically leads to currency depreciation. |
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Relative Interest Rates: Higher interest rates attract foreign investment, increasing currency demand and appreciation. |
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Economic Growth: Stronger economic growth can lead to currency appreciation. |
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Government Policies: Interventions in the foreign exchange market can influence exchange rates. |
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Market Psychology: Expectations and speculation can drive short-term exchange rate movements. |
Trade Agreements and Organizations
Types of Trade Agreements
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Preferential Trade Agreement (PTA): Reduces trade barriers among participating countries. |
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Free Trade Area (FTA): Eliminates tariffs among member countries. |
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Customs Union: FTA plus a common external tariff policy. |
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Common Market: Customs union plus free movement of labor and capital. |
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Economic Union: Common market plus harmonization of economic policies. |
Key Trade Organizations
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World Trade Organization (WTO) |
Deals with the global rules of trade between nations. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible. |
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International Monetary Fund (IMF) |
Promotes international monetary cooperation and provides policy advice and temporary financial assistance to countries to help them build and maintain strong economies. |
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World Bank |
Provides loans and grants to governments of poorer countries for the purpose of pursuing capital projects. |
Impact of Trade Agreements
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Trade Creation: Increased trade due to reduced trade barriers within the agreement, leading to greater efficiency. |
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Trade Diversion: Trade shifts from a more efficient non-member country to a less efficient member country due to the trade agreement. |
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Economic Growth: Trade agreements can stimulate economic growth through increased trade and investment. |