International Trade

1. What is International Trade?

Definition: International trade is also called free trade — trade with no barriers to entry and exit (no trade barriers, no sanctions, no rukawat).

Today “barriers” are usually called sanctions = rukawat in trade.

e.g. Pakistan has free trade: a firm can walk in, open branches, make big profits, then shut down and leave (sir's examples: Pizza Hut came, expanded and left; Burger King, Dunkin' and Shell are now struggling / leaving).

In this chapter we study: what sanctions / barriers a government uses to stop trade, why (protect domestic producers) and what the effects are.

2. Visible vs Invisible Trade

Trade is always of goods or of services — and either can be exported or imported.

3. Balance of Trade (BOT)

Whenever we talk about trade, the concept of balance of trade comes in. It is the X − M part of aggregate demand:

4. Specialisation — Why Countries Trade

A country always trades in the thing it is specialised in: it exports what it specialises in and imports from the country that specialises in the other good.

Sir's own example: he teaches both economics and business but is better at economics → he specialises in it.

When a country trades it gets two benefits → absolute advantage and comparative advantage (explained in sections 8–9).

5. Advantages of Free Trade

1. Economies of scale can be achieved — fall in per-unit average cost. Selling to the whole world means I work on a larger scale and buy resources in bulk ⇒ bulk discounts ⇒ lower AC.
2. GDP rises — GDP = total output produced in a country in a year (e.g. 1,10,000 units in the year = GDP).
3. World output rises — every country produces goods for the other countries too.
4. Employment rises — producing for the whole world ⇒ demand for labour ↑ ⇒ unemployment ↓.
5. Tax revenue rises — more people working ⇒ more tax for the government. (Demerit goods like cigarettes and alcohol, which harm society, are taxed heavily — “double tax” — so extra revenue.)
6. Greater availability of resources — no barriers, so I can buy / sell any amount from any country.
7. BOT surplus and BOP positive are possible — e.g. China's BOT is usually in surplus (export revenue > import expenditure; inflows > outflows).
8. More competition ⇒ firms keep prices low ⇒ benefit to consumers + wider range of choices. The more open a country, the more efficient home producers must become.
9. No chance of monopoly (so many foreign rivals).
10. Bigger platform — firms sell to a larger market ⇒ economies of scale (cheaper raw material in bulk).

6. Disadvantages of Free Trade

1. Diseconomies of scale — working at a very large scale is hard to manage and coordinate ⇒ average cost rises.
2. Domestic industry suffers — people buy imports and leave home products. e.g. in Pakistan an iPhone needs a tax (PTA approval, sir: around AED 1,200–1,500) so people go for Samsung / Oppo / Nokia; with free trade, everyone would just buy the iPhone.
3. Infant industry will die — infant = newly born industry / start-up; nobody buys from it when everyone buys imported.
4. Sunset industry suffers — sunset = declining industry; it sinks faster because people buy imports.
5. Depletion of resources — over-allocation uses up natural resources (all limited) ⇒ shortage.
6. BOT deficit (import expenditure > export revenue) and BOP negative (outflows > inflows). A country like Pakistan usually has BOT deficit.

7. Bilateral Trade

Definition: Bilateral trade is trade between two countries in two goods. The goods can be any — good X, good Y, rice, cotton, TV, mobile …

e.g. Pakistan gives rice to Sri Lanka and gets tea leaves + coffee beans in return → 2 countries, 2 goods ⇒ bilateral trade. The two goods are not fixed.

Trade takes place only when a country is specialised in a particular good = it can produce it efficiently and effectively (more output from fewer resources). A specialised country gets 2 advantages: absolute and comparative.

8. Absolute vs Comparative Advantage

9. Finding Comparative Advantage (the Ratio)

Comparative advantage is found with a ratio called the lower opportunity cost ratio. The ratio you make depends on which good you are asked about:

Reading the ratio is the whole game! “1X : 2Y” means: to make 1 unit of X, this country gives up (forgoes) 2 units of Y.

Picture it: country A has 1 hour and two options — make 1X or make 2Y. Choosing 1X means forgoing 2Y.

10. Why Ratios Matter — Exchange Rate Rule

Trade is done on the basis of the exchange rate. In these sums, sir uses exchange rate and opportunity cost ratio to mean the same thing.

Different ratios are the first condition for a comparative advantage to exist.

11. Worked Example 1 — Same Ratios

Q: Which country has absolute and comparative advantage?

Absolute advantage: X → B (300 > 200) · Y → B (600 > 400)

Country B has absolute advantage in producing both goods.

Comparative advantage (asked about X ⇒ ratio X : Y):

In an MCQ the same example may come as a graph instead of a table: two lines with the same slope (X on the vertical axis, Y on the horizontal axis). A makes up to 200X or 400Y; B makes up to 300X or 600Y.

12. Worked Example 2 — Different Ratios

Absolute advantage: X → A (400 > 200) · Y → A (800 > 600)

Country A has absolute advantage in producing both goods X and Y.

① Comparative advantage in good X (ratio X : Y)

Ratios are different ✓. A forgoes 2Y to make 1X; B forgoes 3Y. A forgoes less, B forgoes more ⇒ A is specialised in X.

Country A has comparative advantage in producing good X.

② Comparative advantage in good Y (ratio Y : X)

A forgoes more (0.5X) to make 1Y; B forgoes less (0.33X) ⇒ B is specialised in Y.

Country B has comparative advantage in producing good Y.

13. Protectionism

Definition: Protectionism = a country moving away from free trade. It is done by the government, which imposes trade barriers (today called sanctions).

Why? To protect the domestic industry from foreign competition — i.e. to make residents switch from foreign goods to domestic goods.

To do this the government uses protectionism tools. The main one is the tariff.

14. Tariff

Tariff ⇒ imported good becomes dearer ⇒ quantity imported falls ⇒ import expenditure changes. By how much / which way depends on PED (price elasticity of demand).

e.g. In Pakistan you must pay a tax (PTA approval) to use the SIM in an imported iPhone. That is a tariff on an imported good — the government wants people to leave the iPhone and use domestic phones (Oppo, Nokia …).

Demand for an imported good can be elastic or inelastic:

If demand is INELASTIC — imported inflation

Imported inflation is a part of cost-push inflation — writing “cost-push” is also correct. Diagram: leftward shift of AS.

If demand is ELASTIC — what follows

15. The Tariff Diagram

For an 8 / 12-marker you must be able to draw this. How to draw it, step by step:

1. Two axes: vertical = price of imported good, horizontal = quantity of imported good.
2. Draw a downward-sloping DD (domestic demand) and an upward-sloping DS (domestic supply). Where they meet = domestic equilibrium.
3. Draw a horizontal line = world supply (= world price, P_w). It is perfectly elastic because there are lakhs of producers all over the world — no single producer can influence the price.
4. At P_w: Q_d > Q_s (read down from where the line touches DD and DS) ⇒ shortage, filled by imports. So imports before tariff = Q_d − Q_s (the big triangle).
5. A tariff makes imports dearer ⇒ draw a second horizontal line ABOVE world supply = world supply + tariff (WS + t) = world price + tariff (P_w + t).
6. Read again: Q_d1 and Q_s1. Still a shortage ⇒ imports after tariff = Q_d1 − Q_s1 (the small triangle).

16. Quota · VER · Embargo

Quota

e.g. coming into Pakistan from the UAE, Saudi Arabia or anywhere, you can bring only 2 iPhones — a quota of 2; more than 2 is not allowed.

Voluntary Export Restraint (VER)

e.g. best example is demerit goods — cigarettes and chhalia (supari). Pakistani cigarettes (Gold Leaf) are loved in Saudi Arabia / UAE: a PKR 1,000 pack is about 10–15 riyals in Pakistan but about 70–80 riyals there, because Pakistanis carry and sell them. So the limit is: only 24 packets of cigarettes (2 cartons × 12) and 8 chhalia tins per passenger — a limit on a specific category of goods.

Embargo

e.g. Pakistani passport says it is not valid for travel to Israel ⇒ embargo on Israel. Alcohol (wine, whisky) trade is banned — companies can only sell under a licence.

17. Subsidy (Dumping) · Devaluation · Exchange Controls

Subsidy = Dumping

What was subsidy in micro is called dumping in macro. Dumping does not mean throwing rubbish!

e.g. During Covid, roads were jammed and oil-producing countries had tonnes of oil but no storage space — they paid buyers to take it away = dumping.

Firms mostly dump to destroy competitors. If our government gives a subsidy to the domestic good, it is dumping — imported goods look dear, people are forced to buy domestic. Dumping can lead to loss of jobs / unemployment.

Devaluation vs Depreciation (of currency)

(This is about currency — not accounting depreciation.) Why devalue? Our goods become cheaper for foreigners and imports become dearer for us ⇒ exports ↑ and imports ↓. Sir's example: China deliberately weakens the yuan.

Exchange controls

e.g. when travelling out you can take only PKR 25 lakh; you can buy only PKR 7,50,000 worth of foreign currency per visa (limits on how much you can sell / buy). Purpose: gives some economic stability by limiting reliance on the exchange rate.

18. Chapter Cheat-Sheet