World trade grew rapidly over the past 40 years, and is
dominated by the developed countries. Primary commodities
are 25 per cent of world trade; the rest is trade in manufactures.
Countries trade because they can buy goods more cheaply abroad. Differences
in costs reflect differences in technology and factor endowments. Scale economies
also lead to international specialization.
Countries make the goods in which they have a comparative advantage
or can produce relatively cheaply. By exploiting international differences
in opportunity costs, trade leads to a pure gain.
When technology diffuses quickly to other countries, relative factor
endowments are the main cause of different relative costs. Countries
produce and export goods that use intensively the factors with which the country
is relatively well endowed.
Intra-industry trade occurs because of scale economies
and consumer demand for diversity. The gain from this trade is cost reduction
and greater diversity of products.
If trade is to balance, and the forex market is to be in equilibrium, each
country must have a comparative advantage in at least one good. The level
of the equilibrium exchange rate offsets international differences in absolute
advantage.
Although international trade can benefit the world as a whole, trade usually
hurts some groups of people, unless the gainers compensate the losers.
By raising the domestic price, a tariff reduces consumption but raises domestic output.
Hence imports fall.
A tariff leads to two distortions that are social costs: overproduction
by domestic firms whose marginal cost exceeds the world price, and under-consumption
by consumers whose marginal benefit exceeds the world price.
When a country affects the price of its imports, the world price is less
than the social marginal cost of importing. This is the case for the optimal
tariffs. Otherwise, arguments for tariffs are usually second-best
solutions. A production subsidy or consumption tax achieves the aim at lower
social cost.
Export subsidies raise domestic prices, reducing consumption
but raising output and exports. They involve waste. Goods are exported for
less than society's marginal production cost and for less than the marginal
benefit to domestic consumers.
Tariffs and other non-tariff barriers fell a lot in the last 40 years.
Trade protection is usually costly to society. Yet governments often adopt
it as an easy option politically.
