Definition of free trade

International Trade and Globalisation

Specialisation and Free Trade (6.1)

Objective

Students should be able to:

• Give a concise definition of free trade and list its five required features.
• Explain why countries adopt free trade (the rationale).
• Define specialisation and state two advantages and two disadvantages.
• Illustrate the impact of removing a tariff with a simple supply‑and‑demand diagram.
• Evaluate the benefits and drawbacks of free trade (AO3).

1. Comparative Advantage (6.1.1)

Comparative advantage is the ability of a country to produce a good or service at a lower opportunity cost than another country. It is the theoretical basis for specialisation and for the gains from free trade.

2. Specialisation by Country (6.1.1)

Specialisation occurs when a country concentrates its resources on producing the goods for which it has a comparative advantage.

• Advantages
  • Higher efficiency – resources are used where they are most productive.
  • Lower average costs and lower prices for consumers.
• Disadvantages
  • Dependence on foreign markets for goods that are not produced domestically.
  • Vulnerability to external shocks (e.g., sudden changes in world prices).

3. Definition of Free Trade (6.1.2)

Free trade is a government policy that removes all barriers to the import and export of goods and services.

4. Five Required Features of Free Trade (syllabus 6.1.2)

1. No tariffs or import duties.
2. No quantitative restrictions (quotas) on imports or exports.
3. No export subsidies are provided to domestic firms.
4. No discriminatory non‑tariff barriers (e.g., restrictive standards, licences that favour domestic producers).
5. No import licences or other administrative restrictions that limit the quantity of imports.

5. Rationale – Why Countries Pursue Free Trade (6.1.2)

1. Specialisation: Countries can concentrate on the goods for which they have a comparative advantage.
2. Efficiency gains: Resources move to their most productive uses, reducing production costs.
3. Higher real incomes: Consumers benefit from lower prices and greater variety; producers gain from larger markets.
4. Economic growth: Access to larger markets encourages investment, innovation and technology transfer.
5. International cooperation: Reducing trade barriers lowers the risk of trade‑related conflicts and promotes peaceful relations.

6. Limitations / Counter‑arguments (useful for AO3 evaluation)

• Infant‑industry argument: New industries may need temporary protection to develop.
• Strategic‑industry argument: Certain sectors (defence, energy) are kept protected for national security.
• Distributional effects: Free trade can create winners (exporters, low‑cost consumers) and losers (workers in protected industries).
• Environmental concerns: Increased transport can raise carbon emissions; trade‑related standards may be needed.

7. Diagram Prompt – Effect of Removing a Tariff (6.1.2)

• Draw a standard supply‑and‑demand diagram for an imported good.
• Vertical axis: Price (P); horizontal axis: Quantity (Q).
• World supply (S_W) is a horizontal line at the world price.
• Domestic demand (D) intersects S_W at the free‑trade equilibrium (P₂, Q₂).
• Introduce a tariff t: shift S_W upward by the amount of the tariff, creating a new equilibrium (P₁, Q₁).
• Shade:
  • Loss of consumer surplus (area between P₁ and P₂ over Q₂).
  • Government revenue (rectangle between P₁ and P₂ over Q₁).
  • Dead‑weight loss (triangles representing loss of producer surplus and efficiency).
• Label all curves and areas clearly.

8. Comparison: Free Trade vs. Protectionism (6.1.2)

Aspect	Free Trade	Protectionism
Tariffs	None or very low	High tariffs imposed
Quotas	Absent	Quantitative limits on imports
Export subsidies	No export subsidies to domestic firms	Export subsidies used to support domestic producers
Non‑tariff barriers	Discriminatory standards, licences, and other measures removed	Discriminatory non‑tariff measures retained
Import licences / administrative restrictions	None	Licences required; quotas on quantity
Consumer prices	Generally lower because of competition	Higher due to reduced competition
Domestic industry	Competes on efficiency and innovation	Shielded from foreign competition

9. Evaluation Tip (AO3 – Paper 2, part d)

10. Environmental / Sustainability Link (new 2027 requirement)

Free trade can increase the volume of international transport, potentially raising carbon emissions. Conversely, trade can spread environmentally‑friendly technologies and enable the adoption of international environmental standards.

6.2 Globalisation & Trade Restrictions

Definition of Globalisation

Globalisation is the increasing integration of national economies through the growth of international trade, investment, and the movement of people, ideas and technology.

Main Causes

• Reduced transport costs (e.g., container shipping, air freight).
• Improved communications and information technology (internet, satellite).
• Growth of multinational corporations (MNCs) that operate in several countries.

Consequences of Globalisation

• Positive
  • Greater market access → larger economies of scale.
  • Faster diffusion of technology and ideas.
• Negative
  • Increased competition can lead to job losses in less‑competitive sectors.
  • Potential cultural homogenisation and environmental pressure.

Types of Trade Restrictions (examples)

Restriction	What it does	Example
Tariff	Tax on imported goods	UK steel import duty of 25 %
Quota	Quantitative limit on imports	EU banana import quota for West African producers
Export subsidy	Financial aid to domestic exporters	US agricultural export subsidies
Embargo	Complete ban on trade with a country	International embargo on North‑Korea

Reasons for Restricting Trade

• Protect infant or strategic industries.
• Safeguard jobs and income in vulnerable sectors.
• Raise government revenue (tariffs).
• Political reasons – e.g., sanctions or retaliation.
• Environmental or health concerns (e.g., bans on hazardous imports).

Consequences of Trade Restrictions

• Higher domestic prices for consumers.
• Reduced choice and possible inefficiency.
• Retaliation from trading partners → trade wars.
• Short‑term protection of domestic jobs but possible long‑term loss of competitiveness.

6.3 Foreign‑Exchange Rates

Definition

A foreign‑exchange (FX) rate is the price of one country’s currency expressed in terms of another country’s currency (e.g., £1 = €1.17).

Why Countries Buy or Sell Foreign Currency

• Imports – need foreign currency to pay for goods and services.
• Exports – receive foreign currency from overseas buyers.
• Investment – buy foreign assets or bring home profits.
• Speculation – aim to profit from expected changes in the exchange rate.

Floating Exchange Rate Determination

In a floating system the rate is set by market forces of supply and demand for the currency.

• Supply of domestic currency – arises when residents buy foreign goods, travel abroad, or invest overseas.
• Demand for domestic currency – comes from foreign buyers of domestic exports, foreign investors, and tourists.

Supply‑and‑Demand Diagram (description)

• Vertical axis: Exchange rate (e) (price of foreign currency).
• Horizontal axis: Quantity of foreign currency.
• Downward‑sloping demand curve (D) and upward‑sloping supply curve (S) intersect at the equilibrium rate (e*).
• A rise in demand (e.g., increased export earnings) shifts D right → higher e (domestic currency depreciates).
• A rise in supply (e.g., higher imports) shifts S right → lower e (domestic currency appreciates).

Consequences of Exchange‑Rate Changes

• Depreciation – makes exports cheaper and imports more expensive → can improve the trade balance but may increase inflation.
• Appreciation – makes imports cheaper and exports more expensive → may reduce inflation but can worsen the trade balance.

6.4 Current Account of the Balance of Payments

Components

• Goods – export and import of physical products.
• Services – tourism, transport, financial services.
• Primary income – earnings on investments (interest, dividends) received from abroad and paid to abroad.
• Secondary income – transfers such as foreign aid, remittances, pensions.

Current‑Account Balance Calculation

Current‑account balance = (Exports of goods + Exports of services) – (Imports of goods + Imports of services) + Net primary income + Net secondary income

Example

Suppose in a year a country records:

• Goods exports: £200 bn; goods imports: £250 bn
• Services exports: £80 bn; services imports: £60 bn
• Net primary income: –£10 bn (more paid abroad)
• Net secondary income: +£5 bn (more received)

Current‑account balance = (200 + 80) – (250 + 60) – 10 + 5 = £-35 bn (a deficit).

Causes & Consequences of Deficits / Surpluses

• Deficit
  • Caused by higher imports than exports, large outflows of primary income, or low inflows of transfers.
  • May lead to borrowing from abroad, a rise in foreign‑exchange liabilities, and potential pressure on the domestic currency.
• Surplus
  • Caused by strong export performance, large inflows of investment income, or high remittances.
  • Can lead to currency appreciation, accumulation of foreign reserves, and increased national saving.

Policy Responses

• Exchange‑rate adjustments (devaluation to boost exports).
• Fiscal measures – reduce public spending to lower import demand.
• Trade policies – temporary tariffs or subsidies (though these may conflict with free‑trade commitments).

Key Take‑away

Free trade removes tariffs, quotas, export subsidies and discriminatory non‑tariff barriers, enabling countries to specialise according to comparative advantage. This generally leads to more efficient resource use, lower consumer prices, higher real incomes, and potential economic growth. However, students must also recognise the limits of free trade – infant‑industry needs, strategic considerations, distributional effects and environmental impacts – and be able to evaluate both sides of the argument using real‑world examples.