The basis for specialisation by country in terms of the best resource allocation and/or low-cost production

International Trade, Globalisation and Foreign Exchange – IGCSE Economics (Syllabus 6.1‑6.4)

Learning Objectives

• Explain why countries specialise in particular goods and how this leads to more efficient resource allocation and lower‑cost production.
• Describe the main features of globalisation, its drivers, and the reasons governments may restrict trade.
• Define foreign exchange, explain why currencies are bought and sold, and identify the main factors that influence exchange rates.
• Understand the structure of the balance of payments, how it records a country’s economic transactions with the rest of the world, and how to calculate a current‑account surplus or deficit.

6.1 Specialisation by Country and Free Trade

Key Definitions

• Scarcity: The fundamental economic problem that resources (land, labour, capital, technology) are limited relative to unlimited wants.
• Specialisation by country: Concentrating production on the goods and services for which a country has a comparative advantage and importing the rest.
• Comparative advantage: The ability to produce a good at a lower opportunity cost than another country.
• Absolute advantage: The ability to produce more of a good with the same resources (or the same amount with fewer resources) than another country.
• Free trade: The removal of barriers (tariffs, quotas, subsidies, embargoes, import licences) that impede the flow of goods, services and factors of production between countries.
• Monopoly (market failure): When a single firm dominates a market, often a side‑effect of protectionist policies that limit competition.

Why Countries Specialise

• Resource endowments: Different mixes of land, labour, capital and technology create comparative advantages.
• Opportunity cost: Producing one good means giving up another; lower opportunity costs generate comparative advantage.
• Economies of scale: Larger output spreads fixed costs, lowering average cost.
• Consumer demand: Specialisation expands variety and reduces prices for consumers.
• Technology & innovation: Advances can shift comparative advantage over time.
• Environmental sustainability (new syllabus point): Countries may specialise in greener industries, but free trade can also encourage “carbon leakage”.

Calculating Opportunity Cost – Example

Opportunity‑cost calculations:

• Country A:

  • OC of 1 unit Wheat = 2⁄5 = 0.4 units Cloth.
  • OC of 1 unit Cloth = 5⁄2 = 2.5 units Wheat.

• Country B:

  • OC of 1 unit Wheat = 3⁄3 = 1 unit Cloth.
  • OC of 1 unit Cloth = 3⁄3 = 1 unit Wheat.

→ Country A has a comparative advantage in Wheat; Country B in Cloth.

Gains from Trade – PPF Diagram (AO2)

• Draw a Production‑Possibility Frontier (PPF) for each country showing the maximum possible output of the two goods.
• Identify the point where each country specialises (produces only the good in which it has comparative advantage).
• Draw the world‑price line (terms of trade) that is flatter than Country A’s PPF and steeper than Country B’s PPF.
• Show the post‑trade consumption points where both countries can consume beyond their own PPFs – the “gains from trade”.
• Label the area between the pre‑trade and post‑trade consumption points; this area represents the net benefit to the world.

Diagram suggestion: Two intersecting PPFs, a world‑price line, and arrows to the specialised production points and new consumption points.

Advantages of Free Trade

• Lower prices and greater variety for consumers.
• Producers gain access to larger markets → economies of scale.
• Resources are allocated to their most productive uses globally, raising world GDP.
• Increased competition spurs innovation and productivity.
• Potential environmental benefits when countries specialise in greener technologies.

Disadvantages / Criticisms of Free Trade

• Short‑run adjustment costs for workers in industries that lose competitiveness.
• Potential dependence on foreign suppliers for essential goods.
• Environmental and labour‑standard concerns when production shifts to countries with weaker regulations (carbon leakage, “race to the bottom”).
• May reinforce existing monopolies if protectionist policies are used to shield dominant domestic firms.

6.2 Globalisation and Trade Restrictions

What is Globalisation?

• Increasing integration of national economies through the growth of international trade, investment, migration and the rapid spread of technology.

Key Drivers and Their Consequences (syllabus requirement)

Consequences of Globalisation

• Higher levels of trade and foreign direct investment (FDI).
• Greater competition for domestic firms.
• Potential for faster economic growth and poverty reduction.
• Risk of widening income inequality within and between countries.
• Environmental pressures from increased production and transport.
• Potential cultural homogenisation and loss of local traditions.

Role of Multinational Corporations (MNCs)

• Operate in several countries, transferring capital, technology and managerial expertise.
• Can create jobs and stimulate host‑country development, but may also repatriate profits and wield market power that can crowd out local firms.

Trade‑restriction Instruments

Reasons Governments Impose Restrictions (syllabus list)

• Infant‑industry protection: Allow new domestic industries to develop.
• Anti‑dumping: Counteract foreign producers selling below cost.
• Strategic/defence: Preserve industries vital for national security.
• Revenue generation: Tariffs as a source of government income.
• Environmental or health concerns: Limit imports that cause pollution, spread disease, or contain harmful substances.
• Protection of demerit goods: Reduce consumption of products deemed socially undesirable (e.g., tobacco, alcohol).
• Monopoly prevention (cross‑cutting): Restricting imports can sometimes create domestic monopolies; governments may intervene to avoid this distortion.

Pros and Cons of Trade Restrictions

6.3 Foreign‑Exchange Rates

Key Definitions

• Foreign exchange (FX): The market where currencies are bought and sold.
• Exchange rate: The price of one currency expressed in terms of another (e.g., £1 = $1.30).
• Floating (market‑determined) exchange rate: Set by supply and demand in the FX market.
• Fixed (pegged) exchange rate: Government or central bank sets a target rate against another currency or a basket and maintains it by buying/selling reserves.
• Managed float (dirty float): Mostly market‑driven but with occasional central‑bank intervention.
• Appreciation: When a currency’s value rises relative to another.
• Depreciation: When a currency’s value falls relative to another.

Why Currencies are Bought and Sold

• Imports: Domestic importers need foreign currency to pay overseas suppliers.
• Exports: Foreign buyers need domestic currency to purchase home‑grown goods.
• Investment: Investors buy foreign currency to purchase overseas assets (FDI, portfolio investment).
• Tourism: Travelers exchange money for the currency of the destination country.
• Speculation: Traders buy or sell currencies hoping to profit from future movements.

Factors that Influence Exchange Rates

• Relative inflation rates: Higher inflation in a country tends to depreciate its currency.
• Interest‑rate differentials: Higher domestic interest rates attract foreign capital → appreciation.
• Economic growth (GDP): Strong growth raises demand for a country’s exports and its currency.
• Political stability & confidence: Uncertainty can cause capital outflows and depreciation.
• Current‑account balance: Persistent deficits increase demand for foreign currency.
• Speculative expectations: Anticipated future movements can become self‑fulfilling.

Supply‑Demand Diagram of the FX Market (AO2)

• Horizontal axis: Quantity of foreign currency.
• Vertical axis: Exchange rate (price of foreign currency in domestic terms).
• Equilibrium where the supply curve (domestic sellers of foreign currency) meets the demand curve (domestic buyers of foreign currency).
• Shift of demand rightward (e.g., higher domestic interest rates) → appreciation.
• Shift of supply rightward (e.g., larger import bill) → depreciation.

Diagram suggestion: Show the initial equilibrium, then illustrate a rightward demand shift and a rightward supply shift with the resulting new equilibrium points.

Impact of Exchange‑Rate Movements

• Depreciation: Exports become cheaper for foreigners → export volumes rise; imports become more expensive → import volumes fall; can improve the trade balance but may raise domestic inflation.
• Appreciation: Imports become cheaper, export competitiveness falls; may worsen the trade balance but helps contain inflation.

6.4 Balance of Payments (BoP)

Purpose of the BoP

• Record all economic transactions between residents of a country and the rest of the world over a given period.
• Show whether a country is a net borrower or lender internationally.

Structure of the BoP (as required by the syllabus)

1. Current Account

   • Goods (exports – imports)
   • Services (tourism, transport, insurance, etc.)
   • Primary income (profits, interest, dividends received & paid)
   • Secondary income (remittances, foreign aid, gifts)

2. Capital Account

   • Transfers of non‑produced, non‑financial assets (e.g., debt forgiveness, migrants’ assets, gifts of intangible assets).

3. Financial Account

   • Direct investment (FDI)
   • Portfolio investment (stocks, bonds)
   • Other investment (loans, currency reserves, bank deposits)

4. Errors & Omissions – statistical adjustments to ensure the accounts balance.

Formula for the Current‑Account Balance (AO2)

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

Interpreting the BoP

• A surplus in the current account (exports > imports) generally means the country is a net lender to the rest of the world.
• A deficit must be financed by capital inflows (foreign investment) or by drawing down foreign‑exchange reserves.
• Persistent deficits can lead to depletion of reserves and may force a devaluation or a shift to a more restrictive exchange‑rate regime.

Example – Simplified BoP (in $ billions)

Policy Implications

• Governments may use exchange‑rate policy, tariffs, or fiscal measures to correct persistent imbalances.
• Improving export competitiveness (e.g., through productivity gains or moving up the value chain) can shift a current‑account deficit toward surplus.
• Environmental taxes (e.g., carbon border adjustments) can affect both the current and financial accounts by altering trade flows.

Exam Checklist – What You Must Be Able to Do

• Define scarcity, specialisation, comparative advantage, absolute advantage, free trade, globalisation, and monopoly.
• Calculate opportunity cost from a production table and identify which country has comparative advantage.
• Draw and label a PPF diagram showing specialisation, the world‑price line, and post‑trade consumption points; explain how total output rises.
• List at least three advantages and three disadvantages of free trade, including an environmental sustainability point.
• Identify the main drivers of globalisation and explain one specific consequence of each driver.
• State the different trade‑restriction instruments and give one reason a government might use each (including environmental/health reasons).
• Explain why currencies are bought and sold and define floating, fixed, and managed‑float exchange‑rate regimes.
• Use a supply‑demand diagram of the FX market to illustrate appreciation and depreciation.
• Calculate a current‑account surplus/deficit using the formula provided and interpret what the result indicates about a country’s international position.
• Describe the four main components of the BoP (current, capital, financial, errors & omissions) and explain how a persistent current‑account deficit can affect exchange‑rate policy.