Advantages and disadvantages of free trade

International Trade & Globalisation – Specialisation, Free Trade, Globalisation, Trade Restrictions, Foreign‑Exchange Rates and the Current Account

Learning Objective

Explain the concepts of specialisation, free trade, globalisation and trade restrictions; analyse the role of foreign‑exchange rates; describe the current‑account component of the balance of payments; and evaluate the overall impact of these factors on an economy in line with the Cambridge IGCSE Economics (0455) syllabus.

6.1 Specialisation & Free Trade

Specialisation

• Occurs when a country concentrates its resources on producing the goods and services for which it has a comparative advantage – i.e. the lowest opportunity cost.
• It enables the country to import the goods it produces less efficiently.

Comparative Advantage – Key Theory

A country has a comparative advantage in Good A if the opportunity cost of producing one unit of A is lower than that of any other country.

Opportunity Cost of 1 unit of Good A = Units of Good B given up ÷ Units of Good A produced

• When each country specialises according to comparative advantage, world output rises.
• Both countries can then trade to obtain a higher standard of living – the classic “gains from trade”.

Free Trade

A policy that removes tariffs, quotas, subsidies and other government‑imposed barriers, allowing goods and services to move between countries without interference.

Advantages of Free Trade

• Increased economic efficiency – resources shift to their most productive uses, raising total output.
• Lower consumer prices – removal of tariffs and greater competition reduce the cost of imports.
• Greater variety of goods – consumers can buy products not produced domestically.
• Economies of scale – firms can serve larger markets, lowering average costs.
• Stimulus for innovation – competition encourages adoption of new technologies and improved processes.
• Improved international relations – trade interdependence can foster diplomatic cooperation.
• Distributional impact (short‑ vs long‑term) – in the short‑term some workers (especially low‑skill) may lose jobs, while in the long‑term the economy can create higher‑skill, higher‑paying jobs.

Disadvantages of Free Trade

• Domestic industry decline – sectors that cannot compete with cheaper imports may shrink, causing job losses.
• Dependence on foreign supply – over‑reliance on imports makes an economy vulnerable to external shocks (political instability, price spikes).
• Unequal distribution of gains – benefits often accrue to consumers and capital owners, while low‑skill workers may suffer.
• Environmental impact – increased production and transport raise carbon emissions and resource depletion.
• Loss of cultural identity – influx of foreign goods may erode local traditions and businesses.
• Adjustment costs – retraining and relocation of workers require time and public spending.

Suggested Diagram

6.2 Globalisation & Trade Restrictions

Definition of Globalisation

The increasing integration of world economies through the growth of international trade, investment, migration, and the rapid spread of information and technology.

Key Drivers of Recent Globalisation

• Fall in transport costs (containerisation, cheaper air freight).
• Advances in communication technology (Internet, mobile phones, satellite).
• Growth of multinational companies (MNCs) operating in several countries.
• Liberalisation of trade policies (reduction of tariffs, removal of quotas).
• Financial integration – global capital markets, foreign‑direct investment and portfolio flows.

Consequences of Globalisation

Multinational Companies (MNCs)

• Advantages – bring foreign capital, create jobs, transfer technology, increase export earnings, and can improve productivity in host economies.
• Disadvantages – may dominate local markets, repatriate most profits, and sometimes exploit labour or the environment.

Trade Restrictions – Types

• Tariffs – taxes on imported goods.
• Quotas – quantitative limits on imports.
• Subsidies – financial assistance to domestic producers to make them more competitive.
• Embargoes / Trade bans – complete prohibition of trade with a particular country.
• Voluntary Export Restraints (VERs) – exporters agree to limit shipments voluntarily.
• Non‑tariff barriers (NTBs) – standards, licences, sanitary‑phytosanitary measures, and other regulatory requirements that restrict imports.

Reasons for Imposing Trade Restrictions

Consequences of Trade Restrictions

• Home country – higher prices for consumers; protection of certain jobs; possible inefficiency and reduced export competitiveness; risk of retaliation from trading partners.
• Partner (export‑receiving) country – loss of market access; reduced export earnings; possible contraction in related industries.

6.3 Foreign‑Exchange Rates

Key Definitions

• Foreign exchange (FX) market – where currencies are bought and sold.
• Exchange rate – the price of one currency expressed in terms of another (e.g., £1 = $1.30).

Types of Exchange Rates

• Spot rate – rate for immediate delivery (usually within two business days).
• Forward rate – rate agreed today for a transaction that will occur at a future date.
• Fixed (pegged) rate – set by the government or central bank and maintained through intervention (buying/selling foreign currency).
• Floating (flexible) rate – determined by market forces of demand and supply.

Factors Influencing Exchange Rates

Impact of Exchange‑Rate Movements

• Depreciation – imports become more expensive, export prices fall for foreign buyers, export volumes rise, trade balance may improve, but inflationary pressure can increase.
• Appreciation – imports become cheaper, export earnings fall, export volumes may drop, trade balance can deteriorate, but lower import prices help control inflation.

Link to the Current Account

The current account records trade in goods and services, net primary income and net secondary income. A persistent current‑account deficit tends to put downward pressure on the domestic currency (depreciation), whereas a surplus creates upward pressure (appreciation). Exchange‑rate movements therefore act as an automatic stabiliser for the current account.

Suggested Diagram

6.4 Current Account of the Balance of Payments

Definition

The current account records a country’s transactions in:

• Goods (exports – imports)
• Services (tourism, transport, financial services)
• Primary income (profits, interest, dividends)
• Secondary income (remittances, foreign aid, gifts)

Calculating the Current‑Account Balance

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

• Positive result = surplus (more money flowing in than out).
• Negative result = deficit** (more money flowing out than in).

Why the Current Account Matters

• Indicates the country’s net position with the rest of the world.
• A large deficit may require financing through capital inflows or borrowing, increasing external debt.
• A large surplus can lead to upward pressure on the domestic currency, affecting export competitiveness.

Causes of Current‑Account Deficits

• High domestic demand for imported goods and services.
• Low export competitiveness (high production costs, weak terms of trade).
• Strong domestic currency (makes imports cheap and exports expensive).
• Large outflows of secondary income (e.g., remittances to overseas families).

Causes of Current‑Account Surpluses

• Export‑led growth (e.g., China’s manufacturing sector).
• High global demand for a country’s natural resources.
• Weak domestic currency that makes exports relatively cheap.
• Significant inflows of secondary income (e.g., oil‑producing nations receiving foreign investment returns).

Policies to Achieve Balance‑of‑Payments Stability

Real‑World Example

After the UK voted to leave the EU, the pound depreciated against the euro and the US dollar. The weaker pound made UK exports (e.g., automobiles, pharmaceuticals) cheaper for overseas buyers, helping to narrow the UK’s current‑account deficit, while imported food and energy became more expensive, contributing to higher inflation.

Evaluation Checklist for Exam Answers

1. Define specialisation, comparative advantage, free trade, globalisation, trade restrictions, foreign‑exchange rate and the current account.
2. Explain how comparative advantage leads to specialisation and the gains from trade (use a PPF diagram).
3. List at least three advantages and three disadvantages of free trade, highlighting distributional effects and short‑ vs long‑term impacts.
4. Discuss globalisation, identify two recent drivers (e.g., digital communication, financial integration) and evaluate both positive and negative consequences.
5. Identify two types of trade restrictions (including a non‑tariff barrier), give reasons for their use and analyse likely consequences for both home and partner countries.
6. Explain how a change in the exchange rate affects imports, exports, inflation, the trade balance and the current account.
7. Describe at least two policies that a government can use to correct a current‑account deficit or surplus.
8. Use real‑world examples (e.g., US‑China tariff dispute, Euro‑dollar fluctuations, China’s export‑led growth, UK post‑Brexit depreciation).
9. Weigh short‑term versus long‑term impacts on consumers, workers, firms and the government, and give a balanced judgement.

Suggested Revision Diagrams

• PPF for two countries showing specialisation, terms of trade and consumption possibilities after trade.
• Demand‑supply diagram for the foreign‑exchange market illustrating depreciation and appreciation.
• Flow diagram of globalisation: transport, communication, MNCs, trade‑policy liberalisation and financial integration.
• Table comparing reasons for trade restrictions with their economic consequences.
• Diagram of the current‑account balance showing surplus vs deficit and the link to exchange‑rate pressure.