Adam Smith’s absolute advantage: a country exports what it can produce with fewer resources than anyone else. Intuitive, but it leaves unanswered what a country does when it is worse at everything.
Ricardo’s comparative advantage answers it, and is the more important result: what matters is not absolute cost but opportunity cost. A country that is worse at producing both goods is still relatively better at one of them, and both countries gain by specialising in the good they give up least to produce.
The Heckscher–Ohlin theorem then explains why costs differ: a country exports the good that uses intensively the factor it has in abundance. A labour-abundant country exports labour-intensive goods.
The Leontief paradox is the standard follow-up: the United States, capital abundant, was found to export relatively labour-intensive goods — an empirical result that did not fit, and which prompted refinements about skill levels and human capital.
| For free trade | For protection |
|---|---|
| Specialisation on comparative advantage raises total output | Infant industry — a new industry needs shelter until it reaches efficient scale |
| Consumers get lower prices and more variety | Protecting employment in a declining sector |
| Competition disciplines domestic producers | Correcting a balance of payments deficit |
| Larger markets allow economies of scale | Anti-dumping — against goods sold below cost to capture a market |
| Technology and ideas move with trade | Strategic and defence self-sufficiency |
The infant industry argument is the respectable one and also the one most abused: it is valid only if the industry will eventually stand on its own, and the protection is removed. Protection that never ends is not the infant industry argument, whatever it is called.
Instruments: tariffs (taxes on imports), quotas (quantity limits), subsidies to domestic producers, exchange controls, and non-tariff barriers such as standards and licensing. A quota and a tariff can restrict imports equally; the difference is that the tariff’s revenue goes to the government while the quota’s premium goes to whoever holds the licence.
Given: domestic demand and supply as in Unit 1, \( Q_d = 900 - 3 P \) and \( Q_s = 100 + 5 P \), with a world price of 60 at which the country can import freely. Asked: the effect of a tariff of 15 per unit.
Under free trade, the domestic price is the world price, 60:
\[ Q_d = 900 - 3(60) = 720 \qquad Q_s = 100 + 5(60) = 400 \qquad \text{Imports} = 720 - 400 = 320 \]With the tariff, the domestic price rises to \( 60 + 15 = 75 \):
\[ Q_d = 900 - 3(75) = 675 \qquad Q_s = 100 + 5(75) = 475 \qquad \text{Imports} = 675 - 475 = 200 \]Four effects, each readable from those numbers:
Who pays? Consumers pay 15 more per unit on all 675 units they still buy. Part of that goes to the government as revenue, part to domestic producers as a higher price, and part is simply lost — the deadweight loss from producing at home what could have been bought cheaper abroad. The tariff redistributes more than it raises, which is the economist’s standard objection to it.
The balance of payments records every transaction between residents and the rest of the world in a year. Credits are inflows, debits are outflows.
| Account | Item | Amount |
|---|---|---|
| Current | Merchandise exports | +3,100 |
| Merchandise imports | −4,300 | |
| Services, net | +1,500 | |
| Primary income, net | −400 | |
| Secondary income (transfers), net | +900 | |
| Current account balance | +800 | |
| Capital | Capital transfers, net | +120 |
| Financial | Foreign direct investment, net | +700 |
| Portfolio investment, net | +250 | |
| Loans and banking capital, net | +310 | |
| Financial account balance | +1,260 | |
| Reserves | Change in reserve assets | −2,180 |
| Sum of all accounts | 0 |
The current account balance is \( 3100 - 4300 + 1500 - 400 + 900 = +800 \) — a surplus, because exports of goods and services plus transfers exceeded imports and income paid out.
The reserve line is −2,180, and the minus sign is the part that confuses people. An increase in reserves is recorded as a debit, because acquiring a foreign asset is a use of foreign exchange, exactly like buying an import. So −2,180 means reserves rose by 2,180.
Check it on the figures above: \( 800 + 120 + 1260 + (-2180) = 0 \).
It balances by construction, because every transaction is entered twice — it is double entry, the same system as the accounting pages. A country that imports more than it exports must be paying for the difference somehow, and that payment is itself an entry. So the balance of payments cannot fail to balance.
What people mean by a “balance of payments deficit” is therefore a deficit on a part of it — normally the current account, or the current and capital accounts together, financed by drawing down reserves. Saying the overall balance of payments is in deficit is, strictly, a contradiction, and examiners test that.
Errors and omissions appears as a balancing item in real statements, because the two sides are compiled from different sources and never quite agree. It is an admission of measurement error, not a category of transaction.
Depreciation is a market fall in a floating rate; devaluation is a deliberate reduction of a fixed rate. The words are not interchangeable and the difference is the exchange rate regime.
Purchasing power parity holds that the rate between two currencies should equal the ratio of their price levels, so that a basket costs the same in both. It fails in the short run — capital flows dominate — but anchors long-run comparisons, and it is why international income comparisons are published at PPP as well as at market rates.
The J-curve is worth knowing: after a devaluation the trade balance often worsens before it improves, because contracted volumes take time to adjust while the higher import prices bite at once. The curve traces that dip and recovery, and it is why devaluation is judged over years, not months.
The Bretton Woods conference of 1944 set up a system of fixed but adjustable exchange rates, with currencies pegged to the dollar and the dollar convertible to gold. It broke down in the early 1970s when that convertibility ended, and the major currencies moved to floating. The institutions it created outlived it:
| Institution | Purpose | Instruments |
|---|---|---|
| International Monetary Fund | Short-term balance of payments support and exchange rate stability | Quotas and drawing rights, Special Drawing Rights, surveillance, conditionality |
| World Bank (IBRD) | Long-term finance for reconstruction and development | Project and programme loans |
| International Development Association | Concessional finance for the poorest countries | Soft loans and credits |
| International Finance Corporation | Finance for the private sector | Equity and loans without sovereign guarantee |
| World Trade Organization | Rules for trade; successor to the GATT from 1995 | Agreements, most-favoured-nation treatment, dispute settlement |
The division of labour to remember: the IMF lends short to fix a payments problem; the World Bank lends long to build something. Special Drawing Rights are an international reserve asset created by the IMF — not a currency, but a claim on the freely usable currencies of members.
The syllabus lists the sources, and they divide cleanly into the ones that add inputs and the one that makes inputs go further:
The examinable contrast: capital accumulation faces diminishing returns, so an economy relying on it alone converges to a plateau. Productivity growth does not, which is why the residual matters more than the inputs in the long run.