Understanding Imports, Exports, and Trade | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Imports are goods and services that firms, individuals, and governments purchase from producers in other countries. Exports are goods and services that firms, individuals, and governments from other countries purchase from domestic producers. Net exports is the value of a country’s exports minus the value of its imports over some period.

There is a trade surplus when net exports are positive, and a trade deficit when net exports are negative.

Trade Protection and Free Trade

A country that does not trade with other countries is an autarky, or closed economy. When a government places restrictions, limits, or charges on exports or imports, such acts are known as trade protection. And when a government places no restrictions or charges on import and export activity, there is free trade.

The world price is the price of a good or service in world markets under free trade. Domestic price refers to the price of a good or service in the domestic country. If the country practices free trade, the domestic price should be equal to the world price. If there is trade protection, the domestic price may be different from the world price.

Terms of Trade

Terms of trade refers to the ratio of an index of the prices of a country’s exports to an index of the prices of its imports, expressed relative to a base value of 100.

Gross Domestic Product (GDP) vs. Gross National Product (GNP)

Gross domestic product (GDP) is the total value of goods and services produced within a country’s borders in a given period. Gross national product (GNP) is similar but measures the total value of goods and services produced by the labor and capital of a country’s citizens.

Benefits and Costs of Trade

The benefits of trade are obvious, such as the US benefiting from cheaper goods and China benefiting from increased employment and income. The costs of trade are primarily borne by those in domestic industries that compete with imported goods.

Absolute Advantage vs. Comparative Advantage

Absolute advantage refers to a country that can produce a good at a lower resource cost than another country. Comparative advantage is the country that can produce a good at a lower opportunity cost than another country.

To illustrate, let us consider hypothetical countries Tinyland and Microland.  Suppose the two economies only produce and consume two products – watches and jackets.  Let’s say Tinyland has 100 workers and Microland has 160 workers, and both countries divide their workforce equally to produce the two products.  The following are the total production volumes each day.

If we calculate on a per worker basis, one Tinyland worker is able to produce 10 watches or 25 jackets in a day, while one Microland worker is only able to produce 4 watches or 20 jackets in a day.

For both products, Tinyland has the absolute advantage as it is able to produce at a lower resource cost.  However, Tinyland has the comparative advantage in producing watches, while Microland has the comparative advantage in producing jackets.

Production Possibility Frontier

The production possibility frontier (PPF) is a curve that shows the possible combinations of two goods that can be produced in an economy. The slope of the PPF measures the opportunity cost of one good in terms of the other good. As the production level increases, the opportunity cost also increases, meaning that the PPF is a downward sloping curve.

Tinyland vs. Microland: Specialization and Trade

When Tinyland and Microland specialize in the products they have a comparative advantage in, both countries can benefit from trade. Tinyland specializes in watches, while Microland specializes in jackets.

In the most extreme case, Tinyland shifts its entire workforce to produce watches, while Microland shifts its entire workforce to produce jackets. Assuming constant opportunity costs for both, Tinyland would be able to produce 1000 watches a day, while Microland can produce 3200 jackets a day. The combined production figures for both countries are now higher.

Ricardian Model of Trade

The analysis of trade specialization and comparative advantage is credited to David Ricardo, whose model is called the Ricardian model of trade. According to Ricardo, the differences in labour productivity are due to differences in technology. A country with a lower opportunity cost in the production of a good has a comparative advantage in that good and will specialize in its production.

Heckscher-Ohlin Model of Trade

Another significant model is the Heckscher-Ohlin model of trade, which has two factors of production – labour and capital. According to this model, differences in the relative amounts of these factors are the source of a country’s comparative advantage.

Under the Heckscher-Ohlin model, there is also a possibility of redistribution of wealth within each country, between the labour force and the owners of capital. When there is trade between two countries, the good that a country imports will fall in price, and the good that a country exports will rise in price.

So, for Tinyland, the price of jackets will fall and the price of watches will increase. As watches are more capital-intensive goods than jackets, the increase in price of watches benefits the owners of capital, at the expense of the labor force. In Microland, the reverse happens where watches decrease in price and jackets increase in price. The labour force benefits as jackets are more labour intensive, at the expense of the owners of capital.

In conclusion, understanding imports, exports, and trade is crucial to grasp the dynamics of international economics. Trade can lead to increased production, specialization, and overall economic growth. However, it’s essential to acknowledge the potential costs and redistributive effects that trade can have on certain industries and segments of the population.