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International Trade

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Reasons / Benefits to trade

reasons to trade
  • To gain from international specialization (absolute/comparative advantage - discussed below)
    • Increased output
    • Lower prices
    • Greater efficiency
  • To gain from international economies of scale
  • To gain from increased variety of goods and services
  • To gain from increased globalization and communication
    • Leads to research and development
  • To reduce international tensions (vested interests)
  • To increase export revenue / sell to larger markets

Entering world trade

IB economicsIB economics

When a country enters into trade with the world, it will find that its domestic prices may be different to prices on the world market.

Because the world market for most goods and services is so big, we draw it as being perfectly elastic. What this means is that we have no power over it and must accept the price that is offered by it.

Only a few countries have real market power over internationally traded goods, and for that reason we assume world supply to be perfectly elastic in most cases - whatever we do domestically does not influence the enormous international supply.

As a result, world price is the same as world supply (that is to say, if we increased supply - a shift downwards - we would thus reduce price)

Scenario 1: World Price is Lower than Domestic Price

IB economics imports

If a country entered into trade and found that world price was lower than domestic price, then this would mean they cannot compete on the world market.

Consumers will now buy the cheaper foreign goods instead of the more expensive domestic goods.

As a result, the domestic producers will be forced into closing. Only those that can compete (the portion of the supply curve below world price) will stay in business.

However, at world price, demand exceeds domestic supply. To satisfy this demand the excess must be imported.

Scenario 2: World Price is Higher than Domestic Price

IB economics exports

If a country entered into trade and found that world price was higherthan domestic price, then this would mean they have an advantage on the world market.

They thus have 2 choices: either they can satisfy all of the domestic demand at the current prices OR they can decide to increase their prices and sell on the world market.

Clearly, the second choice would create more revenue (dependant on elasticities) so they therefore raise prices to where world price is.

At this price some domestic consumers decide not to buy the product (contraction in demand) but there is an extension in supply. This excess supply is thus sold on the world market.

Regulating Trade:

World Trade Organisation IB Economics

IB economics trade

The World Trade Organisation - previously known as the General Agreement for Tariffs and Trade (GATT) set up post-WW2 to combat rising global protectionism.


  1. Facilitation of Free Trade
  2. Regulation of fair competition
  3. Equality amongst member nations in trade
  4. Promotion of developing countries

Benefits of the WTO

  1. Enables countries to solve trade disputes peacefully
  2. Encourages free trade which brings
    • Lower prices
    • Greater consumer surplus
    • Greater diversity of products
    • Better quality of products
    • Higher incomes
  3. Reduces corruption as protectionism often leads to this
  4. Has no power and is optional to join but this encourages transparency and honesty
  5. Can help developing countries out of the poverty trap

Rounds of the WTO

IB economcis WTO

The Tokyo Rounds

The Uruguay Rounds

The Doha Rounds


World Trade photo courtesy of Vichaya Kiatying-Angsulee,
World globe photo courtesy of  nokhoog_buchachon,

Comparative and Absolute Advantage

Absolute Advantage

Absolute advantage can be described as when a country produces more of a good or service using the same (or less) amount of resources. For example, if Cameroon and Nigeria both produced bananas, and both used the same amount of land, labour and capital, but Cameroon produced 10 million tons of bananas whereas Nigeria produced 8 million tons of bananas then Cameroon would have an absolute advantage in banana production.

It is benefitical for countries that have absolute advantages in different products to specialize in these products as they are obviously more effecient at producing them. They should therefore transfer resources out of the production of other products, and into the product they hold an absolute advantage in.

We can use PPC diagram to illustrate this. Imagine two countries (Nigeria and Cameroon) produce two goods (bananas and rice). Their production possibilities are shown on the PPC diagram. Currently, Nigeria produces 5 million tons of bananas and two million tons of rice (point A). Cameroon produces 3m tons of bananas and 6m tons of rice.

Looking at their PPC diagram, it is clear that if all their resources were put into the production of one good, Cameroon would have an absolute advantage in bananas and Nigeria would have an absolute advantage in rice.

Let us imagine they then do this. Nigeria now solely produces rice (9 million tons) and Cameroon solely produces bananas (10m tons). They can now satisfy their original domestic demand for the product they have specialized in (Nigeria would take 2m tons of rice, Cameroon would take 3m tons of bananas).

They would both thus have a lot of their specialized product left over. Nigeria could now export the 7m tons of rice remaining and satisfy all of Cameroons original 6m tons of rice and more!

Likewise, Cameroon could export 7m tons of bananas, satisfying all of Nigeria's 5m demand and more! They will thus both be producing above their PPC curves!

Effects of Absolute advantage

IB economics absolute advantage

We can therefore see that specialization as a result of identifying absolute advantage leads to:

  • Greater output of both products
  • Increased specialization and efficiency
  • Increased revenue from exports
  • Increased trade


Comparative Advantage

Comparative advantage occurs when one country has the absolute advantage in both goods but has a lower opportunity cost in producing only one of the goods.

Let's take Scotland and Wales as an example. They produce potatoes and carrots. Their PPC curves are illustrated below. Currently, Scotland produces 4m tons of carrots and 4m tons of potatoes. Wales produces 3m tons of carrots and 2m tons of potatoes. Clearly, Scotland has the absolute advantage in the production of both goods. It can produce 10m tons of carrots or potatoes if it diverts all its resources into doing so. Wales can only produce a maximum 3m potatoes and 7m carrots.

Nevertheless, Scotland should still trade with Wales. Why? This is because Wales has a lower opportunity cost in the production of carrots. What this means is Wales has to give up less potatoes to produce more carrots than Scotland does. Wales only gives up producing a maxmum 3m tons of potatoes, whereas Scotland would give up a potential 10m tons of potatoes.

If Wales then specialized in carrots, it would produce 7m tons, satisfy its original 2m toon demand, export 4m to satisfy Scotland's demand and still be left with 1m to export.

If Scotland thus specialized in potatoes it would produce 10m tons, satisfy its original 4m ton demand and Wales' 3m ton demand plust have 3m left to export. Both countries would have increased their Production Possibilites.

Calculating Comparative Advantage (HL)

Using the example below, we are going to calculate comparative advantage. We assume both countries use the same resources.

Country Pumpkin Production Turnip Production
  Current Potential Current Potential

In order to calculate comparative advantage, we need to think of two things first:

  • Which good are we calculating it for?
  • Which country are we calculating it for?

Once we have established this we can use the following formula to identify who has the comparative advantage:

Limitations of Absolute and Comparative Advantage

IB economics comparative advantage
  • Works on a two-good-two-country basis
  • Assumes goods have a similar value








Types of Protectionism

IB economics tariff

1. Tariffs

These are the most common form of protectionism. They are essentially a tax on imported goods and services per unit.


  • Increase in price / fall in world supply
  • Loss of consumer surplus
  • Reduction in imports
  • Increase in government revenue (if government is importing)
  • Increase in domestic producer surplus
  • Extension of domestic supply

IB economics subsidy

2. Subsidies

If a government subsidizes domestic firms this makes their costs of production lower and thus they are able to produce more at a lower price. This has the effect of shifting the domestic Supply curve outwards.

Effects (considering it is a fairly small subsidy):

  • No price change
  • No change in consumer surplus
  • Reduction in imports
  • Loss of in government revenue (through subsidy) but gain through less imports
  • Increase in domestic supply

IB economics quota

IB economics commerce

3. Quotas

If a government decides to limit the physical amount of goods/services entering its country, this would be a quota.

If domestic price is higher than world price and a quota is imposed, the quota will act as a 'fake' domestic supply. For example, if Nigeria was importing 100 000 TVs from the USA at $100 per unit, and Nigeria put a quota of 50 000 TVs then the USA would have a choice. Either they could sell all of their TVs at $100 as before, or they could sell at the higher domestic price.

Clearly they would choose to do this (as they know all of their TVs will sell since there is excess demand for them). This decision makes the quota part of domestic supply, causing a new equilibrium to be found (lower than previous domestic equilibrium but higher than previous world equilibrium).


  • Higher prices for consumers
  • Loss of consumer surplus
  • Reduction in imports
  • No change in government revenue
  • No change in real domestic supply


IB economics quota

4. VERs

If a government decides to voluntarily limit the physical amount of goods/services it is exporting this would be a voluntary export restraints. They have the same effect as a quota.


  • Higher prices for consumers
  • Loss of consumer surplus
  • Reduction in imports
  • No change in government revenue
  • No change in real domestic supply

Reasons for Protectionism

IB Economics dumping

  • To protect against dumping
  • To protect 'infant industries'
  • To protect 'sunset industries'
  • To reduce the budget deficit
  • To encourage self-sufficiency
  • Political reasons
  • To encourage diversification
  • Strategic trade policy
  • To boost domestic employment

Reasons against Protectionism

IB economics protectionism
  • Loss of consumer surplus in all cases (aside from subsidies)
  • Encouragement of inefficiency
  • Lack of choice for consumers
  • Potential for retaliation
  • Restriction to benefits of specialisation
  • Worsening income inequalities

Reasons for Free Trade

IBeconomics free trade

These are essentially the benefits of international specialization

  • Benefits of absolute and comparative advantage
  • Increased output
  • Lower prices through economies of scale
  • Allocative efficiency
  • Increased variety of goods and services
  • Increased economic globalisation

Commerce photo courtesy of Stuart
Greengage photo courtesy of dan @
Stack hemp photo courtesy of Naypong, @
Cargo ship photo courtesy of franky242, @


IB economics exchange rates

Exchange Rates

IB Economics Exchange Rates

exchange rates IB economics revisionIB economics revision exchange rates

Countries buy and sell goods off each other all the time. When they receive money for goods they produce (i.e. when they sell their exports), these are known as credits. When they spend money on goods they want (i.e. when they import), these are known as debits. A country's balance of payments will show them where they've spent and received.

Now, imagine the USA wants to buy British trucks. They put in an order for $5000. Seems easy enough. Except, what on earth will the British company want dollars for? Surely, being British, they want Pounds Sterling as this is the currency of their country.

So, before the deal can be made, the USA must go and buy Pounds in the foreign exchange market. This has a direct impact on the demand and supply of both Pounds and Dollars. In this case, dollars are being supplied, and Euros are being demanded. Supply of dollars increases (thus causing its value to go down - or depreciate - as it is less scarce), whilst demand for Pounds increases (thus causing its value to go up - or appreciate - as people want it). This is shown below.

So what we can say is:

  • debits = supply of home currency (we want something, we have to get rid of our currency to buy the other)
  • credits = demand for home currency (other countries want your stuff, they need to buy your currency first)

IB economics currency change

IB economics currency

IB economics exchange rates

There are many reasons why exchange rates may appreciate or depreciate.

1) Speculation - this is the process by which people known as 'speculators' seek to make profit on buying and selling currencies. The idea is that they will buy currencies they feel to be undervalued or about to appreciate, and then sell them when they have appreciated to a peak. To buy a currency they are increasing demand for it (and increasing supply of another currency) and when they sell it they increase supply of that currency (and increase demand of another). A famous example comes with George Sorros who famously bet against the Pound (he thought it was overvalued) and made one billion pounds sterling.... in a day.

2) Demand for Imports or Exports - fashion for a country's goods will cause demand for its currency to rise; for example if the USA produces iPods then demand for them may be very high, causing an appreciation as people must first buy their currency. This works for imports or exports.

3) Inflation - high levels of inflation in a country (whether demand-pull, cost-push or printed) will cause domestic prices to rise. This will lead to less demand for this country's products, as they are relatively more expensive than elswhere, and so demand for their currency will also fall, causing a depreciation.

4) Interest Rates - when a central bank partakes in increasing interest rates, this causes foreigners to want more of that currency since it will give better returns than saving domestically. At the same time, increasing interest rates will cause people to save domestically, which leads to an inwards shift of AD, causing goods to be cheaper (prices fall), and thus the exchange rate will appreciate in both ways. This is true the other way round.

5) Protectionism - this causes a limit on imports owing to tariffs, quotas, VERs, embargos or subsidies. As a result, less is spent abroad, meaning less of the currency can be supplied. The extent to which occurs depends on the level of protectionism.

6) Productivity - if a country finds a way of producing a good more efficiently than any other country, then its products will be cheaper. As a result AS in that country will increase, causing prices to fall. More countries will demand their goods, causing the exchange rate to appreciate.

Currency photo courtesy of Stuart Miles,
Currency photo courtesy of Natara,
Piggy photo courtesy of Stuart Miles,

Differing Exchange Rates and PPP

Countries have different ways of arranging their currency value. Click on the tabs below to find out more.

  • Floating
  • Fixed
  • Managed

Floating exchange rates work in the same way as demand and supply for any other good. The 'invisible hand' determines the rate of exchange compared to another currency. When a currency gains in value, we say that it has 'appreciated'. This can either be due to increased demand or decreased supply. When a currency falls in value, we say that it has 'depreciated'. This can either be due to decreased demand or increased supply.

Example: The USA



Fixed exchange rates occur when the government of a country decides on the value of its currency relative to other currencies and maintains this value despite natural appreciations or depreciations. The way to do this is to constantly be involved in the buying and selling of the currency in order to maintain the fixed value. When a country decides the value they set is untenable, they may decide to devaluate it (a decrease in the value of a currency caused by governmental action) or revalue it (an increase in the value ofa currency caused by governmental action).

Managed exchange rates operate in identical fashion to floating exchange rates, with the exception that there are bounderies set as to how high a currency can appreciate or how low it can depreciate.

Example: Switzerland

Purchasing Power Parity Exchange Rates

The easiest way to remember this is 'how much bang do you get for your buck?'

The idea is simple. When we see an exchange rate - say $1:Y100, we assume that what $1 buys you in the United States, Y100 will buy the same amount in China. If the exchange rate changed to $1: Y200, this should tell us that there is inflation in China. As a result, China's currency will depreciate.

This is too simplistic though. As economists we know that there are many reasons for exchange rate fluctuations. We need a better measure to compare exchange rates - these are known as Purchasing Power Parity Exchange Rates. They are calculated by international organisations to account for the differences in spending power.

As a result, using a PPP Exchange Rate, we know that what $1 buys in the USA, Y100 buys in China. Without a PPP Exchange Rate we don't know how far our money could go. Theoretically we shouldn't need PPP Exchange Rates, but realistically, we do.

We need them because the following things cause the exchange rate to change as well as inflation....

  • Speculation
  • Fashion
  • Inflation
  • Interest Rates
  • Protectionism
  • Producitvity


IB economics Balance of Payments

The Balance of Payments

Recording government balances





















All governments have to keep a record of their spending. You've probably heard the expression 'balancing the books'.... all that means is that if your spending equals your income then you are in equilibrium. When looking at governments, there are two 'balances' that are important

a) The Balance of Trade - the total value of goods and services received and spent by a given country in trade, within a time frame. There is the Visible Balance of Trade and Invisible Balance of trade


b) The Balance of Payments - a more precise measure of the total value of goods and services received and spent by a given country. It focuses on distinct types of credit and debit to give us a clearer picture. These are therefore catagorized into three 'accounts': The Current Account, The Capital Account and the Financial Account'.


If we take a look at the pie chart above, the blue area would represent the current account; this is largest part of most government's balance of payments. The pink would represent capital accounts. and the yellow would show us the financial account balance. See below for an in-depth analysis of these accounts


The Current Account


The current account is where trade in the value of all visible and invisible goods and services are recorded. Put simply, the former are just goods that you can physically touch - they're 'tangible'. Examples include iron, bales of hay, T-shirts and plant pots. Invisible services, on the other hand, are intagible; examples would include tourism or education. Together, visible and invisible trade is actually... the balance of trade. The Balance of Payments Current Account therefore includes the Balance of Trade

It also includes net flows of income and and transfers. Examples of this include money sent home from people working abroad, and amount of money spent on foreign aid.

The Capital Account


The capital account is a record how much has been spent and received on assets that a country naturally has. These are usually geographical or ecological in nature - for example oil. Oil would be a natural asset. If a country were to sell the rights to their unused, untapped oil rights, this would be a sale on the capital account. It records the sale of natural assets.

The Financial Account


The financial account records net flow of investment. So if a country has a lot of successful companies that invest in physical capital from abroad, this would be debited to the financial account. If a government invests in gold, this would be debited from the country's financial acount. Investments in stocks and shares are known as 'portfolio investments'


How the Balance of Payments Balances

IB economics BOT

IB economics gold

The Balance of Payments should, in theory always equal to zero.

If we are in an overall surplus:

  • Surplus credit is money wasted. A country will not just leave a surplus of say $10m lying around.
  • Instead it will invest it or spend it. This will go down as a debit on one of the accounts.

If we are in overall deficit:

We can therefore rely on interventionist measures:

  • a) Central Bank Reserve Selling - For example, if a country was -$10 in deficit on the current account, the government could sell off some dollars in order take out a loan in its own currency. This would go down as a $10m credit on the financial account.
  • b) Exchange Rate Manipulation- By changing how expensive imports and exports are, a country could change how many credits and debits enter the country.
  • c) Protectionism - again any form of protectionism (or lack of protectionism) will influence the level of defecit or surplus.

Photos courtesy of renjith krishnan,ponsulak,




IB economics integration


Types of Integration

IB economics

1. Preferential Trade Agreements

  • This is when certain countries agree to reduce or eliminate tariffs between certain good or services together.
  • It is usually done through a trade pact, ratified by the WTO
  • Mulitlateral Preferential Trade Agreements are those created between more than one country e.g. The South Asian Preferential Trade Agreement
  • Bilateral Trade Agreements are those created between two countries or two bodies e.g. India-Afghanistan 2003.
IB economics NAFTA

2. Free Trade

  • Loose group of countries
  • Agree to reduce protectionist barriers between members
  • Countries can create their own policies to non-members
  • No collective bargaining
  • E.g. NAFTA


IB economics

3. Customs Union

  • Group of countries that set firmer rules
  • Countries agree to abolish protectionism between members
  • Countries adopt a common policy with protectionism to non-members
  • Collective bargaining with non-members in trade deals
  • E.g. CEFTA


CES IB Economics

4. Common Market

  • Countries have fulfilled no protectionist rules between them
  • Collective bargaining /common external policy toward non members
  • All factors of production are free to move without hinderance
  • E.g. EEC



5. Economic and Monetary Union

  • A central bank is created - fiscal and monetary policies are set by the central bank
  • National soveriegnty is still upheld
  • All factors of production are free to move without hinderance
  • Example: European Monetary Union (Euro)
  • Note: no full Economic Union exists as they don't get tax revenue from national banks

Benefits of integration

IB Economics benefits of EU
  • Increased competition
  • Larger Markets
  • Greater efficiency
  • Economies of scale
  • Political harmony
  • Spread of communication and technology






Drawbacks of integration

IB Economics benefits of EU
  • Gains depend on how much trade was previously done with non-member countries
  • Gains depend on the type of goods you now get cheaper - it may be that you gain less than other member countries
  • Harder to create free world trade
  • Loss of trading freedom







Trade Creation

Trade Creation diagram


  • If a country formerly set tariffs but needed a certain good, it would buy at the price of lowest cost producer + tariff.
  • If this country then decided to start a customs union (or any other trade bloc) with the lowest cost producer, they would aim at eliminating tariffs. They would now buy at the lowest cost price.
  • As a result of this, they will increase imports from Q1-Q2 to Q3-Q4.
  • At the same time, the same thing is happening for a good that the country is exporting to their new trade bloc member. They are thus exporting a greater amount too.
  • We can therefore say that trade has been created between the two countries as a result of the elimination of tariffs.


  • Lower prices for consumers in both countries
  • Greater trade (more imports and exports)
  • Loss of government revenue (unless it is exporting goods)
  • Greater income equalities
  • Increased specialization (countries produce the good they have comparative advantage in)
  • Increased gains from economies of scale as a result of specialization
  • Less domestic supply for certain goods

Trade Diversion


  • Imagine now three countries produce a good. Spain is the domestic country, in this example. France and Italy also produce the same good as Spain - wine.
  • Before joining a trade bloc, Spain has tariffs on any foreign wines. Nevertheless, even with the tariff, France enjoys a comparative advantage in wine and produces at a much lower price than Italy. Spain's domestic wine industry produce at the highest equlibrium price.
  • As a result, there is a high demand for French wine, even though it carries a tariff. Spain thus imports Q1-Q2 of French wine, and imports no Italian wine. Domestically Spain produces up to Q1 of wine.
  • If Spain now decided to join a customs union with Italy, it would eliminate the tariff on Italian wine. The French wine though, would still have a tariff, as they are not in the union. As a result, Italian wine would be comparatively cheaper than French wine.
  • Consumers would now import Q3-Q4 of Italian wine and the original Q1-Q2 of French imports would be diverted to Italian imports.
  • Trade will have been created (Q3-Q4 is greater than Q1-Q2) and diverted; thus we say trade diversion is a form of trade creation.
  • The only difference is that Spain would have been even better off had they formed a trade union with the lowest cost producer (France) as the price would be even lower.


  • Lower prices for consumers (but not as great as they could be)
  • Greater trade (more imports and exports) (but not as great as could be)
  • Loss of government revenue (unless it is exporting goods)
  • Greater income equalities (but not as great as could be)
  • Increased specialization (countries produce the good they have comparative advantage in)
  • Increased gains from economies of scale as a result of specialization (but not as great as it could be)
  • Less domestic supply for certain goods


Single Currency

What is a single currency?

IB economics single currency

IB economics euro crisis

Single currencies are a feature of monetary unions. This is when a country gives up its previous currency in order to adopt the currency of the monetary union - for example, the Euro. Single currencies are controlled by the Central Bank of the monetary union (for the Euro this is the European Central Bank), who decide how much to print, and what interest rates are set at.

Benefits of a single currency

  • Increased investment - countries who previously experienced wide fluctuations will now be part of a more stable currency. Furthermore member countries can invest anywhere in the Union easily
  • No loss on currency conversion

Drawbacks of a single currency

  • Inability to use monetary policy as a tool (cannot raise/drop interest rates)

Euros courtesy of Grant Cochrane,
Euro sinking courtesy of Stuart Miles,


IB economics terms of trade

Terms of Trade Explained

The Terms of Trade attempt to explain that the price - not volume - of imports and exports are what is important. It thus measures the average price gained from exports, and the average price gained from imports in the following formula:

IB economics revision terms of trade

By working out the Terms of Trade we can work out two distinct things:

1) Whether global output has increased or decreased
2) Where that output is being generated

IB economics revision terms of trade

Let's have a look at some exaples:

China Chocolate Imports Phone Exports
2001 $1 $20
2002 $1 $40

Firstly, we have no idea how many chocolate bars or how many phones are being bought or sold. BUT, that doesn't stop us working out our Terms of Trade. Using the equation, we can see that:
2001 ToT for China = 20/1= 20
2002 ToT for China = 40/1= 40

What we are therefore saying is that, when import prices remain constant and export prices rise, we now have (in this case) a terms of trade improvement, which allows us to either buy more imports or spend that excess money elsewhere.

What if this were not the case though? What if export prices rose at a faster rate than import prices? Look at the table below:

China TV imports Phone Exports
2002 $1 $40
2003 $2 $40

Using the equation, we can see that:
2002 ToT for China = 40/1= 40
2003 ToT for China = 40/2= 20

What we are therefore saying is that, when export prices remain constant and import prices rise, we now have (in this case) a terms of trade deterioration, which means we either have to spend more to buy the same amount of imports, or buy less imports.

These examples are all good and well, but they do not tell us how many imports and exports have been bought. They just tell us who is able to buy more/less.
The key here is now elasticities. Surely, the PED for imports and exports is key to seeing how many will be bought or sold.

Terms of Trade IMPROVEMENT Reason PED Balance of Trade
Improve due to rising export prices Exports are Inelastic Improves. Continue selling roughly same amount for higher price
Exports are Elastic Worsens. Sell far less at a higher price.
Improve due to falling import prices
Imports are inelastic Improves. Continue buying roughly same amount for lower price
Imports are elastic

Worsens. Buy far more at a slightly higher price.


Terms of Trade DETERIORATION Reason PED Balance of Trade
Worsen due to falling export prices Exports are Inelastic Worsens. Sell roughly same amount at a lower price.
Exports are Elastic Improves. Sell far more at a slightly lower price
Worsen due to rising import prices
Imports are inelastic Worsens. Buy roughly same amount at slightly lower price.
Imports are elastic

Improves. Buy far less at slightly higher price.

Overall Rules:

If Terms of Trade improve and imports or exports are inelastic, the Balance of Trade improves
If Terms of Trade improve and imports or exports are elastic , the Balance of Trade worsens

If Terms of Trade deteriorate and imports or exports are inelastic, the Balance of Trade worsens
If Terms of Trade deteriorate and imports or exports are elastic , the Balance of Trade improves

What this tells us:

If more exports are being sold, we know AD for that country will shift outwards and shows us economic growth.

If more imports are being bought, we know AD for that country will shift inwards and shows us less economic growth .

IB economics revsion terms of trade

When we know the elasticities of imports and exports, and a country's terms of trade we will thus be able to work out the two aims stated at the beginning of this unit:

1) Whether or not a country is buying or selling more/less (global output)
2) Which country is having to produce more (allocation of output)

Changing Terms of Trade

Because the terms of trade is chiefly concerned with prices, anything that changes the prices of imports and exports, changes the Terms of Trade. Examples inculde:

a) Exchange Rates
b) Inflation
c) Interest Rates
d) Productivity


How to measure the Terms of Trade

This is very similar to the Retail Price Index

Set a base year
Give imports and exports a price index of 100 at the base year
Use the equation to work out current year’s price index for imports and exports
Give weighting to a selection of important imports/exports dependent on elasticity
Use the terms of trade equation to work out Terms of Trade
If values increase, this shows an improvement (prices of exports have increased relative to prices of imports)


(price index)
(price index)
2001 (base year) 100 100
2002 102 100
2003 105 100

IB economics revision Terms of Trade

Terms of Trade and the Developing World

Reasons why Terms of Trade may improve in the short-run

IB economics  terms of trade

IB economics terms of trade

IB economics weather

Best remembered as TROL.W

  • 1) The rise of the BRICS economies -the rapid industrialisation of these economies has led for massive demand for hard commodities such as iron, copper, bauxite. Countries that export these raw materials subsequently find that their prices have risen rapidly. Indeed, Australia (not a developing country) has also benefited greatly from the BRICS industrialisation.
  • 2) Renewable resources movement - developed economies have been slowly moving into renewable energy - the USA for example ordered that a certain amount of production must be undertaken with these. Ethanol is a common renewable source of energy. This is made from corn and sugar cane. As a result, demand for commodities such as corn and sugar cane have increased rapidly, causing exporting countries to benefit greatly from increased prices.
  • 3) OPEC and oil prices - the production of commodities is generally capital-intensive, so when oil prices rise (owing to OPECs oligopoly power), then so too do export prices for commodity growing countries. However this may soon be reversed with the development of shale fracking (a process of extracting oil from the ground) in the USA and UK.
  • 4) Luxury item availability -as countries get richer, their demand for luxury items grows greatly. However, smart technology (e.g. laptops, ipads, smart phones) require very unusual metals in their production - such as Neodymium  and Dysprosium. Countries that export these goods thus have faced massively increased demand, as this article shows:
    pritchard/9951299/Japan-breaks- Chinas-stranglehold-on-rare-metals-with-sea-mud-bonanza.html
  • 5) Weather -the last few decades have seen quite a few weather disasters which cause supply to shift inwards and prices to rise. Droughts in the Horn of Africa, floods in Australia and fires in Borneo have all contributed to this.


Reasons for Long-Term Deterioration of Terms of Trade

Ib economics terms of trade deterioration IB economics product variation

Before we go on to study Development Economics, we can see how the Terms of Trade act as an indication of how developing nations suffer. It has long been known that developing nations face deteriorating Terms of Trade. The reason? They are overly reliant on the export of commodities - prices for whom falls constantly, compared to imports. Let's see why.

  • Low Income Elasticity of Demand for their Exports but High Income Elasticity of Demand for Imports
  • Increases in world production and world productivity -owing to new technology and capital-intensive production techniques, the world has seen a boom in the amount that we can produce. GM Crops for example, can be resistant to disease and have very high yields (HYC).
  • No product variation

Impacts of short-term increases and long-term deteriorations in TOT on developing countries:

IB economics primary industry
  • Disparities in wealth (Other countries generate wealth, whilst yours doesn’t)
  • Over reliance on primary industry (cheapest to produce, so easy to fall back on)
  • Less variety of goods within country (as you cannot import so cheaply)
  • Inability to repay debt

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