Trade Policies and the UK's International Trade (AQA A-Level Economics): Revision Notes

Trade Policies and the UK's International Trade

Introduction to trade policies

Trade policies refer to the rules, regulations, and measures that governments use to control and influence international trade. These policies can either promote free trade between countries or restrict it through various protective measures. Understanding trade policies is essential for analysing how countries engage in international trade and why they sometimes choose to limit imports or support exports.

This revision note explores the arguments for protectionism, examines the welfare effects of trade policies, and analyses the UK's international trade patterns.

Understanding comparative and competitive advantage

Before examining trade policies, it's important to distinguish between two key concepts that explain why countries trade.

Competitive advantage is closer to the concept of absolute advantage. A country or firm possesses competitive advantage when it produces higher-quality goods at lower costs and better prices than its competitors. Unlike comparative advantage, which is relatively static, competitive advantage can be created and developed over time through investment, innovation, and strategic policies.

Dynamic factors can build competitive advantage. Successful long-term investment provides countries with modern, efficient production capacity capable of manufacturing high-quality goods that consumers want. Well-funded and organised research and development (R&D) contributes similarly. Investment in education and training develops human capital, making the workforce more productive and competitive.

The case for import controls and protectionism

Import controls are policy tools that governments use to restrict or regulate the flow of goods entering their country. These can be divided into several types:

• Quotas are physical limits on the quantities of imported goods allowed into a country. For example, a government might restrict imports of steel to 1 million tonnes per year.
• Tariffs (also known as import duties) are taxes imposed on imports from other countries. These raise the price of imported goods, making them less competitive against domestic products.
• Export subsidies work in the opposite direction - they are payments given to domestic firms by the government to encourage them to sell their products abroad and to make their goods cheaper in export markets.

Supporters of free trade argue that import controls prevent countries from specialising in activities where they have comparative advantage and from trading their surplus. This leads to inefficient production and reduces economic welfare. However, the case for free trade relies on several assumptions underlying the principle of comparative advantage. When these assumptions are relaxed, the case for protectionism becomes stronger.

Nevertheless, proponents of free trade emphasise the dynamic benefits that result from opening an economy to competition from abroad. Even when some assumptions don't hold perfectly, the competitive pressures from international trade can drive innovation and efficiency improvements.

Infant industries

Many economic activities benefit from increasing returns to scale. As a country specialises in a particular industry and output expands, the industry becomes more productively efficient. This increases its competitive advantage over time.

Sunset industries

A related argument is sometimes made for protecting declining industries in advanced economies like the UK. These are often called sunset industries - older industries facing competition from newer producers in developing countries.

Some economists support selective use of import controls as a supply-side policy tool to prevent unnecessary deindustrialisation. They argue this allows orderly structural change in the manufacturing base of the economy rather than abrupt transitions. Import controls can be justified, at least temporarily, to minimise the social and economic costs of the adjustment process that occurs when an economy's structure changes in response to shifting demand or evolving technology and comparative advantage.

Strategic trade theory

The infant and sunset industry arguments are closely related to strategic trade theory, a relatively new approach that has gained influence in recent years. Strategic trade theory challenges the traditional view that comparative and competitive advantage are "natural" or predetermined. Instead, it argues that governments can actively create competitive advantage by strategically nurturing selected industries or economic sectors.

Governments in developed economies have used two types of strategic trade policy to help declining industries:

• Trade adjustment assistance and other aid to workers and firms in affected industries
• Subsidies on exports or taxes on imports, plus investment or adjustment assistance subsidies to protect industries from foreign competition

However, export subsidies generally violate World Trade Organization (WTO) rules, with limited exceptions such as agricultural products. By contrast, less developed economies more freely use strategic trade policies to protect and promote the growth of their infant industries.

Agricultural efficiency

Specialisation and trade can sometimes reduce efficiency rather than increase it. Monoculture - growing a single crop over large areas - might result from agricultural specialisation and trade. However, this erodes the soil quality and destroys comparative advantage that existed before specialisation occurred. Decreasing returns to scale can weaken the case for complete specialisation.

Changes in demand or cost conditions

Over-specialisation through trade can make a country particularly vulnerable to sudden changes in demand or to changes in the cost and availability of imported raw materials or energy. When costs change and new inventions or technical progress occur, they can quickly eliminate a country's earlier comparative advantage. The greater the uncertainty about the future, the weaker the case becomes for a country specialising in a narrow range of products.

Anti-dumping

Dumping occurs when a country produces too much of a good for its own domestic market, and then sells the surplus at a price below cost in overseas markets. Import controls are often justified as protection against this supposedly "unfair" competition.

Article 6 of the General Agreement on Tariffs and Trade allows countries to protect themselves against dumping where there is material injury to competing domestic industry. However, establishing what constitutes genuine dumping versus normal competitive pricing can be controversial.

Self-sufficiency

Political and strategic considerations sometimes justify protection to ensure a country remains relatively self-sufficient in vital goods. This argument has particular relevance for:

• Military and defence equipment
• Essential foodstuffs
• Energy supplies
• Critical raw materials

Employment protection

Trade unions argue that import controls are necessary to prevent multinational firms from shifting capital to low-wage developing economies and exporting output back to the countries where the capital originated. They advocate for employing labour, however inefficiently, in protected industries rather than allowing labour to suffer mass unemployment.

This is an example of second-best theory. It recognises that the "first best" outcome (free trade in a world of fully employed economies and perfect markets) is unattainable. Therefore, a country can settle legitimately for the second best option. Employing resources inefficiently but protected by tariffs may be better than leaving resources like labour unemployed.

The welfare effects of trade policies

To understand the economic impact of trade policies, economists use the concepts of consumer surplus and producer surplus. These tools allow us to analyse how different policies affect economic welfare.

Consumer and producer surplus in a closed economy

When a country doesn't engage in international trade (a closed economy), domestic demand for a good must be met entirely by domestic supply - that is, by firms producing within the country.

In this diagram, market equilibrium occurs at point X where the domestic supply and demand curves intersect. Consumers pay price $P_1$ for the good, and quantity $Q_1$ is bought and sold.

Welfare gains from opening to free trade

Now consider what happens when the economy opens to international trade and domestically produced goods must compete with cheaper imports.

In this scenario, imports are priced at the world price $P_w$, which is lower than the domestic equilibrium price $P_1$. When the economy opens to trade, equilibrium shifts to point V. Domestic demand increases to $Q_{D1}$, but domestic supply falls to $Q_{S1}$ (where the domestic supply curve intersects the horizontal world price line at $P_w$). The gap between domestic demand and domestic supply - equal to $(Q_{D1} - Q_{S1})$ - is filled by imports.

However, consumers gain additional surplus (area C) beyond what was transferred from producers. This represents a net welfare gain from trade - an increase in total economic welfare that neither producers nor consumers enjoyed before. Households benefit from both the welfare transfer from producers (they "win" what producers "lose") and the additional consumer surplus they now receive.

Welfare losses from imposing tariffs

Suppose domestic firms pressure the government to introduce a tariff to protect the home market. The tariff raises the price of imports.

If the government imposes a tariff equal to $t$, the price rises from $P_w$ to $P_w + t$. At this higher price:

• Domestic demand falls from $Q_{D1}$ to $Q_{D2}$
• Domestic supply increases from $Q_{S1}$ to $Q_{S2}$
• Imports fall from $(Q_{D1} - Q_{S1})$ to $(Q_{D2} - Q_{S2})$

This analysis demonstrates that while tariffs benefit domestic producers and generate government revenue, they create net welfare losses for the economy as a whole. The losses to consumers exceed the gains to producers and government.

Changing patterns of world trade

To many people living in industrial countries during the nineteenth and early twentieth centuries, it seemed natural that the earliest industrialised nations like the UK had gained competitive and comparative advantages in manufacturing. A pattern of world trade developed where industrialised countries in what is now called the Global North exported manufactured goods in exchange for foodstuffs and raw materials produced by countries in the Global South, where comparative advantage lay in primary products.

Countries known as the BRIC nations (Brazil, Russia, India and China) are responsible for exporting large quantities of goods and services to the Global North. These NICs now export manufactured goods to countries in the Global North such as the UK and USA, and import raw materials or commodities such as copper from developing economies like Zambia. They also import crude oil from oil-exporting developing economies such as Saudi Arabia and Venezuela.

This shift in manufacturing reflects changing competitive and comparative advantage and the deindustrialisation of the UK, North America and some major European economies. Only a relatively small proportion of Global North countries' trade is with poorer countries in the non-oil-producing developing world.

The pattern of the UK's international trade

UK trade with the EU versus non-EU countries

The European Union has been a significant trading partner for the UK. Understanding the balance between EU and non-EU trade is essential for analysing the UK's position in the global economy.

By contrast, the UK had a trade surplus of £53.7 billion with non-EU countries in 2020. Non-EU exports totalled £350 billion (51.6% of total exports) while non-EU imports were £296 billion (49.6% of total imports).

Overall, the UK had a small trade surplus of £4.3 billion when EU and non-EU trade are combined.

Trends in UK trade 1999-2020

The composition of UK trade has changed significantly over the past two decades.

The UK has experienced a persistent trade deficit with the EU since 1999. This deficit peaked at 3.7% of GDP in 2016 before falling to 2.3% of GDP in 2020.

Meanwhile, the UK's trade balance with non-EU countries has improved steadily. Starting from near zero in 1999, the non-EU trade surplus grew to approximately 2% of GDP by 2020. This improvement in the non-EU balance has helped offset the continuing deficit with EU countries.

Top trading partners

Four out of the top five countries to which the UK exported in 2020 were EU member states, though the USA was by far the main destination for UK exports. The USA received over £120 billion worth of UK exports, leading Germany by more than £75 billion. Other major export destinations included the Netherlands, Ireland, and France.

Commodity breakdown of UK trade

Understanding what the UK trades provides insight into the structure of the economy and its competitive strengths.

UK exports (2020):

Machinery and transport equipment dominated UK exports of goods, accounting for £113 billion. This category includes vehicles, aircraft, industrial machinery, and electronic equipment. Chemicals were the second-largest export category at £53 billion, including pharmaceuticals - an area where the UK has significant expertise. Other major export categories included:

• Miscellaneous manufactures: £41 billion
• Material manufactures: £34 billion
• Food and live animals: £15 billion
• Fuels: £25 billion

UK imports (2020):

Machinery and transport equipment also headed the list for imports at £155 billion, reflecting the UK's integration into global manufacturing supply chains. Miscellaneous manufactures came second at £72 billion. Other significant import categories included:

• Chemicals: £55 billion
• Material manufactures: £54 billion
• Food and live animals: £41 billion
• Fuels: £28 billion

Calculating trade balances by commodity

Using the export and import data, we can calculate whether the UK has a trade surplus or deficit in each commodity category:

These calculations reveal that the UK runs trade deficits in most major commodity categories. The deficit in machinery and transport equipment is particularly large, despite this being the UK's largest export category. This reflects the UK's position as both a major producer and consumer of manufactured goods, with imports exceeding exports.