4 · Global economy and development

IB Diploma Programme Economics HL, Unit 4 The global economy (first assessment 2022). This topic covers sections 4.1 to 4.10: why countries trade, how they protect their industries, trading blocs, exchange rates, the balance of payments, and economic development. The trade examples use one market, with demand $Q_d = 140 - 2P$ and domestic supply $Q_s = 20 + 4P$, at a world price of 12. All numbers are original.

In 1980 China opened its first special economic zone in Shenzhen, then a small town near Hong Kong. Foreign firms could build factories there and export to the world. Today Shenzhen is a city of more than 17 million people, and China is the world's largest exporter of goods. Over the same years, hundreds of millions of Chinese people left extreme poverty. This topic asks how trade causes growth like this, who loses from it, and why some countries still struggle to develop.

Must-know for this topic:

Why countries trade

International trade gives consumers lower prices and more choice. Firms can sell to bigger markets and gain economies of scale 规模经济. Competition from abroad pushes local firms to be more efficient. Trade also spreads new technology and ideas.

Absolute and comparative advantage

A country has an absolute advantage 绝对优势 in a good if it can make more of it with the same resources. It has a comparative advantage 比较优势 if it can make the good at a lower opportunity cost 机会成本. Trade is based on comparative advantage, not absolute advantage.

Worked example. In one day, one worker makes:

1. A has an absolute advantage in BOTH goods: it makes more of each.
2. But one cloth costs A 2 wheat and costs B only 1 wheat. So B has the comparative advantage in cloth.
3. One wheat costs A only 0.5 cloth and costs B 1 cloth. So A has the comparative advantage in wheat.
4. A specialises in wheat and B in cloth. Any trade price between 1 and 2 wheat per cloth helps both: A gets cloth for less than 2 wheat, and B gets more than 1 wheat for each cloth.

Suppose each country has 100 workers and they trade 120 wheat for 80 cloth (1.5 wheat per cloth). A makes 400 wheat and ends with 280 wheat and 80 cloth; working alone, it could have 80 cloth and only 240 wheat. B makes 100 cloth and ends with 20 cloth and 120 wheat; alone, it could have 20 cloth and only 80 wheat. Both gain.

The theory has limits. It assumes no transport costs, constant opportunity costs, and workers who can move easily from one industry to another. In reality, the workers in a closing cloth factory may not find new jobs quickly. And a country may become too dependent on one or two goods.

The World Trade Organization

The World Trade Organization 世界贸易组织 (WTO), set up in 1995 and now with more than 160 members, sets rules for world trade. It runs rounds of talks to lower trade barriers, and it settles trade disputes 贸易争端 between members. Critics say its rules favour rich countries, and its dispute system has been weak since its appeals body stopped working in 2019.

Trade protection 贸易保护 means government action that limits imports to help domestic producers. Most tools make foreign goods dearer or scarcer.

Types of protection

• Tariffs 关税: taxes on imports.
• Quotas 配额: limits on the quantity of a good that can be imported.
• Production subsidies 生产补贴: payments to domestic producers, which lower their costs.
• Export subsidies 出口补贴: payments to firms for each unit they export.
• Administrative barriers 行政壁垒: slow customs checks, strict product standards, or long paperwork that make importing harder.

The effects of a tariff (HL calculation)

Worked example. Domestic demand is $Q_d = 140 - 2P$ and domestic supply is $Q_s = 20 + 4P$. The country can import as much as it wants at the world price of 12.

1. Free trade. At $P = 12$: $Q_d = 140 - 24 = 116$ and $Q_s = 20 + 48 = 68$. Imports $= 116 - 68 = 48$.
2. Tariff of 4. The domestic price rises to 16: $Q_d = 108$ and $Q_s = 84$. Imports $= 108 - 84 = 24$.
3. Government revenue $= 4 \times 24 = 96$.
4. Deadweight loss. Domestic firms now make 16 extra units that foreign firms made more cheaply: $\tfrac12 \times 4 \times (84 - 68) = 32$. Consumers give up 8 units they valued above the world price: $\tfrac12 \times 4 \times (116 - 108) = 16$. Total: 48.

Who gains and who loses? Consumers lose: they pay more and buy less. Domestic producers gain: they sell more at a higher price. The government gains revenue. Foreign producers lose sales. Society as a whole loses the deadweight loss of 48.

A quota of 24 units would raise the domestic price to 16 in the same way. But there is no tariff revenue. The extra 4 per unit goes to whoever holds the import licences, often foreign firms. A production subsidy of 4 per unit would raise domestic output to 84 while the price stays at 12, so consumers do not lose. But the government pays $4 \times 84 = 336$.

Arguments for and against protection

Many economists accept some of these arguments in a few cases, such as a real infant industry for a limited time. They reject most others, because the losses to consumers are usually larger than the gains to producers.

Countries can agree to lower barriers with each other. This is economic integration 经济一体化.

• A bilateral 双边 agreement is between two countries. A multilateral 多边 agreement is among many (such as the WTO's rules).
• A preferential trade agreement 优惠贸易协定 lowers barriers on some goods only.

Trading blocs 贸易集团 go further, in stages:

Integration brings bigger markets, economies of scale, more competition and more investment. But it can also cause trade diversion 贸易转移: a member buys from a higher-cost partner inside the bloc instead of a lower-cost country outside it. When integration lets a member buy from a lower-cost partner instead of its own higher-cost producers, that is trade creation 贸易创造, which raises efficiency.

A monetary union removes exchange-rate costs and risks, and makes prices easy to compare. But each member loses its own interest rate and exchange rate. In the euro crisis after 2010, countries such as Greece could not devalue or cut interest rates to escape recession.

What sets the exchange rate

The exchange rate 汇率 is the price of one currency in another currency. Under a floating exchange rate 浮动汇率, demand and supply in the foreign exchange market set it.

• Demand for yuan comes from foreigners buying Chinese exports, tourists visiting China, and foreign investors buying Chinese assets.
• Supply of yuan comes from Chinese people and firms buying imports, travelling abroad, and investing abroad.

A rise in a currency's value is an appreciation 升值; a fall is a depreciation 贬值. The exchange rate changes when:

• foreign demand for a country's exports changes;
• interest rates change (higher rates attract hot money 热钱, short-term money looking for the best return);
• inflation differs between countries (high inflation makes exports less competitive);
• investors speculate 投机 that a currency will rise or fall;
• the central bank buys or sells its own currency.

Effects of a change

If the yuan appreciates, Chinese exports become dearer abroad and imports become cheaper in China. Exporters may lose sales, but import prices and inflation fall. A depreciation does the opposite: it helps exporters but raises the price of imported fuel and food.

Worked example (HL). One US dollar buys 7.00 yuan. A Chinese phone is priced at 2,100 yuan. In the US it costs $2{,}100 \div 7.00 = 300$ dollars. If the yuan appreciates to 6.00 per dollar, the same phone costs $2{,}100 \div 6.00 = 350$ dollars.

Fixed and managed systems

• Under a fixed exchange rate 固定汇率, the government or central bank sets the currency's value against another currency and buys or sells to keep it there. The Hong Kong dollar has been fixed to the US dollar since 1983. A deliberate cut in a fixed rate is a devaluation 法定贬值; a deliberate rise is a revaluation 法定升值.
• A managed exchange rate 有管理的浮动汇率 floats, but the central bank steps in to limit big moves. The People's Bank of China sets a daily central rate and lets the yuan move only within a band around it.

Fixed rates give certainty to traders and investors. But the central bank must hold large foreign currency reserves 外汇储备, and it gives up control of its own interest rate. Floating rates adjust by themselves, but they can swing sharply and make planning hard.

The balance of payments 国际收支 records all of a country's money transactions with the rest of the world in one year.

The accounts must add to zero. So a current account deficit is matched by a surplus on the capital and financial accounts: the country pays for extra imports by borrowing or by selling assets to foreigners.

Current account deficits and surpluses

A small deficit can be harmless, for example if it pays for imported machines that raise output later. A large, long-lasting deficit is a problem. The country builds up foreign debt, may need higher interest rates to attract money, and its currency may fall suddenly.

Policies to reduce a deficit:

• Expenditure-switching policies 支出转换政策 move spending from imports to domestic goods: protection, or a lower exchange rate.
• Expenditure-reducing policies 支出削减政策 cut total spending, and so imports: contractionary fiscal or monetary policy. These can cause unemployment.
• Supply-side policies make exports more competitive over the long run.

A persistent surplus can also cause problems: a rising currency, less consumption at home, and trade disputes with deficit countries.

Marshall–Lerner and the J-curve (HL)

A depreciation makes exports cheaper and imports dearer. It improves the current account only if buyers respond enough. The Marshall–Lerner condition 马歇尔-勒纳条件 says this happens when the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than 1.

In the short run, demand is inelastic. Contracts are already signed, and buyers take time to find new suppliers. So right after a depreciation the country pays more for the same imports, and the deficit gets WORSE. Later, volumes adjust and the balance improves. The path looks like a "J".

The terms of trade (HL)

The terms of trade 贸易条件 compare the prices of a country's exports with the prices of its imports:

Worked example. From the base year, a country's export price index rises to 128.9 and its import price index to 117.1. The terms of trade are $128.9 \div 117.1 \times 100 \approx 110.1$. They have improved by about 10%: each unit of exports now buys about 10% more imports.

Better terms of trade are not always good news. If exports become dearer because of domestic inflation, sales may fall. For many low-income countries that export primary products 初级产品 (food, metals, oil), prices swing a lot. Over the long run their terms of trade have often fallen against manufactured goods, so they must export more just to buy the same imports.

Sustainable development

Economic development 经济发展 is broader than growth. It means better living standards: less poverty, better health and education, more freedom and choice. Sustainable development 可持续发展 meets the needs of people today without harming the ability of future generations to meet their own needs. In 2015 the United Nations agreed 17 Sustainable Development Goals 可持续发展目标 (SDGs) for 2030, including no poverty, zero hunger, quality education, clean water and climate action. Poverty and environmental damage are linked: very poor people may have no choice but to cut forests or overuse land.

Measuring development

A country whose HDI rank is much higher than its GNI rank turns its income into health and education well. A country whose HDI rank is much lower may have high income from oil but poor public services or great inequality.

Barriers to development

• The poverty trap 贫困陷阱: people with low incomes cannot save, so there is little money for investment, so productivity and incomes stay low.
• Economic barriers: high inequality; poor infrastructure (roads, power, internet); little access to credit and markets; a large informal economy that pays no taxes; capital flight 资本外逃 (rich people moving money abroad); and unsustainable foreign debt.
• Dependence on primary products: for example, copper makes up most of Zambia's exports, so a fall in the world copper price cuts national income sharply.
• Geography: being landlocked 内陆的 raises transport costs; tropical disease and climate shocks hurt health and farming.
• Political and social barriers: weak institutions, corruption, poor legal and property rights, political instability and conflict, and gender inequality 性别不平等 (when girls cannot go to school, half the country's talent is wasted).

Strategies for development

Most successful countries have used a mix: market reforms and open trade, together with strong government investment in education, health and infrastructure. Every strategy should be judged by the barrier it removes, and by whether the gains are equal and sustainable.

• The benefits of trade; absolute against comparative advantage; the 4/2 against 1/1 table; trade at 1.5 wheat per cloth puts both countries outside their PPCs; the limits of the theory; the WTO (4.1).
• Tariffs, quotas, production and export subsidies, administrative barriers; the tariff worked example: imports 48 → 24, revenue 96, deadweight loss 32 + 16 = 48; who gains and who loses; quota and subsidy compared (4.2).
• The arguments for and against protection, with evaluation (4.3).
• Bilateral, multilateral and preferential agreements; free trade area, customs union, common market, economic and monetary union with examples; trade creation and trade diversion; the costs of a monetary union (4.4).
• Floating, fixed and managed exchange rates; what shifts the demand and supply of a currency; appreciation and depreciation and their effects; the phone priced at 2,100 yuan; devaluation and revaluation; reserves (4.5).
• The current, capital and financial accounts; why they balance; the problems of persistent deficits and surpluses; expenditure-switching, expenditure-reducing and supply-side corrections; HL Marshall–Lerner and the J-curve; HL terms of trade 128.9 / 117.1 → 110.1 and why primary exporters lose (4.6).
• Development against growth; sustainable development and the 17 SDGs (4.7).
• Single and composite indicators: GNI per capita at PPP, HDI, IHDI, GII; comparing HDI and GNI ranks (4.8).
• Barriers: the poverty trap, economic barriers, primary-product dependence, geography, political and social barriers (4.9).
• Strategies: export promotion, import substitution, diversification, FDI, aid, multilateral help, debt relief, microfinance, fair trade, institutions and human capital, each with its problems (4.10).