International trade makes people’s lives in both countries richer when countries produce and exchange the things they are good at producing. Let us study the basic structure of the international economy, from its theoretical foundation to modern trade and currency systems.
Basic Knowledge
The theoretical foundation of trade includes the theory of comparative costs (principle of comparative advantage) proposed by the British economist Ricardo. This is the idea that both countries can benefit if each specializes in and trades goods that it can produce at relatively low cost. Even a country with lower absolute production efficiency can gain from trade by specializing in goods in which it has a comparative advantage.
There are two positions on trade: free trade (abolishing tariffs and import restrictions to promote free transactions) and protectionism (establishing tariffs and import restrictions to protect domestic industries). The postwar multilateral free-trade system was supported by GATT (the General Agreement on Tariffs and Trade), which developed into the WTO (World Trade Organization) in 1995. The basic principles of the WTO are ① most-favored-nation treatment, ② national treatment, and ③ dispute-settlement procedures. In recent years, FTAs (free trade agreements) between two countries or regions and EPAs (economic partnership agreements), which also cover investment and intellectual property in addition to trade, have increased.
In terms of currencies, the exchange ratio between two countries’ currencies is called the exchange rate. An increase in the value of the yen is called yen appreciation (for example, 1 dollar = 100 yen → 80 yen), while a decrease is called yen depreciation (for example, 1 dollar = 100 yen → 130 yen).
Theory of comparative costs (comparative advantage) (Ricardo’s theory that mutually beneficial trade is possible when countries specialize in goods in which they have a relative advantage)
WTO (World Trade Organization) (an international organization that promotes free trade and handles dispute settlement. Established in 1995)
FTA (free trade agreement) (an agreement between two countries or regions concerning tariff abolition and other matters)
EPA (economic partnership agreement) (a comprehensive agreement that includes investment, intellectual property, and other matters in addition to an FTA)
Yen appreciation (an increase in the value of the yen. Disadvantageous for exporters, advantageous for imports and travel)
Protectionism (a policy that protects domestic industries through tariffs and import restrictions)
Further Study (Background and Significance)
One cause of World War II was that countries promoted protectionism and the formation of economic blocs with priority given to their own national interests. After the war, the Bretton Woods system (a fixed exchange-rate system, the IMF, and the World Bank) was established under U.S. leadership, and GATT (later the WTO) promoted multilateral free trade. However, after the Nixon Shock in 1973, the major countries shifted to floating exchange rates.
In recent years, as multilateral negotiations at the WTO, such as the Doha Round, have stagnated, broad economic partnerships such as the TPP (Trans-Pacific Partnership) and RCEP (Regional Comprehensive Economic Partnership) have emerged. Free trade enriches the economy as a whole, but it also creates inequality because particular industries and workers may suffer. The balance between protectionism and free trade remains a focus of policy debate.
- Principle of comparative advantage: gains from trade arise when a country has a comparative advantage even if it has an absolute disadvantage
- The WTO was established in 1995 as the successor to GATT
- Yen appreciation → disadvantageous for exports and advantageous for imports; yen depreciation → advantageous for exports and disadvantageous for imports
- FTAs mainly focus on eliminating tariffs; EPAs include broader economic cooperation
- Basic WTO principles: most-favored-nation treatment and national treatment
- Floating exchange-rate system: a system in which exchange rates change daily according to supply and demand
Points to Note (Easily Confused Concepts)
① Difference between absolute advantage and comparative advantage: absolute advantage means that the production cost of a good is absolutely low, while comparative advantage means that the opportunity cost of a good is relatively low. ② Yen appreciation and yen depreciation: when the number of yen per 1 dollar becomes smaller, it is yen appreciation; when it becomes larger, it is yen depreciation. ③ FTAs and EPAs: an EPA is a broader concept that includes an FTA. ④ GATT is a treaty (agreement), while the WTO is an international organization; they must be distinguished.
Practice
- Explain Ricardo’s theory of comparative costs, giving a specific example.
- State the effects of yen appreciation on Japanese exporting and importing firms.
- Explain the relationship and differences among the WTO, FTAs, and EPAs.