How to Solve: IB Economics – International Trade (Comparative/Absolute Advantage, Terms of Trade, Tariffs/Quotas)

How to Solve: IB Economics – International Trade (Comparative/Absolute Advantage, Terms of Trade, Tariffs/Quotas)

Introduction

"Mastering comparative advantage and trade barriers can earn you 10+ marks in Paper 1 (HL/SL) and Paper 3 (HL) – that’s the difference between a 5 and a 7. Plus, you’ll explain why your country imports bananas instead of growing them in greenhouses!

What You Need To Know First

1. Opportunity cost – What you give up to produce one more unit of a good.
2. Production Possibility Frontier (PPF) – A curve showing maximum output combinations for two goods.
3. Basic supply and demand – How prices and quantities change with shifts in curves.

(If you’re shaky on these, pause and review them first.)

KEY TERMS & FORMULAS

1. Absolute Advantage

• Definition: A country can produce more of a good with the same resources than another country.
• No formula – Just compare output per worker/hour.

2. Comparative Advantage

• Definition: A country has a lower opportunity cost for producing a good than another country.
• Formula (Opportunity Cost):
• Opportunity Cost of Good X = (Max Production of Good Y) / (Max Production of Good X)
• MEMORISE THIS – You’ll calculate this for every trade question.

3. Terms of Trade (ToT)

• Definition: The ratio at which a country can exchange exports for imports.
• Formula:
• ToT = (Index of Export Prices) / (Index of Import Prices) × 100
• Given on exam sheet – But you must know how to interpret it.
• ToT > 100 = Favorable (country gets more imports per export).
• ToT < 100 = Unfavorable (country gets fewer imports per export).

4. Tariffs & Quotas

• Tariff: A tax on imports → Raises domestic price, reduces quantity imported.
• Quota: A limit on import quantity → Reduces supply, raises domestic price.
• No formula – But you must draw and label the welfare effects (consumer/producer surplus, government revenue, deadweight loss).

Step-by-Step Method

Step 1: Identify the Data

• Look for production tables (output per worker/hour) or PPF graphs.
• Note: Absolute advantage = highest output. Comparative advantage = lowest opportunity cost.

Step 2: Calculate Opportunity Costs

• For each good in each country, use:
• Opportunity Cost of Good X = (Max Y) / (Max X)
• Write the opportunity cost in terms of the other good (e.g., "1 car = 2 computers").

Step 3: Determine Comparative Advantage

• The country with the lower opportunity cost for a good has the comparative advantage in that good.
• Trade should happen if opportunity costs differ.

Step 4: Find the Terms of Trade (ToT)

• The mutually beneficial trade ratio must lie between the two countries’ opportunity costs.
• Example: If Country A’s OC for wheat is 1:2 cloth, and Country B’s is 1:3 cloth, trade could be 1 wheat = 2.5 cloth.

Step 5: Draw Tariff/Quota Diagrams (If Applicable)

• Tariff:
• Start with world price (Pw).
• Add tariff (t) → New price = Pw + t.
• Show domestic supply & demand at new price.
• Label:
  • Consumer surplus (CS) loss
  • Producer surplus (PS) gain
  • Government revenue (tariff × imports)
  • Deadweight loss (DWL)
• Quota:
• Start with world price (Pw).
• Quota reduces supply → New supply curve shifts right by quota amount.
• New equilibrium price rises.
• Label:
  • CS loss
  • PS gain
  • Quota rent (extra profit for importers)
  • DWL

Step 6: Calculate Welfare Effects (If Asked)

• Change in CS = Area of trapezoid (use geometry if needed).
• Change in PS = Area of rectangle/triangle.
• Government revenue = Tariff × New import quantity.
• DWL = Total loss not gained by anyone.

Worked Examples

Example 1 – Basic: Comparative Advantage

Question: Country A and B produce wheat and cloth. Their maximum outputs per worker per day:

a) Which country has the absolute advantage in wheat? b) Which country has the comparative advantage in cloth? c) What is a possible terms of trade for 1 ton of wheat?

Step 1: Identify the Data - Country A: 4 wheat OR 8 cloth. - Country B: 2 wheat OR 6 cloth.

Step 2: Calculate Opportunity Costs - Country A: - OC of 1 wheat = 8 cloth / 4 wheat = 2 cloth - OC of 1 cloth = 4 wheat / 8 cloth = 0.5 wheat - Country B: - OC of 1 wheat = 6 cloth / 2 wheat = 3 cloth - OC of 1 cloth = 2 wheat / 6 cloth = 0.33 wheat

Step 3: Determine Comparative Advantage - Wheat: Country A (OC = 2 cloth < Country B’s 3 cloth). - Cloth: Country B (OC = 0.33 wheat < Country A’s 0.5 wheat).

Step 4: Find Terms of Trade - Country A’s OC for wheat = 2 cloth. - Country B’s OC for wheat = 3 cloth. - Mutually beneficial trade: 1 wheat = 2.5 cloth (between 2 and 3).

Answers: a) Country A (4 > 2). b) Country B (lower OC for cloth). c) 1 wheat = 2.5 cloth (or any value between 2 and 3).

What we did and why: - We calculated opportunity costs to find comparative advantage. - Trade happens only if opportunity costs differ. - The terms of trade must benefit both countries (lie between their OCs).

Example 2 – Medium: Tariff Welfare Effects

Question: - World price of steel = $500/ton. - Domestic demand at $500 = 100 tons. - Domestic supply at $500 = 40 tons. - Government imposes a $100 tariff. - New domestic price = $600. - At $600, domestic demand = 80 tons, domestic supply = 60 tons.

a) Calculate the change in consumer surplus. b) Calculate government revenue from the tariff. c) Calculate the deadweight loss.

Step 1: Draw the Diagram (Mentally or on Paper) - Before tariff: - Price = $500. - Imports = 100 - 40 = 60 tons. - After tariff: - Price = $600. - Imports = 80 - 60 = 20 tons.

Step 2: Calculate Consumer Surplus (CS) Change - CS before tariff = ½ × (Max price - Pw) × Qd - Max price = Where demand = 0 (assume $1000 for this example). - CS before = ½ × ($1000 - $500) × 100 = $25,000. - CS after tariff = ½ × ($1000 - $600) × 80 = $16,000. - Change in CS = $16,000 - $25,000 = -$9,000 (loss).

Step 3: Calculate Government Revenue - Tariff revenue = Tariff × New imports - = $100 × 20 = $2,000.

Step 4: Calculate Deadweight Loss (DWL) - DWL = Total loss - Government gain - Total loss = CS loss ($9,000) - PS gain (calculate if needed). - PS gain = Area of rectangle + triangle: - Rectangle = ($600 - $500) × 40 = $4,000. - Triangle = ½ × ($600 - $500) × (60 - 40) = $1,000. - Total PS gain = $5,000. - DWL = $9,000 (CS loss) - $5,000 (PS gain) - $2,000 (gov revenue) = $2,000.

Answers: a) Consumer surplus falls by $9,000. b) Government revenue = $2,000. c) Deadweight loss = $2,000.

What we did and why: - We quantified welfare changes using areas (triangles/rectangles). - Government revenue comes from the tariff × new imports. - DWL is the net loss not gained by anyone.

Example 3 – Exam-Style: Disguised Quota Question

Question (Paper 1, 10-mark): "Using a diagram, explain the effects of a quota on the market for imported cars. Include the impact on domestic producers, consumers, and government revenue."

Step 1: Identify the Market - Good: Imported cars. - Quota = Limit on import quantity.

Step 2: Draw the Diagram
1. Axes: Price (y), Quantity (x).
2. World price (Pw) = Horizontal line.
3. Domestic supply (Sd) and demand (Dd) curves.
4. Before quota: - Imports = Qd - Qs at Pw.
5. After quota: - New supply curve (Sd + quota) shifts right by quota amount. - New equilibrium price rises (Pq). - New quantity = Qq.

Step 3: Label Welfare Effects - Consumer Surplus (CS): - Before: Area above Pw, below Dd. - After: Area above Pq, below Dd → CS falls. - Producer Surplus (PS): - Before: Area below Pw, above Sd. - After: Area below Pq, above Sd → PS rises. - Quota Rent: - Rectangle = (Pq - Pw) × Quota quantity → Extra profit for importers. - Deadweight Loss (DWL): - Two triangles: 1. Production inefficiency (domestic overproduction). 2. Consumption loss (fewer cars bought).

Step 4: Write the Explanation (6-8 marks) "A quota limits the quantity of imported cars, reducing supply. This shifts the supply curve right by the quota amount, raising the domestic price from Pw to Pq. Domestic producers benefit as they sell more cars at a higher price, increasing producer surplus. However, consumers face higher prices and buy fewer cars, reducing consumer surplus. The government does not collect revenue (unlike a tariff), but importers gain quota rent—the extra profit from selling at Pq instead of Pw. The economy suffers a deadweight loss due to overproduction by inefficient domestic firms and reduced consumption."

What we did and why: - We drew the diagram first to visualize effects. - Quota ≠ tariff – No government revenue, but quota rent for importers. - DWL comes from inefficient production and lost consumption.

Common Mistakes

Exam Traps

1-Minute Recap (Night Before the Exam)

"Listen up—this is your 60-second crash course for international trade in IB Economics:

1. Absolute advantage = Who makes more with the same resources. Comparative advantage = Who has the lower opportunity cost (calculate it!).
2. Trade happens only if opportunity costs differ. The terms of trade must be between the two countries’ OCs.
3. Tariffs = Tax on imports → higher price, less imports, government revenue, DWL.
4. Quotas = Limit on imports → higher price, less imports, quota rent for importers, DWL.
5. Diagrams are everything – Label CS, PS, gov revenue, DWL in order. If you forget, draw the world price first, then add the tariff/quota.
6. DWL is the net loss – Don’t just write ‘CS falls’; subtract PS gain and gov revenue.

Now go ace that exam—you’ve got this!