The International Economy

### 1.1 Absolute vs Comparative Advantage

Absolute advantage: a country can produce more of a good with the same resources than another Country (higher productivity).

Comparative advantage (Ricardo, 1817): a country should specialise in producing the goods for Which it has the lowest opportunity cost, even if it has an absolute disadvantage in all goods.

Proposition: Trade based on comparative advantage makes both countries better off.

Setup. Consider two countries, Home and Foreign, producing two goods, Cloth ($C$) and Wine ($W$), Using one factor (labour). Unit labour requirements:

	Cloth (labour per unit)	Wine (labour per unit)
Home	$a_C = 2$	$a_W = 4$
Foreign	$a_C = 6$	$a_W = 3$

Home has absolute advantage in Cloth ($2 \lt 6$). Foreign has absolute advantage in Wine ($3 \lt 4$).

Opportunity costs:

$\mathrm{OC of Cloth in terms of Wine:}$

• Home: $\frac{a_C}{a_W} = \frac{2}{4} = 0.5$ units of Wine per unit of Cloth
• Foreign: $\frac{a_C}{a_W} = \frac{6}{3} = 2.0$ units of Wine per unit of Cloth

Home has a comparative advantage in Cloth (lower OC: 0.5 < 2.0). Foreign has a comparative Advantage in Wine.

$\mathrm{OC of Wine in terms of Cloth:}$

• Home: $\frac{a_W}{a_C} = \frac{4}{2} = 2$ units of Cloth per unit of Wine
• Foreign: $\frac{a_W}{a_C} = \frac{3}{6} = 0.5$ units of Cloth per unit of Wine

Foreign has a comparative advantage in Wine (lower OC: 0.5 < 2.0).

Gains from trade. Suppose each country has 1,200 units of labour.

Autarky (no trade):

• Home: splits labour equally: $C = 1200/4 = 300$, $W = 1200/8 = 150$. Total: 300C + 150W.
• Foreign: splits labour equally: $C = 1200/12 = 100$, $W = 1200/6 = 200$. Total: 100C + 200W.
• World total: 400C + 350W.

Specialisation:

• Home specialises in Cloth: $C = 1200/2 = 600$, $W = 0$.
• Foreign specialises in Wine: $C = 0$, $W = 1200/3 = 400$.
• World total: 600C + 400W.

World output increases: 400C → 600C (+200) and 350W → 400W (+50). Both countries gain if they Trade at an exchange rate between the two opportunity cost ratios:

$0.5 \mathrm{ W/C} \lt \mathrm{World price } p \lt 2.0 \mathrm{ W/C}$

For example, at $p = 1$ (1 unit of Wine for 1 unit of Cloth):

• Home exports 200C, imports 200W. Home consumes: 400C + 200W (gains: +100C, +50W vs autarky).
• Foreign imports 200C, exports 200W. Foreign consumes: 200C + 200W (gains: +100C, 0W vs autarky).

Both are strictly better off. $\blacksquare$

### 1.3 Limitations of the Ricardian Model

1. Constant returns to scale: assumes constant opportunity costs (linear PPF). In reality, increasing opportunity costs (concave PPF) limit the degree of specialisation.
2. One factor of production: ignores capital, land, and technology differences.
3. Zero transport costs: in reality, transport costs reduce the gains from trade and may prevent trade in some goods.
4. Perfect labour mobility within countries: workers can move freely between sectors.
5. No trade barriers: tariffs and quotas reduce the gains from trade.
6. Complete specialisation: in practice, countries rarely specialise completely due to increasing opportunity costs.

Heckscher-Ohlin model (more advanced): countries export goods that intensively use their Abundant factor. A capital-abundant country exports capital-intensive goods; a labour-abundant Country exports labour-intensive goods.

The terms of trade (ToT) measure the ratio of a country’s export prices to its import prices:

$\mathrm{ToT} = \frac{\mathrm{Index of Export Prices}}{\mathrm{Index of Import Prices}} \times 100$

• ToT > 100 (improvement): export prices have risen relative to import prices. A given quantity of exports buys more imports. This is beneficial — “favourable” terms of trade.
• ToT < 100 (deterioration): export prices have fallen relative to import prices. A given quantity of exports buys fewer imports. This is harmful — “adverse” terms of trade.
• ToT = 100: no change from the base year.

Worked Example

Base year (2020): Export price index = 100, Import price index = 100. ToT = 100.

2024: Export prices rose by 15%, Import prices rose by 25%.

$\mathrm{ToT}_{2024} = \frac{115}{125} \times 100 = 92$

Terms of trade deteriorated by 8%. The country needs to export 8.7% more (115/105 = 1.087) just to Buy the same quantity of imports as in 2020.

Factor	Effect on ToT
Exchange rate appreciation	Export prices rise, import prices fall → ToT improves
Higher global demand for exports	Export prices rise → ToT improves
Rising commodity prices (for importers)	Import prices rise → ToT deteriorates
Inflation differentials	If domestic inflation > trading partners’ inflation → ToT deteriorates
Technological progress in export sector	Unit costs fall → export prices may fall → ToT deteriorates

## 3. Exchange Rates### 3.1 Definition

The exchange rate is the price of one currency in terms of another.

$\mathrm{Spot rate: } e = \frac{\mathrm{units of domestic currency}}{\mathrm{one unit of foreign currency}}$

A depreciation of the pound means $e$ rises (more pounds per dollar — the pound is weaker). An appreciation means $e$ falls (fewer pounds per dollar — the pound is stronger).

1. Fixed (pegged) exchange rate:

The central bank commits to buying and selling currency to maintain $e = \bar{e}$.

$\mathrm{If } e \gt \bar{e} \mathrm{ (depreciation pressure): central bank sells foreign reserves, buys domestic currency}$

$\mathrm{If } e \lt \bar{e} \mathrm{ (appreciation pressure): central bank buys foreign reserves, sells domestic currency}$

Advantages: certainty for trade and investment, discipline on monetary policy (cannot inflate away The peg), reduces speculative volatility.

Disadvantages: requires large foreign reserves, loss of independent monetary policy (impossible Trinity), vulnerability to speculative attacks (e.g., Soros vs Bank of England, 1992 — Black Wednesday).

2. Floating exchange rate:

The exchange rate is determined by market forces (supply and demand for the currency).

$e^* : \mathrm{Supply of } £ = \mathrm{Demand for } £$

Advantages: automatic adjustment to BoP imbalances (deficit → depreciation → exports cheaper, Imports dearer → deficit narrows), independent monetary policy, no need for large reserves.

Disadvantages: volatility creates uncertainty for trade and investment, may overshoot (Dornbusch, 1976), can be manipulated for competitive advantage (competitive devaluation).

3. Managed (dirty) float:

The central bank allows the market to set the exchange rate but intervenes occasionally to smooth Excessive fluctuations or achieve policy objectives.

$\bar{e}_{\min} \lt e \lt \bar{e}_{\max}$

$e = f(P, r, Y, Y^*, \mathrm{expectations, speculation})$

Factor	Mechanism
Relative inflation rates	Higher domestic inflation → exports less competitive, imports more attractive → $e$ rises (depreciation) — purchasing power parity (PPP)
Relative interest rates	Higher domestic interest rates → capital inflows (hot money) → demand for £ rises → $e$ falls (appreciation)
Relative growth rates	Faster domestic growth → higher import demand → current account worsens → $e$ rises (depreciation)
Speculation	If markets expect depreciation → sell £ → self-fulfilling depreciation
Current account balance	Persistent deficit → downward pressure on currency
Government debt	High debt → lower confidence → capital outflows → depreciation

Absolute PPP: the exchange rate should equalise the price of identical baskets of goods across Countries:

$e = \frac{P_{domestic}}{P_{foreign}}$

Relative PPP: the exchange rate should adjust to reflect inflation differentials:

$\frac{\Delta e}{e} \approx \pi_{domestic} - \pi_{foreign}$

PPP holds approximately in the long run but fails in the short run due to: trade barriers, Non-traded goods, price stickiness, and speculation.

The Marshall-Lerner condition determines whether a currency depreciation improves or worsens the Current account.

Proposition: A depreciation improves the current account if and only if the sum of the price Elasticities of demand for exports and imports (in absolute value) exceeds unity.

$|E_X| + |E_M| \gt 1$

Where:

• $E_X = \frac{\% \Delta Q_X}{\% \Delta P_X}$ = price elasticity of demand for exports
• $E_M = \frac{\% \Delta Q_M}{\% \Delta P_M}$ = price elasticity of demand for imports

Proof sketch. The current account balance (in domestic currency):

$CA = P_X \cdot X - e \cdot P_M^* \cdot M$

Where $X$ = export volume, $M$ = import volume, $P_X$ = domestic currency price of exports, $P_M^*$ = foreign currency price of imports, $e$ = exchange rate.

A depreciation ($e$ rises) makes exports cheaper for foreigners ($P_X/e$ falls) and imports more Expensive for domestic consumers ($e \cdot P_M^*$ rises). The effect on $CA$ depends on whether the Volume responses are large enough to outweigh the price changes:

$\Delta CA \approx \left(\frac{E_X \cdot P_X \cdot X}{P_X \cdot X + e \cdot P_M^* \cdot M}\right) \times \left(|E_X| + |E_M| - 1\right) \times \frac{\Delta e}{e}$

If $|E_X| + |E_M| \gt 1$: the volume effect dominates → $CA$ improves. If $|E_X| + |E_M| \lt 1$: The price effect dominates → $CA$ worsens (the country spends more on imports because they are more Expensive, without selling enough extra exports). $\blacksquare$

In the short run, $|E_X|$ and $|E_M|$ are low because contracts are fixed, consumers are slow to Change habits, and production takes time to adjust. So $|E_X| + |E_M| \lt 1$ initially → the Current account worsens after a depreciation.

Over time (6–18 months), elasticities increase as consumers find substitutes and firms adjust Production → $|E_X| + |E_M| \gt 1$ → the current account improves.

The path of the current account traces a J-shape:

$CA \mathrm{ falls initially, then rises above the starting level}$

## 5. Globalisation

Globalisation is the increasing interdependence of national economies through the growth of International trade, investment, capital flows, and migration.

1. Technological change: containerisation (shipping costs fell 80% from 1950–2000), the internet, communication technology
2. Trade liberalisation: GATT/WTO rounds, regional trade agreements (EU, NAFTA/USMCA, CPTPP)
3. Capital mobility: deregulation of financial markets, floating exchange rates
4. Multinational corporations (MNCs): production spread across multiple countries (global value chains)
5. Transport improvements: air freight, high-speed rail

1. Lower prices for consumers: access to cheaper imported goods
2. Greater product variety: consumers benefit from a wider range of goods
3. Comparative advantage and efficiency gains: specialisation raises world output
4. Technology transfer: developing countries gain access to advanced technology through FDI
5. Economies of scale: access to larger markets allows firms to exploit scale economies
6. Capital flows to developing countries: FDI and portfolio investment finance development
7. Cultural exchange and understanding

1. Inequality: globalisation may increase within-country inequality (skilled workers gain, unskilled workers lose from import competition). Stolper-Samuelson theorem: trade liberalisation reduces the real wage of the scarce factor.
2. Job losses in import-competing industries: structural unemployment in manufacturing (e.g., Rust Belt in the US, northern England)
3. Environmental degradation: “race to the bottom” in environmental standards; increased transport emissions
4. Loss of sovereignty: international institutions (WTO, IMF) constrain domestic policy
5. Cultural homogenisation: dominance of Western (especially American) culture
6. Vulnerability to external shocks: global financial crises, supply chain disruptions (COVID-19)
7. Exploitation: sweatshop labour in developing countries, tax avoidance by MNCs

Globalisation is not an unambiguous good or bad — it creates winners and losers. The policy Challenge is to capture the benefits while compensating the losers (retraining programmes, regional Development, social safety nets). The retreat from globalisation since ~2016 (Brexit, US-China trade War, reshoring) reflects these tensions.

Economic indicators:

• GDP per capita (PPP-adjusted for comparability)
• GNI per capita (World Bank classification: low <$1,145, lower-middle$1,146–$4,515, upper-middle$4,516–$14,005, high \gt$14,005)
• GDP growth rate
• Industrial structure (share of agriculture/manufacturing/services)

Social indicators:

• Human Development Index (HDI): composite of life expectancy, education (mean years + expected years), and GNI per capita. $0 \leq HDI \leq 1$.
• Poverty rates ($1.90/day extreme poverty line)
• Access to clean water, sanitation, electricity
• Infant mortality rate, maternal mortality rate
• Literacy rate, school enrolment rates

Composite indicators:

• HDI ($0 \leq \mathrm{HDI} \leq 1$): health + education + income
• Multidimensional Poverty Index (MPI): health, education, and living standards
• Genuine Progress Indicator (GPI): adjusts GDP for environmental costs, inequality, and unpaid work

### 6.2 Barriers to Economic Development

1. Poverty trap: low income → low savings → low investment → low growth → low income (vicious cycle)
2. Institutional failure: corruption, weak property rights, poor governance (Acemoglu & Robinson, 2012: “Why Nations Fail”)
3. Human capital deficiency: poor education and health reduce labour productivity
4. Infrastructure deficit: inadequate transport, energy, and communications
5. Geography: landlocked countries, tropical climate, disease burden (Sachs, 2005)
6. Demographic trap: high population growth outpaces economic growth → falling GDP per capita
7. Conflict and political instability: war destroys physical and human capital, discourages investment
8. Terms of trade: primary commodity exporters face volatile and declining terms of trade (Prebisch-Singer hypothesis)
9. Debt burden: heavy debt servicing crowds out public spending on health and education
10. Brain drain: skilled workers emigrate to developed countries

1. Industrialisation: moving from agriculture to manufacturing (Lewis dual-sector model). East Asian “tiger” economies followed export-oriented industrialisation.
2. Import substitution industrialisation (ISI): replacing imports with domestic production (Latin America, 1950s–70s). Often led to inefficient, uncompetitive industries.
3. Export-oriented industrialisation: focusing on producing goods for export (South Korea, Taiwan, Singapore). Higher growth rates than ISI.
4. Agricultural reform: land reform, investment in irrigation and seeds (Green Revolution in India).
5. Investment in human capital: universal education, healthcare, gender equality (World Bank, 2018: 25% of GDP growth attributed to improved health and education).
6. Institutional reform: anti-corruption measures, strengthening property rights, rule of law.
7. Foreign aid: can provide capital, technology, and expertise. But may create dependency and be misappropriated. Effective aid targets institutions and infrastructure, not just cash transfers.
8. Microfinance: small loans to entrepreneurs in developing countries (Grameen Bank, Muhammad Yunus).
9. Debt relief: HIPC (Heavily Indebted Poor Countries) Initiative, cancelled debt for qualifying countries.

Type	Definition	Example
Free trade area	No tariffs between members, but each sets own external tariffs	NAFTA/USMCA
Customs union	Free trade + common external tariff	EU (as customs union)
Common market	Customs union + free movement of factors of production	EU single market
Monetary union	Common market + single currency + common central bank	Eurozone
Economic union	Monetary union + harmonised fiscal and structural policies	EU (partial)

Trade creation (Viner, 1950): a trading bloc replaces high-cost domestic production with Lower-cost imports from a member country. This increases efficiency.

Trade diversion: a trading bloc replaces low-cost imports from a non-member with higher-cost Imports from a member country (due to preferential tariffs). This reduces efficiency.

Policy	Mechanism	Effect
Tariff	Tax on imports	Raises import price → reduces imports, generates revenue
Quota	Physical limit on imports	Restricts supply → raises import price
Subsidy	Payment to domestic producers	Lowers domestic cost → competitive vs imports
Administrative barriers	Health/safety standards, customs procedures	Raises cost/delay of importing
Embargo	Complete ban on imports/exports	Eliminates trade in the targeted good

Welfare analysis of a tariff:

Consumer surplus falls by more than producer surplus and government revenue increase → net welfare Loss (deadweight loss from inefficient domestic production and reduced consumption).

$\mathrm{DWL} = \frac{1}{2} \times (P_w + t - P_w) \times (Q_d^{domestic} - Q_s^{domestic}) = \frac{1}{2} t \times \Delta Q$

Problem 1. Country A can produce 10 cars or 5 trucks per worker per month. Country B can produce 6 cars or 6 trucks per worker per month. (a) Which country has an absolute advantage in each good? (b) Calculate opportunity costs. (c) Which country should specialise in which good? (d) Show that Trade can benefit both countries.

Hint

(a) Country A: absolute advantage in cars (10 \gt 6). Country B: absolute advantage in trucks (6 \gt 5). (b) OC of 1 car: A = 5/10 = 0.5 trucks, B = 6/6 = 1 truck. OC of 1 truck: A = 10/5 = 2 cars, B = 6/6 = 1 car. (c) A has lower OC in cars (0.5 \lt 1) → specialise in cars. B has lower OC in trucks (1 \lt 2) → specialise in trucks. (d) World price between 0.5 and 1 truck per car. At $p = 0.75$: A gains by exporting cars at a price higher than its OC (0.5). B gains by importing cars at a price lower than its OC (1.0). Both better off.

Problem 2. A country’s export price index rises from 120 to 132, while its import price index Rises from 100 to 120. (a) Calculate the initial and new terms of trade. (b) Has the ToT improved or Deteriorated? (c) Explain why this may not be entirely beneficial.

Hint

(a) Initial ToT = 120/100 = 120. New ToT = 132/120 = 110. (b) ToT deteriorated from 120 to 110 (fell by 8.3%). (c) Even though export prices rose by 10%, import prices rose by 20%. The country now needs to export more to buy the same imports. However: if the export price rise is due to higher quality (better technology), the "real" ToT may not have deteriorated. And if import price rise is due to cheaper goods from abroad (more competition), consumers benefit from lower prices.

Problem 3. The exchange rate falls from $1.50/£ to$1.20/£. (a) Has the pound appreciated or Depreciated? (b) If the price elasticity of demand for exports is 0.6 and for imports is 0.8, use The Marshall-Lerner condition to determine the short-run effect on the current account. (c) Explain The J-curve effect.

Hint

(a) More dollars per pound before → now fewer dollars per pound → pound has depreciated (you get fewer dollars for each pound). (b) $|E_X| + |E_M| = 0.6 + 0.8 = 1.4 \gt{} 1$. The Marshall-Lerner condition is satisfied → in the long run, the current account improves. However, these are long-run elasticities. (c) J-curve: in the short run (first 6–12 months), elasticities are lower because contracts are fixed and consumers are slow to change habits. So initially $|E_X| + |E_M| \lt{} 1$ → CA worsens. Over time, as consumers and firms adjust, elasticities rise above 1 → CA improves. The path traces a J-shape.

Problem 4. Explain the advantages and disadvantages of a fixed exchange rate system compared With a floating exchange rate system. In your answer, refer to the concept of the “impossible Trinity” (trilemma).

Hint

The impossible trinity: a country cannot simultaneously have (1) free capital mobility, (2) a fixed exchange rate, and (3) independent monetary policy. It must give up one. Fixed advantages: certainty for trade/investment, discipline on inflation, no speculative volatility. Fixed disadvantages: loss of monetary independence (must set interest rates to defend the peg, not for domestic objectives), requires large reserves, vulnerable to speculative attacks (e.g., ERM crisis 1992). Floating advantages: automatic BoP adjustment, independent monetary policy, no reserve requirement. Floating disadvantages: volatility, overshooting, competitive devaluation risk. *Revision: see [The Financial Sector](03-the-financial-sector) for monetary policy.*

Problem 5. Evaluate the argument that globalisation has increased income inequality both within And between countries.

Hint

Between countries: globalisation has *reduced* inequality between nations — China, India, and other emerging economies have grown rapidly through trade, narrowing the gap with developed countries. Within countries: globalisation has *increased* inequality in many developed countries (Stolper-Samuelson theorem: trade liberalisation benefits the abundant factor — skilled labour in developed countries, unskilled labour in developing countries). In the UK/US: skilled workers and capital owners gained; manufacturing workers lost jobs to import competition and offshoring. Top 1% captured disproportionate gains. However: technology (skill-biased technological change) may be a larger driver of within-country inequality than trade. Policy response: progressive taxation, education and retraining, regional development policies.

Problem 6. “Foreign aid is an effective strategy for promoting economic development.” Evaluate This statement.

Hint

Arguments for: (1) Provides capital that poor countries cannot generate domestically (savings gap). (2) Finances infrastructure (roads, hospitals, schools) with long-term benefits. (3) Can improve health and education (human capital). (4) Emergency/humanitarian aid saves lives. Arguments against: (1) Dependency — may discourage domestic savings and tax effort. (2) Corruption and misappropriation — aid may not reach intended beneficiaries. (3) Dutch disease — large aid inflows appreciate the real exchange rate, making exports less competitive. (4) Tied aid — may benefit donor countries more than recipients. (5) Aid effectiveness depends on institutional quality (Burnside & Dollar, 2000). Evidence: countries with good institutions (Botswana) used aid effectively; countries with poor institutions (DRC) did not. Best practice: aid targeted at institutions, health, and education; with conditionality and monitoring.

Problem 7. Using AD/AS analysis, explain the effects of a depreciation of the exchange rate on The domestic economy. Under what conditions might a depreciation be inflationary?

Hint

AD effects: depreciation makes exports cheaper and imports dearer → net exports rise → AD shifts right → output and price level rise. SRAS effects: imported raw materials become more expensive → production costs rise → SRAS shifts left → price level rises, output falls. Net effect on output: ambiguous (AD shift right vs SRAS shift left). Net effect on prices: unambiguously inflationary (both AD and SRAS shifts push prices up). Conditions for inflationary effect: (1) High import dependence (the UK imports ~30% of consumption). (2) Inelastic demand for imports (necessities like oil, food). (3) Economy near full employment (no spare capacity to absorb demand increase). *Revision: see [Aggregate Demand and Aggregate Supply](02-aggregate-demand-and-supply).*

Problem 8. Explain the Prebisch-Singer hypothesis. Why might developing countries that Specialise in primary commodity exports face a long-term deterioration in their terms of trade?

Hint

Prebisch-Singer hypothesis: the terms of trade for primary commodity exporters decline relative to manufactured goods exporters over the long run. Reasons: (1) Low income elasticity of demand for primary commodities (Engel's law — as income rises, the share spent on food/raw materials falls). (2) High income elasticity of demand for manufactured goods. (3) Technological progress reduces the demand for raw materials (synthetic substitutes, recycling). (4) Agricultural productivity growth is faster than in manufacturing (supply grows faster than demand → prices fall). (5) Oligopolistic pricing in manufacturing vs competitive pricing in primary commodities (manufacturers have pricing power). Implications: developing countries specialising in primary commodities face declining ToT → need to diversify into manufacturing and services.

Problem 9. A customs union is formed between three countries. Explain the difference between Trade creation and trade diversion. Under what conditions is a customs union more likely to create Trade than divert it?

Hint

Trade creation: the union replaces high-cost domestic production with lower-cost imports from a partner country → efficiency gain (consumers benefit, world output increases). Trade diversion: the union replaces low-cost imports from a non-member with higher-cost imports from a partner (because of preferential tariffs) → efficiency loss (consumers lose, world output decreases). Conditions for net trade creation: (1) The union includes countries that are efficient producers (so intra-union trade is genuinely lower-cost). (2) External tariffs are not too high (so trade diversion from non-members is limited). (3) The member countries are economically complementary (different comparative advantages). (4) The union is geographically proximate (lower transport costs). The EU's expansion is estimated to have created more trade than it diverted, but the net effect varies by sector and country.

Problem 10. “A country with a persistent current account deficit should devalue its currency to Restore balance.” Evaluate this policy recommendation.

Hint

Devaluation could help: (1) Makes exports cheaper, imports dearer → improves trade balance (Marshall-Lerner condition). (2) Improves competitiveness of domestic industries. (3) Reduces the trade deficit. But: (1) J-curve effect — the CA may worsen initially. (2) Imported inflation — devaluation raises import prices, potentially causing cost-push inflation. (3) If the deficit is structural (caused by lack of competitiveness, not the exchange rate), devaluation is a temporary fix. (4) Capital flight — if markets expect further devaluation, investors sell the currency, making things worse. (5) Retaliation — trading partners may also devalue (competitive devaluation, "currency wars"). Better approach: address the root cause. If the deficit reflects low productivity → supply-side reforms. If it reflects excessive consumption → fiscal tightening. Devaluation is one tool among many, not a panacea. *Revision: see [Fiscal Policy](04-fiscal-policy) for alternative policy approaches.*

Problem 11. Compare and contrast import substitution industrialisation (ISI) with Export-oriented industrialisation (EOI). Use examples to illustrate your answer.

Hint

ISI: replace imports with domestic production behind tariff walls. Examples: Latin America (Brazil, Argentina, Mexico) 1950s–70s, India pre-1991. Advantages: protects infant industries, reduces dependence on imports, retains foreign exchange. Disadvantages: protected industries become inefficient (no competitive pressure), small domestic market limits economies of scale, leads to balance of payments problems (importing capital goods while exporting little). EOI: focus on producing for export. Examples: East Asian tigers (South Korea, Taiwan, Singapore, Hong Kong) 1960s–90s, China post-1978. Advantages: access to large world markets → economies of scale, competitive pressure drives efficiency and innovation, export earnings finance further investment. Disadvantages: vulnerability to external demand shocks, initially difficult to compete with established firms. Evidence: EOI countries achieved significantly higher growth rates (7–10% vs 3–5% for ISI). The East Asian miracle is widely attributed to EOI combined with education, land reform, and industrial policy.

Problem 12. Explain how the UK’s decision to leave the EU (Brexit) can be analysed using the Theory of comparative advantage and the concept of trade creation and diversion.

Hint

Comparative advantage: leaving the EU's single market means the UK faces tariffs and non-tariff barriers when trading with EU members. This reduces the gains from trade based on comparative advantage — UK producers who were competitive within the EU now face higher costs of exporting. Trade creation/diversion: leaving the EU is like *reverse trade creation* — the UK loses the trade-creating effects of the single market. New trade agreements with non-EU countries may create some trade, but: (1) EU is the UK's largest trading partner (43% of exports) — hard to replace. (2) Non-tariff barriers (regulatory divergence, customs checks) increase costs even without tariffs. (3) Services (80% of UK economy) are particularly affected — harder to negotiate services trade deals. Estimated cost: OBR estimates Brexit reduces long-run UK productivity by 4%. Potential benefits: regulatory autonomy, independent trade policy, control over migration. The net effect depends on how effectively the UK uses its new regulatory freedom.