International trade, global interest rates and global trends
Countries gain by specialising where their opportunity cost is lowest and trading. Global interest rates and trends shape a small economy's trade and capital flows.
Why countries trade
Countries trade because resources, climate, skills and technology differ. Adam Smith explained absolute advantage: a country should export goods it can make with fewer resources than others. David Ricardo went further with comparative advantage: even if one country is better at making everything, both gain if each specialises in the good with the lowest opportunity cost and trades. Trade also brings wider choice, economies of scale from larger markets, competition that keeps firms efficient, and access to technology and inputs a country cannot make itself.
Worked example: comparative advantage and the gains from trade
With one worker-day, Sri Lanka can make 12 kg of tea or 4 machine parts; Country B can make 4 kg of tea or 3 parts. Each has 100 worker-days. Find who has the comparative advantage in each good, and show the gain if both trade.
- Sri Lanka has an absolute advantage in both goods (12 > 4 tea; 4 > 3 parts).
- Opportunity cost of 1 part: Sri Lanka 12 ÷ 4 = 3 kg tea; Country B 4 ÷ 3 = 1.33 kg tea. B gives up less tea, so B has the comparative advantage in parts.
- Opportunity cost of 1 kg tea: Sri Lanka 4 ÷ 12 = 0.33 part; Country B 3 ÷ 4 = 0.75 part. Sri Lanka has the comparative advantage in tea.
- Before trade (each splits 50-50): Sri Lanka 600 tea + 200 parts; B 200 tea + 150 parts. World: 800 tea, 350 parts.
- After specialising (Sri Lanka 70 days tea, 30 days parts; B all parts): Sri Lanka 840 tea + 120 parts; B 0 tea + 300 parts. World: 840 tea, 420 parts.
- World output rises by 40 kg tea and 70 parts. At terms of trade of 1 part = 2 kg tea, Sri Lanka pays 2 kg for a part that costs it 3 kg to make, and B gets 2 kg of tea for 1 part instead of the 1.5 parts it would cost at home.
Sri Lanka should specialise in tea and Country B in parts. World output rises (+40 tea, +70 parts), and any terms of trade between 1.33 and 3 kg of tea per part benefit both.
From comparative advantage to gains from trade
Trade policy: tools and arguments
| Point | Detail |
|---|---|
| Tools of protection | Tariffs (import taxes), quotas, import licences, export subsidies, exchange controls |
| Arguments for protection | Protect infant industries, save jobs, protect the balance of payments, raise revenue, prevent dumping, protect strategic industries |
| Arguments for free trade | Comparative advantage, lower prices, more choice, competition and efficiency, access to technology |
| Trade agreements | Free trade agreements, such as the India-Sri Lanka Free Trade Agreement, and preferential schemes such as the EU's GSP+, which gives eligible Sri Lankan exports, including apparel, reduced-duty access |
Balance of payments and the exchange rate
The balance of payments records all transactions with the rest of the world. The current account covers trade in goods (exports of apparel and tea; imports of fuel, machinery and food), services (such as tourism), primary income (interest and profits) and secondary income, mainly workers' remittances, an important source of foreign exchange for Sri Lanka. The capital and financial accounts record investment and borrowing flows. A depreciation of the rupee makes exports cheaper abroad and imports dearer at home; it improves the trade balance only if demand for exports and imports is elastic enough.
Global macroeconomic trends by type of economy
| Group | Typical features | Main challenges |
|---|---|---|
| Developed economies | High incomes, service-based, ageing populations, strong institutions | Slow growth, high public debt, inflation shocks met with interest rate rises |
| Developing (emerging) economies | Faster growth, industrialising, growing middle class, integration into global supply chains | Debt stress, currency pressure when global rates rise, inequality |
| Underdeveloped (least developed) economies | Low incomes, dependence on farming or a few commodities, large informal sector | Low productivity, price swings in commodities, reliance on aid, vulnerability to climate shocks |
Global trends that affect Sri Lankan business
- Interest rate moves by major central banks change capital flows, exchange rates and the cost of foreign borrowing for developing countries.
- Buyers diversifying supply chains across several countries creates both competition and opportunity for apparel exporters.
- Digital trade in IT and business process services is growing.
- Rising protectionism and trade disputes among large economies can disrupt markets.
- Climate rules and sustainability demands from buyers affect export industries such as tea and apparel.
Sri Lanka's comparative advantage shows in Ceylon tea and in apparel from firms such as MAS and Brandix, sold to buyers abroad, while it imports fuel and machinery it cannot make cheaply. A weaker rupee helps exporters earn more rupees but raises the cost of imported inputs, so exporters must manage both sides.
Short answer: “Distinguish absolute advantage from comparative advantage.” Absolute advantage: producing more with the same resources. Comparative advantage: producing at a lower opportunity cost than another country.
Structured question: “Given output per worker in two countries for two goods, identify each country's comparative advantage and show the gains from trade.” Compute opportunity costs (e.g. part = 3 tea in Sri Lanka, 1.33 in B), assign specialisation, and show world output rising (+40 tea, +70 parts).
Essay: “Explain the theory of comparative advantage and the gains from international trade, and discuss how global trends affect a developing economy such as Sri Lanka.” Explain absolute and comparative advantage with a numerical example, terms of trade, gains from trade, trade policy, the balance of payments, and global interest rate and trade trends.
Comparative advantage = lowest opportunity cost, not most output. Specialise there, trade, and both countries consume beyond their own PPC.