A2 Unit 4 Diagrams
All essential diagrams for Pearson Edexcel IAL A2 Economics Unit 4 (WEC14/01) — international trade, exchange rates, balance of payments, development and the global economy.
4.2 — Comparative Advantage & Free Trade
4.1Gains from Free Trade — Supply & Demand with World Price
Importing country (left): World price Pw < domestic Pd → cheaper imports enter. Domestic supply falls to Qs, demand rises to Qd. Imports = Qd − Qs. CS rises (consumers pay less), PS falls (producers earn less), but net welfare gain = two green triangles.
Exporting country (right): World price Pw > domestic Pd → producers export surplus. Domestic demand falls to Qd, supply rises to Qs. Exports = Qs − Qd. PS rises, CS falls, net welfare gain for producers.
Exporting country (right): World price Pw > domestic Pd → producers export surplus. Domestic demand falls to Qd, supply rises to Qs. Exports = Qs − Qd. PS rises, CS falls, net welfare gain for producers.
Free trade creates net welfare gains for both countries based on comparative advantage (opportunity cost differences). But domestic producers in importing country lobby for protection. You must weigh static welfare gains vs. dynamic arguments (infant industry, strategic industries).
4.2Effect of a Tariff on an Importing Country
Tariff effect: Import tax raises price from Pw to Pw+t.
- Domestic supply rises (Qs₁→Qs₂) — protected producers increase output
- Domestic demand falls (Qd₁→Qd₂) — consumers priced out
- Imports fall (smaller gap between Qd and Qs)
- Tariff revenue = gold rectangle (government gains)
- Two DWL triangles: production inefficiency (left) + consumption loss (right)
- CS falls; PS rises; government gains tariff revenue. Net: welfare loss
The two deadweight loss triangles are key. Left triangle = inefficient domestic production (costs more than world price). Right triangle = consumption destroyed. Both are social waste. Tariff revenue is a transfer from consumers to government — not a net gain.
4.3Exchange Rate Determination & Depreciation
Currency markets: Exchange rate (e.g. £/$) is determined by supply and demand for the currency.
- Demand for £: Foreigners buying UK exports, UK investments, or speculating. Downward sloping (cheaper £ → more attractive UK goods).
- Supply of £: UK residents buying foreign goods (imports), investing abroad. Upward sloping.
- Depreciation/devaluation: D for £ falls → ER falls from ER₁ to ER₀
- Depreciation → exports cheaper, imports more expensive → improves trade balance (if Marshall-Lerner holds)
Floating exchange rate: determined by market forces. Fixed: government intervenes. Marshall-Lerner condition: depreciation improves BoP only if (PED_x + PED_m) > 1. J-curve shows short-run BoP worsens before improving after depreciation.
4.3 — Balance of Payments & Current Account
4.4J-Curve Effect After Depreciation
J-Curve: After a currency depreciation, the current account balance initially worsens before improving.
- Short run: Import/export contracts already signed at old prices. Volume of trade doesn't change immediately. Import bills rise (in domestic currency) → BoP worsens
- Long run: Demand becomes more elastic. Exporters raise volume (now cheaper abroad), importers buy less (now more expensive). BoP improves — provided Marshall-Lerner condition holds
- Marshall-Lerner condition: PED_exports + PED_imports > 1 (in absolute terms)
The J-curve is a key evaluation of exchange rate policy. A government hoping to improve BoP by allowing depreciation must accept a short-term worsening first. The longer the time lag, the larger the initial deficit trough.
4.5Harrod-Domar Growth Model & Poverty Trap
Poverty trap / Vicious cycle: Low income → little savings → low investment → low capital accumulation → low productivity → low growth → low income (repeats).
Harrod-Domar model: Growth rate = Savings ratio / Capital-Output ratio (g = s/k). LDCs need higher savings to fund investment. But with low incomes, savings are minimal → need external financing.
Harrod-Domar model: Growth rate = Savings ratio / Capital-Output ratio (g = s/k). LDCs need higher savings to fund investment. But with low incomes, savings are minimal → need external financing.
- Aid or FDI can inject savings/capital to break the cycle
- Trade access allows export-led growth
- Microfinance allows small-scale investment
Always criticise the Harrod-Domar model — it oversimplifies by assuming only capital matters. Human capital (education, health), institutions, and governance are equally important. Use this as evaluation.