AS Economics (9708) Study Notes: International Economic Issues
Chapter 6.1: The Reasons for International Trade
Welcome to the world of international economics! This chapter explains the fundamental reasons why countries don't just produce everything they need domestically, but instead choose to trade with each other. Understanding these basic theories is essential for grasping later topics like protectionism and exchange rates. Don't worry if the concepts seem mathematical; we will break them down using simple examples!
1. The Foundation: Specialisation and Free Trade
The basic reason for trade is simple: if everyone (or every country) focuses on doing what they are best at, the total output for the world increases. This leads to higher standards of living for everyone involved.
Key Concept: Specialisation
Specialisation occurs when a country focuses its resources (Land, Labour, Capital, Enterprise) on producing a limited range of goods and services where it is most efficient.
Example: Saudi Arabia specialises in oil, while Switzerland specialises in financial services and high-quality watches.
Trade Liberalisation (Free Trade)
When countries specialise, they must then trade their surplus production. Free trade (or trade liberalisation) refers to international trade that is allowed to take place without interference from the government, such as tariffs or quotas. The core benefit of free trade is that it allows countries to consume beyond what their domestic resources allow.
Quick Review: Why Specialise?
- Achieve economies of scale (lower costs from producing large volumes).
- Use resources more efficiently, matching production to unique resource endowments.
- Increase global output and consumption.
Key Takeaway: Trade is driven by specialisation, which relies on the differences in efficiency (costs) between countries. Economists use two main concepts to define this efficiency: Absolute Advantage and Comparative Advantage.
2. Absolute Advantage (AA)
This is the simplest way to explain trade, proposed by Adam Smith.
Definition of Absolute Advantage (AA)
A country has an absolute advantage in the production of a good if it can produce
Example of Absolute Advantage
Imagine two countries, Alpha and Beta, each using 100 workers for one day to produce either Rice or Wheat:
| Country | Rice (tonnes) | Wheat (tonnes) |
|---|---|---|
| Alpha | 20 | 10 |
| Beta | 5 | 8 |
In this example:
- Alpha can produce 20 tonnes of Rice (more than Beta’s 5). Alpha has AA in Rice.
- Alpha can produce 10 tonnes of Wheat (more than Beta’s 8). Alpha has AA in Wheat.
If Alpha has an AA in everything, should it trade? This is where comparative advantage comes in!
3. Comparative Advantage (CA)
This theory, developed by David Ricardo, is the basis for most modern trade analysis. It tells us that even if a country is better at producing everything (has AA in all goods), it should still specialise and trade.
Definition of Comparative Advantage (CA)
A country has a comparative advantage in the production of a good if it can produce that good at a
Remember: Opportunity Cost is what you have to give up to gain something else.
Step-by-Step Calculation of Opportunity Cost (OC)
Let's use the same data for Alpha and Beta:
| Country | Rice (tonnes) | Wheat (tonnes) |
|---|---|---|
| Alpha | 20 | 10 |
| Beta | 5 | 8 |
We calculate the OC for one unit of production:
A. Opportunity Costs for ALPHA:
- To produce 1 tonne of Rice, Alpha must give up: \( 10 / 20 = 0.5 \) tonnes of Wheat.
- To produce 1 tonne of Wheat, Alpha must give up: \( 20 / 10 = 2 \) tonnes of Rice.
B. Opportunity Costs for BETA:
- To produce 1 tonne of Rice, Beta must give up: \( 8 / 5 = 1.6 \) tonnes of Wheat.
- To produce 1 tonne of Wheat, Beta must give up: \( 5 / 8 = 0.625 \) tonnes of Rice.
Conclusion of Comparative Advantage
- Who specialises in Rice? Alpha (OC is 0.5 Wheat) vs Beta (OC is 1.6 Wheat). Alpha has the lower opportunity cost in Rice production. Alpha specialises in Rice.
- Who specialises in Wheat? Alpha (OC is 2 Rice) vs Beta (OC is 0.625 Rice). Beta has the lower opportunity cost in Wheat production. Beta specialises in Wheat.
Did you notice? Even though Alpha was absolutely better at producing both, Beta still found something where its disadvantage was smallest (Wheat). This is the power of CA!
Key Takeaway: Trade decisions are driven by Comparative Advantage (the lowest opportunity cost), not Absolute Advantage. If countries specialise according to CA, global output increases.
4. Benefits of Specialisation and Free Trade
When countries trade based on their comparative advantage, they experience significant benefits:
Higher Global Output and Efficiency
Resources are allocated to where they are most efficiently used. For example, if Alpha focuses solely on Rice and Beta on Wheat, the total combined output of both goods increases compared to if they tried to produce both domestically.
The Trading Possibility Curve (TPC)
A country’s domestic production limit is shown by its Production Possibility Curve (PPC). However, by trading based on comparative advantage, a country can achieve consumption bundles that lie outside its PPC. This is known as the Trading Possibility Curve (TPC).
- The PPC shows *what you can produce*.
- The TPC shows *what you can consume* once you trade.
This movement from the PPC to the TPC represents the main benefit: increased consumption possibilities, leading directly to higher living standards.
Did you know? Free trade encourages competition. Domestic firms are forced to become more innovative and efficient to compete with cheaper, foreign imports. This dynamic efficiency is another crucial benefit.
5. Exports, Imports, and the Terms of Trade
When studying trade performance, we need ways to measure how well a country is doing. One key indicator is the Terms of Trade.
Definitions
- Exports: Goods and services sold to foreign countries (money flows *in*).
- Imports: Goods and services bought from foreign countries (money flows *out*).
Measurement of the Terms of Trade (ToT)
The Terms of Trade (ToT) measures the ratio of a country's average export prices to its average import prices, usually expressed as an index.
The formula is:
\[ \text{Terms of Trade Index} = \frac{\text{Index of Export Prices}}{\text{Index of Import Prices}} \times 100 \]If the ToT index is 100, the ratio is balanced. If the index rises to 120, the ToT has improved.
Interpreting Changes in ToT
- Improvement in ToT (Index increases): Export prices are rising faster than import prices (or import prices are falling faster). The country can buy a larger quantity of imports for the same quantity of exports. This is generally beneficial.
- Deterioration in ToT (Index decreases): Import prices are rising faster than export prices. The country has to export a larger quantity to afford the same quantity of imports. This is generally detrimental, especially for developing countries relying on commodity exports (whose prices fluctuate greatly).
Causes of Changes in the ToT
- Changes in Demand for Exports/Imports: If global demand for your exports increases, their price rises, improving your ToT.
- Changes in Supply Conditions: If your country experiences a better harvest (increasing supply), your export prices might fall (deteriorating ToT).
- Inflation Rates: If domestic inflation is high, your export prices rise, potentially improving the ToT (though making you less competitive globally).
- Exchange Rates: An appreciation of the country's currency makes exports more expensive (higher foreign currency price), generally improving the ToT.
Key Takeaway: The ToT indicates the "purchasing power" of a country's exports. An improvement means the country is getting more imports for its exports.
6. Limitations of the Theories of Absolute and Comparative Advantage
While AA and CA are powerful theoretical tools, they rely on several strict assumptions that rarely hold true in the real world. You must know these limitations for evaluation questions (AO3).
Common Assumptions and Their Limitations:
-
Zero Transport Costs:
Assumption: It costs nothing to ship goods between countries.
Reality Check: In reality, **transport costs** are significant. If the cost of shipping specialised goods outweighs the efficiency gains from specialisation, the benefit of CA disappears. For example, fresh produce is often grown locally despite having cheaper foreign alternatives due to high transport costs. -
Perfect Resource Mobility (within countries):
Assumption: Factors of Production (e.g., workers) can easily switch from producing one good to another (e.g., from car manufacturing to rice farming) without cost or time delay.
Reality Check: Resources are often immobile. A factory designed for textiles cannot instantly be converted to produce electronics. Labour also lacks mobility (workers may lack the necessary skills for the specialised industry, leading to structural unemployment). -
Constant Returns to Scale:
Assumption: The production costs remain constant regardless of output volume.
Reality Check: As discussed in microeconomics, increased specialisation often leads to **economies of scale**, making the cost advantage even greater. However, beyond a certain point, diseconomies of scale may occur. -
No Protectionism or Trade Barriers:
Assumption: Trade is completely free.
Reality Check: Governments frequently use tariffs, quotas, and subsidies (protectionism) to protect domestic industries, distorting the market and preventing countries from specialising purely based on CA. -
Ignorance of Non-Economic Factors:
Assumption: Production decisions are purely economic.
Reality Check: Countries may prioritise non-economic factors, such as achieving self-sufficiency in strategic goods (like food or military equipment) for national security, even if it violates the principle of comparative advantage.
Quick Review Box: CA Limitations Mnemonic
To remember the key limitations, think of T-P-R-O-N:
Transport Costs
Protectionism
Resource Immobility (Labour/Capital)
Output (Non-constant returns, EoS/DoS)
Non-economic goals (e.g., national security)