Download - International Trade Why countries trade and how citizens may or may not benefit from trade
International TradeWhy countries trade and how citizens may or may not benefit from
trade
International Trade Theory Trading among nations is obviously not a new
practice. Countries have been importing and exporting goods with their neighbours for
several thousand years.
Never before, however, has international trade made up such a large percentage of
GDP in so many countries around the world.
Benefits from trade Countries would not trade with each other if
it wasn’t beneficial to both parties. What are some of the benefits that countries receive
from international trade?
Benefit #1 Specialization allows a country to
concentrate on making those goods
which it produces most efficiently.
By using scarce resources most
efficiently, a country can
increase production of these goods and
then exchange them for goods made elsewhere
Domestic production and consumption
will increase due to specialization
Benefit #1 (continued)
Once a country identifies and
begins producing the good(s) it is most suited to
specialize in, it can begin exporting these goods to
foreign nations.
In return, the country will receive a variety of goods and services that
are produced more efficiently elsewhere
Specialization leads to increased consumption
Benefit 1 (continued) Factor endowments, or the factors of
production a country is blessed with, determine what goods and services a country
will produce.
A country with good natural harbours would tend to specialize in shipping, while a
landlocked country would develop alternative areas to specialize in.
The concepts of comparative advantage argues that by specializing and trading,
countries will mutually benefit and use scarce resources most wisely
Benefit #2By specializing in
production of particular goods or
services, economies of scale may be
achieved. I assume you
remember this, yes…?
Economies of Scale By specializing and increasing quantity produced, countries may lower the average cost of production of particular goods and
services, and then trade with foreign countries.
Increasing output to provide for consumers beyond the domestic market allows a country
to lower the average cost of production. Lower costs leads to greater export
competitiveness.
Benefit #3 Obviously, different
countries specialize in producing
different goods and services.
Trade allows countries to enjoy goods and services
that are more efficiently produced in other parts of the
world
Trade leads to greater variety of goods available to
consumers
Benefit #4 Some countries
have an enormous amount of natural resources that are valued worldwide.
Middle East oil producers can trade oil for other goods and services, thus benefitting themselves and their trading partners
Trade allows countries to acquire needed resources
Benefit #5 Domestic producers
are forced to maximize efficiency
when faced with foreign competition.
In the Darwinian business world, those producers
who produce at the lowest cost will
survive, and those who can’t compete
will disappear.
Trade results in increased
competition, leading to greater
efficiency in production
Benefit #6 As goods are traded
from one country to another, knowledge and skills are also
shared among countries, leading
to increased efficiency,
competition and progress
Trade makes possible the flow of
new ideas and technology
Benefit #7 A relationship based
on trade can lead to closer relations
among countries.
If I need resources from another
country, it is in my best interest to remain on good terms with that
country. So perhaps a more peaceful
world results
Trade makes countries
interdependent
Benefit #8 International trade
contributes to specialization,
economies of scale, resource exchange,
increased competition, greater
efficiencies in production, technology
improvements and expanding markets which are all drivers of economic growth
International trade as “an engine of
growth”
Benefit #9 The economic benefits that may
follow from international trade
may allow a country to focus on
economic and human
development objectives, which can improve living
standards for millions of people
Increased international trade
can lead to economic and
human development
Absolute and Comparative Advantage
For Mature Audiences Only (HL)
Absolute Advantage Introduced by our hero, Adam Smith, absolute advantage refers to the ability of
one country to produce something with fewer resources than another country (or produce more quantity of something with the same
amount of resources)
Absolute Advantage Absolute advantage is a very simple concept.
Let’s take a look at the graph on the next slide and make some simple observations
about which country has an absolute advantage in the production of two different
goods
Absolute Advantage The previous PPCs were straight lines, assuming opportunity cost is constant as we move along the PPC. Clearly, Country A has
an absolute advantage in rice production, while Country B has an absolute advantage in
iron ore production.
Absolute advantage theory argues that the countries should specialize in what they
produce most efficiently, and then trade with the other country for the other product
Absolute Advantage and Opportunity Cost
The opportunity cost of rice in Country A is equal to:
25 units of iron ore/100 units of rice = ¼
The opportunity cost of rice in Country B is equal to:
100 units of iron ore/25 units of rice = 4
In order to produce an extra unit of rice, Country A must sacrifice ¼ a unit of iron ore, Country B
must sacrifice 4 units of iron ore
Absolute Advantage and Opportunity Cost
The opportunity cost of iron ore in Country A is equal to:
100 units of rice/25 units of iron ore/ = 4
The opportunity cost of iron ore in Country B is equal to:
25 units of rice/100 units of iron ore/ = 1/4
In order to produce an extra unit of iron ore, Country A must sacrifice 4 units of rice, Country B must sacrifice
1/4 unit of rice
Gains from trade If Country A specializes in rice and country B
specializes in iron ore, adhering to the idea of minimizing opportunity costs, what gains
from trade would occur if they traded on a 1:1 basis, rice for iron ore?
Before trade, Country A could produce 20 rice and 20 iron ore. If they make only rice they could produce 100 rice and trade 20 rice to Country B for 20 iron ore, and thus reach a
point beyond it’s original PPC.
Obviously, Country A is better off…..
Gains from trade Country B should benefit as well from this
relationship. What gains from trade would occur if they traded on a 1:1 basis, iron ore
for rice?
Before trade, Country B could also produce 20 rice and 20 iron ore. If they make only
iron ore they could produce 100 iron ore and trade 20 iron ore to Country B for 20 rice, and thus reach a point beyond it’s original PPC.
Obviously, Country B is also better off…..
Gains from trade Specialization and trade have resulted in both increased production and consumption,
and both countries benefitted.
Before specialization, Country A and B produced 40 units of both rice and iron ore.
After specialization, 100 units of both rice and iron ore were produced.
So absolute advantage theory argues for specialization and trade to increase
production and consumption, and move countries beyond their initial PPCs
Comparative Advantage
Well the idea of absolute advantage is pretty straightforward and it probably didn’t take a genius to articulate it. David Ricardo went a step further with the concept of comparative
advantage. Yup, another fine looking economist…
Comparative Advantage
Ricardo argued that countries could benefit from trade even if one country had an
absolute advantage in both goods being considered.
Ricardo theorized that whichever country had the lower opportunity cost for a particular good should specialize in that good, and
trade with the other country for the good that that country produced at a lower opportunity
cost
Comparative Advantage
Country A Country B
Wheat 20 25
Computers 10 50
Opportunity cost of wheat
10/20 = .5 50/25 = 2
Opportunity cost of computers
20/10 = 2 25/50 = .5
Comparative Advantage
Country B can obviously produce more of both wheat and computers that Country A, but Country A has a lower opportunity cost for wheat production, while Country B has a
lower opportunity cost for computer production.
Ricardo argued that Country B should specialize in computers, while Country A
should specialize in wheat. Let’s see what happens with the 1:1 trade scenario…..
Comparative Advantage
Let’s assume before specialization, Country A was producing 10 wheat and 5 computers.
If they specialize in wheat, they can produce 20, but no computers. Country A can then
trade 10 wheat for 10 computers and reach a point beyond it’s original PPC.
Country A clearly is better off. What about Country B?
Comparative Advantage
Let’s assume before specialization, Country B was producing 5 wheat and 40 computers.
If they specialize in computers, they can produce 50, but no wheat. Country B can then trade 10 computers for 10 wheat and
reach a point beyond it’s original PPC. Country B is also is better off.
Overall, instead of producing 15 wheat, we have 20, and instead of 45 computers, we
have 50. Global production and consumption increases!
The moral of the story
The law of comparative advantage states that if opportunity costs in two or more countries differ, it will be possible for all countries to gain from specialization and
trade according to their comparative advantage, even though one country may have the absolute advantage in all goods.
What if……? If 2 countries have parallel PPCs, then their
opportunity costs for both goods are identical. There would be no gains from
trade or specialization in this example, but this is a rarity anyway…
So it’s that simple? Well, even though many countries use the
law of comparative advantage as the basis for their trade policies, there are many criticisms surrounding it….
Unrealistic assumptions?
Critics claim that the law of comparative advantage depends on unrealistic assumptions, such as:
Factors of production being fixed and immobile, and not changing in quality
Technology being fixed
The existence of perfect competition
Full employment of resources
Imports and exports balancing each other
All governments practicing free trade
More criticisms Transport costs can’t be ignored
Comparative advantage doesn’t account for structural changes in a country’s economy
(shifting from primary sector to secondary/tertiary)
Absolute specialization can pigeon-hole a country to an extreme, making it vulnerable
to external economic forces such as recession or natural disaster….If a country is only producing a few goods, if circumstances change, they could be in big trouble…
Comparative Advantage
Criticisms aside, comparative advantage continues to play a major role in the global
trading scene, and it’s not going away anytime soon….