21.3 - Trade, Comparative & Absolute Advantage
Advantages of international trade and specialisation
International trade involves the buying and selling of goods and services across national borders, allowing countries to exchange exports for imports. This process occurs because natural resources and production capabilities are not evenly spread around the world. As a result, nations focus on producing what they can make efficiently and trade for the rest.
Benefits of international trade
- Access to needed goods - Countries import items they cannot produce domestically due to limited resources, such as raw materials or specific foods, by exporting their own strengths like technology products.
- Greater consumer choice - Trade provides a wider range of products and services, improving quality and encouraging innovation through competition.
- Lower prices and higher living standards - Increased competition reduces costs, while access to cheaper imports boosts overall quality of life.
- Economies of scale for businesses - Selling to international markets allows firms to produce on a larger scale, spreading fixed costs and lowering average costs per unit.
- Knowledge and skill transfer - Trade exposes countries to new ideas, such as advanced production methods introduced by foreign companies operating locally.
Benefits of specialisation
Countries concentrate on goods or services they can produce more efficiently due to their available resources or expertise:
- Cost reductions - Focusing on specific products lowers production expenses, leading to cheaper prices for consumers.
- Efficient resource use - Global resources are allocated more effectively, maximising worldwide output.
- Improved global living standards - Higher overall production increases access to goods and raises economic well-being across nations.
Disadvantages of international trade and specialisation
While international trade and specialisation offer significant benefits, they also present challenges that can affect economies, businesses, and workers.
Drawbacks of international trade
- Transport expenses - Moving goods across borders increases costs due to shipping and logistics.
- Currency exchange issues - Converting between currencies can lead to fees and potential losses from fluctuating exchange rates.
- Additional operational costs - Businesses face expenses for meeting foreign regulations, translating materials, and conducting overseas market research.
- Promotion of globalisation - This can lead to broader issues like cultural homogenisation or environmental concerns from increased global activity.
Drawbacks of specialisation
- Decline of local industries - Domestic sectors may close if foreign competitors produce goods more efficiently, leading to job losses.
- Overdependence on key sectors - Relying heavily on one industry makes a country vulnerable to problems like market downturns or supply disruptions.
- Supply vulnerabilities - Nations become reliant on imports for essential goods, risking shortages if global supplies are interrupted.
- Worker displacement - When industries decline, employees may lack the skills for new jobs, causing unemployment and economic hardship.
Absolute advantage in trade
Absolute advantage occurs when a country can produce a good using fewer resources than another country, leading to higher output per unit of input. If each country specialises in products where it holds an absolute advantage, the total world output rises because resources are used more productively.
Comparative advantage and its limitations
Comparative advantage extends the idea of specialisation by considering opportunity costs, which represent the benefits forgone when choosing one production option over another.
Understanding comparative advantage
Opportunity cost measures how much of one good must be sacrificed to produce an additional unit of another good. A country has a comparative advantage in a good if its opportunity cost for producing it is lower than that of other countries.
Specialisation and maximising output
- Complete specialisation in one good rarely maximises total output; instead, partial specialisation—shifting some resources—often increases production of multiple goods.
- Countries usually produce at points where their combined output exceeds what they could achieve without trade.
- For mutual benefits, trade must occur under suitable terms where neither country is worse off.
- No trade benefits arise if opportunity costs are identical between countries.
Limitations of the law of comparative advantage
- Ignores scale effects - Assumes no benefits or drawbacks from producing on a larger or smaller scale.
- Overlooks trade barriers - Does not account for transport costs or restrictions like tariffs.
- Assumes perfect information - Presumes all parties have complete knowledge of opportunities.
- Expects mobile resources - Factors like labour and capital are assumed to shift easily between industries.
- Neglects externalities - Ignores wider impacts, such as environmental costs.
Terms of trade and their impact
Terms of trade refer to the ratio of export prices to import prices, determining how much a country can import for a given level of exports.
Calculating terms of trade
Where:
- Index of average export prices = A measure of export price changes over time
- Index of average import prices = A measure of import price changes over time
Effects of changes in terms of trade
- Improving terms of trade - When the index rises (export prices increase faster than import prices), a country can afford more imports for the same exports, improving its position.
- Deteriorating terms of trade - When the index falls (import prices rise faster than export prices), a country can afford fewer imports, worsening its position.
For instance, during economic downturns like the 2008-2010 recession, a country's terms of trade might decline if import costs surge relative to export revenues. Trade only happens if terms benefit both parties, with no country paying more for imports than domestic production costs or receiving less for exports than their own costs.
Worked example - Calculating terms of trade index
In 2020, the base year, a country's index of average export prices is 100 and index of average import prices is 100. In 2023, the export price index rises to 125, while the import price index increases to 110. Calculate the terms of trade index for 2023 and interpret the change.
Step 1: Identify the values
- Index of average export prices (2023) = 125
- Index of average import prices (2023) = 110
Step 2: Apply the formula
Step 3: Perform the calculation
Step 4: Interpretation
The terms of trade index of 113.64 indicates an improvement since the base year (100), meaning the country can afford more imports for its exports due to export prices rising faster than import prices.