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….