International Trade Why 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 wasnt 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 #2 By 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 cant 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. Lets 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 its 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 its 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 didnt 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 ACountry B Wheat2025 Computers1050 Opportunity cost of wheat 10/20 =.550/25 = 2 Opportunity cost of computers 20/10 = 225/50 =.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. Lets see what happens with the 1:1 trade scenario…..

Comparative Advantage Lets 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 its original PPC. Country A clearly is better off. What about Country B?

Comparative Advantage Lets 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 its 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 its 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 cant be ignored Comparative advantage doesnt account for structural changes in a countrys 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 its not going away anytime soon….