Why do countries trade? Ch 21 IB International Economics

The gains from international trade  Lower prices  Consumers can buy at lower prices than domestic  Producers can buy less expensive raw materials and semi manufactured goods  Prices may be lower in some countries because they have  access to natural resources  Differences in quality of labour  Differences in quality of capital  Different levels of technology  The main cause of lower prices is comparative advantage (see later)  Greater choice  Consumers have access to domestic and international products International trade: the exchange of goods and services between countries

The gains from international trade  Differences in resources  There will be resources that a country needs to produce other goods but does not have and has to import  Copper, diamonds, oil  Singapore imports almost every natural resource but has a high level of exports to fund their imports  Saudi has oil while Japan has none  Costa Rica has the climate to grow bananas whereas the UK cannot  The USA has a large stock of skilled workers when Sudan’s is comparatively unskilled etc  These differences lead to trade  Economies of scale  The size of the market increases  Demand increases  Production can increase  Production becomes more efficient  Division of Labour and Specialisation can increase  Managers become more knowledgeable  This leads to economies of scale  If countries specialise they acquire experience and expertise (they move down the learning curve – the LRAC curve)  In the long run with larger production and larger markets export industries should get more efficient and competitive leading to a reduction in long-run Singapore has to import almost every natural resource – even water!

The gains from international trade  Increased competition  Prices reduce  Quality improves  Innovation improves giving more variety Task - Find out what Bahrain exports and imports (include values)

HL only

Comparative Advantage  Which goods should a country produce for export and which should it import  The answer lies in the concept of comparative advantage  Watch these videos  Gardening parable - v=RpfV0Oerfr8 v=RpfV0Oerfr8  Mjmfoodie - mfoodie#p/u/67/38hvvAzgXZY mfoodie#p/u/67/38hvvAzgXZY

Comparative Advantage  An example for absolute advantage  This table shows the production outcomes where 2 countries are using the same quantities of resources to produce lamb and cloth  Half of their resources are being used for lamb and the other for cloth  Australia has absolute advantage in producing lamb (it can produce 6 kilos vs 4 kilos with the same resources)  China has absolute advantage in producing cloth (it can produce 3 kilos vs 1 kilo)  In this situation Australia should specialise in lamb and China in cloth CountryKilos of lamb Metres of cloth Australia61 China43 Total without trade 105 Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country CountryKilos of lamb Metres of cloth Australia120 China06 Total without trade 126

Comparative Advantage  If Australia uses all of its resources for lamb it will double its output (assuming constant returns to scale) and make 12  This gives a total of 12 which is 2 more than before (there is an advantage to them specialising)  If China uses all of its resources to make cloth it will double its output to 6  The new total of 6 instead of 5  This situation, where each country has an absolute advantage in the production of one product is known as reciprocal absolute advantage CountryKilos of lamb Metres of cloth Australia61 China43 Total without trade 105 Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country CountryKilos of lamb Metres of cloth Australia120 China06 Total without trade 126

Comparative Advantage  What happens if there is not a situation of reciprocal absolute advantage?  David Ricardo (19 th Century) proved mathematically that trade could still be beneficial to both countries when one country had an absolute advantage in producing all goods  He looked at the opportunity cost of production to explain comparative advantage  This table shows the production outcomes of France and Poland for wine and cheese  France has absolute advantage in producing both goods CountryLitres of wine Opportunity cost of 1 litre of wine Kilos of cheese Opportunity cost of 1 kilo of cheese France34/3 kilos of cheese 4¾ litre of wine Poland13 kilos of cheese 31/3 litre of wine comparative advantage – If a country has comparative advantage it can produce a good at a lower opportunity cost than another country; Country A has to give up fewer units of other goods to produce the good in question than country B

Comparative Advantage  In terms of comparative advantage France has a comparative advantage in production of wine  France has to give up 4/3 kilos of cheese to produce a litre of wine  Poland would have to give up 3 kilos of cheese to produce a litre of wine  4/3 is smaller than 3 so France has the comparative advantage  Poland has a comparative advantage in production of cheese  (1/3 is smaller than ¾)  The theory of comparative advantage tells us that France should specialise in wine and Poland should specialise in cheese  France will consume that wine that they wish and use the extra to trade for cheese CountryLitres of wine Opportunity cost of 1 litre of wine Kilos of cheese Opportunity cost of 1 kilo of cheese France34/3 kilos of cheese 4¾ litre of wine Poland13 kilos of cheese 31/3 litre of wine

Comparative Advantage  We can illustrate this using production possibility curves  The diagram shows exactly the same as the table  When a country has an absolute advantage in producing both goods (France) and the scale of the axes is the same  The comparative advantage for the better producer is in the good where the distance between the production possibilities is the greatest (a)  The comparative advantage for the less efficient producer is where the distance between the production possibilities is least (b)  Thus France has the comparative advantage in Wine and Poland cheese  The slope of the line shows the opportunity costs which is always a constant opportunity cost CountryLitres of wine Opportunity cost of 1 litre of wine Kilos of cheese Opportunity cost of 1 kilo of cheese France34/3 kilos of cheese 4¾ litre of wine Poland13 kilos of cheese 31/3 litre of wine

Comparative Advantage  This only works if the opportunity costs are different  If they are the same there would be no point in trade taking place  The slopes are the same  The opportunity costs are the same

What give a country comparative Advantage?  To a large extent this is due to a country’s factor endowments  If a country has a large amount of arable land it may develop a comparative advantage in agricultural products  A country with beautiful beaches and a favourable climate may develop its comparative advantage in the output of tourist services (climate can be a factor of production!)

Limitations of the theory of comparative advantage  The theory is based upon a number of assumptions  These assumptions limit the application of the theory in real life  Producers have perfect knowledge and are aware of where the least expensive goods may be purchased  There are no transport costs  There are only 2 economies producing goods – not so much of a problem with the use of computer simulations  Costs do not change and returns to scale are constant (no economies or diseconomies of scale)  Goods being traded are identical  This may be ok with commodities but not goods like consumer durables  Factors of production remain in the country  It may be the factors of production that move rather than the goods  Developed countries may invest capital in LDCs to produce goods  Labour may migrate from low-wage to high-wage countries

Test your understanding e.com/watch?v=vc 324aHB2m8

Limitations of the theory of comparative advantage  In spite of limitations, comparative advantage is at the core of international theory  It goes a long way to explain patterns of trade  HL homework - Using a diagram explain the concept of comparative advantage (10 Marks)  All - Research the WTO ready for class discussion