The importance of international trade

Why trade?  1. Sell off unwanted surpluses.

Why trade?  Obtain goods which are impossible to find at home. This applies not just to individuals buying goods, but firms buying raw materials.

Why trade?  Obtain reserves of foreign currency.

Why trade?  Trade allows a country to specialise.

Absolute advantage  Exists when a country is able to produce a good more cheaply in absolute terms than another country.

Absolute advantage DollsTeddy bears Spain2510 France1230

Absolute advantage  So it is mutually beneficial for Spain to specialise in the production of dolls and France to specialise in the production of teddy bears and they trade with each other.  Trade has helped increase their total combined output of dolls and teddybears from …. to ……

There are a couple of assumptions we need to make  1. There are no transport costs.  2. a doll is as valuable as a teddybear.  3. there are constant returns to scale.  4. factors of production can switch easily between doll and teddybear production.  5. products are homogeneous – so a French doll is the same as a Spanish doll.

Absolute advantage  Even though those assumptions are a bit unrealistic – the theory of absolute advantage is still valid.  It makes enormous sense for Belgium to specialise in beer and for Italy to specialise in wine, for example.

Should Barack Obama teach his daughter Maths?

Comparative advantage DollsTeddybears Spain1530 France1210

 In the second example, it is clear that Spain has absolute advantage in both dolls and teddy bears. So, is there any point in Spain trading with France?

The opportunity cost for Spain of producing 1 doll is….. The opportunity cost for France of producing 1 doll is……

 As opportunity costs differ, it is still mutually beneficial for both countries to trade.  Spain has comparative advantage at producing teddybears and France has comparative advantage of producing dolls.

Comparative Advantage  The ability to produce a good relatively more efficiently – or at a lower opportunity cost.

Comparative advantage DollsTeddybears Spain1530 France1210

Comparative advantage DollsTeddybears Spain060 France240

Before specialisation  France and Spain’s combined output was 67 units of dolls and teddy bears.

After Specialisation.  France and Spain’s combined output is 84 units of dolls and teddy bears.

Any relevant example?

 The USA has absolute advantage over Senegal in the production of both movies and sugar. But by allowing Senegal to specialise in sugar and the USA in movies, both countries can end up better off.  (This assumes that watching a movie from America satisfies your utility, some American movies can make you physically sick)

Terms of Trade  The ratio of export prices to import prices.

 Price of exports x100 = TOT  Price of imports

 When terms of trade improve: a country has to export less to be able to buy a given quantity of imports.  When terms of trade worsen: a country has to export more to be able to buy a given quantity of imports.