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 competitionPrices reduceQuality improvesInnovation

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 videosGardening parable -

http://www.youtube.com/watch?v=RpfV0Oerfr8

Mjmfoodie - http://www.youtube.com/user/mjmfoodie#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

Country Kilos of lamb

Metres of cloth

Australia 6 1

China 4 3

Total without trade

10 5

Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country

Country Kilos of lamb

Metres of cloth

Australia 12 0

China 0 6

Total without trade

12 6

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

Country Kilos of lamb

Metres of cloth

Australia 6 1

China 4 3

Total without trade

10 5

Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country

Country Kilos of lamb

Metres of cloth

Australia 12 0

China 0 6

Total without trade

12 6

Comparative Advantage What happens if there is not a

situation of reciprocal absolute advantage?

David Ricardo (19th 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

Country Litres of wine

Opportunity cost of 1 litre of wine

Kilos of cheese

Opportunity cost of 1 kilo of cheese

France 3 4/3 kilos of cheese

4 ¾ litre of wine

Poland 1 3 kilos of cheese

3 1/3 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

Country Litres of wine

Opportunity cost of 1 litre of wine

Kilos of cheese

Opportunity cost of 1 kilo of cheese

France 3 4/3 kilos of cheese

4 ¾ litre of wine

Poland 1 3 kilos of cheese

3 1/3 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

Country Litres of wine

Opportunity cost of 1 litre of wine

Kilos of cheese

Opportunity cost of 1 kilo of cheese

France 3 4/3 kilos of cheese

4 ¾ litre of wine

Poland 1 3 kilos of cheese

3 1/3 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

http://www.youtube.com/watch?v=vc324aHB2m8

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