The Reasons for International Trade
Absolute Advantage
The differentiation between the varying abilities of companies and nations to produce goods
efficiently is the basis for the concept of absolute advantage. As such, absolute advantage looks
at the efficiency of producing a single product. It also looks at how to produce goods and
services at a lower cost by using fewer inputs during the production process compared to the
competition.
Comparative Advantage
Comparative advantage takes a more holistic view of production. In this case, the perspective
lies in the fact that a country or business has the resources to produce a variety of goods and
services rather than focus on just one product.
Benefits of Specialisation
1. Economic Efficiency
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Resource Allocation: Specialisation allows countries to allocate resources more
efficiently. By focusing on producing goods where they hold a comparative advantage,
they maximise output and minimise costs.
Factors Contributing to Efficiency: These include skilled labour, advanced technology,
and natural resource availability. Specialisation harnesses these factors to enhance
production capabilities.
2. Quality Improvement
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Enhanced Product Quality: Concentrating on a limited product range leads to improved
quality, as countries invest in refining production methods and product standards.
Competitive Advantage: The resultant high-quality products often give countries a
competitive edge in international markets, fostering a reputation for excellence in specific
sectors.
3. Economic Growth
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Output and Growth: Specialisation leads to higher output levels, which in turn fuels
economic growth. This growth is critical for national development and increased living
standards.
Trade-Induced Growth: The increased production due to specialisation typically results
in greater trade volumes, further enhancing economic growth.
4. Implications of Free Trade
Trade Liberalisation
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Barrier Removal: Free trade entails the reduction or elimination of trade barriers like
tariffs and quotas, facilitating easier and more cost-effective international trade.
Resource Distribution: It promotes a more efficient global distribution of resources,
allowing countries to import goods that are expensive to produce domestically while
exporting those they can produce more efficiently.
5. Consumer Benefits
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Variety and Pricing: Consumers enjoy a broader variety of goods at more affordable
prices, thanks to international competition and reduced trade barriers.
Quality and Competition: The competitive environment fostered by free trade
encourages better quality products and innovative practices among producers.
6. Economic Integration
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International Cooperation: Free trade fosters deeper economic integration and
cooperation between countries, often leading to stronger political and cultural ties.
Global Supply Chains: It contributes to the development of intricate global supply
chains, enhancing overall productivity and innovation across nations.
Trading Possibility Curve
Conceptual Framework
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Curve Explanation: The trading possibility curve illustrates the range of production and
consumption possibilities a country can achieve through specialisation and trade.
Gains from Trade: It shows the potential benefits countries can reap from trade,
particularly how they can consume more than they could produce on their own.
Analytical Perspective
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Efficiency Indicators: Points within the curve indicate underutilisation of resources,
while those on the curve represent efficient production.
Beyond the Production Frontier: Through trade, countries can achieve consumption
levels that lie beyond their production possibilities frontier, symbolising increased
welfare.
Economic Implications
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Consumption and Efficiency: The curve underscores the role of trade in enhancing both
consumption levels and resource efficiency.
Complementary Trade Relationships: It highlights the importance of finding trade
partners with complementary production profiles to maximise the benefits of trade.
Terms of Trade
The terms of trade measures how the prices of a country’s export prices are changing compared
to its import prices.
Terms of trade (TOT) represent the ratio between a country's export prices and its import prices.
TOT indexes are defined as the value of a country's total exports minus total imports. The ratio is
calculated by dividing the price of the exports by the price of the imports and multiplying the
result by 100.
Causes of changes in the Terms of Trade
Change in the Short Run:
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Changes in demand conditions for exports and imports, changes in global
Supply of key inputs (such as oil),
Changes in relative inflation rates and
Changes in relative exchange rates.
Change in the Long Run:
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World income levels,
Changes in productivity within the country and
Technological developments.
Impact of Changes in a Country’s Terms of Trade
Living standards - An improvement in the terms of trade means that a country can buy a greater
quantity of imports for any given quantity of exports.
Impact on the balance of payments – An improvement in the terms of trade may improve or
worsen the country’s current account balance, depending on why the terms of trade have
improved. If a country’s export prices have risen because of a strong growth in demand from its
trading partners, it is likely that export earnings will increase and the current account may
improve. But if export prices have risen because the country has increasing costs of production,
it is likely that export earnings may fall, as the country’s exports become less competitive.
Impact on inflation – An improvement in the terms of trade because of falling import prices
could result in lower inflation, both directly, because prices of imported goods have fallen but
also indirectly, because domestic producers may have to lower prices to compete with imports. A
worsening terms of trade could cause rising inflation. Workers may seek pay increases to
compensate for rising import prices, leading to an escalation of the wage price ‘spiral’.
Impact on growth and employment – If the terms of trade improve because of growing
demand for exports (leading to higher export prices), it is likely that growth and employment
levels will be maintained, or possibly improved. But if the improvement is because of falling
import prices or rising export prices due to rising costs, it is likely that growth and employment
will fall.
Limitation of the theory of comparative advantage
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Transport costs may outweigh any comparative advantage
Increased specialisation may lead to diseconomies of scale
Governments may restrict trade
Comparative advantage measures static advantage but not any dynamic advantage for
example in the future India could become good at producing books if it made the
necessary investment