International Trade

Key Terms
International trade: The exchange of goods and services between countries.

Absolute advantage: Where a country using a given resource input is able to produce more than other countries with the same input.

Comparative advantage: Where a country can produce a good with a lower resource cost input than other countries.
Theory

What is International Trade?


Quite simply, international trade is the exchange of goods and services between countries. The theoretical basis for international trade is the law of comparative advantage, which advocates that economies specialise and trade with one another.

Assumptions:

  • 2 countries that produce only 2 goods
  • Perfect occupational mobility of factors of production
  • Constant returns to scale
  • Zero transportation costs


    • Absolute Advantage

    Two countries each devote 50% of their resources to manufacturing the products shown below.
    DVD Players Mobile Phones
    UK 1000 500
    Japan 2400 800
    Total Output 3400 1300

    Japan has absolute advantage in the production of both DVD players and mobile phones. With an equal amount of resources allocated to both products, Japan can produce more DVD players and mobile phones.


    Comparative Advantage

    On the last page we saw that Japan has absolute advantage in both TV’s and Cars however it has comparative advantage in making DVD players and the U.K has comparative advantage in producting mobile phones.


    DVD Players Mobile Phones
    U.K 0 1000
    Japan 3600 400
    Total 3600 (+200) 1400 (+100)

    This can be confirmed by calculating the opportunity cost:

    Suppose the U.K wanted to increase the production of mobile phones, the opportunity cost of each extra mobile phone is 2 DVD players (1000 / 500).

    For Japan the same decision has an opportunity cost of 3 DVD players (2400 / 800). The U.K. therefore has the comparative advantage in mobile phones because it has to give up fewer than Japan.

    If Japan wants to increase its production of DVD players, the opportunity cost of one extra DVD player is 1/3 of a mobile phone (800 / 2400).

    For the U.K. the same decision has an opportunity cost of 1/2 a mobile phone (500 / 1000). Japan therefore has the comparative advantage in DVD players.


    Terms of Trade


    Now we have identified that specialisation can increase world output, we can now look at how output is divided between countries, this is known as terms of trade.

    Terms of trade can be summarised by the formula:

    Terms of trade = (Index of export prices / index of import price) x 100



    In our example above, the U.K. produced mobile phones at an opportunity cost of 2 DVD player. The U.K. will not accept any less than 2 DVD players for each mobile phone it trades.

    Equally Japan has an opportunity cost of three DVD players for each mobile. For this reason, it will not pay more than three DVD players for each mobile it buys from the U.K.

    For trade to take place, the terms of trade must lie between the domestic opportunity cost ratios.

    Before specialisation the U.K. was able to produce 1000 DVD players. After specialisation, U.K. consumers are unable to purchase DVD players in the domestic market. For trade to be benefitial, U.K. consumers will want to be able to consume more DVD players then they did before specialisation.

    We can suppose that the U.K. imports 1050 DVD players from Japan to achieve it's goal.

    If the U.K and Japan trade at a rate of exchange of 2.5 DVD players for 1 mobile phone (2.5 : 1) the U.K must export 420 mobile phones to Japan (1050 / 2.5)

    DVD Players Mobile Phones
    UK 1050 (+1050) 580(-420)
    Japan 2550 (-1050) 820 (+420)
    Total Output 3600 1400


    The above table demonstates that output and consumption is greater when coutries specialise. Both countries have benefitted.


    Limitations of Comparative Advantage

    1) Trasport costs may outweigh any comparative advantage.

    2) Increased specialisation may lead to diseconomies of scale.

    3) Measures static advantage but not dynamic advantage.

    Comparative advantage measures static advantage but not dynamic advanatge, this is a limitation of the theory because in the future a country could become more efficient at producing a good it it made the neccesary investments.


    4) Theory is based on the assumption that exchange rates are stable, which is rarerly the case.

    5) Theory assumes that labour can switch between products easily and they will work with the same efficiency, this is unlikely.


    Factors that determine comparative advantage

    1) Quantity and Quality of factors of production available

    Country with larger and more skilled workforce will have comparative advantage.


    2) Investment in research & development

    May give firms cost advantages through superior development techniques.


    3) Movements in the Exchange Rate

    Even countries with lower costs of production may not be able to exploit cost advantage due to the exchange rate. A rise in the value of a currency will increase the price of exports. This eliminates any cost advantage.


    4) Import controls e.g. Tariffs

    Tariffs can be used to create artificial comparative advantage. By raising price of imports the government can protect domestic firms from more efficient foreign producers.


    5) Non-price factors

    Consumers do not just purchase products because they are cheaper than substitutes. Non-price factors such as design, reliability and quality are important in determining comparative advantage.



    Key Patterns of Trade

    1) Trading Blocs

    The emergence of regional trading blocs has impacted on the pattern of world trade. Blocs such as the European Union (E.U) and the African Union has led to trade creation between members but trade diversion outside the bloc.


    2) Deindustrialisation of advanced economies

    Some advanced economies i.e the U.K, have seen trade in manufactured goods fall relative to trade in financial services.


    3) Collapse of Communism

    The collapse of communism has led to an opening up of the former communism countries. These countries have increased their share of world trade by taking advantage of low production costs and low wages.


    4) Rise of newly industrialised countries

    Newly industrialised countries (e.g. China and India) have dramatically increased their share of world trade especially in the manufacturing sector.
    Benefits of International Trade
    Note: The case for import controls is the case against trade.

    The case for trade is the case against import controls.


    1) Same resources yet more output

    International trade results in more output than in a closed economy, this leads to higher productive efficiency. If firms produce more ouput then higher profits can be gained, which can then be reinvested in more efficient production processes.


    2) Economies of Scale

    International trade allows firms to exploit economies of scale by operating in much larger economies.


    3) Counter-balances Monopoly Power

    International trade opens up the market to millions of firms. This prevents domestic monopolies abusing their power as consumers can import from international firms at lower cost.


    4) Enhanced Consumer Choice

    In an international market consumers have a wide range of options. Imagine if a british consumer wanted to buy a car and was limited to the british market, the limited choice would reduce their welfare.


    5) Imports are neccessary

    Some economies cannot produce some goods due to the nature of the country, perhaps due to the climate. E.g. Bananas cannot be produced in some countries therefore it is neccessary to import them which requires international trade to take place.









    ↑