32.1 The Gains from Trade

Question 1

What is a closed economy?

Answer 1

closed economy

An economy that has no foreign trade—a situation referred to as autarky.

Question 2

What are the basic benefits of trade?

Answer 2

Without trade, everyone must be self-sufficient; with trade, people can specialize in what they do well and satisfy other needs by trading.

With international trade, each country is able to concentrate on producing goods and services that it produces efficiently while trading to obtain goods and services that other countries produce more efficiently.

Question 3

What are “gains from trade”?

Answer 3

gains from trade

The increased output attributable to the specialization that is made possible by trade.

Question 4

What is absolute advantage/

Answer 4

When one country can produce some commodity at lower absolute cost than another country.

One region is said to have an absolute advantage over another in the production of good X when an equal quantity of resources can produce more X in the first region than in the second. Or, to put it differently, if it takes fewer resources to produce one unit of good X there than in another country.

Question 5

What is absolute cost?

Answer 5

The absolute cost is the dollar cost of the labour, capital, and other resources required to produce the goods.

Question 6

Do gains from international trade depend on absolute advantage?

Answer 6

The gains from international trade do not depend on the pattern of absolute advantage.

Question 7

Who was the first to provide an explanation of the pattern of international trade in a world which countries had different costs/

Answer 7

The great English economist David Ricardo (1772–1823) was the first to provide an explanation of the pattern of international trade in a world in which countries had different costs. His theory of comparative advantage is still accepted by economists as a valid statement of one of the major sources of the gains from international trade.

Question 8

What is comparative advantage?

Answer 8

When a country can produce a good with less forgone output of other goods than can another country.

A country is said to have a comparative advantage in the production of good X if the cost of producing X in terms of forgone output of other goods is lower in that country than in another. Thus, the pattern of comparative advantage is based on opportunity costs rather than absolute costs.

Question 9

What do the gains from specialization and trade depend on?

Answer 9

The gains from specialization and trade depend on the pattern of comparative, not absolute, advantage.

Question 10

How does world output increase?

Answer 10

World output increases if countries specialize in the production of the goods in which they have a comparative advantage.

Question 11

What would lead to a decline in total world output?

Answer 11

Specialization of production against the pattern of comparative advantage leads to a decline in total world output.

Question 12

The conclusions about the gains from trade arising from international differences in opportunity costs are summarized below.

Answer 12

The opportunity cost of producing X is the output of other products that must be sacrificed in order to increase the output of X by one unit.

Country A has a comparative advantage over Country B in producing a product when its opportunity cost of production is lower. This implies, however, that Country A has a comparative dis advantage in some other product(s).

When opportunity costs for all products are the same in all countries, there is no comparative advantage and there is no possibility of gains from specialization and trade.

When opportunity costs differ in any two countries and both countries are producing both products, it is always possible to increase total production of both products by a suitable reallocation of resources within each country.

Question 13

What is an open economy?

Answer 13

open economy

An economy that engages in international trade.

Question 14

What is intra-industry trade?

Answer 14

The result is that different countries specialize in different versions of similar products, and then trade with one another. Such trade is referred to as intra-industry trade and reflects the prevalence of scale economies and product differentiation in many industries.

Question 15

How do small countries benefit from international trade?

Answer 15

In industries with significant scale economies, small countries that do not trade will have low levels of output and therefore high costs. With international trade, however, small countries can produce for the large global market and thus produce at lower costs. International trade therefore allows small countries to reap the benefits of scale economies.

Question 16

What do economists mean when they refer to “learning by doing”?

Answer 16

The reduction in unit costs that often results as workers learn through repeatedly performing the same tasks. It causes a downward shift in the average cost curve.

Early economists placed great importance on a concept that is now called learning by doing. They believed that as countries gained experience in particular tasks, workers and managers would become more efficient in performing them. As people acquire expertise, costs tend to fall.

Question 17

Why do different countries have different opportunity costs?

Answer 17

• Different Factor Endowments
• Different Climates
• Human Capital
• Acquired Comparative Advantage
• Contrasting Views?

Question 18

What is the “Factor endowment theory of comparative advantage”?

Answer 18

Two Swedish economists, Eli Heckscher and Bertil Ohlin. According to their theory, the international cost differences that form the basis for comparative advantage arise because factor endowments differ across countries. This is often called the factor endowment theory of comparative advantage.

Question 19

How can we contextualize the Factor Endowment theory of comparative advantage?

Answer 19

To see how this theory works, consider the prices for various types of goods in countries in the absence of trade. A country that is well endowed with fertile land but has a small population will find that land is cheap but labour is expensive. It will therefore produce land-intensive agricultural goods cheaply and labour-intensive goods, such as machine tools, only at high cost.

Question 20

How do, according to the Heckscher-Ohlin theory, countries have comparative advantage in the production of a good?

Answer 20

According to the Heckscher-Ohlin theory, countries have comparative advantages in the production of goods that use intensively the factors of production with which they are abundantly endowed.

Question 21

How does climate affect comparative advantage/

Answer 21

Another important influence comes from all those natural factors that can be called climate in the broadest sense. If you combine land, labour, and capital in the same way in Costa Rica and in Iceland, you will not get the same output of most agricultural goods. Sunshine, rainfall, and average temperature also matter. You can, of course, artificially create any climate you want in a greenhouse, but it costs money to create what is freely provided elsewhere.

A country’s comparative advantage is influenced by various aspects of its climate.

Question 22

What is an example of how Human Capital can affect Comparative advantage?

Answer 22

Acquired skills, what economists call human capital, matter greatly in determining comparative advantage. Beginning in the late nineteenth century, ­Germany had an excellent set of trade schools that were attended by virtually every male who did not go on to higher academic education. As a result, Germany developed, and still maintains, a strong comparative advantage in many consumer goods that require significant engineering skills to produce, such as home appliances, power tools, and small machines.

Question 23

How can country’s keep their comparative advantage secured?

Answer 23

With today’s growing international competition and rapidly changing technologies, no country’s comparative advantages are secure unless its firms innovate and keep up with their foreign competitors and its education system produces workers, ­managers, and innovators with the requisite skills.

Question 24

What is the law of one price?

Answer 24

The law of one price states that in the absence of trade frictions, and under conditions of free competition and price flexibility, identical goods sold in different locations must sell for the same price when prices are expressed in a common currency.