4.1.2 Specialisation and Trade

Question 1

What is absolute advantage?

Answer 1

Absolute advantage occurs when a country can supply a product using fewer resources than another nation. If a country using the same factors of production can produce more of a product, then it has an absolute advantage.

Question 1

Explain this table and who has the absolute advantage in what

Answer 1

• With both people having the same factor resource (time) available
• Hilary can lay more bricks than Donald (80 to 40)
• Donald can bake more cakes than Hilary (50 to 20)
• Hilary therefore has the absolute advantage in brick-laying
• Donald therefore has the absolute advantage in baking cakes
• If they both specialise fully, then total output of bricks and cakes can increase

Question 2

Explain comparative advantage

Answer 2

• The relative opportunity cost of production for a good or service is lower in one nation than another country
• A country is relatively more productively efficient than another
• The basic rule is to specialise your scarce resources in the goods and services that you are relatively best at
• This opens up gains from specialisation and trade which then leads to a more efficient allocation of resources

Question 3

Using this table, explain who has the comparative advantage

Answer 3

• Australia has a comparative advantage in producing beef. This is because the opportunity cost of an extra
  unit of beef is 4/5th unit of tobacco, whereas for Malawi the opportunity cost is 1.5 units of tobacco.
  o i.e. Australia needs to give up less tobacco to produce more beef than Malawi does
• Malawi has a comparative advantage in producing tobacco – the opportunity cost of an extra unit of tobacco
  is 2/3rd of beef whereas for Australia it is 5/4.
  o i.e. Malawi needs to give up less beef to produce more tobacco than Australia does

Question 4

What are assumptions behind the theory of comparative advantage and trade?

Answer 4

1. Constant returns to scale – i.e. no economies of scale – which might in reality amplify the gains from trade
2. Perfect factor mobility between industries (e.g. geographical + occupational of labour)
3. No trade barriers such as tariffs and quotas which artificially change the prices at which trade occurs
4. Low transportation costs to get products to market – high logistics costs might erode comparative advantage
5. No significant externalities from production and/or consumption of the products being traded

Question 5

What are the gains from free trade?

Answer 5

1. Free trade allows for deeper specialisation and benefits from economies of scale (increasing returns)
2. Free trade increases market competition and choice and also drives up product quality for consumers
3. Increased market contestability reduces prices for consumers leading to higher real incomes
4. Trade can lead to a better use of scarce resources for example from trade in sustainable technologies

Question 6

How does trade impact allocative efficiency?

Answer 6

Competition from lower-cost import sources drives market prices down closer to marginal
cost and then reduces the level of monopoly (supernormal) profits

Question 7

How does trade impact productive efficiency?

Answer 7

Specializing and selling in larger markets encourages increasing returns to scale
(economies of scale) – i.e. a lower long run average cost of production

Question 8

How does trade impact dynamic efficiency?

Answer 8

Economies open to trade may see more innovative businesses who invest more in
research and development and also in the human capital of their workforce to help raise
labour productivity

Question 9

How does trade impact x efficiency?

Answer 9

Intense competition in markets provides a discipline on businesses to keep their unit costs
under control to remain price competitive and profitable

Question 10

What are 4 drawbacks of specialisation and trade?

Answer 10

1. Volatile global prices affecting export revenues and profits for producers and tax revenues for governments
2. Risks that exports will be affected by geo-political uncertainties and cyclical fluctuations in demand
3. Opening up to trade and investment may cause rising structural unemployment in some industries as the
   pattern of demand, output and jobs changes. Poorer countries may opt instead for a strategy of
   industrialisation aided by import protectionism before they eventually open up their markets
4. Countries that specialise in only a few primary commodities may suffer from the natural resource trap (also
   known as the resource curse) which may make them poorer than countries less dependent on exporting
   primary commodities