6.1 The reasons for international trade Flashcards
What is absolute advantage?
Absolute Advantage - occurs when a country can produce a product using fewer factors of production than another nation
What is comparative advantage?
Comparative Advantage - Ability to produce a product at a lower opportunity cost than another country (in comparison)
Countries can specialise when they have comparative advantage
What is free trade?
This is when you are allowed to trade with other nations without protectionist barriers like tariffs, quotas and regulations They allow members to exploit their comparative advantages, which increases efficiency.
What are the benefits of free trade and specialisation?
Greater efficiency in he world market and an improvement in the allocation if world resources. This is as there is a greater incentive to specialise in the areas where they have a cost advantage. This is as you can supply to domestic market and world markets. Resources will go to countries that are the best at producing them. This is known as the law of comparative advantage - where they specially where they have an opportunity cost advantage.
Countries gain access to goods that they wouldn’t have had access to in their own country through imports
Consumers benefit from lower prices which increases consumer surplus. With free trade there is huge competition which will lead to greater efficiency and lower prices. Also economies of scale benefits can be absolutely huge now that businesses are supplying a much larger size.
You expect greater consumer choice with free trade. Also economic growth as countries can supply the world market and the export gains become massive which boosts AD which leads to an increase in econ grwth
Countries can exploit their comparative advantage, which leads to higher output using fewer resources and increases world GDP which leads to better living standards
Free trade increases economic efficiency as it establishes a competitive market. This lowers the cost of production and increases the output
More exports could lead to higher rates of economic growth
Specialising means countries can exploit economies of scale which will lower their average costs
What is the trade possibilities curve?
The assumptions are
the 2 nations produce w goods and there is a trade - off
There are constant costs in producing each good. This assumes the curve is a straight line.
The 2 nations face different costs of production.
What are the measurements of the term of trade?
They are measured by the volume of imports an economy can receive per unit of exports.
It is calculated by the index price of exports / index price of imports
What are the causes of changes in terms of trade?
Short run factors:
Change in demand and supply for exports and imports. Maybe due to a change in tastes n fashions which lead to an increase in demand for these goods which leads to an increase of price of these goods which means an improvement in TOT. Maybe imports or exports has been affected by weather which effects imports and export prices of that product.
Relative inflation rates push up the price of this basket which leads to an improvement of these TOT but reduce the competitiveness of them
Exchange rate movement effects price of imports and exports
Long run factors:
If there is a pattern when it comes to income changes in the world where developed countries have seen quick sustained increases in income, this severely impacts terms of trade on developed nations. Demand for these primary commodities are quite income inelastic. Demand for manufactured goods will tend to rise more but primary commodities won’t rise as much even though they are normal goods. So for developing countries, the demand for these exports may rise but nowhere near as much as what they import. Could lead to a long term deterioration of the terms of trade.
Increased Productivity or advancements in tech changes will lower costs of production which feeds thru lower prices for exports which leads to a deterioration of a terms of trade but it is not always bad. It actually improves the competitiveness of a nation.
Globalisation has meant that the price of invisibles such as services have been less impacted than visible goods like manufactured goods. The price of manufactured goods has fallen more than services. This means that the terms of trade of countries like the UK who export more services and import more manufactured goods have improved.
What are the impacts of changes in the term of trade?
Improving the terms of trade means the economy can import more goods for each unit they export
worsening terms of trade means that for every import, the country has to export more
What are the limitations of the comparative advantage model?
Assumes perfect knowledge and that they always know and buy from wherever the lowest prices are which isn’t true
Model assumes no transport costs. They may have a cost advantage compared to other countries so the price is lower than other nations but if you add on the fact that there might be huge transport costs then that may distort or erode this advantage. Model assumes no economy of scales. Countries may benefit hugely from economies of scale if they have comparative advantage
Comparative advantage may be eroded if relative inflation is quite high. They assume no import controls which if there is erodes comparative advantage. Non price competitiveness is ignored. Price may be higher in another country but they may still sell large quantities bcause of this. Exchange rate movements are ignored. Comparative advantage with a very strong exchange rate can erode the comparative advantage. R&D is ignored. Even if countried dont have CA they can spend loads on R&D create a great product, patent it and gain monopoly power
Terms of trade analysis
If demands for exports of a given As the terms of trade improves the equation suggests that the quantity level of exports remain the exact same. As a result of that assumption, a country can actually buy in more imports than they could have done before. Only holds if improvement of TOT translates to a higher export revenue
If demand for a good increases, then the price increases. The increase in price leads to the top part of the equation goes up assuming nothing happens to the bottom part, imports. Revenue increase can be seen on the diagram due to higher quantity and price
If a country has high relative inflation, then that will lead to an improvement in the TOT as export prices will increase. This translates to higher export revenues. However we need to know what is happening to the elasticity of demand for exports. We need demand for exports to be very price inelastic. If it is elastic, then buy pushing up the price of it revenue generated will fall.
Deterioration of terms of trade aren’t always bad. Improved productivity or technology will lead to country being more internationally competitive even though it might translate to lower export prices it may lead to greater quantities of exports being sold which leads to higher export revenue which improves a countries economy as a result
TOT ignores international competitiveness ignores the quantities of X and M and also PED of X and M
