Comparative advantage (terms of trade)

Question 1

1 (comparative advantage)

Answer 1

In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them. Country B is 3.5 times better at trucks, and only 1.17 times better at cars. However, the greatest advantage - and the widest gap - lies with truck production, hence Country B should specialise in producing trucks, leaving Country A to produce cars

Question 2

2 (Economic theory)

Answer 2

Economic theory suggests that, if countries apply the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-sufficient and allocate resources towards production of both goods. Taking this example, if countries A and B allocate resources evenly to both goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15, therefore world output is 45 m units.

Question 3

3 (Opportunity cost ratios)

Answer 3

It is being able to produce goods by using fewer resources, at a lower opportunity cost, that gives countries a comparative advantage. The gradient of a PPF reflects the opportunity cost of production. Increasing the production of one good means that less of another can be produced. The gradient reflects the lost output of Y as a result of increasing the output of X.

Question 4

4

Answer 4

Having a comparative advantage in X, Country A sacrifices less of Y than Country B. In terms of two countries producing two goods, different PPF gradients mean different opportunity costs ratios, and hence specialisation and trade will increase world output. Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial

Question 5

Identical PPFs

Answer 5

If PPF gradients are identical, then no country has a comparative advantage, and opportunity cost ratios are identical. In this case, international trade does not confer any advantage.

Question 6

Criticisms 1

Answer 6

It may overstate the benefits of specialisation by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.
The theory also assumes that markets are perfectly competitive with perfect mobility of factors without any diminishing returns and with no transport costs. The reality is likely to be the reverse. This will make the PPF for each country non-linear and bowed outwards. If this is the case, complete specialisation might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialisation.

Question 7

Criticisms 2

Answer 7

Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another.
Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade. Countries can develop new advantages, such as Vietnam and coffee production in the past 30 years.