Week 11 - Comparative advantage and trade

Question 1

Why trade?

Answer 1

Because resources are scarce (i.e. labour).

Division of labour / Specialisation - specialise in what a country is best at and then gain by trading with others.

Question 2

What is absolute advantage?

Answer 2

When a country can produce a good more efficiently (using fewer resources).

Question 3

What is comparative advantage?

Answer 3

This is the basis for trade.

When a country can produce a good at a lower opportunity cost (meaning they give us less when producing the good).

Question 4

Comparative advantage rule?

Answer 4

1. Determine who has the comparative advantage by determining the opportunity cost.
2. Country with the lowest opportunity cost has the comparative advantage.

Question 5

How to determine opportunity cost?

Answer 5

Calculate - what you would give up / what you will keep.
(i.e. loss / gain)
Whichever is lowest is the one to keep.

When asked to compare two countries, calculate as above and answer:
Country B has a comparative advantage in the production of x (0.75<1). While country A has a comparative advantage in the production of y (1<1.45).

Question 6

Why is trade good for the economy as a whole?

Answer 6

1. Open countries grow faster and reduce poverty.
2. Reduced prices of products
3. Stimulate innovation
4. Assist with the product life cycle. (i.e. once a product is fully developed, the routine production can be moved to a country with cheaper labour).

Question 7

What are the limitation to the theory of comparative advantage?

Answer 7

1. Gaps in technology between countries

2. Political instability.

Question 8

How can a government intervene in trade

Answer 8

A government can intervene in trade by applying trade barriers in the form of tariffs.
Which tax imported goods, by creates a Deadweight loss to society.

Question 9

What are 6 other forms of trade restriction?

Answer 9

1. Voluntary export restraint – restrictions on quantity.
2. Production subsides – Help given to domestic producers.
3. Export subsides – Help given to domestic producers to export goods.
4. Discriminatory government procurement - government pushing consumers to buy local.
5. Quotas - Limits on the amount of a particular good that can be imported.
6. Embargo - Ban of trade with another country.

Question 10

What are the non-economic reasons for trade restrictions?

Answer 10

1. Income distribution
2. Strategic or defence arguments
3. Politics

Question 11

What are economic reasons for trade restrictions?

Answer 11

Infant industry.

Question 12

What are the 5 types of capital flow?

Answer 12

1. Foreign direct investment (FDI)
2. Purchase of existing equity (portfolio)
3. Lending by banks, governments and individuals
4. Inter bank lending
5. Speculative flows