Why do countries trade? Ch 21 IB International Economics.
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Transcript of Why do countries trade? Ch 21 IB International Economics.
Why do countries trade?
Ch 21 IB International Economics
The gains from international trade Lower prices
Consumers can buy at lower prices than domestic Producers can buy less expensive raw materials and
semi manufactured goods Prices may be lower in some countries because they
have access to natural resources Differences in quality of labour Differences in quality of capital Different levels of technology
The main cause of lower prices is comparative advantage (see later)
Greater choice Consumers have access to domestic and
international products
International trade: the exchange of goods and services between countries
The gains from international trade Differences in resources
There will be resources that a country needs to produce other goods but does not have and has to import
Copper, diamonds, oil Singapore imports almost every natural resource but has a high
level of exports to fund their imports Saudi has oil while Japan has none Costa Rica has the climate to grow bananas whereas the UK
cannot The USA has a large stock of skilled workers when Sudan’s is
comparatively unskilled etc These differences lead to trade
Economies of scale The size of the market increases Demand increases Production can increase Production becomes more efficient Division of Labour and Specialisation can increase Managers become more knowledgeable This leads to economies of scale If countries specialise they acquire experience and expertise
(they move down the learning curve – the LRAC curve) In the long run with larger production and larger markets export
industries should get more efficient and competitive leading to a reduction in long-run
Singapore has to import almost every natural resource – even water!
The gains from international trade
Increased competitionPrices reduceQuality improvesInnovation
improves giving more variety
Task - Find out what Bahrain exports and imports (include values)
HL only
Comparative Advantage Which goods should a country
produce for export and which should it import
The answer lies in the concept of comparative advantage
Watch these videosGardening parable -
http://www.youtube.com/watch?v=RpfV0Oerfr8
Mjmfoodie - http://www.youtube.com/user/mjmfoodie#p/u/67/38hvvAzgXZY
Comparative Advantage An example for absolute advantage This table shows the production
outcomes where 2 countries are using the same quantities of resources to produce lamb and cloth
Half of their resources are being used for lamb and the other for cloth
Australia has absolute advantage in producing lamb (it can produce 6 kilos vs 4 kilos with the same resources)
China has absolute advantage in producing cloth (it can produce 3 kilos vs 1 kilo)
In this situation Australia should specialise in lamb and China in cloth
Country Kilos of lamb
Metres of cloth
Australia 6 1
China 4 3
Total without trade
10 5
Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country
Country Kilos of lamb
Metres of cloth
Australia 12 0
China 0 6
Total without trade
12 6
Comparative Advantage If Australia uses all of its resources
for lamb it will double its output (assuming constant returns to scale) and make 12 This gives a total of 12 which is 2
more than before (there is an advantage to them specialising)
If China uses all of its resources to make cloth it will double its output to 6 The new total of 6 instead of 5
This situation, where each country has an absolute advantage in the production of one product is known as reciprocal absolute advantage
Country Kilos of lamb
Metres of cloth
Australia 6 1
China 4 3
Total without trade
10 5
Absolute advantage – If a country has absolute advantage it can produce a good using fewer resources than another country
Country Kilos of lamb
Metres of cloth
Australia 12 0
China 0 6
Total without trade
12 6
Comparative Advantage What happens if there is not a
situation of reciprocal absolute advantage?
David Ricardo (19th Century) proved mathematically that trade could still be beneficial to both countries when one country had an absolute advantage in producing all goods
He looked at the opportunity cost of production to explain comparative advantage
This table shows the production outcomes of France and Poland for wine and cheese
France has absolute advantage in producing both goods
Country Litres of wine
Opportunity cost of 1 litre of wine
Kilos of cheese
Opportunity cost of 1 kilo of cheese
France 3 4/3 kilos of cheese
4 ¾ litre of wine
Poland 1 3 kilos of cheese
3 1/3 litre of wine
comparative advantage – If a country has comparative advantage it can produce a good at a lower opportunity cost than another country; Country A has to give up fewer units of other goods to produce the good in question than country B
Comparative Advantage In terms of comparative
advantage France has a comparative advantage in production of wine France has to give up 4/3 kilos
of cheese to produce a litre of wine
Poland would have to give up 3 kilos of cheese to produce a litre of wine
4/3 is smaller than 3 so France has the comparative advantage
Poland has a comparative advantage in production of cheese (1/3 is smaller than ¾)
The theory of comparative advantage tells us that France should specialise in wine and Poland should specialise in cheese
France will consume that wine that they wish and use the extra to trade for cheese
Country Litres of wine
Opportunity cost of 1 litre of wine
Kilos of cheese
Opportunity cost of 1 kilo of cheese
France 3 4/3 kilos of cheese
4 ¾ litre of wine
Poland 1 3 kilos of cheese
3 1/3 litre of wine
Comparative Advantage We can illustrate this using
production possibility curves The diagram shows exactly the
same as the table When a country has an absolute
advantage in producing both goods (France) and the scale of the axes is the same
The comparative advantage for the better producer is in the good where the distance between the production possibilities is the greatest (a)
The comparative advantage for the less efficient producer is where the distance between the production possibilities is least (b)
Thus France has the comparative advantage in Wine and Poland cheese
The slope of the line shows the opportunity costs which is always a constant opportunity cost
Country Litres of wine
Opportunity cost of 1 litre of wine
Kilos of cheese
Opportunity cost of 1 kilo of cheese
France 3 4/3 kilos of cheese
4 ¾ litre of wine
Poland 1 3 kilos of cheese
3 1/3 litre of wine
Comparative Advantage This only works if the opportunity costs are different If they are the same there would be no point in trade taking
place The slopes are the same The opportunity costs are the same
What give a country comparative Advantage?
To a large extent this is due to a country’s factor endowments
If a country has a large amount of arable land it may develop a comparative advantage in agricultural products
A country with beautiful beaches and a favourable climate may develop its comparative advantage in the output of tourist services (climate can be a factor of production!)
Limitations of the theory of comparative advantage The theory is based upon a number of
assumptions These assumptions limit the application of the
theory in real life Producers have perfect knowledge and are aware
of where the least expensive goods may be purchased
There are no transport costs There are only 2 economies producing goods –
not so much of a problem with the use of computer simulations
Costs do not change and returns to scale are constant (no economies or diseconomies of scale)
Goods being traded are identical This may be ok with commodities but not goods like
consumer durables Factors of production remain in the country
It may be the factors of production that move rather than the goods
Developed countries may invest capital in LDCs to produce goods
Labour may migrate from low-wage to high-wage countries
Test your understanding
http://www.youtube.com/watch?v=vc324aHB2m8
Limitations of the theory of comparative advantage
In spite of limitations, comparative advantage is at the core of international theory
It goes a long way to explain patterns of trade
HL homework - Using a diagram explain the concept of comparative advantage (10 Marks)
All - Research the WTO ready for class discussion