Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another. This means a country can produce a good relatively cheaper than other countries. The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare. Note this is different to absolute advantage which looks at the monetary cost of producing a good. Even if one country is more efficient in the production of all goods (absolute advantage) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. Measured with opportunity cost. Country with absolute advantage in both goods specialise in the one it is ‘most best’ at while country with absolute disadvantage in both goods specialise in one it is ‘least worst’ at. Reduces fundamental economic problem of scarcity.
Can produce more of a good with the same amount of resources.
Specialisation of trade
Specialisation can also mean that individual countries can produce certain goods that they are best at producing and then exchange them with other countries. The theory of comparative advantage states countries should specialise in producing those goods where they have a lower opportunity cost (relatively best at producing.) Specialisation requires trade. Specialisation and trade means that countries that produce no oil can consume oil products and countries with large reserves of raw materials can export them in exchange for other goods that they need. This helps reduce the problem of scarcity in individual countries and enables countries PPF to shift outwards. If there is increased trade there will also be increased competition. This means that domestic monopolies will now face competition from abroad therefore they have increased incentives to cut prices and be efficient. However, there are problems. In terms of trade, poor countries may be encouraged to use up their non-renewable resources to sell to developing countries, therefore in the long term we could run out of non-renewable resources. Also trans national companies can exploit LEDC’s. Over specialisation in one country can lead to countries becoming over dependent on one particular commodity, e.g. if a developing country specialises in the production of a primary product their income may be adversely effected by bad weather conditions. Some primary products have quite a low income elasticity of demand. Therefore, they don’t benefit as much from economic growth.
Does not always bring a net output gain- weird.
Production without specialisation and trade
High average costs
Sources of comparative advantage
– Lower regulatory costs, this can lead to a ‘TNC race to the bottom’ to attract FDI investment through lax regulation on things such as environmental standards and working conditions and wages. Ethical argument involved. Few workers’ rights.
-Abundant labour e.g China. Lower wages and highly skilled and motivated workers. Large population, no trade unions.
-China pegs yuan to dollar at lower price to obtain comparative advantage. Its exports are relatively cheaper than other countries especially those of the US. China ‘currency manipulators.’
-Investment in research & development which can drive innovation and invention e.g Nissan in the UK.
Limitations of comparative advantage. Assumptions simplistic. Real world many countries, much more complex.
-Assumption that transport costs are 0. In reality they are 5% of export value so unlikely to eradicate the comparative advantage completely although can have a significant effect. Also ignores pollution costs of transport- (negative externalities.)
-Assumes that scale economies are constant, again this is not necessarily true, in fact some firms export to achieve economies of scale and further improve comparative advantage.
-Goods being traded are almost never homogenous. This makes comparison difficult. E.g. A Samsung TV is different to a Sony one, it is therefore hard to argue whether Japan or Korea has a comparative advantage in televisions.
-It is assumed that goods are traded and factors of production stay in the relevant countries. However, firms will often set up in LDCs enabling production to take place there rather than exporting them. MNCs use countries with lower production costs/ MC.
-TOT/ exchange rates not taken into account.
-According to influential US economist Paul Krugman, the continual application of economies of scale by global producers using new technology means that many countries, including China, can produce very cheaply, and export surpluses. This, along with an insatiable demand for choice and variety, means that countries typically produce a variety of products for the global market, rather than specialise in a narrow range of products, rendering the traditional theory of comparative advantage almost useless.
-Increasing opportunity cost with increasing specialisation due to diminishing returns. Complete specialisation may not bring net output gain.
Domestic opportunity cost ratio
HAS to be different for trade to be profitable. Allows terms of trade to be beneficial to each country.
Terms of trade (exchange rate)
Weighted average export prices/ weighted average import prices x 100. Measured with index, increase in index = improvement in terms of trade. Quantity of exports needed to purchase given level of imports.
It is a measure of a countries relative competitiveness. If export prices rise relative to import prices we say there has been an improvement in the terms of trade. – A unit of export buys relatively more imports. MDCs tend to have better terms of trade than LDCs. Significant- primary goods and development.
Trade deterioration not necessarily a bad thing…
Changes in SR:
-D + S of Xs and Ms
-Relative inflation rates
Changes in LR:
Challenge theory, for TOT to improve and translate to higher X revenues depends on conditions. Whether it is D that has increased, inflation and elasticity.
Other economics benefits of trade
-Ability to exploit economies of scale as firms grow in size nationally and then globally through outsourcing.
-Increased competition, inefficient domestic firms are no longer shielded from world competition. forces them to reduce average costs- gain of consumer surplus. This also leads to a gain in allocative efficiency.
-Can reduce monopoly power- synoptic link. Aggregate gain from trade not always redistributed.
-Countries that produce no oil can consume oil products and countries with large reserves of raw materials can export them in exchange for other goods that they need. This helps reduce the problem of scarcity in individual countries and enables countries PPF to shift outwards
Costs of international trade
-Poor countries may be encouraged to use up their non-renewable resources to sell to developing countries, therefore in the long term we could run out of non-renewable resources. Environmental damage through deregulation.
-Also TNCs can exploit LEDC’s. Over specialisation in one country can lead to countries becoming over dependent on one particular commodity, e.g. if a developing country specialises in the production of a primary product their income may be adversely effected by bad weather conditions. Some primary products have quite a low income elasticity of demand. Therefore, they don’t benefit as much from economic growth. This shows the dependency theory of trade.
-Some countries may become reliant on the growth of other major trading partners and neglect their own domestic economy. Less domestic consumption. Unbalanced economy. 60% for UK.
Reasons for changes in the pattern of trade between the UK and the rest of the world
-There has been a recent growth in the exports of manufactured goods from developing countries to developed countries. This is because developing countries have gained an advantage in the production of manufactured goods, due to their lower labour costs, so production shifted abroad.
-The deindustrialisation of countries such as the UK has meant the manufacturing sector has declined. This means that production of manufactured goods has shifted to other countries, such as China, whilst the UK now focuses more on services, such as finance.
-This has led to the industrialisation of China and India. Their share of world trade has and the volume of manufactured goods that they export has increased.
However, their wage competitiveness has fallen. This is also due to the rise of the middle class in China, who demand higher wages and consume more. Increase in SOL alongside economic growth.
In economics, protectionism is the economic policy of restraining trade between states (countries) through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations.
Protectionism not allowed under WTO
Can be bad for developing countries. Export protecting- Asian Tigers. Shielded infant industries to allow them to grow.
Intended effect is to raise the final price of the goods for consumers and so reduce their demand, thus also reduce the volume of that good/ service imported. In addition some consumers will switch demand to domestic producers who could exploit the situation by raising their prices and using the tariff as a shield. Loss of allocative efficiency.
This involves putting some from of physical limit on imports. This will raise the share of the home market which will be taken up by domestic producers, but because supply is lower the price paid by consumers will rise. Loss of allocative efficiency.
Tax revenue from tariff could be put into infant industry. Usually put up by LDCs in manufacturing. Currently growing but not able to compete internationally due to intellectual property/ technology and economies of scale. However, in the long run businesses will not want these barriers removed and may not be able to cope without them. Average costs may be much more higher than costs internationally and thus there is no comparative advantage in this industry and it should not be supported. Ironic, not going to become competitive without globalisation. However, the Asian Tigers disprove this.
Flooding global markets with batches of goods at a price below their marginal cost of production, undercutting other countries. It is often done in order to gain international market share to get economies of scale to kill of that industry in other countries. E.g. China with steel.
Causes and consequences of protectionist policies
-Protectionism could distort the market and lead to a loss of allocative efficiency. It prevents industries from competing in a competitive market and there is a loss of consumer welfare. Consumers face higher prices and less variety. By not competing in a competitive market, firms have little or no incentive to lower their costs of production.
-Decreased living standards due to slower world economy growth or domestic growth.
-If a country employed several protectionist measures, then a trade deficit would reduce. This is because they will be importing less due to tariffs and quotas on imports. Short term gain but in the long run this could lead to a trade war.
-Governments might want to protect domestic jobs. E.g. Steel industry. But only prolonging the inevitable, decline of an industry cannot compete with China.
General term, defined as a group of countries which join together in a form of agreement to increase trade between themselves and to gain economic benefits from cooperation. At some point there is protectionism.
Preferential trade area EPA with ACP countires
-A trading bloc which gives preferential access to certain products from certain countries. This usually involves reducing but not eliminating some tariffs. E.g. EU and 71 ACP countries. African, Caribbean and Pacific, many of which were former colonies of EU countries. EU thus has guaranteed supply of mining and agricultural products and the ACP has access to certain funds aimed at stabilising prices. Comes form colony days, stole all resources, feel bad.
-The Economic Partnership Agreements between the EU and African, Caribbean and Pacific countries and regions aim at promoting ACP-EU trade – and ultimately contribute, through trade and investment, to sustainable development and poverty reduction.
Trade with ACP countries represents more than 5% of EU imports and exports. The EU is a major trading partner for ACP countries.
The EU is the main destination for agricultural and transformed goods from ACP partners – but commodities (e.g. oil) still form a large part of ACP-EU trade. The EPAs intend to support trade diversification by shifting ACP countries’ reliance on commodities to higher-value products and services.
The majority of ACP countries are either implementing an EPA or have concluded EPA negotiations with the EU
Free trade area
Group of countries agree to remove barriers between themselves but have whatever restrictions they want with other non member countries, ranging from complete embargo, tariffs and quotas to free trade. Degree of autonomy unlike SEM. E.g. NAFTA which Donald Trump wants to pull out of. EFTA.
An agreement were members trade freely amongst each other but erect common barriers against non members. E.g. EU
Common Market/ Single market/ SEM
EU aiming for this, not quite there but close. No tariffs or other restrictions to trade but in addition there is:
-A common system of taxation
-Common system of laws and regulation
-Free movement of goods and services, labour and capital over borders.
-Absence of special treatment by member governments to their own domestic industries, give contracts to whatever companies in the market offer most competitive deals.
Advantages and Disadvantages of SEM
Trade creation is more likely to take place after entry to SEM when the union’s tariff to external countries i.e. country about to join is very high. The abolition of tariff once union is joined is likely to lead to a large reduction in the price off goods imported from other members. Also when, the volume of goods traded between countries is high after the countries have joined, which it is for the UK with the EU trade creation is likely. About 44% of UK exports in goods and services went to other countries in the EU in 2015—£220 billion out of £510 billion total exports. Trade creation and diversion are relatively short term phenomenon.
Long term advantages:
-Increased market size may allow firms to exploit economies of scale, reach new markets, increase in size.
-Increased trade encourages improvements to transport systems. Greater productivity for countries.
-Increased bargaining power of the bloc as a whole, meaning better terms of trade. Although the EU has struggled to do free trade deals with other countries.
-Increased competition encourages investment and reduces potential monopoly power. Lower costs to consumers are firms are forced to reduce costs. Governments can’t give special treatment to domestic firms.
-FDI- access to single market. Nissan. UK english speaking- business language.
-Free movement may mean that resources go towards the most efficient and and wealthy areas of the union, depriving depressed areas of resources needed to achieve long term growth. Large volumes of unskilled migration can depress wage of low earners.
-Inefficient policies. A large percentage (40%) of EU spending goes on the Common Agricultural Policy.
-Cost of administering the system may be high, particularly with greater intervention in the affairs of member states and cost of paying into the EU.
-Discriminatory policies towards non members may lead to more individual trade negotiations worldwide, damaging the efforts to promote global free trade. Trade destruction.
-Problems with euro
-Bureaucracy, can hinder productivity.
-Pressure towards austerity- stagnation in Greece.
-£33 billion regulatory costs. Renewable energy 4.7, working hours directive.
Economic and monetary union
Common market with a common currency. Eurozone only clear example of this.
Complete economic integration
Monetary union PLUS complete harmonisation of Fiscal and Monetary policy. No single member would be able to operate an individual economic policy. EU fetish. Common transport, agriculture, industry, pollution and regional policies.
Major advantages of joining a customs union such as the EU. This occurs when entry causes consumption to move from a high cost producer to a low cost one. Effectively the removal of barriers allows greater specialisation in accordance with comparative advantage. So rather than purchasing goods at a domestically high cost, consumers now obtain these more cheaply from other members of the customs union. In return a country can now export its products to members without a tariff being applied. Gain allocative efficiency.
Major disadvantage when joining Custom union. Involves consumption moving from a low cost producer to a high cost one. Prior to joining EU, importing textiles from Thailand which had a comparative advantage, but on entering EU, UK has to apply tariff. Lose allocative efficiency.
Dependency theory of trade and development. Theory developed by Raul Prebisch and Hans Singer, hence the ‘Prebisch Singer Hypothesis.’
If the PSH holds true then countries with a high export dependence on primary products (i.e. low diversification in their commodity pattern of trade) may lose out from a worsening of the terms of trade. They will have to import a greater quantity of exports to pay for essential imports such as raw materials, consumer goods and capital goods. The PSH suggests that revenue windfall gains from high world commodity prices may to be temporary and threaten the macroeconomic stability of such countries – for example a fall in world demand and prices for a primary commodity will cause a rise in the trade deficit and the fiscal deficit for an exporting country. Low Yed. As incomes rise in the rest of the world, demand doesn’t rise so much. Yed higher for manufactured goods which is what developed countries produce. Increased price- worsened TOT fro LDCs.
New Trade Theory- Paul Krugman
Suggests that the critical factors in determining international patterns of trade are: economies of scale and network effects, these 2 things may be so significant that they outweigh comparative advantage. Another element is the easy entrant- able to gain economies of scale which makes it hard for firms from other countries to compete. Monopolistic competition. LEDC countries may struggle to compete with MEDC countries due to economies of scale, not comparative advantage. NTT suggest that government intervention can be helpful for LEDC countries. E.g Asian Tigers. Therefore suggests that free trade and laissez faire government intervention may be much less desirable for developing economies who find themselves unable to compete with established multi-nationals.
East Asian Miracle- Comparative advantage can change over time. Similar to New Trade Theory.
‘East Asian Miracle.’ Beneffited from globalisation but were not free market economies. State intervention beneficial. Infant industry argument has worked here. State intervention to help private sector not state controlled businesses. Cheap inputs, no taxation, less red tape led to a better investment climate. Subsidies in priority sectors. No TNCs allowed for technological improvement and learning. However, they were under pressure to reduce costs and increase exports so not technically protectionist. If gaining access to international markets early on, then so be it as long as it led to long run export growth.
Bretton Woods Agreement
The Bretton Woods Agreement is the landmark system for monetary and exchange rate management established in 1944. It was developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, from July 1 to July 22, 1944.
General Agreement on Tariffs and Trade. Set up 1948 post WW2 to increase free trade whilst allowing national governments to retain some autonomy. Globalisation not Hyperglobalisation.
Followed on from GATT. More aggressive pursuit of free trade. The World Trade Organization (WTO) is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business. Latest round of talks have failed.
Countries have benefitted from cheap commodity prices from China, may end soon, growing middle class and wages rising. Less competitive.