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31.1: Introduction to International Trade

  • Page ID
    4573
  • [ "article:topic", "opportunity cost", "comparative advantage", "production possibilities frontier", "absolute advantage", "Autarky", "competitive advantage", "authorname:boundless" ]

    Reasons for Trade

    Countries benefit when they specialize in producing goods for which they have a comparative advantage and engage in trade for other goods.

    learning objectives

    • Discuss the reasons that international trade may take place

    International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.

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    International Trade: Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage.

    In addition to comparative advantage, other reasons for trade include:

    • Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
    • Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost declines as output increases.
    • Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to international problems.
    • Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
    • Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater responsiveness to consumer wants and needs, and a wider variety of products.

    To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.

     

    Understanding Production Possibilities

    The production possibility frontier shows the combinations of output that could be produced using available inputs.

    learning objectives

    • Explain the benefits of trade and exchange using the production possibilities frontier (PPF)

    In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.

    PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter. If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required.

    ssibilities-frontier-curve.png 

    Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur.

    If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer.

    The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.

    Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.

     

    Defining Absolute Advantage

    A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.

    learning objectives

    • Relate absolute advantage, productivity, and marginal cost

    Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.

    A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs.

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    China and Consumer Electronics: Many consumer electronics are manufactured in China. China can produce such goods more efficiently, which gives it an absolute advantage relative to many countries.

    Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers. Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers.

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    Absolute Advantage: Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A.

    If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.

     

    Defining Comparative Advantage

    A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.

    learning objectives

    • Analyze the relationship between opportunity cost and comparative advantage

    Comparative Advantage

    In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.

    Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.

    Determining Comparative Advantage

    Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players. Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.

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    Comparative Advantage: Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a comparative advantage in producing CD players. Both nations can benefit from trade.

    For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).

     

    Comparative vs Competitive Advantage

    It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we more often discuss comparative advantage.

     

    Absolute Advantage Versus Comparative Advantage

    Absolute advantage refers to differences in productivity of nations, while comparative advantage refers to differences in opportunity costs.

    learning objectives

    • Differentiate between absolute advantage and comparative advantage

    Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.

    The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time. Country A uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit, and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in making both food and clothing.

    absolute-advantage.jpg 

    Absolute Advantage: Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in food.

    Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

    For example, consider again Country A and Country B in. The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.

    Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.

    Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.

     

    Benefits of Specialization

    Specialization leads to greater economic efficiency and consumer benefits.

    learning objectives

    • Discuss the effects of specialization on production

    Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:

    • Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale for the production of these goods. They benefit from economies of scale which means that the average cost of producing the good falls (to a certain point) because more goods are being produced. Similarly, countries can benefit from increased learning. They simply are more skilled at making the product because they have specialized in it. These effects both contribute to increased overall efficiency for countries. Countries become better at making the product they specialize in.
    • Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally more goods are produced and prices are lower. Consumers benefit from these lower prices and greater quantity of goods.
    • Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to benefit further from economies of scale.
    • Gains from trade: Suppose that Britain and Portugal each produce wine and cloth. Britain has a comparative advantage in cloth and Portugal in wine. By specializing and then trading, Britain can get a unit of wine for only 100 units of labor by trading cloth for labor instead of taking 110 units of labor to produce the wine itself (assuming the price of Cloth to Wine is 1). Similarly, Portugal can specialize in wine and get a unit of cloth for only 80 units of labor by trading, instead of the 90 units of labor it would take to produce the cloth domestically. Each country will continue to trade until the price equals the opportunity cost, at which point it will decide to just produce the other good domestically instead of trading. Thus (in this example with no trade costs) both countries benefit from specializing and then trading.

    Of course, there are also some potential downsides to specialization:

    • Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For example, firms in United States may see demand for their products fall due to cheaper imports from China. This may lead to structural unemployment.
    • Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service produced by a country. For example, the global demand for rubber has fallen due the the availability of synthetic substitutes. Countries may experience high levels of persistent structural unemployment and low GPD because demand for their products has fallen.
    • Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that country. Political or economic changes in the second country may impact the supply of goods or services available to the first.

    As a whole, economists generally support specialization and trade between nations.

     

    Relationship Between Specialization and Trade

    Comparative advantage is the driving force of specialization and trade.

    learning objectives

    • Discuss how countries determine which goods to produce and trade

    Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good of another country. The traders decide on whether they should export or import goods depending on comparative advantages.

    Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient, because they have the ability to produce both products. However, specializing in the product for which they have a comparative advantage and then trading would allow both countries to consume more than they would on their own.

    One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When countries decide what products to specialize in, the essential question becomes who could produce the product at a lower opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one could have gotten if one produced another product instead of one unit of the given product.

    For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard. This means that in the same amount of time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3 bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard.

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    Comparative Advantage: Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in producing mustard.

    There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other – but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of consumption as producing all goods domestically.

     

    Key Points

    • International trade is the exchange of capital, goods, and services across international borders or territories.
    • Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
    • Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency gains for domestic producers.
    • The production possibilities curve shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
    • Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer.
    • Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency.
    • A country that has an absolute advantage can produce a good at lower marginal cost.
    • A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
    • Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.
    • Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
    • Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
    • Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of outputs becomes available to the trading nations.
    • Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not necessarily related to a lower opportunity cost.
    • The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.
    • Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another.
    • The existence of a comparative advantage allows both parties to benefit from trading, because each party will receive a good at a price that is lower than its opportunity cost of producing that good.
    • Whenever countries have different opportunity costs in production they can benefit from specialization and trade.
    • Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors.
    • The disadvantages of specialization include threats to uncompetitive sectors, the risk of over-specialization, and strategic vulnerability.
    • Nations decide whether they should export or import goods based on comparative advantages.
    • Generally, nations can consume more by specializing in a good and trading it for other goods.
    • When countries decide which country will specialize in which product, the essential question becomes who could produce the product at a lower opportunity cost.

    Key Terms

    • comparative advantage: The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.
    • Production possibilities frontier: A graph that shows the combinations of two commodities that could be produced using the same total amount of each of the factors of production.
    • Autarky: National economic self-sufficiency.
    • Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.
    • Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
    • competitive advantage: Something that places a company or a person above the competition

     

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