Using the principle of comparative advantage, explain why economic theory suggest that countries should specialize and trade with each other.

Demands of the question:

  • Explain the reasons why countries should specialize and trade with each other.

Definition:

  • International trade is the process of exchanging goods and services between countries. It involves the buying and selling of imports and exports.
  • Specialisation means to focus on the production of a single good or service or a particular activity in the production of that good or service.
  • A country has a comparative advantage when they can produce a good or service at a lower opportunity cost than another country. If countries specialise where they have a comparative advantage then the level of output and therefore world welfare will be increased.
  • Comparative advantage is a principle of economics which states that trade between two countries will be mutually beneficial as long as their domestic opportunity costs of production differ.


Country D has a comparative advantage on Product B, while Country C has a comparative advantage on Product A.

Reasons for trade:

Stage 1 – opportunity cost ratios

Let’s say that there are two countries – Utopia and Happyland. These countries produce two products – hardware and software. With one unit of their resources they can each produce as shown in Table 1 below.

Table 1 Potential production – Utopia and Happyland
Hardware (units) Software (units)
Utopia 200 1000
Happyland 100 1500

 

This means that the opportunity cost ratios for each country are as follows:

Utopia – for every 1 unit of hardware they produce the opportunity cost is 5 units of software.

Happyland – for every 1 unit of hardware they produce the opportunity cost is 15 units of software.

This means that Utopia has a comparative advantage in the production of hardware as for every unit of hardware they produce they give up less software. This makes them relatively more efficient at the production of hardware.

However, this also means that Happyland has a comparative advantage in the production of software as for every unit of software they produce they only give up one fifteenth of a unit of hardware, whereas Utopia have to give up one fifth of a unit.

We can see this clearly if we plot the production possibility frontiers for the two countries.

Stage 2 – specialisation

If each country now specialises where they have a comparative advantage, then we will get production as shown in Table 3.

Table 3 Specialisation
Hardware (units) Software (units)
Utopia 200 0
Happyland 0 1500
Total production 200 1500

We can see straight away that world production is greater, but each country has now only produced one good and, so once they have specialised, they will want to trade to get some of the other good. The terms of trade (or exchange rate) that they trade at will be determined by the opportunity cost ratios we worked out in stage 1. The terms of trade will settle somewhere between the two opportunity cost ratios to ensure that both countries benefit.

Let’s say they settle on an exchange rate of 1 unit of hardware = 10 units of software and that they agree to trade 75 units of hardware for 750 units of software. The position now will be as shown in table 4.

 

Hardware (units) Software (units)
Utopia 125 750
Happyland 75 750
Total production 200 1500

 

They are better off from specialisation and trade as they can now reach higher levels of consumption of both goods than was possible before specialisation.

Limitations of comparative advantage theory

We need to be careful, as comparative advantage theory does not explain all changes in trade patterns. It is an important explanation, but you also need to take into account that:

  • Transport costs and tariffs will change the relative prices of goods and may therefore ‘blur’ the impact of comparative advantage.
  • Exchange rates do not always relate exactly to what comparative advantage theory suggests as they have many other determinants – this may also negate the theory.
  • Imperfect competition may lead to prices being different to opportunity cost ratios. Imperfect competition may also lead to the exploitation of economies of scale which may adjust to what comparative advantage theory suggests should happen.
  • Comparative advantage theory is a static theory and does not take account of some of the more dynamic elements determining world trade. In particular, the factor of production capital is not a natural resource, and so may come outside the scope of the theory.


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