Gains from international trade
Define trade International trade is the exchange of goods and services between
countries. Trade improves consumer choice and total welfare.
Why do countries trade?
Different countries have different factor endowments eg climate, skilled labour force, and
natural resources vary between nations.
Therefore some countries are better placed in the production of certain goods than
others. This is reflected in a lower a lower internal opportunity cost.
What is free trade?
Free trade occurs when a county abolishes any controls or restrictions on international
such as tariffs or quotas. The advantages of free trade are identical to the gains from
Why abolish barriers protecting domestic industries?
Economic theory predicts all countries gain if they specialise and trade the goods in which
they have a comparative advantage. This is true even if one nation has an absolute
advantage over another country. Comparative advantage is used to justify free trade and
entry economic integration through a customs or economic union
Distinguish between absolute & comparative advantage
Absolute advantage occurs when a country or region can create more of a product
with the same factor inputs.
Comparative advantage exists when a country has lower opportunity cost in the
production of a good or service
Explain the theory of comparative advantage
Comparative advantage is based on differing opportunity costs reflecting the different
factor endowments of the countries involved.
The theory assumes free trade, willingness to specialise and factor mobility.
Specialisation and trade benefits countries providing at an exchange rate between the
respective opportunity cost ratios.
Give an example of trade gains using comparative advantage
Countries benefit if they specialise in the production of a good or service in which they
have a comparative advantage ie a lower internal opportunity cost.
Consider France and the UK producing two goods cars and wine. If each country allocates
half its resources to the production of both goods, the production possibilities are as
shown in the table below.
What does each country give up to produce one extra vat of wine?
For the France, the opportunity cost of each extra vat of wine is 2000/1000 ie two cars.
For the UK, the opportunity cost of each extra vat of wine is 2400/800 ie three cars.
Therefore, the France has a comparative advantage in wine
Assume complete specialisation. Where each country specialises in the products in which
it has the comparative advantage.
Output of both products increases representing a gain in economic welfare.
What does each country give up to produce one extra car?
For the UK the opportunity cost of one extra car is 800/2400 ie 1/3 vat of wine.
For the France the opportunity cost is 1000/2000 ie 1/2 vat of wine.
Therefore the UK has the comparative advantage in cars
Comparative advantage is a dynamic concept. A country can lose or acquire comparative
For example the process of development and training taking place Extensive investment
in CEEs (Central and East European Countries) in new equipment and a skilled but cheap
labour force has seen the Czech Republic begin to acquire a comparative advantage in
the production of cars and electronics.
Comparative advantage can be gained or improved through:
Investment in education and training
Investment in infrastructure,
R&D to improve competitiveness ie lower unit costs, better product
design, and reliability
Lower inflation rates than competitors
What are the limitations of comparative integration
Economic integration requires the removal of trade barriers protecting inefficient
domestic producers. This can have drawbacks
Strategic issues: countries become dependent on imports of essentials from other
countries. A dispute in one country can halt production in another
Infant industries argument Sunrise industries may not be able to become established
if faced with competitors from established companies in member counties with lower unit
costs due to greater economies of scale.
A country may experience the disadvantage of overspecialisation, including
diseconomies of scale,
Vulnerability to sudden changes in demand. All products have a life cycle. Where a
country has specialised in a product consumers no longer want, structural unemployment