The reasons for international trade

Economics AS · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Countries trade because they gain from specialising. A country has an absolute advantage if it can produce more of a good than another country with the same resources. It has a comparative advantage if it can produce the good at a lower opportunity cost. Even a country that is better at everything gains by specialising where its opportunity cost is lowest.

After specialising and trading, a country can consume on a trading possibility curve that lies outside its production possibility curve.

The terms of trade compare export prices with import prices. A rise means each unit of exports buys more imports. The theory has limits: it ignores transport costs and assumes constant costs and free trade.

Rules to remember

Absolute advantage: can produce more of a good with the same resources (or the same output with fewer resources).
Comparative advantage: can produce a good at a lower opportunity cost than another country.
Opportunity cost of 1 unit of good X = output of good Y given up ÷ output of X gained.
Trade benefits both countries when the exchange rate between the goods lies between their two opportunity costs.
Terms of trade index = index of export prices ÷ index of import prices × 100.
A rise in the index is called an improvement; a fall is a deterioration (worsening).
Limitations: transport costs, rising opportunity costs, trade barriers, immobile factors, risk of over-dependence on one product.

Common mistake

Students give the comparative advantage to the country that produces more. Compare opportunity costs, not total output: the lower opportunity cost wins, and one country cannot have the comparative advantage in both goods.

Worked example

With the same resources, Country A can produce 40 cars or 80 tonnes of tea, and Country B can produce 10 cars or 60 tonnes of tea. Who should specialise in which good?

Country A produces more of both goods, so A has the absolute advantage in both.
Opportunity cost of 1 car: in A = 80 ÷ 40 = 2 tonnes of tea; in B = 60 ÷ 10 = 6 tonnes of tea. A is lower.
Opportunity cost of 1 tonne of tea: in A = 40 ÷ 80 = 0.5 car; in B = 10 ÷ 60 = 0.17 car. B is lower.
Each country specialises where its opportunity cost is lower.

Answer: A has the comparative advantage in cars and B in tea. Both gain if 1 car trades for between 2 and 6 tonnes of tea.

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