International Trade (AQA A Level Economics)

The Model of Comparative Advantage

• International trade decreases prices and increases the variety of goods/services available to a nation

  • This results in a higher standard of living
    

• Comparative advantage is the theory developed by David Ricardo in 1817 which states that a country should specialise in the goods/services that it can produce at the lowest opportunity cost

  • By specialising, the volume of production increases

  • Excess production can be exported

  • Goods/services which are not produced in the country can be imported
    

The assumptions of comparative advantage

• As with any economic model, there are underlying assumptions to the theory of comparative advantage: 

1. Transport costs are zero: it does not account for moving goods or services between countries. Depending on a nation's location, this is more or less of a problem

2. There is perfect knowledge: each country knows what it has a comparative advantage in and also the comparative advantages of other countries

3. Factor substitution is easily achieved: economies can quickly adjust to changing global market conditions by switching from capital to labour - and vice versa

4. Constant costs of production: the theory does not take into account the economies of scale that can be achieved with an increase in output
   

Comparative & Absolute Advantage

• Absolute advantage occurs when a country is able to produce a product using fewer factors of production than another country

  • A country may well have absolute advantage but still not have comparative advantage

    • It should produce goods/services in which it has comparative advantage

• Production possibility frontiers can be used to illustrate comparative and absolute advantage

Diagram: Production Possibility Frontier for T-shirts & Computers 

The production possibility frontiers for 2 countries that both produce two goods 

Diagram analysis

• Country A has an absolute advantage as it can produce more of both products

• Country A can produce either 200,000 t-shirts or 100,000 computer chips

  • To produce 100,000 computer chips, it gives up production of 200,000 t-shirts
     

  • The opportunity cost of producing 1 computer chip is
    
     =  = 2 t-shirts
    
    

  • The opportunity cost of producing 1 t-shirt is
    
    = 0.5 computer chip
    
    

• Country B can produce either 80,000 t-shirts or 80,000 computer chips

  • To produce 80,000 computer chips, it gives up production of 80,000 t-shirts
     

  • The opportunity cost of producing 1 computer chip is
    
    = 1 t-shirts

  • The opportunity cost of producing 1 t-shirt is
    
    = 1 computer chip
    
    

• To produce 1 computer chip Country A gives up 2 t-shirts and Country B gives up 1 t-shirt

  • Country B has a comparative advantage in producing computer chips as it is giving up fewer t-shirts, so it should specialise in computer chip production
    

• To produce 1 t-shirt Country A gives up 0.5 computer chips and Country B gives up 1 computer chip

  • Country A has a comparative advantage in producing t-shirts as it is giving up fewer computer chips, so it should specialise in t-shirt production

The gains from trade

• Comparative advantage shows that by specialising, the volume of production increases

  • Resulting in a large increase in the volume of overall global trade
    

• For example: excess production can be exported (Country A exports T-shirts and Country B exports computer chips)

  • Goods/services which are not produced in the country can be imported (Country A imports computer chips and Country B imports T-shirts)