Specialisation & Trade (Edexcel A Level Economics A)

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Written by: Steve Vorster

Reviewed by: Jenna Quinn

Absolute & 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
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

The assumptions of comparative advantage

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

Transport costs are zero: it does not account for moving the goods/services between countries. Depending on a nation's location this is more or less of a problem
There is perfect knowledge: each country knows what it has a comparative advantage in and also the comparative advantages of other countries
Factor substitution is easily achieved: economies can quickly adjust to changing global market conditions by switching from capital to labour - and vice versa
Constant costs of production: the theory does not take into account the economies of scale that can be achieved with an increase in output

Using production possibility frontiers to Illustrate comparative and absolute advantage

Production possibility frontiers can be used to illustrate these concepts

The production possibility frontiers for 2 countries who both produce t-shirts and computer chips

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 $\frac{t - shirts}{computer chips} = \frac{200, 000}{100, 000} =$ 2 t-shirts
- The opportunity cost of producing 1 t-shirt is $\frac{computer chips}{t - shirts} = \frac{100, 000}{200, 000} =$ 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 $\frac{t - shirts}{computer chips} = \frac{80, 000}{80, 000} =$ 1 t-shirts

The opportunity cost of producing 1 t-shirt is $\frac{computer chips}{t - shirts} = \frac{80, 000}{80, 000} =$ 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 and 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 and so it should specialise in t-shirt production

Limitations to the theory of comparative advantage

Comparative advantage does tend to be one of the main factors that drives a nation's manufacturing in a global economy. However, there are limitations and drawbacks to the theory

The Limitations of Comparative Advantage

Over-dependence	Environmental damage	Distribution of Income	Structural unemployment
Specialisation creates a dependence on other countries which generates vulnerability e.g. receiving gas supplies from Russia works well when relations are good but has proven otherwise in an unexpected time of war. There has been an over-dependence on Russian gas	The impact of negative externalities of production is not considered by the theory and these can significantly worsen the quality of life in towns, cities and countries	The GDP/capita is likely to increase, however the distribution of the extra income is likely to be uneven with the wealthier sections of the population gaining more	Although there should be a net increase in employment, as countries specialise certain industries are likely to shut down resulting in unemployment for some workers. These workers may not be able to move into other occupations and if so the number of long-term unemployed will rise

Advantages & Disadvantages of International Specialisation & Trade

The advantages of international specialisation and trade are significant and are backed up by the large increase in the volume of global trade in the past fifty years

Lower prices
Greater variety of goods/services
More competition leads to better quality products
Economies of scale create efficiencies
Higher economic growth
Improved living standards

The Disadvantages of Specialisation and Trade

Disadvantage	Explanation
Global Monopolies Emerge	As transnational firms grow in size and increase market power, they can dictate prices and output in many regions. They are also able to wield their influence to influence governments and gain access to raw materials through bribery and corruption e.g Glencore has recently admitted to multiple allegations of bribery so as to secure favourable mineral rights deals
Exposure to external shocks	Shocks to other economies have a knock-on effect due to the interdependence that develops with trade e.g. the Russian war on Ukraine has created global shockwaves in the energy and grain markets
Deficit on the Current Account of the Balance of Payments	Some countries will import more than they export resulting in a deficit on the current account. When this happens in developed countries, it is usually because the income of the citizens is high and they are importing to improve their standard of living. In developing countries, this situation is usually as a result of a lack of global competitiveness and it is importing necessity products
Unemployment	Many firms that were successful in the local market may well fail in a global market. Employment in successful industries will increase and employment in unsuccessful industries will decrease. Structural unemployment is a particular concern. Government supply-side policies make a significant difference to the length and severity of structural unemployment
Dumping due to illegal Government support	Some governments support key industries to ensure they are globally competitive. This support often comes in the form of subsidies which encourage excess production. This excess production is then dumped on world markets at low prices e.g The USA subsidises cotton farmers to the extent that they have put competitors out of business through the sale of below cost cotton
Challenges for Developing Countries	Start-up firms in developing countries (infant industries) find it harder to compete due to global competition - the ones that survive often have government support. Global monopolies also exert large amounts of pressure on developing countries through the use of monopsony power and transfer pricing
Over-specialisation in developing economies	Developing countries often lack the finance to develop a diversified product base and end up over-specialising in commodity products. This makes the country's GDP very dependent on the commodity prices
Loss of sovereignty and culture	With an increase in trade, languages and cultures have blended impacting on some indigenous languages and cultures. Countries have also lost some sovereignty as they are more easily influenced by dominant trading partners

Last updated: 1 September 2024

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