Free tradeInternational trade is based on specialisation at a national level. Countries exchange goods with others and pay for imports from the revenues received from exporting. To work effectively, this system relies on few, if any, barriers existing to interfere with 'free trade'. Show
The basic principle of free trade dates back to mercantilism and fed through to the early exponents of laissez-faire economics in the seventeenth century. Amongst the most famous early writers on economics was Adam Smith, who produced his ideas on absolute advantage. This was where one country concentrated on developing those goods in which its natural resource base allowed it to produce more than any other country with given resources. Later, David Ricardo developed comparative advantage theory which suggested that a country should exchange goods with another country as long as the domestic opportunity costs were different. As a result of this, production should increase and individual consumption should rise. In essence, these two early economic observations still underpin much of what we know about international trade. Absolute and comparative advantageAbsolute advantage exists when one country is able to produce a good more cheaply in absolute terms than another country. Comparative advantage exists when one country is able to produce a good more cheaply, in comparison to other goods produced domestically, than another country. 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. Comparative advantage - exampleStage 1 - opportunity cost ratiosLet'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
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. Figure 1 PPF's for Happyland and Utopia pre-trade Let's say that they choose to use half their resources on the production of each good. In this case, their consumption (pre-trade) will be as shown in table 2 below. Table 2 Pre-trade consumption
Stage 2 - specialisationIf each country now specialises where they have a comparative advantage, then we will get production as shown in Table 3. Table 3 Specialisation
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.
If we now draw the pre-trade and post-trade PPF's for each country we can clearly see as in Figure 2 below how 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. Figure 2 Production - post specialisation and trade So, consumption increases through specialisation and trade compared to a situation of self-sufficiency. It remains the basic idea behind modern free trade. Despite these advantages, many countries still protect their domestic trade-why? You therefore need to know both the advantages that arise from free trade and the reasons why protectionism still exists (see section 4.2 for details on protectionism). Limitations of comparative advantage theoryWe 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:
What happens when countries have an absolute advantage in the production of a product?Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one's comparative advantage.
What does it mean to have an absolute advantage in production?absolute advantage, economic concept that is used to refer to a party's superior production capability. Specifically, it refers to the ability to produce a certain good or service at lower cost (i.e., more efficiently) than another party.
How does a country have absolute advantage?A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good. Absolute advantage can be the result of a country's natural endowment.
What does it mean for a country to have an absolute advantage quizlet?A country has an absolute advantage when it can produce a good with less resources than another. As such, having an absolute advantage makes for lower costs and greater profit.
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