Theory of comparative advantage (int trade)

Assumptions for theory of CA

- trade is carried out between 2 countries - only 2 commodities are produced and traded - no transport costs is involved in moving goods from one place to another - constant opportunity cost in production of both goods in both countries - perfect mobility of factors of production within each country but not between countries - resources of each country are fully and efficiently employed - no trade barriers imposed by governments

4. Wider variety of goods and services

A country may not be able to produce certain goods and services domestically due to a lack of factors of production that are essential in the production of these goods. With international trade, the country is able to buy these goods from other countries by selling what it has an abundance of. In the process, its people are able to consume a greater variety of goods, leading to greater consumer choice and higher satisfaction levels.

4. Free trade vs Trade barriers

A country might not be able to export as much as it desires due to obstacles to trade imposed by other countries. Trade restrictions are always in practice as countries try to protect their national interests

2. Differences in technology

Arises because different countries have different intensities of research and development activities and different speeds of adoption of new technologies. Economies that can adopt more advanced technology can better combine factors of production to produce the good more efficiently and at a lower opportunity cost than other economies that use relatively old technology. Technology itself is internationally tradeable and it is the ability to keep ahead in the technological race that can give a country the comparative advantage

1. Increasing opportunity costs

Assumption of constant opportunity cost is unlikely to hold in the real world. When a country starts to specialize in the production of one good, it will have to use resources less and less suited to the production of that good and which are more suited to the production of other goods. This causes the country to experience increasing opp costs bc factors of production are not homogeneous. Increasing opp costs can limit the degree of specialization and gains of a country

3. Transport costs

Assumption of no transport costs unlikely to hold in the real world. International trade requires the movement of goods from one country to another and high transport costs may negate the gains from international specialization and trade. In addition, high transport costs of certain bulky goods and materials which command little market value may lower the gains from trade. Too high a transport cost will limit international specialization and trade.

2. Factor immobility within the country

Assumption of perfect mobility of factors of production unlikely to hold in the real world. Country has to move its resources from the production of one good to the other in which it has comparative advantage in to benefit from trade. In the real world, factors are not perfectly mobile, this limits specialization of production of one good in all countries

Free Trade

Can take place when two or more countries can exchange goods and services without any trade barriers between themselves

SOURCES OF CA 1. Differences in factor endowments

Climate and resource endowments differ among countries. Such differences persist largely because international mobility of resources is restricted to some extent. Differences in factor endowment leads to differences in relative prices of factors of production between countries which affect relative prices of goods and services. eg. Singapore has little land and a small labour force. Given her highly educated workforce, it has CA in and exports machinery and pharmaceutical products while importing agricultural products such as rice which is land and labour intensive in their production.

3. Increased competition in world market

Competition from foreign rivals forces domestic firms to be more efficient and competitive in order to survive. Hence domestic firms have greater incentive to innovate and produce goods of a higher quality or at a lower unit cost. Furthermore, competition from foreign producers can prevent domestic monopolies from charging high prices as imports can weaken the power of the monopoly Consumers can enjoy goods at lower prices or with better quality. These result in higher consumer welfare.

2. Stimulates economic growth

If the domestic market is small, economy may not be able to sustain its growth. With international trade, market is expanded globally and this can bring about larger cost savings (economies of scale) for firms in these countries as they increase their scale of production to meet the higher global demand. The higher demand for their products can also generate higher export revenue hence there is an incentive for firms to invest in the country

1. Increased world output

Some countries are more efficient than others in the production of certain goods and services because of different factor endowments and the use of different methods of production. Total world output is increased when countries specialize in the production of goods and services that they are most efficient in producing.

Theory of comparative advantage

The theory of comparative advantage states that under certain conditions, countries can benefit from specialization in the production of goods and services which they have comparative advantage in and trade them for goods and services which they do not have comparative advantage in. Countries can benefit from specialising and exporting products in which they have a comparative advantage and importing products in which they do not have a comparative advantage.

5. Facilitate transfer to technology and ideas

Trade brings with it an exchange of ideas and techniques that increase the efficiency of production and hence stimulates economic growth. The transfer of technology and ideas from more advanced countries can help developing countries speed up their economic development as the latter can avoid the mistakes made by developed countries.

Terms of trade

for specialization and trade to be mutually beneficial for both countries, theory of comparative advantage states the terms of trade (exchange ratio) should be between both countries' opportunity costs to produce both goods terms of trade: rate at which two goods are exchanged

result

therefore, international trade stimulates actual economic growth as exports and investment generate income and employment. Ceteris paribus, increased output and employment will lead to an increase in the standard of living as consumption of goods and services increase