International Trade

International Trade - Law of Comparative Advantage
business_square2

Key Learning Outcomes

  • Understand and explain the advantages of specialisation and international trade
  • Explain and illustrate the Law of Comparative Advantage
  • Explain the terms of trade
  • Calculate the terms of trade and examine the benefits resulting from specialisation
  • Examine the impact on a country of changes in that country’s terms of trade

Introduction: The Law of Absolute Advantage

Definition: The Law of Absolute Advantage states that each country should specialise in the production of that good in which it has an absolute advantage, i.e. if it can produce the good more efficiently / cheaply (at a lower cost) than other countries.

If it costs Country A less per unit in terms of resources to produce a product than Country B, than we say that Country A has absolute advantage in the production of that particular good.

Example: Let us consider the case of two countries, Brazil and France. For the purpose of this example we will assume that both countries only produce two products and each country only has two workers (one producing lemons and one producing olives). The table below shows the output per worker, per country, per year.

2 x 2 x 1 Model

2 Countries

2 Products

1 Factor of Production


Country Lemons (kg per week per worker) Olives (kg per week per worker)
Brazil 1200 600
France 600 2400
World Production 1800 3000
  • One worker in Brazil can produce 1200 kg of lemons and one worker can produce 600 kg of olives per week.
  • One worker in France can produce 600 kg of lemons and one worker can produce 2400 kg of olives per week.

What happens if these countries do not engage in International Trade?

If the two countries produce and supply for their own needs and requirements only and do not engage in trade, each country will have one worker engaging in the production of lemons and one worker engaging in the production of olives.

What happens if both countries engage in International Trade?

  • Brazil has absolute advantage in the production of lemons. Lemons: 1200 / 600 is 2:1 = one worker in Brazil is twice as productive as a worker in France.
  • France has absolute advantage in the production of olives. Olives: 2400 / 600 is 4:1 = one worker in France is four times more productive than a worker in Brazil.
  • Therefore Brazil should specialise in the production of lemons and France should specialise in the production of olives.
  • Both countries should specialise in the production of the goods that it can produce most cheaply and trade for its other requirements.
After Specialisation
Country Lemons (kg per week per worker) Olives (kg per week per worker)
Brazil 2400 0
France 0 4800
World Production 2400 4800


The benefits of trade are very apparent.

  • If trade takes place between the two countries world output of lemons will increase from 1200 kg to 2400 kg and world output of olives will increase from 2400 kg to 4800 kg.
  • By specialising and engaging in international trade both countries can enjoy a higher standard of living and increased economic wealth by sharing the increased output.
  • Brazil will have absolute advantage in the production of lemons.
  • France will have absolute advantage in the production of olives.

 

The Law of Comparative Advantage:

The Law of Comparative Advantage states that assuming there is free trade, a country should specialise in the production of those goods and services in which it is relatively most efficient and trade for the remainder of its requirements.

Example: Let us consider the case of two countries, Ireland and Portugal. The table below shows the output per worker, per country, per week.

Output per worker per week Bottled Water (units) Candles (units)
Ireland 120 90
Portugal 60 70
Total Output 180 160


Not engaging in International Trade

  • If the two countries supply their own needs and do not engage in trade, each country will have one worker engaging in the production of bottled water and one worker engaging in the production of candles.
  • One worker in Ireland can produce 120 bottles of water per week and the second worker can produce 90 candles per week.
  • One worker in Portugal can produce 60 bottles of water per week and the second worker can produce 70 candles per week.

 

Engaging in International Trade

Output per worker per week Bottled Water (units) Candles (units)
Ireland 120 90
Portugal 60 70
Total Output 180 160
  • Examining the above information it is clear that Ireland has absolute advantage in the production of both water and candles.
  • In Ireland, workers can produce 120 bottles of water and 90 candles per week.
  • In Portugal, workers can produce 60 bottles of water and 70 candles per week.
  • This does not mean that Ireland should produce both goods. They will specialise in the production of the product at which they are most efficient i.e. in which they have comparative advantage and trade for all other requirements.
  • Should Ireland specialise in bottled water or candles?

 

With Specialisation
Production of Bottled Water Production of Candles
Ireland : Portugal Ireland : Portugal
120 : 60 90 : 70
2:1 1:3:1
  • From the above ratios we can see that Ireland would be better off specialising in the production of bottled water as an Irish worker is twice as efficient as a Portuguese worker at producing water (120:60 = 2:1)
  • An Irish worker is only 1.3 times as efficient as a Portuguese worker in the production of candles (90:70 = 1.3:1)

 

Total Output after Specialisation
Country Bottled Water Candles
Ireland 240 units 0 units
Portugal 0 units 140 units
Total Output 240 units 140 units
  • If Ireland specialises in the production of bottled water, the second worker will switch from the production of candles and move to the production of bottled water, thereby doubling output to 240 units.
  • If Portugal specialises in the production of candles, the second worker will switch from the production of bottled water and move to the production of candles, thereby doubling output to 140 units.
  • With specialisation, the total output of bottled water has increased by 60 units (180 units increased to 240 units) or 33.33% (60 / 180 x 100 = 33.33%).
  • With specialisation total output of candles decreased by 20 units (160 units decreased to 140 units) or 12.5% (20 / 160 x 100 = 12.5%).
  • Therefore, since the increase of 33.33% is greater than the fall of 12.5%, the world is better off.

Note:

Formula =

Difference in world output after specialisation / original world output prior to specialisation x 100 = %

 

How do we prove this to be the case?

Is the fall in output of candles of 20 units offset by the increase of 60 units in bottled water i.e. is the world better off after specialisation?

  • To understand we need to calculate the value of bottled water : candles in world terms.

In World Terms

Total output bottled water /

Total output candles

 180 / 160 1 candle = 1.125 bottles of water

Total output candles /

Total output bottled water

 160 / 180 1 bottle of water = 0.89 of a candle

In world terms

1 candle = 1.125 bottles of water
1 bottle of water = 0.89 candle

  • In world terms 1 candle = 1.125 bottles of water so a decrease of 20 candles = 22.5 bottles of water (20/1.125 = 22.5).
  • The production of water has increased by 60 bottles, which is greater than 22.5.
  • As the increase of 60 (33.33%) bottles of water is greater than the decrease of 20 (12.5%) candles the world is better off.

 

Terms of Trade

The terms of trade refer to the ratio between the average price of exports and the average price of imports. It may be expressed as the index number showing average price of exports divided by average price of imports

Formula:

Index of export prices X 100

Index of import prices

The terms of trade measures the amount of imports that can be bought per unit of exports.

Example in Ireland:

1 computer = 2 barrels of oil
1 computer = 10 barrels of oil

 

The terms of trade have improved. How can this happen?

  • If export prices are rising faster while import prices remain the same.
  • If export prices are rising faster than import prices.
  • If import prices fall while export prices stay the same.

Now let us look at a practical application of the terms of trade when countries engage in international trade.

Terms of Trade
IRELAND
1 candle is the equivalent of/equals 1.33 bottles of water
(120/90 = 1.33)
1 bottle of water is the equivalent of/equals 0.75 of a candle
(90/120 = 0.75)

 

PORTUGAL
1 candle is the equivalent of/equals 0.86 of a bottle of water
(60/70 = 0.86)
1 bottle of water is the equivalent of/equals 1.2 of a candle
(70/60 = 1.2)

 

Will countries specialise and then trade?

  • If Ireland produces candles, it will want 1.33 bottles of water for 1 candle.
  • If Portugal produces candles, it will want 0.86 of a bottle of water for 1 candle.
  • If Ireland produces bottles of water, it will want 0.75 of a candle for 1 bottle of water.
  • If Portugal produces bottles of water, it will want 1.2 of a candle for 1 bottle of water.

Possible terms of trade

  • The price of one candle: the terms of trade lies between 0.86 of a bottle of water and 1.33 bottles of water.
  • The price of one bottle of water: the terms of trade lies between 0.75 of a candle and 1.2 candles.

 

Sample Exam Q&A

Question
(A) The table below illustrates the Law of Comparative Advantage:
Country Output
(Production per worker per week)
Machines Cars
Spain 20 units 5 units
Japan 40 units 15 units
Total Output 60 units 20 units

 
A (i) Explain how both countries benefit from international trade in the above example.

Sample Answer A (i)
1
Total Output before Specialisation
Country Output
(Production per worker per week)
Machines Cars
Spain 20 units 5 units
Japan 40 units 15 units
Total Output 60 units 20 units

 

In World Terms
1 car = 3 machines Total output machines / Total output cars 60 / 20
1 machine = 1/3 car Total output cars / Total output machines 20 / 60

 

Total Output after Specialisation
Country Machines Cars
Spain 40 units 0 units
Japan 0 units 30 units
Total Output 40 units 30 units
  • With specialisation, the output of machinery has decreased by 20 units (60 units decreased to 40 units) or 33.33% (60/40 x 100 = 66.67% = ↓ 33%).
  • With specialisation, the output of cars has risen by 10 units (20 units increased to 30 units) or 50% (30/20 x 100 = 150% = ↑ 50%).
  • The fall in output of machines of 20 units must be offset by the increase of 10 units in cars.
  • In world terms 1 car = 3 machines so a decrease of 20 machines = 20/3 = 6.67.
  • As the increase of 10 units is greater than 6.67 units the world is better off.
  • Therefore, since the increase of 50% is greater than the decrease of 33.3%, the world is better off.

(7 marks awarded)
A (ii) Calculate the total output when specialisation takes place (show all your workings).

Sample Answer A (ii)
Country Output
(Production per worker per week)
Machines Cars
Spain 20 units 5 units
Japan 40 units 15 units
Total Output 60 units 20 units
  • Examining the above it is clear that Japan has absolute advantage in the production of both machines and cars.
  • A worker in Spain can produce 20 units of machines and a worker can produce 5 units of cars per year.
  • A worker in Japan can produce 40 units of machines and a worker can produce 15 units of cars per year.
  • This does not mean that Japan should produce both. They will specialise in the production of the product at which they are most efficient and trade for all other requirements.
  • Should they specialise in production of machines or cars?

 

Production of Machines Production of Cars
Spain : Japan Spain : Japan
20 : 40 90 : 70
1:2 1:3
  • From the above ratios, we can see that Japan would be better off specialising in the production of cars (for every 1 unit Spain produces, Japan can produce 3 units). The Japanese worker is three times as good at producing cars as the Spanish worker. Therefore Japan will specialise in car production and cease production of machines – trading for these needs.
  • Spain in turn will cease production of cars and specialise in the production of machines.

 

Total Output after Specialisation
Country Machines Cars
Spain 40 Units 0 Units
Japan 0 Units 30 Units
Total Output 40 Units 30 Units
  • Bear in mind that output/production (before specialisation) is per worker per week.
  • As Japan is specialising in the production of cars, their workers will stop production of machines and instead now produce cars – thereby doubling the weekly output in cars.
  • In conjunction with this, Spain will now stop production of cars and its workers will now switch and concentrate on the production of machines, thereby doubling output per week in machines.

(6 marks awarded)
A (iii) Calculate the total output when specialisation takes place (show all your workings).

Sample Answer A (iii)
1 Workings
  • In Spain, a worker can produce 5 units of cars or 20 units of machines. Therefore, producing one unit of cars requires to same effort as producing (20/5 = 4) 4 units of machines. This means that Spain will not be willing to pay more than 4 units of machines for one unit of cars.
  • In Japan, a worker can produce 15 units of cars or 40 units of machines. Therefore, producing one unit of car requires to same effort as producing (40/15 = 2.67) 2.67 units of machines. This means that Japan will not be willing to pay more than 2.67 units of machines for one unit of cars.
  • In Spain, a worker can produce 20 units of machines or 5 units of cars. Therefore, producing one unit of machine requires the same effort as producing (5/20 = 0.25) 0.25 units of cars. This means that Spain will not be willing to pay more than 0.25 units of cars for one unit of machines.
  • In Japan, a worker can produce 40 units of machines or 15 units of cars. Therefore, producing one unit of machine requires the same effort as producing (15/40 = 0.375) 0.375 units of cars. This means that Japan will not be willing to pay more than 0.375 units of cars for one unit of machines.

 

Note: Remember you are using the data from the question not from specialisation.
Spain - 1 car 5 cars
:
20 machines		 20 / 5 = 4 Therefore 1 car is worth 4 machines
Spain - 1 machine 20 machines
:
5 cars		 5 / 20 = 0.25 Therefore 1 machine is worth 0.25 cars
Japan - 1 car 15 cars
:
40 machines		 40 / 15 = 2.67 Therefore 1 car is worth 2.67 machines
Japan - 1 machine 40 machines
:
15 cars		 15 / 40 = 0.375 Therefore 1 machine is worth 0.375 cars

 

SPAIN
1 car is the equivalent of/equals 4 machines
1 machine is the equivalent of/equals 0.25 of a car
JAPAN
1 car is the equivalent of/equals 2.67 machines
1 machine is the equivalent of/equals 0.375 of a car
  • If Spain produces cars, it will want greater than 4 machines for 1 car.
  • If Japan produces cars, it will want greater than 2.67 machines for 1 car.
  • If Spain produces machines it will want greater than 0.25 of a car for 1 machine.
  • If Japan produces machines, it will want greater than 0.376 of a car for 1 machine.

Possible terms of trade:

  • The price of one unit of car: the terms of trade lie between 4 machines and 2.67 machines.
  • The price of one unit of machines: the terms of trade lie between 0.25 of a car and 0.375 of a car.

(12 marks awarded)

 

Student Activity

Q1. Define the Law of Absolute Advantage.

Q2. Define the Law of Comparative Advantage.

Q3. Define and explain the Terms of Trade.

Q4. State the Law of Absolute Advantage and explain how a country has absolute advantage in the production of a product.

Q5. State the Law of Comparative Advantage and describe four assumptions/limitations of the Law of Comparative Advantage.

Q6. Illustrate the sources of comparative advantage for the Irish economy.

 

Q7 The table below illustrates the Law of Comparative Advantage:
Country Output
(Production per worker per week)
Food Clothing
USA 40 units 10 units
China 80 units 30 units
Total Output 120 units 40 units

(i) Explain how both countries benefit from international trade in the above example.

(ii) Calculate the total output when specialisation takes place (show all your workings).

(iii) Calculate the terms of trade for both commodities (show all your workings).

 
Q8 The table below illustrates the Law of Comparative Advantage:
Country Output
(Production per worker per week)
Pork Grapes
Italy 1200 units 1800 units
Austria 2400 units 7200 units
Total Output 3600 units 9000 units

(iv) Explain how both countries benefit from international trade in the above example.

(v) Calculate the total output when specialisation takes place (show all your workings).

(vi) Calculate the terms of trade for both commodities (show all your workings).

 
Q9 The table below illustrates the Law of Comparative Advantage:
Country Output
(Production per worker per week)
Computers Cars
Ireland 40 units 10 units
United Kingdom 80 units 30 units
Total Output 120 units 40 units

(vii) Explain how both countries benefit from international trade in the above example.

(viii) Calculate the total output when specialisation takes place (show all your workings).

(ix) Calculate the terms of trade for both commodities (show all your workings).

 
Q10 The table below illustrates the Law of Comparative Advantage:
Country Output
(Production per worker per week)
Food Machinery
Argentina 5 tonnes 10 tonnes
Mexico 20 tonnes 30 tonnes
Total Output 25 tonnes 40 tonnes

(x) Explain how both countries benefit from international trade in the above example.

(xi) Calculate the total output when specialisation takes place (show all your workings).

(xii) Calculate the terms of trade for both commodities (show all your workings).