Specialisation and Trade

All countries in the world trade with others. An open economy is one that trades freely with other countries, without any barriers. A closed economy is completely self-sufficient and does not trade at all with other countries. In practice, no country has a completely open or closed economy, although Cuba and North Korea have very restricted trade with the rest of the world. Countries like the U.K and the U.S.A. which think of themselves as open economies nonetheless have tariffs and other barriers to trade on many of their imports, and may also place restrictions on their exports. These occur for both economic and political reasons.

The Theory of Comparative Advantage

This theory was developed by David Ricardo in the 19th century, and still underpins the economic argument in favour of free trade (the absence of tariffs or other trade barriers) between countries. It argues that countries will benefit by concentrating on producing some goods rather than being self-sufficient provided there are differences between countries in the relative costs of producing the goods. The theory can be explained by making a number of simplifying assumptions:

There are only two countries (call them A and B)
Only two goods are produced (say wheat and tractors)
There are no transport costs in moving goods
Factors of production (land, labour, capital) are perfecly mobile between wheat and tractor production
Both countries have equal quantities of factors of production, but -
Country A has a more skilled labour force (suited to manufacturing) and country B has a gentle climate (suited to growing wheat)

Let us further assume that the maximum outputs for each country (if they produce exlusively wheat or tractors are as follows:

	Country A	Country B
Wheat	1000 tons	500 tons
Tractors	200	300

If each country was self-sufficient and divided its resources equally between the two goods, country A would produce 500 tons of wheat and 100 tractors. Country B would produce 250 tons of wheat and 150 tractors. Total output of wheat and tractors would be respectively 750 tons and 250.

This is clearly a worse outcome compared to what would happen if each country specialised in the good it is best at producing. Country A could produce 1000 tons of wheat and country B 300 tractors. World output would increase by 250 tons of wheat and 50 tractors. Both countries will benefit if A exports some of its wheat in exchange for tractors, and B exports some of its tractors in exchange for wheat.

In this case each country has an absolute advantage in the production of one of the goods: with the same quantity of resources, country A can produce more wheat than country B, and vice versa for tractors. This means that in country A the cost of producing a ton of wheat is lower than in country B, since it can be produced using less resources. Similarly, country B has a cost advantage in tractors.

Now let’s consider the situation where one country (A) has an absolute advantage in the production of both goods, as shown in the schedule below:

	Country A	Country B
Wheat	1000 tons	500 tons
Tractors	300	200

If each country divides its resources equally between wheat and tractor production, the total output will be 750 tons of wheat and 250 tractors (as before).

This time the advantages of specialisation are less clear. Country A is more efficient at producing both goods, so which should it concentrate on?

The answer can be found by considering the opportunity cost in each country of producing wheat and tractors.

In country A the opportunity cost of 1 tractor is 3.33 tons of wheat.

In country B the opportunity cost of 1 tractor is 2.5 tons of wheat

This means that country B has a comparative advantage (ie lower opportunity cost) of producing tractors.

In country A the opportunity cost of 1 ton of wheat is 0.3 of a tractor

In country B the opportunity cost of 1 ton of wheat is 0.4 of a tractor

Therefore country A has a comparative advantage in producing wheat.

If country A specialises in wheat, and B in tractors, the combined total output will now be 1000 tons of wheat and 200 tractors. There is a gain in wheat production of 250 tons (33% more) but a loss in tractor output of 50 (20% less). Can both countries still benefit by trading?

The answer is ‘yes’, provided that each country can import the good in question at a price which is below the domestic opportunity cost.

Country A will be better off importing tractors provided it gives less than 3.33 tons of wheat per tractor in exchange.

Country B will be better off importing wheat provided it gives less than 0.4 of a tractor per ton of wheat (in other words it will want at least 2.5 tons of wheat for a tractor).

To benefit both countries, the rate of exchange should be between 1 to 2.5 and 1 to 3.33.

This rate of exchange of a country’s exports for its imports is called the terms of trade (see notes on 4.1.4 for a full discussion).

The benefits of trade are not necessarily equally shared. The closer the rate of exchange is to 3.33 tons of wheat per tractor, the more country B benefits from trade, and the closer it is to 2.5 tons per tractor, the more country A benefits.

The gain to a country from trade is shown in Fig 1 below:

Fig 1 shows how country A can benefit from trade. The line AB represents the country’s production possibility frontier (PPF), where it can produce a maximum of 1000 tons of wheat or 300 tractors, or some combination of both. Its domestic opportunity cost of producing a tractor is 3.33 tons of wheat. Without any trade, its PPF is also its consumption possibility frontier (CPF). The CPF shows the possible combinations of wheat and tractors it can consume.

If it can import tractors from country B at a price of 2.75 tons of wheat per tractor, the CPF shifts to AC, as the opportunity cost of a tractor has fallen. The green shaded area therefore represents the gain from trade. The country can now consume more of both goods than without trade.

Note that if the price of a tractor was 3.33 tons of wheat or more, there would be no benefit to the country from trade.

Limitations to the Theory of Comparative Advantage

Transport costs – For goods that are of low value and expensive to transport, such as bricks, it is likely that the transport costs may more than offset the lower opportunity cost of importing.

Externalities – Transporting goods across the globe is a major source of pollution and global warming. This is particularly true of air freight. These external costs reduce the gains from trade to the world economy.

Immobility of factors of production – In our example, country A may find it difficult to shift resources from tractor to wheat production, therefore making it difficult to specialise in wheat, where it has a comparative advantage. Importing tractors might then simply result in structural unemployment amongst workers in tractor manufacturing. It might be better off making its own tractors instead.

Goods are not homogeneous – The theory assumes that all goods are of the same quality and specification and therefore cost (and price to the importing country) is the only consideration. This may partly true for commodities like rice or coal, but certainly not for manufactured goods. Design, brand image and quality are very important considerations too. This is why high cost countries like Germany can still be very competitive in motor car manufacturing.

Demand for a good cannot be met by a single country – In our example, country A may not have sufficient resources (eg land) to grow enough wheat to satisfy the demand for both countries. Country B will therefore have to grow some too.

Political factors – Most countries will restrict trading relationships for political or national security reasons. For instance, it may not be considered a good idea to rely on a potential enemy for the supply of an essential commodity like oil or food, regardless of the relative cost. Security of energy and food supplies are one of the highest priorities for a government.

Advantages and Disadvantages of Trade and Specialisation

Advantages:

Choice and competition – Free trade means buyers hav access to a much wider choice of goods. This increases competition and therefore enourages producers to improve quality, reduce costs and innovate to remain competitive.

Economies of scale – Trade and specialisation result in the growth of fewer, bigger producers.

Higher global GDP – If countries concentrate on the production of goods where they have comparative advantage, global output will be higher, resulting in increased living standards.

Disadvantages:

__Risk of structural unemployment __– As discussed earlier in this section, unrestricted imports may result in unemployment if resources (especially labour) cannot easily be transferred to other industries. South Wales and the North East of England still have high unemployment resulting from the decline of steel and shipbuilding as compaarive advantage has shifted to emerging economies in Asia.

Increased inequality – As discussed in 4.1.1, globalisation and increased world trade have increased inequality within countries. Unskilled workers in rich countries now face competition from lower paid workers in emerging economies, widening the gap between high and low paid workers.

Also, the benefits of trade are not equally shared between countries. Rich countries extract a lot of the added value from primary products by turning them into manufactured goods, which can be sold at much higher prices. For instance, the price paid to growers for coffee beans is a small fraction of the price the multinational food company receives for packaged and branded roasted beans or instant coffee. Primary producing countries therefore receive a small share of the gains from trade.

Risks – As discussed above, specialisation creates dependence on other countries, who may cut of supplies if there is conflict.

There are economic as well as political risks. Trade exposes a country to risks from economic events over which it has no control; for instance Germany suffered a very severe recession after the 2007/8 global financial crisis because its exports (especially of cars) fell sharply.

Specialisation can also create overdependence on a narrow range of goods. This is particularly a problem for primary producers, as commodity prices tend to fluctuate much more than prices of services or manufactured goods. This results in unpredictable incomes for the countries concerned. Venezuala, for instance has been badly afected by a collapse in oil prices.

__Environmental costs __– See notes above on ‘externalities’

Loss of sovereignty – International trade creates interdependence between countries and therefore a loss of some control over the nation’s economy. As discussed in 4.1.1, the power of multinational companies has tended to increase at the expense of national governments. International trade is also governed by a rules based system (the WTO) and economic blocs such as the EU. This reduces the ability of individual countries to make their own decisions (see notes on 4.1.5).

Cultural domination – Some critics of growing world trade argue that it creates a growing domination of western culture in the developing world, with western goods, lifestyles and values marginalising traditional cultures.

Explain the difference between absolute advantage and comparative advantage. Why might it still be in a country's interests to trade with another country when it has an absolute advantage in all goods?: Your answer should include: opportunity cost / production possibility frontier / consumption possibility frontier / terms of trade