’ 3.1: Why do countries trade?

Definitions

1. World Trade Organization is an international body that sets the rules for global trading
and resolves disputes between its member countries. It also hosts negotiations concerning
the reduction of trade barriers between its member nations.
2. A country has a Comparative Advantage in the production of a good when it is able to
produce a good at lower opportunity cost of resources than another country.
3. A country had an Absolute Advantage in the production of a good when it is able to
produce more output than other countries using the same input of factors of production.

Gains from international trade

1. Lower prices
● Ability to buy goods and services at a lower price than the domestic one.
● Consumers are able to buy less expensive products.
● Producers are able to purchase cheaper raw materials and semi-manufactured goods.
● Prices may be lower in some countries than others because of access to natural resources,
differences in the quality of labor forces, quality of capital and levels of technology.
2. Greater choice
● Enables consumers to have a greater choice of products.
● Not only have access to domestic products, but also foreign products.
3. Differences in resources
● Different countries have more quantities of a certain material than other countries.
● Some resources country may need, but doesn’t have.
● In order to get resources, countries must export products to earn foreign currencies and
buy the resources necessary for them.
4. Economies of scale
● International trade → Increase in market size and demand → Increase in level of
production and size of production units → Increase in efficiency → More competition
→ Reduction in long-run average costs.
● Larger production scale → Enables more specialization.
● Larger production scale → Greater scope of division of labor
5. Increased competition
● International trade → Increased competition → Greater efficiency → Consumers are
offered cheaper goods and services and increase in variety of goods available to them.
6. More efficient allocation of resources
● Without government intervention, countries that specialize in producing certain goods
and services will produce them at lower prices and increase their efficiency.
● If this happens at all countries, then the world’s resources are allocated efficiently when
free trade takes place.
7. Source of foreign exchange
● Enables consumers to obtain foreign currencies.
● Beneficial for developing countries as some of them don’t have convertible currency.

World Trade Organization

● International organization that sets the rules for global trading.

● Resolves disputes between its member countries.
● Aims of the World Trade Organization (WTO) are:
1. Administer WTO trade agreements.
2. Be a forum for trade negotiations.
3. Handle trade disputes among member countries.
4. Monitor national trade policies.
5. Provide technical assistance and training for developing countries.
6. Cooperate with other international organizations.

Absolute Advantage vs. Comparative Advantage

1. Absolute Advantage
● A country has this in the production of a good if it can produce it using fewer resources
than another country.
● Shows which country specializes in what kind of product compared to another country
for the same product.

2. Comparative Advantage
● A country has this in the production of a good if it can produce the good at a lower
opportunity cost than another country.
● Country with the higher opportunity cost should specialize in the product compared to
another country for the same product.
● Factors that gives a country a comparative advantage:
❖ A country that is provided with large amount of land → comparative advantage on
agricultural products.
❖ A country with abundant unskilled labor → comparative advantage on labor-
intensive, low-skilled, manufactured goods.
❖ A country with abundant well-educated labor → comparative advantage on financial
services.
❖ A country with favorable weather and climate → comparative advantage on tourist
services.
● Limitations/Assumptions of comparative advantage theory:
❖ In perfect competition, it’s assumed that the producers and consumers have the perfect
knowledge and are aware of where the least expensive goods may be purchased. In
reality, it’s not true as consumers aren’t aware of where most of the products they
consume are produced.
❖ There’s no transportation costs involved. In reality, this is not true as the transport costs
will reduce a country’s comparative advantage and not making international trading
worthwhile, resulting in eliminating competition..
❖ Only two economics produce two goods. However, this theory can be applied to multiple
countries and multiple products and it is still possible to recognize which country has the
comparative advantage for a product.
❖ Costs don’t change and there’s no economies or diseconomies of scale. However,
economies of scale would increase a country’s comparative advantage as the costs of
production fall heavily as a result of it.
❖ Goods being traded are identical. However, problems arise when the goods being traded
are consumer durables aka products that have a long product life cycle. Therefore, it will
be harder to prove which country has a more comparative advantage on these types of
products as they last longer than others.
❖ Factors of production remain in the country. This is not true as developed countries tend
to invest capital on developing countries to produce goods there. Also, labor workforce
might migrate from low-wage to high-wage countries.
❖ There’s a perfect free trade among countries. However, this isn’t likely as there’s a high
chance that government will intervene and create trade barriers in many industries.
Paper 3 Question

Using the same quantities of resources, to produce rice and cloth, China and Pakistan have the
following production outcomes:

Country Kilos of rice Opportunity cost Meters of cloth Opportunity cost

of 1 kilo of rice of 1 metre of cloth

China 5 4 meters of cloth 4 5 kilo of rice

5 4

Pakistan 3 1 meter of cloth 3 1 kilo of rice

1. Calculate the opportunity costs for the table.

2. Draw a diagram to illustrate the information in the table.

Rice (kilos) 3
Ch
in

Pa
a

2 kis
tan
1

1 2 3 4
Cloth (meters)