Traditional Trade Theories: Specialisation as Explanation of Inter-Industry Trade

The Economy: 1.8, 18.5, 18.6, 18.7;

(1) Choose five of your favourite consumer goods. Are they produced in the
country where you bought them? What determines their location of
production?
Raw materials, Technology advancement, Climate, Geographical location etc.
(2) With reference to a standard example, explain the concept of comparative advantage
and apply the concept of opportunity costs to the theory.
Production if 100% of time is spent on one good
Greta 1,250 apples or 50 tonnes of wheat
Carlos 1,000 apples or 20 tonnes of wheat
 Economists distinguish who is better at producing what in two ways: absolute advantage
and comparative advantage.
 Greta has an absolute advantage in both crops. Carlos has an absolute disadvantage. She
can produce more of either crop than he can.
 Although Carlos’ land is worse for producing both crops, his disadvantage is less, relative
to Greta, in apples than in wheat. Greta can produce two and a half times more wheat as
he can but only 25% more apples.
 Greta has a comparative advantage (lower opportunity cost) in wheat; Carlos has a
comparative advantage (lower opportunity cost) in apples. Although she is better, Carlos
is least disadvantaged in producing apples.

According to the theory of comparative advantage, it makes sense for a

country to specialize in the production of those goods that it produces most efficiently and
to buy the goods that it produces less efficiently from other countries, even if this means
buying goods from other countries that it could produce more efficiently itself.
A country has a comparative advantage when it is able to produce goods by using fewer
resources, at a lower opportunity cost (with smallest potential benefit which was lost).
(3) With reference to a standard example, explain how specialisation on
products with comparative advantage increases world real income.

Greta has an absolute advantage in both crops. Although Carlos’ land is worse overall for
producing both crops, his disadvantage is less, relative to Greta, in apples than in wheat.
In the absence of trade, under self-sufficiency, both consume exactly what they produce.

An island has a comparative advantage in producing a good when it is relatively cheaper in

their economy (in the absence of trade). When Greta and Carlos are able to trade, under
complete specialization, Greta produces only wheat; Carlos produces only apples; and they
trade the surplus of their production above what they consume.

We can see that when the economies are closed, total production between the two
countries is 2,500 + 6,000 = 8,500 tonnes of wheat and 3,750 + 5,000 = 8,750 apples. When
countries fully specialize however, Greta is able to produce 10,000 tonnes of wheat and
Carlos can produce 10,000 apples, so there is more of both goods overall. As long as they
can trade, they can both consume more of each good and can, ideally, both be better off.
 Consumption after specialization and trade
Carlos specializes in apples, producing 10,000, and exports (10,000 – 6,000 = 4,000) apples
to Greta, who specializes in wheat, producing 10,000 tonnes and exports (10,000 – 8,000 =
2,000) tonnes of wheat to Carlos.
We can see that specialization and international trade have led to an increase in the size of
the feasible consumption set for both countries.

(4) Critically discuss the impact of trade on income distribution according to

traditional trade theories relating to factor endowments.
A factor endowment represents how many resources a country has at its disposal to be
utilized for manufacturing - resources such as labor, land, money, and entrepreneurship.
Countries with large or diverse factor endowments are typically more wealthy and able to
produce more goods than countries with small factor endowments. Factor endowments
also affect the opportunity cost of specializing in producing certain goods relative to others.

To think about winners and losers from trade, we begin with a model of two stylized
countries, which we call the US and China, where specialization is based on factor
endowments. 
We assume that aircraft production is capital-intensive and that capital is relatively
abundant in the US. In contrast, China has a comparative advantage in consumer electronics
production, which is more labour-intensive and China has an abundance of labour relative
to capital. When the economies begin to trade with one another, the US will specialize in
the production of aircraft, whereas China will specialize in the production of consumer
electronics.
In the example of the US and China, after trade the US specializes in producing aircraft and
China specializes in consumer electronics. Trade and specialization mean that resources shift
from one industry to another. Workers previously employed in electronics in the US must
try to find work in the expanding aircraft manufacturing businesses. Similarly, in China,
employment will expand in consumer electronics production. In the short run at least, those
workers employed in the industry that their nation does not specialize in will lose out.
 The winners in the US: The owners of capital benefit more from trade than workers,
because capital becomes relatively scarce as production of aircraft rises. Since the
 wealthy tend to hold proportionally more of their wealth in capital than the poor, we
would predict a rise in inequality.
 The winners in China: Workers are in higher demand as consumer electronics
production expands. Wages rise as firms compete for workers. Workers benefit more
from trade than the owners of capital, hence we would expect inequality to fall.
In this case, US workers are losing out, and US employers are winning. Workers are working
for lower wages, and profits rise. The effect of imports of labour-intensive electronics and
the shift in US production to less labour-demanding goods (aircraft) is that employers
capture most of the gains from trade. As consumers of electronics, both employers and
workers benefit. This is an example of a general principle about who benefits from
international trade: The owners of relatively scarce factors of production in their own
country prior to trade (US labour in our example) lose from specialization and trade, and the
owners of relatively abundant factors (owners of capital in the US) gain.
The reasoning behind this principle is as follows:
 Factors that are relatively scarce in their own countries, compared with in the rest of
the world, are relatively expensive compared to prices elsewhere when there is no trade.
When their economies start trading with the rest of the world their price is dragged down
towards the world average, because they are effectively competing with their abundant
counterparts in the rest of the world.
 The same reasoning applies in reverse to factors that are relatively abundant in their
own countries relative to the rest of the world.
So, in the US in this example, workers are initially relatively scarce and lose from trade,
while employers gain; in China workers are initially relatively abundant and gain from trade,
while employers lose. The key to understanding this is to focus on the change in relative
scarcity once labour and capital embodied in traded goods and services can flow across
borders.

(5) Discuss whether the traditional concept of comparative advantage can still explain
trade patterns in real world.

Having a comparative advantage in X, Country A sacrifices less of Y than Country B. In

terms of two countries producing two goods, different PPF gradients mean different opportunity
costs ratios, and hence specialisation and trade will increase world output.
If you do everything better than anyone else, should you be self-sufficient and do everything
yourself? Self-sufficiency is one possibility, but it turns out you can do better and make others better
off in the process. By instead concentrating on the things you do the “most best” and exchanging or
trading any excess of those things with someone else for the things that person does the “most
best,” you can both be better off. Comparative advantage fleshes out what is meant by “most best.”
It is one of the key principles of economics and determine trade patterns.
Comparative advantage is a powerful tool for understanding how we choose jobs in which to
specialize, as well as which goods a whole country produces for export.

When there are costs of trade, such as transport or other costs, the pattern of trade may not be well
described by the usual measures of comparative advantage, which simply compare a country’s costs
or autarky prices to those of the world. Instead, a better comparison takes into account the costs of
trade.

(6) Compare the benefits and costs of specialisation in the trade with China for Germany
and the US.

Production specialization according to comparative advantage, not absolute advantage, results in

exchange opportunities that lead to consumption opportunities beyond the PPC. Trade between two
agents or countries allows the countries to enjoy a higher total output and level of consumption
than what would have been possible domestically.

Canada and Mexico can each specialize in the good they have a comparative advantage in and
exchange with one another. This lets both countries enjoy more maple syrup and avocados than
they could have enjoyed without trade. Mexico will export avocados and import maple syrup; this
way Mexicans can enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!
Comparative advantage and opportunity costs determine the terms of trade for exchange under
which mutually beneficial trade can occur.
In order for Canadians to benefit from trade with Mexico, they must be able to import avocados at a
lower opportunity cost than it would cost them to grow domestically. Likewise, Mexico must get
maple syrup more cheaply (in terms of avocados given up) than it could have produced it for
domestically. The terms of trade refer to the trading price agreed upon by two agents, which when
beneficial, will allow both countries to enjoy gains from trade.

Germany-China. Goods worth 205.7 billion euros (232.1 billion U.S. dollars) were traded between
China and Germany in 2019.
"One of the decisive advantages of trade is that specialization effects can be utilized," Christian
Rusche, economist at the German Economic Institute (IW) told Xinhua on Friday. "When states
produce what they do best and then trade it, both the quantity and quality of the goods produced
can be increased."
Germany mainly exported machinery, car and car parts as well as chemical products to China. On
the other hand, China exported mainly electronic goods such as smartphones, network equipment
and textiles to Germany.
"Both countries have benefited from each other, as the economic development of recent years has
shown," Rusche added.
According to Destatis, goods worth 109.7 billion euros were imported from China in 2019, an
increase of 3.4 percent compared to the previous year.

USA-China. International trade allows nations to specialize along the lines of comparative
advantage. The U.S. enjoys comparative advantage in products ranging from civilian aircraft to
agricultural commodities like soybeans. Producers of these goods seek markets abroad through the
reduction of trade barriers. On the other hand, sectors where the U.S. does not have a comparative
advantage (e.g., iron and steel) benefit from greater trade barriers because of reduced foreign
competition.
Unfortunately, protecting industries that do not have comparative advantage (i.e., import-competing
industries) is not costless for exporting industries. There are several channels through which a
nation’s import protection can affect its exports—we discuss three important ones next.
First, as a nation devotes more resources to import-competing industries, it has fewer resources left
to use in its export industries. In the long run, production in exporting industries must fall, and this,
in turn, will reduce exports. In other words, import protection has the unfortunate effect of export
reduction.
A second, more direct channel is retaliatory tariffs imposed by foreign nations. For example, when
U.S. imposes tariffs on Chinese steel imports and China retaliates by imposing tariffs on U.S.
soybeans, U.S. soybean exports are hurt.
Third, tariffs raise the prices of imported inputs that U.S. exporting firms need to make export goods,
which renders U.S. exports less competitive.
While imports have led to job losses in the U.S. manufacturing sector, exports have boosted other
sectors. The sectors that export the most to China, however, stand to suffer directly from the
escalating Sino-American trade tensions. In addition, higher tariffs will escalate the cost of Chinese
intermediate inputs that U.S. firms use in their global supply chains, which can also hurt U.S. exports
to other nations.
Next, we look at the top four merchandise-exporting sectors to China (in terms of 2017 exports in
dollars) between 1991 and 2017. Last year is the most recent year for available data, while 1991
precedes China’s entry into the World Trade Organization (WTO) exactly by a decade. Therefore, our
start date provides a useful benchmark to follow U.S.-China exports before its entry into the WTO
and since that time.

(7) Explain what is meant by the “Resource Curse”

The resource curse is a term used to describe a paradoxical situation in which a country
underperforms economically, despite being home to valuable natural resources. The resource curse
may also be called the resource trap or the paradox of plenty.
There are many potential explanations for this phenomenon, but, generally speaking, it is thought to
be caused by too much of the country’s capital and labor force being concentrated in just a few
resource-dependent industries. By failing to make adequate investments in other sectors, countries
can become vulnerable to declines in commodity prices, leading to long-run economic
underperformance.