Why do countries

trade?
The gains
• Lower prices
• Greater choice
• Differences in resources
• Economies of scale
• Increased competition
• More efficient allocation of resources
• Source of foreign exchange
Lower prices
• Imported goods may be cheaper
• They may be cheaper due to cheaper factors of production and/or
access to natural resources
Greater choice
• Swedes can finally have bananas
Differences in resources
• Different countries possess different natural resources
• Many countries require oil (for example), but simply do not have it.
They must import it
• In order to pay for these imports, a country must export goods and
services to acquire the foreign currency with which they can buy the
oil
Economies of scale
• As a firm moves from a national to an international level, its scale and
scope increase
• The level and size of production will increase
• This leads to specialisation, efficiency, expertise etc.
Increased competition
• More products on the market = more competition
• Domestic firms compete with foreign firms
More efficient allocation of resources
• Countries that are best at producing a certain good will produce them

• World’s resources are being used more efficiently

Source of foreign exchange
• International trade enables countries to obtain foreign exchange
• Without exports, it is difficult for a country to obtain foreign currency
• This is especially important for countries that do not have a
convertible currency
• Ghana sells Gold to the Netherlands, obtains euro in order to buy
bratwurst from Germany
• Totally worth it
Comparative advantage theory
• Absolute advantage
• Comparative advantage
Absolute advantage
• A country has an absolute advantage if it can produce a good using fewer
resources than another country
Absolute advantage
• Australia has an absolute advantage in producing lamb
• China has an absolute advantage in producing cloth
• Therefore, Australia should specialise in lamb and China in cloth
• If Australia specialises in lamb, doubles its production and assuming
constant returns to scale, it would produce 12 kilos of lamb, 2 more than
the 10 being produced now
• If China does the same with cloth, it would produce 6 metres, 2 more
than the 4 being produced now
• In total, more goods will be produced and both countries will gain after
trade
Comparative advantage
• Trade is still beneficial even if one country has an absolute advantage
in producing both goods
• The key is opportunity cost
• A country is said to have a comparative advantage if it can produce a
good at a lower opportunity cost than another country
 Example from the book

In order to produce a litre of wine, France has to give up only 4/3 kg of cheese.
Poland, however, has to give up 3 kg of cheese.

Poland has to give up only 1/3 litres of wine in order to produce 1 kg of cheese,
while France has to give up ¾ of a litre.

Therefore, Poland has the comparative advantage in the production of cheese

while France has the comparative advantage in the production of wine. Trade is
beneficial to both.
 Graphical representation (simple PPC)
Opportunity costs are represented by the slope of the lines

Comparative Comparative advantage

advantage for the for the less efficient
better producer is producer is shown where
shown where the the distance is smallest
distance is
greatest
Identical opportunity costs

No need to trade
Example
After specialising in
cheese production

After trade with

France with a 1:1
ratio of cheese to
wine

Assume Poland is
producing at x
 After trade with
Poland with a 1:1
ratio of cheese to
wine

Assume France is
producing at x After specialising in
wine production
Limitations to the theory
The theory of comparative advantage is based on many assumptions:
1. It assumes perfect knowledge. Producers and consumers know
where the cheapest products can be purchased.
2. No transport costs
3. Only two economies producing only two goods. However, with the
help of computer simulations, this is not such a problem anymore
4. Costs do not change, and returns to scale are constant. Increasing
returns to scale may increase the comparative advantage of a
country
Limitations to the theory
5. It is assumed that all goods are identical. However, even brand
names mark a big difference in products
6. Factors of production remain in the country
7. Assumes free trade. Does not take into account tariffs and other
trade barriers
The World Trade Organisation
• Sets the rules for global trade and resolves disputes
• Founded January 1st 1995
• Replaced the General Agreement on Tariffs and Trade (GATT)
• Since 1947, average tariffs for manufactured goods dropped from 40%
to 4%
• The WTO aims to increase international trade by lowering trade
barriers
The Doha Round
• Current round: Doha
• Previous rounds:
• 1st Round: Geneva Round, 1947
• 2nd Round: Annecy Round, 1949
• 3rd Round: Torquay Round, 1950-51
• 4th Round: Geneva Round, 1955-56
• 5th Round: Dillon Round, 1960-61
• 6th Round: Kennedy Round, 1963-67
• 7th Round: Tokyo Round, 1973-79
• 8th Round: Uruguay Round, 1986-94
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