3.1 International trade: Free trade
The benefits of free trade
● Countries are able to specialise in the production of goods and services that they are best at
which means costs tend to be less. For instance, it is cheaper to grow tropical fruits in the
warmer climates and import them than to try to grow them in the UK.
● Consumers can purchase goods that would not be produced within their own country. In
addition, firms can import products with their exact specifications due to the greater choice,
which increases productivity and profitability.
● Operating in international markets means that demand is likely to be higher and therefore
firms can expand their output whilst benefitting from economies of scale. These cost savings
by firms can then be passed onto the consumers as well.
● Due to the increased competition, domestic firms are forced to improve the quality of their
output and so more efficiently allocate resources. For instance, monopoly power tends to
decline
● The transfer of technology and ideas across borders becomes faster. This means that
innovation in one country has benefits for many others as well.
Absolute and comparative advantages (HL)
Absolute advantage: when a country can produce more of a good and service than another country
with the same amount of resources. This is a result of productivity a country may be more efficient at
producing certain goods than others.
As shown in the diagram, country green has the absolute advantage in the production of good Y
because the PPC cuts the axis higher than country grey. Whereas, country grey has the absolute
advantage in the production of good X.
According to the theory of absolute advantage, if a country is absolutely more efficient in the
production of both goods, then there is no reason for it to specialise and engage in trade. This would
be illustrated if the PPCs did not intersect.
, Comparative advantage: when a country can produce a given amount of output at a lower opportunity
cost than another country. Therefore, it gives up less resources than other countries in producing the
concerned good or service.
As shown in the diagram, country green has the absolute advantage in the production of both goods.
However, according to the theory of comparative advantage, trade is still worthwhile because there is
a difference in opportunity cost. Country grey has the comparative advantage in the production of
good X, whereas country green has the comparative advantage in the production of good Y.
Opportunity cost of producing the good on the horizontal = ΔY/ΔX
Comparative advantage is a result of a difference in factor endowments and technology. For instance,
countries differ in the quality and quantity of factor of production, including stock of human, natural
and physical capital. Technology is embodied in physical capital and therefore also has an effect on
the productivity of country and its comparative advantage.
The exchange rate can also have an effect on the comparative advantage because an exchange rate that
is appreciating will make exports less competitive, whereas a depreciating exchange rate will have the
opposite effect.
Assumptions of comparative advantage:
● Constant costs of production as the PPCs are linear – economies of scale and increasing
returns to scale mean that costs tend to depend on output
● Perfect mobility of factors of production within a country – in reality workers are often
geographically and occupationally immobile
● No transaction costs
● Perfect competition in markets
● Free trade without barriers
Strengths and limitations on comparative advantage
● factors of production are assumed to be fixed : factors of production, labour and capital can
and often do move from country to country & changes in quality may occur
The benefits of free trade
● Countries are able to specialise in the production of goods and services that they are best at
which means costs tend to be less. For instance, it is cheaper to grow tropical fruits in the
warmer climates and import them than to try to grow them in the UK.
● Consumers can purchase goods that would not be produced within their own country. In
addition, firms can import products with their exact specifications due to the greater choice,
which increases productivity and profitability.
● Operating in international markets means that demand is likely to be higher and therefore
firms can expand their output whilst benefitting from economies of scale. These cost savings
by firms can then be passed onto the consumers as well.
● Due to the increased competition, domestic firms are forced to improve the quality of their
output and so more efficiently allocate resources. For instance, monopoly power tends to
decline
● The transfer of technology and ideas across borders becomes faster. This means that
innovation in one country has benefits for many others as well.
Absolute and comparative advantages (HL)
Absolute advantage: when a country can produce more of a good and service than another country
with the same amount of resources. This is a result of productivity a country may be more efficient at
producing certain goods than others.
As shown in the diagram, country green has the absolute advantage in the production of good Y
because the PPC cuts the axis higher than country grey. Whereas, country grey has the absolute
advantage in the production of good X.
According to the theory of absolute advantage, if a country is absolutely more efficient in the
production of both goods, then there is no reason for it to specialise and engage in trade. This would
be illustrated if the PPCs did not intersect.
, Comparative advantage: when a country can produce a given amount of output at a lower opportunity
cost than another country. Therefore, it gives up less resources than other countries in producing the
concerned good or service.
As shown in the diagram, country green has the absolute advantage in the production of both goods.
However, according to the theory of comparative advantage, trade is still worthwhile because there is
a difference in opportunity cost. Country grey has the comparative advantage in the production of
good X, whereas country green has the comparative advantage in the production of good Y.
Opportunity cost of producing the good on the horizontal = ΔY/ΔX
Comparative advantage is a result of a difference in factor endowments and technology. For instance,
countries differ in the quality and quantity of factor of production, including stock of human, natural
and physical capital. Technology is embodied in physical capital and therefore also has an effect on
the productivity of country and its comparative advantage.
The exchange rate can also have an effect on the comparative advantage because an exchange rate that
is appreciating will make exports less competitive, whereas a depreciating exchange rate will have the
opposite effect.
Assumptions of comparative advantage:
● Constant costs of production as the PPCs are linear – economies of scale and increasing
returns to scale mean that costs tend to depend on output
● Perfect mobility of factors of production within a country – in reality workers are often
geographically and occupationally immobile
● No transaction costs
● Perfect competition in markets
● Free trade without barriers
Strengths and limitations on comparative advantage
● factors of production are assumed to be fixed : factors of production, labour and capital can
and often do move from country to country & changes in quality may occur
