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Plan Number:
A-Level 12
Date
Topic:
International Trade
Essay Title:
What are the economic arguments for encouraging free trade between countries?
Explain why comparative advantage is likely to change over time
Free Trade occurs when goods and services are traded between countries without the use of import
controls. For most of the late twentieth century, the prevailing wisdom has been that free trade can lead to
improvements in economic welfare in the global economy. However this has not prevented regular trade
disputes between countries - often when one country feels that unfair trade practices have caused the
benefits from trade to become distorted.
In this half of the essay - the main arguments for free trade should be clearly established and an example of
the potential welfare gains from trade following specialisation should be developed using a model of
comparative advantage between two or more countries.
The case for free international trade
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Trade can lead to an improvement in overall economic welfare if countries specialize in the
products in which they have a production advantage.
Trade allows businesses to exploit economies of scale by operating in international markets.
International competition stimulates higher efficiency and reduces monopoly power
Trade enhances consumer choice and international competition between suppliers helps to
keep prices down
Trade in ideas stimulates product and process innovations that generates better products for
consumers and enhances the overall standard of living.
Comparative advantage exists when a country has a margin of superiority in the production of a good
or service i.e. where the opportunity cost of production is lower. Countries will specialise in and export
those products that use intensively the factors of production which they are most endowed. If each country
specialises in those goods and services where they have an advantage, then total output and economic
welfare can be increased (under certain assumptions).
Consider two countries producing two goods - CDs players and personal computers. With the same factor
resources evenly allocated by each country to the production of both goods, the production possibilities
are as shown in the table below. Each country devotes half its available factor resources to both products.
Comparative advantage
United Kingdom
Japan
Combined output
Mobile Phones
4000
6000
10000
CD Players
1000
3000
4000
The comparative advantage in mobile phones lies with the UK and for CD Players, Japan has the
comparative advantage. If the UK devotes all the available resources to mobile phones (assuming constant
returns to scale) and Japan specialises in the production of CD players - the total output of both goods rises.
Specialisation
United Kingdom
Japan
Combined output
Mobile Phones
8000
3000
11000
CD Players
0
4500
4500
For trade to benefit both countries, an acceptable terms of trade has to be agreed. If Japan exports 1 CD
player for every 3 mobile phones from the UK, the trade flows would look as follows:
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Specialisation and Trade
United Kingdom
Japan
Combined output
Mobile Phones
4700
6300
11000
CD Players
1100
3400
4500
Both countries have ended up with an increased quantity of both goods. There are clearly potential welfare
gains for the consumers.
The theory of the gains from trade arising from comparative advantage is based on a number of underlying
assumptions. These should be mentioned somewhere in the answer
v
v
v
v
Perfect occupational mobility of factors of production (e.g. labour and capital)
Constant returns to scale (i.e. doubling the input leads to a doubling of output)
No externalities arising from production and/or consumption
Ignores transportation costs
If businesses exploit increasing returns to scale when they specialise, the potential gains from trade are
much greater. Equally there may be decreasing returns to specialisation beyond a certain point.
Explain why comparative advantage is likely to change over time
Comparative advantage is a dynamic concept and must be expected to change. For example comparative
advantage in the production of lower valued added textiles has shifted away from Western European
producers to Asian economies where unit labour costs are lower. As industries evolve and develop, so
different countries and producers start to exploit economies of scale and other advantages in the
production of goods and services.
Some of the factors that cause changes in comparative advantage are:
1. Fluctuations in the exchange rate: A significant appreciation of the exchange rate (e.g. for Britain)
means that British exports become relatively more expensive in foreign markets (making them less
competitive). A higher exchange rate causes an increase in relative unit labour costs. A
depreciation (or devaluation) of the exchange rate gives a competitive boost to exporting firms and
makes imports into the economy appear more expensive to consumers.
2. The quantity and quality of factors of production available - this affects the size and efficiency of
the available labour force and the productivity of the existing stock of capital inputs. Productivity
growth is the key to long run economic growth because more output can be produced from inputs.
3. Investment in research & development - important in industries where patents give some firms
significant market advantage and where the emergence of new products can help to sustain an
existing comparative advantage in international markets.
4. Long-term rates of inflation compared to other countries. If country A has an inflation rate
persistently above that of other countries, the relative price of their products goes up and
producers loss competitiveness in foreign markets
5. Import controls such as tariffs and quotas that can be used to create an artificial comparative
advantage for a country's domestic producers
6.
Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales
support). These non-price factors can be vital in industries where prices among competing
suppliers are very close to each other but where consumer demand is heavily influenced by the
quality and reliability of the good or service.
Geoff Riley
January 2, 2000
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