IB Economics/International Economics/Reasons for trade

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Reasons for Trade[edit]


  • Differences in factor endowments: total amount of land, labour, capital, and entrepreneurship a country possesses. Countries have different factor endowments.
  • Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber.
  • Vietnam may produce rice at lower opportunity cost than Japan - thus trade may make producers better off in Vietnam (net welfare increase b/c of increased producer surplus) and consumers better off in Japan (net welfare increase b/c of increased consumer surplus) - trade may make stakeholders in each country better off than w/o trade.
  • Variety and quality of goods: Japan may have a superior quality of finished good technological devices (e.g., televisions or cameras) but may lack many natural resources; hence, it may trade with Indonesia for inputs.
  • Gains from specialization: Countries may gain economies of scale where long run average costs fall (decreasing costs) as output increases (opportunity cost)
  • Political: Countries may wish to forge closer bonds culturally and politically and this can be done through trade.
  • Absolute and comparative advantage (numerical and diagrammatic representations): absolute advantage occurs when a country can produce more of one good than another using the same amount of resources.
  • Efficiency: Domestic firms will be forced to be competitive to continue in the market and thus become more efficient.
  • Differences in demand
  • Increased competition: supposed to lead to lower prices for consumers and greater response to consumer wants/needs.
  • Trade as an 'engine of growth'
  • Non economic advantages (e.g., historical, cultural, political, idealogical, emotional): often used to argue against free trade

Absolute Advantage
For example: (Costs per unit in manpower)


Wheat----------------

England| 10 Portugal|20

It costs 20 units of manpower to produce one unit of wheat in Portugal, while it only costs 10 for England to produce the same unit of wheat. England is said to have an absolute advantage in wheat production.


Comparative advantage is where a country has a lower opportunity cost in the production of a good than another
For example: (costs per unit in man hours)


Wheat-----Wine

England| 15 30 Portugal| 10 15

The opportunity cost of producing 1 more unit of wheat for England is 2 units of Wine. The cost of producing 1 unit of wheat in Portugal is 1.5 units of Wine. Portugal thus has a comparative advantage in the production of wheat because it can produce it at a lower opportunity cost.

  • Opportunity cost: The value of the next best alternative foregone.
  • Limitations of the theory of comparative advantage: There are however limitations, comparative advantage holds numerous simplistic assumptions.
  • There are no transport costs.
  • Costs are constant and there are no economies of scale
  • There are only two economies producing two goods.