Specialisation and Trade

Absolute and Comparative Advantage

Absolute advantage: a situation in which a country can produce more of a good with the same resources than another country. This is based on productivity and efficiency.

Comparative advantage: a situation in which a country can produce a good at a lower opportunity cost than another country. This is based on the trade-offs between producing different goods.

The Theory of Comparative Advantage suggests that countries should specialise in producing goods for which they have a comparative advantage, leading to more efficient allocation of resources and increased overall global output.

Illustrating Comparative Advantage with PPFs

Absolute Advantage

In the diagram, Germany has an absolute advantage in both goods because it can produce more computer chips and more T-shirts with the same resources than Vietnam.

If Germany produces both goods, it can produce 10m computer chips and 100mn T-shirts. If Vietnam produces both goods, it can produce 5m computer chips and 75mn T-shirts.

Comparative Advantage

Opportunity cost can be calculated using the output that must be given up to produce more of the other good.

Opportunity cost of 1 computer chip: T-shirts given up divided by computer chips gained.

• Germany: For every 1 computer chip, it gives up 10 T-shirts, so the opportunity cost is 10 T-shirts per computer chip.
• Vietnam: For every 1 computer chip, it gives up 15 T-shirts, so the opportunity cost is 15 T-shirts per computer chip.

Opportunity cost of 1 T-shirt: Computer chips given up divided by T-shirts gained.

• Germany: For every 1 T-shirt, it gives up 0.1 computer chips, so the opportunity cost is 0.1 computer chips per T-shirt.
• Vietnam: For every 1 T-shirt, it gives up 0.07 computer chips, so the opportunity cost is 0.07 computer chips per T-shirt.

According to the theory of comparative advantage, the country with the lower opportunity cost should specialise in that good.

In this case, Germany has a comparative advantage in computer chip production, while Vietnam has a comparative advantage in T-shirt production.

By following the theory of comparative advantage, Germany specialises fully in computer chips (20m) and Vietnam in T-shirts (150mn). They then trade 5m computer chips for 60mn T-shirts:

• Germany ends up with 15m computer chips and 60mn T-shirts. On its own, it could make only 50mn T-shirts alongside 15m computer chips.
• Vietnam ends up with 5m computer chips and 90mn T-shirts. On its own, it could make only 75mn T-shirts alongside 5m computer chips.

Both countries consume beyond their individual PPFs, even though Germany is better at making both goods. Both gain as long as a computer chip trades for between 10 and 15 T-shirts.

Assumptions of the Comparative Advantage Model

• Zero transport costs: does not account for the costs of moving goods between countries
• Perfect knowledge: assumes all agents have full information about prices, technology, and resources
• Factors of production are mobile within countries: assumes that resources can move freely between industries within a country
• Constant returns to scale: assumes that doubling inputs will double outputs
• No trade barriers: assumes there are no tariffs, quotas, or other restrictions on trade

Impacts of Specialisation and Trade

Advantages of Specialisation and Trade

• Increased efficiency: countries can produce goods at a lower opportunity cost, leading to more efficient allocation of resources.
• Higher output: specialisation allows for increased production and global output, benefiting all countries involved in trade.
• Lower prices: increased competition from international trade can lead to lower prices for consumers.
• Greater variety of goods: trade allows countries to access a wider range of products that they may not be able to produce domestically.
• Economic growth: trade can stimulate economic growth by providing access to larger markets and encouraging innovation and investment.

Disadvantages of Specialisation and Trade

• Dependency on other countries: countries may become reliant on imports for essential goods, making them vulnerable to supply chain disruptions.
• Job losses in certain industries: domestic industries may struggle to compete with foreign producers, leading to unemployment in those sectors.
• Income inequality: trade can exacerbate income disparities between skilled and unskilled workers, as well as between countries.
• Environmental concerns: increased production and transportation associated with trade can lead to higher carbon emissions and environmental degradation.
• Exploitation of workers: some countries may have lower labour standards, leading to poor working conditions and exploitation of workers in certain industries.