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DP IB Economics: HL Your notes

4.1 Benefits of International Trade

Contents
The Advantages of Free Trade
Absolute & Comparative Advantage

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The Advantages of Free Trade

Your notes
The Benefits of International Trade
International trade refers to the exchange of goods and services between countries
International trade involves the exchange of goods/service through exports and imports
International trade is 'free' when there is no government intervention (quotas, taxes etc.) to reduce or
limit trade

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Your notes

The benefits of free trade

Greater choice: with access to a wider variety of goods/services, the standard of living improves
Lower prices: with international competition prices fall giving households the ability to buy more
International cooperation: required for trade helps countries to build better relationships which leads
to lower levels of hostilities

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Flow of new ideas: innovative ideas and technology can be shared between countries
Access to resources: output can increase and costs of production can fall with increased access to Your notes
raw materials
Increased efficiency: international competition allows the most efficient firms to emerge and this
improves the use of global resources
Economic growth: exports are a key component of the gross domestic product of many countries
and an increase in exports can lead to economic growth
Economic development: Increased output leads to lower levels of unemployment which leads to
higher incomes and a higher standard of living
The Benefits of Free Trade When World Price is Above
Domestic Price
The benefits of free trade can be seen for a country where the world price for a good/service is above
the domestic price thus allowing for exports

When the world price (WP) is above the domestic equilibrium price (PE ), a country's firms are able to
export the excess supply
Diagram Analysis
The domestic equilibrium in the market for rice in Vietnam is at PeQe

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The world price of rice is higher at Pw

Vietnamese rice producers are incentivised by the higher prices to produce a higher level of output Your notes
and domestic supply increases from Qe to Qs
Vietnamese consumers now have to pay the world price for rice (Pw) and the domestic demand
contracts from Qe to Qd
The excess domestic supply (Qs- Qd) is now available for export

Worked Example
The Ukraine is one of the world's largest grain producers and due to their comparative advantage,
their domestic price is below the world price.
From the diagram below
a) Calculate the quantity of exports [2]
b) Calculate the export revenue received [2]

Answer:
a) Calculate the quantity of exports
Step 1: Determine Ukraine's excess supply to be exported

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Domestic prices will rise to the world price. At this price the quantity demanded (Qd) is 40,000
kg's and the quantity supplied is 70,000 kg's [1 mark]
The quantity of exports = 70,000 - 40,000 = 30,000 kg's [1 mark] Your notes

b) Calculate the export revenue received

Step 1: Substitute figures into the sales revenue equation

Export sales revenue = price x quantity

Export sales revenue = $ 25 x 30,000 [2 marks]

Export sales revenue = $ 750 ,000

The Benefits of Free Trade When World Price is Below

Domestic Price
The benefits of free trade can be seen for a country where the world price for a good/service is below
the domestic price thus allowing for imports

When the world price (Pw) is below the domestic equilibrium price (Pe), households and firms are
incentivised to increase their imports

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Diagram Analysis
The domestic equilibrium in the market for bananas in Sri Lanka is at PeQe Your notes
The world price of bananas is lower at Pw
Some of Sri Lanka's firms cannot compete with the lower prices and domestic supply contracts from
Qe to Qs
Sri Lanka consumers benefit from the lower world price (Pw) and the domestic demand extends from
Qe to Qd
The excess domestic demand (Qd- Qs) is now met through imports

Worked Example
Sri Lanka consumers enjoy their bananas. Many bananas are grown locally, however their domestic
price is higher than the world price creating an incentive to import bananas. Many bananas are
imported from India.
From the diagram below
a) Calculate the quantity of imports [2]
b) Calculate the import expenditure [2]

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Answers:
Your notes
a) Calculate the quantity of imports
Step 1: Determine Sri Lanka's excess demand to be imported
Domestic prices will fall to the world price of $2.50. At this price the quantity supplied (Qs) is
25,000 kg's and the quantity demanded (Qd) is 73,000 kg's [1 mark]
The quantity of imports = 73,000 - 25,000 = 48,000 kg's [1 mark]

b) Calculate the import expenditure

Step 1: Calculate consumer expenditure on imports

Consumer import expenditure = price x quantity

Consumer import expenditure = $ 2. 50 x 48,000 [2 marks]

Consumer import expenditure = $ 120 ,000

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Absolute & Comparative Advantage

Your notes
Absolute & Comparative Advantage
International trade decreases prices and increases the variety of goods/services available to a nation
This results in a higher standard of living
Comparative advantage is the theory developed by David Ricardo in 1817 which states that a country
should specialise in the goods/services that it can produce at the lowest opportunity cost
By specialising, the volume of production increases
Excess production can be exported
Goods/services which are not produced in the country can be imported
Absolute advantage occurs when a country is able to produce a product using fewer factors of
production than another country
A country may well have absolute advantage but still not have comparative advantage
It should produce goods/services in which it has comparative advantage

The Sources of Comparative Advantage

The sources of comparative advantage can vary from country to country, but some common factors
include

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Your notes

Common sources of comparative advantage

Natural Resources
Countries with abundant natural resources, such as minerals, energy sources, fertile land, or water
bodies, may have a comparative advantage in industries that utilise these resources
E.g. The Ukraine has very fertile farm field and a climate conducive to growing grain

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Labor Force
The quality, skills, and cost of labor can be a significant source of comparative advantage Your notes
Countries with a skilled workforce in specific industries, such as technology, engineering, or
manufacturing, may have a competitive edge in those sectors
Countries with lower labor costs may have a comparative advantage in labor-intensive industries

Technology
Access to advanced technology, innovation, and research capabilities can create a comparative
advantage

Capital and Infrastructure

The availability and quality of capital and infrastructure, such as transportation networks,
communication systems, and reliable utilities, can contribute to a comparative advantage
Well-developed infrastructure facilitates efficient production, distribution, and connectivity,
giving countries an edge in international trade

Economies of Scale
Companies or countries that can achieve economies of scale in production have a comparative
advantage
Spreading fixed costs over a larger output, reduces per-unit costs and allows firms to offer
competitive prices in the global market

Government Policies and Support

Government policies, such as trade agreements, subsidies, tax incentives, and intellectual property
protections, can influence a country's comparative advantage
Strategic government support can help industries develop and compete in the global market

Using PPC to Illustrate the Gains from Trade

Production possibility frontiers can be used to illustrate these concepts and the gains from
international trade

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Your notes

The production possibility frontiers for 2 countries who both produce t-shirts & computer chips
Diagram Analysis
Country A has an absolute advantage as it can produce more of both products
Country A can produce either 200,000 t-shirts or 100,000 computer chips
To produce 100,000 computer chips, it gives up production of 200,000 t-shirts

t− shirts 200 ,000

The opportunity cost of producing 1 computer chip is = = 2 t-
computer chips 100 ,000
shirts

computer chips 100 ,000

The opportunity cost of producing 1 t-shirt is = = 0.5 computer
t− shirts 200 ,000
chip
Country B can produce either 80,000 t-shirts or 80,000 computer chips
To produce 80,000 computer chips it gives up production of 80,000 t-shirts

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t− shirts 80,000
The opportunity cost of producing 1 computer chip is = = 1 t-
computer chips 80,000
shirts Your notes
computer chips 80,000
The opportunity cost of producing 1 t-shirt is = = 1 computer chip
t− shirts 80,000

To produce 1 computer chip Country A gives up 2 t-shirts and Country B gives up 1 t-shirt
Country B has a comparative advantage in producing computer chips as it is giving up fewer t-
shirts and so it should specialise in computer chip production
To produce 1 t-shirt Country A gives up 0.5 computer chips and Country B gives up 1 computer chip
Country A has a comparative advantage in producing t-shirts as it is giving up fewer computer
chips and so it should specialise in t-shirt production

The Gains from Trade

By specialising, the volume of production increases
Excess production can be exported (Country A exports T-shirts and Country B exports computer
chips)
Goods/services which are not produced in the country can be imported (Country A imports computer
chips and Country B imports T-shirts)

Worked Example
Using information from the table below, explain which country should specialise in producing T-
shirts and which country should specialise in producing computer chips [2]

T-Shirts Computer Chips

Country A 200,000 100,000

Country B 80,000 80,000

Answer:
Method A
Step1: Cross Multiply and identify highest output
80,000 x 100,000 = 8,000,000
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200,000 x 80,000 = 16,000,000 [1 mark]

Your notes
Step 2: Using highest output, state who has comparative advantage
Country A should specialise in producing T-shirts (200,000)
Country B should specialise in producing computer chips (80,000)

Worked Example
Using information from the table below, calculate which country should specialise in producing T-
shirts and which country should specialise in producing computer chips [3]

T-Shirts Computer Chips

Country A 200,000 100,000

Country B 80,000 80,000

Answer:
Method B
Step 1: Calculate the opportunity costs for Country A

t− shirts 200 ,000

The opportunity cost of producing 1 computer chip is = = 2 t-
computer chips 100 ,000
shirts

computer chips 100 ,000

The opportunity cost of producing 1 t-shirt is = = 0.5
t− shirts 200 ,000
computer chip

Step 2: Calculate the opportunity costs for Country B

t− shirts 80,000
The opportunity cost of producing 1 computer chip is = = 1 t-
computer chips 80,000
shirts
computer chips 80,000
The opportunity cost of producing 1 t-shirt is = = 1 computer
t− shirts 80,000
chip

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Step 3: State who has comparative advantage in each product

Your notes
Country B has a comparative advantage in producing computer chips as it is giving up fewer t-
shirts (1 as opposed to 2) and so it should specialise in computer chip production
Country A has a comparative advantage in producing t-shirts as it is giving up fewer computer
chips (0.5 as opposed to 1) and so it should specialise in t-shirt production
[2 marks for any correct working and 1 mark for the correct answer]

Limitations to the Theory of Comparative Advantage

Comparative advantage does drives a nation's manufacturing in a global economy, but the theory
has several limitations
The Limitations of Comparative Advantage Theory

Limitation Explanation

Over- Specialisation creates a dependence on other countries which generates

dependence vulnerability e.g. receiving gas supplies from Russia works well when relations
are good but has proven otherwise in an unexpected time of war. There has
been an over-dependence on Russian gas

Environmental The impact of negative externalities of production is not considered by the

Damage theory & these can significantly worsen the quality of life in towns, cities &
countries

Distribution of The GDP/capita is likely to increase, however the distribution of the extra
Income income is likely to be uneven with the wealthier sections of the population
gaining more

Structural Although there should be a net increase in employment, as countries specialise

Unemployment certain industries are likely to shut down resulting in unemployment for some
workers. These workers may not be able to move into other occupations & if so
the number of long-term unemployed will rise

Flawed As with any economic model, there are underlying assumptions to the theory
Assumptions of comparative advantage
1. Transport costs are zero: it does not account for moving the goods/services
between countries. Depending on a nation's location this is more or less of a
problem

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2. There is perfect knowledge: each country knows what it has a comparative

advantage in and also the comparative advantages of other countries - this is
not always true Your notes
3. Factor substitution is easily achieved: economies can quickly adjust to
changing global market conditions by switching from capital to labour - and
vice versa. This is idealistic
4. Constant costs of production: the theory does not take into account the
economies of scale that can be achieved with an increase in output

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