Principle of Absolute Advantage

When a country can produce more of a good with the same amount of
resources than another country it is said to have an Absolute Advantage in
that good.
In other words, given the same amount of resources, a country can produce a
good more cheaply (lower unit cost) > Country should specialise in the good
that they have absolute advantage in and by trading can be better off
Trade between countries could take place and be beneficial to both countries
when each country produces the good in which it is more efficient and trades
for other goods which it needs but does not produce
Assumptions
1. 2 countries
2. 2 goods
3. Same amounts of different resources
4. Resources are divided equally between the 2 goods
5. Resources are at full employment and completely mobile
6. Free trade
7. No transport costs, only production cost
8. Constant returns to scale in production
9. No money is used (Barter Trade)
Principle of Comparative Advantage
When a country can produce a good with a lower opportunity cost in terms
of other goods forgone over another country, it enjoys Comparative
Advantage. i.e. country is relatively more productively efficient than another
Principle of Comparative Advantage states that the trade can benefit all
countries, even if one country has the absolute advantage in all goods as long
as each country specialises in the goods in which they have a comparative
advantage.
Assumptions
1. 2 countries
2. 2 goods
3. Same amounts of different resources
4. Resources are divided equally between the 2 goods
5. Country has an absolute advantage in the production of both goods
6. Resources are at full employment and completely mobile
7. Free trade

8. No transport costs, only production cost

9. Constant returns to scale in production
10. No money is used (Barter Trade)
Using Tables to Illustrate C.A.
Dividing resources equally between air-conditioner and car production,
production levels and both goods are higher in Japan and Korea in absolute
terms
Country
Air conditioners
Cars
(million units)
(million units)
Japan
600
400
South Korea
400
100
Total
1000
500
To identify which country could specialise in a particular product, we need to
analyse the internal opportunity cost for each country
South Korea
400 A/C : 100 C
Thus,
4 A/C : 1 C or 1 A/C : 4 C
Japan
600 A/C : 400 C
Thus,
6 A/C : 4C or 1A/C : 2/3 C or 3/2 A/C : 1 C
Air-conditioners

Cars

(million units)

(million units)

Japan

1 A/C : 2/3 C

1 C : 3/2 A/C

South Korea

1 A/C : 1/4 C

1 C : 4 A/C

Country

Although Japan has the Absolute Advantage in Both these goods; South
Korea has a Comparative Advantage in Air-cons, and Japan has a
Comparative Advantage in Cars.
If both countries completely specialize in the production of the good in which it
has a comparative advantage, after specialization, Japan will have 800 cars
and South Korea 800 air conditioners. Now both countries trade for the good
that it does not produce.
A mutually beneficial rate of exchange is one that leaves both countries
better off from having traded.
Without trade, Japan gets 2/3 for every air conditioner it gives up while South
Korea gets for every air-conditioner it gives up.

Thus, the rate of exchange or terms of trade between air-conditioners and

cars must be between 1 air-conditioner for car (lower limit) and 1 airconditioner for 2/3 car (upper limit)
Assume the exchange rate is 1 air-conditioner for car and Japan exports
200 cars in exchange for 400 air-conditioners. South Korea has 400 airconditioners and 200 cars after trade. Compared with the self-sufficient
situation, Japan has 200 more cars while South Korea has 100 more cars.
Air-conditioners

Cars

(million units)

(million units)

Japan

-200

+200

South Korea

+100

Country

South Korea is definitely better off by 100 cars but Japan has gained 200 cars
at the expense of 200 of air conditioners. The opportunity cost of 1 airconditioners is 2/3 car in Japan i.e. on its own if Japan forgoes 200 airconditioners, it will gain 133 cars. With trade Japan forgoes 299 airconditioners to gain 200 cars. Thus, there is a net gain of 67 cars so
specialization and trade benefits both countries.

Using PPC to Illustrate C.A.

PPC can be used to show the potential gains from trade.

Country A
PPC = AA
CPC = a
Country B

PPC = BB
CPC = b
Slope of the PPC is determined by the Opp Cost.
Slope of the CPC is determined by the exchange-rate
The gentler PPC for country B implies that country B has a comparative
advantage in the production of food and country A has a comparative
advantage in the production of Machines.
A will specialize in Machines and B will specialize in Food.
For both countries to benefit from the trade, the exchange rate must be at a
rate that is steeper than Bs PPC but gentler than As PPC (2 dotted lines).
Since A specializes in machines, it can trade away its machines for food at the
rate denoted by dotted line a while B, specializing in food, can trade away its
food for machines at the same rate denoted by dotted line b
Implies that A and B can consume anyway along their respective lines a
and b
New consumption point > Gain to them
Using Japan- Korea E.g.
Before:
Japan 600 A/C, 400 C (Point A)
After:
Japan 800 C at the rate of 1A/C : C
Gain: 1600 A/C for selling 800 C in exchange
Japan sells 200 cars and get 400 A/C in exchange and is thus at point b.
Thus, the possibilities of Japans preferred point of consumption between the
two goods lie on the new consumption possibility (dotted line)
The consumption possibility line pivots outwards, showing the gains from
specialization and trade

Before:
South Korea 400 A/C, 100 C (Point a)
After:
South Korea 800 A/C at the rate of 1 A/C : C
Gain: 400 C for selling 800 A/C in exchange
South Korea sells 400 A/C and gets 200 C in exchange and is at point b.
Thus, the possibilities of South Koreas preferred point of consumption
between the two goods will lie on the new consumption possibility line (dotted
line)
The consumption possibility line pivots outwards, showing the gains from
specialization and trade

Limitations of comparative advantage

Theory assumes trade is free from restrictions like tariffs and quotas
Tariffs Prices of imported goods pushed higher distort comparative
cost advantage
Cost increase is artificial as it is the result of policy decision and thus
reversible
Ignores transport costs and other trade costs
In reality, high transportation cost between 2 countries may offset a
countrys lower COP Trading partners will find it cheaper to produce
itself despite its high COP
Increase in price unavoidable
Assumes constant opportunity cost ratios as resources are moved
from one industry to another
Assumes resources are perfect substitutes they are equally
productive when being utilized by different industries
Not likely since some resources may be more efficient in one industry
than in others and some may be immobile
Assumes perfect market conditions
In reality
there is a lack of market knowledge of foreign markets and the type of

goods produced
Perfect market conditions do not exist
Result in complete specialization
Countries fear over-specialisation and being totally dependent on
foreign producers for strategic, political and economic situations
Assumes barter trade
Fluctuations in monetary exchange rate between countries could disrupt
trade
Governments could impose restrictions on the purchase of foreign
currency to limit the countrys imports
Monetary cost of good to be traded and thus C.A. could be significantly
affected by these fluctuations
Assumes unchanged comparative advantage
Discovery of new methods of production and raw materials affect the
efficiency of production in countries and hence C.A. Countries may
lose or gain a C.A.

Anti-Trade Policies (Protectionism)

Refers to the protection of human industries from foreign competition by the
imposition of trade barriers on foreign products by the government.
Reasons for protectionism
To protect infant industries
Protectionist measures for an infant industry which has a potential
comparative advantage but is too young or undeveloped to realise this
potential, especially with the trend towards globalisation, in the face of more
established foreign competitors, is necessary.
Infant industries are newly set up industries with growth potential in the long
run. They face high start-up cost at their initial stage of production. Subsidies
which help to lower COP and as a result price can be given to these producer.
This will make them more competitive against the more efficient foreign

producers. Protection can be given until it matures and is able to expand its
output sufficiently to reap economies of scale and establish market share that
is able to compete with the firms
Hence, protectionism is necessary in the short run to produce a level playing
field.
Negative implications/ Evaluation
Local industry may become complacent and produce low quality goods
at high prices with limited variety if protectionism is implemented as a
long term measure.
Thus, the argument stands if only those infant industries with potential
C.A. and growth are protected.
In addition, government protection must be removed once these
industries are able to compete on its own to avoid misallocation of
scarce resources.
Protection against dumping
Dumping takes place when the goods are sold in a foreign market at a price
below cost or below that sold at home market
In view of globalisation, dumping may be undertaken by a foreign government
to drive out local producers of another country. In the short term, consumers
benefit from the low prices of foreign goods but in the longer term, persistent
undercutting of domestic prices will force the domestic industry out of
business and cause widespread unemployment. This will also allow the
foreign firm to establish itself as a monopoly and dominate the overseas
market. Hence, some countries may be unfairly victimised by competing
foreign imports that are dumped in their markets.
E.g. USA has been blaming China for dumping goods in their country by
undervaluing the Yuan.
Thus, protectionism such as tariffs is thus often used to reduce imports and
increase domestic production.

Negative implication/Evaluation
Assuming dumping is a predatory nature, protection via tariffs on
dumped goods can be justified to prevent the long term exploitation of
the consumer and to protect the firms from losing their competitiveness
Foreign producers may be more efficient than local producers. With
protectionism, cheaper foreign goods are reduced in the home market.
Increase in prices and COL.
Smaller variety of goods available in domestic market
Improve Trade Balance and Domestic employment

A country may attempt to use protectionist measures to narrow her gap

through the use of tariffs or quotas
have an effect on restricting imports into the country by making imported
goods more expensive
import expenditure falls
Reduce trade deficit
With improvement in trade balance
AD increase
Increase in Real NY by multiplier effect
With production increase, firms will experience a fall in stocks and inventories
and will start hiring people
More job opportunities
Reduces unemployment
E.g. US
Negative implication/Evaluation
Protectionist measures will undoubtedly harm the trade position of the
countrys trading partners as their export to the country will fall
beggar-thy-neighbour measure
May result in retaliation from affected countries
Hence, if they retaliate with their own set of protectionist measure,
countrys exports will fall and offset any improvement in their trade
deficit
decrease in volume of world trade
impedes recovery and growth if there is worldwide recession
Protect declining industries/ sunset industries
Prevent massive structural unemployment in those industries which employ a
substantial proportion of the workforce
With the trend towards globalization, structural unemployment arise due to:
Faster rate of economic transformation and technology transfers
new machines and methods
make old skills obsolete
Greater flow of cheaper imports which compete directly with domestic
producers
decline in dd for domestic goods
retrenchment of workers as import-substitutes domestic firms lose
their C.A. and shut down
workers face difficulty seeking employment in other industries
Protectionism such as tariffs to reduce imports and increase domestic
production provides a buffer for workers in these sunset industries with the
opportunity to retrain and seek employment in other expanding sectors
They can also make use of protectionism to reorganize and restructure
themselves to compete effectively with foreign rivals again.

Negative implication/Evaluation
Use of tariffs to reduce unN
brings about loss of consumer welfare in terms of high prices and
fewer goods consumed
loss of societal welfare
Delays or slows down restructuring process and prolong the inefficient
use of economys resources
Protect strategic industries to ensure self-efficiency (non-economic)
With increased trade and specialisation, country will be more reliant on
imports
On the grounds of self-sufficiency, especially in times of wars and not to be
dependent on insecure or politically undesirable sources of goods, certain
industries such as transportation equipment, aircraft and food are protected to
ensure sufficient supply when the need arises.
Methods of Protectionism
Tariffs or Import Duties
These act in exactly the same way as a tax by artificially raising the
price of foreign products as they enter the country
The effect is to shift the supply curve leftwards and raise the price of
imports.
Tariffs may be in the form of ad valorem or specific
Used to restrict imports and protect home industries with the aim to
raise the price of imports, making them less competitive than local
products
Most effective when demand for imports is price elastic
Also used as a means of raising tax revenue and they are normally
imposed on goods with price inelastic demand
Figure below illustrates the case of a good that is partly home produced
and partly imported.
Domestic demand DDdom
Supply curves SSdom
Assuming that the country is too small to affect world prices, it is a price taker.
Pw is the world price where the country can buy all it wants and SSworld, the
world supply curve is perfectly price elastic. At price Pw the quantity
demanded is M. Of this, OJ is produced locally and JM is imported

Assuming the government imposes a tariff T

shifts the world supply curve to the country by the amount of the tariff.
effective horizontal world supply curve shifts up to SSworld+tariff
price rises to Pw+T
domestic consumption falls to L
domestic production rises to K
amount imported is reduced to KL

Evaluation
The effect on consumer and surpluses can be seen by comparing area
A,B,C and D
Short term
Tariffs raise price but have little effect on the quantity if demand is
price inelastic
government earns tax revenue (Area C)
consumer surplus falls (Areas A+B+C+D) due to rise in price and
fall in consumption from M to L
Local consumers pay higher price for lower quality domestic
products
fall in consumer sovereignty as they are forced to buy domestic
goods at a higher price
Local producers enjoy an increase in producer surplus (Area A)
due to higher prices paid by consumers
Efficiency discouraged as inefficient local producers can continue to
produce and sell their goods
Society incurs deadweight welfare loss (Areas B+D) due to
misallocation of resources
Long term
Other countries may retaliate by imposing other trade restrictions on

the domestic countrys exports

Domestic employment increases

Import Quotas
Takes the form of a physical limitation on the quantity of a commodity
which is allowed to enter the country in a given year
May be set on the value or volume of imports
Quotas do not bring in revenue to the state unless they are operated by
means of import licences
In the Figure below,
World price of Pw: amount of imports JM.
Assuming the government now imposes a quota of KL on the import of this
product, the quota will have the effect of increasing the domestic supply
(SSdom) by the amount of the quota
Represented by
Rightward shift off the SSdom to SSdom+Quota [restrict world SS to the
amount of quota]
New equilibrium is now Pquota
Amount of imports is reduced to KL (i.e. the quota)
Domestic price (Pquota) is higher than the original pre-quota price of Pw

Evaluation
The effect on consumer and producer surpluses can be seen by comparing
the areas labeled A, B, C & D.
NOTE not all the effects are the same as the tariff.
Short term
Domestic Consumer surplus falls
Domestic Producer surplus increases
Net welfare loss

Long Term
Increase in price resulting from this measure is indefinite. It would
depend largely on the PED for the product
Quotas raise no revenue for the government, unlike tariffs
Quotas are administratively cumbersome. They are costly to the
government when implemented and can easily lead to corruption
Quotas are set on volume over a period of time
penalizes a local importing firm that wishes to expand within that
period of time
result in rigidity in the domestic economy
Quotas are disruptive as additional foreign goods cannot enter the
domestic market
Physical Control/ Ban / Embargo
Most extreme form of quota since it is a complete ban
Can be placed on imports from a particular country
E.g.
Iraq during the gulf war or on imports of certain goods such as weapons and
hard drugs
In Singapore, chewing of gum and its indiscriminate disposal imposes an
external cost on society and hence the government took the decision to ban
the import and sale of chewing gum several years ago
Evaluation
Political and social rather than economic tool
Results in loss of economic gains from trade
In the long run, countries who adopt this measure eventually are
pressured to open their borders to trade.
Foreign exchange control
Importers need foreign currencies to buy goods and services from abroad
American firms will require payments in US $, German firms in Euros
Country obtains its supplies of foreign currencies by means of the effort of
its exporters
A system of exchange control will require the foreign currencies earned by
exporters to be surrendered to the central bank which will pay for them in
the home currency
Importers wanting foreign currency must apply to the central bank which
can thus control the variety and volume of imports by controlling the issue
of foreign currency
Evaluation
Black markets may form for foreign exchange, rendering above
measures ineffective
Results in uncertainty in trade. Regular markets may be closed and
local firms may be unable to purchase goods from certain countries

 Difficult for domestic Central bank to control and monitor all foreign
exchange transactions
Domestic consumers may have to pay more for goods of inferior
quality
Subsidies
Voluntary Export Restraint
An agreement between two countries where the government of the
exporting country agrees to restrict the volume of its exports of a certain
good or service
May do so to prevent tariffs or quotas from being imposed on the products
E.g. Japan has entered into a number of VER with EU members and with
USA in the exports of car
Product Standard Regulations
Imply the use of harsh health and safety standards to limit imports
Complex customs procedures create frontier delays by imposing the need
for laborious and difficult paperwork for goods entering a country
Trade patterns
Refers to the type, volume and direction of goods and services a country
trade.
Determinants of trade patterns (is this important?)
Comparative Advantage
A countrys C.A. is governed by the quantity and quality of its FOPs in
comparison with its trading partners, this manifest in the relative opportunity
COP
Factor Endowments (domestic supply)
If a country i.e. Thailand is not naturally endowed with the resources and
technologies to produce a product like cars
domestic supply will be low
domestic price will be high
Thailand will be a net importer of cars
If Thailand imports capital, technology and processes that help in production
of cars
shift domestic supply curve for cars
make Thailand a net exporter of cars

World Demand
Global demand for i.e. oil rises economy find itself a net exporter of product
E.g. US recently become a net exporter of petroleum products after years of
being net importer
In 2009, domestic price of oil in US is higher US is a net importal of oil
World demand increases
world price increase
domestic SS quantity increase
become net exporter of oil

Other Determinants
Formation of Free Trade Areas
Chapter 15
Tariffs, Quotas, Subsidies
protect domestic industry
altering trade patterns (altering amount of imports)
E.g. trade sanctions imposed on Cuba has resulted in Cubas inability to
import modern cars and the US unable to import Cuban cigars
Exchange rate controls
E.g. China has long been accused of undervaluing the Yuan to gain an

artificial C.A. that results in a persistent trade surplus with the US

Trade patterns in Singapore
Resource endowment:
Well-educated and trained labour force
suitable for knowledge-intensive high-value add manufacturing
Good infrastructure
E.g. Industrial Parks, R&D, communication and transport facilities
Advanced technology
E.g. IT, robotics, automation
Such resources are best suited to produce:
High-end
High-tech
High value-added
Knowledge-based products
Examples of exports
Electronics: disk-drives
Biomedical: Pharmaceuticals
Chemicals: Petrochemicals
Marine: Oil rigs and ship repair
Value-added products
Immediate products such as electronic valves and telecommunication
equipment are imported into SG, reprocessed and are then re-exported but as
value added products for final assembly in countries such as Malaysia and
China
What SG does not have:
Natural resources
shortage of land
no mineral deposits
favourable climate for agricultural activities
Cheap, unskilled labour
In short, our natural resource endowment does not favour nor
support such forms of economic activity
Examples of imports:
Agricultural/ Fresh produce: meat, fruits, eggs, vegetables
Primary commodities: Oil, metals like copper, aluminium and steel
Low end manufactures: cheap slippers footwear