SPECIALISATION AND TRADE

Absolute and Comparative Advantage:

A country has absolute advantage in the production of a good or service if it can
produce it using fewer resources and at a lower cost than another country
Comparative advantage occurs when a country can produce a good or service at a
lower opportunity cost than another country
OUTPUT:
TEXTILES
BOOKS
INDIA
2
3
UK
1
4
TOTAL
3
7
For UK to produce 1 textile, has to foregone 4 books
For India to produce 1 textile, has to foregone 1.5 books
India has a comparative advantage in producing textiles
as it has lower opportunity cost

If UK produces a book, opportunity cost is (0.25)

If India produces a book, opportunity cost is 2/3 (0.66)

UK has a comparative advantage in producing books as

it has lower opportunity cost
OUTPUT AFTER SPECIALISATION:
TEXTILES
BOOKS
INDIA
4
0
UK
0
8
TOTAL
4
8
After specialization, output doubles
ASSUMPTIONS AND LIMITATIONS TO THE THEORY OF COMPARATIVE
ADVANTAGE

Assumes a perfectly competitive market. In reality, this is likely to be different, which

results in full benefit of specialization not happening
Specialising fully could lead to structural unemployment, since workers might not gain the
transferable skills they need to change between sectors, or they are simply unable to
change
Comparative advantage doesnt consider the exchange rate when considering the cost of
production for both countries (if the price of one good increases, it is more worthwhile
producing that good, even if the country has a comparative advantage in the other good)
Comparative advantage is derived from a simple model with two countries, but the global
trade market is significantly more complex than this
Countries do not produce a handful of goods and services, like the theory suggests.
Rather, a wide variety of goods and services are produced, and there is very little
specialization. This is helped by advancement of technology.

ADVANTAGES AND DISADVANTAGES OF SPECIALISATION AND TRADE

Advantages:
Greater world output, so there is a gain economic welfare
There could be potentially be higher quality of G&S, since production is focused on what
people and businesses are best at
A greater variety of goods and services could be produced
Lower average costs, since the market becomes more competitive
There is an increased supply of goods to choose from
Outward shift of PPF curve
Higher opportunities of Economies of Scale
Disadvantages:
Less developed countries might use up their non-renewable resources too quickly, so they
might run out
Countries could become over-dependent on the export of one commodity such as wheat. If
there are poor weather conditions, or the price falls, then the economy would suffer a
downturn
There could be more structural unemployment, since production moves abroad
Some countries might become stuck in the production of only one G or S, so they cannot
develop further.
FACTORS INFLUENCING PATTERN OF TRADE
COMPARATIVE
ADVANTAGE

IMPACT OF
EMERGING
ECONOMIES
GROWTH OF
TRADING BLOCS
& BILATERAL
TRADING
AGREEMENTS

CHANGES IN
RELATIVE
EXCHANGE RATE

- Growth in exports of manufactured

from developing countries to developed
countries. This is because developing
countries gained advantage in
production of manufactured goods, due
to lower labour costs
- Collapse of communism means more
countries involve in world trade

Wage competitiveness has

fallen. This is due to the rise of
mid class in China, who
demand higher wages and
consume more

- With more trading blocs, trade is

created between members
-Trade creation (high cost to low cost)
- Trade diversion (low cost to high
cost)

- Policies of developed
countries limits the ability of
developing countries to export
primary commodities (EU
Common Agricultural Policy
means domestic farmers
receive subsidies to encourage
production and lower costs.
This increases incomes and
protects the industry, but
farmers on other countries find
it hard to compete, therefore
they are not able to access the
market in developed countries)
Limits their participation in
trade

- China has been running a trade

surplus with US. Since 2006, US trade
deficit has narrowed with China, and

China has reduced their trade surplus

too.
- China has planned this change from
export-led growth to growth fueled by
domestic consumption.
-When running the trade surplus, China
had kept their currencys value low, in
order to make exports cheap

TRADING BLOCS AND WORLD TRADE ORGANIZATION (WTO)

TYPES OF TRADING BLOCS:

FREE TRADE AREA

CUSTOMS UNION

COMMON MARKET

MONETARY UNIONS (currency union)

- Countries agree to trade goods with

other members without protectionist
barriers
- Allow members to exploit their
comparative advantage, which increases
efficiency
- Common trade policy with the rest of the
world
(they might use a common external tariff)
- Free trade among members
- Free trade in goods and services, a
common external tariff and allows free
movement of capital and labour across
borders
-

Share the same currency.

Most economically integrated
A common central monetary policy
Same interest rates

COSTS AND BENEFITS OF REGIONAL TRADE AGREEMENTS:

1. Trade creation and Trade diversion
Trade creation (high cost to low cost)
Trade diversion (low cost to high cost)
- Usually, countries stop importing from a cheaper producer outside the bloc to a more expensive
one inside the bloc.
- Moreover, protectionist barriers are often imposed on countries who are not members, so trade
is diverted from producers outside the bloc to producers within the bloc (UK trades mainly within
the EU, at the expense of former trade links in the Commonwealth)
2. Reduced transaction costs

- No barriers to trade or no border controls, so it is cheaper and simpler to trade

3. Economies of scale
- Firms can take advantage of a larger potential market in which to trade (EU has 500 million
people to sell to)
- By specializing, firms and countries can exploit their comparative advantage, gains of efficiency
and advanced tech can be reaped
4. Enhanced competition
- Firms operate in a more competitive market, they become more efficient and better allocation
of resources
5. Migration
- Being a member of Customs Union, supply of labour increased -> helps fill labour shortages
(countries might lose their best workers)
ROLE OF WTO IN TRADE LIBERALISATION:
- Promotes world trade through reducing trade barriers and policing existing agreements
- Settles trade disputes, by acting as the judge, and organizes trade negotiations
POSSIBLE CONFLICTS BETWEEN REGIONAL TRADE AGREEMENTS AND WTO:
- Rise in protectionism : A common external tariff contradicts the WTOs principles, since
although there is free trade
between members, protectionist barriers are imposed on those
who are not members
- WTO is argues to be too powerful, or that it ignores the problems of developing countries : This
could be since developed countries do not trade completely freely with developing countries,
which limits their ability to grow
- Setting up a free trade are or customs union violate the WTOs principle of having all trading
partners treated equally. This is especially if a common external tariff is applied. However, they
can complement the trading system and the WTO strives to ensure that non-members can trade
freely and easily with the members of a trade bloc.