Economics Cue Cards Ch. 4

Front 1

What are the reasons for Trade?

Back 1

1)Different factor endowments - some economies are rich in natural resources while others have relatively little. Trade enables economies to specialise in the export of some resources and earn revenue to pay for imports of other goods.
2)Increased welfare - specialisation (where countries have a comparative advantage - see the next section for more detail on this) and trade allow countries to gain a higher level of consumption than they would do domestically and this leads to increased welfare and higher living standards.
3)To gain economies of scale - with specialisation and production on a larger scale than may be possible domestically, a country may be able to gain more economies of scale. This will lead to lower average costs and benefit consumers through lower prices.
4)Diversity of choice - trade enables us to access goods and services that we may not be able to produce ourselves. What would be an example in your country of goods that you can only get through trade?
5)Political / historical reasons - some trade takes place for political and other reasons relating to history and tradition, though this is generally diminishing in importance.
6)Increased competition - increased global competition may help to spur domestic productivity improvements and give domestic firms a better incentive to innovate and improve their products. This will benefit consumers.
7)Trade may be an 'engine for growth' - increased trade may help to spur greater domestic economic growth and drive further improvements in living standards.

Front 2

What is Free Trade?

Back 2

International trade is based on specialisation at a national level. Countries exchange goods with others and pay for imports from the revenues received from exporting. To work effectively, this system relies on few, if any, barriers existing to interfere with 'free trade'.

The basic principle of free trade dates back to mercantilism and fed through to the early exponents of laissez-faire economics in the seventeenth century. Amongst the most famous early writers on economics was Adam Smith, who produced his ideas on absolute advantage. This was where one country concentrated on developing those goods in which its natural resource base allowed it to produce more than any other country with given resources. Later, David Ricardo developed comparative advantage theory which suggested that a country should exchange goods with another country as long as the domestic opportunity costs were different. As a result of this, production should increase and individual consumption should rise. In essence these two early economic observations still underpin much of what we know about international trade.

Front 3

What are Absolute and comparative advantage?

Back 3

Absolute advantage exists when one country is able to produce a good more cheaply in absolute terms than another country.

Comparative advantage exists when one country is able to produce a good more cheaply, in comparison to other goods produced domestically, than another country.

Comparative advantage is a principle of economics which states that trade between TWO countries will be MUTUALLY beneficial as long as their domestic opportunity costs of production differ.

Front 4

What are the limitations of Comparative Advantage Theory?

Back 4

1)Transport costs and tariffs will change the relative prices of goods and may therefore 'blur' the impact of comparative advantage.
2)Exchange rates do not always relate exactly to what comparative advantage theory suggests as they have many other determinants - this may also negate the theory.
3)Imperfect competition may lead to prices being different to opportunity cost ratios. Imperfect competition may also lead to the exploitation of economies of scale which may adjust to what comparative advantage theory suggests should happen.
4)Comparative advantage theory is a static theory and does not take account of some of the more dynamic elements determining world trade. In particular, the factor of production capital is not a natural resource, and so may come outside the scope of the theory.

Front 5

What is Free Trade Continued?

Back 5

Free trade is trade that occurs between countries without any barriers or hindrances. This means that firms are able to sell directly into a country as easily as the firms within that country are able to trade. The firm exporting into the country should not face any additional barriers, taxes, regulations or any other obstacles that prevent them selling their goods/services.
Free trade at an international level means that this freedom is true for trade between all countries. In this way countries gain the benefits from competition that exist where the national markets are free from barriers and restrictions. Economic theory tells us clearly that this is likely to deliver significant benefits, but it is far from being universally true.