MACRO 15
INTERNATIONAL TRADE
Trade blocs
3 main types
Preferential trade agreements between countries where trade
barriers are reduced on some but not all goods
Free trade agreements
Customs union
International Trade
Different factor endowments mean some countries can produce
goods and services more efficiently than others
Absolute advantage
o Country is able to produce more of a good or service with the
same amount of resources or same amount of good or service
with fewer resources
Comparative advantage
o Country can produce goods at lower opportunity cost
o Sacrifices less resources in production
o More important
o Opportunity cost = sacrifice / gain
There can be gains from trade if each country specialises in the
production of the product in which it has the lower opportunity cost
Limitations of the theory of comparative advantage
Assumes goods are homogenous
Factors of production are assumed too be perfectly mobile
Assumed perfect knowledge
Governments may restrict trade
Transport costs may outweigh any comparative advantage
Increased specialisation may lead to diseconomies of scale
Comparative advantage measures static advantage but not dynamic
advantage
o India could become good at producing books if it made
investment
, Terms of trade
Measures rate of exchange of one good or service for another
Terms of trade must lie within the opportunity cost ratios for both
countries for international trade to be mutually beneficial
Calculate terms of trade as index number
Terms of trade = 100 x average export price index / average import
price index
If export prices are rising faster than import prices terms of trade
index will rise
o Fewer exports have to be given up in exchange for a given
volume of imports
If import prices rise faster than export prices the terms of trade
deteriorate
o More exports have to be sold to finance a given amount of
imported goods and services
Terms of trade fluctuate in line with changes in export and import
prices
Exchange rate and rate of inflation can both influence direction of
any change in terms of trade
The distinction between comparative and absolute advantage
Absolute advantage
o When a country can supply a product using fewer resources
than another nation
o If a country is using the same factors of production and can
produce more of a product it has absolute advantage
Comparative advantage
o The relative opportunity cost of production for a good or
service is lower in one nation than another country
o Country is relatively more productively efficient than another
o Specialise scarce resources in the goods and services best at
making
o Opens up gains from specialisation and trade which can lead
to a more efficient allocation of resources
Theoretical assumptions make it unrealistic
Constant returns to scale
o No economies of scale, would amplify gains from trade
Perfect factor mobility
No trade barriers
o Tariffs and quotas
Low transportation costs
INTERNATIONAL TRADE
Trade blocs
3 main types
Preferential trade agreements between countries where trade
barriers are reduced on some but not all goods
Free trade agreements
Customs union
International Trade
Different factor endowments mean some countries can produce
goods and services more efficiently than others
Absolute advantage
o Country is able to produce more of a good or service with the
same amount of resources or same amount of good or service
with fewer resources
Comparative advantage
o Country can produce goods at lower opportunity cost
o Sacrifices less resources in production
o More important
o Opportunity cost = sacrifice / gain
There can be gains from trade if each country specialises in the
production of the product in which it has the lower opportunity cost
Limitations of the theory of comparative advantage
Assumes goods are homogenous
Factors of production are assumed too be perfectly mobile
Assumed perfect knowledge
Governments may restrict trade
Transport costs may outweigh any comparative advantage
Increased specialisation may lead to diseconomies of scale
Comparative advantage measures static advantage but not dynamic
advantage
o India could become good at producing books if it made
investment
, Terms of trade
Measures rate of exchange of one good or service for another
Terms of trade must lie within the opportunity cost ratios for both
countries for international trade to be mutually beneficial
Calculate terms of trade as index number
Terms of trade = 100 x average export price index / average import
price index
If export prices are rising faster than import prices terms of trade
index will rise
o Fewer exports have to be given up in exchange for a given
volume of imports
If import prices rise faster than export prices the terms of trade
deteriorate
o More exports have to be sold to finance a given amount of
imported goods and services
Terms of trade fluctuate in line with changes in export and import
prices
Exchange rate and rate of inflation can both influence direction of
any change in terms of trade
The distinction between comparative and absolute advantage
Absolute advantage
o When a country can supply a product using fewer resources
than another nation
o If a country is using the same factors of production and can
produce more of a product it has absolute advantage
Comparative advantage
o The relative opportunity cost of production for a good or
service is lower in one nation than another country
o Country is relatively more productively efficient than another
o Specialise scarce resources in the goods and services best at
making
o Opens up gains from specialisation and trade which can lead
to a more efficient allocation of resources
Theoretical assumptions make it unrealistic
Constant returns to scale
o No economies of scale, would amplify gains from trade
Perfect factor mobility
No trade barriers
o Tariffs and quotas
Low transportation costs
