ECON10120 – Economic Principles and Skills

Student ID: 093238351

Why do countries trade with each other? Show, using examples, why this may
be to do with the principle of comparative advantage?

Why Do Countries Trade?

Countries trade for a number of reasons:
1. Resources not available
2. Offsetting costs of imports
3. Improve Competition
4. More money in the economy
5. Make relations with other countries.
6. Opportunity costs/Specialization
7. Absolute Advantage
8. Comparative Advantage

One of them is simply the good cannot be made in the countries due to the
weather for example, may be too cold to grow bananas and similar goods. The
government may need to offset the cost of importing goods into the country by
exporting goods in which the country specializes itself for the benefit and revenue of
other countries. This may also help in reducing surpluses in a market or resolve
shortages. Imports and exports will also improve the competition within a nation.
Costs of production and prices will have to be kept lower so that demand will remain
for their good that is produced in Country A as well as costs to continue making a
product and become innovative, which will benefit the government, aggregate
demand and the consumers happiness.
Exports benefit the country through the circular flow of income and more
money from abroad enters the country and lowers the price of the currency to make
them more internationally price competitive. This will also lead to the Multiplier Effect.
The Multiplier Effect is defined as: The multiplier effect occurs when a change in
aggregate demand causes a further change in aggregate output for the economy. To
illustrate more plainly with an example: if a company spends $1 million to build a
factory employing 100 new workers, those workers will require infrastructure like
housing, gas stations, a grocery store, and so forth, which will in turn employ other
workers who require the same services; to pick a number, say that all of these
workers will spend $2 million per year on consumables, which represent "increased
aggregate output" from the economy. Since there was an initial $1 million input which
created a $2 million output, the multiplier is 2.
Sometimes there may be a need to trade so that stable relations can be made
with other countries that may have fallen out with each other and are looking to
resolve the conflict without resulting in war, or may begin to start new relations with a
country.
There is also the opportunity cost and specialization of producing goods that
the country cannot produce themselves that well, a theoretical example would be the
production of crop 1 in Country A is hard to make because of the weather, available
resources and manpower. This then takes up the resources that could be used to
make crop 2.

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Student ID: 093238351

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As we can see from the graph of country A’s production possibility frontier
(PPF) if they specialized in Crop 1 they would have 20 units of it, whereas Crop 2
only has 10 units made if it was specialized in. Indirectly this will help the work force,
as they will have less demanding work to complete as they can make double what
they were before so for half the effort they can still produce as many of Crop A as
they were making of Crop B themselves. This helps out the government as the
workers won’t overwork themselves and can remain on task for longer periods of
time in the short run and makes them feel better about working and more
determined.

Comparative Advantage
Oxford Dictionary defines comparative advantage as:

Comparative Advantage is the ability of an individual or group to carry out a

particular economic activity (such as making a specific product) more
efficiently than another activity.

Ricardo's theory of comparative advantage is typically used as the backbone of arguments in

favour of free trade – in other words abolishing tariffs and quotas on goods imported from
foreign countries. It is claimed that, by trading freely with other countries – even those that, on
paper, are more efficient at producing goods and services – one can become more prosperous
than by closing one's borders.
Edmund Conway, Daily Telegraph
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To show comparative advantage I will use an example below.

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Here we see two countries that are particularly good at producing one good but not
so much for the other good. France has the option of 10 million tons of pork or 20
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http://www.telegraph.co.uk/finance/economics/6122712/Ricardos-theory-shows-that-win-win-situations-do-exist.html

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Student ID: 093238351
million tons of wine; Germany on the other hand has 20 million tons of pork or 10
million tons of wine. The cost of France to produce an extra ton of pork is 2 tons of
wine compared with Germany’s cost of an extra ton of pork is 0.5 tons of wine. We
can say that Germany has comparative advantage in the terms of pork production
however, the cost is inverted in the terms of wine as and extra ton of wine will cost
France 0.5 tons of pork but it will cost Germany 2 tons of pork and so France will
have comparative advantage in the production of wine.

Absolute Advantage

Absolute Advantage is the ability of an individual or group to carry out a

particular economic activity more efficiently than another individual or
group.
Oxford Dictionary

Example:

Lamb Beef
(Million Tons) (Million Tons)
Wales 20 10
New Zealand 20 20

What we can see in the above table is that per day Wales and New Zealand
can produce 20 millions tons of lamb each or 10 million and 20 million tons of beef
respectively per day. If the two countries were self-sufficient and had no need to
trade then Wales could either make 20 million tons of lamb or they could make 10
million tons of beef. New Zealand on the other hand could make 20 million tons of
lamb or 20 million tons of beef or anywhere along the production possibility curve, (It
would be unreasonable to produce the two in the PPF rather than along it as it would
lead to a misallocation of resources.)

Below we see a graph of the two product possibility frontiers

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When self sufficient we can say that in Wales, The cost of one million tons of

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beef is two million tons of lamb and so the exchange ratio in Wales is 1:1. In New
Zealand the cost of one million tons of beef is one million tons of lamb so the
exchange rate in New Zealand is 1:1.
If both countries were to produce at half of each so that the country has a
smaller amount but obtaining both at the same time. (Wales producing 10 million
tons of lamb and 5 million tons of beef and New Zealand producing 10 million tons of
lamb and 10 million tons of beef) then we can see that New Zealand can produce 5
more tons of beef than Wales whilst maintaining the same amount of lamb. This is
called Absolute Advantage as they can produce the same or more at both products
than another country.
Here we see that New Zealand has comparative advantage as it can produce the
same amount or more than Wales when specializing in that particular good. Even
though this may be the case, there will still be beneficial for Wales and New Zealand
even though New Zealand will have this advantage over Wales.
If Wales was to specialize in the production of lamb and New Zealand were to
specialize in beef then the production would change to along the Y axis for Wales
and X axis for New Zealand on the graphs, Wales would have 20 million tons of lamb
and 0 tons of beef and New Zealand will have 0 tons of lamb and 20 million tons of
beef. The countries will then bargain on what amounts by negotiation and until they
reach an agreement. In this example we’ll say that Wales trade 7.5 million tons of
lamb to 5 million tons of Beef from New Zealand. This will result in 12.5 million tons
of lamb for Wales and 5 million tons of beef and 15 million tons of beef and 7.5
million tons of lamb for New Zealand. This means that after trade Wales has gained
2.5 million tons of lamb from the original equilibrium of 10 and has not lost any beef
from the original equilibrium point of 5. New Zealand has gained 5 million tons of
lamb from the original equilibrium point of 10 and lost 2.5 million tons of beef from the
original point of 10. This will look like this to simplify:

Original Amount Amount Amount Amount Amount

Produced Produced Traded Consumed Gained
Wales 10 Lamb 20 Lamb OUT: 7.5 12.5 Lamb 2.5 Lamb
5 Beef 0 Beef Lamb 5 Beef
IN: 5 Beef
New Zealand 10 Beef 20 Beef OUT: 5 Beef 15 Beef 5 Beef
10 Lamb 0 Lamb IN: 7.5 Lamb 7.5 Lamb

So as we can see mathematically Wales have gone from being able to consume 15
million tons per day (Lamb + Beef) to 20 Million tons of one good only to 17.5 million
tons. They have reached a new equilibrium that is not possible on their old PPF,
which will look like this.

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 ECON10120 – Economic Principles and Skills
Student ID: 093238351

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New Zealand have gone from being able to consume 20 millions tons that have been
produced of both goods lamb and beef, than it remained the same amount and
specialized in beef before trade which then it increased to 22.5 million tons
consumed which is an increase of 2.5 million tons and a new place of their PPF
shown below:

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Conclusion
Richard’s Theory of comparative and Absolute advantage means that trade
will benefit countries by increasing production and efficiency beyond what it would be
able to do self-sufficiently, however such examples only work in free markets and the
inclusion of tariffs, quotas restrict trade and make it less favorable to trade then first
seems.

Bibliography
Lecture Notes
Seminar Notes
Lecturer’s Handouts and Presentations
The Telegraph
All Images/graphs were self-made from notes.

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