Chapter 25 : The reasons for international trade

• Absolute advantage

  A country can produce a good or service using fewer resources and at a lower cost than another country
• Comparative advantage

  A country can produce a good or service at a lower opportunity cost than another country
• Countries can specialise where they have comparative advantage, which increases economic welfare
• Free trade area

  Countries agree to trade goods with other members without protectionist barriers, e.g. NAFTA
• Free trade area

  • Allows members to exploit their comparative advantages, which increases efficiency
• Customs union

  Countries have established a common trade policy with the rest of the world, e.g. common external tariff
• Monetary union

  Members share the same currency, e.g. Eurozone
• Full economic union

  Common market with a customs union, common freedom of movement of goods, services, capital and labour, and a common external trade policy, e.g. EU
• Economic and monetary union

  Economic union with a common currency
• Trade creation

  A country consumes more imports from a low cost producer, and fewer from a high cost producer
• Trade diversion

  Trade shifts to a less efficient producer, usually a more expensive one inside a trading bloc instead of a cheaper one outside
• Trade diversion is more likely to occur where external tariffs are high, which results in goods produced within the trading bloc becoming cheaper to import than goods produced outside the trading bloc
• Benefits of free trade

  • Countries can exploit their comparative advantage, leading to higher output using fewer resources and increased world GDP, improving living standards
  • Establishes a competitive market, lowering the cost of production and increasing output
  • Trade creation due to fewer barriers, leading to more consumption and large increases in economic welfare
  • Potential for higher rates of economic growth through more exports
  • Exploitation of economies of scale through specialisation, lowering average costs
• Assumptions of the Trade Possibilities Curve

  • Two nations produce two goods and there is a trade-off
  • Constant costs in producing each good, so the curve is a straight line
  • The two nations face different costs of production
• Terms of trade


  Measures the volume of imports an economy can receive per unit of exports
• Calculating the terms of trade

  Index price of exports / Index price of imports x 100
• Terms of trade above 100 are improving, whilst those below 100 are worsening
• Globalisation


  • Price of invisibles (services) has been less impacted than visibles (manufactured goods)
  • Price of manufactured goods has fallen more than services
• Countries that export more services and import more manufactured goods

  Their terms of trade has improved
• Prebisch-Singer hypothesis


  Over time, due to falling commodity prices in relation to manufactured goods, the terms of trade for developing countries has fallen
• Globalisation reducing the price of manufactured goods

  Has offset the Prebisch-Singer effect slightly