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Principle of Absolute Advantage

When a country can produce more of a good with the same amount of
resources than another country it is said to have an Absolute Advantage in
that good.
In other words, given the same amount of resources, a country can produce a
good more cheaply (lower unit cost) > Country should specialise in the good
that they have absolute advantage in and by trading can be better off
Trade between countries could take place and be beneficial to both countries
when each country produces the good in which it is more efficient and trades
for other goods which it needs but does not produce
1. 2 countries
2. 2 goods
3. Same amounts of different resources
4. Resources are divided equally between the 2 goods
5. Resources are at full employment and completely mobile
6. Free trade
7. No transport costs, only production cost
8. Constant returns to scale in production
9. No ‘money’ is used (Barter Trade)
Principle of Comparative Advantage
When a country can produce a good with a lower opportunity cost in terms
of other goods forgone over another country, it enjoys Comparative
Advantage. i.e. country is relatively more productively efficient than another
Principle of Comparative Advantage states that the trade can benefit all
countries, even if one country has the absolute advantage in all goods as long
as each country specialises in the goods in which they have a comparative
1. 2 countries
2. 2 goods
3. Same amounts of different resources
4. Resources are divided equally between the 2 goods
5. Country has an absolute advantage in the production of both goods
6. Resources are at full employment and completely mobile
7. Free trade

South Korea has a Comparative Advantage in ‘Air-cons’. 6 A/C : 4C or 1A/C : 2/3 C or 3/2 A/C : 1 C Air-conditioners Cars (million units) (million units) Japan 1 A/C : 2/3 C 1 C : 3/2 A/C South Korea 1 A/C : 1/4 C 1 C : 4 A/C Country Although Japan has the Absolute Advantage in Both these goods. Dividing resources equally between air-conditioner and car production. Japan will have 800 cars and South Korea 800 air conditioners. and Japan has a Comparative Advantage in ‘Cars’. If both countries completely specialize in the production of the good in which it has a comparative advantage. . Japan gets 2/3 for every air conditioner it gives up while South Korea gets ¼ for every air-conditioner it gives up. only production cost 9.8.A. production levels and both goods are higher in Japan and Korea in absolute terms Country Air conditioners Cars (million units) (million units) Japan 600 400 South Korea 400 100 Total 1000 500 To identify which country could specialise in a particular product. 4 A/C : 1 C or 1 A/C : 4 C Japan 600 A/C : 400 C Thus. Without trade. No transport costs. No ‘money’ is used (Barter Trade) Using Tables to Illustrate C. Constant returns to scale in production 10. Now both countries trade for the good that it does not produce. we need to analyse the internal opportunity cost for each country South Korea 400 A/C : 100 C Thus. after specialization. A mutually beneficial rate of exchange is one that leaves both countries better off from having traded.

on its own if Japan forgoes 200 airconditioners. Thus. South Korea has 400 airconditioners and 200 cars after trade. Air-conditioners Cars (million units) (million units) Japan -200 +200 South Korea 0 +100 Country South Korea is definitely better off by 100 cars but Japan has gained 200 cars at the expense of 200 of air conditioners. Japan has 200 more cars while South Korea has 100 more cars. it will gain 133 cars.Thus. Country A PPC = AA’ CPC = a Country B . there is a net gain of 67 cars so specialization and trade benefits both countries.e. Using PPC to Illustrate C. With trade Japan forgoes 299 airconditioners to gain 200 cars.A. Compared with the self-sufficient situation. the rate of exchange or terms of trade between air-conditioners and cars must be between 1 air-conditioner for ¼ car (lower limit) and 1 airconditioner for 2/3 car (upper limit) Assume the exchange rate is 1 air-conditioner for ½ car and Japan exports 200 cars in exchange for 400 air-conditioners. PPC can be used to show the potential gains from trade. The opportunity cost of 1 airconditioners is 2/3 car in Japan i.

Before: Japan → 600 A/C. the exchange rate must be at a rate that is steeper than B’s PPC but gentler than A’s PPC (2 dotted lines). can trade away its food for machines at the same rate denoted by dotted line ‘b’ → Implies that A and B can consume anyway along their respective lines “a” and “b” → New consumption point > Gain to them Using Japan.Korea E. showing the gains from specialization and trade . Since A specializes in machines. For both countries to benefit from the trade. specializing in food. it can trade away its machines for food at the rate denoted by dotted line “a” while B. the possibilities of Japan’s preferred point of consumption between the two goods lie on the new consumption possibility (dotted line) The consumption possibility line pivots outwards.g. Thus. 400 C (Point A) After: Japan → 800 C at the rate of 1A/C : ½ C Gain: 1600 A/C for selling 800 C in exchange Japan sells 200 cars and get 400 A/C in exchange and is thus at point b.PPC = BB’ CPC = b • Slope of the PPC is determined by the Opp Cost. A will specialize in Machines and B will specialize in Food. • Slope of the CPC is determined by the exchange-rate The gentler PPC for country B implies that country B has a comparative advantage in the production of food and country A has a comparative advantage in the production of Machines.

Before: South Korea → 400 A/C. the possibilities of South Korea’s preferred point of consumption between the two goods will lie on the new consumption possibility line (dotted line) The consumption possibility line pivots outwards. showing the gains from specialization and trade Limitations of comparative advantage ♪ Theory assumes trade is free from restrictions like tariffs and quotas  Tariffs → Prices of imported goods pushed higher → distort comparative cost advantage  Cost increase is “artificial” as it is the result of policy decision and thus reversible ♪ Ignores transport costs and other trade costs  In reality. high transportation cost between 2 countries may offset a country’s lower COP → Trading partners will find it cheaper to produce itself despite its high COP  Increase in price unavoidable ♪ Assumes constant opportunity cost ratios as resources are moved from one industry to another  Assumes resources are perfect substitutes → they are equally productive when being utilized by different industries  Not likely since some resources may be more efficient in one industry than in others and some may be immobile ♪ Assumes perfect market conditions In reality  there is a lack of market knowledge of foreign markets and the type of . Thus. 100 C (Point a) After: South Korea → 800 A/C at the rate of 1 A/C : ½ C Gain: 400 C for selling 800 A/C in exchange South Korea sells 400 A/C and gets 200 C in exchange and is at point b.

Anti-Trade Policies (Protectionism) Refers to the protection of human industries from foreign competition by the imposition of trade barriers on foreign products by the government. especially with the trend towards globalisation. in the face of more established foreign competitors. Reasons for protectionism To protect infant industries Protectionist measures for an infant industry which has a potential comparative advantage but is too young or undeveloped to realise this potential. They face high start-up cost at their initial stage of production. could be significantly affected by these fluctuations ♪ Assumes unchanged comparative advantage  Discovery of new methods of production and raw materials affect the efficiency of production in countries and hence C. Subsidies which help to lower COP and as a result price can be given to these producer.goods produced  Perfect market conditions do not exist ♪ Result in complete specialization  Countries fear over-specialisation and being totally dependent on foreign producers for strategic.A. political and economic situations ♪ Assumes barter trade  Fluctuations in monetary exchange rate between countries could disrupt trade  Governments could impose restrictions on the purchase of foreign currency to limit the country’s imports  Monetary cost of good to be traded and thus C.A. is necessary. Infant industries are newly set up industries with growth potential in the long run.A. → Countries may lose or gain a C. This will make them more competitive against the more efficient foreign .

Negative implications/ Evaluation  Local industry may become complacent and produce low quality goods at high prices with limited variety if protectionism is implemented as a long term measure. persistent undercutting of domestic prices will force the domestic industry out of business and cause widespread unemployment. Protection against dumping Dumping takes place when the goods are sold in a foreign market at a price below cost or below that sold at home market In view of globalisation.  In addition.producers. → Increase in prices and COL. cheaper foreign goods are reduced in the home market. Thus. Protection can be given until it matures and is able to expand its output sufficiently to reap economies of scale and establish market share that is able to compete with the firms Hence. protectionism is necessary in the short run to produce a level playing field. E.  Thus. and growth are protected. Negative implication/Evaluation  Assuming dumping is a predatory nature. protection via tariffs on dumped goods can be justified to prevent the long term exploitation of the consumer and to protect the firms from losing their competitiveness  Foreign producers may be more efficient than local producers. In the short term. This will also allow the foreign firm to establish itself as a monopoly and dominate the overseas market. the argument stands if only those infant industries with potential C. Hence. consumers benefit from the low prices of foreign goods but in the longer term. government protection must be removed once these industries are able to compete on its own to avoid misallocation of scarce resources.A. protectionism such as tariffs is thus often used to reduce imports and increase domestic production.g. → Smaller variety of goods available in domestic market Improve Trade Balance and Domestic employment . some countries may be unfairly victimised by competing foreign imports that are “dumped” in their markets. With protectionism. dumping may be undertaken by a foreign government to drive out local producers of another country. USA has been blaming China for dumping goods in their country by undervaluing the Yuan.

and shut down → workers face difficulty seeking employment in other industries Protectionism such as tariffs to reduce imports and increase domestic production provides a buffer for workers in these sunset industries with the opportunity to retrain and seek employment in other expanding sectors They can also make use of protectionism to reorganize and restructure themselves to compete effectively with foreign rivals again. .A country may attempt to use protectionist measures to narrow her gap through the use of tariffs or quotas → have an effect on restricting imports into the country by making imported goods more expensive → import expenditure falls → Reduce trade deficit With improvement in trade balance → AD increase → Increase in Real NY by multiplier effect With production increase. if they retaliate with their own set of protectionist measure.A. firms will experience a fall in stocks and inventories and will start hiring people → More job opportunities → Reduces unemployment E. country’s exports will fall and offset any improvement in their trade deficit → decrease in volume of world trade → impedes recovery and growth if there is worldwide recession Protect declining industries/ “sunset” industries Prevent massive structural unemployment in those industries which employ a substantial proportion of the workforce With the trend towards globalization. US Negative implication/Evaluation  Protectionist measures will undoubtedly harm the trade position of the country’s trading partners as their export to the country will fall → beggar-thy-neighbour measure  May result in retaliation from affected countries  Hence. structural unemployment arise due to:  Faster rate of economic transformation and technology transfers → new machines and methods → make old skills obsolete  Greater flow of cheaper imports which compete directly with domestic producers → decline in dd for domestic goods → retrenchment of workers as import-substitutes domestic firms lose their C.g.

it is a price taker. Methods of Protectionism Tariffs or Import Duties  These act in exactly the same way as a tax by artificially raising the price of foreign products as they enter the country  The effect is to shift the supply curve leftwards and raise the price of imports. especially in times of wars and not to be dependent on insecure or politically undesirable sources of goods.  Tariffs may be in the form of ad valorem or specific  Used to restrict imports and protect home industries with the aim to raise the price of imports. the world supply curve is perfectly price elastic. Domestic demand → DDdom Supply curves → SSdom Assuming that the country is too small to affect world prices. making them less competitive than local products  Most effective when demand for imports is price elastic  Also used as a means of raising tax revenue and they are normally imposed on goods with price inelastic demand Figure below illustrates the case of a good that is partly home produced and partly imported.Negative implication/Evaluation  Use of tariffs to reduce unN → brings about loss of consumer welfare in terms of high prices and fewer goods consumed → loss of societal welfare  Delays or slows down restructuring process and prolong the inefficient use of economy’s resources Protect strategic industries to ensure self-efficiency (non-economic) With increased trade and specialisation. At price Pw the quantity demanded is M. aircraft and food are protected to ensure sufficient supply when the need arises. Of this. country will be more reliant on imports On the grounds of self-sufficiency. OJ is produced locally and JM is imported . certain industries such as transportation equipment. Pw is the world price where the country can buy all it wants and SSworld.

C and D Short term  Tariffs raise price but have little effect on the quantity if demand is price inelastic → government earns tax revenue (Area C) → consumer surplus falls (Areas A+B+C+D) due to rise in price and fall in consumption from M to L  Local consumers pay higher price for lower quality domestic products → fall in consumer sovereignty as they are forced to buy domestic goods at a higher price  Local producers enjoy an increase in producer surplus (Area A) due to higher prices paid by consumers  Efficiency discouraged as inefficient local producers can continue to produce and sell their goods  Society incurs deadweight welfare loss (Areas B+D) due to misallocation of resources Long term  Other countries may retaliate by imposing other trade restrictions on .B. → effective horizontal world supply curve shifts up to SSworld+tariff → price rises to Pw+T → domestic consumption falls to L → domestic production rises to K → amount imported is reduced to KL Evaluation ♪ The effect on consumer and surpluses can be seen by comparing area A.Assuming the government imposes a tariff T → shifts the world supply curve to the country by the amount of the tariff.

the quota will have the effect of increasing the domestic supply (SSdom) by the amount of the quota Represented by → Rightward shift off the SSdom to SSdom+Quota [restrict world SS to the amount of quota] → New equilibrium is now Pquota → Amount of imports is reduced to KL (i.e.the domestic country’s exports  Domestic employment increases Import Quotas  Takes the form of a physical limitation on the quantity of a commodity which is allowed to enter the country in a given year  May be set on the value or volume of imports  Quotas do not bring in revenue to the state unless they are operated by means of import licences In the Figure below. B. C & D. Short term  Domestic Consumer surplus falls  Domestic Producer surplus increases  Net welfare loss . World price of Pw: amount of imports →JM. the quota) → Domestic price (Pquota) is higher than the original pre-quota price of Pw Evaluation ♪ The effect on consumer and producer surpluses can be seen by comparing the areas labeled A. NOTE not all the effects are the same as the tariff. Assuming the government now imposes a quota of KL on the import of this product.

unlike tariffs  Quotas are administratively cumbersome. rendering above measures ineffective  Results in uncertainty in trade. countries who adopt this measure eventually are pressured to open their borders to trade.Long Term  Increase in price resulting from this measure is indefinite. Foreign exchange control  Importers need foreign currencies to buy goods and services from abroad  American firms will require payments in US $.g. They are costly to the government when implemented and can easily lead to corruption  Quotas are set on volume over a period of time → penalizes a local importing firm that wishes to expand within that period of time → result in rigidity in the domestic economy  Quotas are disruptive as additional foreign goods cannot enter the domestic market Physical Control/ Ban / Embargo  Most extreme form of quota since it is a complete ban  Can be placed on imports from a particular country E. German firms in Euros  Country obtains its supplies of foreign currencies by means of the effort of its exporters  A system of exchange control will require the foreign currencies earned by exporters to be surrendered to the central bank which will pay for them in the home currency  Importers wanting foreign currency must apply to the central bank which can thus control the variety and volume of imports by controlling the issue of foreign currency Evaluation  Black markets may form for foreign exchange. It would depend largely on the PED for the product  Quotas raise no revenue for the government. Iraq during the gulf war or on imports of certain goods such as weapons and hard drugs In Singapore. Regular markets may be closed and local firms may be unable to purchase goods from certain countries . chewing of gum and its indiscriminate disposal imposes an external cost on society and hence the government took the decision to ban the import and sale of chewing gum several years ago Evaluation  Political and social rather than economic tool  Results in loss of economic gains from trade  In the long run.

technology and processes that help in production of cars → shift domestic supply curve for cars → make Thailand a net exporter of cars .g.A. Thailand is not naturally endowed with the resources and technologies to produce a product like cars → domestic supply will be low → domestic price will be high → Thailand will be a net importer of cars If Thailand imports capital. is governed by the quantity and quality of its FOPs in comparison with its trading partners. Difficult for domestic Central bank to control and monitor all foreign exchange transactions  Domestic consumers may have to pay more for goods of inferior quality Subsidies Voluntary Export Restraint  An agreement between two countries where the government of the exporting country agrees to restrict the volume of its exports of a certain good or service  May do so to prevent tariffs or quotas from being imposed on the products E.e. volume and direction of goods and services a country trade. Determinants of trade patterns (is this important?) Comparative Advantage A country’s C. Japan has entered into a number of VER with EU members and with USA in the exports of car Product Standard Regulations  Imply the use of harsh health and safety standards to limit imports  Complex customs procedures create frontier delays by imposing the need for laborious and difficult paperwork for goods entering a country Trade patterns Refers to the type. this manifest in the relative opportunity COP Factor Endowments (domestic supply) If a country i.

US recently become a net exporter of petroleum products after years of being net importer In 2009.World Demand Global demand for i. trade sanctions imposed on Cuba has resulted in Cuba’s inability to import modern cars and the US unable to import Cuban cigars ♪ Exchange rate controls E. Quotas.e.g. oil rises → economy find itself a net exporter of product E.g.g. domestic price of oil in US is higher → US is a net importal of oil → World demand increases → world price increase → domestic SS quantity increase → become net exporter of oil Other Determinants ♪ Formation of Free Trade Areas Chapter 15 ♪ Tariffs. China has long been accused of undervaluing the Yuan to gain an . Subsidies → protect domestic industry → altering trade patterns (altering amount of imports) E.

IT. automation Such resources are best suited to produce:  High-end  High-tech  High value-added  Knowledge-based products Examples of exports  Electronics: disk-drives  Biomedical: Pharmaceuticals  Chemicals: Petrochemicals  Marine: Oil rigs and ship repair Value-added products Immediate products such as electronic valves and telecommunication equipment are imported into SG. unskilled labour → In short. communication and transport facilities  Advanced technology → E. R&D. that results in a persistent trade surplus with the US Trade patterns in Singapore Resource endowment:  Well-educated and trained labour force → suitable for knowledge-intensive high-value add manufacturing  Good infrastructure → E.g.g. aluminium and steel Low end manufactures: cheap slippers footwear .A. metals like copper. Industrial Parks. fruits.artificial C. robotics. eggs. vegetables  Primary commodities: Oil. reprocessed and are then re-exported but as value added products for final assembly in countries such as Malaysia and China What SG does not have:  Natural resources → shortage of land → no mineral deposits → favourable climate for agricultural activities  Cheap. our natural resource endowment does not favour nor support such forms of economic activity Examples of imports:  Agricultural/ Fresh produce: meat.