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Free trade and protection: Why do nations trade?

This tutorial was written by Ken Edge Head Teacher Social Science Cardiff High School Outcomes Overview Content Review exercises More

Outcomes
HSC Topic: The Global Economy is covered in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 31-33. The specific outcomes for this tutorial are: H1 demonstrates understanding of economic terms, concepts and relationships H3 explains the role of markets within the global economy H4 analyses the impact of global markets on the Australian and global economies H7 evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments H8 applies appropriate terminology, concepts and theories in contemporary and hypothetical economic contexts.

Overview
Historically, nations have been trading with each other for hundreds of years in the pursuit of profit and because they do not have enough resources (land, labour and capital) to satisfy all the needs of consumers. For example, Japan has a highly skilled labour force that use technologically advanced equipment to produce cars and electrical equipment, however it does not have its own oil fields. Saudi Arabia has large supplies of oil, but lacks the built capital to produce cars and electrical equipment.

absolute advantage C. Australia has a large supply of natural resources such as coal. Most manufactured goods (such as TV's.Trade between Saudi Arabia and Japan will allow both countries to obtain goods and services that they cannot produce themselves. bauxite and grazing land. clothing and footwear products. Pacific Brands. a highly skilled and low cost workforce and the Chinese government's enthusiasm for investing in industrial infrastructure. Factor endowments Each country has different types and amounts of resources that will determine what they can or cannot produce. In the period 2000 to 2009 China became the world's manufacturing leader. Factor endowments are determined by: o o o o o geographical features such as climatic conditions and natural resources historical development and political stability social and demographic issues economic development. This was because China could produce quality manufactured items at very cheap prices. iron ore. The combination of these resources (land. Japan has a highly skilled workforce that uses advanced technology to produce cars and electrical equipment. China has a large population and can supply cheap labour to produce competitively priced textile. Increasingly businesses outsourced their manufacturing to China. size and quality of the workforce and access to capital entrepreneurial skills and the freedom to pursue entrepreneurial activities. comparative advantage. Specialisation and trade can then deliver higher living standards to all countries as resources are being used more efficiently. labour. These include: A. capital and enterprise) is referred to as a country's factor endowment. other electrical equipment and cars) have become cheaper. closed its Australian manufacturing plants and outsourced their production to Chinese firms. different factor endowments B. For example. A. . China's rise as the world's leading manufacturing nation was caused by Chinese business investment in manufacturing capacity. For example. As a result the world's disposable income increased because electrical and manufactured items fell in price. a textile firm that produces brands of clothing such as Bonds. Content There are a number of reasons why nations are motivated to trade.

trade would be beneficial for each of these countries. Production costs for each country are fixed. These two countries each produce only wheat and cloth. f. This is illustrated in Table 2. B. Australia and China. The theory of absolute advantage The Scottish economist Adam Smith first explained the theory of absolute advantage in 1776. greater production of each good could occurr. Table 1 Absolute Advantage:. In this example Australia produces more wheat while China can produce more cloth. Trade allows countries to have access to goods and services that are not produced or cannot be produced efficiently. labour and capital). When each country specialises in the production of the goods they have an absolute advantage in. b. There are no trade barriers. however the quality differs. where the production of wheat has increased by 25 units and . A simple economic model can be used to illustrate the principle of absolute advantage.Because of different factor endowments. Our economic model is based on the following assumptions: a. d. Australia then has an absolute advantage in the production of wheat and China an absolute advantage in the production of cloth. while China can produce 5 units of wheat and 25 units of cloth. c. such as tariffs between the two countries. There are only two countries. Resources are transferable between the production of wheat and cloth. With a given amount of resources Australia can produce 30 units of wheat and 20 units of cloth.production before specialisation Wheat (units) Australia China Total output 30 5 35 Cloth (units) 20 25 45 Table 1 shows the production for each country before specialisation. He argued that a country has an absolute advantage in the production of a good when it can produce more of that good with a given amount of resources than another country. e. Each country has the same amount of resources (land.

The principal is based on the relative efficiencies of production where each country has a comparative advantage in producing the commodity in which it has the lower opportunity cost. 20 5 25 Cloth (units) 10 5 15 . Theory of comparative advantage Adam Smith's theory of absolute advantage is a simple explanation of the benefits of international trade.production of cloth by 5 units. Australia has an absolute advantage in the production of both wheat and cloth. However. a classical economist. developed the principal of comparative advantage to explain this situation. Remember? Opportunity costs are what must be given up in order to consume or produce another good. both countries can gain from specialisation and trade. By using the theory of comparative advantage. Table 2 Production gains after specialisation Wheat (units) Australia China Total output 60(+30) 0 (-5) 60 (+25)(net gain) Cloth (units) 0 (-20) 50 (+25) 50 (+5)(net gain) C. For example. The principal of comparative advantage can be illustrated using Tables 3 and 4. Table 3 Comparative advantage: production before specialisation Wheat (units) Australia China Total Output D. can there be benefits from trade? In 1817 David Ricardo. In the example above. if one country has an absolute advantage in the production all goods. going on an overseas holiday may involve giving up the purchase of a new car.

A modern approach to comparative advantage . So it is more practical for Australia to specialise in the production of wheat.Table 4 Opportunity costs Opportunity cost Country Australia China E.5 units of cloth to produce an extra unit of wheat. From Table 4: o 1 unit of wheat 0. trade will lead to higher standards of living than would be otherwise possible.5 (10/20) units of cloth 1 (5/5) units of cloth 1 unit of cloth 2 (20/10) units of wheat 1 (5/5) units of wheat Australia has a comparative advantage in the production of wheat since it has to give up only 0. China has a comparative advantage in the production of cloth since it has to give up only 1 unit of wheat to produce an extra unit of cloth. while Australia must give up 2 units of wheat to produce an extra unit of cloth. Table 5 Production levels after specialisation Wheat (units) Australia China Total output 40 (+20) 0 (-5) 40 (+15) (net gain) Cloth (units) 0 (-10) 10 (+5) 10 (-5) (net gain) From Table 5 we can see that total output has increased when countries specialise in the production of goods and services based on comparative advantage. (Note: the fall in total output of cloth is outweighed by the rise in total output of wheat). o Australia has a comparative advantage in the production of wheat and China has a comparative advantage in the production of cloth. Consequently it is more practical for China to specialise in the production of cloth. As both countries are using their resources more efficiently. Trade between the two countries should be beneficial because of the different opportunity costs for these commodities. while China must give up 1 unit of cloth to produce an extra unit of wheat.

Since 1980 the Chinese government established special economic zones (SEZs) such as in Shenzen. investment funds. Macmillan 1990). increased infrastructure and reduced tariffs. ii. The Comparative Advantage of Nations (London. Transnational corporations are playing a very important role in this development because they are able to coordinate their production activities by moving resources. iii. in order to develop manufacturing industries and promote economic development. These SEZs were given incentives including decreased taxation. technological innovation and product differentiation) rather than comparative advantage that is becoming an important factor in determining the pattern and direction of international trade. production components. Factor endowments and comparative advantages are important in countries that have industries based on natural resources and where production does not rely on high levels of technology or where the labour force is relatively unskilled. Answer . iv. suggests that instead of different factor endowments being the basis for international trade much of the world's trade is taking place between nations with similar factor endowments. Some of these zones specialise such that in China there is an area with hundreds of factories producing toys. These SEZs established many hundreds of manufacturing firms located together. Porter suggests that it is competitive advantage (based on lower costs. Revision Exercise 1 Use the following table Cameras (units) TV sets (units) Japan Australia i. Answer Calculate the opportunity cost of producing one camera for Australia. Shanghai and Guangzhou. As a result the SEZs had reduced costs for manufacturing. China's increased manufacturing trade is a good example of competitive advantage. others produce textiles and others produce shoes. and were interested in learning from each other to increase innovation and use of technology. technology and labour across the world. 50 10 40 20 Which country has an absolute advantage in the production of cameras? Answer Which country has an absolute advantage in the production of TV sets? Answer Calculate the opportunity cost of producing one camera for Japan.Michael Porter.

v. vi. vii. The material may be very useful for assessment tasks. Answer Calculate the opportunity cost of producing one TV set for Australia. Calculate the opportunity cost of producing one TV set for Japan. viii. Answer For which good does Australia have a comparative advantage? Answer For which good does Japan have a comparative advantage? Answer More The Austrade web site has a section especially designed for students. .