6.1 The reasons for international trade
- Syllabus
- 9708–2026–2027
- Topic
- 6.1
- Level
- AS
Learning objectives
6.1.1Absolute vs comparative advantage• Distinction between absolute and comparative advantage6.1.2Specialisation and free trade• Benefits of specialisation and free trade (trade liberalisation), including the trading possibility curve6.1.3Terms of trade• Exports, imports and the terms of trade:- measurement of the terms of trade- causes of changes in the terms of trade- impact of changes in the terms of trade6.1.4Limits of advantage theories• Limitations of the theories of absolute and comparative advantage
Absolute advantage uses productivity; comparative advantage uses opportunity cost
| Idea | Comparison | Decision rule |
|---|---|---|
| Absolute advantage | Output from the same resources, or resources needed for the same output | More output or fewer inputs |
| Comparative advantage | Opportunity cost of one good in terms of the other | Lower opportunity cost |
For each producer, calculate the opportunity cost of 1 unit of each good. If all resources make 30 X or 60 Y, then 1 X costs 2 Y and 1 Y costs 0.5 X. Compare the same good across producers; the lower ratio identifies comparative advantage.
Country A can make 30 X or 60 Y; Country B can make 20 X or 20 Y. A has absolute advantage in both. Yet A's cost of 1 Y is 0.5 X and B's is 1 X, so A has comparative advantage in Y; B's cost of 1 X is 1 Y versus A's 2 Y, so B has comparative advantage in X.
Both can gain only if the trading rate lies between their opportunity costs. Here, 1 X must exchange for more than 1 Y for B to gain and less than 2 Y for A to gain.
Do not choose specialisation from absolute output alone. If opportunity-cost ratios are equal, neither country has comparative advantage and the simple model gives no gain from trade.
Specialisation and trade extend consumption possibilities
The gain-from-trade sequence is: different opportunity costs → specialisation according to comparative advantage → greater combined output or lower resource cost → exchange at a rate between opportunity-cost ratios → consumption possibilities beyond the country's own production possibility curve (PPC).
| Curve | What it shows | How to read it |
|---|---|---|
| PPC | Maximum combinations the country can produce with its own resources | A point outside is not domestically producible now |
| Trading possibility curve (TPC) | Combinations it can consume after specialising and exchanging output at the given terms of trade | A point beyond the PPC can be consumed, not produced domestically |
Potential benefits include better resource allocation, greater world output, economies of scale and learning, lower prices, stronger competition, wider choice, larger export markets and higher average living standards. Trade liberalisation removes barriers that prevent these exchanges.
Gains are larger when opportunity-cost differences are substantial, the exchange rate lies between the ratios, and transport and other trade costs are low. They can be reduced by barriers, adjustment costs, weak mobility, market concentration or dependence on a narrow export market.
Aggregate gains do not mean every firm, worker, region or country gains immediately. Import-competing jobs can fall, income distribution can worsen, and over-specialisation can increase exposure to external shocks.
Measure and evaluate the terms of trade
Terms of trade (TOT) index = (export price index ÷ import price index) × 100. A rise is an improvement: export prices have risen relative to import prices, so a given volume of exports can purchase more imports. A fall is a deterioration.
Use index ratios, not changes in trade values or volumes. If export prices are 150 and import prices are 125 relative to the base year, TOT = 150 ÷ 125 × 100 = 120: a 20% improvement from the base index of 100.
| Channel | Likely improvement | Likely deterioration |
|---|---|---|
| Exchange rate | Appreciation tends to raise foreign-currency export prices and lower domestic import prices | Depreciation tends to do the reverse |
| Demand for exports | Stronger demand can raise export prices | Weaker demand can lower them |
| Supply/productivity | Restricted export supply can raise export prices | Higher productivity or export subsidy may lower export prices |
| Relative inflation | Domestic export prices rising faster than import prices | Trading-partner/import prices rising faster |
| Commodity prices | Higher prices improve TOT for a commodity exporter | Higher prices worsen TOT for an importer |
| TOT movement | Possible benefits | Possible costs | Key condition |
|---|---|---|---|
| Improvement | Greater import purchasing power; cheaper imported inputs; lower cost-push inflation | Weaker export competitiveness; more imports; possible lower output/employment or current-account deterioration | PED of exports/imports, cause of the change and trade dependence |
| Deterioration | Stronger export competitiveness; possible higher export volume and employment | Less import purchasing power; dearer imported inputs; cost-push inflation and lower living standards | Elasticities, import dependence and whether export prices fell because demand weakened |
TOT measures relative prices, while the balance of trade/current account depends on export and import values. An improvement does not guarantee a current-account improvement: higher export prices may reduce export volume, and cheaper imports may increase import demand.
Test the limits of trade-advantage theories
Absolute and comparative advantage provide a benchmark: with different opportunity costs, specialisation and exchange at a mutually beneficial rate can increase combined output and consumption. Whether the predicted gain occurs depends on the model's assumptions.
| Simplifying assumption | Real-world limitation and consequence |
|---|---|
| Two goods/countries and known, constant opportunity costs | Many products, changing technology, factor endowments, government policy and increasing costs can alter comparative advantage |
| No transport or transaction costs | High freight, insurance, border and information costs can exceed the opportunity-cost gain |
| Free trade and competitive markets | Tariffs, quotas, subsidies, monopoly power or dumping distort prices and trade patterns |
| Resources move smoothly between domestic uses | Occupational/geographical immobility and time lags create structural unemployment and adjustment costs |
| Private prices reflect social costs and benefits | Pollution, resource depletion and other externalities can make apparent efficiency socially costly |
| Aggregate gains are sufficient | Gains may be unequal; over-specialisation creates commodity, demand and supply-shock dependence; strategic or infant industries may matter |
Evaluate significance, not just number of limitations. Compare the size of the opportunity-cost gap with trade and adjustment costs, the time horizon, market structure, distribution and whether policy can reduce the constraint. A limitation can shrink or redistribute gains without removing every gain from trade.
International immobility of factors is not itself a contradiction: trade in goods can substitute for factor movement. The relevant adjustment problem is whether labour and capital can move between industries within the country. Nor does one country having absolute advantage in all goods eliminate comparative advantage.