Structured Response a) + b) on Absolute Advantage, Comparative Advantage and Trade ( [8] + [12] marks, 45 minutes)

Table 1:

Output of Tables

Output of Chairs

Country A

100

60

Country B

60

120

Total Output

160

180

Table 2:

Output of Tables

Output of Chairs

Country A

200

0

Country B

0

240

Total Output

200

240

. Suppose one country were more efficient at producing both products. Discuss whether it is the case the specialisation and trade will always benefit both countries. [12]

In the case where a country could produce both products more efficiently, as illustrated in table 3, it would have an absolute advantage in the production of both goods. However, despite this, there may still be a basis for trade due to comparative advantage. As seen in table, Country A can only produce coal at an opportunity cost to oil of 1 : 2, however, Country B can produce the coal at an opportunity cost of 2 : 1. Thus, Country B will have a comparative advantage in the production of coal despite being less efficient at it.

After specialisation and trade at a ratio of 1 : 1 as seen in table 4, both countries can serve to benefit, Country B can consume an extra 100 units of coal if maintaining the same consumption level of Oil as seen in table 3, or an extra 100 units of Oil if it maintains the same level of coal consumption. Similarly, country B can also consume an extra 100 units of coal following the specialisation and trade, thus creating a mutually beneficial situation, where, despite the absolute advantage of Country A in the production of both goods, both countries can still benefit from trade.

One key benefit of this trade would be the increase in the potential quantities of each good consumed in each country due to the implementation of a trading possibility curve showing the maximum combination of goods that can be consumed following specialisation and trade. This will, on the one hand, help increase welfare by making more efficient use of the scare resources available, in turn leading to an easing of the basic economic problem of scarcity. Moreover, by promoting higher levels of output, specialisation and trade will help promote better long term growth prospects.

Another potential benefit of specialisation and trade can be the unaccounted for increases in efficiency due to economies of scale. Due to comparative advantage trade models only taking into account constant returns to scale, economies of scale associated with improved infrastructure, increased automation and bulk purchases of raw materials can then cause an even more efficient use of scarce resources than initially predicted as the average cost per unit falls with the increases in output. This would then lead to even higher levels of output thus further promoting economic development and the associated increases in welfare, GDP and employment.

However, despite these potential benefits, certain scenarios may not be as favourable. In the case where one country not only has an absolute advantage in the production of both goods, but can also produce them at the same opportunity cost, there would be no real basis for trade as no country would benefit from such a transaction. Similarly, even in the cases where there is a comparative advantage, the difference in opportunity costs may be relatively small, in this case, it is very likely that the costs omitted by the comparative advantage trade analysis, such as transportation or diseconomies of scale, would outweigh any potential benefits from the trade, thus, once again becoming harmful. Moreover, due to the difference the relative size of the economies, the demand in one may be insufficient in order to justify full specialisation of both countries, at least a certain trading ratios. As seen in the example below, were both countries to specialise in the product they had a comparative advantage in, the total amount of oil produced would fall. This could then lead to a substantial shortage problems, particularly if any of the countries is highly dependent on the consumption of oil, perhaps due to a need to use petrol consuming vehicles as a result of a large surface area. In this case, one or both of the countries would end up suffering falls in welfare as the total amount of oil available for consumption would fall, hence making trade on the basis of comparative advantage beneficial only to a certain extent, at least within the theoretical example of bilateral trade in a two country world.

Overall, while not always beneficial, trade on the basis of comparative advantage will likely be mutually beneficial to both countries provided that the difference in the opportunity costs are substantial, the trading is done at a ratio between the two opportunity costs and provided that the costs omitted within the analysis are not substantial enough as to outweigh the potential benefits. It is also likely to be most effective in consumer good industries as many countries will likely be reluctant to trade a strategic industry such as military armaments or agriculture despite comparative advantages elsewhere.

Table 3:

Output of Coal

Output of Oil

Country A

300

600

Country B

200

100

Total output

500

700

Table 4:

Output of Coal

Output of Oil

Country A

200

800

Country B

400

0

Total Output

600

800