Week 12 study guide
DepartmentEconomics for Management Studies
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Chapter 33 The Gains from International Trade Notes
33.1 The Gains from Trade
x open economy : an economy that engages in international trade
x closed economy : an economy that has no foreign trade
Interpersonal, Interregional, and International Trade
x without trade, everyone must be self-sufficient; with trade, people specialize in what they do well, satisfy other needs by trading
x with trade, each individual, region, or nation is able to concentrate on producing goods and services that it produces efficiently
while trading to obtain goods and services that it does not produce efficiently
x gains from trade : increased output due to the specialization according to comparative advantage that is made possible by trade
Illustrating the Gains from Trade
x absolute advantage : the situation that exists when one country can produce some commodity at lower absolute cost than
x comparative advantage : the situation that exists when a country can produce a good with less forgone output of other goods
than can another country
x the gains from specialization and trade depend on the pattern of comparative, not absolute, advantage
x world output increases if countries specialize in the production of the goods in which they have a comparative advantage
x specialization of production against the pattern of comparative advantage leads to a decline in total world output
x conclusions about gains from trade arising from international differences in opportunity costs are:
1. Country A has a comparative advantage over Country B in producing a product when the opportunity cost of production in
Country A is lower. This implies, however, that it has a comparative disadvantage in some other product(s).
2. The opportunity cost of product X is the amount of output of other products that must be sacrificed in order to increase the
output X by one unit.
3. When opportunity costs for all products are the same in all countries, there is no comparative advantage and there is no
possibility of gains from specialization and trade.
4. When opportunity costs differ in any two countries and both countries are producing both products, it is always possible to
increase production of both products by a suitable reallocation of resources within each country.
The Gains from Trade with Variable Costs
x In industries with significant scale economies, small countries that do not trade will have low levels of output and therefore high
costs. With international trade, however, small countries can produce for the large global market and thus produce at lower costs.
International trade therefore allows small countries to reap the benefits of scale economies.
x learning by doing : the reduction in unit costs that often results as workers learn together repeatedly performing the same tasks;
it causes a downward shift in the average cost curve
Sources of Comparative Advantage
x according to the Heckscher-Ohlin theory, countries have comparative advantages in the production of goods that use intensively
the factors of production with which they are abundantly endowed
x climate affects comparative advantage
x with today’s growing international competition, no country’s comparative advantages are secure unless its firms innovate and
keep up with their foreign competitors
33.2 The Determination of Trade Patterns
The Law of One Price
x The law of one price states that when a product is traded throughout the entire world, the price in various countries will differ by
no more than the cost of transporting the product between countries. Aside from differences due to these transport costs, there is
a single world price.
The Pattern of Foreign Trade
x countries export products whose world price exceeds the price that would exist domestically if there were no foreign trade
x countries export goods for which they are low-cost producers; that is, export goods for which have a comparative advantage
x countries import products whose world price is less than the price that would exist domestically if there were no foreign trade
x countries import goods for which they are high-cost producers; that is, import goods for which have a comparative disadvantage
Is Comparative Advantage Obsolete?
x the theory that comparative advantage determines trade flows is not obsolete, but the theory that comparative advantage is
completely determined by forces beyond the reach of decisions made by private firms and by public policy has been discredited
The Terms of Trade
x terms of trade : the ratio of the average price of a country’s exports to the average price of its imports
x a rise in a country’s terms of trade is beneficial because it expands the country’s consumption possibilities
33.1 The Gains from Trade
x Country A has an absolute advantage over Country B in the production of a specific product when the absolute resource cost of
the product is less in Country A than in Country B.
x Country A has a comparative advantage over Country B in the production of a specific good if the forgone output of other goods
is less in Country A than in Country B.
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