Theories of International Trade

There are many reasons why countries trade among each other. One of the important reasons is that it allows countries to specialise in the goods and services in which they are more efficient when compared to other countries.

a)      The Principle Of Absolute Advantage

For simplicity, let us assume that there are only two countries, A and B, with each country possessing a basket of resources which can be used to produce two goods, rice and corn.

Country A is more efficient in the production of rice while Country B is more efficient in corn production.

Now, if trade is possible between these two countries, each will tend to specialise in the commodity in which it is more efficient.

After complete specialisation we obtain the following result:

As seen above, after complete specialisation, total output has increased. In order to benefit from specialisation, the rate of exchange must be beneficial to both countries. It must lie between the opportunity cost of producing the product in each country for it to be favourable to both.

After the specialisation and the trade at  = _________________

It is clear from the table above, that both countries are better off than when they were self-sufficient.

b)     Principle of Comparative Advantage

This principle states that even where one country has an absolute advantage over the other country in products, specialisation and trade can still benefit both countries, if each has a comparative cost advantage. This comparative cost refers to the opportunity of producing the products.

For country A has an absolute advantage in the production of rice and corn. For Country A, the opportunity costs of producing 1 unit of rice is   _________________________  units of corn.

For Country B, the opportunity cost of producing 1 unit of rice is _________________ units of corn.

In terms of the units of corn forgone, rice production is cheaper in Country __________ than in Country ___________  Country       has a comparative advantage in rice production.

If Country ______________ were to specialise completely in _______________ production and country _____________ to partially specialise in _________, total output will increase.

After specialisation:

Thus, it can be seen that there is still a gain from specialisation.

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