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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
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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.

Trade between Saudi Arabia and Japan will allow both countries to obtain goods and services that they cannot produce themselves. Specialisation and trade can then deliver higher living standards to all countries as resources are being used more efficiently.

Content

There are a number of reasons why nations are motivated to trade. These include:

different factor endowments
absolute advantage
comparative advantage.

Factor endowments

Each country has different types and amounts of resources that will determine what they can or cannot produce. The combination of these resources (land, labour, capital and enterprise) is referred to as a country's factor endowment.

Factor endowments are determined by:
- geographical features such as climatic conditions and natural resources
- historical development and political stability
- social and demographic issues
- economic development, size and quality of the workforce and access to capital
- entrepreneurial skills and the freedom to pursue entrepreneurial activities.
For example, Australia has a large supply of natural resources such as coal, iron ore, bauxite and grazing 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, clothing and footwear products. In the period 2000 to 2009 China became the world's manufacturing leader. Increasingly businesses outsourced their manufacturing to China. This was because China could produce quality manufactured items at very cheap prices. For example, Pacific Brands, a textile firm that produces brands of clothing such as Bonds, closed its Australian manufacturing plants and outsourced their production to Chinese firms. China's rise as the world's leading manufacturing nation was caused by Chinese business investment in manufacturing capacity, a highly skilled and low cost workforce and the Chinese government's enthusiasm for investing in industrial infrastructure. Most manufactured goods (such as TV's, other electrical equipment and cars) have become cheaper. As a result the world's disposable income increased because electrical and manufactured items fell in price.

Because of different factor endowments, trade would be beneficial for each of these countries. Trade allows countries to have access to goods and services that are not produced or cannot be produced efficiently.

The theory of absolute advantage

The Scottish economist Adam Smith first explained the theory of absolute advantage in 1776. 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.

A simple economic model can be used to illustrate the principle of absolute advantage.

Our economic model is based on the following assumptions:

There are only two countries, Australia and China.
These two countries each produce only wheat and cloth.
Each country has the same amount of resources (land, labour and capital), however the quality differs.
Resources are transferable between the production of wheat and cloth.
Production costs for each country are fixed.
There are no trade barriers, such as tariffs between the two countries.

Table 1 Absolute Advantage:- production before specialisation

	Wheat (units)	Cloth (units)
Australia	30	20
China	5	25
Total output	35	45

Table 1 shows the production for each country before specialisation.

With a given amount of resources Australia can produce 30 units of wheat and 20 units of cloth, while China can produce 5 units of wheat and 25 units of cloth.

In this example Australia produces more wheat while China can produce more cloth.

Australia then has an absolute advantage in the production of wheat and China an absolute advantage in the production of cloth.

When each country specialises in the production of the goods they have an absolute advantage in, greater production of each good could occurr.

This is illustrated in Table 2, where the production of wheat has increased by 25 units and production of cloth by 5 units.

Table 2 Production gains after specialisation

	Wheat (units)	Cloth (units)
Australia	60(+30)	0 (-20)
China	0 (-5)	50 (+25)
Total output	60 (+25)(net gain)	50 (+5)(net gain)

Theory of comparative advantage

Adam Smith's theory of absolute advantage is a simple explanation of the benefits of international trade. However, if one country has an absolute advantage in the production all goods, can there be benefits from trade?

In 1817 David Ricardo, a classical economist, developed the principal of comparative advantage to explain this situation. 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.

Remember?
Opportunity costs are what must be given up in order to consume or produce another good. For example, going on an overseas holiday may involve giving up the purchase of a new car.

The principal of comparative advantage can be illustrated using Tables 3 and 4.

Table 3 Comparative advantage: production before specialisation

	Wheat (units)	Cloth (units)
Australia	20	10
China	5	5
Total Output	25	15

In the example above, Australia has an absolute advantage in the production of both wheat and cloth. By using the theory of comparative advantage, both countries can gain from specialisation and trade.

Table 4 Opportunity costs

	Opportunity cost
Country	1 unit of wheat	1 unit of cloth
Australia	0.5 (10/20) units of cloth	2 (20/10) units of wheat
China	1 (5/5) units of cloth	1 (5/5) units of wheat

From Table 4:

Australia has a comparative advantage in the production of wheat since it has to give up only 0.5 units of cloth to produce an extra unit of wheat, while China must give up 1 unit of cloth to produce an extra unit of wheat. So it is more practical for Australia to specialise in the production of wheat.
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. Consequently it is more practical for China to specialise in the production of cloth.

Australia has a comparative advantage in the production of wheat and China has a comparative advantage in the production of cloth. Trade between the two countries should be beneficial because of the different opportunity costs for these commodities.

Table 5 Production levels after specialisation

	Wheat (units)	Cloth (units)
Australia	40 (+20)	0 (-10)
China	0 (-5)	10 (+5)
Total output	40 (+15) (net gain)	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). As both countries are using their resources more efficiently, trade will lead to higher standards of living than would be otherwise possible.

A modern approach to comparative advantage

Michael Porter, The Comparative Advantage of Nations (London, Macmillan 1990), 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.

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.

Porter suggests that it is competitive advantage (based on lower costs, technological innovation and product differentiation) rather than comparative advantage that is becoming an important factor in determining the pattern and direction of international trade. China's increased manufacturing trade is a good example of competitive advantage. Since 1980 the Chinese government established special economic zones (SEZs) such as in Shenzen, Shanghai and Guangzhou. These SEZs were given incentives including decreased taxation, increased infrastructure and reduced tariffs, in order to develop manufacturing industries and promote economic development. These SEZs established many hundreds of manufacturing firms located together. As a result the SEZs had reduced costs for manufacturing, and were interested in learning from each other to increase innovation and use of technology. Some of these zones specialise such that in China there is an area with hundreds of factories producing toys, others produce textiles and others produce shoes.

Transnational corporations are playing a very important role in this development because they are able to coordinate their production activities by moving resources, production components, investment funds, technology and labour across the world.

Revision

Exercise 1
Use the following table

	Cameras (units)	TV sets (units)
Japan	50	40
Australia	10	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. Answer
Calculate the opportunity cost of producing one camera for Australia. Answer
Calculate the opportunity cost of producing one TV set for Japan. Answer
Calculate the opportunity cost of producing one TV set for Australia. Answer
For which good does Australia have a comparative advantage? Answer
For which good does Japan have a comparative advantage? Answer

The Austrade web site has a section especially designed for students. The material may be very useful for assessment tasks.