Absolute and comparative advantage
Absolute advantage means making more of a good with the same resources. Comparative advantage means making a good at a lower opportunity cost. Opportunity cost is what you give up to make one more unit.
Example: one worker in A makes 6 wheat or 3 cloth, in B 2 wheat or 2 cloth. A is better at both. But in A, 1 cloth costs 2 wheat; in B, 1 cloth costs 1 wheat. B should make cloth, A should make wheat.
This idea comes from David Ricardo (1817). It shows that even a country that is worse at everything can still gain from trade.
Limits of the theory
- It assumes no transport costs and full employment.
- Workers cannot always move between industries quickly.
- Heavy specialisation can make a country depend on one product.
Terms of trade and the gains from trade
The terms of trade are the rate at which goods swap between countries. Both gain only if the rate lies between the two opportunity costs. In our example, cloth costs 1 wheat in B and 2 wheat in A, so any rate from 1 to 2 wheat per cloth helps both.
An index of terms of trade = (index of export prices ÷ index of import prices) × 100. If it rises, each unit of exports buys more imports.
Wider benefits: lower prices, more choice, economies of scale, competition, and new ideas and technology.
Protectionism, trade blocs and the WTO
Protectionism means limiting imports to help local producers.
- Tariff: a tax on imports. Home price rises, local output rises, imports fall, the government gets revenue, consumers lose and there is a deadweight loss.
- Quota: a limit on the quantity of imports.
- Subsidy: money to local firms so they can sell cheaper.
- Non-tariff barriers: strict standards, paperwork, licences.
Reasons given: protect infant industries, jobs, national security, stop dumping (selling abroad below cost). Risks: higher prices, less efficiency, retaliation.
Trade blocs
From weakest to strongest link: free trade area (no tariffs between members), customs union (plus a common external tariff), common market (plus free movement of labour and capital), monetary union (plus a single currency). Blocs can create trade but also divert it from cheaper outside producers.
The WTO
The World Trade Organization (1995) sets trade rules, holds talks to cut barriers and settles disputes between member countries.
The foreign exchange market, net exports and capital flows
A currency has a price: the exchange rate. It is set by demand (foreigners buying our exports and assets) and supply (we buying foreign goods and assets).
What shifts it
- Higher real interest rate at home (real rate ≈ nominal rate − inflation) → foreign savers buy our bonds → capital inflow → demand for our currency rises → it appreciates.
- Higher home inflation → our goods dearer → demand for our currency falls → it depreciates.
- Higher incomes abroad → more demand for our exports → our currency appreciates.
- Tastes, expectations and speculation also shift demand and supply.
- Expansionary monetary policy (lower rates) → capital outflow → depreciation.
Effect on net exports
Net exports = exports − imports. When our currency appreciates, our exports cost more abroad and imports cost less at home, so net exports fall. A depreciation does the opposite.
Capital flows
Money moves to where the real return is highest. A country with a higher real interest rate gets a capital inflow (a financial-account surplus); a country with a lower rate sees a capital outflow.
Try it
Pick two friends. Time how many sandwiches and how many paper boats each can make in 2 minutes. Work out each person's opportunity cost of one boat. Who should make boats? Then use the slider in the last 3D step: predict the net-exports bar before you move it.
Key formulas and definitions
- Opportunity cost of X = output of Y given up ÷ output of X gained
- Comparative advantage: lower opportunity cost
- Gainful terms of trade lie between the two countries' opportunity costs
- Terms of trade index = (export price index ÷ import price index) × 100
- Net exports NX = X − M
- Real interest rate ≈ nominal interest rate − inflation rate
- Higher real rate → capital inflow → currency appreciates → NX falls
Worked examples
1. In country P a worker makes 10 phones or 5 shirts a day. In country Q, 4 phones or 4 shirts. Who has the comparative advantage in shirts?
Opportunity cost of 1 shirt: in P = 10 ÷ 5 = 2 phones; in Q = 4 ÷ 4 = 1 phone. Q gives up less, so Q has the comparative advantage in shirts. P has it in phones (1 phone costs P 0.5 shirt, Q 1 shirt).
2. Using the example above, will a rate of 1 shirt = 1.5 phones benefit both countries?
Yes. P would give up 2 phones to make a shirt at home but pays only 1.5 phones by trading. Q gets 1.5 phones for a shirt instead of only 1 at home. The rate lies between 1 and 2, so both gain.
3. Will a rate of 1 shirt = 2.5 phones work?
No. 2.5 is outside the range 1–2. P can make a shirt at home for only 2 phones, so P will not pay 2.5. Trade will not happen at that rate.
4. An export price index is 120 and the import price index is 100. Find the terms of trade index.
Terms of trade = (120 ÷ 100) × 100 = 120. Terms of trade have improved: each unit of exports buys 20% more imports than in the base year.
5. Nominal interest rate is 7% and inflation is 4%. Find the real interest rate.
Real rate ≈ 7% − 4% = 3%.
6. A tariff of 10 per unit raises the home price of steel from 50 to 60. Imports fall from 40 000 to 25 000 units. How much tariff revenue does the government collect?
Revenue = tariff × imports after the tariff = 10 × 25 000 = 250 000 (currency units).
7. The central bank of country A raises interest rates while inflation stays the same. Trace the effect on A's currency and net exports.
Real interest rate rises → foreign investors buy A's assets → capital inflow → demand for A's currency rises → A's currency appreciates → A's exports dearer, imports cheaper → net exports fall.
Common mistakes
- Thinking a country that is better at everything gains nothing from trade. It still gains by focusing on where its advantage is biggest.
- Comparing outputs instead of opportunity costs when finding comparative advantage.
- Saying an appreciation raises net exports. A stronger currency makes exports dearer, so net exports fall.
- Mixing up nominal and real interest rates. Capital flows follow the real rate (nominal minus inflation).