Theories of International Trade

Sunday, January 27, 2013


1. Absolute Advantage 
It refers to the possession of certain advantages (lower labour costs, plentiful supplies of raw materials etc) by a country which enable it to produce a product more cheaply than other countries. 

Suppose two countries, Sealand and Skyland have resources that enable them to produce either Shirts or Perfumes, or a combination of both.

As per this example; 
- Sealand has Absolute Advantage in producing Shirts 
- Skyland has Absolute Advantage in producing Perfumes 

Therfore; 
- Sealand should specialize in the production of Shirts 
- Skyland should specialize in the production of Perfumes

Effects of Specialization








Before Specialization: 

If both the countries allocate resources equally between Shirts and Perfumes, Sealand can produce 200 Shirts and 15 units of perfumes and Skyland can produce 150 Shirts and 20 Units of Perfumes. Thus, the combined outputs of both the countries are 350 Shirts and 35 units of Perfumes. 

After Specialization: 
If both the countries specialize according to the principle of Absolute Advantage, Sealand can produce 400 Shirts and Skyland can produce 40 Units of Perfumes. 

Conclusion: 

After Specialization; Output of Shirts increased by 50 units, 
Output of Perfumes increased by 05 units. 
Therefore, it can be concluded that International Specialization increases world output.

2. Comparative Advantage 
It refers to the possession of certain advantages (lower costs and prices, innovative products etc) by a country which enable it to produce a product at a lower opportunity cost than other countries. 

Suppose two countries, Sealand and Skyland have resources that enable them to produce either Shirts or Perfumes, or a combination of both.



Calculation of Opportunity Cost 

1. Sealand: 

Opportunity cost of producing 400 Shirts = 30 units of Perfumes 
Opportunity cost of producing 01 Shirt = 30/400 
Opportunity cost of producing 01 Shirt = 0.075 units of Perfumes 

Similarly, 

Opportunity cost of producing 30 units of Perfumes = 400 Shirts 
Opportunity cost of producing 01 unit of Perfumes = 400/30 
Opportunity cost of producing 01 unit of Perfumes = 13.33 Shirts

2. Skyland: 

Opportunity cost of producing 300 Shirts = 40 units of Perfumes 
Opportunity cost of producing 01 Shirt = 40/300 
Opportunity cost of producing 01 Shirt = 0.133 units of Perfumes 

Similarly, 

Opportunity cost of producing 40 units of Perfumes = 300 Shirts 
Opportunity cost of producing 01 unit of Perfumes = 300/40 
Opportunity cost of producing 01 unit of Perfumes = 07.5 Shirts










Thus; 

Sealand has a lower Opportunity Cost in producing Shirts (01 Shirt = 0.075 units of Perfumes) and should specialize in its production. 

Skyland has a lower Opportunity Cost in producing Perfumes (01 unit of Perfumes = 07.50 units of Shirts) and should specialize in its production.
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