Theory of Trade - A2 Economics

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  • Created on: 15-06-13 10:29
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Theory of Trade
The growing integration of the world's economy where business increasingly produce all or
part of their raw materials in the cheapest parts of the world and increasingly, market their
products on a worldwide basis. A business may make parts for a product in several different
centuries and assemble them in another as it is cost effective and efficient method to get the
item to its customers. They will tend to make use of their firms' competitive advantage by
locating their production wherever it is most efficient. This means decisions taken in one part
of the world will affect another E.g. Peugeot 206's successor was produced in a new factory
in Slovakia, leading to 2300 jobs lost in Coventry.
Multinational corporations
The speed of globalisation has been increased by:
Technological change ­ development of the internet and other communication
methods has meant customers are able to check prices with ease (reduced
asymmetric information)
Revolution of transportation ­ reduction of bottlenecks and high costs of
transportation associated with shipping
Growth of east European market bases economies, especially since the opening up
of the USSR, has increased the markets available to global business as the open
markets are available to foreign competition. These markets, with lower COP, attract
inward investment from foreign nationals.
Trade has become increasing liberated through organisations/treaties such as the
General Agreement on Tariff and Trade (GATT) and the World Trade Organisation
This has led to:
Foreign competitors entering markets previously monopolised by domestic
businesses, e.g. EON is a German company that does business in the UK, and the
BT serves customers worldwide especially within the Far East.
Structural unemployment and deindustrialisation can occur as production moves out
of developed countries to less developed ones. We have seen this with Dyson
moving to Asia, Black and Decker to the Czech Republic, and numerous banks
moving to India.
Globalisation has increased economies of scale, as firms are able to spread fixed
costs over more units.
Mergers have helped to reduce costs and increase supplies to a global market.
Impact of globalisation on the UK
Decreases unit costs, which decreases price of finished goods, thus decreasing
costpush inflation
In some sectors, it has increased jobs, as demand for British goods have increased
Increase use of British specialised labour in the production of cross country products
e.g. airplanes

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Some multinationals have demanded subsidies to move to areas of structural
unemployment, or threatened to move elsewhere
Increased job insecurity in large movable companies e.g. manufacturing firms who
have been able to move abroad. This impacts confidence, affecting consumption and
The theory underlying international trade
International trade is important since it maximises the output which can be gained from world
resources and so contributes to the reduction of scarcity.…read more

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Comparative advantage exists when the opportunity cost is the lowest.
E.g. If one country X can produce 1 apple and 2 bananas, and another country Y produces 1
apple and 3 bananas, country X is the better producer. This is because it has to give up less
to produce bananas.…read more

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If country Y gave up 40 wheat, it would produce 10 machines, and vice versa. To determine
the OC for wheat, we would need to divide 10 by 40, which is 0.25. For every wheat that we
produce, we give up 0.25 machine.
Therefore, country Y has a comparative advantage in producing wheat because the
opportunity cost ratio is the lowest. It gives up fewer machines to produce wheat.
2.…read more

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Worked example of comparative advantage
Consider two countries producing two products ­ digital cameras and vacuum cleaners.
With the same factor resources evenly allocated by each country to the production of both
goods, the production possibilities are as shown in the table below.
Prespecialisation Digital Cameras Vacuum Cleaners
UK 600 600
United States 2400 1000
Total 3000 1600
Working out the comparative advantage
To identify which country should specialise in a particular product we need to analyse
the internal opportunity costs for each country.…read more

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Total 3360 1800
Compared with the prespecialisation output levels, consumers in both countries now have
an increased supply of both goods to choose from.
Is trade really beneficial?
The period since WW2 has seen a great movement towards the freeing of trade. This has
been championed by nations such as the USA. A primary reason for the creation of the EU
was to allow free trade between the member nations.…read more

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The index is calculated by:
In the base year, all the index numbers will be 100, and so the overall terms of trade index will
be 100. If the terms of trade index rise to 110, this means that 10% more imports can be
gained from the same amount of exports.…read more

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Extra reading on TOT
Improvement in TOT
More imports are received for a given number of exports ­ for this to happen, export
prices will need to rise while import prices will need to fall
The effect of this improvement in the TOT on the total amount spent on imports and
exports (the trade balance) depends on the PED for imports and exports
If the UKs TOT improves (export prices have risen), and foreign demand for UK
exports is elastic, then less ill be spent…read more

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The problems intensified in 1998 with the collapse in the currencies of many Asian
developing countries. A big fall in the terms of trade signifies a reduction in real living
standards since imports of goods and services have become relatively more expensive.
Other points to note:
Improvements in TOT can come from inflation and an appreciation in the exchange
Countries that sell exports that are inelastic gain from increased TOT, but lose if their
goods are elastic.…read more

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Factors determining comparative advantage
The quantity and quality of factors of production available (e.g. the size and efficiency
of the available labour force and the productivity of the existing stock of capital inputs).
If an economy can improve the quality of its labour force and increase the stock of
capital available it can expand the productive potential in industries in which it has an
advantage.…read more



This is a 9 page well written summary on the reasons for globalisation and reasons for trade. It is an excellent resource for producing your own revision documents from or for reading and learning if you are able to do this.

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