The reasons for International Trade

Comparative advantage exists when a country can produce a good at a lower opportunity cost than another country. The theory shows that trade benefits both countries even if one is absolutely more productive at everything, provided their opportunity costs differ.

Consider two countries with different opportunity costs of producing two goods. Each country should specialise in the good in which it has the lower opportunity cost — its comparative advantage. For example, if Country Y sacrifices only 1 unit of cloth to produce a unit of wine, while Country X sacrifices 2 units of cloth, then Y has the comparative advantage in wine and X in cloth (X gives up less wine per cloth). By specialising this way, total world output of both goods rises, because resources are concentrated where they are most efficient.

The two countries then trade at a ratio (the terms of trade) that lies between their two opportunity costs, which is beneficial to both. Because each can exchange its specialised output at a favourable rate, each country can consume a combination of goods beyond its own production possibility curve. This is shown by the trading possibility curve, which lies outside the PPC — the visible proof of the gains from trade.

Therefore both countries end up able to consume more of both goods than they could in isolation, raising living standards in each. The key insight is that mutual gains depend on differences in opportunity cost, not on one country being better in absolute terms.

The terms of trade measure export prices relative to import prices: ToT = (export price index ÷ import price index) × 100.

In Country Z, export prices (copper) fell while import prices (manufactures) rose. This means the numerator falls and the denominator rises, so the terms of trade deteriorate (fall). Each unit of copper exports now buys fewer manufactured imports than before.

The effect on the economy is likely to be harmful. To pay for the same volume of imports, Country Z must now export more copper, straining its resources. Export revenue falls (especially as copper demand is fairly inelastic), reducing national income and government revenue, and likely worsening the current account. Because Country Z is heavily dependent on a single primary commodity, it is vulnerable to exactly this kind of price shock.

This illustrates the risk of over-specialisation in a primary commodity, and supports a case for diversification to reduce dependence on copper and improve resilience.

Specialisation according to comparative advantage means concentrating on the goods a country produces at the lowest opportunity cost and trading for the rest. It brings substantial benefits, but is not always beneficial.

The case that it is beneficial. Specialisation raises world output (resources used most efficiently), allows countries to consume beyond their PPC (the trading possibility curve), and delivers lower prices, more choice, economies of scale, competition and access to technology. These raise living standards and support growth. For most economies, participating in trade based on comparative advantage is far better than self-sufficiency.

The case against / limitations. The benefits rest on assumptions that may not hold. Factors are immobile, so specialisation can cause structural unemployment when uncompetitive industries decline. Over-specialisation — especially in a single primary commodity — leaves a country vulnerable to demand and price shocks and to a deteriorating terms of trade, a serious risk for developing economies. Transport costs and trade barriers can erode the gains, externalities (e.g. environmental damage) are ignored, and the gains may be unequally distributed between and within countries. Comparative advantage also assumes constant opportunity costs, which break down as a country specialises.

Judgement. Specialisation according to comparative advantage is generally beneficial because the efficiency and consumption gains are real and large. However, it is not always beneficial: the outcome depends on factor mobility, the degree of specialisation, the type of goods, and how structural change is managed. Over-reliance on one volatile export, or specialisation that causes lasting unemployment, can leave a country worse off. The most defensible conclusion is that economies should exploit comparative advantage to capture the gains from trade, but balance efficiency against resilience — diversifying and supporting displaced workers so that specialisation raises welfare overall rather than creating vulnerability.

An improvement in the terms of trade means export prices rise relative to import prices, so each unit of exports buys more imports. This sounds unambiguously good, but the effect depends on why it happens and on elasticities.

The case that it is good. With improved terms of trade, a given volume of exports earns more imports, so the country can enjoy higher consumption and living standards for the same export effort. If the improvement comes from rising demand for the country's exports, export revenue rises, boosting national income, employment and the current account. Cheaper imports also reduce imported inflation and lower input costs for firms.

The case against / why it may not be good. The effect on the current account and output depends on price elasticity of demand for exports. If demand for exports is price-elastic, the higher export prices cause a more-than-proportionate fall in export volumes, so export revenue falls and the current account worsens — and domestic output and employment may fall. An improvement caused by a stronger exchange rate can make exports less competitive, harming exporters. The cause matters: an improvement from higher export demand is helpful, but one from a currency appreciation may damage competitiveness.

Judgement. An improvement in the terms of trade is not always good. It clearly benefits a country when demand for its exports is inelastic (so revenue holds up) or when it reflects genuinely higher demand for exports — then both consumption and the current account improve. But when export demand is elastic or the improvement comes from a loss of competitiveness, export revenue and output can fall. The most defensible conclusion is that an improvement in the terms of trade raises potential consumption per export, but its overall effect on the economy depends on the elasticity of demand for exports and imports and the cause of the change — so it is beneficial in some circumstances but harmful in others.