Question 1

If a country has an absolute advantage in producing everything, why should it bother to trade?

Accepted Answer

It should trade because of comparative advantage. Even if it is more efficient at producing all goods, it will have a lower opportunity cost in one particular good. By specialising in that good and trading, it can obtain other goods even more cheaply (in terms of resources saved) than producing them itself. This specialisation increases total world output and allows the country to achieve a higher level of consumption.

Question 2

Does an 'improvement' in the Terms of Trade always benefit an economy?

Accepted Answer

Not necessarily. An improvement means export prices rise relative to import prices. If this is due to strong global demand for a country's exports, it is beneficial. However, if the higher export prices are due to domestic inflation making goods less competitive, the quantity of exports may fall significantly, potentially worsening the current account balance and leading to unemployment in export industries.

Question 3

Are the gains from trade shared equally between countries?

Accepted Answer

No, the distribution of gains is determined by the final Terms of Trade. The country whose Terms of Trade improve the most compared to its pre-trade opportunity cost ratio will gain a larger share. For example, if the world price settles very close to Country A's domestic opportunity cost, Country B will receive the majority of the gains from the trade.

The reasons for international trade

What you need to know

The reasons for international trade