Schedule M - Trade Theory (macro In The Wrong Deck!)

Question 1

Define an Absolute Advantage

Answer 1

An absolute advantage refers to the ability of a country to produce a good or service more efficiently and with fewer resources than another country.

Question 2

Why might a country specialise in the goods they have an absolute advantage in producing?

Answer 2

According to the theory of absolute advantage, a country may specialise in producing what they have an absolute advantage in so that they can maximise output and productivity, leading to overall economic growth

Question 3

Define comparative advantage

Answer 3

Comparative advantage is where a country can produce a good or service at a lower opportunity cost than that of another country

Question 4

Why would a country specialise in the good or service they have a lower opportunity cost in producing?

Answer 4

They can achieve higher levels of efficiency and productivity. This leads to increased total output and welfare for all countries involved in trade.

Question 5

State and briefly explain 5 assumptions of the comparative advantage theory

Answer 5

1. Constant returns to scale - assuming no economies of scale which in reality amplifies the gains from trade
2. No trade barriers - tariffs and quotas may artificially change the prices at which trade occurs
3. Low transportation costs - high logistics costs in getting product to market might erode comparative advantage
4. Exchange rate movements ignored
5. Non price competitiveness ignored

Question 6

What are the 4 main reasons why we gain from free trade (think micro)?

Answer 6

1. Free trade allows for deeper specialisation and benefits from economies of scale
2. Free trade increases market competition and choice and also drives up product quality for consumers
3. Increased market contestability reduces prices for consumers leading to higher real incomes
4. Trade can lead to better use of scarce resources for example from trade in sustainable technologies

Question 7

How can trade improve allocative efficiency?

Answer 7

Competition from lower-cost import sources drives market prices down closer to marginal cost and then reduces the level of monopoly (supernormal) profits.

Question 8

How can trade improve productive efficiency?

Answer 8

Specialising and selling in larger markets encourages increase in returns to scale (economies of scale), i.e. a lower long run average cost of production

Question 9

How can trade improve dynamic efficiency?

Answer 9

Economies open to trade may see more innovative businesses who invest more in R and D and also in the human capital of their workforce to help raise labour productivity.

Question 10

How might trade lead to X efficiency?

Answer 10

Intense competition in markets provides a discipline on businesses to keep their unit costs under control to remain price competitive and profitable

Question 11

What does the terms of trade measure?

Answer 11

The terms of trade is a measure of the ratio of export prices to import prices. This is the rate at which goods are exchanged for another.

Question 12

What are some drawbacks of specialisation and trade (compared to everyone just producing things domestically)? - try to give 4

Answer 12

1. Volatile global prices affecting export revenues
2. Risks that exports will be affected by geo-political uncertainties and cyclical fluctuations in demand
3. Opening up trade and investment may cause rising structural unemployment
4. Countries that specialise in few PRIMARY COMMODITIES may suffer from the natural resource trap (resource curse) which may make them poorer than a countries less dependent on exporting primary commodities

Question 13

The terms of trade is like the CPI - an index. What is meant when we say the terms of trade have deteriorated?

Answer 13

The price of a given basket of exports for a nation can buy less imports than what it could have done before.

Question 14

What is meant when we say the terms of trade have improved?

Answer 14

The basket of exports’ price can buy more in terms of imports than what it could have done before.

Question 15

What short run factors impact on the terms of trade?

Answer 15

1. Demand and supply for exports and or imports changes
2. Relative inflation rates (may be good for the terms of trade if the price of exports goes up, but bad for competitiveness)
3. Exchange rate movements

Question 16

What long run factors can impact on the terms of trade? - state and explain why (3 of them)

Answer 16

1. Incomes (as incomes rise, normal luxury goods may be imported more- they are more income elastic, Prebisch Singer - for developing countries)
2. Productivity
3. Technology (for both 2 and 3 - lower costs of production may reduce export prices = deterioration in the terms of trade but it is good for competitiveness)

Question 17

What observation did Prebisch and Singer make?

Answer 17

They observed a long term decline in commodity prices and worsened terms of trade for primary exporters.

Question 18

Why did Prebisch and Singer observe a deterioration in the terms of trade for countries dependent on natural resource exports?

Answer 18

The price of manufactured products has increased massively as the world’s growth was boosted by globalisation. Therefore, the price of the goods that developing countries import are greater than the price the goods they export (primary products).
The primary products are more income INELASTIC so demand for them has not necessarily increased as the world got richer. The opposite is the case for the income ELASTIC manufactured/capital/secondary goods (so effect of YED and wealth effect).

Question 19

What did Prebisch and Singer advise developing countries dependent on natural resource exports?

Answer 19

Use revenues from exports when there are temporary rises in natural resource prices/primary product prices to PROMOTE DIVERSIFICATION and focus on import substitution policies.