Cambridge A Level Economics: Absolute and comparative advantage, free trade and the terms of trade (9708)

This guide covers section 6.1 (outcomes 6.1.1 to 6.1.4) of the Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. Topics 1 to 6 are AS Level content, so this is AS Level content and it is assumed knowledge for A Level Papers 3 and 4. All countries, goods and figures below are invented for illustration. Use the revision notes for recall and the practice set to test yourself. The course hub and checklist show the rest of the syllabus, and the diagnostics show where to start. Opportunity cost and the PPC are covered in the production possibility curves guide.

What this unit covers

Outcome	What you must be able to do
6.1.1	Distinguish absolute from comparative advantage
6.1.2	Explain the benefits of specialisation and free trade (trade liberalisation), including the trading possibility curve
6.1.3	Define and measure the terms of trade, explain what changes them and analyse the impact of a change
6.1.4	Explain the limitations of the theories of absolute and comparative advantage

6.1.1 Absolute and comparative advantage

Absolute advantage means being able to make a good with fewer resources than a rival country needs, or to make more of it from the same resources. It is a comparison of efficiency in terms of resources used.

A country has a comparative advantage in a good if it can produce it at a lower opportunity cost than another country. It is a comparison of what must be given up. The two ideas can point in different directions, and this is the key insight of the theory: a country with an absolute advantage in everything still has a comparative advantage in only some goods.

Worked example 1: finding both advantages

Country Alpha and Country Beta each make tea and cloth using only labour. The table shows labour-hours needed per unit. Alpha has 240 labour-hours and Beta has 432.

	Hours per unit of tea	Hours per unit of cloth
Alpha	5	8
Beta	9	12

Step 1, absolute advantage. Alpha needs fewer hours for both goods, so it has an absolute advantage in both.

Step 2, maximum output if all labour makes one good. Alpha: 240 ÷ 5 = 48 tea or 240 ÷ 8 = 30 cloth. Beta: 432 ÷ 9 = 48 tea or 432 ÷ 12 = 36 cloth.

Step 3, opportunity costs. In Alpha, 1 tea costs 5 ÷ 8 = 0.625 cloth and 1 cloth costs 8 ÷ 5 = 1.6 tea. In Beta, 1 tea costs 9 ÷ 12 = 0.75 cloth and 1 cloth costs 12 ÷ 9 = 1.33 tea.

Step 4, comparative advantage. Alpha gives up less cloth per tea (0.625 against 0.75), so Alpha has the comparative advantage in tea. Beta gives up fewer tea per cloth (1.33 against 1.6), so Beta has the comparative advantage in cloth.

A check: with two goods and two countries, if one country has the lower opportunity cost of tea, the other must have the lower opportunity cost of cloth. If both countries had identical opportunity costs, there would be no comparative advantage and no gain from specialising.

6.1.2 Specialisation, free trade and the trading possibility curve

Specialisation means a country concentrates on the goods in which it has a comparative advantage. Free trade (trade liberalisation) means exchange without tariffs, quotas or other barriers. Together they let countries produce more in total and consume more than they could alone.

Worked example 2: the gains from specialising

Before trade, each country spends half its hours on each good.

	Tea	Cloth
Alpha (120 hours each)	24	15
Beta (216 hours each)	24	18
World total	48	33

After specialising completely, Alpha makes 48 tea and Beta makes 36 cloth. World output is 48 tea and 36 cloth, which is 3 more cloth with no loss of tea.

The gain is shared through trade. The price of tea in cloth must lie between the two opportunity costs: above 0.625 (or Alpha would rather make cloth itself) and below 0.75 (or Beta would rather make tea itself). Take 2/3 cloth per tea, so 3 tea exchange for 2 cloth. Alpha sells 24 tea and receives 24 × 2/3 = 16 cloth.

After trade	Tea	Cloth	Change from before
Alpha	48 − 24 = 24	16	+1 cloth
Beta	24	36 − 16 = 20	+2 cloth

Both countries consume more cloth and no less tea (the 3 extra cloth is shared 1 and 2). Neither could do this by producing at home alone.

The trading possibility curve

A trading possibility curve (TPC) shows the combinations of two goods a country can consume after specialising and trading at given terms. It lies outside the production possibility curve (PPC) when the terms of trade differ from the domestic opportunity cost.

For Alpha, the PPC is a straight line from 48 tea (no cloth) to 30 cloth (no tea). The TPC starts at the same 48 tea on the horizontal axis but ends at 48 × 2/3 = 32 cloth on the vertical axis, because all the tea could be swapped for cloth. It is a steeper-than-PPC line that lies outside it everywhere except the tea-only point. Alpha’s after-trade point (24 tea, 16 cloth) is on the TPC. On the PPC, 24 tea would allow only 15 cloth, so the point lies outside the PPC: trade has pushed consumption beyond what Alpha could produce.

The better the price Alpha gets for its tea, the more cloth each unit buys and the further out the TPC swings. At 0.75 cloth per tea (Beta’s opportunity cost) Alpha would take the whole gain.

Wider benefits of free trade

• Greater variety and lower prices for consumers, because imports compete with domestic goods.
• Larger markets let firms gain economies of scale and lower their unit costs.
• Competition pushes firms to improve efficiency and innovate.
• Access to resources and inputs a country lacks.
• Higher export revenue and, through the multiplier, higher income and employment, although this is not guaranteed.

6.1.3 Exports, imports and the terms of trade

Exports are goods and services sold to other countries. Imports are goods and services bought from other countries. The terms of trade (ToT) show the rate at which a country’s exports exchange for its imports.

Measurement

Terms of trade index = (index of average export prices ÷ index of average import prices) × 100.

If export prices rise faster than import prices, the index rises: the terms of trade have improved, because each unit of exports buys more imports. If import prices rise faster, the index falls and the terms of trade have worsened (deteriorated).

Worked example 3: measuring a change

Country A (illustrative), base year index 100 for both prices.

Year	Export price index	Import price index	Terms of trade
1	114	95	114 ÷ 95 × 100 = 120.0
2	114	120	114 ÷ 120 × 100 = 95.0

The terms of trade fell from 120.0 to 95.0. The percentage change is (95.0 − 120.0) ÷ 120.0 × 100 = −20.8%. Export prices did not move, so the whole change is due to dearer imports. Say “worsened” and give the figures.

Causes of a change

Cause	Effect on terms of trade
Rise in world demand for a country’s main export	Export prices rise: improve
Rise in the price of imported oil or other key inputs	Import prices rise: worsen
Appreciation of the exchange rate (prices set in home currency)	Import prices in home currency fall: improve
Depreciation of the exchange rate	Import prices in home currency rise: worsen
Higher productivity or lower costs in export industries	Lower export prices, so ToT may worsen even though competitiveness improves
Higher inflation at home than abroad	Export prices rise faster than import prices: improve at first, but competitiveness falls
Increase in the supply of a commodity from many producers	Export prices fall for commodity exporters: worsen

Impact of a change

An improvement means the country gets more imports for the same exports. Suppose it exports 400 units at 18 currency units (cu) while imports cost 15 cu each. The exports buy 400 × 18 ÷ 15 = 480 import units. Before the rise in export prices (when export prices were 15 cu) they bought only 400.

Do not stop there. The effect on export revenue depends on the price elasticity of demand for exports. Suppose export prices rise 20%:

• If demand is elastic, with PED of −1.8, volume falls 36%. Revenue index = 1.20 × 0.64 = 0.768, a 23.2% fall. The improved terms of trade then worsen the current account.
• If demand is inelastic, with PED of −0.5, volume falls 10%. Revenue index = 1.20 × 0.90 = 1.08, an 8% rise.

Other impacts to consider: cheaper imports lower costs for firms and reduce imported inflation, but a worsening of the terms of trade means a country must export more to buy the same imports, which reduces real income and living standards. A fall in the terms of trade is not always bad: if it comes from higher productivity, firms are more competitive and sell more.

6.1.4 Limitations of the theories

The theory rests on assumptions that rarely hold. State the limitation, then say what it does to the case for specialisation.

• Transport costs and trade costs. They reduce or remove the gain. In example 2 the total gain was 3 cloth. If shipping the goods costs the equivalent of 3 cloth, the net gain is zero; if it costs more, trade makes the countries worse off in total.
• Increasing opportunity costs. The model uses constant costs, but resources are not equally suited to every good. As Country H shifts resources into cloth, it gives up more tea for each extra unit:

Step	Extra cloth	Tea given up	Tea per cloth
1	20	10	0.50
2	20	15	0.75
3	20	25	1.25

The comparative advantage shrinks as output rises, so specialisation tends to stop short of complete.

• Factors are not perfectly mobile. Workers may take time to retrain, so unemployment can result from specialising.
• Static analysis. Comparative advantage can change over time with education, technology and investment, which is why some countries protect infant industries.
• Overspecialisation and dependence. A country relying on one export is exposed to price falls, shortages of imports and political disputes. Example 3 shows how fast the terms of trade can move.
• Other assumptions. Perfect competition, full employment, perfect information, identical goods and no trade barriers are assumed. Real trade involves exchange-rate changes, differences in quality, imperfect competition and external costs such as pollution from transport.
• Distribution. Gains are not shared equally. Some workers, industries and regions lose.

Common errors

• Saying a country with an absolute advantage in both goods should not trade. It still gains from specialising where its opportunity cost is lower.
• Judging comparative advantage by which country makes more of a good. Compare opportunity costs.
• Reversing the terms of trade formula. Exports sit on the top.
• Calling a rise in the index “worse”. A higher figure is an improvement.
• Ignoring the elasticity of demand when assessing the impact of a change in the terms of trade.
• Listing assumptions without saying how each limits the benefits.

Official syllabus

Cambridge International AS & A Level Economics 9708, syllabus for examination in 2026, 2027 and 2028, published by Cambridge University Press & Assessment (Cambridge International Education). Section 6.1, The reasons for international trade, outcomes 6.1.1 to 6.1.4.