Pearson Edexcel International Advanced Level Economics: Comparative advantage (YEC11) – Revision Notes

These notes condense statements 1 to 3 of 4.3.2 Trade and the global economy in the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018). The topic belongs to Unit 4, an International A2 unit that the specification marks as IAL compulsory. For full explanations use the study guide, then try the practice questions. See also the course hub, the printable checklist and the free diagnostics. All figures are invented and illustrative. Trading blocs, the WTO and protectionism are separate statements.

Definitions

• Specialisation: concentrating resources on the goods a country makes at lowest opportunity cost.
• Absolute advantage: using fewer resources to make a good than a rival does.
• Comparative advantage: giving up less of other goods to make a good than a rival does.
• Opportunity cost: the next best alternative given up.
• Terms of trade: the relationship between export prices and import prices, measured as an index.
• Improvement / deterioration: a rise / fall in the index.
• Unit labour cost: labour cost per unit of output.

Formulas

Measure	Formula
Opportunity cost of good A in goods of B	output of B given up ÷ output of A gained
Terms of trade index	export prices ÷ import prices, times 100
Percentage change	(new − old) ÷ old × 100
Unit labour cost	wage ÷ output per worker
Share of world exports	country’s exports ÷ world exports × 100
Change in quantity	% change in price × price elasticity of demand
Revenue index	price index × quantity index

Method in steps: finding comparative advantage

1. Write the output per unit of input for each country and good.
2. For each country, find what one good costs in units of the other.
3. The country with the lower opportunity cost has the comparative advantage in that good.
4. The mutually beneficial exchange rate lies between the two opportunity costs.
5. Check total output before and after specialisation.

Worked reminder 1

Output per worker-day (Countries G and H, illustrative):

	Fish	Timber
G	6	3
H	2	2

G has an absolute advantage in both goods. One timber costs G 6 ÷ 3 = 2 fish and costs H 2 ÷ 2 = 1 fish. H has the comparative advantage in timber, and G in fish (0.5 timber against H’s 1.0). One timber should exchange for between 1 and 2 fish.

Assumptions and limitations

Assumption	If it fails
Two countries, two goods	Real trade is multilateral and many-good, so gains are harder to predict
Constant opportunity costs	Costs rise with specialisation, so gains stop short of full specialisation
No transport costs, no barriers	Costs and barriers can wipe out the gain
Factors mobile within a country	Displaced workers may become structurally unemployed
Full employment, perfect information	Unused resources and poor information reduce gains
Static world	Comparative advantage changes; infant industries may need support

Also: gains are shared unequally, and a country dependent on primary exports faces price volatility.

Benefits and costs of specialisation and trade

• Benefits: higher output, economies of scale, lower prices, more choice, competition and innovation.
• Costs: overdependence, structural unemployment, damage to infant industries, environmental cost, loss of self-sufficiency.

Patterns and volume of world trade: one-line chains

• Emerging economies: rapid growth and productivity gains, so a rising share of exports and imports.
• Changing comparative advantage: investment, skills and technology shift opportunity costs, so exports move from primary goods to manufactures to services.
• Blocs and bilateral agreements: lower barriers between partners, so more trade between them.
• Relative exchange rates: appreciation raises export prices abroad and cuts import prices, so exports fall and imports rise (depending on elasticity). Depreciation reverses this.
• Protectionism: barriers up, trade volume in those goods down.

Worked reminder 2

Country K’s exports are 80 of world exports of 2,000, a 4.0% share. Later they are 150 of 2,500, a 6.0% share. Exports rose 87.5% and the world’s 25%, so K gained share.

Terms of trade

Method in steps

1. Put both indices on the same base year and currency.
2. Divide the export index by the import index, times 100.
3. Compare years and give the percentage change.
4. Say “improved” or “deteriorated” and what it means: more or fewer imports per unit of exports.

Worked reminder 3

Year	Export prices (index)	Import prices (index)	Terms of trade index
1	100	100	100.0
2	108	120	90.0
3	108	100	108.0

Year 2 is a deterioration of 10%. From year 2 to 3 the index rises (108 − 90) ÷ 90 = 20%.

What moves the terms of trade

Factor	Chain
Relative inflation	Higher domestic inflation raises export prices relative to import prices, so the index rises, but competitiveness falls
Relative productivity	Faster productivity growth cuts unit costs and export prices, so the index falls and competitiveness rises
Relative labour costs	Wages above productivity raise export prices, so the index rises; the reverse lowers it
Exchange rate	Appreciation lowers import prices in home currency, so the index rises; depreciation raises import prices, so it falls
Import and export prices	Direct. Commodity price swings cause large moves

Worked reminder 4

A 20% depreciation (foreign units per home unit falls from 1.00 to 0.80) raises the home-currency price of imports from 100 to 100 ÷ 0.80 = 125. With export prices fixed at 100 in home currency, the index falls from 100 to 100 ÷ 125 × 100 = 80.

Effects of a change

Effect	Chain
Export revenue	Depends on price elasticity of demand: a price rise raises revenue if demand is inelastic and cuts it if elastic
Living standards	An improvement means more imports per unit of exports, so higher real income. A deterioration does the reverse
Balance of trade	Dearer imports with inelastic demand raise the import bill and widen a deficit. Cheaper exports with elastic foreign demand raise export revenue

Must-know distinctions

• Absolute advantage compares resources used; comparative advantage compares opportunity costs.
• The terms of trade compare prices; competitiveness compares costs and prices against rivals.
• An improvement in the terms of trade is not the same as a better balance of trade.
• Revenue (price times quantity) is not the same as price.

Evaluation toolkit

• Elasticity of demand for exports and imports.
• Time: short run versus long run.
• The cause of the change (productivity gain or price fall in weak markets).
• Size of the trade sector in the economy.
• Which groups gain and lose.

Quick self-test

1. Export price index 135, import price index 150. Calculate the terms of trade.
2. The terms of trade rise from 80 to 92. Calculate the percentage change.
3. Using worked reminder 1, which country has the comparative advantage in fish, and what is its opportunity cost?
4. A currency depreciates 20% and import prices are fixed abroad. State the effect on the home-currency import price index starting from 100.
5. A firm raises price 20% and price elasticity of demand is −0.5. Find the change in revenue.
6. Wages rise 8% and output per worker 2%. Find the change in unit labour cost.
7. State two assumptions of comparative advantage theory.
8. Explain why a deterioration in the terms of trade may raise export volumes.
9. Explain how a rise in export prices could leave a country with lower export earnings.
10. Country M’s exports grow from 3% to 5% of world exports. State two possible reasons.

Answers

1. 135 ÷ 150 × 100 = 90.0.
2. (92 − 80) ÷ 80 = 15%.
3. G; it gives up 0.5 timber per fish.
4. 100 ÷ 0.80 = 125, a 25% rise.
5. Quantity falls 10%. Revenue index 1.2 × 0.9 = 1.08, a rise of 8%.
6. 1.08 ÷ 1.02 = 1.059, a rise of 5.9%.
7. Any two: two countries and goods; constant opportunity costs; no transport costs; no trade barriers; perfect factor mobility within countries; full employment.
8. Lower export prices make exports more competitive abroad, so volume may rise. Revenue depends on elasticity.
9. If foreign demand is elastic, the higher price cuts volume by a larger percentage.
10. For example, productivity gains lowering costs; a trade agreement lowering barriers; a depreciation making exports cheaper abroad.

Where marks are usually lost

• Putting import prices on top of the index formula.
• Stating the direction of a change without saying what it means for imports bought per unit of exports.
• Confusing absolute and comparative advantage, or asserting that the country with the absolute advantage in everything gains nothing from trade.
• Calculating opportunity cost with the numerator and denominator swapped.
• Forgetting that revenue depends on elasticity.
• Listing assumptions without saying what happens when they fail.
• Treating all five influences on the terms of trade as pushing the same way.
• Evaluating with a summary rather than a judgement that names what the answer depends on.
• Mixing percentages and percentage points.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018, Pearson Education Limited: Unit 4, section 4.3.2 Trade and the global economy, statements 1 to 3.