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

This guide teaches 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): specialisation and comparative advantage, patterns and volume of world trade, and the terms of trade. The International AS units are Units 1 and 2; Units 3 and 4 add the International A2 content. Unit 4, Developments in the global economy, is marked IAL compulsory, so this topic is A2 material. Every country, firm and figure below is invented and illustrative.

Related pages: the revision notes, the practice questions, the course hub, the printable checklist and the free diagnostics. Trading blocs, the WTO and protectionism are statements 4 and 5 and are not taught here.

What this guide covers

Ref	Skill
4.3.2 (1a)	Explain the benefits and costs of specialisation and trade internationally
4.3.2 (1b)	Distinguish absolute from comparative advantage; state the assumptions and limitations of the theory
4.3.2 (2a)	Explain what shapes patterns of trade and why they change: emerging economies, changing comparative advantage, trading blocs and bilateral agreements, relative exchange rates, protectionism
4.3.2 (2b)	Explain changes in trade flows between countries and the reasons
4.3.2 (3a)	Understand and calculate the terms of trade
4.3.2 (3b)	Explain how relative inflation, relative productivity, relative labour costs, the exchange rate and import and export prices influence them
4.3.2 (3c)	Analyse the effects of a change on export revenues, living standards and the balance of trade

1a. Benefits and costs of specialisation and trade

Specialisation means a country concentrates its resources on the goods it produces at lowest opportunity cost, then trades for the rest.

Benefits:

• Output rises because resources move to their best use.
• Larger markets allow economies of scale, so unit costs fall.
• Consumers gain lower prices, more variety and access to goods that cannot be made at home.
• Competition from imports pressures domestic firms to cut costs and innovate.

Costs:

• Overdependence on a few exports exposes a country to price swings and demand shocks.
• Workers in declining industries lose jobs, and retraining takes time (structural unemployment).
• Imports can undercut domestic firms, and fragile infant industries may never get started.
• Transport and the extra output can add environmental costs.

1b. Absolute and comparative advantage

Absolute advantage means making a good with fewer resources, or making more from the same resources, than a rival. Comparative advantage means giving up less of other goods to make it. Trade depends on the second, not the first.

Worked example 1: gains when one country is better at everything

Output per worker-year. Country P has 100 workers and Country Q has 200 (illustrative).

	Rice (tonnes)	Bicycles
Country P	8	4
Country Q	5	1

Step 1, absolute advantage: P is better at both goods.

Step 2, opportunity costs. P: 1 bicycle costs 8 ÷ 4 = 2 rice. Q: 1 bicycle costs 5 ÷ 1 = 5 rice. Bicycles are cheaper in P, so P has the comparative advantage in bicycles. Q gives up 1 ÷ 5 = 0.2 bicycles per rice against P’s 4 ÷ 8 = 0.5, so Q has it in rice.

Step 3, output before trade. P splits workers 50/50: 400 rice and 200 bicycles. Q splits 100/100: 500 rice and 100 bicycles. World: 900 rice and 300 bicycles.

Step 4, full specialisation. P makes 100 × 4 = 400 bicycles. Q makes 200 × 5 = 1,000 rice. World output is 1,000 rice and 400 bicycles: 100 more of each.

Step 5, the mutually beneficial price. Both countries gain only if one bicycle trades for between 2 and 5 rice. Take 4 rice. P sells 100 bicycles for 400 rice and consumes 300 bicycles and 400 rice (100 more bicycles than before). Q consumes 600 rice and 100 bicycles (100 more rice). Neither is worse off. A price nearer 2 favours Q, nearer 5 favours P.

Assumptions of the theory

• Two countries and two goods (the model is simplified).
• Constant opportunity costs, so complete specialisation is possible.
• No transport costs and no trade barriers.
• Factors move freely between industries within a country but not between countries.
• Full employment, perfect information and similar quality goods.
• Prices reflect opportunity costs; no externalities.

Limitations

Each assumption that fails limits the theory:

• Transport and trade costs shrink or erase the gain. If shipping costs absorb the whole gain (in example 1, worth 100 bicycles to P), trade no longer benefits P.
• Opportunity costs usually rise as a country specialises, so the gain stops short of full specialisation.
• Factors are not perfectly mobile, so workers displaced from one industry may stay unemployed.
• Barriers, subsidies and exchange rate moves distort relative prices.
• The model is static. Comparative advantage changes (section 2), and protecting an infant industry may build a future advantage the model cannot see.
• Gains are not shared equally, and the distribution depends on the price agreed.
• Specialising in primary products exposes a country to volatile prices.

Evaluation. The theory shows that trade can raise world output even when one country is better at everything. It is weakest as a guide for a developing economy with one export, where the risks of dependence and the chance to build new advantages matter more than today’s opportunity costs.

2. Patterns and volume of world trade

A country’s pattern of trade is which goods it trades and with whom. Its volume is how much. Five influences from the specification:

1. Emerging economies. Fast growth, large labour forces and rising productivity let them take a growing share of world exports and become big import markets.
2. Changing comparative advantage. Investment, education, technology and capital accumulation shift opportunity costs, so a country moves from primary goods to manufactures to services. Rising wages can erode a low-cost advantage.
3. Trading blocs and bilateral agreements. Removing barriers between members raises trade between them. How blocs create or divert trade is a separate topic.
4. Relative exchange rates. Appreciation raises export prices abroad and lowers import prices; depreciation does the reverse.
5. Protectionism. Higher barriers cut trade in the affected goods; falling barriers raise it.

Worked example 2: a changing share of world trade

Country E (emerging, illustrative). World goods exports rise from 20,000 to 26,000 over ten years; E’s exports rise from 600 to 1,430 (same currency units).

• Share of world exports: 600 ÷ 20,000 = 3.0%, then 1,430 ÷ 26,000 = 5.5%.
• Growth: E, (1,430 − 600) ÷ 600 = 138.3%; world, 6,000 ÷ 20,000 = 30%.
• E’s exports grew over four times as fast as the world’s, so its share almost doubled.

Reasons might include rising productivity, a fall in domestic costs relative to partners, new trade agreements or a competitive exchange rate. The numbers show the change; you must explain why.

Worked example 3: exchange rate and protection

An exporter in Country A sells a machine at 400 A-units. At 0.50 foreign units per A-unit the foreign price is 200. A appreciates to 0.55, so the price is 400 × 0.55 = 220, up 10%. If the price elasticity of demand for the machine is −1.5, volume falls 15% and foreign-currency revenue changes by 1.10 × 0.85 = 0.935, a 6.5% fall.

If Country B cuts its tariff on a good from 20% to 5%, a 100-unit import price falls from 120 to 105, down 12.5%. With price elasticity of demand −1.2, import volume rises 15%.

3. The terms of trade

Index = 100 × export price index ÷ import price index.

A rise means each unit of exports buys more imports (an improvement); a fall means fewer (a deterioration). Both indices need the same base year and currency.

Worked example 4: calculating and interpreting

Country A, base year = 100 (illustrative).

Year	Export prices (index)	Import prices (index)	Terms of trade index
1	100	100	100.0
2	110	104	110 ÷ 104 × 100 = 105.8
3	110	125	110 ÷ 125 × 100 = 88.0

From year 2 to 3 the index fell (88.0 − 105.8) ÷ 105.8 = 16.8%. Export prices were unchanged, so dearer imports caused the whole deterioration.

Influences on the terms of trade (3b)

• Export and import prices. Directly set the index. Commodity price swings move it fast.
• Relative inflation. If domestic inflation is 6% and partners’ is 2%, domestic export prices rise relative to import prices, which improves the index in the short run. It also cuts competitiveness (1.06 ÷ 1.02 gives a 3.9% relative rise).
• Relative productivity. Faster productivity growth lowers unit costs and export prices, which tends to lower the index while raising competitiveness.
• Relative labour costs. Unit labour cost = wage ÷ output per worker. If wages rise 6% and productivity 10%, unit labour cost changes by 1.06 ÷ 1.10 = 0.964, down 3.6%. Cheaper exports may lower the index.
• The exchange rate. Suppose export prices are fixed in domestic currency and import prices in foreign currency. An 8% appreciation cuts the import index from 125 to 125 ÷ 1.08 = 115.7. The index rises from 88.0 to 110 ÷ 115.7 × 100 = 95.0. Depreciation does the opposite.

Effects of a change (3c)

Export revenues. Revenue is price times quantity, so the effect depends on price elasticity of demand for exports. A firm sells 1,000 units at 50 (revenue 50,000). Prices rise 10% to 55.

• Elastic demand (−1.8): volume falls 18% to 820. Revenue is 55 × 820 = 45,100, down 9.8%.
• Inelastic demand (−0.4): volume falls 4% to 960. Revenue is 52,800, up 5.6%.

Living standards. An improvement raises real income because the same exports buy more imports. If import prices rise from 50 to 56, 50,000 of export revenue buys 892.9 units instead of 1,000, 10.7% fewer.

Balance of trade. Exports are 1,000 units at 50 and imports 900 units at 50, a surplus of 5,000. Import prices rise 12% and import demand has elasticity −0.5, so volume falls 6% to 846. Imports cost 846 × 56 = 47,376. The surplus shrinks to 2,624. Inelastic import demand makes a deterioration worsen the balance.

Evaluation. The effect depends on the elasticities, the time horizon, and why the index moved. A fall caused by productivity gains may raise export volumes and employment. A fall caused by weak commodity prices usually just cuts income.

Common errors

• Inverting the formula (import over export).
• Saying a rise in the index always raises export revenue.
• Treating the terms of trade as the same as competitiveness.
• Mixing currencies or base years.
• Naming a factor without saying which way prices move.

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.