Therefore, to have a more complete understanding of economics, we now include the foreign sector in our discussion - opening up the subject of economics to the entire world.
Why Countries Trade
The logic goes that it is best for each country to specialise in producing the goods and services that it is 'best' at producing, instead of trying to produce all goods and services that are locally consumed. The portion of the goods and services the country produces that is not sold domestically (the surplus) can then be sold to other countries. The goods and services that are not produced domestically can then be imported from countries who specialise in those goods and services.
Taking a moment to clarify two words:
Exports are goods that are produced within the country that are sold to the rest of the world.
Imports are goods that produced in the rest of the world but purchased for use in the domestic economy.
Another reason for interntaional trade is that not all countries have access to all the natural resources to be able to produce all required goods and services. For instance, South Africa has a lot of platinum, but no crude oil. Therefore, South Africa will export platinum and import oil.
How is it decided what goods a country will import or export?
Absolute advantage
To clarify the concept of absolute advantage, we take two countries as an example: Belgium and China.Let's say a worker in Belgium can produce 100kg of chocolate or 5 TVs per week. A worker in China, however, can produce 50kg of chocolate or 10TVs per week.
We say that Belgium as an absolute advantage in the production of chocolate (100kg > 50kg).
China, on the other hand as an absolute advantage in the production of TV's (10 TVs > 5 TVs).
It is argued then that Belgium should specialise in producing chocolate (100kg per worker per week) and China should specialise in producing TVs (10 TVs per worker per week). Belgium, however, also wants TVs and China also wants chocolate. Therefore, Belgium will exchange some of its chocolate for TVs from China. Let's say that it is agreed that Belgium will trade 50kg of its chocolate for 5 TVs from China. After the trade, both Belgium and China are each able to consume 50kg of chocolate and 5 TVs.
Comparative advantage
Absolute advantage is, however, not a necessity for international trade. It is sufficient for a country to have a comparative or relative advantage over another country.We use a fictional example of German and India to illustrate the concept of comparative advantage. Let's say a worker in Germany can produce 2 cars and 8 barrels of wine per week and that a worker in India can produce 1 car and 6 barrels of wine per week.
Germany has an absolute advantage in the production of cars (2 > 1) and wine (8 > 6). So - we could expect that Germany has no interest in trading with India. However, we must consider an additional point, which is: opportunity cost.
For Germany, the opportunity cost (what Germany has to forego) for producing 2 cars is 8 barrels of wine. So, the opportunity cost of producing one car is 4 barrels of wine.
For India, the opportunity cost for producing 1 car is 6 barrels of wine.
Because 4 barrels of wine is less than 6 barrels of wine - we say that Germany has a relative or comparative advantage over India in the production of cars.
However -
for Germany, the opportunity cost for producing 8 barrels of wine is 2 cars. So, the opportunity cost of producing 1 barrel of wine is 1/4 of a car.
For India, the opportunity cost for producing 6 barrels of wine is 1 car. So, the opportunity cost of producing 1 barrel of wine is 1/6 of a car.
Because 1/6 of a car is less of a cost than 1/4 of a car - we say that India has a relative or comparative advantage over Germany in the production of wine.
The rule is that a comparative advantage in the production of a particular good is a sufficient condition for exporting that good.
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