at the end of the lesson at the end of the lesson you should be able to:you should be able to:

• identify the 3 identify the 3 conditions of conditions of trade trade

• identify the identify the limitations of limitations of the theory of the theory of absolute/comparative absolute/comparative advantageadvantage

Conditions of trade:Conditions of trade:1)The terms of trade (TOT)

must lie between the two domestic opportunity cost ratios

2)The exchange rate (ER) must lie between the two domestic opportunity cost

3) The O.C. ratios must

differ

Limitations of theory:Limitations of theory:1. Non price theory • Trade is not necessarily

based on price alone but other non-price aspects such as quality

• High costs producers can still sell their goods if their quality is better

Limitations of Limitations of theory:theory:

2. Perfect factor mobility • In practice, there is likely

to be a certain amount of factor immobility.

• when country X shifts production from cloth to wheat, labour is not easily redeployed to the wheat industry

• causes unemployment in cloth industry

Limitations of theory:Limitations of theory:3. Constant cost is unlikely• theory is ignoring the

possibility of diseconomies of scale (DEOS) and diminishing returns as output expands which can lead to higher average cost

• On the other hand, increasing returns can lead to lower average cost

Limitations of theory:Limitations of theory:4 Barriers to trade and

transport cost• trade barriers such as the

imposition of tariffs and quotas

• transportations cost etc. have not been factored into model.

• these cause SS to fall P may restrict trade n

specialization

Benefits of Benefits of Trade and Trade and

GlobalizationGlobalization

11 ..Efficient allocation Efficient allocation

of resource.of resource.Principle of Principle of

comparative comparative advantage – most advantage – most efficient producer efficient producer

produces the good produces the good cost cost PP

22Foreign Foreign

competition competition improves quality improves quality

of Goods and of Goods and ServicesServices

33Exports Exports

generates higher generates higher Income Income - -

Economic Growth Economic Growth & higher SOL& higher SOL

44Specialization & Specialization &

large scale large scale productionproduction output output

EOS EOS lower lower average costaverage cost

PP

55increase in productivity increase in productivity

& creation of new & creation of new products/industryproducts/industry

as inputs not available as inputs not available locally can be readily locally can be readily

importedimported

6 6 Increase in Increase in

variety of goods variety of goods and servicesand services