(2014) A Level H2 Econs Paper 2 Essay Q1

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1. In order for specialisation to be beneficial, it must be accompanied by exchange.

(a) Explain how benefits to the economy can arise from specialisation and exchange. [10]

A country such as the USA would have absolute advantage in the production of most goods as compared to Vietnam due to higher technology and better quality of work force. However, the theory of comparative advantage states that countries can still benefit from trade and specialisation even though one country may have absolute advantage in all goods, which in this situation, appears to be the case for the USA.

Given that countries have different factor endowments, their respective opportunity costs differ. Vietnam with relatively more labour resources would have comparative advantage in labour intensive goods such as textiles. World output can increase, and countries can enjoy a higher consumption of all goods by exporting goods they have a comparative advantage in and importing goods they have a comparative disadvantage in. This can be illustrated with the use of numerical examples.

Given that 2 units of resources are divided equally between textiles and car production, USA can produce 100 units of textiles and 50 units of cars, while Vietnam can produce 80 units of textiles and 10 units of cars. The total production of textile and cars are 180 units and 60 units respectively.

Even though US has absolute advantage in production of both textiles and cars, it only has comparative advantage in the production of cars, since its opportunity cost of producing 1 unit of car is 2 units of textiles which is lower than that of Vietnam with 8 units of textiles. Conversely, Vietnam has a comparative advantage in the production of textiles. Thus, US should specialise in the production of cars and Vietnam in textiles. However, it should be noted that the country with absolute advantage in both goods should partially specialise and not fully, for output to increase.

Hence, if US puts 0.3 unit of resources to textile and 1.7 unit to car production, and Vietnam allocates all 2 units to the production of textile, US will produce 30 units of textiles and 85 units of cars while Vietnam can produce 160 units of textiles. This will increase total output of textiles and cars to 190 and 85 respectively. Thus, world output of both rises after specialisation.

To benefit from specialisation, countries must trade, and will only benefit from trade if the Terms of Trade (TOT) lies between the 2 countries’ domestic opportunity costs. In this case, terms of trade of 1 car should be between 2-8 units of textiles. Thus if TOT is 1 unit of car to 5 units of textiles, US will benefit because it can now get 5 textiles in return for 1 car, which is higher than the 2 textiles it could get before trade because its opportunity cost was 1 car to 2 textiles. Vietnam will also benefit because it only needs to sell 5 units of textiles to get 1 unit of car now, since it needed to give up 8 units of textiles to produce 1 car before trade.

Therefore, with trade, both US and Vietnam are now able to enjoy higher consumption of the goods.

Specialisation and trade enable countries to consume beyond its Production Possibility Curve (PPC), thus increasing standard of living.

(b) Very often these benefits are not fully achieved in domestic and international markets. Discuss the reasons for this. [15]

Transportation costs

1. In the explanation illustrating the benefits from specialisation and exchange, there is no consideration for transportation (& insurance) costs between countries

2. Large, bulky items such as large & heavy furniture or items requiring refrigeration/freezing such as volatile drug compounds may be very costly to transport between countries, especially if across large distances

3. Such transport costs may reduce or completely negate the benefits from specialisation & exchange

4. This might explain why these benefits are not fully achieved in international markets

Protectionism

1. Countries may impose protectionist policies such as tariffs on certain imports

2. Tariffs increase the prices of such imports, which may result in such benefits from specialisation & trade to be partially or fully eliminated

Non-economic reasons

1. Countries can sometimes choose to ignore the benefits of specialisation and exchange and instead, produce goods that they do not have a comparative advantage in

2. This can be in the case of goods such as food or military ammunition or weapons

3. Goods such as food & military ammunition or weapons play a part in the country’s self-sufficiency and security

4. A country may also opt to import goods despite having a comparative advantage in the production of such goods due to consumers’ varying tastes & preferences.
   E.g. while Germany may have a comparative advantage in the production of cars and does not need to import cars, it can still choose to import Japanese / Korean cars in order to satisfied varied needs of differing consumers’ tastes & preferences

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