World Economy Essay

5688 Words Nov 26th, 2011 23 Pages
Free Trade
Free trade may also be called International Trade.
Free Trade occurs when goods and services are traded between countries without the use of import controls. For most of the late twentieth century, the prevailing wisdom has been that free trade can lead to improvements in economic welfare in the global economy. However this has not prevented regular trade disputes between countries - often when one country feels that unfair trade practices have caused the benefits from trade to become distorted. Free trade is very important to all developed countries as there are likely to be economies of scale - when producing for larger markets (foreign markets), average costs of production will be lower. There is likely to be a wider choice
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Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains.
As an example we can consider two countries producing two goods - CDs players and personal computers. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below. Each country devotes half its available factor resources to both products.

Comparative advantage | Product A | Product B | Country 1 | 400 | 100 | Country 2 | 600 | 300 | Combined output | 1000 | 400 |

The comparative advantage in product A lies with Country 1 and for Product B, Country 2 has the comparative advantage. If country 1 devotes all the available resources to Product A (assuming constant returns to scale) and Country 2 specialises in the production of Product B - the total output of both goods rises.

Comparative advantage | Product A | Product B | Country 1 | 800 | 0 | Country 2 | 300 | 450 | Combined output | 1100 | 450 |

For trade to benefit both countries, an acceptable terms of trade has to be agreed. If Country B exports 1 unit of Product B for every 3 units from Country A, the trade flows would look as follows:

Comparative advantage | Product A | Product B | Country 1 | 470 | 110 | Country 2 | 630 | 340 |
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