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To become wealthier, countries want to use their resources—land,
labor, capital and entrepreneurship—in the most efficient
manner. However, there are differences among countries
in the quantity, quality and cost of these resources.
The advantages that a country may have, vary:
- abundant minerals
- climate suited to agriculture
- well trained labor force
- new innovative ideas
- highly developed infrastructure like good roads,
telecommunications system, etc.
Instead of trying to produce everything by themselves,
countries often concentrate on producing things that
they can produce most efficiently. They then trade those
for other goods and services. In doing so, both the
country and the world become wealthier. Learn more about
the theory of specialization
and trade.
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Specialization
and Trade
Two economies, Cottonland
and Woodland, have the same resources and produce
both cloth and furniture.
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Cottonland
Without trade, produces
- 8 bales of cloth
- 4 pieces of furniture
- Total production 12
units
Time taken to produce
- 1 bale of cloth – 1
hour
- 1 piece of furniture
– 2 hours
With trade
- 16 bales of cloth
- 0 pieces of furniture
- Total production 16
units
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Woodland
Without trade, produces
Time taken to produce
- 1 bale of cloth – 2
hours
- 1 piece of furniture
– 1 hour
With trade
- 0 bales of cloth
- 16 pieces of furniture
- Total production 16
unit
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Since Cottonland is more
efficient in cloth production, it can double its
cloth output to 16 bales a day by transferring
all its resources to that industry. By doing so
Cottonland will eliminate the furniture industry.
However, it can trade the surplus cloth for furniture.
Similarly, Woodland can
direct all its resources to the production of
furniture and produce 16 pieces of furniture.
Although its cloth industry will suffer it can
trade the surplus pieces of furniture for cloth
bales.
Through specialization
and trade, the supply of goods in both economies
increases, which brings the prices down, making
them more affordable.
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Trade also provides a wider variety
of goods to consumers: cars from Japan, salmon from
Scandinavia, bananas from South America, are just a
few.
Most industrialized countries
can produce just about anything they want. For instance,
the U.S.:
- Could conceivably devote
all its resources to the production of tropical
fruits.
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Such reallocation of resources
makes no economic sense.
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- Could compensate for
the unsuitable weather by building hothouses,
developing irrigation techniques and retraining
workers.
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The resources that are
directed towards the tropical fruit industry could
be used more efficiently elsewhere.
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- Would never have to
import tropical fruit again.
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Countries achieve greater
total wealth by devoting resources to their most
productive industries.
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Even if a country can produce everything more efficiently
than another country, there is still scope for trade.
A country can maximize its wealth by putting its resources
into its most competitive industries, regardless of whether
other countries are more competitive in those industries.
This is called the law of comparative
advantage.
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Law of
Comparative Advantage
Suppose Cottonland produces
both cloth and furniture better than Woodland:
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Bales of cloth per day
Pieces of furniture per day
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Cottonland
10
05
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Woodland
2
3
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| Cottonland has
an absolute advantage—is more efficient—in
the production of both cloth and furniture. However
to achieve greater wealth, each country should specialize
in the item in which it enjoys greatest advantage
among all the products it produces—comparative
advantage. |
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| In terms of
opportunity cost, or the cost of not
transferring resources, Cottonland is twice as efficient
in producing cloth as furniture. |
Cottonland
Woodland |
Opportunity
Cost
1 piece of furniture = 2 bales of cloth
1 piece of furniture = 2/3 bales of cloth
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Since Woodland’s
opportunity cost for producing furniture is less
than Cottonland’s, it makes economic sense for Woodland
to focus on furniture.
Cottonland should continue producing cloth and trade
for Woodland’s furniture. Whereas, Woodland should
concentrate on furniture and trade it for cloth
with Cottonland. Channeling resources into the most
productive enterprise in each country will result
in more products to trade. |
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Even though it makes economic sense to allocate resources
to the most productive industries, no country wants to
rely on only a few products. This makes the country vulnerable
to changes in the world economy, such as recession, new
trade laws and treaties, and new technologies.
A country that relies too heavily on one product is
especially susceptible to market forces. If demand suddenly
drops or if a cheaper alternative becomes available,
the economy of that country could be damaged.
Many Middle East countries that are largely dependent
on their oil exports see their economic fortunes rise
and fall in tandem with the oil market.
 
The degree to which countries specialize is influenced
by that country’s terms of trade—i.e.
the relative prices of a country’s imports and exports.
It is most advantageous to have declining import prices
compared with the prices of exports. Exchange rates
and productivity differences affect the terms of trade
more than any other factors.
By developing a diversified economy, a country can
make sure that even if some industries are suffering,
other, more competitive industries will keep the economy
relatively healthy. The United States is competitive
in finance, entertainment, aerospace, industrial equipment,
pharmaceuticals and communications, among others.
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Competitiveness is used to describe the relative productivity
of companies and industries. If one company can produce
better products at lower prices than another, it is said
to be more competitive. This is a matter of concern for
governments, since it is difficult for uncompetitive industries
to survive.
In the long run, competitiveness depends on:
- a country’s natural resources
- its stock of machinery and equipment, and
- the skills of its workers in creating goods and
services that people want to buy
Natural resources are predetermined and must be used
efficiently, but a country’s infrastructure and its
workers’ skills have to be developed over time. The
ability of a society to do this effectively determines
whether it can remain competitive in the global economy.
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The law of comparative advantage says that a country can
become more competitive by directing its resources to
its most efficient industries. This enables a country
to achieve economies of scale—increasing its output
in a particular industry so that its costs per unit decrease.
Such lower-cost goods are more in demand in international
markets.
Certain industries that require heavy research and
development or capital expenditures cannot be competitive
unless they can spread the costs over many units. If
a sophisticated weapons industry knows that it has access
to foreign markets and could export, it may increase
the scale of its manufacturing operations and become
more efficient and competitive in the international
markets.
Other factors affecting a country’s trade competitiveness
can be complex.
- Sometimes it is difficult to move resources from
one industry to another—it would cost a great deal
of money to turn a shoe factory into a car factory
- Governments often attempt to restrict or encourage
international trade to achieve domestic economic goals—increasing
employment in certain industries, or maintaining economic
independence
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Knowledge-Intensive
Products Contributed to a U.S. Export Boom
From 1986 to 2001 there
was an enormous boom in U.S. exports, especially
in manufactured goods. Exports went up from $227
billion to $731 billion. One of the driving forces
behind the increase in exports was the success
of U.S. companies in selling "knowledge-intensive"
manufactured goods to other industrialized countries.
The value of knowledge-intensive
products depends on the skills that went into
producing them, rather than the actual cost of
the components. For example, while producing a
new compact disc, the expenses of paying the artist,
advertising, marketing and legal and other fees
far outweigh the actual cost of the physical disc.
Production of such knowledge-intensive
goods relies more on a well-educated and skilled
workforce than on natural resources. A number
of products fit this description, from computer
software to custom-built aircraft engine parts.
Such products are produced for specific market
niches and substitutes are not easy to come by.
These knowledge-intensive
products are becoming a major force in international
trade and a source of wealth for economies well
positioned to compete in those markets.
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More data on U.S. Census Bureau: Foreign Trade Statistics. 
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