Why do countries trade at all? The answer is the single most important idea in Unit 3: comparative advantage. Even if one country is better at producing everything, both countries can still gain by specialising in what they give up the least to produce.
Absolute vs comparative advantage
Absolute advantage: producing a good using fewer resources than another country. Comparative advantage: producing a good at a lower opportunity cost than another country. Trade is driven by comparative, not absolute, advantage.
The Production Possibility Frontier
The PPF shows the maximum combinations of two goods an economy can produce with its resources fully and efficiently employed. Its slope is the opportunity cost.
Sources of comparative advantage
Differences in natural resources (Australia's minerals), climate and land, labour (quantity, skills, cost), capital and technology. Trade liberalisation — reducing protection — lets each country move toward its comparative advantage, raising total output and consumption.
Protection and its costs
Governments often protect domestic industries with tariffs (a tax on imports), subsidies (payments to domestic producers) and quotas (limits on import quantity). Arguments for protection include the infant-industry argument, protecting employment, national security and preventing dumping. But protection has costs — shown clearly on the demand and supply model in the "We do".
Let's build the tariff diagram together and read off every effect. Watch how the import gap narrows once the tariff lifts the domestic price.
Read off the effects of the tariff
- Price rises from Pw to Pw + t.
- Domestic production rises (move up along S).
- Domestic consumption falls (move up along D).
- Imports shrink — the gap between domestic demand and domestic supply narrows.
- Government collects tariff revenue (tariff × imports).
- Efficiency falls: consumers pay more and a deadweight loss arises.
1. Country X can produce 200 wheat or 400 cloth; Country Y can produce 300 wheat or 150 cloth. Calculate each country's opportunity cost of cloth, and state which country should specialise in cloth and why.
2. Using the demand and supply model, explain the effect of a tariff on the domestic price, domestic production, domestic consumption and the volume of imports. Refer to a diagram.
3. Explain how a subsidy to domestic producers differs from a tariff in how it protects an industry and who bears the cost.
4. Outline two arguments for protection and give one counter-argument to each.
5. Explain one benefit of trade liberalisation for the Australian economy.