How does the theory of comparative advantage, explain why a developed country such as the USA might wish

to trade with a developing country such as Vietnam. When the USA trades with Vietnam, both countries are most likely to benefit from a specialisation of production, allowing them to exploit benefits of an increase in production. As a result, there would be an increase in consumption through an increase in trade due to the reduction of tariffs and trade barriers. The theory of comparative advantage bases its findings through to the differing opportunity cost of the production of goods between countries. It assumes that there are only two countries involved in trade, and only these two goods are being produced by the two countries. There are no transport cost, tariffs or extra cost involved other than the cost of production. In the case of the USA and Vietnam, USA is likely to specialise in the production of a good produced by high-end manufacturing industries, such as cars, and Vietnam in agricultural products such as wheat. We would take cars and wheat to be the two goods involved in the numerical illustration of the Principle of Comparative Advantage. Table 1: Production Possibilities before specialisation (per unit of resource) Cars(million units) 10 2 Wheat(million kg) 50 40

USA Vietnam

Table 2: Opportunity cost ratios 1 unit of cars(C) 5W 20W I kg of wheat(W) 1/5C 1/20C

USA Vietnam

We assume that both countries have the same amount of resources (10 units), and before specialisation, resources are divided equally among the production of both goods. USA should specialise in the production of cars because they incur a smaller opportunity cost compared to Vietnam (5W compared to 20 W respectively). Vietnam should specialise in the production of wheat because they incur a small opportunity cost in producing wheat compared to USA (1/20W compared 1/5W respectively). Since the USA is able to produce more of each good with 1 unit of resources, USA would specialise partially in the production of wheat being more resource-efficient. Assuming that the USA uses 8 units of resource in the production of cars, and the rest in the production of wheat, Thailand would specialise completely, dedicating all 10 units of resource to the production of wheat, we will see a gain in production as seen is Table 3. Table 3: Production Possibilities before and after Specialisation Before Specialisation Cars(million units) 50 10 60 After Specialisation Cars(million units) 80 0 80(+20)

USA Vietnam World

Wheat(million kg) 250 200 450

Wheat(million kg) 100 400 500(+50)

We see that the world output for cars has increased from 60 million units to 80 million units, while world output for wheat has increased from 450 million kg to 500 million kg). In order for both countries to benefit from this specialisation, both countries have to trade the goods they produce, to increase world consumption. For both countries to benefit from trade, the rate which exports are exchanged for imports are exchanged for imports have to lie between the opportunity costs ratios for car and wheat. From Table 2, we know that USA should not accept less than 5 units of wheat for 1 unit of cars, otherwise, they might as well have produced their own wheat, and trade within her own country. Vietnam also should not accept more than 20 units of wheat for 1 unit of cars for the same reason. Assuming that the terms of trade are agreed at 10 units of wheat for 1 unit of car, and USA exports 18 units of cars to Vietnam, Vietnam would export 180 units of wheat to USA. The consumption gain from trade would be displayed in Table 4. Table 4: Consumption gains before and after trade Without Trade and Specialisation Cars(units) Wheat(units) 50 250 10 200 60 450 After Trade and Specialisation Cars(units) Wheat(units) 62(+12) 280(+30) 18(+8) 220(20) 80(+20) 500(+50)

USA Vietnam World

As can be seen from Table 4, specialisation and trade, allows consumers in both countries to enjoy a greater amount of goods with the same amount of resources, thus leading to a higher material standard of living.

Discuss what effect such a trade agreement might have on the economies of the participating countries. Generally, when there is a reduction in tariffs, increase in foreign investment and exports available, there would be advantages such as a possible increase in national income, wide variety of consumer goods available, inflow of capital goods to increase productive capacity. However, there would be negative side-effects as well from the benefits obtained, such a deficit in the balance of payments, as well as unemployment. These effects would differ between the developed and developing countries. Positive effects on a developing country (Vietnam) Since there is a reduction in tariffs, the costs of importing high technology goods (such as computers and television sets) which the USA specialises in would become cheaper, and thus there is a fall in the cost of living, giving the consumers in Vietnam higher standard of living. When goods are imported from overseas, consumers In Vietnam would also gain from the increase in consumer surplus of enjoying goods at a cheaper price due to the reduction in tariffs, which reduces the cost of the product. With the increase in exports As a result of the inflow of foreign investment from the USA, firms in Vietnam would be able to utilise the extra funds to engage in research and development, or to purchase capital goods which would allow Vietnam to increase their productive capacity, and at the same time, reducing their production costs, leading to increased national income an and economic growth in the long run as a result of the expansion in Aggregate Supply. This would be shown in Figure 1. Since investments are also a part of Aggregate Demand, there would also be an increase in the AD curve.

As seen in Figure 1, the increase in Aggregate Supply and Aggregate Demand as a result of the increase in investments, leading to R&D and increase in capital goods, led to an increase in real output of Vietnam from Y1 to Y2, leading to increasing national income and thus promoting economic growth in the country, while the general price level is kept constant at P. The opening up of export markets would mean that firms in Vietnam would be able to gain access to larger consumer markets and thus achieve economies of scale, which are cost reduction while output increases. As a result, Vietnam would be able to increase its export revenue, leading to an increase in AD, increasing national income and employment (because increasing output means more hands and equipment are required to produce the goods), leading to economic growth. Positive effects on developed countries (USA) With the reduction in tariffs, the decreased costs for Vietnamese exporters would mean cheaper

imports of primary products (e.g. wheat) and low-technology goods (mass produced shirts), resulting in a fall in the cost of living for USA consumers, increasing their material standard of living. With the flow of investments funds into Vietnam, will allow US firms to produce goods at a lower cost, the higher profits will be sent back into the US, when the cheaper exports from Vietnam return to the US, or are sold to other countries overseas. The bigger export market for US goods would mean an increase in AD, which would increase income and employment, because more people are being employed to keep up with the production of goods, in order to meet the increased demand for US goods from countries that it enters into trade agreements with such as Vietnam. Negative effects on developing countries (Vietnam) When more goods are imported as a result of the reduction in tariffs, this may lead to unemployment within Vietnam itself, because the cheaper imports may substitute the local goods, and thus industries decline, retrenching redundant workers to deal with the decreased demand for their goods, producing a smaller output. This may lead to a decrease in national income, because unemployed workers do not earn any income, as a result, leading to decreased economic growth. When trade increases, there would be a deficit in the balance of payments, as a result foreign debt would be incurred which would have to be paid from the national reserve. This would be particularly the case because Vietnam exports cheap goods, which require low-technology, while it imports expensive goods such as cars from the US, total value of exports would be lesser than total value of imports, and extra payments have to be made. Negative effects on developed countries (USA) Cheaper imports from Vietnam as a result of the reduction in tariffs and increases trade, low-end manufacturing industries would be closed down, as a result of the more price-competitive imports from Vietnam. This would lead to unemployment among the workers in the USA, leading to decreased national income, giving rise to decreased economic growth. As a result of the unemployment, trade unions in the USA may force the government to impose protectionist measures, which result in reduced consumer surplus, because consumers are forced to buy local products that are more expensive.