The theory of comparative advantage suggests that countries should specialise in producing goods and services where they have the lowest opportunity cost (i.e., they are relatively most efficient) and trade them for goods in which they have a higher opportunity cost.

• Basis of Trade: This theory explains why countries trade even if one country has an absolute advantage in everything (can produce all goods more efficiently).

• Changing Comparative Advantage: A country's comparative advantage is not static and can change over time.

  • Deindustrialisation in Developed Countries: Developed economies (like the UK) have seen their comparative advantage shift away from manufactured goods to services (e.g., finance, technology) due to relatively higher labour costs.

  • Industrialisation in Developing Countries: Developing countries, particularly emerging economies, have gained a comparative advantage in labour-intensive manufactured goods due to lower wage costs. This has shifted global manufacturing production.

Impact of Emerging Economies

The rapid economic growth and industrialisation of emerging economies (e.g., China, India, Brazil) have significantly changed the global pattern of trade.

• Shift in Manufacturing: Emerging economies have become the major exporters of manufactured goods to developed countries, displacing domestic production in the West.

• Increased Share of World Trade: These nations' overall share of world trade has increased dramatically.

• Growing Demand for Imports: As incomes rise in emerging economies, a growing middle class increases demand for imported luxury goods, technology, and services from developed countries, creating new markets for exports.

• Changing Composition of Trade: Even within emerging economies, their comparative advantage evolves. For example, as labour costs rise (due to an ageing population or a growing middle class), some may shift from low-cost textiles to more capital-intensive engineered goods or higher-value manufacturing.

Growth of Trading Blocs and Bilateral Trading Agreements

Trading agreements alter trade flows by changing the relative prices and costs of goods between member countries and non-members.

• Trading Blocs (e.g., EU, ASEAN): Groups of countries with preferential trading arrangements, often involving the reduction or elimination of internal trade barriers.

  • Trade Creation: This occurs when high-cost domestic production is replaced by cheaper imports from a member country (a more efficient producer within the bloc). This increases overall welfare.

  • Trade Diversion: This occurs when a country shifts imports from a cheaper non-member producer to a more expensive member producer because of the common external tariffs/barriers imposed on non-members. This can reduce overall welfare.

• Bilateral Trading Agreements (BTA): Agreements between two countries or two trading blocs to reduce trade barriers between them. They promote trade flows specifically between the signatories.

Changes in Relative Exchange Rates

An exchange rate is the price of one currency in terms of another. Fluctuations in exchange rates affect the price competitiveness of a country's exports and imports.

• Currency Appreciation (Strengthening): The currency becomes more valuable relative to others (e.g., £1 buys more $).

  • Exports become relatively more expensive for foreign buyers, leading to a fall in demand (assuming demand is elastic).

  • Imports become relatively cheaper for domestic buyers, leading to a rise in demand.

  • Effect on Trade Pattern: Tends to worsen the net trade balance (Exports - Imports). A strong currency can lead to a trade deficit.

• Currency Depreciation (Weakening): The currency becomes less valuable relative to others (e.g., £1 buys fewer $).

  • Exports become relatively cheaper for foreign buyers, leading to a rise in demand.

  • Imports become relatively more expensive for domestic buyers, leading to a fall in demand.

  • Effect on Trade Pattern: Tends to improve the net trade balance. Countries may use a competitive devaluation to intentionally boost exports, though this can be inflationary (imported inflation) and may be met with retaliation from other countries.

  • Marshall-Lerner Condition & J-Curve: A depreciation will only improve the balance of trade if the sum of the price elasticities of demand for imports and exports is greater than one in the long run. The J-Curve effect describes the short-run worsening of the trade balance immediately after a depreciation before it improves in the long run.