Specialisation & Free Trade

Countries trade for three broad reasons.

• Different resources. Saudi Arabia has oil; New Zealand has grazing land for sheep; Brazil has the climate for coffee. Each can produce some goods that others cannot, or cannot produce as cheaply.
• Different costs. Even when two countries can make the same product, one is usually cheaper at it. Concentrating on the goods each makes most cheaply, and trading for the rest, raises total output.
• Different tastes. Consumers want variety. Even a country that can make every good itself may still want German cars, French wine, Italian fashion or Japanese electronics.

The first two of these are the basis for specialisation by country.

2. Specialisation by country

Specialisation by country is when a country concentrates on producing the goods and services it can make most efficiently, and trades for the rest rather than trying to produce everything itself.

This is the same idea as the division of labour, applied to whole economies instead of individual workers. A country specialises where it has an advantage, exports the surplus, and uses the foreign currency it earns to import the goods it has chosen not to make.

The basis for specialisation

A country specialises in a good for one of two reasons, and often both at once.

• Best use of resources (resource allocation). A country directs its land, labour, capital and enterprise toward the goods its resources are best suited to. Land with a tropical climate goes into coffee or cocoa; a workforce with strong technical education goes into electronics or finance. Resources end up where they are most productive.
• Low-cost production. A country specialises in goods it can produce at a lower cost than other countries can. Producing on a large scale for the world market also lets firms spread fixed costs and gain economies of scale, pushing average cost down further.

When each country does this, world resources are used more efficiently and total world output rises, so there is more for every country to share through trade.

Advantages of specialisation

• Higher output and incomes. Concentrating on what a country does best raises productivity, so total output is higher than if the country spread its resources across everything.
• Lower average costs. Producing more units of fewer goods lets firms exploit economies of scale, cutting unit costs.
• Better quality and reputation. A country that focuses on a few industries builds skill, expertise and a reputation for quality, which raises demand for its exports.
• Wider consumption. Export earnings pay for imports, so a country can consume goods it does not produce itself and enjoy a greater variety than its own resources allow.

Disadvantages of specialisation

• Vulnerability to price swings. A country that exports mainly one product is exposed when the world price of that product falls.
• Loss of self-sufficiency. A country that imports all of an essential good (food, fuel, medicine) has no fallback if war, disease or a natural disaster disrupts trade.
• Risk of resource depletion. Specialising in a non-renewable resource can exhaust it, leaving the economy with no replacement industry.
• Structural unemployment. Workers in industries that a country chooses not to develop, or that decline, may struggle to find new jobs if their skills do not transfer.

Because of these risks, most countries specialise partially: they keep a diversified base while still concentrating on their strongest industries.

3. Free trade

Free trade is international trade between countries with no government-imposed barriers to the flow of goods and services: no tariffs, no quotas and no restrictive subsidies.

Free trade is what specialisation points toward if a country follows the logic to its conclusion: produce what you are best at, and buy everything else from wherever it is cheapest. In practice almost no country has completely free trade with every partner; most combine low barriers with some protected sectors.

Advantages of free trade

The benefits fall on different groups, so a discussion of free trade can draw distinct points from each.

For consumers:

• Lower prices. Imports add competition, so domestic firms must keep prices down to compete.
• Wider choice. Consumers can buy goods that could not be produced at home, such as tropical fruit in cold countries or advanced electronics in countries without those industries.
• Better quality. Foreign competition pushes domestic firms to raise their standards.

For firms:

• Larger markets. Exporters can sell to the whole world, not just their domestic population, allowing them to expand output and gain economies of scale.
• Cheaper inputs. Firms can import the cheapest raw materials, machinery and components from anywhere, lowering their costs of production.

For the economy as a whole:

• Faster economic growth. Export earnings finance imports of capital goods, and competition raises productivity, both of which lift GDP.
• More efficient use of resources. Resources flow toward the industries where the country is most productive.
• Transfer of ideas and technology. Contact with foreign firms spreads new techniques and designs.

Taken together, these gains spread across consumers, firms and the wider economy, as the diagram summarises.

Disadvantages of free trade

Free trade is not costless, and honest "discuss" answers acknowledge the drawbacks.

• Structural unemployment in domestic industries that cannot compete with imports.
• Over-dependence on foreign suppliers for essential goods.
• Harm to infant industries. New industries may be wiped out by established foreign rivals before they have a chance to grow.
• Loss of strategic industries, such as the ability to produce food, energy or defence equipment.
• Wider inequality, as the gains may flow disproportionately to skilled workers and to firms in the country's strongest industries.
• Environmental costs from long transport chains and from production in countries with weaker regulation.

The standard view is that free trade raises total welfare but creates winners and losers, so it works best alongside policies that help those who lose out to adjust.