Benefits to the economy arising from specialisation and exchange can be explained using the Theory of Competitive Advantage. Under this theory, trade after specialisation can be beneficial for both economies as long as there is difference in the relative opportunity cost between the countries.
Assume that two countries, USA and China, produces two commodities only – plastic and clothes. Both of them have two units of resources. Before specialisation, both economies allocate resources equally for the production of both goods, according to the table below.
From the table above, USA can use 1 unit of resource to produce 30 units of plastic or 20 units of clothes. Hence, the opportunity cost of producing 1 unit of plastic is 2/3 unit of clothes. On the other hand, China can produce 10 units of plastic or 15 units of clothes with 1 unit of resource. Hence, the opportunity cost of producing 1 unit of plastic is 3/2 units of clothes.
As USA has a lower opportunity cost of producing plastic than China, USA will specialise in producing plastic since it has a comparative advantage in plastic production. Contrastingly, China will specialise in producing clothes as she has a comparative advantage in clothes production due to the lower opportunity cost compared to USA.
Assuming perfect factor mobility, constant cost of production and that USA specialises partially by using 1.5 units of resources to produce plastic while China specialises completely, the output by both countries after specialisation is as follow.
As the opportunity cost of producing 1 unit of plastic is 2/3 unit of clothes, USA will only exchange 1 unit of plastic for more than 2/3 unit of clothes. Likewise, China will not be willing to exchange for 1 unit of plastic with more than 3/2 units of clothes. Hence, an acceptable terms of trade for 1 unit of plastic is between 2/3 and 3/2 units of clothes.
Assuming that the terms of trade is 1 unit of plastic for 1 unit of clothes, and that USA exchanges 12 units of plastic for 12 units of clothes with china, the output after specialisation and after trade will be as follow, if there is no trade barrier and no transport cost.
By comparing Table 1 with Table 3, the total output has increased for both plastic and clothes production. Furthermore, each economy is now able to consume more than before specialisation and before exchange.
Hence, specialisation and exchange benefits the economy in terms of ability to consume beyond their individual maximum output possibilities.
Furthermore, with specialisation according to its comparative advantage, countries can reap internal economies of scale as output increases. This can be due to technical and managerial economies. As output increases, it is now more worthwhile for division of labour to take place. This increases productivity as labour is employed at areas which they are most productive in, thus lowering average cost of production. Furthermore, superior machines which can perform complex operations can be used more effectively and intensively than at lower output. This also lowers average cost of production. Also, it is now possible to hire specialist managers for different functions, raising productivity. The cost is also spread over a larger output, again lowering average cost of production. Ultimately, the lowering of average cost of production will enhance the benefit arising from comparative advantage described above. Moreover, if producers decide to pass on the cost savings to consumers, consumers will be able to enjoy the goods at a lower price and the goods will also be more competitive in the international market.
On the other hand, exchange allows economies to gain access to a wider range of goods. This increases consumers’ level of satisfaction as they are able to consume a greater variety and possibly higher quality goods, including those that the economy is unable to produce itself.
If exchange includes capital goods, there will be transfer of technology between economies. This facilitates technological advancement as it increases potential growth and is crucial for sustained economic growth.
Furthermore, exchange creates dependency and reliance between economies. This foster ties between economies and promotes cooperation, enhancing world peace and prosperity.
In conclusion, not only does specialisation and exchange allow an economy to increase consumption beyond the PPC curve, it also enhances consumers’ satisfaction and foster sustained economic growth.
(b)
The benefits arising from specialisation and exchange are heavily subjected to assumptions mentioned in part (a). Under circumstances where the assumptions do not hold, benefits will not be fully achieved in domestic and international markets. In the domestic market, violations to the assumptions of constant or lowering cost of production and perfect factor mobility will reduce its benefits. In the international market, trade restrictions, transport costs and lack of suitable terms of trade often limit the benefits.
Domestically, while specialisation will generally lead to a decrease in average cost of production as output increases due to economies of scale, excessive specialisation may have the opposite impact. Beyond a certain level of output, internal diseconomies of scale might occur. This is mainly due to managerial diseconomies as it becomes increasingly difficult to coordinate and control production. Furthermore, the increasing complexity and bureaucratises may lead to slow decision making in adjustment to fast changing market condition. This leads to increase inefficiency and increases the average cost of production.
The extent of impact to the economy due to internal diseconomies of scale will be dependent on their decision on specialisation. Economies that is better able to determine and specialise only up till the output before diseconomies of scale sets in will be able to achieve the benefits of specialisation more. As such, if internal diseconomies of scale sets in relatively early, the economy should avoid full specialisation and only partially specialise in order to achieve the lowest average cost of production.
Furthermore, factor immobility is inevitable in all economies. This is due to both occupational and geographical immobility. Occupational immobility refers to barriers to the mobility of factors of production between different industries and occupations. Labour experiences occupational immobility as they usually possess job-specific skills leading to loss in productivity as they are transferred away to perform tasks they are less proficient in. Capital also experiences occupational immobility as machineries may have specific purpose and cannot be used in other industries. Geographical immobility refers to the difficulty to move from one geographical area to another. Labour can be geographically immobile due to the unwillingness to settle in new area, high cost of moving, and lack of information. Factor immobility reduces the ability of an economy to specialise as it will increase the cost of production significantly, eroding away potential benefits of specialisation and trade.
Economies that have policies implemented in order to reduce factor immobility will likely be able to reap the benefits of specialisation and trade more. Government can invest in education and retraining for workers so that they are equipped with the relevant skills and knowledge.In Singapore, the Continuing Education and Training (CET) plan is in place to maintain the competitiveness of the Singapore workforce and prepare for the future. Factor immobility can also be reduced by the improvement in the provision of information and government’s policy to encourage firms to move to area with higher level of unemployment.
Internationally, trade restrictions are the main impediment to the benefits of specialisation and exchange. Countries may argue for protectionism in order to save jobs in declining industry, protect infant industry until it is ready for international competition, and reduce balance of payments deficit. For instance, Malaysia’s automobile company, Proton, has been protected with the infant industry argument. Countries can implement protectionist measures by imposing tariffs on imports, setting import quotas, and offering subsidies to domestic producers. All these limit the extent of trade.
Trade restrictions affect countries that are less open more severely. Countries will benefit more from specialisation and exchange if they open their economy more and have more trading partners and relations. For example, Singapore’s high trade to GDP ratio of around 400% during 2008 to 2011 is attributed to Singapore’s openness to trade, with numerous regional and bilateral Free Trade Agreements, efficient custom administration, and minimal import and export procedures. This has allowed Singapore to greatly benefit from the benefits of specialisation and exchange.
Also, the assumption of the absence of transport cost is unrealistic in real world. Significant transport cost exists to transfer goods across borders. Freight cost increases as the weight and size of the good and distance of transportation increases. This not only reduces the feasibility of exchange but also erodes away the potential benefits from specialisation and exchange. In fact, transport cost is a serious obstacle to trade that most countries’ largest trading partner is their neighbouring country. This is because exchange is much more beneficial between nearby economies due to low transport cost.
However, with globalisation and advancement of space-shrinking technologies, the above issue has been steadily declining over time. Goods can now be transported much faster and cheaper due to improvement in technologies. Furthermore, with the advent of the container, goods are now able to be moved easily between different modes of transport. Together with the uniformity, efficiency, and ease of loading and unloading, cost of transport has lowered dramatically. These have increased exchange volume and benefits from specialisation and exchange.
Lastly, in the event whereby there is no suitable term of trade, benefits from specialisation and exchange will also not be achieved. This is because countries will not gain anything from trading with each other.
In conclusion, numerous hindrances exist to prevent benefits from specialisation and exchange to be fully achieved in domestic and international markets. In order to maximise the benefits, government must implement appropriate policies in order to reduce the obstacles. This includes careful specialisation to prevent diseconomies of scale from happening, encouraging education and retraining, and actively signing Free Trade Agreements with rest of the world.