(a) Define tariff. (b) State the following laws: i. The law of absolute cost advantage: ii. The law of comparative cost advantage. (c) Outline any four assu...

Answer Details

(a) Tariff. A tariff is a tax or duty imposed on goods that are imported (or sometimes exported) as they cross a country's border. It raises the price of the affected goods and is used to earn revenue and to protect domestic industries.

(b) The two laws.

• (i) Law of absolute cost advantage (Adam Smith). A country should specialise in producing and exporting the commodity that it can produce more cheaply (using fewer resources) than another country, and import the commodity that the other country produces more cheaply. Trade then benefits both because each concentrates on what it makes at lower absolute cost.
• (ii) Law of comparative cost advantage (David Ricardo). Even if one country is more efficient (has an absolute advantage) in producing both goods, mutually beneficial trade is still possible if each country specialises in the good in which it has the lower opportunity cost (its comparative advantage) and trades for the other. Each gains by giving up less of the alternative good.

(c) Four assumptions behind the law of comparative cost advantage.

• There are only two countries producing two commodities (the 2 x 2 model).
• Labour is the only factor of production, and it is homogeneous (labour theory of value).
• Factors are perfectly mobile within each country but immobile between countries.
• There are constant costs / constant returns to scale in production.
• There are no transport costs and no trade barriers (free trade).
• There is full employment of resources and perfect competition.

Examination takeaway. The key difference is that absolute advantage compares actual costs, while comparative advantage compares opportunity costs; comparative advantage is the more powerful law because it shows gains from trade even when one country is better at everything.