Factors that Encourage Free Trade

Demand Side Factors

1. Differences in tastes & preferences

2. Stimulate EG & development

Differences in tastes & preferences

Intra-industry Trade

Engage in free trade despite having similar resource endowments if consumer preference is different.

• Norway & Sweden both produce fish & meat

  • Norway prefers fish: Export meat & import fish

  • Sweden prefers meat: Export fish & import meat

Engage in free trade despite having similar resource endowments due to brand differentiation.

• Germany & Japan both produce cars, but different brands

Stimulate EG & Development

(particularly for countries with small domestic demand; SSOE)

• Trade enlarges market size by creating demand from multiple countries

  • Increase X (assume M constant) → increased X-M → increased AD → multiplier → increased RNY & output

    • Increased MEI (more optimistic) → increase I

  • Increased output → increased FOP (derived labour) → decreased dd-deficient unNt

Supply Side Factors

1. Immobility of Resources

2. Potential iEOS

3. Differences in Resource Endowments

Immobility of Resources

Geographical immobility (Capital, Land, Labour)

• Land & natural assets cannot be transferred across countries

• Capital cannot be transferred if there are insufficient infrastructure or political instability.

Potential for iEOS

(particularly for countries with small domestic demand; SSOE)

• Access to larger external market → expand prod scale → greater iEOS → lower AC → increase profits

Differences in Resource Endowments

Varying qualities & quantities of factor endowments.

• Theory of competitive advantage: Able to produce at a lower opportunity cost than another country

  • Principle of CA: Countries can gain from trade by specializing in the production of goods they have a CA in, & trade them for other goods they produce less efficiently in.

• Assume favorable Terms Of Trade (ToT)