Question

How does comparative advantage lead to gains from trade?

Short answer

Comparative advantage leads to gains from trade by allowing countries to specialize in producing goods where they have a lower opportunity cost. This specialization increases overall production efficiency and enables countries to trade with each other for a wider variety of goods. As a result, both countries can consume more goods than they could without trade, maximizing the use of resources and improving overall welfare.

Step-by-step solution

Introduction to Comparative Advantage

Comparative advantage is an economic principle that states that countries should specialize in producing goods in which they have a lower opportunity cost. Opportunity cost refers to the value of the next best alternative that must be foregone to produce a certain good. By specializing in goods where they have a comparative advantage, countries can increase their overall production and benefit from trade.

Example of Comparative Advantage

Suppose we have two countries, Country A and Country B. They both can produce two goods: apples and bananas. The production possibilities are as follows: - Country A: 1 hour of labor can produce either 10 apples or 5 bananas - Country B: 1 hour of labor can produce either 4 apples or 2 bananas

Determine Opportunity Costs

First, we need to calculate the opportunity cost of producing apples and bananas for both countries: - Country A: the opportunity cost of producing 1 apple is \( \frac{5}{10} \) bananas, and producing 1 banana requires giving up the production of \( \frac{10}{5} \) apples - Country B: the opportunity cost of producing 1 apple is \( \frac{2}{4} \) bananas, and producing 1 banana requires giving up the production of \( \frac{4}{2} \) apples

Identify Comparative Advantages

Now, we can identify each country's comparative advantage: - Country A has a comparative advantage in apple production, as its opportunity cost of 0.5 bananas per apple is lower than Country B's opportunity cost of 0.5 bananas per apple - Country B has a comparative advantage in banana production, as its opportunity cost of 2 apples per banana is lower than Country A's opportunity cost of 2 apples per banana

Specialization and Trade

To maximize their production, both countries should specialize in producing goods in which they have a comparative advantage. Country A should specialize in apple production, while Country B should specialize in banana production. Now let's assume that both countries decide to trade. Country A will trade 10 apples to Country B for 5 bananas.

Gains from Trade

By specializing in their respective products and engaging in trade, both countries are better off than they would be without trade. Country A now has access to 5 bananas and 10 apples, while Country B also has access to 5 bananas and 10 apples. In conclusion, comparative advantage leads to gains from trade by allowing countries to specialize in producing goods where they have a lower opportunity cost. By specializing and trading, countries can increase their overall production and consumption of goods, resulting in a more efficient use of resources and greater overall welfare.