Question

How does comparative advantage lead to gains from trade?

Short answer

Comparative advantage leads to gains from trade as it encourages countries to specialize in the production of goods and services for which they have a lower opportunity cost compared to others. This maximizes their production efficiency, allowing them to produce and trade their surplus goods with other countries that specialize in different products. As a result, the total production of goods and services increases, and both trading countries benefit from a larger variety of goods at lower prices.

Step-by-step solution

Understanding Comparative Advantage

Comparative advantage is an economic principle that explains how countries can benefit from trading with each other. It suggests that a country should specialize in the production of goods and services for which it has a lower opportunity cost compared to others. By doing so, these countries can maximize their production efficiency and increase their gains from trade. Opportunity cost is the cost of forgoing the next best alternative when making a choice.

Showing Opportunity Costs through a Production Possibilities Frontier (PPF)

To demonstrate the concept of comparative advantage, let us consider two countries: Country A and Country B. These two countries can produce two goods, apples and oranges. The production possibilities frontier (PPF) for each country is a graphical representation of the combinations of apples and oranges that each country can produce given their resources and technology. The slope of the PPF represents the opportunity cost of producing one good in terms of the other.

Comparing Opportunity Costs and Determining Comparative Advantage

Let's assume that Country A can produce 60 apples or 30 oranges with its resources, while Country B can produce 40 apples or 20 oranges. To determine the comparative advantage, we need to identify the opportunity cost: For Country A: Opportunity cost of producing 1 apple = \( \frac{30 \, oranges}{60 \, apples} = \frac{1}{2} \) orange Opportunity cost of producing 1 orange = \( \frac{60 \, apples}{30 \, oranges} = 2 \) apples For Country B: Opportunity cost of producing 1 apple = \( \frac{20 \, oranges}{40 \, apples} = \frac{1}{2} \) orange Opportunity cost of producing 1 orange = \( \frac{40 \, apples}{20 \, oranges} = 2 \) apples Comparing the opportunity costs, we can see that both countries have the same opportunity cost. In this case, there is no comparative advantage, and both countries can specialize in producing both goods. However, if we change the opportunity costs, let's say Country A can produce 80 apples or 40 oranges and Country B can produce 40 apples or 60 oranges: For Country A: Opportunity cost of producing 1 apple = \( \frac{40 \, oranges}{80 \, apples} = \frac{1}{2} \) orange Opportunity cost of producing 1 orange = \( \frac{80 \, apples}{40 \, oranges} = 2 \) apples For Country B: Opportunity cost of producing 1 apple = \( \frac{60 \, oranges}{40 \, apples} = \frac{3}{2} \) oranges Opportunity cost of producing 1 orange = \( \frac{40 \, apples}{60 \, oranges} = \frac{2}{3} \) apples In this case, Country A has a comparative advantage in producing apples, while Country B has a comparative advantage in producing oranges.

Specialization and Trade

When countries specialize in producing goods in which they have a comparative advantage, they can increase their production efficiency and trade with each other, leading to gains from trade. For example, let's assume that both countries allocate half of their resources to produce each good: Country A: 40 apples and 20 oranges Country B: 20 apples and 30 oranges Total production: 60 apples and 50 oranges Now, let's see how both countries can benefit from trade by specializing in their comparative advantage: Country A specializes in apples: 80 apples and 0 oranges Country B specializes in oranges: 0 apples and 60 oranges Total production: 80 apples and 60 oranges As we can see, after specialization, the total production of apples and oranges has increased, which shows gains from trade. By trading their surplus goods, both countries can enjoy more apples and oranges than they could produce on their own.