Question

How does comparative advantage lead to gains from trade?

Short answer

Comparative advantage leads to gains from trade by encouraging countries to specialize in producing goods with lower opportunity costs, resulting in more efficient resource allocation. As countries produce what they have a comparative advantage in and trade with each other, they both benefit from increased productivity, lower prices, and greater variety for consumers. This mutual exchange fosters economic growth and a higher overall output for both countries.

Step-by-step solution

1. Concept of Comparative Advantage

Comparative advantage refers to a country's ability to produce a particular good or service at a lower opportunity cost compared to other countries. This means that a country with a comparative advantage can produce a good using fewer resources, which allows them to specialize in the production of that good and trade with other countries that have a comparative advantage in another good.

2. Gains from Trade

Gains from trade refer to the benefits that countries receive from engaging in international trade, i.e., exchanging goods and services with other countries. These benefits include increased efficiency, lower prices, and greater variety for consumers, which altogether contribute to economic growth for the countries involved.

3. Comparative Advantage and Specialization

When a country has a comparative advantage in producing a specific good, it can specialize in the production of that good. By focusing on the good with the lowest opportunity cost, the country can allocate its resources more efficiently, leading to higher overall productivity and economic growth.

4. Trade and the Reallocation of Resources

When countries engage in trade, they effectively reallocate resources in a way that benefits both trading partners. The country with a comparative advantage in producing a good exports that good to its trading partner. In return, the trading partner imports the good that it has a comparative disadvantage in producing, as it is more cost-effective to buy the good from the country with a comparative advantage. This mutually beneficial exchange allows both countries to concentrate on producing goods in which they have a comparative advantage, ultimately increasing economic output and growth.

5. Example: Country A and Country B

Let's consider an example with two countries, Country A and Country B. Country A has a comparative advantage in producing wheat, while Country B has a comparative advantage in producing rice. \(Opportunity \ Cost \ of \ Wheat \ in \ Country \ A = 2 \ Rice\) \(Opportunity \ Cost \ of \ Rice \ in \ Country \ B = \dfrac{1}{3} \ Wheat\) In this example, Country A should specialize in wheat production and Country B should specialize in rice production. Both countries can then trade wheat for rice, allowing both to increase their overall output of both goods. Since Country A has a lower opportunity cost in producing wheat compared to Country B, they can export wheat to Country B and import rice. Similarly, Country B can export rice to Country A and import wheat. This trade allows both countries to maximize their production, lower prices, and provide more variety to consumers. In conclusion, comparative advantage leads to gains from trade by encouraging countries to specialize in industries with lower opportunity costs, reallocate resources efficiently, and participate in mutually beneficial trade with other countries. As a result, both countries experience greater economic output, lower prices, and a wider variety of goods and services.