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 in which they have a lower opportunity cost than other countries. By specializing and trading, countries can increase their total production and consumption of goods and services, resulting in a more efficient allocation of resources and an overall higher standard of living. This concept is supported by an example of two countries trading apples and bananas based on their comparative advantages, resulting in increased consumption of both goods for both countries.

Step-by-step solution

Understand Comparative Advantage

Comparative advantage is an economic principle that states a country or an individual can produce a specific good at a lower opportunity cost than another country or individual. In other words, a country has a comparative advantage in producing a good if it can produce it more efficiently (using fewer resources or time) than another country.

The Importance of Specialization Based on Comparative Advantage

Specialization based on comparative advantage allows countries to focus on producing the goods in which they have a comparative advantage. By doing so, they can produce more of these goods and trade them with other countries to obtain the goods that they do not have comparative advantage in producing. This enables both trading partners to enjoy a higher total consumption of both goods, leading to gains from trade.

An Example for Comparative Advantage and Gains from Trade

Consider two countries, Country A and Country B, that produce only two goods: apples and bananas. The table below shows the opportunity cost of producing one unit of each good in each country. | Country | Opportunity cost of 1 apple | Opportunity cost of 1 banana | |---------|------------------------------|-------------------------------| | A | \(\frac{1}{2}\) banana | 2 apples | | B | \(\frac{1}{3}\) banana | 3 apples | Country A has a comparative advantage in producing apples because it has a lower opportunity cost for apples (\(\frac{1}{2}\) banana) than Country B (\(\frac{1}{3}\) banana). Country B has a comparative advantage in producing bananas because it has a lower opportunity cost for bananas (3 apples) than Country A (2 apples). Now, let's assume that before trade, both countries produce and consume both goods equally. However, once these countries realize their comparative advantages, they decide to specialize in the production of those goods in which they have a comparative advantage. Country A focuses on producing apples, and Country B focuses on producing bananas. This would lead to an increase in the total production of apples and bananas in both countries. Country A can produce more apples at a lower opportunity cost, while Country B can produce more bananas at a lower opportunity cost.

Trading and Gains from Trade

Now that both countries are specializing in their comparative advantage goods, they can exchange these goods with each other. Suppose that Country A trades 10 apples with Country B in exchange for 20 bananas. Both countries have now increased their consumption of both goods compared to the situation before trade and specialization. By specializing in producing goods where they have a comparative advantage and trading those goods, both countries experience gains from trade and an overall increase in their standard of living. In conclusion, comparative advantage leads to gains from trade by encouraging countries to specialize in the production of those goods in which they have a comparative advantage and trade them with other countries. This results in more efficient use of resources and an overall increase in the consumption of goods and services.