Chapter 2: Problem 2

What is the basis for trade: absolute advantage or comparative advantage? How can an individual or a country gain from specialization and trade?

Short Answer

Expert verified

The basis for trade is comparative advantage, where parties specialize and trade in goods and services they can produce at a lower opportunity cost. This allows for efficient resource allocation, increased output, and economic prosperity.

Step by step solution

Defining Absolute Advantage

Absolute advantage refers to the capability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources. It's about producing something more efficiently than others.

Understanding Comparative Advantage

Comparative advantage refers to the ability of a party to produce a good or service at a lower opportunity cost than other parties. It doesn't matter if one is absolutely efficient at producing something; what matters is what one sacrifices to produce it. It's the ability to produce goods and services at a lower opportunity cost, not necessarily faster or more efficiently.

Determining the Basis for Trade

The basis for trade is most frequently cited as comparative advantage. Although absolute advantage can help industries and countries become exceedingly skilled and efficient, it's comparative advantage that fundamentally drives the trade because it enables countries to engage in trade, emphasizing the selling goods they produce more efficiently (lower opportunity cost) and buying goods they produce less efficiently (higher opportunity cost).

Benefits of Specialization and Trade

Specialization and trade encourage better resource allocation and efficient production, leading to increased output and economic growth. By focusing on the production of goods and services where they have a comparative advantage, countries can trade for goods/ services where they have a comparative disadvantage. This increases overall productivity and allows for more efficient resource use. It also provides consumers with a greater variety of goods and services, potentially at lower costs.

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