Chapter 33: Problem 12

How does comparative advantage lead to gains from trade?

Short Answer

Expert verified

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.

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