Trading is important for any economy or firm as it allows them to obtain more goods than their initial potential. The key question sparked in a trade between two parties is, what should be traded and how much? This essential question can be answered using the concept of comparative advantage. Suppose two economies are trading. Then the economy which holds a comparative advantage over another economy in producing a good should specialize in trading away that good. It is important to note that it is always the case that both economies in a trade have a comparative advantage over the other in the production of at least one good. This means if one economy has comparative advantage in the production of some Good A, then necessarily the other economy must have comparative advantage in Good B. Why must it be true that both economies must have comparative advantage in at least one good every trade? Suppose there are two economies (Economy 1 and Economy 2) which both produce two goods (Good A and Good B). For every good, suppose Economy 1 can produce it more efficiently than Economy 2 can, provided that both economies allocate all their resources towards production of that good. Then, it could be misinterpreted that Economy 1 actually has comparative advantage in the production of both goods. However, this is not the case! Economy 1 will only have comparative advantage in the single good which it produces most efficiently, while Economy 2 will have comparative advantage in the other one. Recall that Economy 1 produces each individual good by itself more efficiently than Economy 2. However, if Economy 1 produces Good A and Good B at the same time, it will not be as efficient as Economy 1 producing one good and Economy 2 producing the other. Therefore, if one of the economies is specializing in the production of one good, because they have a comparative advantage, then the other economy must have comparative advantage in the production of the other goods and therefore would specialize in the production of the other goods in the two economies' trade.
Now let’s look at a concrete example of trade between two countries:
The table below shows the United States and England both producing coats and gloves.
Suppose the United States wants to trade with England. In order for the trade to be most efficient for both countries, each must select for trading the good which they have comparative advantage in. To find these comparative advantages, we can calculate the opportunity costs for each country producing coats and gloves:
We found that for the United States, 1 coat has an opportunity cost of producing 23 of a glove, while 1 glove has an opportunity cost of producing 32of a coat. In England, producing 1 coat has an opportunity cost of producing 4 gloves and producing 1 glove has an opportunity cost of producing 14of a coat. To find the comparative advantages, we must figure out which country has a lower opportunity cost in the production of each good. From our work, it is evident that in the production of coats, the United States has a lower opportunity cost. England, however, has a lower opportunity cost in the production of gloves. Thus, The United States has a comparative advantage in the production of coats, and England a comparative advantage in the production of gloves. Since each country will specialize in the good which they hold comparative advantage in, The United States will specialize in the production of coats which they will trade in exchange for gloves. On the other hand, England will specialize in the production of gloves in exchange for coats.
Now, each country has to also know how much of each good they should trade to make it beneficial for both. First, let’s consider how many gloves England should trade in exchange for 1 coat from The United States. For the opportunity cost of 1 coat, The United States can produce 23of a glove on its own, so it would not make much sense for them to trade a coat for less gloves than that. On the other hand, England can produce 4 of its own gloves for the opportunity cost of one coat. So it should not be willing to give up more than 4 gloves for 1 coat in the trade. Therefore, both parties would benefit only if the amount of gloves England exchanges for the 1 coat is between 23 and 4. Now, let’s analyze how many coats the United States should trade in exchange for 1 glove from England. For the opportunity cost of 1 glove, England can produce 14 of a coat on its own. So if they receive less coats than that, then the trade would not benefit them. On the other hand, The United States can produce 1 glove for the opportunity cost of 32coats, so it should be willing to give no more than32coats in the trade. Thus for both parties to benefit in the trade, the amount of coats The United States should trade in exchange for a glove from England should be anywhere between 14and 32.
Now let's analyze other possible terms of trades and see if they benefit both parties. If the United States decided to give up 1 coat in exchange for 3 gloves from England, would this be a beneficial trade for both parties? The answer would be yes. This is because for the opportunity cost of 1 coat, The United States can produce only 23 of a glove by itself, so it clearly benefits from this trade. Meanwhile, England would also benefit from this trade because on their own, they can produce 1 coat at the cost of 4 gloves and the trade allows them to obtain one at the cost of 3. Let’s now consider another scenario where England gives up 3 gloves in exchange for 6 coats from The United States. Would this trade be beneficial for both countries? The answer would be no, because only England would benefit from this trade. In this situation, the terms of trade can be simplified as being 1 glove for every 2 coats, because the ratio remains equivalent. The United States would not benefit from this trade as they would be receiving each glove at the cost of 2 coats, but producing a glove on their own would cost them just 32 of a coat. England, on the other hand, would benefit from this trade because it can only produce 14of a coat for the opportunity cost of 1 glove, while the trade yields them 2.
Trading is an effective method to further enhance production in an economy. In the next article, we will look at a graph which can be used to model the production of an economy and how to further understand how trade affects an economy's production.
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