Comparative Advantage and the Gains from Trade © 2003 South-Western/Thomson Learning

The Logic of Free Trade Exports Goods and services produced domestically, but sold abroad

The Logic of Free Trade Imports Goods and services produced abroad, but consumed domestically

The Theory of Comparative Advantage Opportunity Cost and Comparative AdvantageOpportunity Cost and Comparative Advantage Specialization and World ProductionSpecialization and World Production Gains from International TradeGains from International Trade The Terms of TradeThe Terms of Trade

The Theory of Comparative Advantage Absolute Advantage The ability to produce a good using fewer resources than another country

The Theory of Comparative Advantage Comparative Advantage The ability to produce a good at a lower opportunity cost than another country

The Theory of Comparative Advantage Mutually beneficial trade between any two countries is possible when one is relatively better at producing a good than the other. Being relatively better means having the ability to produce a good at a lower opportunity cost – that is, at a lower sacrifice than other goods foregone.

Specialization and World Production If countries specialize according to comparative advantage, with the same resources the world can produce more of at least one good without decreasing production of any other good. the world can produce more of at least one good without decreasing production of any other good.

Gains from International Trade As long as opportunity costs differ, specialization and trade can be beneficial to all involved, regardless of whether the parties are nations nations statesstates countries, orcountries, or individualsindividuals even if one party has an absolute advantage or disadvantage.

The Terms of Trade Terms of Trade The ratio at which a country can trade domestically produced products for foreign-produced products

Turning Potential Gains Into Actual Gains Exchange Rate The amount of one currency that is traded for one unit of another currency

Turning Potential Gains Into Actual Gains When consumers are free to buy at the lowest prices, they will naturally buy a good from the country that has the comparative advantage.

Important Provisos Costs of TradingCosts of Trading Size of CountriesSize of Countries Increasing Opportunity CostIncreasing Opportunity Cost Government Barriers to TradeGovernment Barriers to Trade

The Sources of Comparative Advantage Countries often specialize in products based on their own particular endowments of natural resources. But natural resources are not the only basis for comparative advantage.

The Sources of Comparative Advantage Countries often develop strong comparative advantages in the goods they have produced in the past, regardless of why they began producing those goods in the first place.