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Gains from Trade: Definition & Example

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  • 0:01 Comparative Advantage
  • 0:50 Examples
  • 2:01 Calculating Opportunity Cost
  • 4:59 Lesson Summary
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Lesson Transcript
Instructor: Kallie Wells
Economists believe all parties involved in trade will end up better off than before. This lesson will explain and provide an example, showing the benefits of trade to everyone involved.

Comparative Advantage

In economics, the gains from trade are the net benefits to an agent from entering into voluntary trade. An agent can be a business, an individual, or a country. Trade can increase the welfare of all participants when countries specialize in producing the goods they can produce at the lowest cost relative to other participants. This concept is known as comparative advantage.

Comparative advantage is not producing what you produce best but producing goods that you can produce cheaper, at the lowest opportunity cost, than all other participants. When countries specialize in producing goods, they have a comparative advantage. Then, when they enter into trade with other countries, all participants experience increased net benefits.

Examples

A production possibility frontier curve, also known as a PPF curve, shows all combinations of two goods a country can produce given its resources. Any point inside the PPF is an inefficient allocation of resources, any point on the PPF is an efficient allocation of resources, and any point outside the PPF is unattainable given the country's limited resources. When two countries specialize and trade, they are able to obtain a point that, left to self-sufficiency, is unattainable.

Let's consider two countries, Skippy and Smuckers, and imagine that both produce peanut butter and jelly. The chart below shows the PPF for both countries. We assume a linear PPF, so the opportunity cost is constant. If Skippy used all of its resources to produce peanut butter, it can produce 40 jars. If it used all of its resources to produce jelly, it can produce 10 jars. If Smuckers used all of its resources to produce peanut butter, it can produce 5 jars. If Smuckers used all of its resources to produce jelly, it can produce 30 jars.

Calculating Opportunity Cost

Calculating Opportunity Cost for Peanut Butter

To determine which country should specialize in peanut butter, we need to determine the opportunity cost to produce peanut butter for both countries. Essentially, we need to find out how many jars of jelly would have to be forgone to produce one jar of peanut butter. The calculations are as follows:

Skippy

40 peanut butter = 10 jelly

4 peanut butter = 1 jelly

1 peanut butter = 1/4 jelly

Smuckers

5 peanut butter = 30 jelly

1 peanut butter = 6 jelly

The opportunity cost of Skippy to produce peanut butter is 1/4 jar of jelly. The opportunity cost of Smuckers to produce peanut butter is 6 jars of jelly. Therefore, Skippy has the comparative advantage. It costs Skippy less, i.e., 1/4 jar of jelly compared to 6 jars of jelly, to produce peanut butter, so Skippy should specialize in peanut butter.

Calculating Opportunity Cost for Jelly

To determine which country should specialize in producing jelly, you have to determine the opportunity cost of both countries again, but for jelly instead of peanut butter. The calculations are as follows:

Skippy

10 jelly = 40 peanut butter

1 jelly = 4 peanut butter

Smuckers

30 jelly = 5 peanut butter

1 jelly = 1/6 peanut butter

The opportunity cost of Skippy to produce jelly is 4 jars of peanut butter and only 1/6 jars of peanut butter for Smuckers. Therefore, Smuckers has the comparative advantage and should specialize in producing jelly.

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