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Gains From Trade and the Benefit of Specialization

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  • 0:10 Why Nations Trade
  • 1:30 Benefits of Specialization
  • 4:19 Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Explore one of the most widely accepted ideas in economics - the idea that nations benefit from specialization and exchange, reaping gains from trade.

Why Nations Trade

Why do nations trade goods with each other? Nations exchange goods with each other when they expect to gain from the exchange. We call that gains from trade. Adam Smith, a famous economist from the 18th century, talked about this in his book, Wealth of Nations, and so did economist David Ricardo.

The theory of comparative advantage teaches us that nations should specialize in the production of the goods in which they have the lowest opportunity cost, and trade with other nations.

The reason this works is because nations tend to have different resources, and they're not equally efficient when they are producing goods, which means they have different opportunity costs. When they have different opportunity costs of producing goods, it is possible to gain from trading. When both nations trade, they both will experience an increase in output, because they don't have to switch between one task and another. They also increase their skill level because they're doing the same task over and over again. This makes them more productive, and empowers them to produce at a level that goes beyond their production possibilities curve.

The Benefit of Specialization

For example, let's say that the United States can produce more strawberries with the same amount of resources than Canada can. This means the U.S. has an absolute advantage in the production of strawberries. Now, my first thought about that would be, the U.S. should definitely specialize in strawberries because in this example, they are the best at it. But my perspective is nearsighted, because I'm not accounting for the concept of opportunity cost, which shows me what the U.S. would have to give up in order to specialize.

Having an absolute advantage in the production of a good doesn't always mean you have a comparative advantage.

The graph shows Canada has the lowest opportunity cost for strawberries
Fruit Opportunity Cost Graph

So let's take this idea further and see where it leads:

The U.S. can produce 20 strawberries or 80 apples while Canada can produce 15 strawberries or 5 apples. That means that the opportunity cost to the United States of producing 1 strawberry is 80/20, or 4 apples. It also means that if the U.S. specialized in strawberries, they'd have to give up 4 times as many apples to do so.

Canada's opportunity cost of producing 1 strawberry is 5/15, or 1/3 of an apple. If they decide to specialize in strawberries, they'd only have to give up only 1/3 of the amount of apples to do so.

We can also look at these opportunity costs from the opposite perspective. The opportunity cost to the U.S. of producing 1 apple is 20/80, or 1/4 of a strawberry while Canada's opportunity cost of producing 1 apple is 3 strawberries.

Here's what that looks like:

Who has the comparative advantage in strawberries? The country with the lowest opportunity cost for strawberries, which is Canada.

Who has the comparative advantage in apples? In this case, it's the U.S. because they have the lowest opportunity cost of producing apples.

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