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
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.
Based on this information, now we can conclude that the United States should specialize in apples while Canada should specialize in strawberries.
If these two countries exchange apples and strawberries, they will both experience gains from trade. In the beginning, it looked like the U.S. should produce both goods for its own people, because it has an absolute advantage in both goods, but based on the law of comparative advantage, they both are better off if they specialize and trade. Both economies will become more productive.
To summarize what we've talked about, having an absolute advantage in the production of two goods isn't always the same as having a comparative advantage.
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 (a comparative advantage), and trade with other nations.
When nations specialize, this exchange creates gains from trade. The benefits of specialization include a larger quantity of goods and services that can be produced, improved productivity, production beyond a nation's production possibility curve, and finally, resources that can be used more efficiently.
Once you complete this lesson you'll be able to:
- Understand the theory of comparative advantage
- Explain the benefits of specialization