Gains from Trade: Definition & Example

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  • 0:04 Resources
  • 0:54 Opportunity Cost
  • 1:37 Comparitive Advantage
  • 2:44 Specialization and Trade
  • 3:43 Gains From Trade
  • 4:03 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Sometimes doing everything yourself isn't always the best economic decision. This lesson explains and provides an example, showing how specializing and trading can benefit everyone involved.

Resources

A gain from trade is a simple concept - two parties traded and both parties got something out of it. But, in economics terms, this can mean something a little more complex.

Colleen and Corey live on adjacent pieces of land in the middle of a very flat state. They divide up their land into fields for growing grain and space for orchards with fruit trees. Colleen was raised on the farm and is very productive. Corey is kind of new in town and is also new at farming; he's excited about it but not very productive. Not yet anyway.

Right now, if they both use the resources they have, Colleen can grow 30 bushels of grain and 15 bushels of fruit. Corey has some catching up to do; he only grows 18 bushels of grain and 6 bushels of fruit.

When they bump into each other selling their fruit at the farmers market, they start chatting about trading fruit and grain with each other and whether the two of them would be better off.

Opportunity Cost

To answer that question, let's look at the concept of opportunity cost. Back when Colleen was going to State University where she studied agriculture, her dad made her an offer. He would pay her $5,000 if she would stay home one semester and run the family farm while he and Colleen's mom took a long vacation. Colleen loved studying agriculture and wanted to get her degree as soon as possible, so she turned him down.

The world trading system is based on two economic principles:

The first is opportunity cost, or the value of doing an alternative. The opportunity cost for Colleen of pausing school was $5,000. The economic cost of going to school was the tuition, room and board, plus the $5,000 she isn't making while being in school.

Comparative Advantage

The other economic principle is comparative advantage, or when an individual or country has a lower opportunity cost to make something. Right now, Colleen is better at growing both grain and fruit, but she may not have a comparative advantage in growing both. Let's find out:

The opportunity cost for growing grain is calculated like this:

Colleen: 30 grain = 15 fruit so 1 grain = 1/2 or 0.5 fruit

Corey: 18 grain = 6 fruit so 1 grain = 1/3 or 0.33 fruit

In other words, Colleen must give up 0.5 bushel of fruit to grow 1 bushel of grain while Corey only has to give up 0.33. Cory has comparative advantage in grain, since his opportunity cost is less.

Now for fruit:

Colleen: 15 fruit = 30 grain so 1 fruit = 2 grain

Corey: 6 fruit = 18 grain so 1 fruit = 3 grain

So, Colleen gives up two bushels of grain to grow one fruit while Corey gives up three. Colleen has comparative advantage in fruit, since her opportunity cost is less.

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