Comparative advantage explains how individuals, businesses, or countries benefit from specializing in what they do best and trading for other goods or services. It is the foundation of mutually beneficial trade.
- Absolute vs. Comparative Advantage
- Absolute Advantage: Producing more with the same resources.
- Comparative Advantage: Producing at a lower opportunity cost.
- Opportunity Cost and Specialization
- Comparative advantage is based on opportunity cost: what is given up to produce something.
- Specialization increases efficiency and total output.
- Terms of Trade
- Trade is mutually beneficial when the terms of trade (price) fall between the opportunity costs of both parties.
- Example: If one country gives up 2 units of A to produce 1 unit of B, it will trade if it can get more than 1 unit of A per unit of B.
Gains from Trade
- Increased Total Output: Specialization and trade lead to more goods and services overall.
- Better Allocation of Resources: Resources are used where they are most efficient.
- Mutual Benefits: Both trading partners can consume beyond their production possibilities.
For example, if Country A has a lower opportunity cost for producing wheat and Country B has a lower opportunity cost for producing cars, both benefit by specializing and trading