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Why do people trade?

Why do people trade?

As a follow up to the last blog post where I wrote about international trade and tariffs, I want to dig in a little deeper and answer the question, Why do people trade?" It’s really simple actually.  Trading between people, businesses, and countries occurs because the other party has something you want.  That’s the basic reason why people trade.  Someone else has something that you either want or need.  Trading baseball cards is a perfect example at the most individual level.  If you live in Boston and have a player card from the New York Yankees and your best friend lives in New York and has a Boston Red Sox player’s card you two will get on the phone, have a short discussion and the trade will happen.  After all, between those two bitter rivals who would want a player from the rival team?  This is how trade works at the simplest level.

            Let’s dig deeper into this concept by looking at what happens between countries.  In a previous lesson we learned about Adam Smith, the great economic thinker and moral philosopher from Scotland who lived during the 1700s championed a theory called ABSOLUTE ADVANTAGE.  In simple terms, absolute advantage refers to the ability of a person, firm, or country to produce a greater quantity of goods or services than a competitor using the same amount of resources.  So, an island country like Jamaica may be able to produce a lot more fish than a land locked country like Germany.  But Germany, because of where it is located produces a lot of coal.  Therefore, the theory of absolute advantage would say that Germany has an absolute advantage over Jamaica in coal production and Jamaica has an absolute advantage over Germany in the production of fish.

 

The theory of absolute advantage makes sense right?  If something takes a smaller quantity of inputs to produce a good then that’s what should be produced.  The theory of Comparative advantage takes this one step further.  Comparative advantage was a theory developed by David Ricardo in 1817.  It brings opportunity cost into the picture.  Remember our previous lesson on Opportunity cost?  That is the cost of the greatest foregone alternative for choosing to do one thing over another.  Therefore, Comparative advantage is the ability of a country (or person) to produce a good or service at a lower marginal and opportunity cost over another.

            Let’s look at how this plays out and how nations can gain from trade.  But I want to ask you a question first.  Is it possible for a country to have an ABSOLUTE ADVANTAGE in producing in everything still have different countries that have different comparative advantage in something and be able to gain from trade with that country?  It doesn’t seem like it, but it is possible!  Let me show you how.

Look at this simple chart.  Country A HAS AN ABSOULTE ADVANTAGE of country B in both production of Food and computers.  They just produce more!

For example, consider again Country A and Country B in . The opportunity cost of producing 1 unit of computers is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.

Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.  Make sense?  It was just simple division to determine which country had a comparative advantage in the production of a certain good or service.  So this is how gains from trade can happen, EVEN if one country has an absolute advantage in their production.

This can get a little confusing, but once you go through some of the exercises in the study guide this will sink in.  Just remember, the bottom line is this:  an individual our country can still have a comparative advantage in a good or service even of their trading partner has an absolute advantage in both goods being considered.  The gains from trade can help all be more successful. 

 

Output per day of work

 

Food

Computers

Country A

6

3

Country B

1

2

 

Source: Boundless. “Absolute Advantage Versus Comparative Advantage.” Boundless Economics. Boundless, 26 May. 2016. Retrieved 10 Jun. 2016 from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/international-trade-31/introduction-to-international-trade-124/absolute-advantage-versus-comparative-advantage-493-12589/

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