Comparative advantage drives international trade, allowing countries to specialize in goods they produce most efficiently. This concept explains why nations trade, even when one has an absolute advantage in producing everything.

Opportunity costs determine comparative advantage, influencing which goods countries should produce and export. By specializing and trading based on these advantages, nations can increase their overall output and consumption, leading to mutual benefits and economic growth.

Comparative Advantage and International Trade

Production costs in comparative advantage

• Opportunity cost determines comparative advantage, the value of the next best alternative forgone when choosing to produce a good (leisure time, other products)
• Country has comparative advantage if lower opportunity cost than trading partner, can produce good at relatively lower cost compared to other goods it could produce (wheat vs. cars)
• Differences in production costs between countries lead to comparative advantages from factors like resource availability (land, labor), technology (automation), and productivity (skilled workforce)
• Countries should specialize in producing and exporting goods for which they have a comparative advantage, allows for more efficient allocation of resources (labor, capital) and increased overall output (GDP growth)
• Factor endowments, such as natural resources or skilled labor, influence a country's comparative advantage

Mutual benefits of international trade

• Absolute advantage is a country's ability to produce a good using fewer resources than another country (US in aircraft production)
• Country with absolute advantage in all goods can still benefit from trade (US trading with Mexico)
• Mutually beneficial trade occurs when countries specialize based on comparative advantages, each country focuses on producing and exporting good for which it has lowest opportunity cost (China in electronics, Brazil in coffee)
• Two countries (A and B) producing two goods (X and Y):
  1. Country A has absolute advantage in both goods, but comparative advantage in good X
  2. Country B has comparative advantage in good Y
  3. If each country specializes based on comparative advantage and trades, both countries can consume more of both goods than without trade
• The terms of trade determine the relative prices at which countries exchange goods in international markets

Opportunity cost of trade benefits

• Opportunity cost calculations determine relative costs of producing different goods
• Calculate opportunity cost of producing a good:
  1. Divide amount of other good forgone by amount of good produced
  2. $\text{Opportunity cost of good X} = \frac{\text{Amount of good Y forgone}}{\text{Amount of good X produced}}$
• Country A can produce 10 units of good X or 5 units of good Y with its resources:
  • Opportunity cost of producing 1 unit of good X = $\frac{5}{10}$ = 0.5 units of good Y
  • Opportunity cost of producing 1 unit of good Y = $\frac{10}{5}$ = 2 units of good X
• Comparing opportunity costs determines which goods countries should specialize in producing and trading, country with lower opportunity cost for a good has comparative advantage (Japan in automobiles, France in wine)
• Specialization and trade based on comparative advantage increase overall output and consumption possibilities for both countries (higher standard of living)

Trade Considerations

• Gains from trade arise when countries specialize and exchange goods based on comparative advantage
• Economic efficiency improves as resources are allocated to their most productive uses through specialization
• Trade barriers, such as tariffs or quotas, can reduce the potential benefits of international trade