Ever wondered why countries trade? It's all about making the most of what they're good at. Some countries are better at making certain things, like pencils or erasers, using fewer resources. This is called absolute advantage.

But there's more to it. Comparative advantage looks at what a country gives up to make something. Even if a country isn't the best at making pencils, it might still be smart to focus on them if it's their strongest skill. This idea drives international trade.

Absolute and Comparative Advantage

Absolute Advantage

• Ability to produce a good using fewer resources than another country
• Country A produces 10 units of Good X with 100 workers (pencils)
• Country B produces 8 units of Good X with 100 workers (pencils)
• Country A has an absolute advantage in producing Good X (pencils) since it can produce more with the same number of workers

Comparative Advantage

• Lower opportunity cost of producing a good compared to another country
• Country A produces either 10 units of Good X or 5 units of Good Y with 100 workers (pencils or erasers)
• Country B produces either 8 units of Good X or 2 units of Good Y with 100 workers (pencils or erasers)
• Country A's opportunity cost of producing Good X is 0.5 units of Good Y ($5 \text{ units of Y} / 10 \text{ units of X}$)
• Country B's opportunity cost of producing Good X is 0.25 units of Good Y ($2 \text{ units of Y} / 8 \text{ units of X}$)
• Country B has a comparative advantage in producing Good X (pencils) due to its lower opportunity cost (0.25 < 0.5)

Opportunity Costs

• Value of the next best alternative foregone when making a choice
• Amount of one good a country must give up to produce one more unit of another good in international trade
• Calculate opportunity cost of producing each good for each country
• Country with lower opportunity cost for a good has comparative advantage in producing that good
• Countries should specialize in producing goods for which they have a comparative advantage to allow for efficient resource allocation and greater overall output (pencils and erasers)

Gains from Trade

• Specialization leads to more efficient resource allocation and increased overall output when countries focus on producing goods for which they have a comparative advantage (pencils and erasers)
• Increase in total output and consumption possibilities resulting from specialization and trade based on comparative advantage
• Both countries can consume more of both goods than they could without trade (pencils and erasers)

1. Before specialization and trade:

   • Country A produces 5 units of Good X and 2.5 units of Good Y (pencils and erasers)
   • Country B produces 4 units of Good X and 1 unit of Good Y (pencils and erasers)

2. After specialization and trade:

   • Country A specializes in Good Y and produces 5 units (erasers)
   • Country B specializes in Good X and produces 8 units (pencils)
   • Trade 1 unit of Good Y for 2 units of Good X (erasers for pencils)
     • Country A consumes 4 units of Good X and 4 units of Good Y (pencils and erasers)
     • Country B consumes 6 units of Good X and 1 unit of Good Y (pencils and erasers)
   • Both countries consume more of both goods compared to the pre-trade situation (pencils and erasers)