International trade allows countries to specialize based on their comparative advantages. This concept, rooted in differences in opportunity costs, explains why nations trade even when one has an absolute advantage in producing all goods.

By focusing on what they do best and trading for other goods, countries can consume beyond their production possibilities. This mutually beneficial exchange leads to increased efficiency and economic growth for all trading partners.

Comparative Advantage and International Trade

Production Costs and Comparative Advantage

• Comparative advantage determined by opportunity cost of producing a good
  • Opportunity cost is value of next best alternative foregone when choosing to produce a good
  • Country has comparative advantage in producing a good if it has lower opportunity cost than another country
• Differences in opportunity costs arise from differences in productivity and production costs
  • Country with lower production costs for a good will have lower opportunity cost and comparative advantage
• Having absolute advantage (lowest production costs) in all goods does not negate comparative advantage
  • Opportunity costs still differ between goods within country, allowing for specialization and trade (bananas vs. coffee)

Mutual Benefits of Trade

• Trade creates mutual benefits when countries specialize according to comparative advantages
  • Each country produces and exports good(s) in which it has comparative advantage (US exports aircraft, China exports textiles)
  • Each country imports good(s) in which it has comparative disadvantage
• Even if country has absolute advantage in all goods, it can still benefit from trade
  • By specializing in its comparative advantage goods, it can produce more efficiently
  • Trading for its comparative disadvantage goods allows it to obtain them at lower opportunity cost
• Mutual benefits arise from consuming beyond domestic production possibilities frontier
  • Specialization and trade allow countries to consume combinations of goods not possible through domestic production alone (US consumes more textiles, China consumes more aircraft)

Opportunity Costs and Advantageous Trade

• Opportunity costs determine relative prices of goods within a country
  • Relative price of a good is opportunity cost of producing it in terms of another good
  • $Relative price of X in terms of Y = \frac{Opportunity cost of X}{Opportunity cost of Y}$
• Differences in relative prices between countries create potential for advantageous trade
  • Country will export good with lower relative price domestically and import good with higher relative price (US exports soybeans, Japan exports cars)
• Extent of specialization and trade depends on opportunity costs and relative prices
  • Complete specialization occurs when opportunity cost of producing a good is constant
  • Partial specialization occurs when opportunity cost of producing a good increases as more is produced (increasing marginal costs)
• Advantageous trade allows countries to consume beyond their production possibilities frontier
  • Consumption possibilities frontier with trade determined by terms of trade (exchange rate between exported and imported goods)