COMPARATIVE ADVANTAGE AND TRADE

The gains from specialization and trade are based not on absolute advantage but on’ comparative advantage. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, This increase in the size of the economic pie can be used to make everyone better off.

In our example, the farmer spends more time growing potatoes, and the rancher spends more time producing meat. As a result, the total production of pottatoes rises from 40 to 44 ounces, and the total production of meat rises from 16 to 18 ounces. The farmer and rancher share the benefits of this increased production.

There is another way to look at the gains from trade-in terms of the price that each party pays the other. Because the farmer and rancher have different opportunity costs, they can each think they are getting a bargain. That is, each benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good.

Consider the proposed deal from the viewpoint of the farmer. The farmer gets 5 ounces of meat in exchange for 15 ounces of potatoes. In other words, the farmer buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is lower than his opportunity cost for 1 ounce of meat, which is 4 ounces of potatoes. Thus, the farmer benefits from the deal because he gets to buy meat at a good price.

Now consider the deal from the rancher’s viewpoint. The rancher buys 15 ounces of potatoes for a price of 5 ounces of meat. That is, the piece of potatoes is 113 ounce of meat. This price of potatoes is lower than her opportunity cost of 1 ounce of potatoes, which is 112 ounce of meat. The rancher benefits because she gets to buy potatoes at a good price.

The principle of comparative advantage establishes that there are gains from specialization and trade. but it leaves open a couple of related questions: What determines the price at which trade takes place? How are the gains from trade shared between the trading parties? The precise answer to these questions is beyond the scope of this chapter, but we can state one general rule: For both parties to gain from trade, the price at which tpey trade must lie between the two opportunity costs. In our example, the farmer and rancher agreed to trade at a rate of 3 ounces of potatoes for each ounce of meat. This price is between the farmer’s opportunity cost (4 ounces of potatoes per ounce of meat) and the rancher’s opportunity cost.(2 ounces of potatoes per ounce of meat). As long as the trading price lies somewhere in this range, each party will benefit by buying a good at a price that is lower than his or her opportunity cost.

The moral of the story of the farmer andthe rancher should now be clear. Trade can benefic everyone In society because it allows people to specialize in activities in which they have a comparative advantage.