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Trade Basics

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Why Trade?

Why should countries trade? Simply put, if a country can produce a good for less than another country, then the opportunity for advantageous trade exists. Of course, the opportunity for advantageous trade also exists when a country can produce a good that another country is unable to produce. In each of these cases, both the consuming country and the producing country will be better off with trade than without it.

Let's use an example to explain. Say Jim lives on an island with a coconut tree. Sally lives on another island with a banana tree. Jim tires of eating coconuts and desires something new to eat. Surprisingly enough, Sally is tired of bananas and would love some nice sweet coconut. In this example, trade would benefit both parties.

This example presents only one of the two cases in which trade is adventurous. In the other case, a country can produce goods at an absolutely or relatively lower price than another country. These conditions are called the absolute advantage and the comparative advantage respectively.

Advantages in Trade

A country may have two advantages over another country (or countries) regarding trade. Absolute advantage occurs when a producer can use the smallest amount of inputs to produce a given amount of output compared to other producers. Absolute advantage may apply to many countries. Comparative advantage happens when a producer has a lower opportunity cost of production than another producer. Comparative advantage may also apply to many countries, but in this SparkNote it will be restricted to cases of two countries and two goods. Each of these two cases will be discussed in detail in the following paragraphs.

Farmer John has a pistachio farm. It takes him five hours worth of work to harvest one pound of nuts. Farmer Rick also has a pistachio farm. It takes him four hours worth of work to harvest one pound of nuts. Farmer Erica owns a third pistachio farm. She can harvest one pound of nuts in three hours. In this example, Farmer Erica is said to have the absolute advantage in pistachio production since she is able to produce the largest amount of output in the smallest amount of time.

In terms of trade, it is always most beneficial for the producer with the absolute advantage in the production of a good to specialize in the production of that good. For instance, in the above example, it was far more productive for Farmer Erica to spend time harvesting pistachios than it was for Farmer Rick or Farmer John to do the same. Farmer Erica therefore has a lower cost of production than either of the other two producers. Applying this idea to international trade leads us to the conclusion that goods should be produced for which the cost of production is lowest.