Why should countries trade? Simply put, if a country can produce a good or service 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 or service 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.
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, here we’ll restrict ourselves to cases of two countries and two goods. Each of these two cases will be discussed in detail in the following paragraphs.
Farmer Jason has a pistachio farm. It takes him six hours worth of work to harvest one pound of nuts. Farmer Harry also has a pistachio farm. It takes him five hours worth of work to harvest one pound of nuts. Farmer Jessica owns a third pistachio farm. She can harvest one pound of nuts in four hours. In this example, Farmer Jessica 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 Jessica to spend time harvesting pistachios than it was for Farmer Jason or Farmer Harry to do the same. Farmer Jessica 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.
In a more complex model though, producers can produce many different goods. Often times, if a producer chooses to produce one good, he or she must give up the opportunity to produce another good. This is called the opportunity cost of producing a good. The opportunity cost describes what is sacrificed or relinquished when one choice is taken over another. Absolute advantage and comparative advantage are theoretically straightforward. When a producer has an absolute advantage, he can produce a given output by using fewer inputs than any competing producer. When a producer has a competitive advantage, he can produce one product with a smaller amount of inputs than the competition. He therefore must produce another product with a greater amount of inputs than the competitor, hence the designation of comparative advantage. When either an absolute advantage or a comparative advantage exists, benefits from international trade are guaranteed.