BEC - Gains from Trade and Exchange Rates Lesson

Gains from Trade and Exchange Rates Lesson

The production possibilities curve can also demonstrate how individuals and nations will benefit from trade.  

In general, there are two basic gains that occur from trade: greater production and better allocation of goods and services. The concept of comparative advantage is central to determining if countries will benefit from specialization and trade. 

Absolute v. Comparative Advantage

Production capabilities for countries can be viewed in two ways. First, we can look at which country holds an absolute advantage in the production of a good. This means we look to see which country can produce a good more efficiently (by producing either more of the good or by producing it using the least amount of resources). While absolute advantage identifies how the productive capabilities of nations differ, it doesn't necessarily reflect if the country should produce the good. 

Comparative Advantage and Trade Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

The concept of comparative advantage is used to determine if specialization and trade between nations can be beneficial. Comparative advantage is based on opportunity costs. Thinking back on information represented in the PPC, a country must be willing to give up the production of one good to increase its production of another good.   So, if two countries capable of producing the same goods believe specialization and trade would be beneficial, opportunity cost is used to determine which country should produce which good. Essentially, a country should produce the good for which it has the comparative advantage. That is, the good for which it has the lower opportunity cost compared to the other country.  

 

	Output Per Hour
Country	Cars	Trucks
Country A	4	6
Country B	10	12

 

Production Possibilities Curves for Country A and B

The x and y intercepts demonstrate which country has the absolute advantage in a particular good. In the case presented above, Country B holds the absolute advantage in the production of both goods. Just because Country B is better at producing both goods, we must look at comparative advantage to see if specialization and trade would benefit the countries.

Finding Comparative Advantage

Two models- the output model and the input model - are used to determine comparative advantage and the appropriate model is based on the type of information you are given. If the information given is in terms of finished goods/services, the output model would be used. If the information given is in terms of resources used to produce the good or service, the input (or resource) model would be used. 

Output Model:

The Output Model is used when resources are fixed at the same amount for each nation and the amount of goods and services that can be produced differs between the nations.

To determine comparative advantage when presented with output, you establish a ratio of the items in terms of what is not produced/to what is produced.  

For example, if Country A produces cars in that 1 hour, they cannot produce trucks. What would be the opportunity cost for each car Country A produces?

Before we can "compare" anything and determine comparative advantage, we must find the opportunity for Country B if they produce cars. We would use the same problem set up, but the numbers for Country B.

Country B's opportunity cost of producing cars is 12/10 or 1.2 trucks. Each car produced by Country B requires them to give up producing 1.2 trucks.  

Now, compare the opportunity cost. Remember the country with the lowest opportunity cost for the production of a good has the comparative advantage. That means Country B should specialize in the production of cars. This scenario can be worked to determine who holds the comparative advantage in the production of trucks, also. In this situation, Country A can produce a truck, and it "costs" .67 cars. Country B can produce a truck and it "costs" .83 cars. Country A holds the comparative advantage in the production of tanks and should specialize in tank production.

Input Model:  
The Input Model is used when the amount of goods and services is fixed at the same amount for each nation and the amount of resources needed to produce those goods/services differs between nations.

Sometimes the information for a country can be presented in terms of the resources required to produce a certain quantity of a good. In these instances, we use the reciprocal of the ratio in the output model.  

Remember to quote the opportunity cost in terms of the item that is given up when a decision is made to produce another item.

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