Why Nations Trade
Why do nations trade goods with each other? Nations exchange goods with each other when they expect to gain from the exchange. We call that gains from trade. Adam Smith, a famous economist from the 18th century, talked about this in his book, Wealth of Nations, and so did economist David Ricardo.
The theory of comparative advantage teaches us that nations should specialize in the production of the goods in which they have the lowest opportunity cost, and trade with other nations.
The reason this works is because nations tend to have different resources, and they’re not equally efficient when they are producing goods, which means they have different opportunity costs. When they have different opportunity costs of producing goods, it is possible to gain from trading. When both nations trade, they both will experience an increase in output, because they don’t have to switch between one task and another. They also increase their skill level because they’re doing the same task over and over again. This makes them more productive, and empowers them to produce at a level that goes beyond their production possibilities curve.
The Benefit of Specialization
For example, let’s say that the United States can produce more strawberries with the same amount of resources than Canada can. This means the U.S. has an absolute advantage in the production of strawberries. Now, my first thought about that would be, the U.S. should definitely specialize in strawberries because in this example, they are the best at it. But my perspective is nearsighted, because I’m not accounting for the concept of opportunity cost, which shows me what the U.S. would have to give up in order to specialize.
Having an absolute advantage in the production of a good doesn’t always mean you have a comparative advantage.
The graph shows Canada has the lowest opportunity cost for strawberries
Fruit Opportunity Cost Graph
So let’s take this idea further and see where it leads: