LESSON 2

• Basic reasons why countries engage in international trade:

  • Countries benefit from their differences by reaching an arrangement in which one does the things it does relatively well
  • Countries trade to achieve economies of scale, especially if each country produces only a limited range of goods
• The concept of comparative advantage:

  • David Ricardo suggested that countries should specialize by allocating their scarce resources to produce goods and services for which they have a comparative advantage
  • A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries
• Comparative Advantage:

  • The ability to produce a good at a lower opportunity cost than another producer
  • Opportunity Cost: Whatever must be given up to obtain some item, measures the trade-off between the two goods that each producer faces
• Production possibilities:

  • Any economy has limited resources, leading to trade-offs in production
  • To produce more of one good, the economy must sacrifice some production of another good
  • Production possibility frontier graphically illustrates the combinations of output that the economy can possibly produce given the available factors of production
• The gains from trade:

  • Country A can produce wine more efficiently by making cheese and trading it with Country B
  • Country B can produce cheese more efficiently by making wine and trading it
  • Trade allows countries to benefit from their comparative advantages
• Misconceptions about comparative advantage:

  • Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition, fails to recognize trade is based on comparative advantage
  • Myth 2: Foreign competition based on low wages is unfair and hurts other countries, used to promote protectionist trade policies
  • Myth 3: Trade does not exploit a country, denying the opportunity condemns poor people to continue to be poor
• Adding transport costs and nontraded goods:

  • Specialization in the real international economy is not extreme due to the existence of more than one factor of production, protection of industries, and transportation costs
  • Introducing transport costs makes some goods nontraded, examples include services like haircuts and auto repair that cannot be traded internationally