With trade, each country can concentrate on producing goods and services that it produces more efficiently, while trading to obtain goods and services that it does not produce efficiently.

As a result, the total output of trading nations can be increased, leading to higher living standards of the residents of those nations. The mutual benefits realised as a result of trade are the gains from trade.

1.1 Theory Of Comparative Advantage

The theory of comparative advantage attempts to explain what leads to gains from trade.

Assumptions:

• Resources are fully employed

• Only two countries (e.g. A and B)

• Two products (e.g. rice and cloth)

• No transportation cost for goods across national boundaries

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The following table shows the amounts of rice and cloth that can be produced

with one unit of resources in Country A and Country B:

Rice (Kg)

Cloth (Yard)

Country A

50

30

Country B

5

10

The following table shows the opportunity costs of rice and cloth in Countries A and B:

Rice (Kg)

Cloth (Yard)

Country A

0.6 yards of cloth

1.67 kg of rice

Country B

2.0 yards of cloth

0.50 kg of rice

The table shows that the sacrifice of cloth in producing rice is much lower in Country A than it is in Country B. Country A has a lower cost in producing rice.

Similarly, the sacrifice of rice involved in producing one yard of cloth is lower in Country B than in Country A. Country B has the lower cost in producing cloth.

If trade is allowed between these two countries, they can specialise in the production of goods that have lower opportunity cost. The following illustrates the changes in production resulting from each country’s producing one more unit of a commodity in which it has the lower opportunity cost: