Trade

Now, let’s talk about trade. The intention of trade is to improve utility for all parties involved. Obviously, if you didn’t think you were getting any benefit out of a trade, you wouldn’t make it. Oftentimes, though, the largest mutual benefits come from trade relationships where one party specializes in the production of good X and the other party specializes in the production of good Y.

To understand how this process works, it’s important to understand the difference between absolute and comparative advantages. An absolute advantage is based on the maximum output of goods, whereas comparative advantage is based on opportunity cost. For example, a large company with a million employees might be able to build more chairs than a much smaller company with less resources and just 10 employees. The large company therefore has an absolute advantage. However, producing more items does not mean it is producing them at a lower opportunity cost. For example, each chair built by the large company may tradeoff with 3 potential tables built but only tradeoff with 2 tables built for the small company. The small company has a lower opportunity cost of producing a single chair than does the large company; thus, the smaller company has a comparative advantage in producing chairs.

Now let’s imagine that, instead of companies, we were dealing with countries who wanted to trade with each other. To maximize total utility, each trade partner should produce the goods where they have a comparative advantage. This is the concept of specialization.

That’s specialization in action, but it’s trade terms that determine whether or not the countries are better off after the trade. They’re typically expressed as exchanges, like “1 strawberry for 5 blueberries.” In the example with Motivalaland and Bhandaristan, trade terms of “1 iPad for 2 phones” would be beneficial to both countries. Motivalaland gets 2 phones, for each iPad it makes, which is double the domestic opportunity cost of producing one iPad in Motivalaland. Bhandaristan gets half an iPad for every phone it makes, which is more than the ⅓ iPad opportunity cost of each phone.