law of comparative advantage in international trade

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1. The law of comparative advantage: Mutually beneficial exchange is possible whenever relative production costs differ prior to trade.

This law applies to all exchanges, whether between individuals or nations.

Opportunity cost is the key to comparative advantage: Individuals and nations gain by producing goods at relatively low costs and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.

Oranges are grown at lower cost in Florida than in Iowa, for example, while Iowa excels in producing corn. Floridians and Iowans share gains from exchange according to comparative advantage by trading Florida oranges for Iowa corn. Similar gains are realized when Americans trade with foreigners?efficiency requires using all the world's resources in the relatively most productive ways.

Suppose Brazilians can grow coffee more easily than they can catch salmon, while Alaskans find it relatively easier to catch salmon than to grow coffee. Alaskans have a comparative advantage in salmon fishing, and Brazilians, in coffee production. Trading Alaskan salmon for Brazilian coffee clearly benefits both groups. The table below shows how both parties to a trade can gain whenever their opportunity costs differ. If Alaskans and Brazilians each specialize in their areas of comparative advantage, and if 1 pound of salmon trades for, say, 1 pound of coffee, then Alaskans can consume an extra 4 pounds of coffee daily while Brazilians can consume an additional 4 pounds of salmon. Note that the Alaskan opportunity cost of producing 1 pound of coffee is 5 pounds of salmon before trade, while each pound of coffee costs Brazilians only 1/5 of a pound of salmon.

A party has an absolute advantage if producing a good absorbs fewer resources than another ...