ECB1101 · Introductory Microeconomics
Gains from Trade
Trade is driven by comparative advantage — lower opportunity cost — not absolute advantage (more raw output). A producer has an absolute advantage if it can make more of a good with the same resources; it has a comparative advantage if it can make the good at a lower opportunity cost. The counter-intuitive headline the exam loves: specialisation is dictated by comparative, not absolute, advantage, and because one country's opportunity cost of a good is the reciprocal of its cost of the other, no one can have a comparative advantage in everything. Each side specialises where its opportunity cost is lowest, trades at a price strictly between the two opportunity costs (the terms-of-trade range), and both consume beyond their own PPF. The gain is pure reallocation — no extra resources — and it vanishes only if the two opportunity costs are equal.
What this chapter covers
- 012.1 Absolute vs comparative advantage
- 02Computing opportunity cost from an output table
- 03Why no one has a comparative advantage in everything
- 04Comparative advantage decides who specialises
- 05The terms-of-trade range (a strict inequality)
- 06Proving everyone gains — the autarky check
- 07Where the gains come from: pure reallocation
Worked example: comparative advantage and the terms of trade
- +2(a) US: opportunity cost of 1 computer = shirts given up ÷ computers gained = 100 ÷ 20 = 5 shirts. China: 100 ÷ 10 = 10 shirts.
- +1(b) Computers: the US gives up only 5 shirts vs China's 10, so the US has the comparative advantage in computers.
- +1(b) Shirts: the opportunity cost of a shirt is the reciprocal — US gives up ⅕ of a computer, China only ⅐ — so China has the comparative advantage in shirts.
- +2(c) A computer trade only beats self-supply if its price is above the US's own cost (5 shirts) and below China's (10 shirts): 5 shirts < price of 1 computer < 10 shirts.
Key terms
- Absolute advantage
- The ability to produce more of a good than another producer from the same resources — a comparison of raw output. It does NOT decide who should specialise; a country can hold an absolute advantage in both goods and still gain by importing one.
- Comparative advantage
- The ability to produce a good at a lower opportunity cost than another producer. This — not absolute advantage — decides who specialises where. Because opportunity costs are reciprocals across the two goods, no producer can have a comparative advantage in everything.
- Opportunity cost (from an output table)
- The opportunity cost of one unit of a good = the units of the OTHER good given up ÷ the units of this good gained. For 100 shirts OR 20 computers, one computer costs 100/20 = 5 shirts, and one shirt costs 20/100 = ⅕ of a computer.
- Terms of trade
- The price at which the two goods exchange. A mutually beneficial trade requires a price strictly between the two producers' opportunity costs — each side will only trade for better than its own cost of making the good itself.
- Gains from trade
- The extra consumption both producers enjoy by specialising according to comparative advantage and trading. The gain is pure reallocation — no extra resources or technology — and both can consume at a point beyond their own PPF.
Gains from Trade FAQ
Why does comparative advantage, not absolute advantage, decide who specialises?
Because what matters for a trade is what each producer GIVES UP, not how much they can make. A country can be better at making both goods (absolute advantage in both) and still gain by importing the one it is relatively worse at. The exam plants the bigger output number precisely so you pick the wrong specialiser — always rank by opportunity cost, never by raw output. And since one country's opportunity cost of a good is the reciprocal of its cost of the other, being the cheaper producer of computers automatically makes you the dearer producer of shirts: no one has a comparative advantage in everything, which is exactly what makes trade possible.
How do I find the range of prices at which both countries gain?
A trade only happens if it beats making the good yourself, so the price of a computer must sit strictly between the two producers' opportunity costs. With the US costing 5 shirts per computer and China 10, the range is 5 < price < 10 shirts per computer: the US exports computers only for more than its own 5-shirt cost, and China imports them only for less than its own 10-shirt cost. State it as a strict inequality, then pick any rate inside (say 7) to show both end up better off.
How do I prove both countries actually gain?
Compare each country's consumption bundle WITH trade against what it could reach ALONE (autarky). Take the terms of trade (say 7 shirts per computer). Each country specialises completely, trades along that rate, and you check the resulting bundle beats its autarky split. For example, China specialises in shirts (100), sells 50 at 7 shirts per computer to get about 7.1 computers, and consumes (50 shirts, 7.1 computers) — more computers than the (50, 5) it could reach alone. Both bundles improve, which is the proof the marker wants.
Where do the gains from trade come from?
Pure reallocation — nothing is added. No extra workers, no new technology. Each country simply stops doing the thing it was relatively bad at and lets the other do it, so world output of both goods rises because production moved to the lower-opportunity-cost producer. That is the entire case for specialisation and trade. The corollary: if the two opportunity costs were equal (no difference to exploit), there would be no comparative advantage and no gains from trade — trade pays only when opportunity costs differ.
Exam move
Full marks want three things on paper, so build the habit: (1) the two opportunity-cost divisions from the output table (e.g. 100÷20 and 100÷10), (2) the comparative-advantage verdict with a one-line reason ('lower opportunity cost'), and (3) the terms-of-trade range stated as a strict inequality between the two opportunity costs. Then, if asked to prove the gains, pick a rate inside the range and show both consumption bundles beat autarky. If a graph is required, label both axes and both PPFs, mark each production and consumption point, and draw the terms-of-trade line reaching a consumption point OUTSIDE the frontier — unlabelled diagrams lose marks in Section C.
