Comparative Advantage - Demonstrating the Benefits of Specialisation and Trade

#Economics #Trade #Exams

Link to a fully worked solution on PDF:
https://drive.google.com/file/d/1M8qU...

In this video, I demonstrate the benefits of trade between two countries when one of the two countries has an absolute advantage in the production of both products.

Comparative advantage is an economic term that refers to an economy's ability to produce goods and services at a lower opportunity cost than that of trade partners. 
Source: https://www.investopedia.com/terms/c/...

So, the first thing that we are going to have to work out is the production possibilities for both countries we can do this figuring out the maximum amount of each good that each country can produce when they 100% of their resources to its production. Because this table shows what the countries produce when they allocate half their resources to the production of each good to get maximum production we are simply going to multiply these numbers all by two.

Now we have the production possibility frontiers for each good we can then calculate the opportunity cost of production for each good. For fruit the opportunity cost of its production in Thule is... in Agartha it is… as a result, Agartha has a comparative advantage in the production of fruit.

Moving on, the way comparative advantage works is if one country has the comparative advantage in the production of one good, by definition, the other country must have a comparative advantage in the production of the other good – No country can have a comparative advantage in the production of both goods when comparing exclusively to one other country.

Now that we have ascertained which country should specialize in the production of each good, we allow them to fully specialize and hopefully you will see that the global production of honey has actually fallen – making both countries worse of in the consumption of honey.
This is due to Agartha having an absolute advantage in the production of both goods and will require Agartha to devote most of its resources to the production of fruit – which is the product that it has a comparative advantage in the production of – and a smaller portion of its resources to the production of honey.

This is how you deal with all situations in which one country has an absolute advantage in the production of both products.

So, for both countries to gain from specialization, global production in each good need to be either maintained or increased. This will require Agartha producing at least 20 units of Honey to take global production to 60.

Because the opportunity cost of Honey in Agartha is 2 Fruit the 20 extra units of Honey production will cost 40 units of Fruit production – which will reduce their fruit output to 120 (160-40=120)

So, it is clear that the world production of Honey has been maintained but the global production of fruit has increased from 90 to 120; meaning that these two countries are better off.

We aren’t finished yet. Thule still needs to trade with Agartha to allow it to have at least 10 fruit and Agartha needs to trade with Thule to ensure that they have at least 40 Honey. Because the Terms of Trade are 1 Fruit = 1 Honey, Thule will trade 20 Honey with Agartha in exchange for 20 Fruit.

So, although both countries remain at their pre-specialization consumption levels of Honey, both Thule and Agartha are consuming more fruit following specialization than they did previously. As a result, both countries gain from trade and their populations can both enjoy higher standards of living due to their increased consumption levels.

I hope the video helps :)

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