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Course: AP®︎/College Macroeconomics > Unit 1
Lesson 3: Comparative advantage and the gains from trade- Comparative advantage, specialization, and gains from trade
- Comparative advantage and absolute advantage
- Opportunity cost and comparative advantage using an output table
- Terms of trade and the gains from trade
- Input approach to determining comparative advantage
- When there aren't gains from trade
- Comparative advantage worked example
- Lesson summary: Comparative advantage and gains from trade
- Comparative advantage and the gains from trade
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When there aren't gains from trade
In a previous lesson we learned that there is the potential for two countries to gain from trade. But it is also possible that there might not be the potential to gain from trade. In this video, we explore the circumstance that would lead to there being no gains from trade.
Want to join the conversation?
- I have a question! Is it possible that a country can have both comparative advantage?(21 votes)
- A country cannot have comparative advantage in both goods! That's the whole idea of "comparative". For example, I can be relatively better at baking brownies than at baking cookies, but I cannot at the same time be relatively better at baking cookies than baking brownies.(42 votes)
- At the same time, country A can produce more goods than country B, so A can sell it to B and still have more gain than B?
Do I get it right? Thank you(4 votes)- No, gains from trade are based on comparative advantage, not absolute advantage.(11 votes)
- How does the math work?(4 votes)
- The math involved in determining opportunity cost and trade terms is based on comparing the ratios of input or output for different goods in different entities. Opportunity cost is calculated by considering the trade-offs involved in producing one unit of a good instead of another. Trade terms are determined based on ensuring that both parties benefit from the exchange by trading at prices below their respective opportunity costs.(1 vote)
- I'm curious... What happens if a country had a lower opportunity cost in producing BOTH goods.(4 votes)
- Even if a country is better at producing both goods, trading can still be beneficial if it specializes in the good it's comparatively better at making.(1 vote)
- At5:51, Sal says that since they have the same slope, they have the same O.C. and therefore no comparative advantage. So I wonder, if you have two PPCs and they have different slopes, would their intersection point mean anything?(3 votes)
- If two production possibility curves (PPCs) have different slopes, it means that the opportunity costs of producing one good in terms of the other differ between the two entities or countries. In this case, the intersection point of the two PPCs represents the level of production where the opportunity costs for both goods are equal for both entities. It doesn't necessarily indicate a comparative advantage, but it does show a point where the trade-offs between producing one good over the other are the same for both parties. This point can be used as a reference for potential trade, but further analysis is needed to determine comparative advantage and optimal trading terms.(1 vote)
- Country A has the absolute advantage so for country B there will be some benefit of trading.. Imagine, country A does not need so many bananas, so it would be beneficial for country B to trade then..(1 vote)
- Not true. Because their comparative OCs are the same, it just makes sense for them to split the production between apples and bananas. They can't get a better trade deal than their OC.(3 votes)
- I have a problem. I submitted an assignment recently and in it person A had an opportunity cost of producing 1 piece of firewood of 3 fishes. Person B had an opportunity cost of producing 1 piece of wood of 2 fishes. The question that was asked was "what is the maximum number of fishes person B will be willing to pay person A for one bundle of wood"
I reasoned that since the opportunity cost of producing 1f for person B was 1/2 *w, he would want to trade at a price greater than his opportunity cost because if he were to trade 2f for 1w he wouldn't be gaining anything but in fact would be wasting his time (and isn't time our most precious commodity)! So, the maximum he would want to trade his fish for would be 1f for 1 wood. The actual answer is 2 fishes for 1 wood. I just can't bring myself to agree with this. Can someone please help me out?(2 votes)- Your reasoning is generally correct. Person B's opportunity cost of producing one piece of wood is 2 fishes, so they would want to trade at a price higher than their opportunity cost to make the trade worthwhile. However, it seems there might be a misunderstanding or misinterpretation of the question or the information given. If Person A's opportunity cost of producing one piece of wood is 3 fishes, and Person B's opportunity cost of producing one piece of wood is 2 fishes, then Person B indeed has a comparative advantage in producing wood. In this case, Person B would be willing to pay less than their opportunity cost for one bundle of wood, not more. The correct answer would indeed be 1 wood for 2 fishes, as Person A values wood more than fishes due to their higher opportunity cost.(1 vote)
- How come you just don't do it in basic math instead of making it more difficult?(1 vote)
- There are different formulas for solving these equations because if we were just to use "basic math" our answers would be incorrect.(1 vote)
- I think in the example, Country A has absolute advantages in both apples and bananas. Am I correct?(1 vote)
- Yes, that is correct. Given the available resources, Country A has a higher production possibilities frontier than Country B.(1 vote)
Video transcript
- [Instructor] So let's say
we're in a very simplified world where we have two countries,
Country A and Country B and they're each capable of
producing apples or bananas or some combination of them
and what this chart tells us if Country A put all their
energy behind apples in a day they could produce three apples, and if they put all of their
energy behind bananas in a day they could produce six bananas. Similarly, Country B, if
they put all of their energy behind apples in a day they
could produce two apples, and Country B if they put all
of their energy behind bananas in a day they could produce four bananas. So given this, who has the
comparative advantage in apples and who has the comparative
advantage in bananas and how should they trade? Pause this video and try to
figure it out on your own. All right so when we're thinking
about comparative advantage we really want to think about, well, what is the opportunity cost of producing an apple in each country and what is the opportunity cost of producing a banana in each country? And so let me make another
little subcolumn right over here. Opportunity cost, and so
what is the opportunity cost of an apple in Country A? And pause this video at any
point if you get inspired. Well, to produce three apples they would have to trade off six bananas. And so that means that per apple, they are not producing two bananas. So this is two bananas, two bananas. I'll just write bana, bananas per apple. And their opportunity cost for bananas is just going to be
the reciprocal of that. So one over two apples, apples per banana and then for Country B we
can do a similar calculation and you might be noticing
something interesting is about to happen. What's Country B's
opportunity cost of apples? Well, one way to think about it, if they produce two apples, that means they're giving up four bananas. Or they're giving up
two bananas per apple. So two bananas, bananas per apple. And once again, if we
want to think in terms of the opportunity cost of a banana, well, to produce four bananas
they're giving up two apples. So this is one half of
an apple per banana. Per, I'll just write,
banana right over there. So this one is a little bit interesting. They have the same
opportunity cost for apples in terms of bananas, and they
have the some opportunity cost for bananas in terms of apples. And so because they have
the same opportunity costs. So let me write this down,
same opportunity costs. There is no comparative advantage. So no comparative advantage in either. Advantage in either. And so based on our very simple model here there are no gains from trade. Another way we could visualize this that maybe makes it maybe
hopefully a little bit more clear. So let me make one axis here. I'm trying to draw a
straight line, all right. And then this is my other
axis right over here. And let's make this one right
over here, this horizontal one let's make this the apples axis and let's make the vertical
one the bananas axis. And we're saying per
day and this of course is apples per day and so
if we look at Country A. Let me do Country A in a new color. So Country A, let's say orange. If they put all their energy behind apples they could produce one, two. Let me spread this out a little bit. They could produce one,
two, three apples in a day. If they put all their
energy behind bananas they could produce, let's just
say this is two, four, six. So that's six, this is four, this is two. This is three right over here. Let me put markers in-between
to make this clear. So if they put all of
their energy into bananas they could produce six in a day and so their production possibilities if we assume it is a linear trade-off would look something like this and the slope right over here, this would be the opportunity cost. So the slope right over here,
every time we increase apples by one we decrease bananas by two. So in this situation, we
would have, so the slope here is equal to, well, it's
actually a negative slope. It's equal to negative two
bananas, bananas per apple. So this right over here, this slope based on how I picked the axes, this is giving me the
opportunity cost for apples in terms of bananas. Every time I increase an apple how many bananas am I actually giving up? So that is my opportunity cost there. And now if we think about Country B. Let me do this in a new color. I'm running out of colors. Country B right over here
they could either produce four bananas or two apples
or things in-between. But notice, it has the exact same slope The slope is the opportunity cost. And if we switch these
axes right over here then the slope would be the
opportunity cost for bananas in terms of apples, but
the big takeaway here, if you see the production
possibilities of two countries and we're talking about two goods and they have the same slope, then that means their opportunity costs are going to be the same, and there's not going to be a gain from trade. Remember, the whole point
of comparative advantage and trading is that both
countries will benefit. That's really the big takeaway here. But there are situations where both countries wouldn't benefit because they have the
same opportunity cost and this was an example of one of them. Now the other case,
sometimes one will have a comparative advantage over the other. They do have different opportunity costs and then you might have
no gains from trade. Maybe there's some way that they can't know each
other's opportunity costs. There's some way that they don't trade. Maybe irrespective of
what the models tell us about comparative advantage
some country says, hey, I don't want to produce bananas. Apples are the future, that's
a higher skilled industry, whatever else, so there's
definitely scenarios, especially even in our model,
in our very simplified model where there might not be gains from trade. And the classic one of course is when there's no comparative
advantage and both countries have the same opportunity
costs in the goods.