Why trade helps both sides
How specialising and trading lets both partners consume more, what price makes a trade worth it, and why it applies to countries.
FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Show how specialising raises total output
- State the range of prices at which both sides gain
- Apply comparative advantage to people and to countries
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 10 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 3
What it is
Continue Mankiw's farmer and rancher. Without trade, each makes and eats their own food:
- Farmer: 4 hours on each, making 4 oz meat and 16 oz potatoes.
- Rancher: 4 hours on each, making 12 oz meat and 24 oz potatoes.
With trade. The farmer spends all 8 hours on potatoes (their comparative advantage), making 32 oz. The rancher spends 6 hours on meat and 2 on potatoes, making 18 oz meat and 12 oz potatoes. The farmer then trades 15 oz of potatoes for 5 oz of meat.
| After the trade | Meat | Potatoes |
|---|---|---|
| Farmer | 5 (was 4) | 17 (was 16) |
| Rancher | 13 (was 12) | 27 (was 24) |
Both have more of both foods. Total output has risen from 16 to 18 oz of meat and from 40 to 44 oz of potatoes, because each now does more of what they give up least to make.
Text description
The farmer's production possibilities frontier, a straight line from 8 ounces of meat to 32 ounces of potatoes. Without trade the farmer produces and eats at A: 16 ounces of potatoes and 4 of meat, on the frontier. With specialisation and trade the farmer eats at A*: 17 ounces of potatoes and 5 of meat, a point outside the frontier that the farmer could not reach alone.
Quick check
Tap an answer to check it.
Before trade the farmer ate 4 oz of meat and 16 of potatoes. What do they eat after the trade?
- 15 of the 32 ounces were traded away
Show answer
5 oz of meat and 17 of potatoes. 32 − 15 = 17 potatoes, plus the 5 oz of meat received.
Why it matters
The price must lie between the two opportunity costs. In the deal, the farmer pays 3 oz of potatoes for each ounce of meat (15 ÷ 5). That is less than the farmer's own cost of meat (4 oz of potatoes) and more than the rancher's (2 oz). So both gain. Mankiw's rule: for both to gain, the price must fall between the two opportunity costs, here between 2 and 4 oz of potatoes per ounce of meat. Outside that range, one side would be better off making the good itself.
Should Tom Brady mow his own lawn? Mankiw imagines the star footballer can mow his lawn in 2 hours, in which he could instead earn 20,000 dollars filming an advert. A neighbour takes 4 hours, in which they could earn 40 dollars at a fast-food job. Brady has the absolute advantage, but the neighbour has the comparative advantage. Any payment between 40 and 20,000 dollars leaves both better off.
Countries. The same logic applies. Mankiw's example: an American and a Japanese worker each make one car a month, but an American worker makes 2 tonnes of food against 1 in Japan. A car costs 2 tonnes of food in the US and 1 tonne in Japan, so Japan has the comparative advantage in cars and the US in food. Goods bought from abroad are imports; goods sold abroad are exports.
Where the idea comes from. Adam Smith argued in 1776 that it pays to buy what would cost more to make at home. David Ricardo set out comparative advantage as economists know it in 1817, with England, Portugal, wine and cloth. Mankiw notes that economists' opposition to trade restrictions still rests largely on this principle. He also notes that trade can make some groups worse off even when it benefits a country overall, a point for the later lesson on trade's winners and losers.
Worked example
Two flatmates share chores for a week. Times are made up.
| Minutes per task | Cooking a meal | Cleaning a room |
|---|---|---|
| Chen | 30 | 20 |
| Dana | 60 | 30 |
- Chen: a meal costs 30 ÷ 20 = 1.5 cleaned rooms. Dana: a meal costs 60 ÷ 30 = 2 rooms.
- So Chen has the comparative advantage in cooking (1.5 < 2), and Dana in cleaning (a room costs Dana ½ a meal, against ⅔ for Chen).
- If Dana cleans in exchange for Chen cooking, any rate between 1.5 and 2 rooms per meal leaves both better off.
Common mistake
Thinking trade is a contest in which one side's gain is the other's loss. Specialising by comparative advantage increases total output, so both sides can gain. How the gain is split depends on the price, which must lie between the two opportunity costs.
Key terms
- gains from trade
- the extra output and consumption made possible by specialising and trading
- imports
- goods produced abroad and sold at home
- exports
- goods produced at home and sold abroad
- terms of trade
- here, the price of one good in units of the other agreed in a trade
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| gains from trade | the extra output and consumption made possible by specialising and trading |
| imports | goods produced abroad and sold at home |
| exports | goods produced at home and sold abroad |
| terms of trade | here, the price of one good in units of the other agreed in a trade |
Practice
Work it through
For Ana, a pot costs 3 baskets to make; for Ben, a pot costs 5 baskets. They agree to trade pots for baskets.
- Ana makes pots; she gains only above her own cost of 3
- Ben gains only below his own cost of 5; above it he would make his own
- (3 + 5) ÷ 2
Quick quiz
Tap an answer to check it.
In Mankiw's farmer–rancher deal, at what price does the farmer buy meat?
- That is the farmer's own opportunity cost of meat
- That is the rancher's opportunity cost of meat
Show answer
3 oz of potatoes per ounce of meat. 15 oz of potatoes for 5 oz of meat.
Why does Brady benefit from hiring his neighbour?
- Brady is faster; that is absolute advantage
Show answer
His opportunity cost of mowing (20,000 dollars) is far above the neighbour's (40 dollars). Comparative advantage, not speed, decides who should do the job.
Who developed comparative advantage as economists know it today, according to Mankiw?
- Smith argued for buying what costs more to make at home; Ricardo developed comparative advantage
Show answer
David Ricardo, in 1817. Ricardo's example used England, Portugal, wine and cloth.
In short
- Specialising by comparative advantage raises total output; trade lets both consume more.
- Both sides gain only if the price lies between their opportunity costs.
- The same logic applies to people (Brady and the lawn) and to countries.
- Smith and Ricardo laid the foundations; economists' case for free trade still rests largely on it.
Mastery check
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Check yourself
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In Mankiw's example, by how much does total potato output rise with specialisation?
Show answer
From 40 to 44 ounces.
Between which two prices must a trade lie for both sides to gain?
Show answer
Between the two parties' opportunity costs of the good.
In Mankiw's US–Japan example, which country has the comparative advantage in cars?
Show answer
Japan: a car costs it 1 tonne of food, against 2 in the US.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 3.
- On this site: Absolute and comparative advantage.
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