When individuals or countries specialize in the things that they are good at, meaning that they are most efficient at or that have the lowest opportunity costs, then they can trade with others and end up with more than they could have if they tried to do everything themselves.

When one person or country has a lower opportunity cost in a specific activity than another person or country, then it is said to have a comparative advantage in that activity. A comparative advantage indicates an area where specialization should occur in order to increase total production. Then, the good that is specialized in can be traded for the other good.

Even if one party can do more of everything than the other party, both can still gain from specialization and trade due to comparative advantage.

The concept of comparative advantage is often confused with the concept of absolute advantage. Absolute advantage is when one person or country can do more of a particular activity than the other party, based on the total amount of production that is possible for that activity. Absolute advantage has nothing to do with opportunity costs and has no effect on potential gains that can be made from specialization and trade. When determining specialization, only comparative advantage matters.

One type of question that comes up very often on tests relating to opportunity costs, specialization, and trade involves a hypothetical situation of two countries (or individuals) that can each produce two goods in ratios that are given by numbers of units of each good that it can produce. People often ask me questions about this, so I will try to explain it here. I will use two different methods for explanation: a formula and an example. Those who are more comfortable with learning concepts using a formula can start with the next section before proceeding to the example. Those who are uncomfortable with using formulas can just skip to the example.

Using a formula:

This type of question typically looks like this:

Country A can produce (a) number of units of good 1, or it can produce (b) number of units of good 2; country B can produce (c) number of units of good 1, or it can produce (d) number of units of good 2. Which good should each country specialize in?

The answer, using a formula, involves figuring the opportunity cost of each good for each country. The country with the lower opportunity cost for a good should specialize in that good. The opportunity cost for each good can be calculated with a formula:

For country A, the opportunity cost of good 1 is (b) / (a). The opportunity cost of good 2 is (a) / (b).
For country B, the opportunity cost of good 1 is (d) / (c). The opportunity cost of good 2 is (c) / (d).

Using an example instead of just a formula:

Japan can produce 5 cars or 10 computers in an hour. The United States can produce 3 cars or 12 computers in an hour. Which good should each country specialize in?

To get the answer, first determine the opportunity cost of the two goods for each country. The country with the lower opportunity cost for a good should specialize in that good, and trade with the other country for the other good.
For Japan, the opportunity cost if 1 car is 2 computers (you get this number by dividing the number of computers that Japan can produce (10) by the number of cars that it can produce (5) in the same amount of time. Using the same method, the opportunity cost to Japan for computers is 1/2 (5 divided by 10).

For the United States, you use the same method to calculate the opportunity costs. For cars, that would be 4 (12 divided by 3); for computers, that would be 1/4 (3 divided by 12).

This means that for cars, Japan's opportunity cost is 2 while the United States' opportunity cost is 4. Since Japan's opportunity cost is lower than the United States' (2 For computers, Japan's opportunity cost is 1/2 while the United States' opportunity cost is 1/4. Since the United States' opportunity cost is lower than Japan's (1/4

Then, with specialization, Japan can trade cars to the United States for computers, and both countries will have more than if they both produced both products and consumed only what they produced themselves.

To illustrate how specialization can increase total production, start with the above example. Assume that without trade, each country will spend an equal amount of time on the production of each good. That means that in the same period of time, Japan can produce 5 cars and 10 computers, while the United States can produce 3 cars and 12 computers. Together, the two countries produce 8 cars and 22 computers. But with specialization, Japan will produce 10 cars and zero computers, while the United States produces zero cars and 24 computers. Together, with specialization, they end up producing 10 cars and 24 computers. This is an increase of two cars and two computers due to each country specializing in the good that it is most efficient at.

You might ask: if they trade, what would be a fair price? The opportunity costs represent the cost of each good for each country if they do not trade. In order to gain from trade, the trade ratio (relative price) should be somewhere between the opportunity costs for each country. Otherwise, one country will not gain from the trade, and the trade will not occur. Since in the above example, the opportunity cost per computer for a car is 2 in Japan while it is 4 in the United States, any price between 2 cars per computer and 4 cars per computer will benefit both countries.

In this example, you might also be asked which country has an absolute advantage in each good. Since Japan can produce 5 cars in an hour while the United States can only produce 3 cars in an hour, Japan has an absolute advantage in cars (5>3). Since the United States can produce 12 computers in an hour while Japan can only produce 10 computers in an hour, the United States has an absolute advantage in computers (12>10). The absolute advantage was not part of the specialization and trade calculations because it is irrelevant. It would be entirely possible for one country to have an absolute advantage in both goods and still gain from trade, due to different opportunity costs.

It would not be possible for one country to have a comparative advantage in both goods, since comparative advantage is determined by the relative costs of the two goods. [If good A costs more in terms of good B, then it follows that good B could not cost more in terms of good A].

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