Why Nations Trade

          Trading relationships between countries can benefit them whether they have abundant resources or few resources. The answer to this involves two related concepts: absolute and comparative advantage.

          A country has an absolute advantage over another when it can produce more of a given product using a given amount of resources. Suppose two people, Steve and Snookie, want to make some money and they decide to produce pies and pinatas. Steve can make 6 pies and 2 pinatas in one hour. Snookie, however, can only make 1 pie and 1 pinata in an hour. Thus, Steve has an absolute advantage over Snookie.

          When a nation has a lower opportunity cost in producing a certain good, it has a comparative advantage in producing that good. Comparative advantages consist in the ability to produce a product most efficiently given all the other products that could be produced. Steve can produce 6 pies and 2 pinatas in one hour, while Snookie can produce 1 pie and 1 pinata in an hour. The opportunity cost for Steve in producing each pie is 1/3 of a pinata. To produce 1 pinata, it costs 3 pies to Steve. Nevertheless, Snookie's opportunity cost for producing 1 pinata is 1 pie and viceversa. Thus, Snookie has a comparative advantage over Steve.

The law of comparative advantage states that a nation is bette off when it produces goods and services for which it has a comparative advantage. Each country can then use the money it earns selling those goods to buy other goods that it cannot produce as efficiently.