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Trade

What is Trade?

Trade is the exchange of goods and services between individuals, businesses, and nations. From exchanging a PB&J sandwich for a bag of lays to trading tanks for planes, it is a fundamental economic practice at all levels of society. It promotes efficiency, specialization, and economic growth. This article explores the benefits of trade and the principles that drive it.

Specialization and Efficiency
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Trade enables countries to focus on producing the goods and services they can make most efficiently, a concept known as specialization. Through this: 

  • Resources are allocated to industries where they have the greatest productivity. 

  • Countries can consume beyond their production possibilities curve (PPC) by trading for goods they cannot efficiently produce themselves. 

  • Trade leads to technological advancements and higher incomes, as businesses can access larger markets. 

  • Nations can enjoy a greater variety of goods and services that they may not be able to produce domestically. 

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Absolute Advantage

Absolute advantage is the capability to produce more of a given product than the other party for the same input of resources. It can either be presented from an input perspective or an output perspective. 

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Input Perspective: Party X uses fewer resources (eg. labor, time) than Party Y to make a good/service, giving them an absolute advantage. 

 

Output Perspective: With both parties having the same resources, Party X can make more of a good/service than Party Y, giving them an absolute advantage. 

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Comparative Advantage

When discussing advantages, what truly matters is comparative advantage – the ability produce a good or service at a lower opportunity cost than another entity. Even if a party has an absolute advantage in multiple goods, it should specialize in the good for which it has a comparative advantage. To understand who has a comparative advantage, we have to calculate the opportunity cost of producing goods.

 

Input Perspective: Opportunity Cost of Good A = Input Required for Good B / Input Required for Good A. 

 

Output Perspective: Opportunity Cost of Good A = Production of Good A / Production of Good B ​

 

Opportunity costs must be calculated for both parties, for both goods to compare. The party with the lower opportunity cost for the good should specialize in it. 

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Identifying Comparative Advantages: The Quick and Dirty Method

Cross price elasticity of demand (XED) measures how the quantity demanded of one good responds to the price change of another good. 

 

The formula is: XED=%change in quantity demanded of good A / %change in price of good B

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If XED is positive, the goods are substitutes, goods that can replace each other, like tea and coffee. A price increase in one will lead to increased demand for the other. If XED is negative, the goods are complements, goods that are used together. A price increase in one will lead to a decrease in demand for the other.

Terms of Trade

The terms of trade (TOT) determine how much of one good a country is willing to trade for another. 

 

It is expressed as a ratio: Terms of Trade= (Import Prices / Export Prices) ​x 100 

 

For trade to be beneficial, the terms of trade must fall between both parties’ opportunity costs.

TL;DR
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  • Trade is the exchange of goods and services, enhancing efficiency and economic growth. 

  • Trade expands production possibilities, enhances efficiency, and benefits all nations regardless of absolute productivity.

  • Specialization allows countries to focus on what they produce best, increasing total output. 

  • Absolute Advantage is the ability to produce more of a good using the same or fewer resources. 

  • Comparative Advantage is the ability to produce a good at a lower opportunity cost, guiding optimal trade decisions. 

  • Opportunity Cost Calculation:

  • Input Method: Opportunity Cost of Good A = Input for B / Input for A. 

  • Output Method: Opportunity Cost of Good A = Output of B / Output of A. 

  • Quick and Dirty Method: A shortcut using cross-multiplication to determine comparative advantage quickly. 

  • Terms of Trade (TOT) must fall between both parties’ opportunity costs for trade to be beneficial. 

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