Chapter 32, Problem 32.1LO

To determine

:

Reasons behind gains from specialization in production and engagement in international trade.

Concept Introduction:

International Trade: Trade between two different countries is known as international trade.

Opportunity Cost: It refers to the amount of next best alternative that is foregone in order to take up one course of action. For example, an entrepreneur leaving his job to start his/her own business foregoes a salary. That salary is the opportunity cost of the entrepreneur.

Specialization in production: A country specializes in a production process due to absolute or comparative cost advantage.

Absolute Advantage refers to the ability of a nation to produce a good or a service more efficiently than the other countries.

Comparative Advantage refers to the ability of a nation to produce a good or a service at a lower opportunity cost in comparison with the other countries.

Explanation of Solution

Answer:

1. Gains from specialization: Economies of scale is an advantage that the country receives from specialization. The average cost of production decreases and total output increases with higher output.
2. Gains from trade: Two countries trade with each other only when they find it to be mutually beneficial. The benefits the country receives through more production and consumption of goods because of specialization of production and international trade is known as gains from trade.

A country may have absolute cost advantage but international trade should depend on comparative cost advantage. The country/economy producing a commodity at a lower opportunity cost can produce it more efficiently.

An example will make it clear. Suppose there are two countries producing two goods: cars and trucks.

The below table shows the total output of both countries:

Labor Hours	Cars	Trucks
Country A	10	5
Country B	8	2

As country B produces both cars and trucks with less number of labor hours than country A (10 hours> 8 hours for cars and 5 hours > 2 hours for trucks), country B has an absolute advantage in the production of both cars and trucks.

Opportunity cost of producing a car in both countries are as follows:

Opportunity Cost	Cars	Trucks
Country A	10/5 = 2 trucks	5/10 = 0.5 cars
Country B	8/2 = 4 trucks	2/8 = 0.25 cars

If every country produces the good in which they have specialization, then the trade could take place.

If Country A produces a car, it has to spend 10 hours. It could have assembled 2 trucks in that time. Alternatively, the time spent to build a truck could have been used to make half a car.

Same explanation goes for country B as well. The time spent to finish a truck could have been used to finish 0.25 cars and time spent to build a car could have been used to finish 4 trucks.

Thus, the country A has a comparative advantage in the production of cars as it has to forego only 2 trucks to build a car instead of 4 trucks by country B.

Country B has a comparative advantage in the production of trucks as it has to forego only 0.25 cars to build a truck instead of 0.5 trucks by country A.