Douglas A. Ruby
Revised: 06/18/2003

Basic Definitions

Relative Prices

Production & Production Possibilities

Overview of Economics

Macroeconomic Principles

Microeconomic Principles

Macroeconomic Theory

Microeconomic Theory
as a basis for Specialization and Exchange

For many years, economists sought to understand the motivations behind the trading and exchange of goods and services among individuals, regions, and nations.

It was first thought that trade was the result of a given nation exploiting its Absolute Advantage in production of goods relative to the productive ability of other nations. A country is said to have the Absolute Advantage in production if it can produce the same amount of output with less input relative to other countries. For example, given the following data:

Table 1
 1 unit of Rice 1 unit of Tea Indonesia 5 labor hrs. 2 labor hrs. Thailand 3 labor hrs. 6 labor hrs.

In this case, Indonesia has the absolute advantage in tea production and Thailand the the absolute advantage in rice production. Based on this concept of production advantage, Indonesia should devote its resources to and specialize in tea production. Thailand should specialize in rice production and export some of this rice in trade for Indonesia's tea.

However, it was often observed that one country possessed the absolute advantage in the production of both (all) goods.

Table 2
 1 unit of Rice 1 unit of Tea Indonesia 4 labor hrs. 2 labor hrs. Thailand 5 labor hrs. 15 labor hrs.

We might expect that in such a case, this country (Indonesia in the above example) would find it more efficient to engage in production of all goods to meet domestic consumption needs and avoid relationships with its economic partners. In reality, trade still takes place among nations, even though one country has the absolute advantage in all goods or other countries lack an absolute advantage in the production of any good.

Figure 1, Production Possibilities

Suppose, for example, that Indonesia attempts to use its resources in the production of all desired goods -- in this case rice and tea. As shown in the diagram on the right, Indonesia, with 100 labor hours available could produce 50 units of tea (100 hours / 2 required hours per unit of tea) and no rice defined by point A, 25 units of rice (100 hours / 4 required hours per unit of rice) and no tea defined by point C, or some combination inbetween (30 tea and 10 rice -- point B). These points, are known as a Production Possibilities and the line connecting them, is known as the Production Possibilities Frontier (PPF).

In the absence of trade with other countries, these production combinations of rice and tea also represent points of possible consumption. The availablility of greater quantities of the two goods is only possible with more resources (labor) or with improvements in productivity. However, with trade it might be possible for Indonesia to consume beyond its PPF

Trade, and the gains from trade, is better explained by the concept of Comparative Advantage. This concept is based on the notion of opportunity costs within one country as compared to its economic partners. For example, in table 2 above we find that in Indonesia, in order to produce one more unit of rice, resources must be pulled from their next best use -- tea production. Specifically,
1 unit of rice will require the sacrifice of 2 units of tea
since 1 unit of rice requires 4 hours of labor input that must be drawn from tea production. Pulling 4 labor hours away from tea, means giving up the production of 2 units of tea (each 'kilo' of tea requiring 2 labor hours). This sacrifice of tea represents the opportunity "cost" of producing each additional unit of rice.

Thus in the case of Indonesia

1 unit of rice will "cost" 2.0 units of tea
1 unit of tea will "cost" 0.5 unit of rice
and in the case of Thailand
1 unit of tea will "cost" 3.0 units of rice
1 unit of rice will "cost" 0.333 unit of tea

The opportunity costs of rice production (1 unit) are lower in Thailand [0.333 unit of tea rather than 2.0 units of tea]. Thailand should specialize in rice production.

In Indonesia, the opportunity costs of tea production (1 unit) are lower than in Thailand [0.50 unit of rice rather than 3.0 units of rice]. Indonesia should specialize in tea production.

 figure 2a, Indonesia figure 2b, Thailand

Suppose that Indonesia does specialize in tea production and Thailand specializes in rice production. Chances are that consumers in both countries would like to be able to consume both goods. Thus Indonesia would like to import some rice in trade for tea and Thailand would like to import tea in trade for rice.

It would be necessary for these two countries to agree on a Terms of Trade (ToT) to allow the exchange process to go forward.

Suppose that these two countries agree on a ToT of:

1 rice = 1 tea.
Indonesia would benefit since that country could now acquire 1 rice at a trading cost of 1 tea which is less than the domestic opportunity costs of 2.0 units of tea.

Thailand would benefit since that country could now acquire 1 tea at a trading cost of 1 rice which is less than the domestic opportunity costs of 3.0 units of rice.

As long as the ToT is less than domestic opportunity costs in each country, an incentive for trade will exist. The the case of Indonesia and Thailand the ToT (tea : rice) will fall in the following interval:

{Thailand's opp. costs} 1:3 < ToT < 2:1 {Indonesia's opp. costs}
 figure 3a, Indonesia figure 3b, Thailand

With trade, it becomes possible for Indonesia to specialization in the production of (50 units of) tea, export some of this tea (perhaps 20 units) to Thailand for an equivalent amount of rice (assuming a ToT = 1:1). This allows Indonesia to consume 30 units of tea as before trade, and consume 20 units of rice as defined by point T. The additional 10 units of rice consumed represents Indonesia's Gains from Trade.