The principle of free trade is based on the law of comparative advantage. The law of comparative advantage states that if countries specialise in producing what they have a relative advantage (lower opportunity cost) then there will be a net gain to society. This essay is an explanation of the difference between absolute and comparative advantage.
This occurs when one country can produce a good with fewer resources than another. For example if France can produce wine with less resources than the UK, then France should specialise in the production of wine.
· If the UK can produce wheat with less resources then it will have an absolute advantage.
· Therefore UK will specialise in wheat, and France in wine.
· Production will be maximised by each country specializing and then trading, both countries will gain
A country has a comparative advantage over another in the production of a good if it can produce it at a lower opportunity cost. I.e. if it has to forego less of other goods in order to produce it.
· Thus trade between countries can still be beneficial even if one country can produce all goods with less resources. For example a developed country may have an absolute advantage in both computers and cloth.
· However the developed country has a comparative advantage in computers because only a small amount of cloth has to be foregone.
· The developing country has a higher opportunity cost for computers because it would have to forego a lot of cloth to produce a computer.
Benefits of Trade
1. The law of comparative advantage states that trade can benefit all countries if they specialise in the goods in which they have a comparative advantage. As a result consumption increases because of specialisation.
2. Specialisation will result in economies of scale . Economies of scale occur when increased output leads to lower average costs of production. This is a major feature of globalisation and the specialisation it enables.