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:

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.

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

1 unit of rice will require the sacrifice of 2 units of tea

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

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

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.

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.

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Supplement: Gains from Trade

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Concepts for Review:

• Absolute Advantage
• Comparative Advantage
• Gains from Trade
• Opportunity Costs
• Production Possibilities
• Production Possibilities Frontier (PPF)
• Specialization
• Terms of Trade

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