International Trade & the Balance of Payments

Why countries trade

International trade lets countries specialise in what they produce relatively efficiently and exchange for the rest, raising total world output and consumption.

Absolute advantage: a country can produce a good using fewer resources than another.
Comparative advantage: a country can produce a good at a lower opportunity cost than another. Trade benefits both countries when each specialises in the good in which it has the lower opportunity cost, provided the terms of trade lie between the two domestic opportunity-cost ratios.

Here A has a comparative advantage in cloth (lower opportunity cost), B in wine; both gain by specialising and trading.

Assumptions/limitations: ignores transport costs, assumes constant returns and factor mobility, two-country two-good simplicity, and that trade barriers are absent.