Once you know who has the comparative advantage in each good (Absolute and Comparative Advantage), the next question is what happens if each specializes and they trade. The surprising answer: both can end up with more than they could make on their own.
Key idea
When each producer specializes in its comparative-advantage good and they trade, total output rises, and both can consume beyond their own PPC. The terms of trade (the price of one good in units of the other) must lie between the two producers' opportunity costs; then each gets the other good for less than it would cost to make it.
Why it works
Take Ana and Ben from the last lesson. A loaf costs Ana $\tfrac{1}{2}$ shirt to make and costs Ben 1 shirt. If they trade at $\tfrac{3}{4}$ shirt per loaf, Ana gets $\tfrac{3}{4}$ shirt for a loaf that cost her only $\tfrac{1}{2}$ shirt to make, and Ben gets a loaf for $\tfrac{3}{4}$ shirt instead of the 1 shirt it would cost him. Each gains $\tfrac{1}{4}$ shirt per loaf. At terms below $\tfrac{1}{2}$, Ana would rather make shirts herself; above 1, Ben would rather bake. Inside the band, both gain.
Worked example: Total output before and after
Before trade, Ana splits her day: 3 loaves and 1.5 shirts. Ben splits his: 2 loaves and 2 shirts. What happens to total output if Ana makes only bread and Ben only shirts?
- Before: $3 + 2 = 5$ loaves and $1.5 + 2 = 3.5$ shirts.
- After: Ana makes 6 loaves; Ben makes 4 shirts.
- Total output rises by 1 loaf and 0.5 shirt, with the same work.
Answer: From 5 loaves and 3.5 shirts to 6 loaves and 4 shirts.
Worked example: Does the deal work for both?
Ana and Ben specialize and trade 2 loaves for 1.5 shirts ($\tfrac{3}{4}$ shirt per loaf). What does each consume?
- Ana keeps $6 - 2 = 4$ loaves and gets 1.5 shirts. On her own, 4 loaves would leave time for only 1 shirt: she is outside her PPC.
- Ben keeps $4 - 1.5 = 2.5$ shirts and gets 2 loaves. On his own, 2 loaves leave time for only 2 shirts: he is outside his PPC too.
Answer: Ana: 4 loaves and 1.5 shirts. Ben: 2 loaves and 2.5 shirts. Both are better off.
Common mistake
Thinking trade is a contest where one side's gain is the other's loss, or that a producer who is better at everything has nothing to gain. Ana is better at bread and Ben at shirts here, but even when one side has the absolute advantage in both goods, both gain as long as their opportunity costs differ. Check any proposed deal: is each side's consumption point outside its own PPC?
Economists broadly agree that trade raises total output and income. They also agree the gains are not shared evenly: workers and firms that compete with imports can lose, sometimes for years. How much to help them, and how, is debated. Trade at the World Price measures the winners and losers in one market.