The principle of free trade is based on the law of comparative advantage. The law of comparative advantage states that if countries specialize 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 specialize in the production of wine.
If the UK can produce wheat with less resources then it will have an absolute advantage.
Therefore UK will specialize in wheat, and France in wine.
Production will be maximized 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. Ie 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 specialize in the goods in which they have a comparative advantage. As a result consumption increases because of specialization.
2. Specialization 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 globalization and the specialization it enables.
Source by Richard Pettinger