As we have seen, economics is all about voluntary production and exchange. People and nations do business with one another because all expect to gain from the transactions. Centuries ago, European merchants ventured to the Far East to ply the lucrative spice trade. These days, American consumers buy wines from Italy, cars from Japan, electronics from Korea, and millions of other products from countries around the world.

Many people assume that trade between nations is a zero-sum game—a game in which, for one party to gain, another party must lose. This is how poker works. If one player walks away from the table a winner, someone else must have lost. But this is not how voluntary trade works. Voluntary trade is a positive-sum game: Both parties to a transaction score positive gains. After all, who would voluntarily enter into an exchange if he or she did not believe there was some gain from it? To understand how all parties to an exchange (whether individuals or nations) can gain from it, we need to consider the concept of comparative advantage developed by David Ricardo roughly 200 years ago, and how this concept differs from the concept of absolute advantage.

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Figure 7 shows hypothetical production possibilities frontiers for the United States and Mexico. To simplify the analysis, we assume that opportunity costs are constant (PPFs are straight lines); however, the same analysis applies to PPFs with increasing opportunity costs. Both countries are assumed to produce only crude oil and silicon chips. Given the PPFs in Figure 7, the United States has an absolute advantage over Mexico in producing both products. An absolute advantage exists when one country can produce more of a good than another country. In this instance, the United States can produce 2 times more oil (40 million versus 20 million barrels) and 5 times as many silicon chips (40 million versus 8 million chips) as Mexico.

At first glance, you might wonder why the United States would even consider trading with Mexico. The United States has so much more production capacity than Mexico, so why wouldn’t it just produce all of its own crude oil and silicon chips? The answer lies in comparative advantage.

One country has a comparative advantage in producing a good if its opportunity cost to produce that good is lower than the other country’s. We can calculate each country’s opportunity cost for each good using the production possibility frontiers in Figure 7.

If the United States uses all of its resources efficiently, it can produce a maximum of 40 million barrels of oil or 40 million silicon chips. It can also produce some of both goods, though clearly not 40 million of each, because in order to produce more of one good, it must reduce production of another (its opportunity cost). Because the PPF is linear, the tradeoff between oil and chips is constant. For the United States, it can substitute 1 million barrels of oil for 1 million silicon chips, which means it can produce 20 million barrels of oil and 20 million silicon chips. The opportunity cost for each good is summarized as follows:

Now let’s look at Mexico. If it uses its resources efficiently, it can produce a maximum of 20 million barrels of oil or 8 million silicon chips. For Mexico, although the tradeoff between goods also is constant, the tradeoff is not one-for-one as in the United States. Because Mexico is better at producing oil than silicon chips, its opportunity cost for each good is as follows:

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Note that the values of 0.4 and 2.5 are reciprocals of one another. In other words, 1/0.4 = 2.5, and 1/2.5 = 0.4. This relationship exists when calculating opportunity costs in a two-product economy.

Now that we have determined the opportunity cost of each good in both countries, we can conclude that Mexico has a comparative advantage over the United States in producing oil. This is because Mexico gives up only 0.4 chips for every barrel of oil it produces, while the United States must give up 1 chip. Thus, Mexico’s opportunity cost of producing oil is less than that of the United States, giving Mexico a comparative advantage.

Conversely, the United States has a comparative advantage over Mexico in producing silicon chips: Producing a silicon chip in the United States costs one barrel of oil, whereas the same chip in Mexico costs two-and-a-half barrels of oil. Table 1 summarizes the opportunity costs of each good and which country has the comparative advantage.

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Note that each country has a comparative advantage in one good, even though the United States has an absolute advantage in both goods. However, it is comparative advantage that generates gains from trade. These relative costs suggest that the United States should pour its resources into producing silicon chips, while Mexico specializes in crude oil. The two countries can then engage in trade to their mutual benefit. As long as opportunity costs differ between countries, specialization and trade can be mutually beneficial, allowing all countries to consume more.

The same idea applies to individuals. Although we have focused on trade between countries, the concept of comparative advantage explains why individuals specialize in a few tasks and then trade with one another. For example, if you are relatively better at understanding economics than your roommate who is on the golf team, you might offer to tutor him in economics in exchange for golf lessons. Comparative advantage explains all trade: between individuals as well as between countries.

To see how specialization and trade can benefit all trading partners, let’s return to our example in which the United States has the ability to produce more of both goods than Mexico. Assume that each country is at first (before trade) operating at point a in Figure 7. At this point, both countries are producing and consuming only their own output; the United States produces and consumes 20 million barrels of oil and 20 million silicon chips; Mexico, 10 million barrels of oil and 4 million chips. Table 2 summarizes these initial conditions.

Now assume that Mexico focuses on oil, producing the maximum it can: 20 million barrels. We also assume both countries want to continue consuming 30 million barrels of oil between them. Therefore, the United States only needs to produce 10 million barrels of oil because Mexico is now producing 20 million barrels. For the United States, this frees up some resources that can be diverted to producing silicon chips. Because each barrel of oil in the United States costs one chip, reducing oil output by 10 million barrels means that 10 million more chips can be produced.

Table 3 shows each country’s production after Mexico has begun specializing in oil production.

Notice that the combined production of crude oil has remained constant, but the total output of silicon chips has risen by 6 million chips. Assuming that the two countries agree to share the added 6 million chips between them equally, Mexico will now ship 10 million barrels of oil to the United States in exchange for 7 million chips. From the 10 million additional chips the United States produces, Mexico will receive 4 million (its original production) plus 3 million for a total of 7 million, leaving 3 million additional chips for U.S. consumption. The resulting mix of products consumed in each country is shown in Table 4. Clearly, both countries are better off, having engaged in specialized production and trade.

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The important point to remember here is that even when one country has an absolute advantage over another, both countries still benefit from trading with one another. In our example, the gains were small, but such gains can grow. As two economies become more equal in size, the benefits of their comparative advantages grow.

Before leaving the subject of international trade and how it contributes to growth in both countries, we should take a moment to note some practical constraints on trade. First, every transaction involves costs, including transportation, communications, and the general costs of doing business. Even so, over the last several decades, transportation and communication costs have been declining all over the world, resulting in growing global trade.

Second, the production possibilities curves for nations are not linear, but rather governed by increasing costs and diminishing returns. Therefore, it is difficult for countries to specialize in producing one product. Complete specialization would be risky, moreover, because the market for a product can always decline, perhaps because the product becomes technologically obsolete. Alternatively, changing weather patterns can wreak havoc on specialized agricultural products, adding further instability to incomes and exports in developing countries.

Finally, although two countries may benefit from trading with one another, expanding this trade may well hurt some industries and individuals within each country. Notably, industries finding themselves at a comparative disadvantage may be forced to scale back production and lay off workers. In such instances, government may need to provide workers with retraining, relocation, and other help to ensure a smooth transition to the new production mix.

When the United States signed the North American Free Trade Agreement (NAFTA) with Canada and Mexico, many people experienced what we have just been discussing. Some U.S. jobs went south to Mexico because of low production costs. By opening up more markets for U.S. products, however, NAFTA did stimulate economic growth, such that retrained workers ended up with new and better jobs.

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