Question

Why does trade arise according to David Ricardo? Explain free-trade equilibrium and the gains from trade. Give diagrams for at least one country.

Answer 1

Ans) According to Ricardo, trade occurs on the basis of comparative advantage. Comparative advantage is when one party can produce goods with lower opportunity cost. Opportunity cost is the cost of something that must be given up to get something else.

According to comparative advantage theory, countries should specialise is what they are good at and trade that with something they are less good. This is known as specialisation. Eg- Japan is good in technology, so it specialises in that.

When world price is lower than the domestic price, country imports goods. Import lowers the price. This hurts domestic producers while it benefits domestic consumers. But gain to consumers is more than loss to producers. So, there is overall gain from the trade.

Similarly, when world price is above domestic price, country exports good. This increases price. Export hurt domestic consumers but benefits domestic producers. The gain to producers is more than the loss to consumers. Therefore there is overall gain from the trade.

So we see that, trade always brings overall benefit.