A.  Absolute and Comparative Advantage

For the purpose of the model we will take that there are two countries and two goods involved in trade. The objective of both countries is to gain from trade. The strategy is through specialisation.

Absolute Advantage
 

Absolute Advantage refers to a situation where there are two countries in which one country has an advantage in the production of one good while the other country has the advantage in the other good. In the example above Australia and Japan produce two goods for trade, Wine and Televisions. Workers in Australia can produce 100 barrels of wine and 20 television sets in a week while Japanese workers can produce 40 barrels of wine and 300 television sets in a week. In this two country world production of wine stands at 140 and television sets at 320.

Australia has the advantage in the production of wine and Japan has the advantage in television set production. So Australia will concentrate on the production of wine while Japan will specialise in producing television sets.
 

As a result of specialisation production in both countries will double and world production will increase from 140 to 200 wine and 320 to 600 television sets. They will now commence trade exchanging televisons for quantities of wine.

Comparative Advantage
 

Comparative Advantage occurs where there are two countries and two goods but one country has the advantage in both goods. In the example above Brazil is superior in the production of both coffee and golf balls. But Brazil will specialise in the production of coffee since it has a comparatively greater advantage in producing coffee than golf balls. Argentina will concentrate on the production of the golf balls.
 
 

Because of the rate of exchange (also known as the Terms of Trade), which will be calculated in the next section, world production will have increased because coffee has a greater value than golf balls.

B. Terms of Trade

When Argentina and Brazil decide to engage in trade a very important process that must be engaged in is the establishment of a rate of exchange or the terms on which trade will take place. Rather than exchanging currencies goods are being traded.
 

Using golf balls as the central"currency"
 

Under a system of Opportunity Cost, for every 1 unit of golf balls produced Argentina will sacrifice production of 2 units of coffee. In Brazil for every 1 unit of golf balls produced 4 units of coffee are produced. The terms of trade will thus be

3 Coffee for 1 Golf Ball

To establish that the rate of exchange has shown a gain for world trade. While there was a gain of 180 in coffee production: there was a fall of 40 in production of golf balls. Since 3 coffee = I golf ball that means that – 120 in terms of coffee which proves a net gain of + 60.

C. Assumptions

The comparative advantage theory is based on the following assumptions

(1) Free Trade
There are no tariffs on imports between the trading countries
(2) Transport Costs
It is possible that transport costs would erode the gains from specialisation. So there are no transport costs.
(3) Returns to Scale
Returns to scale are likely to be constant. This means that 2 men are likely to produce twice as much as one man.
(4) Mobility of Factors of Production
The factors of production have a high degree of mobility domestically although it is not presumed that they are internationally mobile.
(5) Benefits to the Community
All the community should benefit from trade.