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Even if a country had a considerable absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial .
When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.
When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms.
To understand these patterns we must know something about the factors that determine exchange rates.
An exchange rate is the ratio at which two currencies are traded. The price of one currency in terms of another.
For any pair of countries, there is a range of exchange rates that can lead automatically to both countries realizing the gains from specialization and comparative advantage.
Exchange rates determine the terms of trade.
The Sources of Comparative Advantage
Factor endowments refer to the quantity and quality of labor, land, and natural resources of a country.
Factor endowments seem to explain a significant portion of actual world trade patterns.
Trade Barriers: Tariffs, Export Subsidies, and Quotas
Protection is the practice of shielding a sector of the economy from foreign competition.
A tariff is a tax on imports.
Export subsidies are government payments made to domestic firms to encourage exports. Closely related to subsidies is dumping . A firm or industry sells products on the world market at prices below the cost of production.
A quota is a limit on the quantity of imports.
The Case for Free Trade
The case for free trade is based on the theory of comparative advantage. When countries specialize and trade based on comparative advantage, consumers pay less and consume more, and resources are used more efficiently.
When tariffs and quotas are imposed, some of the gains from trade are lost.