The Price of the Trade

The principle of comparative advantage establbhes that there are gains from specialization ai>d trade, but it leaves open a couple of related questions: What determines the price at which trade takes place? How are the gains from trade shared between the trading parties? The precise answer to then- questions is beyond the scope of thb chapter, but we can state one general rule: For both parties to gain from trade, the price at iMcit they trade nnni lie between Ihe HM opportunity costs.

In our example, the farmer and rancher agreed to trade at a rate of 3 ounccs of potatoes for each ounce of meat. This price b between the rancher's opportunity cost (2 ounces of potatoes per ounce of meat) and the farmer's opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4.

To see why the price has to be in thb range, consider what would happen if it were not. If the price of meat were below 2 ounces of potatoes, both the farmer and the rancher would want to buy meat, because the price would be below their opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes, both would want to sell meat, because the price would be above their opportunity costs. But there are only two members of this economy. They cannot both be buyers of meat, nor can they both be sellers. Someone has to tike the otlier side of the deal.

A mutually advantageous trade can be struck at a price between 2 and 4. In thb price range, the ranclter wants to sell meat to buy potatoes, and the farmer wants to sell potatoes to buy meat. Each party can buy a good at a pricc that is lower n i than his or her opportunity cost. In the end. both of them specialize in the good for which he or she has a comparative advantage and are, as a result, better off.

QUICK QUIZ RobinjonCruto*can9athe< 10 coconutĀ» of catch 1 fah per hour. HiĀ» friend

Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe's opportunity cost of catching one fish? What it Friday's? Who has an absolute advantage in catching fish? Who hw a comparativo advantage In catching fish?

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