The Basics of Trade
"The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity and judgement with which it is any where directed, or applied, seem to have been the effects of the division of labour."

What is the basis for trade? Why is free trade viewed as such a key piece of the economic puzzle? The answer lies in the concept of specialization / division of labor, but before we get there, let's look at the situation facing an ancient empire, one of the many that have risen and fallen over the years. To make life easy, let's assume this empire supplies its people with luxuries (L) and necessities (N). We can capture the situation facing the empire's ruler with the aid of a possibility line.

Now what is a ruler to do? An obvious possibility would be to 'take' some resources which would expand the possibility curve outward. There are, however, potential limitations to this strategy. The empire may have to devote an increasingly large amount of resources to provision of security which will drain it of its ability to produce both L and N. The end result would be the eventual collapse of the empire. A second possibility would be to promote productivity growth - to get more out of existing resources which could be accomplished by a division of labor and specialization.

A third possibility is trade for more stuff, to enter into a mutually beneficial exchange. To get a "picture" of the situation, you can look at the situation below where we have two empires with their respective possibility lines. Left on its own, Empire A could produce anywhere along the blue possibility line. If it settled on the midpoint, it could supply 10 units of L and 2.5 units on N. If it produced only luxury items (L), it could produce 20 units. In Empire B, meanwhile, the possibilities are different and here a possible mix would be 5 units of L and 7.5 units on N. If all of Empire B's resources were devoted to production of Necessities (N), then they could produce 15 unit.

Can you devise a scheme to expand the consumption possibilities open to the two Empires? [You will note the introduction of a new term - the consumption possibility curve. Once we introduce trade there is a wedge between what we produce and what we consume]. If you can, then you have the makings of a deal that will result in trade.  After you have tried for a while to find the deal, try checking out one solution.

The solution is based on the concept of comparative advantage which is closely related to the concept of opportunity cost. If you look at country A, you can see the cost of one unit of necessities costs 4 units of luxuries. In Empire B, meanwhile, the cost of one unit of necessities is 2/3 of a unit of luxuries. If there was no trading you would expect the prices of the goods would be different - luxuries would be more expensive in Empire B and necessities in Empire A. In this simple example we would say Empire A has the comparative advantage in luxuries and Empire B has the comparative advantage in necessities. This is the basis for the deal.