Why trade can leave every party better off, with an example

The principle. Trade can make everyone better off is the fifth of the principles of economics. Exchange is not a contest in which one side wins only what the other loses: trade lets each party concentrate on the goods it is best suited to produce, and buyers gain a wider range of goods at lower prices.

Comparative advantage, the reason both gain. A party has a comparative advantage in a good when it can produce that good at a lower opportunity cost, that is, by giving up less of the other good; the idea goes back to David Ricardo. Judged by absolute advantage alone, a party that is better at producing everything would seem to have no reason to trade; yet, as long as the two parties' opportunity costs differ, even such a party has a comparative advantage in one of the goods and the other party in the other. (If their opportunity costs were the same, neither would have a comparative advantage, and specialising would bring no gain.) When each specialises in the good of its comparative advantage, total output rises and both can gain from trading.

Example (our own). Asha and Babu run two small tailoring workshops in Jaipur. In a week Asha can stitch either 120 shirts or 40 trousers; Babu can stitch either 40 shirts or 20 trousers. Asha is faster at both, so she has the absolute advantage in both goods.

• Comparative advantage. A trouser costs Babu 2 shirts but costs Asha 3, so Babu has the comparative advantage in trousers. A shirt costs Asha a third of a trouser but costs Babu half, so Asha has the comparative advantage in shirts.
• Without trade. Each spends half the week on each good: Asha makes 60 shirts and 20 trousers, Babu 20 shirts and 10 trousers. Together: 80 shirts and 30 trousers.
• With specialisation. Babu makes only trousers (20). Asha spends 70 per cent of her week on shirts (84) and 30 per cent on trousers (12). Together: 84 shirts and 32 trousers, which is more of both goods than before.
• The trade. Babu gives Asha 9 trousers for 22 shirts, a price of about 2.44 shirts per trouser, which lies between their opportunity costs (2 for Babu, 3 for Asha). Babu ends with 22 shirts and 11 trousers (against 20 and 10 without trade). Asha ends with 62 shirts and 21 trousers (against 60 and 20).

Both have more of both goods, although Asha was better than Babu at making each of them.

Conclusion. Because opportunity costs differ, specialising by comparative advantage raises total output, and a price set between the two parties' opportunity costs lets each of them gain. That is why trade can make everyone who takes part better off.