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Economics Principles: Why is Trade So Important in an Economy?

An Introduction to Trade

It’s well known that trade is an essential component of the modern global economy. Without trade, our local grocery stores wouldn’t carry produce from around the world, our households would be bare of exotic furnishings, and many of our modern appliances would inaccessible and unaffordable to the average consumer. Depending on how narrowly you wish to define trade, its absence would imply society itself ceasing to exist, and the individual would be forced to scavenge for themselves.

We understand on an intuitive level that trade is powerful, but most of us also take trade for granted. Why is it that trade works so well? Say, for instance, the United States produces toasters at a faster and cheaper rate than India. Why should the U.S. ever buy from India if the per toaster cost of buying a toaster from India is higher than buying one from the states? This is due to a concept known as opportunity cost, and we will analyze in this article precisely how this works.

What is Opportunity Cost?

When you buy a hamburger at McDonalds, how much does it cost you. An accountant might argue the burger costs you $6.69 as well as $0.40 sales tax. An economist, however, would find the cost to be higher. Ask yourself the question, what else could you have spent this $7.09 on? Perhaps it could have been used to buy chicken nuggets. Or maybe even invested in some way.

Opportunity costs are opportunities missed out by choosing any activity over another. It doesn’t even need to involve cash. When you choose to do homework, you’re costing yourself the time you could have spent binge drinking in a dumpster behind the local Wendy’s. Every decision you make has an opportunity cost.

An Example of Opportunity Cost

Now recall the burger you bought from Mcdonald's. After purchasing the burger, you check your bank accounts to find you have finally drained your savings. Dejected and depressed, you sullenly walk towards your home wondering how you’re going to pay rent. As you walk past a thrift shop, you spot in the corner of your eye one of the rarest magazines ever put to print.

You only know of it because your grandfather used to collect them, and he would always drone on about the one magazine he could never find, worth over $10,000, now sitting on the magazine shelf for only seven dollars and nine cents. You scramble through your pockets looking for any loose change you could summon to aid in your lucky break, but all you can find is a quarter.

In your head, you are professing profanities prolifically, and the burger in your stomach suddenly isn’t settling well. You think back to your 9th-grade economics class, and recall the concept of opportunity cost. “Oh, what cruel irony!?” You scream to into the sky. “I should have known that the cost of that burger was not only the monetary cost, but also the opportunity cost of the money I could have made had I instead chosen to purchase this magazine, making the total economic cost $10,006.69!” While you cry on the street, onlookers appear curious but subtly avoid you. The opportunity cost of helping you is too high for them to bother.

How Does Opportunity Cost Affect Trade?

Hopefully, you now understand at least the basics of what opportunity cost is, but what role does it play in trade? Earlier I asked why the U.S. would decide to purchase toasters from India if the U.S. can produce them for itself faster, cheaper, and at higher quantities. If we think of costs in a pure accounting sense, then it wouldn’t make sense for the U.S. to purchase from India, however, when we consider the opportunity cost of the U.S. making toasters, the picture begins to become clear.

Let’s assume that the U.S. is also producing plane parts and that these parts use many of the same materials as the toasters. Furthermore, the U.S. only has a limited amount of labor hours available to delegate to the tasks of toaster and plane making. It may happen to be that plane parts are selling much more than toasters for the same amount of time and resources put into them. Because of this, it would make more sense for the U.S. to focus on producing plane parts instead. There is still a demand for toasters, of course, so whatever amount of toasters the U.S. is not producing to meet demand is being imported from overseas.

When we look at it this way, making toasters costs the U.S. more than it costs India because the U.S. could be using those resources to make more valuable things. This principle then would imply that each country should produce what resource it is relatively best at producing.

An Example of Opportunity Cost in Trade

Say that theoretical country A didn’t participate in trade. That would make them responsible for producing every resource needed for them to remain self-sufficient. If country A excels at producing grain, for instance, they will have to delegate many of their resources to other activities in which they’re less efficient, such as iron mining. The cost of iron mining is then not only the cost of the mining operation itself but also the profit lost by not producing grain. If country A decided to instead focus on producing grain, they could trade their excess grain to country B, which specializes in iron mining. Both countries would end with more because they wouldn’t be wasting resources on tasks they aren’t proficient in.

Trade: Conclusion

There are of course many other reasons trade is necessary, but this highlights the core concept of why trade will always be economically superior to its alternative. All parties that participate in trade, granted the trade is fair, will end up with more total resources than would be possible without trade. This is because trade allows countries to specialize in the production of specific commodities and not waste time and resources doing something necessary but inefficient.

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