How do countries decide what goods they should produceand trade with othercountries?

Answer 1

They decide what to import based on the "comparative advantage" (Theory developed by David Ricardo) .

* Nations will import goods if it costs them less to import than producing it themselves.

They decide this based on the opportunity costs. Let me explain this with the following example.

* Assume there are 2 countries, namely the US and UK. The US can produce 200 cars and 100 computers while the UK can produce 150 cars and 150 computers.

As you can see the US can produce more cars than the UK while the UK can produce more computers than the US. However, international trade is based on "comparative advantage"

* Comparative advantage : If a nation can produce a good (X) at a lower opportunity cost than Another Country, it will specialise in the production of that good (X). It will then trade that good (X) for other goods ( Y ).

* Therefore lets examine "opportunity costs" (O.C) . Now O.C is calculated with a simple formula... O.C=sacrifice/gain. OR (more mathematical) O.C= dy/dx (change in Y/change in X)

Now getting back to our example.

Lets look at the US first

The opportunity cost of Cars : O.C=sacrifice/gain

O.C=100/200 (they have to sacrifice computers to produce 200 cars)

Therefore: O.C of 1 car is 1\2 a computer.

Opportunity costs of computers :O.C= 200/100

O.C of 1 computer equals 2 cars.

Now lets look at the UK

O.C of cars : O.C=150\150 = 1

O.C of computers: O.C= 150\150=1

As you can see since the US has a lower O.C in producing cars they will specialise in producing cars while the import computers from the UK since the UK has a lower O.C in producing computers. Therefore the it is cheaper for the US to buy computers from the UK while it is cheaper for the UK to buy cars from the US.