Canada buys auto parts—and many other goods and services—from other countries. At the same time, it sells many goods and services to other countries. Goods and services purchased from abroad are imports; goods and services sold abroad are exports.

As illustrated by the opening story, imports and exports have taken on an increasingly important role in the Canadian economy. Over the last 50 years, both imports into and exports from Canada have grown faster than the Canadian economy. Panel (a) of Figure 8-1 shows how the values of Canadian imports and exports have grown as a percentage of gross domestic product (GDP). Panel (b) shows imports and exports as a percentage of GDP for a number of countries. It shows that foreign trade is more important for some countries than it is for Canada.

Foreign trade isn’t the only way countries interact economically. In the modern world, investors from one country often invest funds in another nation; many companies are multinational, with subsidiaries operating in several countries; and a growing number of individuals work in a country different from the one in which they were born. The growth of all these forms of economic linkages among countries is often called globalization.

In this chapter, however, we’ll focus mainly on international trade. To understand why international trade occurs and why economists believe it is beneficial to the economy, we will first review the concept of comparative advantage.

To produce auto parts, any country must use resources—land, labour, capital, and so on—that could have been used to produce other things. The potential production of other goods a country must forgo to produce an auto part is the opportunity cost of that part.

In some cases, it’s easy to see why the opportunity cost of producing a good is especially low in a given country. Consider, for example, shrimp—much of which now comes from seafood farms in Vietnam and Thailand. It’s a lot easier to produce shrimp in Vietnam, where the climate is nearly ideal and there’s plenty of coastal land suitable for shellfish farming, than it is in Canada. Conversely, other goods are not produced as easily in Vietnam as in Canada. For example, Vietnam doesn’t have the base of skilled workers and technological know-how that makes Canada so good at producing high-technology goods. So the opportunity cost of a tonne of shrimp, in terms of other goods such as aircraft, is much less in Vietnam than it is in Canada.

In other cases, matters are a bit less obvious. It’s as easy to produce auto parts in Canada as it is in Mexico, and Mexican auto parts workers are, if anything, less efficient than their Canadian counterparts. But Mexican workers are a lot less productive than Canadian workers in other areas, such as aircraft and chemical production. This means that diverting a Mexican worker into auto parts production reduces output of other goods less than diverting a Canadian worker into auto parts production. That is, the opportunity cost of producing auto parts in Mexico is less than it is in Canada.

So we say that Mexico has a comparative advantage in producing auto parts. Let’s repeat the definition of comparative advantage from Chapter 2: A country has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that country than for other countries.

Figure 8-2 provides a hypothetical numerical example of comparative advantage in international trade. We assume that only two goods are produced and consumed, auto parts and airplanes, and that there are only two countries in the world, Canada and Mexico. (In real life, auto parts aren’t worth much without auto bodies to put them in, but let’s set that issue aside). The figure shows hypothetical production possibility frontiers for Canada and Mexico.

As in Chapter 2, we simplify the model by assuming that the production possibility frontiers are straight lines, as shown in Figure 2-1, rather than the more realistic bowed-out shape shown in Figure 2-2. The straight-line shape implies that the opportunity cost of an auto part in terms of airplanes in each country is constant—it does not depend on how many units of each good the country produces. The analysis of international trade under the assumption that opportunity costs are constant, which makes production possibility frontiers straight lines, is known as the Ricardian model of international trade, named after the English economist David Ricardo, who introduced this analysis in the early nineteenth century.

In Figure 8-2 we have grouped auto parts into bundles of 10 000, so, for example, a country that produces 500 bundles of auto parts is producing 5 million individual auto parts. You can see in the figure that Canada can produce 2000 airplanes if it produces no auto parts, or 1000 bundles of auto parts if it produces no airplanes. Thus, the slope of Canada’s production possibility frontier, or PPF, is −2000/1000 = −2. That is, to produce an additional bundle of auto parts, Canada must forgo the production of 2 airplanes.

Similarly, Mexico can produce 1000 airplanes if it produces no auto parts or 2000 bundles of auto parts if it produces no airplanes. Thus, the slope of Mexico’s PPF is −1000/2000 = −1/2. That is, to produce an additional bundle of auto parts, Mexico must forgo the production of 1/2 an airplane.

Economists use the term autarky to refer to a situation in which a country does not trade with other countries—it is self-sufficient. We assume that in autarky Canada chooses to produce and consume 500 bundles of auto parts and 1000 airplanes. We also assume that in autarky Mexico produces 1000 bundles of auto parts and 500 airplanes.

The trade-offs facing the two countries when they don’t trade are summarized in Table 8-1. As you can see, Canada has a comparative advantage in the production of airplanes because it has a lower opportunity cost in terms of auto parts than Mexico has: producing an airplane costs Canada only ½ a bundle of auto parts, while it costs Mexico 2 bundles of auto parts. Correspondingly, Mexico has a comparative advantage in auto parts production: 1 bundle costs it only ½ an airplane, while it costs Canada 2 airplanes.

As we learned in Chapter 2, each country can do better by engaging in trade than it could by not trading. A country can accomplish this by specializing in the production of the good in which it has a comparative advantage and exporting that good, while importing the good in which it has a comparative disadvantage. Let’s see how this works.

Figure 8-3 illustrates how both countries can gain from specialization and trade, by showing a hypothetical rearrangement of production and consumption that allows each country to consume more of both goods. Again, panel (a) represents Canada and panel (b) represents Mexico. In each panel we indicate again the autarky production and consumption assumed in Figure 8-2. Once trade becomes possible, however, everything changes. With trade, each country can move to producing only the good in which it has a comparative advantage—airplanes for Canada and auto parts for Mexico. Because the world production of both goods is now higher than in autarky, trade makes it possible for each country to consume more of both goods.

Table 8-2 sums up the changes as a result of trade and shows why both countries can gain. The left part of the table shows the autarky situation, before trade, in which each country must produce the goods it consumes. The right part of the table shows what happens as a result of trade. After trade, Canada specializes in the production of airplanes, producing 2000 airplanes and no auto parts; Mexico specializes in the production of auto parts, producing 2000 bundles of auto parts and no airplanes.

The result is a rise in total world production of both goods. As you can see in Table 8-2, with trade, Canada is able to consume both more airplanes and more auto parts than before, even though it no longer produces auto parts, because it can import parts from Mexico. Mexico can also consume more of both goods, even though it no longer produces airplanes, because it can import airplanes from Canada.

The key to this mutual gain is the fact that trade liberates both countries from self-sufficiency—from the need to produce the same mixes of goods they consume. Because each country can concentrate on producing the good in which it has a comparative advantage, total world production rises, making a higher standard of living possible in both nations.

Now, in this example we have simply assumed the post-trade consumption bundles of the two countries. In fact, the consumption choices of a country reflect both the preferences of its residents and the relative prices—the prices of one good in terms of another in international markets. Although we have not explicitly given the price of airplanes in terms of auto parts, that price is implicit in our example: Mexico sells Canada the 750 bundles of auto parts Canada consumes in return for the 750 airplanes Mexico consumes, so 1 bundle of parts is traded for 1 airplane. This tells us that the price of an airplane on world markets must be equal to the price of one bundle of 10 000 auto parts in our example.

One requirement that the relative price must satisfy is that no country pays a relative price greater than its opportunity cost of obtaining the good in autarky. That is, Canada won’t pay more than 2 airplanes for each 1 bundle of 10 000 auto parts from Mexico, and Mexico won’t pay more than 2 bundles of 10 000 auto parts for each 1 airplane from Canada. Once this requirement is satisfied, the actual relative price in international trade is determined by supply and demand—and we’ll turn to supply and demand in international trade in the next section. However, first let’s look more deeply into the nature of the gains from trade.

It’s easy to accept the idea that Vietnam and Thailand have a comparative advantage in shrimp production: they have a tropical climate that’s better suited to shrimp farming than that of Canada, and they have a lot of usable coastal area. So Canada imports shrimp from Vietnam and Thailand. In other cases, however, it may be harder to understand why we import certain goods from abroad.

Canadian imports of auto parts from Mexico is a case in point. There’s nothing about Mexico’s climate or resources that makes it especially good at manufacturing auto parts. In fact, it almost surely takes fewer hours of labour to produce an auto seat or wiring harness in Canada than in Mexico.

Why, then, do we buy Mexican auto parts? Because the gains from trade depend on comparative advantage, not absolute advantage. Yes, it takes less labour to produce a wiring harness in Canada than in Mexico. That is, the productivity of Mexican auto parts workers is less than that of their Canadian counterparts. But what determines comparative advantage is not the amount of resources used to produce a good but the opportunity cost of that good—here, the quantity of other goods forgone in order to produce an auto seat. And the opportunity cost of auto parts is lower in Mexico than in Canada.

Here’s how it works: Mexican workers have low productivity compared with Canadian workers in the auto parts industry. But Mexican workers have even lower productivity compared with Canadian workers in other industries. Because Mexican labour productivity in industries other than auto parts is relatively very low, producing a wiring harness in Mexico, even though it takes a lot of labour, does not require forgoing the production of large quantities of other goods.

In Canada, the opposite is true: very high productivity in other industries (such as high-technology goods) means that producing an auto seat in Canada, even though it doesn’t require much labour, requires sacrificing lots of other goods. So the opportunity cost of producing auto parts is less in Mexico than in Canada. Despite its lower labour productivity, Mexico has a comparative advantage in the production of many auto parts, although Canada has an absolute advantage.

Mexico’s comparative advantage in auto parts is reflected in global markets by the wages Mexican workers are paid. That’s because a country’s wage rates, in general, reflect its labour productivity. In countries where labour is highly productive in many industries, employers are willing to pay high wages to attract workers, so competition among employers leads to an overall high wage rate. In countries where labour is less productive, competition for workers is less intense and wage rates are correspondingly lower.

As the accompanying Global Comparison shows, there is indeed a strong relationship between overall levels of productivity and wage rates around the world. Because Mexico has generally low productivity, it has a relatively low wage rate. Low wages, in turn, give Mexico a cost advantage in producing goods where its productivity is only moderately low, like auto parts. As a result, it’s cheaper to produce these parts in Mexico than in Canada.

The kind of trade that takes place between low-wage, low-productivity economies like Mexico and high-wage, high-productivity economies like Canada and the United States gives rise to two common misperceptions. One, the pauper labour fallacy, is the belief that when a country with high wages imports goods produced by workers who are paid low wages, this must hurt the standard of living of workers in the importing country. The other, the sweatshop labour fallacy, is the belief that trade must be bad for workers in poor exporting countries because those workers are paid very low wages by our standards.

Both fallacies miss the nature of gains from trade: it’s to the advantage of both countries if the poorer, lower-wage country exports goods in which it has a comparative advantage, even if its cost advantage in these goods depends on low wages. That is, both countries are able to achieve a higher standard of living through trade.

It’s particularly important to understand that buying a good made by someone who is paid much lower wages than most Canadian workers doesn’t necessarily imply that you’re taking advantage of that person. It depends on the alternatives. Because workers in poor countries have low productivity across the board, they are offered low wages whether they produce goods exported to Canada or goods sold in local markets. A job that looks terrible by rich-country standards can be a step up for someone in a poor country.

International trade that depends on low-wage exports can nonetheless raise a country’s standard of living. This is especially true of very-low-wage nations. For example, Bangladesh and similar countries would be much poorer than they are—their citizens might even be starving—if they weren’t able to export goods such as clothing based on their low wage rates.

International trade is driven by comparative advantage, but where does comparative advantage come from? Economists who study international trade have found three main sources of comparative advantage: international differences in climate, international differences in factor endowments, and international differences in technology.

Differences in Climate One key reason the opportunity cost of producing shrimp in Vietnam and Thailand is less than in Canada is that shrimp need warm water—Vietnam has plenty of that, but Canada doesn’t. In general, differences in climate play a significant role in international trade. Tropical countries export tropical products like coffee, sugar, bananas, and shrimp. Countries in the temperate zones export crops like wheat and corn. Some trade is even driven by the difference in seasons between the northern and southern hemispheres: winter deliveries of Chilean grapes and New Zealand apples have become commonplace in North American and European supermarkets.

Differences in Factor Endowments Canada is a major exporter of forest products—lumber and products derived from lumber, like pulp and paper—to the United States. These exports don’t reflect the special skill of Canadian lumberjacks. Canada has a comparative advantage in forest products because its forested area is much greater compared to the size of its labour force than the ratio of forestland to the labour force in the United States.

Forestland, like labour and capital, is a factor of production: an input used to produce goods and services. (Recall from Chapter 2 that the factors of production are land, labour, and capital.) Due to history and geography, the mix of available factors of production differs among countries, providing an important source of comparative advantage. The relationship between comparative advantage and factor availability is found in an influential model of international trade, the Heckscher–Ohlin model, developed by two Swedish economists in the first half of the twentieth century.

Two key concepts in the model are factor abundance and factor intensity. Factor abundance refers to how large a country’s supply of a factor is relative to its supply of other factors. Factor intensity refers to the fact that producers use different ratios of factors of production in the production of different goods. For example, oil refineries use much more capital per worker than clothing factories. Economists use the term factor intensity to describe this difference among goods: oil refining is capital-intensive, because it tends to use a high ratio of capital to labour, but auto seats production is labour-intensive, because it tends to use a high ratio of labour to capital.

According to the Heckscher-Ohlin model, a country that has an abundant supply of a factor of production will have a comparative advantage in goods whose production is intensive in that factor. So a country that has a relative abundance of capital will have a comparative advantage in capital-intensive industries such as oil refining, but a country that has a relative abundance of labour will have a comparative advantage in labour-intensive industries such as auto seats production.

The basic intuition behind this result is simple and based on opportunity cost. The opportunity cost of a given factor—the value that the factor would generate in alternative uses—is low for a country when it is relatively abundant in that factor. Relative to Canada, Mexico has an abundance of low-skilled labour. As a result, the opportunity cost of the production of low-skilled, labour-intensive goods is lower in Mexico than in Canada.

The most dramatic example of the validity of the Heckscher–Ohlin model is world trade in clothing. Clothing production is a labour-intensive activity: it doesn’t take much physical capital, nor does it require a lot of human capital in the form of highly educated workers. So you would expect labour-abundant countries such as China and Bangladesh to have a comparative advantage in clothing production. And they do.

That much international trade is the result of differences in factor endowments helps explain another fact: international specialization of production is often incomplete. That is, a country often maintains some domestic production of a good that it imports. A good example of this is Canada and oil. Saudi Arabia exports oil to Canada because Saudi Arabia has an abundant supply of oil relative to its other factors of production; Canada exports medical devices to Saudi Arabia because it has an abundant supply of expertise in medical technology relative to its other factors of production. But Canada also produces some oil domestically because the size of its domestic oil reserves in Alberta makes it economical to do so.

In our supply and demand analysis in the next section, we’ll consider incomplete specialization by a country to be the norm. We should emphasize, however, that the fact that countries often incompletely specialize does not in any way change the conclusion that there are gains from trade.

Differences in Technology In the 1970s and 1980s, Japan became by far the world’s largest exporter of automobiles, selling large numbers to North America and the rest of the world. Japan’s comparative advantage in automobiles wasn’t the result of climate. Nor can it easily be attributed to differences in factor endowments: aside from a scarcity of land, Japan’s mix of available factors is quite similar to that in other developed countries. Instead, as we discussed in the Chapter 2 Business Case on lean production at Toyota and Boeing, Japan’s comparative advantage in automobiles was based on the superior production techniques developed by its manufacturers, which allowed them to produce more cars with a given amount of labour and capital than their North American or European counterparts.

Japan’s comparative advantage in automobiles was a case of comparative advantage caused by differences in technology—the techniques used in production.

The causes of differences in technology are somewhat mysterious. Sometimes they seem to be based on knowledge accumulated through experience—for example, Switzerland’s comparative advantage in watches reflects a long tradition of watchmaking. Sometimes they are the result of a set of innovations that for some reason occur in one country but not in others. Technological advantage, however, is often transitory. As we also discussed in the Chapter 2 Business Case, by adopting lean production, auto manufacturers in North America have now closed much of the gap in productivity with their Japanese competitors. In addition, a technological advantage can be acquired or supported by government funding for research and development. For instance, government support for nuclear and aerospace industries has helped Canada occupy a niche in the world markets for these products. At any given point in time, however, differences in technology are a major source of comparative advantage.