The Gains from Trade

Economics studies voluntary exchange. People and nations do business with one another because they expect to gain through these transactions. Foreign trade is nearly as old as civilization. Centuries ago, European merchants were already sailing to the Far East to ply the spice trade. Today, people in the United States buy cars from South Korea and electronics from China, along with millions of other products from countries around the world.

Virtually all countries today engage in some form of international trade. Those that trade the least are considered closed economies. A country that does not trade at all is called an autarky. Most countries, however, are open economies that willingly and actively engage in trade with other countries. Trade consists of imports, goods and services purchased from other countries, and exports, goods and services sold abroad.

Many people assume that trade between nations is a zero-sum game: a game in which, for one party to gain, the other party must lose. Poker games fit this description; one person’s winnings must come from another player’s losses. This is not true of voluntary trade. Voluntary exchange and trade is a positive-sum game, meaning that both parties to a transaction can gain.

To understand how this works, and thus why nations trade, we need to consider the concepts of absolute and comparative advantage. Note that nations per se do not trade; individuals in specific countries do. We will refer to trade between nations but recognize that individuals, not nations, actually engage in trade. We covered this earlier, in Chapter 2, but it is worthwhile to go through it again.

Absolute and Comparative Advantage

Figure 2 shows hypothetical production possibilities frontiers for the United States and Canada. For simplicity, both countries are assumed to produce only beef and guitars. Given the production possibility frontiers (PPFs) in Figure 2, the United States has an absolute advantage over Canada in the production of both products. An absolute advantage exists when one country can produce more of a good than another country. In this case, the United States can produce twice as much beef and 5 times as many guitars as Canada. This is not to say that Canadians are inefficient in producing these goods, but rather that Canada does not have the resources to produce as many goods as the United States does (for one thing, its population is barely a tenth the size of that of the United States).

Production Possibilities for the United States and Canada The production possibilities frontiers (PPF) shown here assume that the United States and Canada produce only beef and guitars. In this example, the United States has an absolute advantage over Canada in producing both products; the United States can produce twice as many cattle and 5 times as many guitars as Canada. Canada nonetheless has a comparative advantage over the United States in producing beef.

At first glance, we may wonder why the United States would be willing to trade with Canada. If the United States can produce so much more of both goods, why not just produce its own cattle and guitars? The reason lies in comparative advantage.

International trade allows consumers to buy goods (such as televisions) produced in many countries. Competition from trade allows for greater variety and lower prices.

Yuri Arcurs/age fotostock

One country enjoys a comparative advantage in producing some good if its opportunity costs to produce that good are lower than the other country’s. In this example, Canada’s comparative advantage is in producing cattle. As Figure 2 shows, the opportunity cost for the United States to produce another million cows is 1 million guitars; each added cow essentially costs 1 guitar.

Contrast this with the situation in Canada. For every guitar Canadian manufacturers forgo making, they can produce 2.5 more cows. This means cows cost only 0.4 guitar in Canada (1/2.5 = 0.4). Canada’s comparative advantage is in producing cattle, because a cow costs 0.4 guitar in Canada, while the same cow costs an entire guitar in the United States. By the same token, the United States has a comparative advantage in producing guitars: 1 guitar in the United States costs 1 cow, but the same guitar in Canada costs 2.5 cows.

Table 1 summarizes the opportunity costs of each good in each country and shows which country has the comparative advantage for each good. These relative costs suggest that the United States should focus its resources on guitar production and that Canada should specialize in beef.

Gains from Trade

To see how specialization and trade can benefit both countries even when one has an advantage in producing more of both goods, assume that the United States and Canada at first operate at point a in Figure 2, producing and consuming their own beef and guitars. As we can see, the United States produces and consumes 40 million cattle and 40 million guitars. Canada produces and consumes 20 million cattle and 8 million guitars. This initial position is similarly shown as points a in Figure 3.

The Gains from Specialization and Trade to the United States and Canada Assume Canada specializes in cattle. If the two countries want to continue consuming 60 million cows between them, the United States needs to produce only 20 million. This frees up resources for the United States to begin producing more guitars. Because each cow in the United States costs 1 guitar to produce, reducing beef output by 20 million cattle means that 20 million more guitars can be produced. When the two countries trade their surplus products, both are better off than before.

Assume now that Canada specializes in producing cattle, producing all that it can—40 million cows. We will assume that the two countries want to continue consuming 60 million cows between them. This means that the United States needs to produce only 20 million cattle, because Canada is now producing 40 million. This frees up some American resources to produce guitars. Because each cow in the United States costs a guitar, reducing beef output by 20 million cattle means that 20 million more guitars can now be produced.

Thus, the United States is producing 20 million cattle and 60 million guitars. Canada is producing 40 million cattle and no guitars. The combined production of cattle remains the same, 60 million, but guitar production has increased by 12 million (from 48 to 60 million).

The two countries can trade their surplus products and will be better off. This is shown in Table 2. Assuming that they agree to share the added 12 million guitars between them equally, Canada will trade 20 million cattle in exchange for 14 million guitars. Points b in Figure 3 show the resulting consumption patterns for each country. Each consumes the same quantity of beef as before trading, but each country now has 6 million more guitars: 46 million for the United States and 14 million for Canada. This is shown in the last column of the table.

One important point to remember is that even when one country has an absolute advantage over another, countries still benefit from trade. The gains are small in our example, but they will grow as the two countries approach one another in size and their comparative advantages become more pronounced.

The Challenge of Measuring Imports and Exports in a Global Economy

Before the growth of globalization of manufacturing, the brand names of products would indicate their origin. For example, Sony televisions were made in Japan, Nokia telephones were made in Finland, and a Ford car would be made in the United States using American steel, engines, cloth, and, of course, American labor.

A domestic content label of an “imported” Toyota truck.

Eric Chiang

Today, a product’s brand name does not tell the entire story. Production has become very complex, with parts sourced from around the world. With such complexities in trade, how then are imports and exports measured?

Do sales of Levi’s jeans count as American exports? Although Levi’s are an American brand that has for much of its history been produced in the United States, today nearly all Levi’s jeans are made in Asia. Therefore, the American-brand jeans we buy count as an import. On the other hand, we also consume many products that may seem foreign, but are made in America. The majority of Toyota and Honda cars, for example, are assembled in American factories using American steel, glass, and other materials. The same is true to a lesser extent for luxury brands such as BMW, which produces many compact cars in South Carolina. For all but a few parts (such as the engine and transmission) that are made in Japan or Germany, these cars are as American as apple pie, and are not counted as imports.

In order to measure imports and exports accurately, the United States Bureau of Economic Analysis tabulates data from documents collected by U.S. Customs and Border Protection, which details the appraised value (price paid) for all shipments of goods into and out of the ports of entry (whether by land, air, or sea). The value of imported and exported services is more difficult to measure, and is based on a survey of monthly government and industry reports to determine the value of all services bought from and sold to foreigners.

The globalized economy has been spurred in large part due to falling transportation and communication costs in the past few decades. Companies face ever greater competition, applying more pressure to reduce production costs. The expansion of the production process to a worldwide factory is just one way our economy has changed, and this trend is likely to continue into the future.

Practical Constraints on Trade At this point, we should take a moment to note some practical constraints on trade. First, every transaction involves costs. These include transportation, communications, and the general costs of doing business. Over the last several decades, however, transportation and communication costs have declined all over the world, resulting in growing world trade.

Second, the production possibilities frontiers for nations are not linear; rather, they are governed by increasing costs and diminishing returns. Countries find it difficult to specialize only in one product. Indeed, specializing in one product is risky because the market for the product can always decline, new technology might replace it, or its production can be disrupted by changing weather patterns. This is a perennial problem for developing countries that often build their exports and trade around one agricultural commodity.

Although it is true that trading partners benefit from trade, some individuals and groups within each country may lose. Individual workers in those industries at a comparative disadvantage are likely to lose their jobs, and thus may require retraining, relocation, or other help if they are to move smoothly into new occupations.

When the United States signed the North American Free Trade Agreement (NAFTA) with Canada and Mexico, many U.S. workers experienced this sort of dislocation. Some U.S. jobs went south to Mexico because of lower wages. States such as Texas and Arizona experienced greater levels of job dislocation due to their proximity to Mexico. Still, by opening up more markets for U.S. products, NAFTA has stimulated the U.S. economy. The goal is that displaced workers, newly retrained, will end up with new and better jobs, although there is no guarantee this will happen.