1 Reasons for Trade

Besides technology differences across countries, which is the focus of the Ricardian model, there are many other reasons why countries trade goods. Before we get into the details of the Ricardian model, let’s briefly explore the other reasons for trade.

Proximity

The proximity of countries is a reason for trade primarily because it affects the costs of transportation. Countries that are near one another will usually have lower shipping costs added to the cost of their traded goods. The proximity of countries to one another helps to explain why Canada is among the top exporters of snowboards to the United States and why Canada is the United States’ largest trading partner overall. There are many other examples of how the closeness of countries affects trade partners. The largest trading partner of many European countries is another European country, and the largest trading partner of many Asian countries is Japan or China. Sometimes neighboring countries take advantage of their proximity by joining into a free-trade area, in which the countries have no restrictions on trade between them.

Resources

Proximity is only a partial explanation for trade patterns. As you can see in Table 2-1, Austria sells about three times the value of snowboards to the United States as does Canada, despite being farther away, and Mexico (included among “All other countries” in Table 2-1) sells only $12,000 of snowboards to the United States. Why do Austria and Canada rank higher than Mexico in their sales of snowboards to the United States? Among other reasons, Austria and Canada have cold climates and mountains, making skiing and snowboarding more popular than in Mexico. In many cases, the local production of (and expertise for) ski and snowboard equipment develops as a result of being in a place where snow sports are common. This local production occurs because of either high demand for equipment or the ready supply of a complementary good (such as a snowy mountain). This is an example of how the geography of a country (mountains and climate, in this case) affects its exports. Ski resorts can also be found in many of the other countries listed in Table 2-1, including Switzerland, Slovenia, Italy, Poland, and France.

Geography includes the natural resources (such as land and minerals) found in a country, as well as its labor resources (labor of various education and skill levels) and capital (machinery and structures). A country’s resources are often collectively called its factors of production, the land, labor, and capital used to produce goods and services. In the next two chapters, we study how the resources of a country influence its trade patterns and how trade leads to economic gains or losses for different factors of production.

In some cases, a country can export a good without having any advantage in the natural resources needed to produce it. One example is “icewine,” which is a type of wine invented in Germany but now also produced in the Niagara Falls region of Canada and the United States (see Side Bar: Can Comparative Advantage Be Created? The Case of “Icewine”). Neither Taiwan nor Mexico has many mountains with ski resorts, so what explains their exports of snowboards? A hint is provided by noticing that the wholesale price of a snowboard purchased by the United States from these countries is very low: Taiwan sold snowboards to the United States for $45 and Mexico’s wholesale price was just $13. These prices are very low compared with the highest-priced countries shown, which are Switzerland ($226), Tunisia ($171), the Netherlands ($159), and Poland ($155). The low prices from Taiwan and Mexico indicate that the snowboards they sell to the United States are either lower-quality or unfinished boards imported into the United States for further processing. This type of trade in unfinished goods is an example of offshoring, a process in which a company spreads its production activities across several countries and trades semifinished products among them. The snowboards coming into the United States from Mexico (at $13) and Canada (at $16) are probably semifinished.

Absolute Advantage

We’ve now explained some possible reasons for many countries to export snowboards to the United States, but we haven’t yet explained the imports from China, the largest exporter of snowboards to the United States, and from the Netherlands, the eighth largest exporter in 2012 and the country with one of the highest wholesale prices, $159. The Netherlands has no mountains at all, so natural resources are not the reason that it exports snowboards. The Netherlands is, however, known for having very high-quality manufactured products, such as those made by the electronics firm Philips. That is also true for its neighboring country Germany (included among “All other countries” in Table 2-1), which sold only 3 snowboards to the United States in 2012 at an average price of $876 each! That price indicates that the snowboards must be of very high quality and that Germany has the world’s most advanced technology for producing snowboards. In fact, Germany is recognized as a world leader in the methods used to produce many goods, including chemicals, machine tools, motor vehicles, and steel products. When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. Germany has an absolute advantage in many industries, and it produces high-quality goods. But if Germany has an absolute advantage in producing snowboards, why does the United States import so many more snowboards from China, which uses less advanced technologies than Germany in most industries?

Furthermore, although Germany is a world leader in many technologies, so is the United States. So why should the United States import snowboards from Germany or China at all? Why doesn’t it just produce all the snowboards it needs with U.S. technology and factors of production?

Can Comparative Advantage Be Created? The Case of “Icewine”

In Ricardo’s original example of trade between Portugal and England, he gave Portugal an absolute advantage in both wine and cloth, based on its favorable climate. England would find it very difficult to grow grapes for wine and not so difficult to produce cloth, so it had a comparative advantage in cloth. This raises the question: What if a new technology could be discovered that would allow England to produce world-class grapes and wine? Would it be possible for it to create a new comparative advantage in wine?

Harvesting frozen grapes to make icewine.

AP Photo/Julie Jacobson

Something like this occurred in the Niagara Falls region of Canada, which sells a product called “icewine.” First developed in Germany in 1794 (when Ricardo was 21 years old), icewine is produced by allowing grapes to freeze on the vine. Freezing concentrates the sugars and flavors of the grapes, which are picked by hand and then processed into a sweet dessert wine. In 1983 several wineries in the Niagara Falls region of Canada experimented with producing this wine, and it has since taken off to become a local specialty. The cold climate of Niagara Falls offers an advantage in producing icewine, because the temperature should be −10°C to −13°C before picking. The yield from this process is very low—an entire vine might make only one bottle—which is why it is sold in half-bottles. But demand is high because of the unique flavor of this wine, and the half-bottles often sell for $50 or more. Icewine is now also being produced in the Okanagan Valley region of British Columbia, Canada, which similarly enjoys a climate warm enough in the summer to grow grapes and cold enough in the winter to freeze them. Will England ever be able to develop this wine? If so, the comparative advantage between England and Portugal in Ricardo’s original model might be reversed!

Comparative Advantage

These questions indicate that absolute advantage is not, in fact, a good explanation for trade patterns. This is one of the key lessons from this chapter. Instead, comparative advantage is the primary explanation for trade among countries. To get an idea of what comparative advantage means, let us consider the example of trade between Portugal and England, as described by David Ricardo (see Side Bar: David Ricardo and Mercantilism).

To keep things simple, Ricardo considered just two commodities: wine and cloth. Ricardo allowed Portugal to have an absolute advantage in the production of both goods. Portugal’s absolute advantage may reflect, for example, its more favorable climate for growing grapes and raising sheep. Even though Portugal can produce wine and cloth more easily than England, England is still able to produce both cloth and wine, but it is relatively more difficult to produce wine in England than cloth—as any visitor to England will know, it lacks the steady sunshine needed to produce good grapes! Based on these assumptions, Ricardo argued that England would have a comparative advantage in producing cloth and would export cloth to Portugal, whereas Portugal would have comparative advantage in producing wine and would export wine to England.

David Ricardo and Mercantilism

David Ricardo.

Bettman/Corbis

David Ricardo (1772–1823) was one of the great classical economists, and the first model we study in this book is named after him. At the time that Ricardo was writing, there was a school of economic thought known as mercantilism. Mercantilists believed that exporting (selling goods to other countries) was good because it generated gold and silver for the national treasury and that importing (buying goods from other countries) was bad because it drained gold and silver from the national treasury. To ensure that a country exported a lot and imported only a little, the mercantilists were in favor of high tariffs (taxes that must be paid at the border when a good is imported). The mercantilist school of thought was discredited shortly after the time that Ricardo wrote, but some of these old ideas are still advocated today. For example, the United States sometimes insists that other countries should buy more from its companies and sometimes restricts import purchases from other countries; proponents of these ideas are called “mercantilists.”

Ricardo was interested in showing that countries could benefit from international trade without having to use tariffs and without requiring exports to be higher than imports. He considered a case that contrasted sharply with what mercantilists believed to be best for a nation: in his writings about trade, Ricardo assumed that the value of exports equaled the value of imports (a situation called balanced trade) and that countries engaged in free trade, with no tariffs or other restrictions to limit the flow of goods across borders. Under these assumptions, can international trade benefit every country? Ricardo showed that it could. All countries gain from trade by exporting the goods in which they have comparative advantage.

Ricardo’s ideas are so important that it will take some time to explain how and why they work. It is no exaggeration to say that many of the major international institutions in the world today, including the United Nations, the World Bank, and the World Trade Organization, are founded at least in part on the idea that free trade between countries brings gains for all trading partners. This idea comes from the writings of David Ricardo (and Adam Smith, a great classical economist of the eighteenth century).

From this example, we can see that a country has comparative advantage in producing those goods that it produces best compared with how well it produces other goods. That is, Portugal is better at producing wine than cloth, and England is better at producing cloth than wine, even though Portugal is better than England at producing both goods. This is the idea behind the quotation from Ricardo at the start of the chapter—it is advantageous for Portugal to import cloth from England because England has a comparative advantage in cloth. In our snowboard example, we would expect that China has a disadvantage compared with Germany or the United States in producing many manufactured goods, but it is still better at producing snowboards than some other goods, so it is able to export snowboards to the United States.

It will take us most of the chapter to explain the concept of comparative advantage and why it works as an explanation for trade patterns. As indicated by the other quotation at the beginning of the chapter, from Nobel laureate Paul Samuelson, this concept is far from obvious, and students who master it will have come a long way in their study of international trade.