1.3 3Comparative Advantage and Trade

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Gains from Trade

A family could try to take care of all its own needs—growing its own food, sewing its own clothing, providing itself with entertainment, and writing its own economics textbooks. But trying to live that way would be very hard. The key to a much better standard of living for everyone is trade, in which people divide tasks among themselves and each person provides a good or service that other people want in return for different goods and services that he or she wants.

The reason we have an economy is that there are gains from trade: by dividing tasks and trading, two people (or 7 billion people) can each get more of what they want than they could get by being self-sufficient. Gains from trade arise, in particular, from this division of tasks, which economists call specialization: each person engages in a different task that he or she is good at performing.

The advantages of specialization, and the resulting gains from trade, were the starting point for Adam Smith’s 1776 book The Wealth of Nations, which many regard as the beginning of economics as a discipline. Smith’s book begins with a description of an eighteenth-century pin factory where, rather than each of the 10 workers making a pin from start to finish, each worker specialized in one of the many steps in pin-making:

The same principle applies when we look at how people divide tasks among themselves and trade in an economy. The economy, as a whole, can produce more when each person specializes in a task and trades with others.

The benefits of specialization are the reason a person typically focuses on the production of only one type of good or service. It takes many years of study and experience to become a doctor; it also takes many years of study and experience to become a commercial airline pilot. Many doctors might have the potential to become excellent pilots, and vice versa, but it is very unlikely that anyone who decided to pursue both careers would be as good a pilot or as good a doctor as someone who specialized in only one of those professions. So it is to everyone’s advantage when individuals specialize in their career choices.

© The New Yorker Collection 1991 Ed Frascino from cartoonbank.com. All Rights Reserved.

Markets are what allow a doctor and a pilot to specialize in their respective fields. Because markets for commercial flights and for doctors’ services exist, a doctor is assured that she can find a flight and a pilot is assured that he can find a doctor. As long as individuals know that they can find the goods and services that they want in the market, they are willing to forgo self-sufficiency and are willing to specialize.

Comparative Advantage and Gains from Trade

One of the most important insights in all of economics is that there are gains from trade—that it makes sense to produce the things you’re especially good at producing and to buy from other people the things you aren’t as good at producing. This would be true even if you could produce everything for yourself: even if a brilliant brain surgeon could repair her own dripping faucet, it’s probably a better idea for her to call in a professional plumber.

How can we model the gains from trade? Let’s stay with our aircraft example and once again imagine that the United States is a one-company economy where everyone works for Boeing, producing either large or small jets. Let’s now assume, however, that the United States has the ability to trade with Brazil—another one-company economy where everyone works for the Brazilian aircraft company Embraer, which is, in the real world, a successful producer of small commuter jets.

Both countries could produce either kind of jet. But as we’ll see in a moment, they can gain by producing different things and trading with each other. Let’s return to the simpler case of straight-line production possibility curves. America’s production possibilities are represented by the production possibility curve in panel (a) of Figure 3-1, which is similar to the production possibility curve in Figure 2-1. According to this diagram, the United States can produce 40 small jets or 30 large jets, or some combination of the two. Recall that this means that the slope of the U.S. production possibility curve is −¾: its opportunity cost of 1 small jet is ¾ of a large jet.

Here, both the United States and Brazil have a constant opportunity cost of small jets, illustrated by a straight-line production possibility curve. For the United States, each small jet has an opportunity cost of ¾ of a large jet. Brazil has an opportunity cost of a small jet equal to ⅓ of a large jet.

Panel (b) of Figure 3-1 shows Brazil’s production possibilities. Like the United States, Brazil’s production possibility curve is a straight line. Brazil’s production possibility curve has a constant slope of −⅓. Brazil can’t produce as much of anything as the United States can: at most it can produce 30 small jets or 10 large jets. But it is relatively better at manufacturing small jets than the United States. While the United States sacrifices ¾ of a large jet per small jet produced, for Brazil the opportunity cost of a small jet is only ⅓ of a large jet. Table 3-1 summarizes the two countries’ opportunity costs of small jets and large jets.

3-1
U.S. and Brazilian Opportunity Costs of Small Jets and Large Jets

Now, the United States and Brazil could each choose to make their own large and small jets, not trading any airplanes at all. Let’s suppose that the two countries start out this way and make the consumption choices shown in Figure 3-1: in the absence of trade, the United States produces and consumes 16 small jets and 18 large jets per year, while Brazil produces and consumes 6 small jets and 8 large jets per year.

But is this the best the two countries can do? No, it isn’t. Given that the two producers—and therefore the two countries—have different opportunity costs, the United States and Brazil can strike a deal that makes both of them better off.

Table 3-2 shows how such a deal works: the United States specializes in the production of large jets, manufacturing 30 per year, and sells 10 to Brazil. Meanwhile, Brazil specializes in the production of small jets, producing 30 per year, and sells 20 to the United States. The result is shown in Figure 3-2. The United States now consumes more of both small jets and large jets than before: instead of 16 small jets and 18 large jets, it now consumes 20 small jets and 20 large jets. Brazil also consumes more, going from 6 small jets and 8 large jets to 10 small jets and 10 large jets. As Table 3-2 also shows, both the United States and Brazil reap gains from trade, consuming more of both types of plane than they would have without trade.

3-2
How the United States and Brazil Gain from Trade

By specializing and trading, the United States and Brazil can produce and consume more of both large jets and small jets. The United States specializes in manufacturing large jets, its comparative advantage, and Brazil—which has an absolute disadvantage in both goods but a comparative advantage in small jets—specializes in manufacturing small jets. With trade, both countries can consume more of both goods than either could without trade.

Both countries are better off when they each specialize in what they are good at and trade. It’s a good idea for the United States to specialize in the production of large jets because its opportunity cost of a large jet is smaller than Brazil’s: . Correspondingly, Brazil should specialize in the production of small jets because its opportunity cost of a small jet is smaller than the United States: ⅓ < ¾.

What we would say in this case is that the United States has a comparative advantage in the production of large jets and Brazil has a comparative advantage in the production of small jets. A country has a comparative advantage in producing something if the opportunity cost of that production is lower for that country than for other countries. The same concept applies to firms and people: a firm or an individual has a comparative advantage in producing something if its, his, or her opportunity cost of production is lower than for others.

One point of clarification before we proceed further. You may have wondered why the United States traded 10 large jets to Brazil in return for 20 small jets. Why not some other deal, like trading 10 large jets for 12 small jets? The answer to that question has two parts. First, there may indeed be other trades that the United States and Brazil might agree to. Second, there are some deals that we can safely rule out—one like 10 large jets for 10 small jets.

To understand why, reexamine Table 3-1 and consider the United States first. Without trading with Brazil, the U.S. opportunity cost of a small jet is ¾ of a large jet. So it’s clear that the United States will not accept any trade that requires it to give up more than ¾ of a large jet for a small jet. Trading 10 large jets in return for 12 small jets would require the United States to pay an opportunity cost of 10/12 = 5/6 of a large jet for a small jet. Because 5/6 > ¾, this is a deal that the United States would reject. Similarly, Brazil won’t accept a trade that gives it less than ⅓ of a large jet for a small jet.

The point to remember is that the United States and Brazil will be willing to trade only if the “price” of the good each country obtains in the trade is less than its own opportunity cost of producing the good domestically. Moreover, this is a general statement that is true whenever two parties—countries, firms, or individuals—trade voluntarily.

While our story clearly simplifies reality, it teaches us some very important lessons that apply to the real economy, too.

First, the model provides a clear illustration of the gains from trade: through specialization and trade, both countries produce more and consume more than if they were self-sufficient.

Second, the model demonstrates a very important point that is often overlooked in real-world arguments: each country has a comparative advantage in producing something. This applies to firms and people as well: everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something.

Crucially, in our example it doesn’t matter if, as is probably the case in real life, U.S. workers are just as good as or even better than Brazilian workers at producing small jets. Suppose that the United States is actually better than Brazil at all kinds of aircraft production. In that case, we would say that the United States has an absolute advantage in both large-jet and small-jet production: in an hour, an American worker can produce more of either a large jet or a small jet than a Brazilian worker. You might be tempted to think that in that case the United States has nothing to gain from trading with the less productive Brazil.

But we’ve just seen that the United States can indeed benefit from trading with Brazil because comparative, not absolute, advantage is the basis for mutual gain. It doesn’t matter whether it takes Brazil more resources than the United States to make a small jet; what matters for trade is that for Brazil the opportunity cost of a small jet is lower than the U.S. opportunity cost. So Brazil, despite its absolute disadvantage, even in small jets, has a comparative advantage in the manufacture of small jets. Meanwhile the United States, which can use its resources most productively by manufacturing large jets, has a comparative disadvantage in manufacturing small jets.

If comparative advantage were relevant only to airplane manufacturers, it might not be that interesting. However, the idea of comparative advantage applies to many activities in the economy. Perhaps its most important application is in trade—not between individuals, but between countries. So let’s look briefly at how the model of comparative advantage helps in understanding both the causes and the effects of international trade.

RICH NATION, POOR NATION

Try taking off your clothes—at a suitable time and in a suitable place, of course—and take a look at the labels inside that say where the clothes were made. It’s a very good bet that much, if not most, of your clothing was manufactured overseas, in a country that is much poorer than the United States is—say, in El Salvador, Sri Lanka, or Bangladesh.

Why are these countries so much poorer than the United States? The immediate reason is that their economies are much less productive—firms in these countries are just not able to produce as much from a given quantity of resources as comparable firms in the United States or other wealthy countries. Why countries differ so much in productivity is a deep question—indeed, one of the main questions that preoccupy economists. In any case, the difference in productivity is a fact.

But if the economies of these countries are so much less productive than ours, how is it that they make so much of our clothing? Why don’t we do it for ourselves?

Although less productive than American workers, Bangladeshi workers have a comparative advantage in clothing production.

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The answer is “comparative advantage.” Just about every industry in Bangladesh is much less productive than the corresponding industry in the United States. But the productivity difference between rich and poor countries varies across goods; there is a very great difference in the production of sophisticated goods such as aircraft but not as great a difference in the production of simpler goods such as clothing. So Bangladesh’s position with regard to clothing production is like Brazil’s position with respect to producing smaller jets. While Brazil is not as good as the United States at making either small or large jets, producing smaller jets is what Brazil does comparatively well.

Although Bangladesh is at an absolute disadvantage compared with the United States in almost everything, it has a comparative advantage in clothing production. This means that both the United States and Bangladesh are able to consume more because they specialize in producing different things, with Bangladesh supplying our clothing and the United States supplying Bangladesh with more sophisticated goods.

Comparative Advantage and International Trade, in Reality

Look at the label on a manufactured good sold in the United States, and there’s a good chance you will find that it was produced in some other country. On the other side, many U.S. industries sell a large fraction of their output overseas.

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Should all this international exchange of goods and services be celebrated, or is it cause for concern? Politicians and the public often question the desirability of international trade, arguing that the nation should produce goods for itself rather than buy them from foreigners. Industries around the world demand protection from foreign competition: Japanese farmers want to keep out American rice, American steelworkers want to keep out European steel. And these demands are often supported by public opinion.

Economists, however, have a very positive view of international trade. Why? Because they view it in terms of comparative advantage. As we learned from our example of U.S. large jets and Brazilian small jets, international trade benefits both countries. Each country can consume more than if it didn’t trade and remained self-sufficient. Moreover, these mutual gains don’t depend on each country being better than other countries at producing one kind of good. Even if one country has, say, higher output per worker in both industries—that is, even if one country has an absolute advantage in both industries—there are still gains from trade.

Sources of Comparative Advantage

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 ClimateIn 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 U.S. and European supermarkets.

Differences in Factor EndowmentsCanada 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 labor force than the ratio of forestland to the labor force in the United States.

Forestland, like labor and capital, is a factor of production: an input used to produce goods and services. Due to history and geography, the mix of available factors of production differs among countries, providing an important source of comparative advantage.

Consider world trade in clothing. Clothing production is a labor-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 labor-abundant countries such as China and Bangladesh to have a comparative advantage in clothing production. And they do.

Differences in TechnologyIn the 1970s and 1980s, Japan became by far the world’s largest exporter of automobiles, selling large numbers to the United States 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 advanced countries. Instead, 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 labor and capital than their 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. (See the upcoming Business Case for more on these techniques.)

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. American auto manufacturers have now closed much of the gap in productivity with their Japanese competitors. In addition, Europe’s aircraft industry has closed a similar gap with the U.S. aircraft industry. At any given point in time, however, differences in technology are a major source of comparative advantage.

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Check Your Understanding

Refer to the graph below to answer the following questions.

Refer to the table below to answer the following questions. These two countries are producing textiles and wheat using equal amounts of resources.

Back in the 1980s, when the U.S. economy seemed to be lagging behind that of Japan, commentators often warned that if we didn’t improve our productivity, we would soon have no comparative advantage in anything. What is wrong with this statement?

IT IS INACCURATE; THOSE COMMENTATORS MISUNDERSTOOD COMPARATIVE ADVANTAGE. It happens all the time. Students, pundits, and politicians confuse comparative advantage with absolute advantage. What the commentators meant was that we would have no absolute advantage in anything—that there might come a time when the Japanese were able to produce more goods in an absolute sense than we were. (It didn’t turn out that way, but that’s another story.) And they had the idea that in that case we would no longer be able to benefit from trade with Japan.

A country has an absolute advantage in producing a good or service if the country can produce more output per worker than other countries. Likewise, an individual has an absolute advantage in producing a good or service if he or she is better at producing it than other people. Having an absolute advantage is not the same thing as having a comparative advantage.

Just as Brazil, in our example, is able to benefit from trade with the United States (and vice versa) despite the fact that the United States may be able to produce absolutely more goods than Brazil, in the real-world nations will still gain from trade even if they are less productive in all industries than the countries with whom they trade

To learn more, see pages 21–22, including Figure 3-2.