1.1 Module 16: Gains from Trade

(left) Susana Gonzalez/Bloomberg via Getty Images
(right) Scott Olson/Getty Images

Comparative Advantage and International Trade

The United States 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 U.S. economy. Over the last 50 years, both imports into and exports from the United States have grown faster than the U.S. economy as a whole. Panel (a) of Figure 16-1 shows how the values of U.S. 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 significantly more important for many other countries than it is for the United States. (Japan is the exception.)

Panel (a) illustrates the fact that over the past 52 years, the United States has exported a steadily growing share of its GDP to other countries and imported a growing share of what it consumes. Panel (b) demonstrates that international trade is significantly more important to many other countries than it is to the United States, with the exception of Japan.

Source: Bureau of Economic Analysis [panel (a)] and World Trade Organization [panel (b)].

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 module and the next, 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.

Production Possibilities and Comparative Advantage, Revisited

To produce auto parts, any country must use resources—land, labor, 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. In other cases, matters are a bit less obvious. It’s as easy to produce auto parts in the United States as it is in Mexico, and Mexican auto parts workers are, if anything, less efficient than their U.S. counterparts. But Mexican workers are a lot less productive than U.S. 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 U.S. worker into auto parts production. That is, the opportunity cost of producing auto parts in Mexico is less than it is in the United States.

So we say that Mexico has a comparative advantage in producing auto parts. Let’s repeat the definition of comparative advantage from Module 4: 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 16-2 provides a hypothetical 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, the United States 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 curves for the United States and Mexico.

The U.S. opportunity cost of 1 bundle of auto parts in terms of airplanes is 2: for every additional bundle of auto parts, 2 airplanes must be forgone. The Mexican opportunity cost of 1 bundle of auto parts in terms of airplanes is ½: for every additional bundle of auto parts, only ½ of an airplane must be forgone. Because the opportunity cost is lower, the United States has a comparative advantage in airplane production, and Mexico has a comparative advantage in auto parts production. In autarky, each country is forced to consume only what it produces: 1,000 airplanes and 500 bundles of auto parts for the United States; 500 airplanes and 1,000 bundles of auto parts for Mexico.

In Figure 16-2 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 the United States can produce 2,000 airplanes if it produces no auto parts, or 1,000 bundles of auto parts if it produces no airplanes. Thus, the slope of the U.S. production possibility curve, or PPF, is −2,000/1,000 = −2. That is, to produce an additional bundle of auto parts, the United States must forgo the production of 2 airplanes.

Similarly, Mexico can produce 1,000 airplanes if it produces no auto parts or 2,000 bundles of auto parts if it produces no airplanes. Thus, the slope of Mexico’s PPF is −1,000/2,000 = −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. We assume that in autarky the United States chooses to produce and consume 500 bundles of auto parts and 1,000 airplanes. We also assume that in autarky Mexico produces 1,000 bundles of auto parts and 500 airplanes.

The trade-offs facing the two countries when they don’t trade are summarized in Table 16-1. As you can see, the United States 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 the United States 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 the United States 2 airplanes.

As we’ve learned, 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.

The Gains from International Trade

Figure 16-3 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 the United States and panel (b) represents Mexico. In each panel we indicate again the autarky production and consumption assumed in Figure 16-2. 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 the United States 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.

Trade increases world production of both goods, allowing both countries to consume more. Here, each country specializes its production as a result of trade: the United States concentrates on producing airplanes, and Mexico concentrates on producing auto parts. Total world production of both goods rises, which means that it is possible for both countries to consume more of both goods.

Table 16-2 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, the United States specializes in the production of airplanes, producing 2,000 airplanes and no auto parts; Mexico specializes in the production of auto parts, producing 2,000 bundles of auto parts and no airplanes.

The result is a rise in total world production of both goods. As you can see in the Table 16-2 column at far right showing consumption with trade, the United States 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 the United States.

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.

Comparative Advantage versus Absolute Advantage

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 labor to produce an auto seat in the United States 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 labor to produce an auto seat in the United States than in Mexico. That is, the productivity of Mexican auto parts workers is less than that of their U.S. 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 given up in order to produce an auto seat. And the opportunity cost of auto parts is lower in Mexico than in the United States.

The opportunity cost of producing auto parts is higher in the United States than in Mexico.

Caro/Alamy

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

In the United States, the opposite is true: very high productivity in other industries (such as high-technology goods) means that producing an auto seat in the United States, even though it doesn’t require much labor, requires sacrificing lots of other goods. So the opportunity cost of producing auto parts is less in Mexico than in the United States. Despite its lower labor productivity, Mexico has a comparative advantage in the production of auto parts, although the United States 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 labor productivity. In countries where labor 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 labor is less productive, competition for workers is less intense and wage rates are correspondingly lower.

The kind of trade that takes place between low-wage, low-productivity economies like Mexico and high-wage, high-productivity economies like the United States gives rise to two common misperceptions. One, the pauper labor 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 labor 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.

International trade that depends on low-wage exports can raise a country’s standard of living, as it has in Mexico and elsewhere.

Bloomberg via Getty Images

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 U.S. 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 America 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.

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:

1. international differences in climate
2. international differences in factor endowments
3. international differences in technology

1. 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.

2. 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. (Recall that the factors of production are land, labor, physical capital, and human 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 labor, but auto seats production is labor-intensive, because it tends to use a high ratio of labor 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 labor will have a comparative advantage in labor-intensive industries such as auto seats production.

Canada’s comparative advantage in forest production has little to do with the skill of its storied lumberjacks and a lot to do with the size of its forests.

iStockphoto

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 the United States, Mexico has an abundance of low-skilled labor. As a result, the opportunity cost of the production of low-skilled, labor-intensive goods is lower in Mexico than in the United States.

The most dramatic example of the validity of the Heckscher–Ohlin model is 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.

Lean production involves organizing workers and parts to ensure a smooth work flow, minimize waste, and allow for flexibility to change.

Corbis/Photolibrary

3. 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, as we discussed in the Section 1 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 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.

SKILL AND COMPARATIVE ADVANTAGE

In 1953 U.S. workers were clearly better equipped with machinery than their counterparts in other countries. Most economists at the time thought that America’s comparative advantage lay in capital-intensive goods. But Wassily Leontief made a surprising discovery: America’s comparative advantage was in something other than capital-intensive goods. In fact, goods that the United States exported were slightly less capital-intensive than goods the country imported. This discovery came to be known as the Leontief paradox, and it led to a sustained effort to make sense of U.S. trade patterns.

The main resolution of this paradox, it turns out, depends on the definition of capital. U.S. exports aren’t intensive in physical capital—machines and buildings. Instead, they are skill-intensive—that is, they are intensive in human capital. U.S. exporting industries use a substantially higher ratio of highly educated workers to other workers than is found in U.S. industries that compete against imports. For example, one of America’s biggest export sectors is aircraft; the aircraft industry employs large numbers of engineers and other people with graduate degrees relative to the number of manual laborers. Conversely, we import a lot of clothing, which is often produced by workers with little formal education.

In general, countries with highly educated workforces tend to export skill-intensive goods, while countries with less educated workforces tend to export goods whose production requires little skilled labor.

Figure 16-4 illustrates this point by comparing the goods the United States imports from Germany, a country with a highly educated labor force, with the goods the United States imports from Bangladesh, where about half of the adult population is still illiterate. In each country industries are ranked, first, according to how skill-intensive they are. Next, for each industry, we calculate its share of U.S. imports. This allows us to plot, for each country, various industries according to their skill intensity and their share of U.S. imports.

Source: John Romalis, “Factor Proportions and the Structure of Commodity Trade,” American Economic Review 94, no. 1 (2004): 67–97.

In Figure 16-4, the horizontal axis shows a measure of the skill intensity of different industries, and the vertical axes show the share of U.S. imports in each industry coming from Germany (on the left) and Bangladesh (on the right). As you can see, each country’s share of U.S. imports reflects its skill level. The curve representing Germany slopes upward: the more skill-intensive a German industry is, the higher its share of U.S. imports. In contrast, the curve representing Bangladesh slopes downward: the less skill-intensive a Bangladeshi industry is, the higher its share of U.S. imports.

Module 16 Review

Check Your Understanding

In autarky, the equilibrium price of a good in the domestic market is $10. If the world price of the same good is $8 and the country opens up to trade, how will the domestic quantity supplied and demanded be affected? Will the country be an importer or an exporter of the good?