Since 1992 our trade defi cit has ballooned from just $30 billion to hundreds of billions.
What can we do to reverse this trend? Should we restrict this profusion of imports, or should we listen to the reasoning of the economics profession, which is nearly unanimous in arguing for free trade?
Specialization and Trade
The basis for international trade is specialization . Different nations specialize in the production of those goods and services for which their resources are best suited. An
A downward trend in tariffs since 1947
If we will not buy, we cannot sell.
—President William McKinley
Specialization is the basis for international trade. It is the division of productive activities so that no one is self-suffi cient.
Figure 2
U.S. Tariffs, 1820–2012
Although tariffs fl uctuated widely from the 1820s through the early 1930s, there has been a strong downward trend. Today tariffs average less than 5 percent of the price of our imported durable goods.
Source: U.S. Department of Commerce.
Duties collected as a percentage of dutiable imports
1840 1860 1880 1900 1920
Year
1940 1960 1980 2000 2020
1820 70
60
50
40
30
20
10
Tariff of Abominations (1828) Morrill and War Tariffs (1861–64) McKinley Tariff (1890) Wilson-Gorman Tariff (1894) Underwood Tariff (1913) GATT (1947)
Smoot-Hawley Tariff (1930) Kennedy Round of GATT (1967) Tokyo Round of GATT (1979) Uruguay Round of GATT (1993)
Fordney-McCumber Tariff (1922) Reciprocal Trade Agreements Acts (1934) Doha Round of WTO begins (2001)
on the web
470 C H A P T E R 1 9
individual who attempts to be entirely self-suffi cient would have to make her own nails, grow her own food, spin her own cloth, sew her own clothes, make her own tools, ad infi nitum. It is much easier and a lot cheaper to work at one particular job or specialty and use one’s earnings to buy those nails, food, clothes, and so on.
What makes sense individually also makes sense internationally. Thus, just as it pays for individuals to specialize and trade, it pays for nations to do so. And that’s exactly what we do: On a national basis we specialize and trade. But it would be impossible to do this unless there were a big enough market in which to buy and sell the goods and services we produce. Of course, the United States has long been the world’s largest national market.
Adam Smith recognized the advantages of foreign trade more than two centuries ago when he wrote:
If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. The general industry of the country . . . will not thereby be diminished . . . but only left to fi nd out the way in which it can be employed with the greatest advantage. 1
Smith’s argument provides the basis for international trade. Country A specializes in making the products that it can make most cheaply. Country B does the same. When they trade, each country will be better off than they would have been if they didn’t specialize and trade.
Absolute Advantage
Let us say that workers in Brazil can produce more cell phones per hour than workers in Arge n tina. But Argentinian workers can turn out more PlayStations per hour than can Brazilian workers. We would say, then, that Brazilian workers have an absolute advantage in producing cell phones, while Argentinian workers have an absolute advantage in producing PlayStations. Absolute adva n tage is the ability of a country to produce a good using fewer resources than another country.
Common sense tells us that Brazil should trade some of its PlayStations for some of Arge n tina’s cell phones. However, the basis for trade is not absolute advantage, but com- parative adva n tage. This concept shows us just how much two countries can gain by trading.
Comparative Advantage
Back in Chapter 2 we introduced production possibility curves, which showed how much a country could produce if its output were limited to just two goods. Now we’ll look at the production possibil i ties frontiers of Peru and Pakistan (see Figure 3).
Notice that the production possibilities frontiers of Peru and Pakistan are straight lines, rather than the curves we had in Chapter 2. To keep things simple, let’s assume that the r e sources used to produce corn are equally suitable for producing cameras. That enables us to have straight-line production possibility frontiers, which will help us demonstrate the law of comparative advantage.
Peru can produce two bushels of corn for every camera it makes. And Pakistan can pr o duce one bushel of corn for every two cameras it makes. Are you ready for the million- dollar que s tion? OK, here’s the question: Should Pakistan and Peru trade with each other?
What’s your answer? If you said yes, then you’re right! That’s because both nations are be t ter off by trading than by not trading. Pakistan gains by trading cameras to Peru for corn; Peru gains by trading corn to Pakistan for cameras. So both nations gain by trading.
Let’s go back to the concept of opportunity cost. What is Pakistan’s opportunity cost of pr o ducing two cameras? In other words, to produce two cameras, what does Pakistan give up?
It pays for nations to specialize, just as it pays for individuals.
Absolute advantage is the ability of a country to produce a good at a lower cost than its trading par t ners.
The propensity to truck, barter and exchange one thing for another is common to all men, and to be found in no other race of animals .
—Adam Smith The production possibilities frontier is a curve representing a hypothetical model of a two- product economy operating at full employment.
1 Adam Smith, The Wealth of Nations, vol. 1, ed. Edwin Cannan (London: University Paperbacks by Methuen, 1961), pp. 478–79.
International Trade 471
The answer is one bushel of corn. Now what is the opportunity cost of growing two bushels of corn for Peru?
Peru’s opportunity cost is one camera. Now we’re ready for the law of comparative adva n tage. The law of comparative advantage states that total output is greatest when each product is made by the country that has the lowest opportunity cost. If the relative opportunity costs of pr o ducing goods (what must be given up in one good in order to get another good) differ between two countries, there are potential gains from trade.
Please glance back at Figure 3. You’ll notice that Peru produces at point D (40 bushels of corn and 20 cameras). Pakistan is at point G (20 bushels of corn and 40 cameras).
Table 2 r e states points D and G.
The law of comparative advantage states that total, output is greatest when each product is made by the country that has the lowest opportunity cost.
Figure 3
Production Possibilities Curves Peru, operating at full capacity, can produce 80 bushels of corn or 40 cameras. Pakistan, operating at full capacity, can produce 40 bushels of corn or 80 cameras.
Bushels of corn
D
E A. Peru
10 10 20
20 30
30 40
40 50
60 70 80
Bushels of corn
G F
H B. Pakistan
10 20 30
10 20 30 40
40
50 60 70 80
Cameras Cameras
C
We know that Pakistan can gain by trading cameras for corn, while Peru can gain by tra d ing corn for cameras. So let’s have Pakistan specialize in the production of cam- eras, placing it at point H of Figure 3. Meanwhile Peru, which now specializes in grow- ing corn, will produce at point C of Figure 3. Table 3 restates points C and H.
Now Peru and Pakistan can trade. Let’s assume the terms of trade are one camera for one bushel of corn. Pakistan will send Peru 40 cameras in exchange for 40 bushels of corn. This brings us to Table 4.
TABLE 2 Production and Consumption of Corn and Cameras before Specialization and Trade
Pakistan Peru
Bushels of corn 20 40
Cameras 40 20
TABLE 3 Production of Corn and Cameras after Specialization
Pakistan Peru
Bushels of corn 0 80
Cameras 80 0
472 C H A P T E R 1 9
It should be pretty obvious that both countries gained by specializing and trading.
Just compare the numbers in Table 2 with those in Table 4. Pakistan gained 20 bushels of corn and Peru gained 20 cameras.
Let’s work out another comparative advantage example. If France used all its resources, it could turn out 10 cars or 20 fl at-screen TVs, while Spain, using all its resources could turn out 5 cars or 15 TVs.
Which country has a comparative advantage in building cars, and which country has a comparative advantage in building TVs? Write your answers here:
has a comparative advantage building cars.
has a comparative advantage building TVs.
Solution: The opportunity cost to France of producing one car would be two TVs. The opportunity cost to Spain of producing one car would be three TVs. So France has a comparative advantage building cars and Spain has a comparative advantage building TVs.
Suppose the terms of trade were fi ve TVs for two cars. Why would it pay for France to trade two cars in exchange for fi ve TVs?
Solution: If France produced both cars and TVs, for every fi ve TVs it made, it would be making two and a half fewer cars. But if France traded with Spain, she could produce just two cars and get fi ve TVs in exchange.
Next question: Why would it pay for Spain to trade fi ve TVs for two cars?
Solution: If Spain produced both cars and TVs, for every two cars she made, Spain would be ma k ing six fewer TVs. But if Spain traded with France, she could produce just fi ve TVs and get two cars in exchange. If you’d like a little more practice, see the box “How Comparative Advantage Leads to Gains from Specialization and Trade.”
You probably never heard of the renowned facelift surgeon Dr. Khorsheed, but he is a legend in his own country, not just for his splendid work, but because of the great illustration he provides of the law of comparative advantage (see the box “To Facelift or to File: That Is the Question”).
Absolute Advantage versus Comparative Advantage
One of the things economists are fond of saying is that you can’t compare apples and oranges. Here’s a corollary: You can’t compare absolute advantage and comparative advan- tage. The words may not exactly trip off your tongue, but still they ring true. Let’s see why.
First, what is absolute advantage? It means that one country is better than another at pr o ducing some good or service (that is, it can produce it more cheaply). For example, the United States enjoys an absolute advantage over Japan in building commercial air- craft. But the Japanese enjoy an absolute advantage over the United States in making cameras. They can turn out ca m eras at a lower cost than we can, while we can build planes at a lower cost than the Japanese can.
So absolute advantage is a comparison of the cost of production in two different countries. What about comparative advantage? Let me quote myself: “The law of com- parative advantage states that total output is greatest when each product is made by the country that has the lowest opportunity cost.”
TABLE 4 Consumption of Corn and Cameras after Trade
Pakistan Peru
Bushels of corn 40 40
Cameras 40 40
473 So we can say that as long as the relative opportunity costs of producing goods
differ among nations, there are potential gains from trade even if one country has an absolute adva n tage in producing everything. Therefore absolute advantage is not neces- sary for trade to take place, but comparative advantage is.
H E L P
E X T R A
J ust glance at Figure A and answer this question: Which country should specialize in producing telescopes and which country should specialize in producing micro- scopes?
Solution: If Canada used all its resources, it could produce either 60 telescopes or 30 micr o scopes. The opportunity cost of producing one microscope would be two telescopes.
If Belgium used all its resources it could produce either 30 telescopes or 90 microscopes. The opportunity cost of producing one telescope would be three microscopes.
Clearly, then, Canada should specialize in making telescopes and Belgium should specia l ize in making microscopes.
If one microscope could be traded for one telescope, let’s see how Canada would gain by trading its telescopes for Belgium’s microscopes.
If Canada didn’t specialize and trade, the opportunity cost for every microscope it produced would be not pro- ducing two telescopes. But it can now trade one telescope and receive in return one microscope. It’s better to give up one telescope in exchange for one microscope than to give up two telescopes for one microscope (by producing both rather than specializing and trading).
Now let’s see how Belgium gains from trading its microscopes for Canada’s telescopes. If Belgium didn’t trade, the opportunity cost of producing one telescope would be three microscopes. But if Belgium specialized in making microscopes, it would give up just one micro- scope in e x change for one telescope.
How Comparative Advantage Leads to Gains from Specialization and Trade
Telescopes
A. Canada
Microscopes
10 20 30 40 50 60
60 50 40 30 20 10
Telescopes
B. Belgium
Microscopes
10 20 30 40 50 60 70 80 90
70 80 90
80 90
70 60 80
90
70
50 40 30 20 10
Figure A
Production Possibilities Curves
Operating at full capacity, Canada can produce 60 telescopes or 30 microscopes. Operating at full capacity, Belgium can produce 30 telescopes or 90 microscopes.
474 C H A P T E R 1 9
“The Gains from Trade” box summarizes most of what we’ve covered over the last fi ve pages. I guarantee that when you have worked your way through this discussion, you will have become a great advocate of free trade.
The Arguments for Protection
America’s gargantuan trade defi cit is a weight around American workers’ necks that is pulling them into a cycle of debt, bankruptcy and low-wage service jobs.
–Richard Trumka, AFL–CIO secretary-treasurer–
As America continues to hemorrhage manufacturing jobs, there is a growing outcry for protection against the fl ood of foreign imports. But American consumers are virtually addicted to Japanese cars, South Korean TVs, Chinese microwave ovens, and hundreds of other manufactured goods from all over the world. How do we justify taxing or excluding so many things that so many Amer i cans want to buy?
Four main arguments have been made for protection. Each seems plausible and strikes a responsive chord in the minds of the American public. But under closer exam- ination, all four are essentially pleas by special interest groups for protection against more effi cient competitors.
(1) The National Security Argument Originally this argument may have been advanced by Amer i can watchmakers, who warned the country not to become dependent on Swiss watchmakers b e cause in the event of war Americans would not be able to make the timing devices for explosives without Swiss expertise. Yet during one long, drawn-out war, World War II, the United States was able to develop synthetics, notably rubber, to replace the supplies of raw materials that were cut off. And the Germans were able to convert coal into oil. It would appear, then, that the Swiss watch argument may have been somewhat overstated.
If our country were involved in a limited war, it is conceivable that our oil supplies from the Mideast might be cut off (although no American president would stand by passively while this ha p pened), but we could probably replace these imports by producing more oil ourselves and by dra w ing on our strategic oil reserve. When Iraqi forces invaded Kuwait in Four main arguments for
protection
Does our dependence on foreign suppliers make us vulnerable in time of war?
Fereydoon Khorsheed is known in his country as the Michelangelo of facelifts. He can do two a day at $3,000 a pop. The only problem is that he has to spend half the day doing paperwork, lea v ing him time to perform just one operation. So he hires Ashok Desai for $200 a day to deal with insurance companies, to do billing, fi ling, scheduling, and to keep the books. Now he is free to spend his entire working time doing facelifts, and his earnings double to $6,000 a day.
A perfectionist, Dr. Khorsheed soon discovers that it takes Mr. Desai a full day to do what he, Dr.
Khorsheed, did in just half a day.
Question: Who has an absolute advantage in doing paperwork and who has an absolute advantage in doing facelifts?
Answer: Dr. Khorsheed has an absolute advantage in both endeavors. Mr. Desai can’t do facelifts at all, and Dr. Khorsheed is twice as fast at paperwork.
Next question: Should Dr. Khorsheed fi re Mr. Desai and do the paperwork himself?
Answer: Clearly not. He now earns $6,000 doing facelifts, pays Mr. Desai $200, leaving a net income of
$5,800. If Dr. Khorsheed did paperwork for half the day, he’d have time for only one facelift and earn just $3,000.
So while Dr. Khorsheed is both a better facelifter and a better paperworker, it pays for him to specialize in facelifting, in which he has a comparative advantage, and leave the paperwork to Mr. Desai.
To Facelift or to File: That Is the Question
International Trade 475
Let’s look at the gains from trade, this time from a somewhat different prospective. By just glancing at Table A, you should easily be able to answer these ques- tions:
1. Which country has an absolute advantage in pro- ducing shoes and which country has an absolute advantage in producing soybeans?
2. Which country has a comparative advantage in pro- ducing shoes and which country has a comparative advantage in producing soybeans?
Did you write down your answers? Please do that now. OK, let’s see if we got the same a n swers:
1. The United States has an absolute advantage in pro- ducing both shoes and soybeans.
2. The United States has a comparative advantage in producing soybeans, while China enjoys a com- parative advantage in producing shoes.
So it will pay for the United States to trade soy- beans for Chinese shoes. And, of course, it will pay for the Chinese to trade their shoes for our soybeans.
I’d like to take credit for this example, but it actu- ally appeared in the Federal Reserve Bank of Dallas’s 2003 annual report. As we’ll see, trade expands the eco- nomic pies of both China and the United States, leaving the consumers of both nations much better off than before they traded. That, indeed, is the reason why economists love free trade.
Table B shows China and the United States before and after trade. Before trade, China produced 500 pairs of shoes and the United States produced 300 pairs. After trade, China pr o duced all the shoes—all 2,000 pairs. So total shoe production after trade rose from 800 pairs to 2,000 pairs.
Now let’s see what happened to soybean produc- tion, which is shown in Table B. Before trade, the United States produced 4,000 bushels, while China pro- duced 3,000. After trade the United States produced 10,000 bushels, while China did not produce any soy- beans. So total ou t put of soybeans rose from 7,000 before trade to 10,000 after trade.
Because trade enabled the United States to special- ize in soybean production, and China to specialize in shoe production, the total output of both goods rose very substantially.
At the bottom of Table B, we have consumption of shoes and soybeans in both countries. Trade enabled China to increase its consumption of shoes from 500 pairs
to 1,500 pairs. In the United Sates, shoe consumption rose from 300 pairs to 500. Similarly, soybean consumption rose from 3,000 bushels to 5,000 in China, while in the United Sates it rose from 4,000 to 5,000.
Let’s sum up. China enjoyed a comparative advan- tage in producing shoes, while the United States had a comparative advantage in producing soybeans. By spe- cializing in the good each n a tion produced most effi - ciently, and then trading for the other good, both nations were much better off.
* Table A and Table B are adopted from the 2003 Annual Report of the Federal Reserve Bank of Dallas, p. 16.
The Gains from Trade
Table A Hypothetical Labor Force and Output, United States and China*
United
China States
Labor force 500 100
Output per worker
Shoes (pairs) 4 5
Soybeans (bushels) 8 100
Table B Hypothetical Employment, Production, and Consumption, United States and China*
United
China States
No Free No Free
Employment Trade Trade Trade Trade
Shoes 125 500 60 0
Soybeans 375 0 40 100
Production
Shoes 500 2,000 300 0
Soybeans 3,000 0 4,000 10,000
Consumption
Shoes 500 1,500 300 500
Soybeans 3,000 5,000 4,000 5,000