ECON102: Principles of Macroeconomics

 

The American statesman Benjamin Franklin (1706–1790) once wrote: "No nation was ever ruined by trade." Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decades – for example, Japan, South Korea, China, and India – have done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.

In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.

A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a country's natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of "drilling a hole." Producing oil in other countries can require considerable exploration and costly technologies for drilling and extraction – if they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world's richest copper mines.

As some have argued, "geography is destiny." Chile will provide copper, and Guatemala will produce coffee, and they will trade. When each country has a product others need, and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage.

Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: "What do we give up to produce this good?" It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity.

For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land, and financial resources to produce other goods, such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simplify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantages in greater detail and relates them to trade.

A Numerical Example of Absolute and Comparative Advantage

Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further, assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries: labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 20.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.

Country	Oil (hours per barrel)	Corn (hours per bushel)
Saudi Arabia	1	4
United States	2	1

Table 20.1 How Many Hours It Takes to Produce Oil and Corn

In Table 20.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing corn.

To simplify, let's say that Saudi Arabia and the United States each have 100 worker hours (see Table 20.2). Figure 20.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.

Country	Oil Production using 100 worker hours (barrels)		Corn Production using 100 worker hours (bushels)
Saudi Arabia	100	or	25
United States	50	or	100

Table 20.2 Production Possibilities Before Trade

Figure 20.2 Production Possibilities Frontiers (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A) or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here, it chooses to produce/consume 60 barrels of oil, leaving 40 work hours to allocate to produce 10 bushels of corn, using the data in Table 20.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce, given the current level of resources and technology.

Arguably, Saudi and U.S. consumers desire both oil and corn to live. Let's say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 20.3 shows. Given the information in Table 20.1, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil, and it can allocate the remaining worker hours to produce 60 bushels of corn.

Country	Oil Production (barrels)	Corn Production (bushels)
Saudi Arabia (C)	60	10
United States (C')	20	60
Total World Production	80	70

Table 20.3 Production Before Trade

The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn – or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 20.4 summarizes these calculations.

Country	Opportunity cost of one unit of oil (in terms of corn)	Opportunity cost of one unit of corn (in terms of oil)
Saudi Arabia	¼	4
United States	2	½

Table 20.4 Opportunity Cost and Comparative Advantage

Again, recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil ( ¼ < 2 in Table 20.4), it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.

In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 20.1) and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 20.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.

Gains from Trade

Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produced/consumed 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receive in exchange an amount of oil greater than 20 barrels, it will gain from trade.

With trade, the United States could consume more of both goods than it did without specialization and trade. (Recall that the chapter Welcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage). Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table 20.5 illustrates the range of trades that would benefit both sides.

The U.S. economy, after specialization, will benefit if it:	The Saudi Arabian economy, after specialization, will benefit if it:
Exports no more than 60 bushels of corn	Imports at least 10 bushels of corn
Imports at least 20 barrels of oil	Exports less than 60 barrels of oil

Table 20.5 The Range of Trades That Benefit Both the United States and Saudi Arabia

The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs, it must give up four barrels of oil for every additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.

Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 20.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 20.3 to that in Table 20.6).

Country	Quantity produced after 100% specialization – Oil (barrels)	Quantity produced after 100% specialization – Corn (bushels)
Saudi Arabia	100	0
United States	0	100
Total World Production	100	100

Table 20.6 How Specialization Expands Output

What if we did not have complete specialization, as in Table 20.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 20.2 shows. Consider what occurs when trade is allowed, and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.

Figure 20.3 Production Possibilities Frontier in Saudi Arabia Trade allows a country to go beyond its domestic production-possibility frontier.

Starting at point C, which shows Saudi oil production of 60, reduces Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 20.3). Notice that even without 100% specialization, if the "trading price," in this case, 20 barrels of oil for 20 bushels of corn, is greater than the country's opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade.