"Mon Dieu!", frets the Frenchman, "Yankeeland is such a colossus that if we let it into Europe it will soon dominate our commerce and all the jobs will go to America. We need steep tariffs to keep American products out of Europe."
The U.S. laborer, recently discharged from his job in the vineyards of Napa Valley, has a different story. "Those French folks, they're willing to work at a wage below the living wage required by Americans. If we tolerate continued sale of French wines in the U.S., it will completely destroy our wine industry and lead to the loss of U.S. jobs to foreign workers. We've got to keep foreign products out of the U.S. or it will wreck our economy."
Given two countries, one of which can produce Product A but not B, and the other can produce B but not A, and given that both countries would like to consume both products, it is easy to make the argument for trade. Suppose Guatemala can produce bananas but not bread (i.e. grain) and it would like to consume both. Suppose Alberta can make bread but not bananas and it would like to consume both. Trade is a means for Alberta to have bananas and for Guatemala to have bread.
It is also easy to argue the benefits of trade where each country can produce both products but where each country has an "absolute advantage" in the production of one of the two products. Suppose both grain and bananas can be cultivated and grown in Alberta but the Canadian farmer if he devotes his time exclusively to the production of grain can easily grow 2,000 bushels in a year whereas, if he devotes his time exclusively to the production of bananas, can, because of the temperate climate, only produce ten pounds of bananas a year. If he splits his time equally between the production of grain and bananas he can have 1,000 bushels of wheat - perhaps ample - but only five pounds of bananas - at most a banana ever other month.
Suppose the Albertan specializes in the production of grain and that he can find a Guatemalan who will swap him a pound of bananas for a bushel of grain. Then the Albertan can harvest the 2,000 bushels he produces, keep 1,000 bushels for his own use, send the extra 1,000 to Guatemala and receive 1,000 pounds of bananas. He ends up with 1,000 bushels of wheat and 1,000 pounds of bananas, far more than he could have had without trade.
Would this swap be advantageous to the Guatemalan? We are talking "mutual absolute advantage" where each country is superior to the other in the production of one product. Suppose the Guatemalan can, in spite of the tropical climate, produce ten bushels of grain per year if he devotes all his time to grain production. By contrast, he can produce 2,000 pounds of bananas. If he devotes half his time to each, he can have five bushels of grain per year and 1,000 pounds of bananas. That may be a bonanaza of bananas but it is a paucity of porridge.
If the Guatemalan can work out the trade - remember a pound of bananas for a bushel of grain - he can devote his time to producing bananas and count on trade to bring him all the bread and cereal he wants. He can, for example, produce the 2,000 pounds of bananas, keep for his own consumption 1,000 pounds (at two or three pounds of banans per day that is all he will want), send the extra 1,000 pounds to Alberta, and receive in exchange 1,000 bushels of grain. He ends up with 1,000 bushels of grain and 1,000 pounds of bananas far more than the five and 1,000 if he divides his time equally and doesn't trade.
Clearly, trade makes sense where one country has an absolute advantage in the production of one product and the other country has an absolute advantage in the production of the other. This is the case sometimes called "mutual absolute advantage."
Can trade make sense to both players if one player has an absolute advantage in the production of both prdoucts? Suppose, as shown in Table 1, that a worker in the US can produce one bushel of wheat per hour whereas the comparable worker in Erehwon requires ten hours to produce a bushel of wheat. Apparently the US worker has an absolute advantage in the production of grain. But suppose she also has an absolute advantage in the knitting and assembly of garments, being able to produce one garment in 40 hours whereas her counterpart in Erehwon requires 50 hours. Given that the US worker is superior to the Erehwonian in the production of both grain and garments, surely the US worker has nothing to gain from trade and ought to be self suficient. We shall see this proposition is not necessarily so.
| Table 1. Production Time Required | ||
|---|---|---|
| Product | in U.S. | in Erehwon |
| one bushel of grain | 1 hour | 10 hours |
| one garment | 40 hours | 50 hours |
Some of the different combinations the US worker might make are presented in Table 2. In combination I, she puts all her time - 2,000 hours - into producing grain and, at one hour per bushels, she can produce 2,000 bushels of grain. This leaves no tiem for garments and she is accordingly garbed like Godiva. At the other extreme, in combination IV, she puts in all her time producing garments. With 2,000 working hours and using 40 hours per garment, she produces 50 garments and no food. She looks marvellous in the garments after the first week or two and her friends all envy her splendid wardrobe and how well she wears it. After the third or fourth week, however, her friends are alarmed to catch her salting her sandals, peppering her pajamas, and braising the buttons on her blouse.
Combination III is a half and half division of her time. She puts in half her time, that's 1,000 hours, producing grain and, at one hour per bushel, produces 1,000 bushels. The remaining 1,000 hours is devoted to producing garments. At 40 hours per garment, she produces 25 garments.
Combination II is your turn. She produces 1,200 bushels of grain and you are asked to figure how many garments she can make. When you think you have the answer, move your mouse over this link.
| Table 2. Production Possibilities - US | ||
|---|---|---|
| Grain Production | Garment Production | |
| I | 2,000 | 0 |
| II | 1,200 | ? |
| III | 1,000 | 25 |
| IV | 0 | 50 |
Thee different production possibilities are displayed graphically in Figure 1. The downward sloping line displays the various possible combinations of grain (horizontal axis) and garments (vertical) that she can produce if she fully uses her time. The labels on this line - "50", "25", "20" and "0" - correspond to the garment possibilities tabulated in Table 2 and you can read the corresponding grain quantities from the horizontal axis. The point marked "50," for example, depicts the production of 50 garments (vertical axis) and no grain, combination IV from TAble 2. The point marked "20," corresponding to combination II, represents 1,200 bushels of grain and the 20 garments you calculated.
(Consistent with the simplifying assumptions made at various places here, the "production possibilities frontier" presented in Table 2 and Figure 1 assumes a linear trade-off between production of grain and garments. A more realistic depiction would doubtless show a graph that is concave from below. More realism can be puchased only at the price of complexity here and it is convenient to assume a simple linear trade-off between production of food and clothing.)
All combinations of grain and garments that the US worker can produce given that she works 2,000 hours per year are represented by points on this production possibilities line. Points to the left of, or below, the line represent production possibilities that she can achieve if she works less than 2,000 hours; they are feasible. Points above, or to the right of, the production possibilities line, represent production combinations that are inconsistent with working only 2,000 hours per year; they are not feasible.
Consider, for example, the point indicated by a small red rectangle and the label "30." it represents production of 1,400 bushels (horizontal axis) and 30 garments (vertical). Verify that it requires more than 2,000 hours of her time.
Now suppose it is possible for her to specialize in the production of grain and then to trade 20 bushels of grain for one garment. Producing 2,000 bushels of grain (and no garments), she might swap 600 bushels of that grain for 30 garments. Why don't you check that such a swap is consistent with the terms of trade suggested here? As summarized in Table 3, she ends up with 1,400 bushels of grain and 30 garments. This very combination represented by the small red square in Figure 1 is the same combination you determined was not feasible, that she could not achieve that combination with the production possibilities trade-offs we assumed and in the absence of trade.
| Table 3. A Consumption Possibility With Trade - US | ||||
|---|---|---|---|---|
| Production | Imports | Exports | Consumption | |
| Grain | 2,000 | 600 | 1,400 | |
| Garments | 0 | 30 | 30 | |
Note that this "consumption possibility" must be superior to the two points labelled "25" and "20" in Figure 1. Thus, in relation to the pointed marked "25," the red rectangle must be superior because it represents more grain (1,400 bushels as compared to 1,000) and more garments (30 as compared to 25). And, as you verified with regard to the point labelled "20," the red rectangle represents more grain (1,400 bushels compared to 1,200) and more garments (30 compared to 20). If we assume "more" is better then the red rectangle represents a consumption possibility that is superior to that represented by the other two points.
Implicit here is the crass assumption of economics that "more is better." Perhaps 1,200 bushels of grain (your point represented by the number "20" in Figure 1) is quite enough for a healthy diet so that the 1,400 represented by the red rectangle is not superior. But it is not inferior since the extra 200 bushels can either be thrown away or, better, given to the homeless and hungry.
To get a better idea of the consumption possibilities in the US, consider Figure 2. From Figure 1 it repeats the production possibilities line labelled "50/25/20". This production possibilities line also depicts consumption possibilities in the absence of trade. Consistent with our "more is better" orientation, points above or to the right of this production possibilities line represent superior consumption possibilities.
The triangle LMN in Figure 2, enclosing as it does the feasible possibilities that would be of interest to one or the other party to the swaps, represents the area of particular interest. The LN border bounds the area that would be of interest to the US trading partner. The slope of this line - namely 40 bushels for one garment (divide the 2000 horizontal intercept by the 50 vertical intercept) - suggests the limit of what would be interesting to the US trading partner. If she must give more than 40 bushels for a garment, she is better off to take 40 hours away from the production of grain and to use it to produce a garment. She is indifferent to trades taking place represented by points on this line LN and all the advantage from trade goes to the Erehwonian. The MN border of this triangle is the opposite extreme: it represents trades at five bushels being swapped for one garment. At five bushels per garment, as we shall see, the Erehwonian would be indifferent to trade and the US farmer would get all the advantage from trade. The LM border to the triangle represents, assuming the Erehwonian works 2,000 hours per year and requires 50 hours to produce a garment, the upper limit of 40 garments that are available to trade for wheat. Points within the triangle LMN are feasible and represent different trades that might make sense to both partners. For example, 1,400 bushels and 30 garments, the red rectangle labelled "30" in Figure 2, represents the trade discussed in connection with Table 3 and which you verified implied consumption that was not possible without trade. The American farmer correctly concludes - see Figure 2 - that we can gain from trade.
Trade will only flourish if both parties gain. We've perused the US perspective; let's now examine the Erewhonian.
Assuming that the Erehwonian also works 2,000 hours per year and recalling (Table 1) that it takes him 10 hours to produce a bushel of wheat and 50 hours for a garment, some of the production possibilities for the Erehwonian are tabulated in Tabe 4. If, for example, as shown in combination I, he puts in all his time producing grain, he will produce 200 bushels and no garments. In combination III, putting in half his time on each, he produces 100 bushels and 20 garments. In combination IV, devoting all his time to production of garments, with 2,000 working hours and requiring 50 hours per garment, he produces 40 garments. For combination II, assuming he devotes 75 percent of his time to production of grain, you should determine how many garments he can produce.
| Table 4. Production Possibilities - Erehwon | ||
|---|---|---|
| Grain Production | Garment Production | |
| I | 200 | 0 |
| II | 150 | ? |
| III | 100 | 20 |
| IV | 0 | 40 |
These production possibilities are depicted graphically in Figure 3. Points on the line "40/10/0" represent different combinations of grain and garments he can produce. Points on the line, which imply working the full 2,000 hours, and points below or to the left of the line, implying working less than 2,000 hours per year, are feasible production possibilities. Points above the line or to the right of it, requiring more than 2,000 hours, are not feasible. Verify, for example, that the red rectangle labelled "10" representing 600 bushels and 10 garments designates a production possibility not consistent with the 2,000 working hours assumption.
Now consider trade and assume, as before, one garment can be swapped for 20 bushels of grain. If Erewhon ships 30 garments to the US and receives in exchange 600 bushels of grain, as summarized in Table 5, Erehwon can consume 600 bushels and 10 garments, the red rectangle in Figure 3. It can vastly increase its consumption possibilities as compared with the no-trade situation.
| Table 5. A Consumption Possibility With Trade - Erehwon | ||||
|---|---|---|---|---|
| Production | Imports | Exports | Consumption | |
| Grain | 600 | 600 | ||
| Garments | 40 | 30 | 10 | |
To further explore trade from the perspective of Erehwon, consider Figure 4. The triangle "40/0/0" represents the area of interest. Points within this triangle represent combinations of grain and garments that Erehwon might be able to achieve through trade.
The left side of this triangle, "40/10/0" represents the production possibilities frontier from Figure 3. Trade taking place at five bushels for one garment, the ratio implied by the slope of this line, has little interest for the Erehwonians. If the Erehwonian wants five bushels of grain, he can simply cut back on production of one garment, freeing up 50 hours of his time with which he can produce, at 10 hours per bushel the five bushels of grain. Furthermore, points below this production possibility line, or to its left, are very unattractive. He can produce more grain by shifting production from garments to grain than he could obtain by producing the garments and trading them for graim at terms of trade implied by points to the left of the production possibilities line. This production possibility curve designated "40/10/0" corresponds to the termsof trade implied by the red line MN in prior Figure 2. To the extent trade takes place at points represented by this line, the US gets the full advantaage of the swap and the Erehwonians are indifferent.
Now consider the diagonal red line labelled "40/0". If the terms of trade are that 40 bushels swap for one garment, starting with 40 garments, the Erehwonian can arrive at any combination of grain and garments represented by points on this line. If, for example, he wants to be adorned like Adam, he can swap the 40 garments he produces for 1,600 bushels represented by the intersection of the red line with the horizontal axis. The trades represented by points on this red line, however, will result in little enthusiasm from the US farmer. She can arrive at these various combinations quite on her own without the help of the Erehwonian. The diagonal red line assumes that all the benefits of trade go to the Erehwonian and none to the US farmer.
Between the production possibilities frontier and the diagonal red line, Figure 4 depicts combinations that benefit both trading partners, both benefit. The small red rectangle in Figure 4, for example, corresponds to 600 bushels and 10 garments which is more than the Erehwonian could achieve without the benefit of trade. The similar red rectangle in prior Figure 2 corresponded to the US farmer achieving 1400 bushels and 30 garments. The totals for the trading partners are 2,000 bushels (600+1400) and 40 garments (10+30). These totals result from the US farmer producing 2,000 bushels and the Erehwonian producing 40 garments with both specializing in the product in which they have a "comparative advantange."
Foreign trade theory simply extends the concept of specialization across international boundaries. Early economists - particularly Adam Smith in 1776 - extolled the efficiencies gained from specialization. You, as a financial executive, know that it is better to spend your time working with issues in finance, accounting and economics, than to spend your time in marketing or production. You have a "comparative advantage" in understanding issues such as now being discussed over somebody with a degree and experience in marketing.
A few decades after Adam Smith, English economist David Ricardo demonstrated that specialization also applied to the application of resources in the international sphere by enunciating the "theory of comparative advantage" that we are now discussing. Just as it makes sense for you to specialize in finance and economics while other specialize in physics and fire fighting, so it makes sense for Guatemala to produce bananas and Kansas to produce corn.
Eighteenth and Nineteenth Century economists tended to approach issues such as this from the perspective of the "Labor Theory of Value" according to which a basic, perhaps "the" basic, factor of production was labor. Consistent with this approach, you and I have been discussing international trade in terms of the time it takes the US farmer and her Erehwonian counterpart to produce grain and garments.
But Twenty-First Century managerial persons like you and I realize that production involves, in addition to labor, several other factors of production such as land, capital, technology, managerial ability and a willingness to bear risk. The arguments made so far apply to these other factors of production as well.
Consider, for example, Table 6 which relates to the production possibilities for the two countries for a "package" or resources or factors of production. The "package" might be a certain number of workers, so many acres of land, a certain amount of capital, etc. The numbers are one thousand times the productive capacity of the US farmer and the Erehwonian worker but we are no longer talking about labor by itself but rather a package of resources that includes certain amounts of labor, land, etc.
| Table 6. Production Possibilities | ||
|---|---|---|
| United States | Erehwon | |
| Bushels of Grain | 2,000,000 | 200,000 |
| or Garments | 50,000 | 40,000 |
As before, assume a linear trade off is possible in both countries so that the US could either produce 2,000,000 bushels of grain or 50,000 garments or it could produce some linear combination of the two such as 1,600,000 bushels and 10,000 garments by applying 80 percent of its resources to the production of grain and 20 percent to garments. (Yes, admittedly this linear tradeoff does some violence to the comments about specialization a few paragraphs back.) Similarly, the Erehwonians, devoting 80 percent of their resources to the production of grain and 20 percent to garments, might produce 160,000 bushels and 8,000 garments. Total grain production of the two countries is therefore 1,760,000 bushels. Observe that the US could, if it specialized in grain production and could count on trade to provide it with enough garments, produce 2,000,000 bushels, which is more than the 1,760,000 bushels the two countries can produce by devoting 80 percent of their resources to the production of grain.
Similarly, applying 20 percent of their resources to garment production, the US produces 10,000 garments and Erehwon 8,000 garments, a total of 18,000 garments. Observe that Erehwon, if it specialized in garment production and could count on trade to provide it with enough grain, could produce 40,000 garments or more than twice as many garments.
If both countries can specialize in the production of the product in which they have a comparative advantage, then the total production of the two countries is greater than if they act alone. If trade can be counted on to distribute this largesse in some manner so that both countries can arrive at more than if they act along, then trade clearly pays.
It isn't necessary for the purpose of this argument to assume that the package of resources used in the US to be the same size as the package in Erehwon. Let the US package consist of 1,000 workers and the Erehwonian of ten and let's go back to the "labor theory of value." Now the 1,000 US workers produce 2,000 bushels each, as before, and the ten Erehwonians produce 20,000 bushels each, not as before. Now the Erehwonians have an absolute advantage in the production of wheat. Or, if the 1,000 US workers make garments they can make 50,000 garments, or 50 garments each, as before, but, if the 10 Erehwonians work on garments, they can make 4,000 garments each, a very considerable absolute advantaage. Now, if we want to talk "absolute advantage" per worker, the Erehwonian has it all over the US worker. As before, however, it still makes sense for the US to specialize in the product in which it has a comparative advantage - yes grain - and for Erehwon to specialize in garments and to use trade to distribute the bounty - the extra world production over what could be produced if each tried to be self sufficient.
Nor, dropping the labor orientation, need we assume that the constituents of the two productive packages in the two countries are the same. Let the US productive package in Table 6 consist of 75 workers, 50,000 acres, 5 tractors and 4 combines and let the Erehwonian production package consist of 200 workers and 1,000 acres and still the results are the same. Let the US package of factors of production be capable of producing eiher 2,000,000 bushels or let it be capable of producing 50,000 garments and let the Erehwonian package be capable of producing either 200,000 bushels or 40,000 garments - these again are the numbers in Table 6 - and, given suitable terms of trade, it will make sense for the US package to be devoted to the production of grain and the Erehwonian to the production of garments.
Comparative advantage is an "alternative opportunity" cost concept. Don't let that fancy term throw you as it can easily be illustrated with a few simple ratios from Table 6.
Consider first the tradeoff between grain and garments in the US. In the US we can produce either 2,000,000 bushels or 50,000 garments; that is 40 bushels per garment. Suppoe we are already producing some of both and we want another bushel of wheat. Given that it takes the same amount of resources to produce 40 bushels as one garment, another bushel requires us to sacrifice 1/40 th of a garment. One fourtieth of a pair of trousers is a belt loop. That's nothing; keep your coat buttoned and nobody will notice one of your belt loops is missing. The cost of a bushel of wheat in terms of the sacrifice of clothing is minimal.
It's a different story in Erehwon. The Erehwonians can produce 200,000 bushels of grain or 40,000 garments; that is five bushels per garment. If they want another bushel they must give up one fifth of a garment. One fifth of a pair of trousers is the belp loops, the zipper and part of a leg; be careful, people may notice! The cost of bushels in terms of garments is greater in Erehwon.
To summarize, measuring cost of bushels in terms of garments sacrificed, that cost is trivial in the US but could be substantial in Erehwon. The cost of grain in the US in terms of garments not produced is cheaper than in Erehwon. We should produce grain where the cost is less in terms of the sacrifice of garments. We should prdouce the grain in the US.
Now let's consider the cost of garments in terms of grain. Recall that in the US, 40 bushels requires the same productive resources as one garment. Given that the US is producing both, to get one more garment, it must give up 40 bushels of wheat. Now consider Erehwon...
Wait a minute! Specialization ought to work between you and me too. How about if I do the explaining and if you do the exploring? Why don't you figure the cost of producing garments in terms of bushels sacrificed or lost in both countries and determine which has the comparative advantage in the production of garments. Then mouse here.
Hopefully, you will agree that that the cost of garments - in terms of grain foregone -is far less in Erewhon than in the US. Erewhon has a comparative advantage in garments.Here's another way you might view the numbers in Table 6. The US can produce 10 times as much grain as Erehwon but only 25 percent more garments. It should specialize in grain. Erehwon can produce only one tenth (10 percent) the grain of the US but it can make 80 percent as many garments. It should specialize in garments
Can there be situations in which trade provides no benefit? There can indeed. Consider Table 7 in which the figures are the same as those in Table 6 except that Erehwon can now produce 1,600,000 bushels. Playing with the ratios, you will note that neither has a comparative advantage in either product. For both countries, the cost of another bushel is one fortieth of a garment. In both countries they must sacrifice a belt loop if they want another bushel. Likewise the cost of a garment in terms of grain is 40 bushels and that's true in both countries. This situation suggests that a farmer in Saskatchewan who plants oats and durum wheat will not gain much from trade with a Manitoba farmer who plants the same crops.
| Table 7. Production Possibilities Revised | ||
|---|---|---|
| United States | Erehwon | |
| Bushels of Grain | 2,000,000 | 1,600,000 |
| or Garments | 50,000 | 40,000 |
You look wide awake and very intent. To prove to yourself that's so, why don't you go back to Table 6, leave the Erehwon numbers alone and suggest one change in the US numbers so that trade loses its appeal. Then revert to the original numbers in Table 6 and suggest a different change to the US numbers so that again trade would have few advantages.
While there are doubtless situations in which neither potential trading partner has a comparative advantage over the other, or where the comparative advantage is more than overshadowed by transportation costs and other inconveniences of accomplishing the swap, nevertheless trains, trucks and shipping armadas testify to the prevalence of trade and, where the trade occurs between developed and underdeveloped countries, to the significance of comparative advantage.
You may be wondering about the mechanics of making these swaps. The US farmer doesn't speak Erehwonian and the Erehwonian hasn't met the US farmer. Neither wants to visit the other country. How do they get together?
With the help of a vast network of merchants, jobbers, arbitrageurs and others, the US farmer and the Erehwonian get together through the marketplace. In that marketplace they are confronted by prices and exchange rates. Are there forces working in these markets to facilitate trade?
Consider first what the prices might be in the absence of trade. Let some US workers use their 2,000 hours to produce 2,000 bushels of grain and let the price of grain be $20 a bushel. Their annual income will be $40,000. Let other US workers use their 2,000 hours to produce garments which, recalling that it takes 40 hours to produce a garment in the US, allows them to make 50 garments. If these workers expect to earn as much in a year as the grain-producing farmers, they should be able to sell these garments for $800 each so that they too will earn $40,000 per year.
If the prices do not permit farmers and garment workers to earn approximately the same annual income we would expect workers to move to the occupation which pays more and this migration of workers ought to increase the production of the product which provides the higher income and this greater production would be expected to put downward pressure on the price of that product. Suppose, for example, the price of grain is $50 a bushel so that the farm worker earns $100,000 a year. We would expect garment workers who earn only $40,000 a year to move into the agricultural area and as the number of such farm workers increases and grain production increases, we would expect the price of grain to go down. At the same time, with fewer garment makers, we would expect fewer garments to be made and as they become scarcer we would expect their price to increase. Accordingly, in the absence of trade with Erehwon, we would expect garments, which take 40 times as long to produce in the US as grain to sell for 40 times as much. In Table 8, you will accordingly find in the US column prices that conform to this 40 to 1 relationship and we are going to use $20 a bushel and $800 a garment.
Editorial aside: Throughout this discussion of trade and comparative advantage, we have used numbers that are round and easy to work with and no pretense is made that they conform to actual conditions in the US. Per farm worker a great deal more than 2,000 bushels can be produced in a year, and we would hope that what the farmer earns in compensation for his/her time (forget what he/she gets as a reward for the use of capital and for bearing risk) is a great deal more than $40,000 per year. Further, at the time of this writing, the price of grain is nowhere near $20 a bushel. Further editorial comment: As our federal government continues to print money (euphemistically called "monetizing the public debt"), you can count on the price of grain going far in excess of $20 a bushel.
| Table 8. Prices Without Trade | ||
|---|---|---|
| United States | Erehwon | |
| Bushels of Grain | $20 | 100YU |
| or Garments | $800 | 500YU |
Recalling from the earlier discussion that an Erehwonian requires ten hours to produce a bushel of grain and can produce a garment in 50 hours, and making the same assumptions about the mobility of resources in Erehwon and the absence of trade, expect the price of a garment to be five times the price of a bushel of grain. The currency unit in Erehwon is the YU and, respecting the five to one ratio, in Table 8 you will see that the price of grain is 100 YUs per bushel and the price of garments is 500 YUs.
Now let there be trade and let the initial exchange rate be $1 trades for 1/2 YU. At that exchange rate the American has little incentive to buy from Erewhon. Consider first the cost of buying domestic grain versus the cost of buying Erehwonian grain. The US citizen can buy a bushel of US grain for $20. If she were to take that $20 and convert it into YUs at $1 for half a YU, she would get only 10 YUs and, with grain selling for 100 YUs in Erehwon, the 10 YUs would permit her to buy only one tenth of a bushel. With $20 she can buy either a full bushel in the US or she can buy only a tenth of a bushel in Erehwon. She will buy in the US.
Similarly, assuming one dollar buys only half a YU, she will prefer to buy her garments in the US rather than Erehwon. Why don't you, to confirm the high opinion I have of you for working this far through a difficult manuscript, take the $800 she would require to buy a garment in the US, translate that into YUs and determine what fraction of a garment she could buy in Erehwon. With an exchange rate with $1 trading for half a YU, we may conclude she would buy both grain and garments from US sources.
Using this same exchange rate, it can easily be seen that the Erehwonian would prefer to buy both products in the US rather than in Erehwon. I'll do the arithmetic for grain. He could buy a bushel of grain in the Erehwonian market for 100 YU. That same 100 YU could, assuming $1 trades for half a YU, be used to acquire $200 in the foreign exchange market. With $200 the Erehwonian could buy, at $20 per bushel, ten times as much or 10 bushels in the US market. The Erehwonian would buy grain in the US market rather than the Erehwonian market.
It's your turn. Confirm that with the 500 YU required to buy a garment in Erehwon, the Erehwonian could buy a garment in the US market and have money left over.
We have seen that with $1 trading on the foreign exchange markets for half a YU both the American and the Erehwonian would find it advantageous to buy both grain and garments in the US market. US productive resources - labor, land, capital, etc. - would be kept busy producing the grain and garments for both countries. At the other extreme, there would be no work for the Erehwonian worker, no crops to plant, no use for his sewing machines.
Presumably this situation would not long last. At least three things might happen to change it.
First, with plenty of business for US producers and US resources stretched to their limits, we might find US prices rising. Suppose, for example, that US prices doubled. Grain, even at $40 a bushel, would still be a bargain for the Erehwonian. In Erehwon, it requires 100 YU to buy a bushel but 100 YU can, at $1 for half YU, be used to acquire $200, and $200 - even at $40 per bushel - can be used to buy five bushels rather than the paltry one that could be purchased in Erehwon. The Erehwonian would still find it desirable to buy grain in the US.
But if the price of garments doubled in the US, from $800 to $1,600, the Erehwonian would no longer buy in the US market. The 500 YU he could use to buy an ensemble in Erehwon would translate to $1,000 and that $1,000 would not be enough to buy a garment in the US. The Erehwonian would buy his garments in Erehwon.
The American might likewise find it attractive to buy her ensembles in Erehwon. The $1,600 she would now need to buy an ensemble in the US could, at an exchange rate of $1 per half YU, be traded for 800 YU and 800 YU would be enough to buy an ensemble for 500 YU in Erewhon and leave 300 YU for some other purchase.
To summarize, if prices in the US were twice as high as shown in Table 8, the consumers of both countries would find it to their advantage to buy grain in the US market and both sets of consumers would want to buy their garments in the Erehwonian market. That result corresponds to what the theory of comparative advantage suggests in this illustration: the US should produce grain for both markets since the US has a comparative advantage in grain; and Erehwon should produce garments for both markets as Erehwon has a comparative advantage in garments.
Second, instead of prices rising in the US, prices might fall in Erehwon. Recall that with the prices in Table 8 and with an exchange rate of $1 per half YU, everybody bought in the US and nobody bought in Erehwon. WIth no Erehwonian products being sold, presumably the productive resources in Erehwon will be underutilized. The workers will be unemployed, the land will lie fallow. Perhaps the prices of some of the factors of production will be reduced and perhaps the prices of grain and garments will reflect the lower costs of the productive resources. Why don't you determine how much the price of garments would have to fall in Erehwon to persuade the Erehwonians to buy at home and to begin to persuade the Americans to buy garments in Erehwon.
Good for you! Now take that price reduction you just determined, assume that the price of grain in Erehwon goes down by a similar percent, and show that the consumers of both countries would continue to buy their grain in the US market.
Presumably there would be some price movement, possibly slight, in both countries with US prices rising and Erehwonian prices going down. The combined effect of both price movements would tend to promote the sale of American grain in both markets and the sale of Erehwonian garments in both markets.
A third event, possibly more interesting in the present context, might occur so that, even if the prices in both countries remained the same as in Table 8, trade would still take place as predicted by the theory of comparative advantage: the exchange rate might change with the dollar becoming more valuable in relation to the YU.
At the prices in Table 8 and with $1=0.5YU, it has been shown that the consumers of both countries would tend to buy both products in the US. That implies that US dollars stay "at home" but it also implies that Erehwonian YUs migrate to the US. As the Erehwonians buy more and mrore in the US, they part with more and more YUs, and these YUs begin to accumulate in the hands of foreign exchange dealers, in US businesses, in US banks and in our federal reserve system. Here a YU, there a YU, everywhere a YU YU. Eventually foreign exchange dealers, US businesses, US financial institutions begin to wonder if there is any point accumulating more YUs since the only purpose of YUs is to buy Erehwonian products that can be bought more cheaply in the US. Eventually the value of the YU should decline in foreign exchange markets or, and this is the same in a two country model, the value of the US dollar should rise in relation to the YU.
Suppose that eventually the YU weakens (or equivalently the dollar strengthens) so that $1=1YU. At that exchange rate, the consumers in both countries would continue to find it advantageous to buy grain in the US. The Erehwonian, for example, could take the 100 YUs required for a bushel in Erehwon, convert it to $100 and use it to buy five bushels in the US. Likewise, the consumers in both countries would find it advantageous to buy garments in Erehwon. The US consumer, for example, could take the $800 required for a US garment, convert it to 800 YUs, use 500 YUs to buy a garment in Erehwon and have 300 YUs left over. As suggested by the theory of comparative advantage, if the exchange rate were $1=1YU, consumers in both countries would buy grain in the US and consumers in both countries would buy garments in Erehwon.
The word "eventually" occurs several times in the last two paragraphs. Do not expect a prompt adjustment in the exchange rate to occur to validate the concepts of comparative advantage. Beside the balance of trade, many other factors - international capital movements, the operations of central banks, the activities of the International Monetary Fund - influence exchange rates so that prompt adjustments to realign trade with the theory of comparative advantage are not to be expected. A tendency - a long-run tendency perhaps - for exchange rates to reflect comparative advantage exists. Let one country specialize in consuming rather than producing for a long period of time (the US from 1979 to 2007 perhaps?) and one would expect the value of its currency to decline, yes "eventually."
One factor, for example, that might bolster the value of a currency above a value consistent with comparative advantage concepts for a long period of time is a belief in the wisdom of the fiscal and monetary policies pursued by that country. For an extended period following WWII financial leaders in many countries considered the US dollar to be the "currency of choice." During the early part of this period, this belief was doubtless bolstered by the productive prowess of the US. But any belief in the wisdom of US fiscal and monetary policies could only be supported by the even less disciplined policies of some other countries such as several in South America. Since 1979, however, in the face of mounting trade deficits, the US continued to follow fiscal and monetary policies based on the conviction that the dollar would always be a strong currency and that the productive might of the US would continue to guarantee US prosperity. Leading financial institutions in the US and many of its economists have espoused the view that a little inflation - say two to four percent a year - is a good thing and is even a prerequisite to maintaining full use of productive resources. While there is limited empirical evidence that low levels of inflation "go with" high levels of emploment, there is overwhelming evidence that high levels of inflation are consistent with social chaos and complete stagnation. In the German hyperinflation of 1922-25, the only employment German workers could find was unpaid service distributing handbills for Nazi and Communist causes.
As technology improves over the decades, the long-run trend of prices should be downward - two to three percent a year - rather than upward two to four percent a year. The Fed belief that a little inflation is a good thing - has a doctor ever told you that a little fever is a good thing? - is consistent with ever-growing federal deficits, monetizing the public debt (yes printing money) and social chaos. It is consistent with zero employment, zero production and zero trade.
Returning from this editorial aside on a world that tolerates "debasing" the currencies of all players, let us investigate what exchange rates are consistent with comparative advantage in a sane world. Given the prices in Table 8, we have seen that an exchange rate of $1=1/2 YU results in the consumers of both countries buying both grain and garments in the US; in other words, it results in a situation which, in a long-term perspective, is incompatible with comparative advantage and incompatible, in a very long-term perspective, with a continued exchange rate of $1=1/2 YU. If the dollar strengthens and the YU weakens so that $1 =1 YU, we have also seen that, consistent with comparative advantage theory, both sets of consumers buy US grain and both buy Erehwonian garments. At what exchange rate between $1=1/2 YU and $1=1 YU will Erehwonian garments begin to compete with US garments?
For Erehwonian garments to be competitive in this simple two nation model, and given the prices in Table 8, the exchange rate must be such that the consumers in the two nations, jingoistic considerations aside, find that Erehwonian garments cost no more than US garments. Thus a US consumer who would have to pay $800 for a garment in the US must, with $800, be able to acquire 500 YU to enable her to buy an Erehwonian garment for no more than $800. If $800=500 YU is the proper relationship, then, dividing both sides of the equality by 800, we arrive at an exchange rate of $1=0.625YU. At such an exchange rate, the US consumer can take the $800 she would require for a US garment, could convert it into 500 YU (namely 800 X 0.625) and have enough to buy a garment in Erehwon. Likewise, the Erehwonian, at $1=0.625YU, could take the 500 YU required to buy a garment in Erehwon and convert it into $800 (namely 500/0.625) and would have the $800 needed to buy a garment in the US; the Erehwonian could buy the garment in either country for 500 YU. As the dollar strengthened so that $1 was worth more than 0.625 YU, the consumers of both countries would find it cheaper to buy their garments in Erehwon.
Notice that, while $1=0.625 YU permits consumers in both countries to buy garments in either country at the same price, such an exchange rate does not make the consumers of the two countries change where they buy their grain. With the $20 needed to acquire a bushel in the US, the US consumer could only acquire 12.5 YU (or 20 X 0.625) and 12.5 is nowhere near the 100 YU required to buy a bushel in Erehwon. Likewise the Erehwonian, who would need 100 YU to buy a bushel in his home country, could use that 100 YU to acquire $160 (or 100/0.625) and $160 would permit the Erehwonian to buy 8 bushels in the US at $20 per bushel. Both sets of consumers would, at $1=0.625YU prefer to buy their grain in the US.
Inasmuch as you are now an expert in comparative advantage (you've gone this far haven't you?) and related exchange rate issues, why don't you determine what the exchange rate would have to be to make the two sets of consumers indifferent concerning where they bought their grain. At this exchange rate you've just determined, the US consumer could use the $20 required to acquire a bushel in the US to acquire 100 YU which would permit her to buy a bushel in Erehwon. Likewise, the Erehwonian could buy grain in his home market for 100 YU or could use the 100 YU to acquire $20 which would permit him to buy a bushel in the US.
One more project for you. At what exchange rate would the consumers of both countries prefer to buy both products in Erehwon. At such a price dollars would flow from the US to Erehwon as US consumers bought both grain and garments in Erehwon and no YUs would flow from Erehwon to the US as Erehwonians would find it cheaper to buy both products in their home market. Again, we would expect in the long run, pressures to re-establish two-way trade. As YUs disappeared from the US and as dollars begin to accumulate in Erehwon, we would expect the dollar to decline in value so that it could not be used to acquire 5 YU; stated differently, we would expect the relative value of the YU to rise so that 5 YUs could be used to acquire more than $1. In the long run, possibly a lengthy long run, we would expect exchange rates to be such that trade conformed to the concepts of comparative advantage.
To summarize, at exchange rates between $1=0.625YU and $1=5YU, we would expect bilateral trade and a confirmation of comparative advantage.
Changes in trade patterns can be painful. Let some US workers be producing garments in a no-trade environment and let trade then be permitted and further suppose that there is now a comparative advantage for garments from Erehwon. US gament workers, long comfortable in their trade, are now likely to be unemployed. They can of course move to farming but are likely to resist the challenges of changing occupations and of moving to new areas. While much of the theory of comparative advantage assumes mobility of factors of production within the borders of a nation (see below), nevertheless there is frictional unemployment and resistance to change. Frequently the potential victims of the trade challenge call on their government for "protection."
Of the many weapons of protection - and we shall discuss only a few - perhaps the simmplest is an import embargo. Let the US forbid the importation of garments and the garment workers are "protected" in a sense. They are "protected" from competition with Erehwonian garments which is to say that the US - and perhaps Erehwon - may be denied the consumption possibilities presented by trade.
Import quotas, less Draconian than outright import embargos, limit the amount of a foreign product that can be imported into a country. Thus the US negotiated with Japan in 1981 a "voluntary" restraint on the number of Japanese-made cars that could be imported into the US market, a restraint which was dropped a few years later.
Import tariffs impose a tax on foreign products entering the domestic market. The U.S. has many of these - on orange juice and on rubber footwear, for example - and their presence is a testament to the political power of the protected domestic industries. It is also a testament to the sloth of US consumers who permit themselves to be denied the benefits of free trade. It witnesses the power of the organized few over the disorganized many.
The reverse of an import tariff is an export subsidy. In the early part of the Nineteenth Century, the English landed gentry who played a key role in United Kingdom politics, fought to maintain the Corn Laws which provided a subsidy for UK agricultural exports. In the midst of the debate which preceded the repeal of the Corn Laws, David Ricardo, English economist and politician, enunciated the theory of comparative advantage much as we know it today. Thanks to the farm lobby many nations continue to subsidize the export of agricultural products. Export subsidies, just like import tariffs, disturb the more productive use of resources that would result from unshackled trade. An export subsidy favors one industry at the expense of others and thereby distorts the pattern of international production that would otherwise prevail.
Some trade restrictions relate to the practice of "dumping." This term relates to the attempt of the industry of one nation to take over the market of another by selling below cost in that other nation, the theory being that when the industry in the target country has been destroyed, the marauding industry will raise prices to high levels. Under the Comprehensive Trade Act of 1988, the US President has the power to impose trade sanctions if an investigation reveals dumping by foreign companies or industries. The US Department of Commerce has a staff that diligently explores dumping complaints made by US industries. On their surface, anti-dumping activities such as these seem to be benign and indeed seem to reinforce free trade principles.
Caution should, however, be exercised in anti-dumping activities. Let's suppose that Japan has no particular comparative advantage in the production of autos and further suppose it costs a Japanese manufacturer $60,000 (US equivalent) to manufacture a car and that the manufacturer attempts to take over the US market by selling in the US at $50,000. Does this really threaten the US auto industry? If $60,000 really is the cost of making these cars and the putative dumper sells them both here and in the home market (Japan) at $50,000, the dumper threatens its own financial existence even more directly than it threatens the US auto maker. If this really is what the Japanese car maker is doing it may for a few years threaten the US auto industry but it surely guarantees the extinction of the Japanese manufacturer unless it can quickly destroy the world market and then take over. If the dumper sells in the home market at the same price as in the foreign market and if that price is below average cost for an extended period of time, it is reasonable to suppose that the dumper will be driven out of business and the US industry may have some opportunities in the Japanese market.
Often dumpers do not sell in the foreign market at the same price as in their domestic market; instead they may maintain a higher price at home than abroad. Suppose Japanese made cars sell in the Japanese market at the equivalent of $100,000 and let the Japanese exporters attempt to take over the US market by doubling their production and selling in the US market at $50,000 and let the average cost of all cars produced be greater than $50,000. Is this dumping? If it is, it is providing the US consumer with cars at a low price in terms of their cost and further note that in a very real sense the Japanese consumer who buys at $100,000 is subsidizing a US consumer who buys at $50,000. If Japanese consumers want to subsize Americans, should we deny them that pleasure?
| Table 9. Average and Differential Cost | ||
|---|---|---|
| Cars Produced | Total Cost | Average Cost |
| 100,000 | $6,000,000,000 | $60,000 |
| 200,000 | 11,000,000,000 | 55,000 |
| Differential cost per car = (11,000,000,000-6,000,000,000)/100,000 | $50,000 | |
Let's also be cautious about what we mean by "selling in the US below cost." Let the average cost of the first 100,000 cars produced per year be $60,000 as in the previous paragraphs and let 100,000 cars be what the company can sell in the Japanese market. Total production costs are accordingly $6 billion. Now let the manufacturer double production to be able to invade the US market with the extra 100,000 cars and let the total cost be $11 billion. Yes, we are assuming that the extra 100,000 cars do not cost an additional $6 billion. Auto production is a labor intensive activity and there may be a "learning curve" at work here. Note that 200,000 cars costing $11 billion implies that the average cost per car is $55,000. Anti-dumping arguments should not come into play if the Japanese sell their cars at more than $55,000.
But economics by and large teaches us that we should "live at the margin," and we should make decisions "at the margin." The additional cost of the extra 100,000 cars produced is $5 billion (namely $11 billion less $6 billion). The differential cost per car is accordingly $5 billion divided by 100,000 cars, or $50,000. The Japanese manufacturer can increase its profit it it can sell the additional cars at more than $50,000 in the US market.
Oh yes, and to increase its profit it must maintain its price at $100,000 in the Japanese market. Selling in the US market at a price below average cost may well be dumping; this is a legal question. But for the dumper to maintain and improve its profit, it must have the financial support of its domestic market. In the hypothetical circumstances posited here, the Japanese consumer, the Japanese car buyer is the one who really bears the brunt of the effort to invade the US market. It is the Japanese consumer who is subsidizing the US car buyer and helping the Japanese manufacturer drive the US manufacturer out of existence.
Can dumping lead to improved use of the factors of production around the World? Possibly, just possibly. Autos, for example, must be produced in large quantities if they are to be produced efficiently. If producing 200,000 autos rather than 100,000 leads to a better use of productive resources, then possibly, just possibly, dumping promotes the use of productive resources in a more efficient manner than would be possible without dumping. With America having been dominant in the production of cars and electronic appliances long before Japan graduated from toy soldiers, it is surprising that American manufacturers did not resort to dumping and it is surprising that Japan is widely accused of being a dumper.
Who benefits from the anti-dumping activities of the US Department of Commerce? Clearly the US industries and their workers threatened by foreign dumpers. Setting aside the arguments in favor of producing in larger rather than smaller quantities, the whole World would seem to benefit from anti-dumping activities as they counteract the efforts of dumpers to interfere with the efficient use of resources which comparative advantage implies. And, to the extent dumpers maintain prices in their domestic markets, anti-dumping activities may be viewed as an effort to help the foreign consumer. If Japanese drivers pay $100,000 for the same car for which US drivers pay $50,000, then in response to our anti-dumping activities the Japanese government should mint a medal for our Department of Commerce.
Many discussions of comparative advantage, including this one, make different assumption about the mobility of resources within a country as compared with across international barriers.
In arriving at the prices in Table 8, the prices that would prevail in the two countries in the absence of international trade, it was assumed that productive resources would flow from one sector to another within a country so that resources receive similar rewards no matter where employed within a country. Let the farm hand earn more than the garment worker and we assumed that garment workers would put down the thimble and take up the plow. Such a movement of course is slow and only approximate. People are attracted to particular occupations for many reasons in addition to monetary reward; nurses, for example, do not pursue their professions solely because of the pay. Furthermore, after people commit their lives to some endeavor, they are reluctant to switch to another; after thirty years caring for the sick and injured, the nurse - even though she may hear that software engineers are well paid - is unlikely to convert to the care and comfort of computers. Neverthelss, we have assumed in much of the above discussion and many similar treatments of comparative advantage assume that there is considerable freedom of movement of resources within a particular country. The student enrolling in college does look at what he/she can find out about the relative income of doctors, lawyers and CPAs and it is a fact - not of course the only one - that determines the choice of profession.
But note that a different assumption is made about the movment of productive resources across international borders. Comparative advantage assumes that goods and services - the end product of productive activity - can indeed move across intenational boundaries; US wheat can be sold in Erehwon and Erehwonian garments can be sold in the US. To the contrary, comparative advantage generally assumes that the beginning point of that activity - the land, labor and other factors of production cannot move with a similar facility across international barriers.
Consider for example land and climate. The Alberta farmer might like to produce bananas but she cannot move her land to the tropics. Nor can the Guatemalan who would like to grow grain move his land to the temperate zones.
Labor - people - can of course move. Over the past several decades, many people have moved to the US and Canada based in part on a belief in the prosperity of US workers. But even labor finds it difficult to move across international barriers with various countries, including the US, imposing a variety of immigration restricitons. Even in the absence of immigration restrictions - and movement across international boundaries within the Euopean Union becomes increasingly easy - people still like to stay in the general area where they were born, where their parents are buried, where their language is spoken. Breathes there a man with soul so dead he never to himself has said "This is my home, my native land!"?
Here is your opportunity to check whether you are a world-class expert in comparative advantage and some of the concepts of foreign trade. You must be pretty good if you have got this far with this dense and difficult discussion but to really check your expertise, click on this link and you will be taken to a quizzer on comparative advantage. I'll grade your answers and give you a score.