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their frontiers.
Because opportunity costs differ in the two countries, gains are possible if the two
countries specialize and trade with one another. Specifically, it is cheaper, in terms of real
resources forgone, for either country to acquire its computers in the United States. By a
similar line of reasoning, the opportunity cost of TVs is higher in the United States than in
Japan, so it makes sense for both countries to acquire their televisions in Japan.4
Notice that if the slopes of the two production possibilities frontiers, JN and US, were
equal, then opportunity costs would be the same in each country. In that case, no poten-
tial gains would arise from trade. Gains from trade arise from differences across countries,
not from similarities. This is an important point about which people are often confused. It
is often argued that two very different countries, such as the United States and Mexico,
cannot gain much by trading with one another. The fact is just the opposite:
Two very similar countries may gain little from trade. Large gains from trade are most
likely when countries are very different.
The pattern is apparent in U.S. trade statistics”with one big exception. Canada, a country
very similar to the United States, is our biggest trading partner. But that is mainly because
the two nations share a huge and very porous border. However, our next three biggest

To review the concept of the production possibilities frontier, see Chapter 3.

As an exercise, provide this line of reasoning.

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346 The United States in the World Economy

trading partners, in order, are China, Mexico, and Japan”three countries very different
from the United States.
How nations divide the gains from trade depends on the prices that emerge from world
trade”a complicated topic taken up in the appendix to this chapter. But we already know
enough to see that world trade must, in our example, leave a computer costing more than
one TV and less than four. Why? Because if a computer bought less than one TV (its op-
portunity cost in the United States) on the world market, the United States would produce
its own TVs rather than buying them from Japan. And if a computer cost more than four
TVs (its opportunity cost in Japan), Japan would prefer to produce its own computers
rather than buy them from the United States. So we conclude that, if both countries are to
trade, the rate of exchange between TVs and computers must end up somewhere between
4:1 and 1:1. Generalizing:
If two countries voluntarily trade two goods with one another, the rate of exchange be-
tween the goods must fall in between the price ratios that would prevail in the two
countries in the absence of trade.
To illustrate the gains from trade in our concrete example, suppose the world price
ratio settles at 2:1”meaning that one computer costs as much as two televisions. How
much, precisely, do the United States and Japan gain from world trade in this case?
Figure 2 helps us visualize the answers. The blue production possibilities frontiers, US
in Panel (b) and JN in Panel (a), are the same as in Figure 1. But the United States can do
better than line US. Specifically, with a world price ratio of 2:1, the United States can buy
two TVs for each computer it gives up, rather than just one (which is the opportunity cost
of a computer in the United States). Hence, if the United States produces only computers”
point S in Figure 2(b)”and buys its TVs from Japan, America™s consumption possibilities
will be as indicated by the brick-colored line that begins at point S and has a slope of 2”
that is, each computer sold brings the United States two television sets. (It ends at point A
because 40 million TV sets is the most that Japan can produce.) Because trade allows the
United States to choose a point on AS rather than on US, trade opens up consumption
possibilities that were simply not available before (shaded gray in the diagram).

F I GU R E 2
The Gains from Trade


90 90

80 80

70 70
Television Sets

Television Sets

60 60
50 50
J A U.S. consumption
40 40
Japanese consumption possibilities
30 30
U.S. production
Japanese production possibilities
20 20
10 10
0 10 20 30 40 50 60 0 10 20 30 40 50 60
Computers Computers

(a) Japan (b) United States

NOTE: Quantities are in millions.

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Chapter 17 347
International Trade and Comparative Advantage

A similar story applies to Japan. If the Japanese produce only television sets”point J in
Figure 2(a)”they can acquire a computer from the United States for every two TVs they give
up as they move along the brick-colored line JP (whose slope is 2). This result is better than
they can achieve on their own, because a sacrifice of two TVs in Japan yields only one-half of
a computer. Hence, world trade enlarges Japan™s consumption possibilities from JN to JP.
Figure 2 shows graphically that gains from trade arise to the extent that world prices
(2:1 in our example) differ from domestic opportunity costs (4:1 and 1:1 in our example).
How the two countries share the gains from trade depends on the exact prices that emerge
from world trade. As explained in the appendix, that in turn depends on relative supplies
and demands in the two countries.

Must Specialization be Complete?
In our simple numerical and graphical examples, international specialization is always
complete”for example, the United States makes all the computers and Japan makes all the
TV sets. But if you look at the real world, you will find mostly incomplete specialization.
For example, the United States is the world™s biggest importer of both petroleum and au-
tomobiles. But we also manufacture lots of cars and drill for lots of oil at home. In fact, we
even export some cars. This stark discrepancy between theory and fact might worry you.
Is something wrong with the theory of comparative advantage?
Actually, there are many reasons why specialization is typically incomplete, despite the
validity of the principle of comparative advantage. Two of them are simple enough to
merit mentioning right here.
First, some countries are just too small to provide the world™s entire output, even when they
have a strong comparative advantage in the good in question. In our numerical example,
Japan just might not have enough labor and other resources to produce the entire world out-
put of televisions. If so, some TV sets would have to be produced in the United States.
Second, you may have noticed that in this chapter we have drawn all the production
possibilities frontiers (PPFs) as straight lines, whereas they were always curved in previous
chapters. The reason is purely pedagogical: We wanted to create simple examples that
lend themselves to numerical solutions. It is undoubtedly more realistic to assume that
PPFs are curved. But that sort of technology leads to incomplete specialization, which is a
complication best left to more advanced courses.

The principle of comparative advantage takes us a long way toward under-
standing the fallacy in the “cheap foreign labor” argument described at the
beginning of this chapter. Given the assumed productive efficiency of Ameri-
can labor, and the inefficiency of Japanese labor, we would expect wages to
be much higher in the United States.
In these circumstances, one might expect American workers to be apprehensive about
an agreement to permit open trade between the two countries: “How can we hope
to meet the unfair competition of those underpaid Japanese workers?” Japanese labor-
ers might also be concerned: “How can we hope to meet the competition of those
Americans, who are so efficient in producing everything?”
The principle of comparative advantage shows us that both fears are unjustified. As
we have just seen, when trade opens up between Japan and the United States, workers
in both countries will be able to earn higher real wages than before because of the increased
productivity that comes through specialization.
As Figure 2 shows, once trade opens up, Japanese workers should be able to acquire
more TVs and more computers than they did before. As a consequence, their living

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Part 4
348 The United States in the World Economy

standards should rise, even though they have been left vulnerable to competition from
the super-efficient Americans. Workers in the United States should also end up with
more TVs and more computers. So their living standards should also rise, even though
they have been exposed to competition from cheap Japanese labor.
These higher standards of living, of course, reflect the higher real wages earned be-
cause workers become more productive in both countries. The lesson to be learned here
is elementary:
Nothing helps raise living standards more than a greater abundance of goods.

Despite the large mutual gains from international trade, nations often interfere with the
free movement of goods and services across national borders. In fact, until the rise of the
free-trade movement about 200 years ago (with Adam Smith and David Ricardo as its
vanguard), it was taken for granted that one of the essential tasks of government was to
impede trade, presumably in the national interest.
Then, as now, many people argued that the proper aim of government policy was to
promote exports and discourage imports, for doing so would increase the amount of
money foreigners owed the nation. According to this so-called mercantilist view, a na-
Mercantilism is a doctrine
that holds that exports are tion™s wealth consists of the amount of gold or other monies at its command.
good for a country, whereas Obviously, governments can pursue such a policy only within certain limits. A country
imports are harmful.
must import vital foodstuffs and critical raw materials that it cannot provide for itself.
Moreover, mercantilists ignore a simple piece of arithmetic: It is mathematically impossi-
ble for every country to sell more than it buys, because one country™s exports must be some
other country™s imports. If everyone competes in this game by cutting imports to the bone,
then exports must shrivel up, too. The result is that everyone will be deprived of the mu-
tual gains from trade. Indeed, that is precisely what happens in a trade war.
After the protectionist 1930s, the United States moved away from mercantilist policies
designed to impede imports and gradually assumed a leading role in promoting free trade.
Over the past 60 years, tariffs and other trade barriers have come down dramatically.
In 1995, the United States led the world to complete the Uruguay Round of tariff reduc-
tions and, just before that, the country joined Canada and Mexico in the North American
Free Trade Agreement (NAFTA). The latter caused a political firestorm in the United
States in 1993 and 1994, with critic (and 1992 presidential candidate) Ross Perot predict-
ing a “giant sucking sound” as American workers lost their jobs to competition from
“cheap Mexican labor.” (Does that argument sound familiar?) Most of the world™s trading
nations are now engaged in a new multiyear round of trade talks, under guidelines
adopted at an important meeting in Doha, Qatar, in 2001. (See “Liberalizing World Trade:
The Doha Round.”)
Modern governments use three main devices when seeking to control trade: tariffs,
quotas, and export subsidies.
A tariff is simply a tax on imports. An importer of cars, for example, may be charged
A tariff is a tax on imports.
$2,000 for each auto brought into the country. Such a tax will, of course, make automobiles
more expensive and favor domestic models over imports. It will also raise revenue for the
government. In fact, tariffs were a major source of tax revenue for the U.S. government
during the eighteenth and nineteenth centuries”and also a major source of political con-
troversy. But the United States is a low-tariff country nowadays, with only a few notable
exceptions. However, many other countries rely on heavy tariffs to protect their indus-
tries. Indeed, tariff rates of 100 percent or more are not unknown in some countries.
A quota is a legal limit on the amount of a good that may be imported. For example,
A quota specifies the maxi-
mum amount of a good the government might allow no more than 5 million foreign cars to be imported in a year.
that is permitted into the In some cases, governments ban the importation of certain goods outright”a quota of
country from abroad per
zero. The United States now imposes quotas on a smattering of goods, including textiles,
unit of time.
meat, and sugar. Most imports, however, are not subject to quotas. By reducing supply,

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Chapter 17 349
International Trade and Comparative Advantage

quotas naturally raise the prices of the goods subject to quotas. For example, sugar is
vastly more expensive in the United States than it is elsewhere in the world.
An export subsidy is a government payment to an exporter. By reducing the exporter™s An export subsidy is a
payment by the govern-
costs, such subsidies permit exporters to lower their selling prices and compete more ef-
ment to exporters to permit
fectively in world trade. Overt export subsidies are minor in the United States. But some
them to reduce the selling
foreign governments use them extensively to assist their domestic industries”a practice
prices of their goods so they
that provokes bitter complaints from American manufacturers about “unfair competi- can compete more effec-


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