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chemicals. In general, as we emphasized in Chapter 3:
TRADE IS A WIN-WIN SITUATION Both parties must expect to gain from any voluntary
exchange. Trade brings about mutual gains by redistributing products so that both par-
ties end up holding more preferred combinations of goods than they held before. This
IDEAS FOR
principle, which is one of our Ideas for Beyond the Final Exam, applies to nations just as
BEYOND THE
it does to individuals.
FINAL EXAM




INTERNATIONAL VERSUS INTRANATIONAL TRADE
The 50 states of the United States may be the most eloquent testimonial to the large gains
that can be realized from specialization and free trade. Florida specializes in growing or-
anges, Michigan builds cars, California makes software and computers, and New York
specializes in finance. All of these states trade freely with one another and, as a result, en-
joy great prosperity. Try to imagine how much lower your standard of living would be if
you consumed only items produced in your own state.
The essential logic behind international trade is no different from that underlying trade
among different states; the basic reasons for trade are equally applicable within a country
or among countries. Why, then, do we study international trade as a special subject? There
are at least three reasons.


Political Factors in International Trade
First, domestic trade takes place under a single national government, whereas foreign
trade always involves at least two governments. But a nation™s government is normally
much less concerned about the welfare of other countries™ citizens than it is about its own.
So, for example, the U.S. Constitution prohibits tariffs on trade among states, but it does
not prohibit the United States from imposing tariffs on imports from abroad. One major
issue in the economic analysis of international trade is the use and misuse of political im-
pediments to international trade.


The Many Currencies Involved in International Trade
Second, all trade within the borders of the United States is carried out in U.S. dollars,
whereas trade across national borders almost always involves at least two currencies.
Rates of exchange between different currencies can and do change. In 1985, it took about
250 Japanese yen to buy a dollar; now it takes fewer than half that many. Variability in ex-
change rates brings with it a host of complications and policy problems.


Impediments to Mobility of Labor and Capital
Third, it is much easier for labor and capital to move about within a country than to move
from one nation to another. If jobs are plentiful in California but scarce in Ohio, workers can
move freely to follow the job opportunities. Of course, personal costs such as the financial



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Chapter 17 343
International Trade and Comparative Advantage



burden of moving and the psychological burden of leaving friends and familiar surround-
ings may discourage mobility. But such relocations are not inhibited by immigration
quotas, by laws restricting the employment of foreigners, or by the need to learn a new
language.
There are also greater impediments to the transfer of capital across national boundaries
than to its movement within a country. For example, many countries have rules limiting
foreign ownership. Even the United States limits foreign ownership of broadcast outlets
and airlines and, recently, political furors arose when a Chinese company sought to pur-
chase a U.S. oil company and when a Middle Eastern company offered to take over the
management of several U.S. ports. Foreign investment is also subject to special political
risks, such as the danger of outright expropriation or nationalization after a change in
government.
But even if nothing as extreme as expropriation occurs, capital invested abroad faces
significant risks from exchange rate variations. An investment valued at 250 million yen is
worth $2.5 million to American investors when the dollar is worth 100 yen, but it is worth
only $1 million when it takes 250 yen to buy a dollar.



THE LAW OF COMPARATIVE ADVANTAGE
The gains from international specialization and trade are clear and intuitive when one
country is better at producing one item and its trading partner is better at producing an-
other. For example, no one finds it surprising that Brazil sells coffee to the United States
and the United States exports software to Brazil. We know that coffee can be produced us-
ing less labor and other inputs in Brazil than in the United States. Likewise, the United
States can produce software at a lower resource cost than can Brazil. One country is said to have
In such a situation, we say that Brazil has an absolute advantage in coffee production, an absolute advantage
over another in the produc-
and the United States has an absolute advantage in software production. In such cases, it
tion of a particular good if
is obvious that both countries can gain by producing the item in which they have an ab-
it can produce that good
solute advantage and then trading with one another.
using smaller quantities of
What is much less obvious, but equally true, is that these gains from international trade resources than can the
still exist even if one country is more efficient than the other in producing everything. This les- other country.
son, the principle of comparative advantage, is one we first encountered in Chapter 3.2 It
One country is said to
is, in fact, one of the most important of our Ideas for Beyond the Final Exam, so we repeat it
have a comparative
here for convenience.
advantage over another in
THE SURPRISING PRINCIPLE OF COMPARATIVE ADVANTAGE Even if one country is at the production of a particu-
lar good relative to other
an absolute disadvantage relative to another country in the production of every good, it
goods if it produces that
still has a comparative advantage in making the good at which it is least inefficient (com-
good less inefficiently as
pared with the other country).
compared with the other
The great classical economist David Ricardo (1772“1823) discovered about
country.
200 years ago that two countries can still gain from trade even if one is more efficient
than the other in every industry”that is, even if one has an absolute advantage in pro-
ducing every commodity.
In determining the most efficient patterns of production, it is comparative advantage,
not absolute advantage, that matters. Thus a country can gain by importing a good even
IDEAS FOR
if that good can be produced more efficiently at home. Such imports make sense if they BEYOND THE
FINAL EXAM
enable the country to specialize in producing goods at which it is even more efficient.


The Arithmetic of Comparative Advantage
Let™s see precisely how comparative advantage works using a hypothetical example first
suggested in Chapter 3. Table 2 gives a rather exaggerated impression of the trading posi-
tions of the United States and Japan a few years ago. We imagine that labor is the only


To review, see page 49.
2




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Licensed to:
Part 4
344 The United States in the World Economy



input used to produce computers and television sets in the two countries and
TA BL E 2
that the United States has an absolute advantage in manufacturing both goods.
Alternative Outputs from One
In this example, one year™s worth of labor can produce either 50 computers or
Year of Labor Input
50 TV sets in the United States but only 10 computers or 40 televisions in Japan.
In the U.S. In Japan
So the United States is the more efficient producer of both goods. Nonetheless,
Computers 50 10 as we will now show, it pays for the United States to specialize in producing
Televisions 50 40 computers and trade with Japan to get the TV sets it wants.
To demonstrate this point, we begin by noting that the United States has a
comparative advantage in computers, whereas Japan has a comparative advantage in pro-
ducing televisions. Specifically, the numbers in Table 2 show that the United States can pro-
duce 50 televisions with one year™s labor, whereas Japan can produce only 40, giving the
United States a 25 percent efficient edge over Japan. However, the United States is five
times as efficient as Japan in producing computers: It can produce 50 per year of labor
rather than 10. Because America™s competitive edge is far greater in computers than in tel-
evisions, we say that the United States has a comparative advantage in computers.
From the Japanese perspective, these same numbers indicate that Japan is only slightly
less efficient than the United States in TV production but drastically less efficient in com-
puter production. So Japan™s comparative advantage is in producing televisions. Accord-
ing to Ricardo™s law of comparative advantage, then, the two countries can gain if the
United States specializes in producing computers, Japan specializes in producing TVs,
and the two countries trade.
Let™s verify that this conclusion is true. Suppose Japan transfers
TA BL E 3
1,000 years of labor out of the computer industry and into TV
Example of the Gains from Trade
manufacturing. According to the figures in Table 2, its computer
U.S. Japan Total output will fall by 10,000 units, while its TV output will rise by
40,000 units. This information is recorded in the middle column of
Computers 125,000 210,000 115,000
Televisions 225,000 140,000 115,000 Table 3. Suppose, at the same time, the United States transfers
500 years of labor out of television manufacturing (thereby losing
25,000 TVs) and into computer making (thereby gaining 25,000 computers). Table 3
shows us that these transfers of resources between the two countries increase the world™s
production of both outputs. Together, the two countries now have 15,000 additional TVs
and 15,000 additional computers”a nice outcome.
Was there some sleight of hand here? How did both the United States and Japan gain
both computers and TVs? The explanation is that the process we have just described in-
volves more than just a swap of a fixed bundle of commodities, as in our earlier cookies-
and-milk example. It also involves a change in the production arrangements. Some of Japan™s
inefficient computer production is taken over by more efficient American makers. And
some of America™s TV production is taken over by Japanese television companies, which
are less inefficient at making TVs than Japanese computer manufacturers are at making
computers. In this way, world productivity is increased. The underlying principle is both
simple and fundamental:
When every country does what it can do best, all countries can benefit because more of
every commodity can be produced without increasing the amounts of labor and other
resources used.
Where does the United States hold and lack comparative advantage? Among our big
export powerhouses are the aerospace industry, agriculture, chemicals, high-tech services,
financial services, entertainment, and higher education. We are, of course, huge importers
of petroleum, television sets, automobiles, computers, clothing, toys, and much else.


The Graphics of Comparative Advantage
The gains from trade also can be illustrated graphically, and doing so helps us understand
whether such gains are large or small.
The lines US and JN in Figure 1 are closely related to the production possibilities fron-
tiers of the two countries, differing only in that they pretend that each country has the



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Licensed to:

Chapter 17 345
International Trade and Comparative Advantage



same amount of labor available.3 In this case, we as-
sume that each has 1 million person-years of labor. For 60
example, Table 2 tells us that for each 1 million years of
U
labor, the United States can produce 50 million TVs
50
and no computers (point U in Figure 1), 50 million
computers and no TVs (point S), or any combination J




Television Sets
40
between (the line US). Similar reasoning leads to line




(millions)
JN for Japan.
U.S. production
America™s actual production possibilities frontier 30 possibilities frontier
would be even higher, relative to Japan™s, than shown
Japanese
in Figure 1 because the U.S. population is larger. But 20 production
Figure 1 is more useful because it highlights the differ- possibilities
frontier
ences in efficiency (rather than in mere size), and this is
10
what determines both absolute and comparative ad-
vantage. Let™s see how. N S
The fact that line US lies above line JN means that the
0 10 20 30 40 50 60
United States can manufacture more televisions and
Computers
more computers than Japan with the same amount of (millions)
labor. This difference reflects our assumption that the
F I GU R E 1
United States has an absolute advantage in both
Production Possibilities
commodities.
Frontiers for Two
America™s comparative advantage in computer production and Japan™s comparative ad-
Countries (per million
vantage in TV production are shown in a different way: by the relative slopes of the two years of labor)
lines. Look back to Table 2, which shows that the United States can acquire a computer on
its own by giving up one TV. Thus, the opportunity cost of a computer in the United States
is one television set. This opportunity cost is depicted graphically by the slope of the U.S.
production possibilities frontier in Figure 1, which is OU/OS 5 50/50 5 1.
Table 2 also tells us that the opportunity cost of a computer in Japan is four TVs. This
relationship is depicted in Figure 1 by the slope of Japan™s production possibilities fron-
tier, which is OJ/ON 5 40/10 5 4.
A country™s absolute advantage in production over another country is shown by its hav-
ing a higher per-capita production possibilities frontier. The difference in the compara-
tive advantages between the two countries is shown by the difference in the slopes of

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