15.3: The gains from trade- Comparative advantage (2024)

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    In the opening chapter of this text we emphasized the importance of opportunity cost and differing efficiencies in the production process as a means of generating benefits to individuals through trade in the marketplace. The simple example we developed illustrated that, where individuals differ in their efficiency levels, benefits can accrue to each individual as a result of specializing and trading. In that example it was assumed that individual A had an absolute advantage in producing one product and that individual Z had an absolute advantage in producing the second good. This set-up could equally well be applied to two economies that have different efficiencies and are considering trade, with the objective of increasing their consumption possibilities. Technically, we could replace Amanda and Zoe with Argentina and Zambia, and nothing in the analysis would have to change in order to illustrate that consumption gains could be attained by both Argentina and Zambia as a result of specialization and trade.

    Remember: The opportunity cost of a good is the quantity of another good or service given up in order to have one more unit of the good in question.

    So, let us now consider two economies with differing production capabilities, as illustrated in Figures 15.1 and 15.2. In this instance it is assumed that one economy has an absolute advantage in both goods, but the degree of that advantage is greater in one good than the other. In international trade language, there exists a comparative advantage as well as an absolute advantage. It is frequently a surprise to students that this situation has the capacity to yield consumption advantages to each economy, even though one is absolutely more efficient in producing both of the goods. This is termed the principle of comparative advantage, and it states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies. This is a remarkable result, and much less intuitive than the principle of absolute advantage. We explore it with the help of the example developed in Figures 15.1 and 15.2.

    Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.

    We will name these two imaginary economies the US and Canada. Their production possibilities are defined by the PPFs in Figure 15.1. Canada can produce 5 units of V or 35 units of F, or any combination defined by the line joining these points. With the same resources the US can produce 8V or 40F, or any combination defined by its PPF1. With no trade, Canadians and Americans consume a combination of the goods defined by some point on their respective PPFs. The opportunity cost of a unit of V in Canada is 7F (the slope of Canada's PPF is 5/35=1/7). In the US the opportunity cost of one unit of V is 5F (slope is 8/40=1/5). In this set-up the US is more efficient in producing V than F relative to Canada, as reflected by the opportunity costs. Hence we say that the US has a comparative advantage in the production of V and that Canada has therefore a comparative advantage in producing F.

    Figure 15.1 Comparative advantage – production

    15.3: The gains from trade- Comparative advantage (2)

    Canada specializes completely in Fish at 35, where it has a comparative advantage. Similarly, the US specializes in Vegetable at 8. They trade at a rate of 1:6. The US trades 3V to Canada in return for 18F.

    Prior to trade each economy is producing all of the goods it consumes. This no-trade state is termed autarky.

    Autarky denotes the no-trade situation.

    The gains from trade

    We now permit each economy to specialize in producing where it has a comparative advantage. So Canada specializes completely by producing 35F and the US produces 8V. Having done this the economies must now agree on the terms of trade. The terms of trade define the rate at which the two goods will trade post-specialization. Let us suppose that a bargaining process leads to agreement that one unit of V will trade for six units of F. Such a trading rate, one that lies between the opportunity costs of each economy, benefits both economies. This exchange rate lies between Canada's opportunity cost of 1:7 and the US opportunity cost of 1:5. By specializing in F, Canada can now obtain an additional unit of V by sacrificing six units of F, whereas pre-trade it had to sacrifice seven units of F for a unit of V. Technically, by specializing in F and trading at a rate of 1:6 Canada's consumption possibilities have expanded and are given by the consumption possibility frontier (CPF) illustrated in Figure 15.2. The consumption possibility frontier defines what an economy can consume after production specialization and trade.

    Figure 15.2 Comparative advantage – consumption

    15.3: The gains from trade- Comparative advantage (3)

    Post specialization the economies trade 1V for 6F. Total production is 35F plus 8V. Hence one consumption possibility would be (18,5) for the US and (17,3) for Canada. Here Canada exchanges 18F in return for 3V.

    The US also experiences an improved set of consumption possibilities. By specializing in V and trading at a rate of 1:6 its CPF lies outside its PPF and this enables it to consume more than in the pre-specialization state, where its CPF was defined by its PPF.

    Evidently, the US and Canada CPFs are parallel since they trade with each other at the same rate: If Canada exports six units of F for every unit of V that it imports from the US, then the US must import the same six units of F for each unit of V it exports to Canada. The remarkable outcome here is that, even though one economy is more efficient in producing each good, specialization still leads to gains for both economies. The gain is illustrated by the fact that each economy's consumption possibilities lie outside of its production possibilities2.

    Terms of trade define the rate at which the goods trade internationally.

    Consumption possibility frontier defines what an economy can consume after production specialization and trade.

    Comparative advantage and factor endowments

    A traditional statement of why comparative advantage arises is that economies have different endowments of the factors of production – land, capital and labour endowments differ. A land endowment that facilitates the harvesting of grain (Saskatchewan) or the growing of fruit (California) may be innate to an economy. We say that wheat production is land intensive, that aluminum production is power intensive, that research and development is skill intensive, that auto manufacture is capital intensive, that apparel is labour intensive. Consequently, if a country is well endowed with some particular factors of production, it is to be expected that it will specialize in producing goods that use those inputs. A relatively abundant supply or endowment of one factor of production tends to make the cost of using that factor relatively cheap: It is relatively less expensive to produce clothing in China and wheat in Canada than the other way around. This explains why Canada's Prairies produce wheat, why Quebec produces aluminum, why Asia produces apparel. But endowments can evolve.

    How can we explain why Switzerland specializes in watches, precision instruments, and medical equipment, while Vietnam specializes in rice, tourism and manufactured goods and components? Evidently, Switzerland made a decision to educate its population and invest in the capital required to produce these goods. It was not naturally endowed with these skills, in the same way that Greece is endowed with sun or Saskatchewan is endowed with fertile flat land.

    While we have demonstrated the principle of comparative advantage using a two-good example (since we are constrained by the geometry of two dimensions), the conclusions carry over to the case of many goods. Furthermore, the principle has many applications. For example, if one person in the household is more efficient at doing all household chores than another, there are still gains to specialization provided the efficiency differences are not all identical. This is the principle of comparative advantage at work in a microcosm.

    Application Box 15.1 The one hundred mile diet

    In 2005 two young British Columbians embarked on what has famously become known as the 'one hundred mile diet'—a challenge to eat and drink only products grown within this distance of their home. They succeeded in doing this for a whole year, wrote a book on their experience and went on to produce a TV series. They were convinced that such a project is good for humanity, partly because they wrapped up ideas on organic farming and environmentally friendly practices in the same message.

    Reflect now on the implications of this superficially attractive program: If North Americans were to espouse this diet, it would effectively result in the closing down of the midwest of the Continent. From Saskatchewan to Kansas, we are endowed with grain-producing land that is the envy of the planet. But since most of this terrain is not within 100 miles of any big cities, these deluded advocates are proposing that we close up the production of grains and cereals exactly in those locations where such production is extraordinarily efficient. Should we sacrifice grains and cereals completely in this hemisphere, or just cultivate them on a hillside close to home, even if the resulting cultivation were to be more labour and fuel intensive? Should we produce olives in greenhouses in Edmonton rather than importing them from the Mediterranean, or simply stop eating them? Should we sacrifice wine and beer in North Battleford because insufficient grapes and hops are grown locally?

    Would production in temperate climates really save more energy than the current practice of shipping vegetables and fruits from a distance—particularly when there are returns to scale associated with their distribution? The 'one hundred mile diet' is based on precepts that are contrary to the norms of the gains from trade. In its extreme the philosophy proposes that food exports be halted and that the world's great natural endowments of land, water, and sun be allowed to lie fallow. Where would that leave a hungry world?

    Table 15.1 shows the patterns of Canadian merchandise trade in 2008. The United States was and still is Canada's major trading partner, buying almost three quarters of our exports and supplying almost two thirds of Canadian imports. Table 15.2 details exports by type. Although exports of resource-based products account for only about 40 percent of total exports, Canada is now viewed as a resource-based economy. This is in part because manufactured products account for almost 80 percent of US and European exports but only about 60 percent of Canadian exports. Nevertheless, Canada has important export strength in machinery, equipment, and automotive products.

    15.3: The gains from trade- Comparative advantage (2024)
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