AskDong

Since my posts are not part of any specific outline, I thought this week I would move slightly towards the other tent in Economics, Macroeconomics, after convering basic supply and demand curves last week. We’ll talk about topic that is endlessly debated, but one in which most Economists (both left and right leaning) tend to agree more than disagree, Trade. Trade is generally framed as international trade, but at it’s essence international trade is no different than trading between two individuals. Just as the companies in Massachusetts import and export good to California, the U.S. trades with countries like India and China.

Adam Smith who set the ground for modern Economics with his book, The Wealth of Nations, not only recognized the value of trade, but was the first to quantitively to understand that value. He introduced the idea of absolute advantage as the reason for trade. For example let’s say we have two countries, Canada and the U.S. with 100 units of labor it can devote to producing Hockey Pucks, and or Beer. Canada produces Hockey Pucks at a rate 10 for each unit of labor, and Beer at rate of 5 can for each unit of labor. Without trade, Canada might choose to produce 500 hockey pucks, and 250 cans of beer. The U.S., on the other hand, can produce 10 cans of beer for each unit of labor and 5 hockey pucks for each unit of labor. The U.S. then might choose to produce 500 cans of beer and 250 hockey pucks. Canada has the absolute advantage in the production of hockey pucks, and the U.S. in beer because each country needs less labor than the other to make the product it’s absolutely advantaged in.

If we introduce trade, each country is able to take advantage of it’s absolute advantage in production of hockey pucks in the case Canada, and Beer for the U.S. Each country specializes and trades with the other to get the product it decides not to make.

As a result the total production of both hockey pucks and cans of beer is maximized for 1000 of each. If we assume that trade partners only engage in trade if it benefits them, we can assume that both the U.S. and Canada benefit with both more beer and hockey pucks. For simplicity’s sake let’s just assume that beer and hockey pucks are both worth $1 and trade effectively 1:1, the U.S. and Canada can both have 500 hockey pucks, and 500 cans of beer. Without trade neither of the countries had the ability to produce both products at that level.

Adam Smith was smart to recognize the benefit of trade via absolute advantage, but the beauty of trade is that it does not rely on absolute advantage. David Ricardo followed up on Adam Smith with the notion of comparative advantage. With comparative advantage, trade should always occurs as long as countries differ in relative ability in producing different goods. A country need not be the best producer of beer, but rather just be better producer of beer than it is of hockey pucks. Going back to example above, let’s say instead that Canada can actually produce both hockey pucks, and beer at a rate of 20 per unit of labor. As a result Canada has an absolute advantage in producing both beer and hockey pucks. If trade required absolute advantage there would be no trade in this scenario. However trade is beneficial even when Canada is so much better than the U.S.

Each country’s production might look something like this:

The U.S. has a comparative advantage in the production of beer over hockey pucks, and Canada a comparative advantage in producing hockey pucks. Comparative advantage is measured relative to other goods that a country might produce. Embedded within comparative advantage is the concept of opportunity cost which is the cost of not doing something else. In the case of the U.S. the opportunity cost of producing 5 hockey pucks is 10 cans of beer. With comparative advantage the countries should produce:

Like the earlier situation with absolute advantage, the total production of each good is maximized, and each country can consume more of each good via trade. The terms of trade determine how much each country benefits, but regardless both countries benefit.

Let’s say for example that hockey pucks are worth $5, and beer a $3, i.e. hockey pucks trade at a 3:5 ratio to beer.

Both countries are able to set the terms of trade that each ends up having more than each country would have been able to produce for itself without trade. Trade is really about specilization. A country or individual should do what they’re best at and trade for goods and services that they don’t have. There’s a reason, I don’t farm, and make clothes for myself - I’m not very good at it, and much better at sitting in cubicle. Trade allows for the efficent allocation of labor and capital.

Clearly, I’ve given the most simple textbook explanation of trade here. There are legitimate reason to be concerned about how trade is conducted such as environmental and labor practice. However most opponents of trade tend to be opponents of trade for reasons that are revealed in the simple textbook example. Trade hurts U.S. hockey puck makers. It’s this protectionism that drives opposition to free trade. Opponents forget that other industries stand to benefit with free trade, and more importantly consumers benefit. While the larger macroeconomic landscape is more complicated as we introduce other concepts such as imbalances, current accounts, exchange rates, interest rates, etc, trade is at the core of the global economic picture.