Beyond Our Shores—International Trade

Why do most economists believe in free (unobstructed) trade between nations? This is because of a principle that dates back to 1776, enunciated by Adam Smith in his book the Wealth of Nations and elaborated on 100 years later by another English economist, David Ricardo. Called the principle of comparative advantage, it demonstrates that both trading partners benefit from trade. Until that date, it was believed that national wealth depends on how much gold the country amassed. And if it had no gold mines of its own, it could accumulate gold only by creating a trade surplus that was paid in gold. Because of the structure of bilateral trade, only one country can have a surplus and the other must have a deficit. This means that trade can benefit only one country, while the other must lose. Essentially, trade was considered a zero-sum game. In what follows, assume that fiscal and monetary policies brought both trading economies value.

Adam Smith showed that if in U.S.  – trade from Mexico the U.S. has a 10 to 1 productivity advantage in aircraft production, while Mexico has a 5 to 1 advantage in shoe production. It pays the U.S. to produce and export aircraft and import shoes, while it pays Mexico to produce and export shoes and import aircraft because each one has an advantage in producing their respective goods. This is a matter of common sense.

But what about the common case where a country (for example the U.S.) has a productivity advantage in both goods? For example, the U.S. has a 10 to 1 advantage in aircraft production and a 5 to 1 advantage in shoe manufacturing. This is where the degree of advantage otherwise called comparative advantage comes in to play.

We encounter this situation in everyday life. For instance, a dentist has a 10 to 1 productivity advantage over his hygienist in drilling and a 5 to 1 advantage in cleaning teeth. It would still be worth it to him to specialize in drilling and hire a hygienist to do the cleaning; to benefit, he charges the patient $300 an hour to drill and pays the nurse $80 an hour to clean. Similarly, a doctor who is a terrible typist would specialize in medicine and hire a secretary to type. And in precisely the same vein, the U.S. would specialize in making expensive aircrafts and would import shoes, where it has a comparative disadvantage relative to Mexico. Ultimately, both countries benefit.

What are the types of characteristics of a product and country that might produce such a situation? Let’s suppose that in order to manufacture an aircraft, sophisticated technology is required (relative to shoe production). This is called a technologically-intensive good. By the same token, shoe production is called a labor-intensive product because it requires much labor to produce (in a relative sense). If Mexico is labor abundant relative to the U.S., it will specialize in a labor-intensive product, while the U.S. with abundant scientists and engineers will specialize in aircraft manufacturing—a technology-intensive product. A combination of product characteristics and country features give rise to comparative advantage. A country has comparative advantage in a good that intensively uses its abundant factor of production (labor, capital, etc.), while giving rise to mutually beneficial free trade within its limits.

But economists do not make the commercial policy of a country. Rather, it is a result of conflicting political pressures, including pressure groups designed to protect local industries from foreign competition that use instruments to raise the prices of foreign imports. As a consequence, local consumers are drawn to the local substitute product and away from imports.

So what is wrong with that? Usually the industries that need protection are those in which the country lacks comparative advantage. For example, this could include brooms that used to be produced in the U.S. or other labor-intensive goods (textiles, footwear, simple lumber goods) that should be manufactured in less developed or developing countries. Making them in the U.S. draws resources from other industries, such as sophisticated equipment in which the country has a comparative advantage, thereby creating waste and inefficiency. This is especially true if the tax is levied on selected individual products that are usually least efficiently made at home. Indeed, the cost of this import protection to the economy can be measured by the amount it raises the domestic price, and the degree to which it keeps out foreign imports. Conversely, removing the tax increases production efficiency all around.

We will continue this in the next column.

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Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

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