Micro Lecture 22: Comparative Advantage

Size: px

Start display at page:

Download "Micro Lecture 22: Comparative Advantage"

Loraine Johns
5 years ago
Views:

1 Micro Lecture 22: Comparative Advantage Economists generally support free trade: when polled, more than 90 percent of economists believe that trade restrictions reduce general economic welfare. 6 During the last two decades, administrations have generally supported trade liberalization. The Clinton administration strongly advocated NAFTA (North Free Trade Agreement) and pushed for freer trade in other international forums. Subsequently, the Bush administration urged Congress to pass fast-track authority that would allow the administration to negotiate agreements reducing trade barriers even more. Many s and members of Congress do not share the enthusiasm of economists and the recent administrations, however. In a December 0, 998 Wall Street Journal article, Jackie Calmes reported on the difficulties encountered by the administration in its efforts to promote free trade: President Clinton keeps trying to sell the idea that foreign trade is good for the U.S. economy. Yet eight years into a record peacetime expansion, many s still aren t buying. The latest poll for The Wall Street Journal and NBC News illustrates the hurdle faced by the administration and other free traders. Given a choice of statements, a lopsided 58% majority of those polled agreed that foreign trade has been bad for the U.S. economy because cheap imports have cost wages and jobs here. Just 32% said trade has been good because foreign demand for U.S. goods has spawned economic growth and produced jobs for s. In a January 27, 999 Wall Street Journal article, Michael M. Phillips also reported on the administration s efforts: President Clinton s top economic advisers went to Capitol Hill yesterday to present their free-trade agenda for the year - and left with a clear picture of how controversial that agenda will be. Sen. Kent Conrad (D. N.D.) railed against Canadian wheat imports Sen. Frank Murkowski (R. Alaska) complained that the glut of foreign oil has pushed down oil prices and cost jobs in the energy industry. Most vehement was Democrat Sen. John D. Jay Rockefeller IV (D. W.Va.) who condemned what he called an illegal flood of cheap steel from Japan, Russia, Brazil and elsewhere. [But] Generally, free trade benefits the nation as a whole Puzzles: Is it true that free trade benefits the nation as a whole as Phillips writes? If so, why then do most s and many members of Congress oppose free trade? 6 Fuller and Geide-Stevenson, A Survey of Republicans, Democrats and Economists, Eastern Economic Journal, Winter 2007, pp Alston, Kearl, and Vaughan, "Is There a Consensus Among Economists in the 990s?", Economic Review, May 992, pp Kearl, Pope, Whiting, and Wimmer, "A Confusion of Economists?", Economic Review, May 979, pp

2 2 Theory of Comparative Advantage: Specialization and Trade The theory of comparative advantage asserts the following: Specialization: If each nation specializes in (produces more of) the good in which it enjoys a comparative advantage, the production of goods in the world as a whole can increase. Trade: Furthermore, if, after specialization, each nation exports the good in which it enjoys a comparative advantage and imports the good in which it suffers a comparative disadvantage, consumers in each nation can have more goods available to enjoy. We can illustrate these points by considering an example. Assume that the table below indicates how much more (or less) wheat and textiles can be produced in the United States and Mexico when one more (or less) worker is employed in each country s wheat and textile industries: United States Mexico Wheat Textiles Wheat Textiles worker worker worker worker 200 bushels 200 yards 20 bushels 00 yards were employed in the wheat industry, would rise by 200 bushels; if one less wheat industry, would fall by 200 bushels. were employed in the textile industry, would rise by 200 yards; if one less textile industry, would fall by 200 yards. were wheat would rise by 20 bushels; if one less wheat would fall by 20 bushels were textile would rise by 00 yards; if one less textile would fall by 00 yards. In the U.S.: If one more wheat industry, wheat production would rise by 200 bushels; if one less wheat industry, would fall by 200 bushels. If one more textile industry, textile production would rise by 200 yards; if one less textile industry, would fall by 200 yards. In Mexico: If one more wheat would rise by 20 bushels; if one less wheat industry, would fall by 20 bushels. If one more textile textile production would rise by 00 yards; if one less textile would fall by 00 yards.

3 3 Absolute Advantage The U.S. enjoys an absolute advantage in the production of both wheat and textiles. When one more worker is employed by the wheat industry rises by 200 bushels, whereas in Mexico, would only rise by only 20 bushels. Similarly, when one more worker is employed by the textile industry, textile production rises by 200 yards, whereas in Mexico, would rise by only 00 yards. Why might this be true? It is easy to explain why the U.S. has an absolute advantage in the production of wheat. The Midwest has the ideal climate and soil for growing grain. No other area of the world has better conditions for growing grain. Consequently, the Midwest s ideal conditions give the U.S. an absolute advantage in. The U.S. s absolute advantage in is explained by the fact that workers have more and better machines to use than do our counterparts. With superior machines, workers can produce more. Comparative Advantage: Opportunity Cost Is Crucial Comparative advantage differs from absolute advantage. Comparative advantage is determined on the basis of opportunity cost. Opportunity cost refers to what must be given up or foregone when an activity is pursued. First, consider the U.S. Opportunity Cost of Wheat in the U.S. Move one worker from the textile industry to the wheat industry: Wheat Production worker 200 more bushels 200 fewer yards would rise by 200 bushels and would fall by 200 yards. The opportunity cost of producing 200 bushels of wheat is 200 yards of textiles; therefore, in the U.S. the opportunity cost of bushel of wheat is yard of textiles. Opportunity Cost of Textiles in the U.S. Move one worker from the wheat industry to the textile industry: Wheat Production worker 200 fewer bushels 200 more yards would rise by 200 yards and would fall by 200 bushels. The opportunity cost of producing 200 yards of textiles is 200 bushels of wheat; therefore, in the U.S. the opportunity cost of yard of textiles is bushel of wheat.

4 4 Now, consider Mexico Opportunity Cost of Wheat in Mexico Move one worker from the textile industry to the wheat industry: Wheat Production worker 20 more bushels 00 fewer yards would rise by 20 bushels and would fall by 00 yards. The opportunity cost of producing 20 bushels of wheat is 00 yards of textiles; therefore, in Mexico the opportunity cost of bushel of wheat is 5 yards of textiles. Opportunity Cost of Textiles in Mexico Move one worker from the wheat industry to the textile industry: Wheat Production worker 20 fewer bushels 00 more yards would rise by 20 yards and would fall by 00 bushels. The opportunity cost of producing 00 yards of textiles is 20 bushels of wheat; therefore, in Mexico the opportunity cost of yard of textiles is a bushel of wheat. 5 Summary of Opportunity Costs Opportunity Cost of bushel of Wheat yard of Textiles United States yard of textiles bushel of wheat Mexico 5 yards of textiles bushels of wheat Since the opportunity cost of wheat is less in the U.S., the U.S. has a comparative advantage in ; since the opportunity cost of textiles is less in Mexico, Mexico has a comparative advantage in. NB: Mexico enjoys a comparative advantage in even though it does not enjoy an absolute advantage. Comparative Advantage and Specialization: Produce More of One Good Suppose that each country specializes by transferring workers: From the industry in which it does not enjoy a comparative advantage. To the industry in which it does enjoy a comparative advantage. More specifically, suppose that worker is transfer from the textile industry to the wheat industry Mexico transfers 2 workers from the wheat industry to textile industry. What happens to wheat and in the U.S.? rises by 200 bushels and falls by 200 yards: Wheat Production worker U.S. 200 more bushels 200 fewer yards What happens to wheat and in Mexico? Since the transfer of one worker from the wheat industry to the textile industry would reduce wheat production by 20 bushels and raise by 00 yards, the transfer of two workers will reduce by 40 bushels and raise textile production by 200 yards: Wheat Production 2 workers Mexico 40 fewer bushels 200 more yards 5

5 5 Summary Wheat Production U.S bushels worker 200 yards Mexico 40 bushels 2 workers +200 yards World +60 bushels 0 yards Gains from Specialization When each country specializes in the production of the good in which it enjoys a comparative advantage, the world as a whole can produce more. In our example, when worker is transferred from the textile industry to the wheat industry and 2 workers are transferred from the wheat industry to the textile industry, increases by 60 bushels in the world as a whole with no reduction in the world s production of textiles. Gains from Specialization: 60 bushels of wheat. Comparative Advantage: Specialization and Trade After specialization occurs we will show that if each nation exports the good in which it enjoys a comparative advantage and imports the good in which it suffers a comparative disadvantage, it is possible to make more goods available to its consumers. To do so, we will consider three different trading scenarios: 200 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for yard 40 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for 5 yards 00 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for 2 yards 200 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for yard In this case, the U.S. sends 200 bushels of wheat to Mexico in exchange for 200 yards of cloth. We say that the terms of trade are bushel of wheat for yard of cloth. It is easy to calculate what happens to the amount of wheat and cloth available to the consumers in each nation: Wheat Wheat Textile Textile Trade Production Production Trade 200 more bushels worker 200 fewer yards å 200 bushels 200 yards ç 40 fewer bushels 2 workers 200 more yards Wheat (bushels) Textile (yards) Prod Trade Cons Prod Trade Cons U.S Mexico World Question: Would the U.S. have an incentive to agree to these terms of trade? Answer: No. The amount of wheat and textiles available to consumers has been unaffected; consumers would enjoy all the gains from specialization.

6 6 40 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for 5 yards In this case, the U.S. sends 40 bushels of wheat to Mexico in exchange for 200 yards of cloth. We say that the terms of trade are bushel of wheat for 5 yards of cloth. It is easy to calculate what happens to the amount of wheat and cloth available to the consumers in each nation: Wheat Wheat Textile Textile Trade Production Production Trade 200 more bushels worker 200 fewer yards 40 bushels 200 yards 40 fewer bushels 2 workers 200 more yards Wheat (bushels) Textile (yards) Prod Trade Cons Prod Trade Cons U.S Mexico World Question: Would Mexico have an incentive to agree to these terms of trade? Answer: No. The amount of wheat and textiles available to consumers has been unaffected; the U.S. would enjoy all the gains from specialization. 00 bushels of wheat for 200 yards of cloth Terms of Trade: bushel for 2 yards In this case, the U.S. sends 00 bushels of wheat to Mexico in exchange for 200 yards of cloth. We say that the terms of trade are bushel of wheat for 2 yards of cloth. It is easy to calculate what happens to the amount of wheat and cloth available to the consumers in each nation: Wheat Wheat Textile Textile Trade Production Production Trade 200 more bushels worker 200 fewer yards 00 bushels 200 yards 40 fewer bushels 2 workers 200 more yards Wheat (bushels) Textile (yards) Prod Trade Cons Prod Trade Cons U.S Mexico World Both the U.S. and Mexico would have an incentive to agree to these terms of trade because the consumers of both nations would have more wheat available and the same amount of textiles.

7 7 In fact, any terms of trade between bushel for yard and bushel for 5 yards could make more wheat and the same amount of textiles available to the consumers of both nations. Micro Lab 22. allows us to confirm the numbers that we calculated. To access the lab, click on the red computer icon. Micro Lab 22.: Comparative Advantage Theory of Comparative Advantage Summary: The Importance of Opportunity Cost If each nation specializes in (produces more of) the good in which it enjoys a comparative advantage, the production of goods in the world as a whole can increase. Furthermore, if, after specialization, each nation exports the good in which it enjoys a comparative advantage and imports the good in which it suffers a comparative disadvantage, consumers in each nation can have more goods available to enjoy. Why is trade controversial? The most important reason that free trade is so controversial is that while specialization and trade can benefit the citizens of each nation as a whole, particular groups within each nation can be hurt. In the example we just completed, fewer textiles would be produced in the U.S. Clearly, this is not good news for the owners of textile firms and also not good news for those workers who are employed by the textile industry. So, while s as a whole are helped, some groups of s, those associated with the textile industry, would be hurt. Generalizing: Those groups associated with the production of the good being imported would be hurt while those associated with the production of the good that is being exported would be helped. An Aside: Labor versus Management. We are accustomed to thinking that the interests of labor and management always conflict. When it comes to trade, however, labor and management within an industry have the same interests. If the industry is exporting goods, both labor and management have an incentive to favor free trade; if the industry is facing competition from foreign firms, both labor and management typically oppose free trade.

Micro Handout 22: Comparative Advantage

Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Micro Handout 22: Comparative Advantage Broadly speaking, economists support free trade: when polled, more than 90 percent of economists