When it comes to China, there are genuine giants that need to be conquered and dragons to tame. Protecting intellectual property rights and leveling the playing field for international trade are serious matters that must be resolved. But that will happen through honest negotiation.
International Trade, Comparative Advantage, and Protectionism
(Part C)
by
Charles Lamson
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Absolute Advantage vs. Comparative Advantage A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does. Suppose country A and country B produce wheat, but as climate is more suited to wheat and its labor is more productive. Country A will produce more wheat per acre than country B and use less labor in growing it and bringing it to market. Country A enjoys an absolute advantage over country B in the production of wheat. A country enjoys a comparative advantage in the production of a good if that good can be produced at lower cost in terms of other goods. Suppose countries C and D both produce wheat and corn and C enjoys an absolute advantage in the production of both---that is, C's climate is better than D's, and fewer of these resources are needed to produce a given quantity of both wheat and corn. Now C and D must each choose between planting land with either wheat or corn. To produce more wheat, either country must transfer land from corn production; to produce more corn, either country must transfer land from wheat production. The cost of wheat in each country can be measured in bushels of corn, and the cost of corn can be measured in bushels of wheat. Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. That is, to produce an additional bushel of wheat, C must give up two bushels of corn. At the same time, producing a bushel of wheat in country D requires the sacrifice of only one bushel of corn. Even though C has an absolute advantage in the production of both products, D enjoys the comparative advantage in the production of wheat because the opportunity cost (the loss of potential gain from other alternatives when one alternative is chosen) of producing wheat is lower in D. Under these circumstances, David Ricardo's theory of comparative advantage (from last post), claims D can benefit from trade if it specializes in the production of wheat. Gains from Mutual Absolute Advantage To illustrate Ricardo's logic in more detail, suppose Australia and New Zealand each have a fixed amount of land and do not trade with the rest of the world. There are only two goods---wheat, to produce bread, and cotton, to produce clothing. This kind of two-country/two-good world does not exist, but its operations can be generalized to many countries and many goods.  To proceed, we have to make some assumptions about the preferences of the people living in New Zealand and the people living in Australia. If the citizens of both countries go around naked, there is no need to produce cotton; all the land can be used to produce wheat. However, assume that people in both countries have similar preferences with respect to food and clothing: The population of both countries use both cotton and wheat, and preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton. Finally, we assume that each country has only one hundred acres of land for planting and the land yields are as given in Table 2. New Zealand can produce three times the wheat that Australia can on 1 acre of land, and Australia can produce three times the cotton that New Zealand can in the same space. New Zealand has an absolute advantage in the production of wheat, and Australia has an absolute advantage in the production of cotton. In cases like this, we say the two countries have mutual absolute advantage. TABLE 2 Yield per Acre of Wheat and Cotton  If there is no trade and each country divides its land to obtain equal units of cotton and wheat production, each country produces 150 bushels of wheat and 150 bales of cotton. New Zealand put 75 acres into cotton but only 25 acres into wheat, while Australia does the reverse (Table 3). TABLE 3  We can organize the same information in graphic form as production possibility frontiers (curves illustrating the various amounts of two products that can be produced when both depend on the same finite resources) for each country. In Figure 1, which presents the positions of the two countries before trade, each country is constrained by its own resources and productivity. If Australia put all its land into cotton, it would produce 600 bales of cotton (100 acres * 6 bales/acre) and no wheat; if it put all its land into wheat, it would produce 200 bushels of wheat (100 acres * 2 bushels/acre) and no cotton. The opposite is true for New Zealand. Recall from part 6, a country's production possibility frontier represents all combinations of goods that can be produced, given the country's resources and state of technology. Each country must pick a point along its own production possibility curve.  Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both. Australia should produce cotton, New Zealand should produce wheat. Transferring all land to wheat production in New Zealand yields 600 bushels; transferring all land to cotton production in Australia yields 600 bales. An agreement to trade 300 bushels of wheat for 300 bales of cotton would double both wheat and cotton consumption in both countries. (Remember, before trade both countries produced 150 bushels of wheat and 150 bales of cotton. After trade, each country will have 300 bushels of wheat and 300 bales of cotton to consume. Final production and trade figures are in Table 4 and Figure 2). TABLE 4   Trade enables both countries to move beyond their previous resource and productivity constraints.  The advantages of specialization and trade seem obvious when one country is technologically superior at producing one product and another country is technologically superior at producing another product. However, let us turn to the case in which one country has an absolute advantage in the production of both goods. Gains from Comparative Advantage Table 5 contains different land yield figures for New Zealand and Australia. now New Zealand has a considerable absolute advantage in the production of both cotton and wheat, with 1 acre of land yielding six times as much wheat and twice as much cotton as 1 acre in Australia. Ricardo would argue that specialization and trade are still mutually beneficial. TABLE 5  Again, preferences imply consumption of equal units of cotton and wheat in both countries. With no trade, New Zealand would divide its 100 available acres evenly, or 50/50, between the two crops. The result would be 300 bales of cotton and 300 bushels of wheat. Australia would divide its land 75/25. Table 6 shows that final production in Australia would be 75 bales of cotton and 75 bushels of wheat. (Remember, we are assuming that in each country, people consume equal amounts of cotton and wheat.) Again, before any trade takes place each country is constrained by its own domestic production possibilities curve. TABLE 6  Imagine we are at a meeting of trade representatives of both countries. As a special adviser, David Ricardo is asked to demonstrate that trade can benefit both countries. He divides his demonstration into three stages, which you can follow in Table 7. TABLE 7 Realizing a Gain from Trade When One Country Has a Double Absolute Advantage  In stage one, Australia transfers all its land into cotton production. It will have no wheat and 300 bales of cotton. New Zealand cannot completely specialize in wheat because it needs 300 bales of cotton and will not be able to get enough cotton from Australia. This is because we are assuming that each country wants to consume equal amounts of cotton and wheat. In stage two, New Zealand transfers 25 acres out of cotton and into wheat. Now New Zealand has 25 acres in cotton that produce 150 bales and 75 acres in wheat that produce 450 bushels. Finally, the two countries trade. We assume New Zealand ships 100 bushels of wheat to Australia in exchange for 200 bales of cotton. After the trade, New Zealand has 350 bales of cotton and 350 bushels of wheat; Australia has 100 bales of cotton and 100 bushels of wheat. Both countries are better off than they were before the trade (Table 6), and both have moved beyond their own production possibility frontiers.  Why Does Riccardo's Plan Work? To understand why Ricardo's scheme works, let us return to the definition of comparative advantage. The real cost of producing cotton is the wheat that must be sacrificed to produce it. When we think of cost this way it is less costly to produce cotton in Australia than to produce it in New Zealand, even though an acre of land produces more cotton in New Zealand. Consider the "cost" of 3 bales of cotton in the two countries. In terms of opportunity cost, 3 bales of cotton in New Zealand cost 3 bushels of wheat; in Australia, 3 bales of cotton cost only 1 bushel of wheat. Because 3 Bales are produced by 1 acre of Australian land that, to get 3 bales an Australian must transfer 1 acre of land from wheat to cotton production. Because an acre of land produces a bushel of wheat, losing 1 acre to cotton implies the loss of one bushel of wheat. Australia has a comparative advantage in cotton production because its opportunity cost, in terms of wheat, is lower than New Zealand's. This is Illustrated in Figure 3.  Conversely, New Zealand has a comparative advantage in wheat production. A unit of wheat in New Zealand costs 1 unit of cotton; a unit of wheat in Australia costs 3 units of cotton. When countries specialize in producing goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 667-671* end |
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