AYUNTAMIENTO DE MONTERREY PRESENTE

Within any particular nation the companies and industries do some things better than they do other things. That is, for example, one nation may be twice as good at making computers as it is at growing corn. Another nation may be better at growing corn than at producing computers. The principle of com-

parative advantage explains how these relative differences within countries can

lead to beneficial trade between partners.

Returning to our example of the island, imagine that you and Jane both are still fishing and farming to survive. She spends half a day fishing and one day farming and she gets all the food she needs for a week. Since you do not fish very well it takes you a whole day to get a week’s fish. It takes you a day and half to get your farming done. Jane is more efficient than you are in both tasks since she spends less time in both tasks. She has absolute advantage in both tasks. However, because Jane is better at fishing than farming she spends twice as much of her time farming as she does fishing. Because you are better at farming than fishing, you spend 1.5 as much time fishing as farming.

Because both Jane and you are relatively better at one task than another task, there are comparative advantages. Jane’s is fishing and yours is farming. Does it make sense for you to specialize in what you do best and for Jane to specialize in what she does best, and trade fish for fruits and vegetables? Let us look at a simple example as shown in Exhibit 4.3 to show how trade in such a situation can work for both sides’ benefit.

In this example, we compare US and Chinese production of computers and bicycles. Many people in the US and Europe now fear that production of many goods will go to developing nations, with their low-cost labor and increasingly sophisticated production technologies. However, even if, for example, the Chinese can do most things more cheaply, the theory of comparative advantage suggests that trade can still be beneficial to the world’s trading partners.

To illustrate the point, we arbitrarily make the Chinese television and bicycle manufacturers more efficient than their US counterparts. For the example of absolute advantage shown in Exhibit 4.3, we considered only labor costs and input, but since we know that much more than labor goes into producing something, we generalize in this example to consider broadly the input of

Exhibit 4.3

Resource Inputs Opportunity Costs

Computer Bicycle Computer Bicycle

China 10 2 5 0.2

United States 100 4 25 0.04

comparative advantage

the relative advantage in production efficiency that a nation has internally over another

resources. Thus, in this illustration, the Chinese use 10 units of resources (e.g. labor, materials, capital, machinery, etc.) to produce one computer and 2 units of resources to produce a bicycle. In comparison, the US producers use 100 resource units for a computer and 4 units for a bicycle. The Chinese have absolute advantage in the production of both products because they use fewer resources.

Comparative advantage relates to the idea of opportunity costs. Opportunity costs mean that when you choose to produce one good, you have to give up the opportunity to produce another good. Thus, there is a trade-off each country makes when it decides to produce one good in place of another. A country has comparative advantage in good A if it has to give up producing fewer units of good B than does another country. This means that within that country it is relatively more efficient to produce one product than another product.

We estimate opportunity costs by comparing the relative resource inputs into producing a good. That is, how many resources would you have to switch from one product to produce another product? In our example, you can see that if the Chinese want to produce another computer with the required 10 units of resources, they must give up production of five bicycles. The opportunity costs are 10/2, or 5. That is, for every computer produced instead of bicycles they lose about five bicycles. US manufacturers must give up 25 bicycles for each computer since they are comparatively less efficient than are the Chinese in computer production. For the US producers, however, an additional bicycle costs only a very small fraction of the resources that produce a computer (4/100 = 0.04). This is relatively better than the Chinese output (2/5 = 0.2). Thus, although the Chinese have absolute advantage in both products, the US has comparative advantage in bicycle production and the Chinese have comparative advantage in computer production.

Comparative Advantage and Production Gains The theory of comparative advantage suggests that countries should specialize not only in those products for which they have absolute advantage but also in those products for which they have comparative advantage. With specialization and trade it becomes possible with comparative advantage for both trading partners to gain.

Exhibit 4.4 shows how it works out. In this Exhibit, we show how each country could use 10,000 resource units in the production of bicycles and computers.

With no trade between the US and China, which economists call the state of autarky or lack of trade, each country would have to produce and consume its own output. Each country would then produce a mixture of computers and bicycles by allocating its 10,000 resource units between the two products. The Chinese could produce up to 1,000 computers with no bicycles or up to 5,000 bicycles with no computers. US manufacturers could produce up to 100 computers with no bicycles or 2,500 bicycles without any computers. These are the extremes of the production possibilities; more realistically, each country would produce a mix of products depending on consumer tastes. It is unlikely that there would be no demand for at least some bicycles or some computers in each country.

For the sake of illustration, let us assume that each country divides its 10,000 resource units equally between bicycle production and computer

opportunity costs

the choice to produce one good requires you to give up the opportunity to produce another good

autarky

production. Using the required resource units per computer and per bicycle, Exhibit 4.4 shows the production from 10,000 resource units spread equally between products based on the required resource inputs for each country (see Exhibit 4.3 for the resource units required to produce each product). Chinese manufacturers can produce 500 computers (5,000/10) and 2,500 bicycles (50,000/2) in China and 50 computers (5,000/100) and 1,250 bicycles (5,000/4) in the US.

If each country specializes in its area of comparative advantage, as shown in Exhibit 4.4, production becomes greater in both bicycles and computers! Unlike for absolute advantage, total specialization by each country does not always produce more in both products. Had the Chinese completely specialized in computers and the US in bicycles, the world would have many more com- puters and slightly fewer bicycles than before specialization. However, the Chinese could increase world production output using only 70 percent of their resources and still allocate the remaining 30 percent to bicycle production. With the US totally specializing in bicycle production, worldwide production is now higher than before in both products.

Comparative Advantage and Consumption Gains With the production gains, there are now 150 more computers and 250 more bicycles available for Chinese and US American consumers. However, in order to get these goods, China and the US must trade.

Without trade, Chinese and US consumers were limited in what they could purchase by the range of production possibilities in the trade-offs between com- puters and bicycles. Exhibit 4.4 shows the net gains in consumption possibilities for the two-country world assuming they were divided equally between China and the US. With trade and the right forms of specialization, consumers in both

Exhibit 4.4

Production Gains from Trade

Before Specialization After Specialization Net Gain (Loss)

Computers Bicycles Computers Bicycles Computers Bicycles

China 500 2,500 700 1,500 200 –1,000

US 50 1,250 0 2,500 –50 1,250

Total 550 3,750 700 4,000 150 250

Consumption Gains from Trade

Before Trade After Trade Net Gain (Loss)

Computers Bicycles Computers Bicycles Computers Bicycles

China 500 2,500 575 2,625 75 125

US 50 1,250 125 1,375 75 125

countries now can consume more than would be possible in a world without trade. Theoretically, at least, everyone benefits.

Free trade advocates rely heavily on the theory of comparative advantage to offset arguments that low-cost countries such as China will eventually produce everything, leaving the developed world with nothing but local service industries and many lost jobs. The argument is that no country can have com- parative advantage in everything.

Ricardo’s theory of comparative advantage looks at the efficiency of production primarily through labor costs as the basis of comparative advan- tage. For example, it is easy to see in today’s world that countries like Mexico, China, and the Czech Republic have lower wages than the US or Germany, and thus are more efficient at producing some products. However, there are other sources of comparative advantage besides the efficiency of resource inputs. In the next section, we consider other sources of comparative advantage as outlined by two Swedish economists, Eli Heckscher4_{and the Nobel prizewinner Bertil}

Ohlin.5

The Heckscher–Ohlin Theory and the Role of Factor