Absolute Advantage

A nation has an absolute advantageCondition whereby a country is the only source of a product or is able to make more of a product using the same or fewer resources than other countries. if (1) it’s the only source of a particular product or (2) it can make more of a product using the same amount of or fewer resources than other countries. Because of climate and soil conditions, for example, France had an absolute advantage in wine making until its dominance of worldwide wine production was challenged by the growing wine industries in Italy, Spain, and the United States. Unless an absolute advantage is based on some limited natural resource, it seldom lasts. That’s why there are few, if any, examples of absolute advantage in the world today.

Comparative Advantage

How can we predict, for any given country, which products will be made and sold at home, which will be imported, and which will be exported? This question can be answered by looking at the concept of comparative advantageCondition whereby one nation is able to produce a product at a lower opportunity cost compared to another nation., which exists when a country can produce a product at a lower opportunity cost compared to another nation. But what’s an opportunity cost? Opportunity costs are the products that a country must decline to make in order to produce something else. When a country decides to specialize in a particular product, it must sacrifice the production of another product.

Let’s simplify things by imagining a world with only two countries—the Republic of High Tech and the Kingdom of Low Tech. We’ll pretend that each country knows how to make two and only two products: wooden boats and telescopes. Each country spends half its resources (labor and capital) on each good. Figure 3.2 "Comparative Advantage in the Techs" shows the daily output for both countries: High Tech makes three boats and nine telescopes while Low Tech makes two boats and one telescope. (They’re not highly productive, as we’ve imagined two very small countries.)

First, note that High Tech has an absolute advantage (relative to Low Tech) in both boats and telescopes: it can make more boats (three versus two) and more telescopes (nine versus one) than Low Tech can with the same resources. So, why doesn’t High Tech make all the boats and all the telescopes needed for both countries? Because it lacks sufficient resources to make all the boats and all the telescopes, High Tech must, therefore, decide how much of its resources to devote to each of the two goods. Let’s assume that each country could devote 100 percent of its resources on either of the two goods. We’ll pick boats as a start. If both countries spend all their resources on boats (and make no telescopes), here’s what happens:

• When we assumed that High Tech spent half of its time on boats and half of its time on telescopes, it was able to make nine telescopes (see Figure 3.2 "Comparative Advantage in the Techs"). If it gives up the opportunity to make the nine telescopes, it can use the time gained by not making the telescopes to make three more boats (the number of boats it can make with half of its time). Because High Tech could make three more boats by giving up the opportunity to make the nine telescopes, the opportunity cost of making each boat is three telescopes (9 telescopes ÷ 3 boats = 3 telescopes).
• When we assumed that Low Tech spent half of its time on boats and half of its time on telescopes, it was able to make only one telescope (Figure 3.2 "Comparative Advantage in the Techs"). If it gives up the opportunity to make the telescope, it can use the time gained by not making the telescope to make two more boats. Because Low Tech could make two more boats by giving up the opportunity to make one telescope, the opportunity cost of making each boat is half a telescope (1 telescope ÷ 2 boats = 1/2 of a telescope).
• Low Tech, therefore, enjoys a lower opportunity cost: Because it must give up less to make the extra boats (1/2 telescope vs. 3 telescopes), it has a comparative advantage for boats. And because it’s better—that is, more efficient—at making boats than at making telescopes, it should specialize in boat making.

Now to telescopes. Here’s what happens if each country spends all its time making telescopes and makes no boats:

• When we assumed that High Tech spent half of its time on boats and half of its time on telescopes, it was able to make three boats (Figure 3.2 "Comparative Advantage in the Techs"). If it gives up the opportunity to make the three boats, it can use the time gained by not making the boats to make nine more telescopes. Because High Tech could make nine more telescopes by giving up the opportunity to make three boats, the opportunity cost of making each telescope is one-third of a boat (3 boats ÷ 9 telescopes = 1/3 of a boat).
• When Low Tech spent half of its time on boats and half of its time on telescopes, it was able to make two boats. If it gives up the opportunity to make the two boats, it can use the time to make one more telescope. Thus, if High Tech wants to make only telescopes, it could make one more telescope by giving up the opportunity to make two boats. Thus, the opportunity cost of making each telescope is two boats (2 boats ÷ 1 telescope = 2 boats).
• In this case, High Tech has the lower opportunity cost: Because it had to give up less to make the extra telescopes (1/3 of a boat vs. 2 boats), it enjoys a comparative advantage for telescopes. And because it’s better—more efficient—at making telescopes than at making boats, it should specialize in telescope making.

Each country will specialize in making the good for which it has a comparative advantage—that is, the good that it can make most efficiently, relative to the other country. High Tech will devote its resources to telescopes (which it’s good at making), and Low Tech will put its resources into boat making (which it does well). High Tech will export its excess telescopes to Low Tech, which will pay for the telescopes with the money it earns by selling its excess boats to High Tech. Both countries will be better off.

Things are a lot more complex in the real world, but, generally speaking, nations trade to exploit their advantages. They benefit from specialization, focusing on what they do best, and trading the output to other countries for what they do best. The United States, for instance, is increasingly an exporter of knowledge-based products, such as software, movies, music, and professional services (management consulting, financial services, and so forth). America’s colleges and universities, therefore, are a source of comparative advantage, and students from all over the world come to the United States for the world’s best higher-education system.

France and Italy are centers for fashion and luxury goods and are leading exporters of wine, perfume, and designer clothing. Japan’s engineering expertise has given it an edge in such fields as automobiles and consumer electronics. And with large numbers of highly skilled graduates in technology, India has become the world’s leader in low-cost, computer-software engineering.

Managing the National Credit Card

Are trade deficits a bad thing? Not necessarily. They can be positive if a country’s economy is strong enough both to keep growing and to generate the jobs and incomes that permit its citizens to buy the best the world has to offer. That was certainly the case in the United States in the 1990s. Some experts, however, are alarmed at our rapidly accelerating trade deficit. Investment guru Warren Buffet, for example, cautions that no country can continuously sustain large and burgeoning trade deficits. Why not? Because creditor nations will eventually stop taking IOUs from debtor nations, and when that happens, the national spending spree will have to cease. “Our national credit card,” he warns, “allows us to charge truly breathtaking amounts. But that card’s credit line is not limitless.”Warren E. Buffet, “Why I’m Not Buying the U.S. Dollar,” Wall Street Week with Fortune, http://www.pbs.org/wsw/news/fortunearticle_20031026_03.html (accessed May 25, 2006).

By the same token, trade surpluses aren’t necessarily good for a nation’s consumers. Japan’s export-fueled economy produced high economic growth in the 1970s and 1980s. But most domestically made consumer goods were priced at artificially high levels inside Japan itself—so high, in fact, that many Japanese traveled overseas to buy the electronics and other high-quality goods on which Japanese trade was dependent. CD players and televisions were significantly cheaper in Honolulu or Los Angeles than in Tokyo. How did this situation come about? Though Japan manufactures a variety of goods, many of them are made for export. To secure shares in international markets, Japan prices its exported goods competitively. Inside Japan, because competition is limited, producers can put artificially high prices on Japanese-made goods. Due to a number of factors (high demand for a limited supply of imported goods, high shipping and distribution costs, and other costs incurred by importers in a nation that tends to protect its own industries), imported goods are also expensive.“Why Are Prices in Japan So Damn High?” The Japan FAQ, http://www.geocities.com/japanfaq/FAQ-Prices.html (accessed May 25, 2006).

Balance of Payments

The second key measure of the effectiveness of international trade is balance of paymentsDifference between the total flow of money coming into a country and the total flow of money going out.: the difference, over a period of time, between the total flow of money coming into a country and the total flow of money going out. As in its balance of trade, the biggest factor in a country’s balance of payments is the money that comes in and goes out as a result of imports and exports. But balance of payments includes other cash inflows and outflows, such as cash received from or paid for foreign investment, loans, tourism, military expenditures, and foreign aid. For example, if a U.S. company buys some real estate in a foreign country, that investment counts in the U.S. balance of payments, but not in its balance of trade, which measures only import and export transactions. In the long run, having an unfavorable balance of payments can negatively affect the stability of a country’s currency. Some observers are worried about the U.S. dollar, which has undergone an accelerating pattern of unfavorable balances of payments since the 1970s. For one thing, carrying negative balances has forced the United States to cover its debt by borrowing from other countries.Warren E. Buffet, “Why I’m Not Buying the U.S. Dollar,” Wall Street Week with Fortune, http://www.pbs.org/wsw/news/fortunearticle_20031026_03.html (accessed May 25, 2006); “U.S. Trade in Goods and Services—Balance of Payments (BOP) Basis, 1960 thru 2010,” June 9, 2011, http://www.census.gov/foreign-trade/statistics/historical/gands.txt (accessed August 21, 2011). Figure 3.4 "U.S. Imports, Exports, and Balance of Payments, 1994–2010" provides a brief historical overview to illustrate the relationship between the United States’ balance of trade and its balance of payments.