Many of the important ideas in economics were first worked out by analyzing international trade. Economists argue that free trade enhances efficiency.

In running our personal affairs, virtually all of us exploit the advantages of free trade and comparative advantage without thinking twice. For example, many of us have our shirts laundered at professional cleaners rather than wash and iron them ourselves. Anyone who advised us to "protect" ourselves from the "unfair competition" of low-paid laundry workers by doing our own wash would be thought looney. --Alan Blinder, "Free Trade," The Concise Encyclopedia of Economics

Here is an example from David Friedman's Hidden Order: The Economics of Everyday Life.

There are two ways we can produce automobiles. We can build them in Detroit or we can grow them in Iowa. Everyone knows how we build automobiles. To grow automobiles, we first grow the raw material from which they are made--wheat. We put wheat on shhips and send the ships out into the Pacific. They come back with Hondas on them.

As this example illustrates, trade is a way of transforming our output into different output. Using trade, we can produce more goods where we have a comparative advantage, and trade them for goods where another country has a comparative advantage. Indeed, the concept of comparative advantage first was developed almost 200 years ago by David Ricardo in the context of analyzing international trade.

The Ricardian Model

Suppose that the United States can produce 6 cars per worker per year, and 90 tons of wheat per worker per year. Suppose that the rest of the world can produce 4 cars per worker per year, and 50 tons of wheat per worker per year. The United States is more productive in both industries, which means that the U.S. has an absolute advantage in both. The naive view is that the United States cannot gain from trade, because we are more efficient. But we can show that this view is wrong.

Suppose that Americans like to spend half of their income on cars and half their income on wheat, and that we have 100 workers. If we do not trade, then half of our workers will make cars and half will produce wheat. With 50 workers producing cars, we produce 300 cars. With 50 workers producing wheat, we produce 4500 tons of wheat.

Next, suppose that we can trade. We can specialize in producing wheat, so that 100 workers produce 9000 tons of wheat. Then, we keep 4500 tons of wheat and trade 4500 tons of wheat in the world market.

In the world market, 50 tons of wheat can trade for 4 cars. If a car costs $10,000, then a ton of wheat will cost $800. So our 4500 tons of wheat can trade for 360 cars.

With no trade, we produce and consume 4500 tons of wheat and 300 cars. With trade, we produce 9000 tons of wheat, but we consume 4500 tons of wheat and 360 cars. We export 4500 tons of wheat and import 360 cars. The opportunity to trade increases our ability to consume by 60 cars compared with no trade.

Trade with diminishing returns

Here is an example with diminishing returns. Suppose that everyone consumes tacos, which consist of hamburger meat and tortillas. If you multiply the number of ounces of hamburger meat times the number of tortillas, you have a measure of consumer happiness, which we will call the index of satisfaction.

The United States has 100 units of labor, which can be allocated either to producing hamburger meat or producing tortillas. If we allocate 25 units to producing meat and 75 units to producing tortillas, then we obtain 22 ounces of meat and 66 tortillas. Multiplying 22 by 66 gives a total satisfaction index of 1452. Below is a table that gives consumption possibilities for different allocations of labor.

Because the trade-off between meat and tortillas is one for one, if the price of a tortilla is 10 cents, then the price of an ounce of meat will also be 10 cents. (All we really know about prices in this economy is the relative price of meat in terms of tortillas. That is, we know that the price of an ounce of meat is the same as the price of a tortilla, because the cost trade-off between the two is one for one. However, the price of ten cents is arbitrary. We could have fixed the price of a tortilla at $5, in which case the price of an ounce of meat would be $5.)

Next, consider another economy, Mexico, that also does not trade. It has the same amount of labor as the United States, but labor is not as productive in either the meat industry or the tortilla industry.

In Mexico, giving up one ounce of meat means that they can produce two more tortillas. Therefore, in Mexico, if the price of a tortilla is 10 cents, then the price of an ounce of meat will be 20 cents.

Note that the United States has higher productivity in terms of both tortillas and meat. The United States has an absolute advantage in both goods. However, the gains from trade come from comparative advantage, not absolute advantage.

The key to this entire example is the fact that the United States has to give up one tortilla for one ounce of meat, while Mexico only has to give up two tortillas for one ounce of meat. This means that the relative cost of meat will be higher in Mexico, so that Mexico will have a comparative advantage in producing tortillas.

Prior to trade, prices are different in the two countries. A tortilla costs 10 cents in each country, but an ounce of meat costs 10 cents in the United States and 20 cents in Mexico. When trade opens up, Mexico will want to import cheap meat from the United States, which means that it will have to export tortillas. Eventually, free trade leads to a new price of meat that is the same in both countries.

When trade opens up between the two countries, Mexico will shift 25 workers from meat to tortillas, so that it produces 57 tortillas and 15 ounces of meat. The United States will shift 25 workers from tortillas to meat, so that it produces 57 ounces of meat and 34 tortillas. Total production will be 72 ounces of meat and 91 tortillas.

After trading 15 ounces of meat for 18 tortillas, the United States consumes 42 ounces of meat and 52 tortillas, for a total satisfaction index of 2184. Thus, both countries are better off with trade.

Key Points

1. Beneficial trade is possible whenever there is comparative advantage. A country does not have to be absolutely more productive in an industry in order to export goods in that industry.

2. Without trade, relative prices between goods can differ in two countries. These relative prices are what indicate comparative advantage. A country will export the goods that are relatively more expensive abroad than at home.

3. With trade, the relative prices of goods will be equalized. Arbitrage helps to ensure that this is the case.

4. With trade, both countries are better off. Each country will produce more of the good where it has a comparative advantage, and trade some of that good for the other good.