I. Trade Happens

If you read the introduction and checked your clothing label, you probably noticed that your shirt isn’t from the same country that you’re sitting in right now. How did it get here? Well, trade.

We read about it in the news. We travel by ports and see huge container ships coming into and out of the harbor. Trade is everywhere.

But why do countries trade?

In short, countries trade because they are different.

Imagine for a moment that you’re a fourth grader who stinks at math, but is great at spelling. In the desk next to you, there is a kid who is great at math, but can’t spell to save his life. Wouldn’t it be great if the math nerd could take your math test for you? You’d likely be more than happy to take his spelling test for him. He’d be happy to take your math test, ignore his vocabulary practice, and go play with his calculator. Both of you would be better off.

That’s trade. The nerd does math because that’s his strength. You take spelling tests because that’s your strength.

The only difference between the above example and international trade are the actors.  Extend the idea to countries, and you have the basis for trade.

Central America exports bananas, because they have the natural climate to grow them. The U.S. could also grow bananas, but it would have to build expensive greenhouses and irrigation systems. On the other hand, the U.S. exports airplanes because we have many solid engineers, natural resources, and infrastructure.

As we look around us, it’s easy to see that trade happens. We also know from observation that trade probably follows a pattern where countries sell the stuff they are good at making (and countries buy the stuff they are less good at making). Now, let’s put some slightly more formal definitions onto these concepts.

II. Opportunity Cost

Remember why we decided the U.S. doesn’t grow bananas? It’s not because the U.S. can’t grow bananas. After all, we could go through all the hassle of building greenhouses, paying for lots of heat in the winter to keep the banana plants alive, and so on.

On the other hand, in the tropics, all we have to do to grow a banana plant is stick it outside. Mother nature takes care of the rest, and she doesn’t cost a penny.

So, all of the money and resources that would go into growing bananas in the U.S. might as well be used for something else. Instead of building a banana greenhouse, we would be better served building a factory. Instead of paying for heat in the winter, we could hire a great new baseball player from Japan to play in the Major Leagues.

That gets us to the idea of opportunity cost. Put simply, opportunity cost is what we give up to make one thing instead of another thing. For example, if we decide to grow bananas in the colder U.S., we have to spend money building greenhouses and paying for heat. As a result we have to give up the Japanese baseball players we could have hired to make even better baseball teams.

The opportunity cost of growing bananas in the U.S. is what we give up in terms of other stuff to grow them domestically.

Let’s take a look at a numerical example:

Suppose that a U.S. farm can produce 10 tons of bananas or 50 tons of corn in one year. Suppose that a Costa Rican farm can produce 5 tons of bananas or 10 tons of corn in one year.

To grow 1 ton of bananas in the U.S., we have to give up 5 tons of corn (10 bananas ÷ 50 corn).

To grow 1 ton of bananas in Costa Rica, we only have to give up 2 tons of corn (5 bananas ÷ 10 corn).

What have we learned? We’ve shown that the opportunity cost (what we give up) to grow bananas is greater in the U.S. than in Costa Rica.

III. Comparative Advantage

With our knowledge of opportunity cost (what we give up to produce one thing instead of another), we can now take a look at the idea of comparative advantage.

Many people struggle with the idea of comparative advantage, but we think that’s completely unnecessary. Here’s why:

A country has a comparative advantage when its opportunity cost is lower.

That’s it! That wasn’t so bad, was it? Let’s go back to the example.

As we saw above, the U.S. has to give up 5 tons of corn if it chooses to produce 1 ton of bananas. In contrast, Costa Rica has to give up only 2 tons of corn to produce 1 ton of bananas. The opportunity cost for Costa Rica is lower, which means that in our example, Costa Rica has a comparative advantage in bananas.

But wait, you say, the U.S. farm can produce more bananas and more corn than the Costa Rican farm!

True, the fact that the U.S. farm can produce more bananas and more corn in one year than its Costa Rican counterpart is known as absolute advantage. In trade, we really don’t care about absolute advantage. We care about comparative advantage because we care about opportunity cost. We don’t care about how much of something we have, but rather how much we gave up to get it. (Think about it - In a lifetime you could probably build a TV by yourself, but in a lifetime of work you could earn enough money to buy more than one TV. The opportunity cost of building your own TV is so high that you will probably choose to work at a different job and buy one instead.)

IV. Why Should I Care About All This?

All of this talk about opportunity cost, comparative advantage, bananas, and corn may seem like an interesting discussion, but why is it important? What benefits does trade bring?

By allowing countries to specialize in producing goods for which they have a comparative advantage, trade has the capacity to make more goods available for common consumption. To see why this is the case, let’s take a look at a new example.

Suppose that the opportunity cost of 1 bottle of wine in France is 1 bottle of beer.
Suppose that the opportunity cost of 1 bottle of wine in Germany is 2 bottles of beer.

Let’s say the French want 100 bottles of beer. If they produce the beer themselves, they will have to give up 100 bottles of wine. However, if they let the Germans make the beer, and instead focus themselves on producing wine, they will produce 100 bottles of wine. If the Germans produce 100 bottles of beer, the world only loses 50 bottles of wine. (That’s the opportunity cost of producing 100 bottles of beer in Germany.)

Let’s total it up.

Beer: -100 (France stops making beer) + 100 (Germany starts making beer) = 0

Wine: +100 (France starts making wine) - 50 (Germany stops making wine) = +50

With the agreement between France and Germany to each specialize, the world can enjoy an additional 50 bottles of beer.

V. Conclusion

We’ve seen that trade can be good. (Who doesn’t want an extra 50 bottles of beer?) But we can’t yet be convinced that this optimal arrangement will be reached. After all, there is no world government out there telling France and Germany what to do. To figure out and predict if trade will be beneficial or follow the pattern we predicted, we need to develop slightly more detailed explanations for why countries trade in the ways they do.

The different models we will examine in the next few sections all try to explain and predict the pattern of trade. They do this by giving different reasons for why countries are different. For example, our first model argues that countries are different because workers in different countries are more productive at producing certain goods and less productive at producing others.

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