In our last module, we learned that trade can make two countries better off when each specializes in the productions of the good for which it has a comparative advantage. The goal in this model is to further illustrate why trade between two countries is still advantageous to both countries even if one country has an absolute advantage in the production of all goods. For example, food and clothing. So, let's pick up where we left off in the last module with the debate between David Ricardo and John Strawman and our example of America and Europe, both of which produce only two goods: food and clothing. Now, to extend this example, let's assume that both America and Europe have 600 hours of labor available. Let's further assume that costs are constant so that we can draw our production possibilities curve as a straight line rather than a bold curve. And to keep things really simple, let's also assume transportation costs are zero so we don't have to worry about how much it costs to ship food and clothing back and forth between America and Europe. Now finally, as illustrated in this table, let's recall that in Europe, it takes three full hours of labor to produce a unit of food but only one unit of labor in America. And in Europe, it takes four hours of labor to produce a unit of clothing but only two hours of labor in America. So, at this point, why don't you try to draw the production possibilities frontiers for both America and Europe under these assumptions. And, so that you and I are on the same page, please put clothing on the vertical axis and food on the horizontal axis. So, take a few minutes now to draw your figures and when you're ready, let's see if your figures look like mine. Okay, do your figures look like this? Here we see that America can produce 300 units of clothing or 600 units of food or some linear combination thereof. This is indicated by the production possibilities frontier drawn as a red line in the left hand figure. In contrast, Europe can produce 150 units of clothing or 200 units of food and this is indicated by the production possibilities frontier drawn as a black line in the right hand figure. So, one conclusion that we can draw from these figures is that if Europe completely cuts off trade with America, the best the Europeans can do is to consume no more than 150 units of clothing or 200 units of food or some combination thereof. Do you see that? Take a minute now to make sure you understand this. Now at this point in the demonstration, David Ricardo turns to John Strawman and says this, "Suppose I sent you to America with 150 units of clothing. How many units of food could you trade that for?" So what's the answer to Ricardo's question? Please take a minute now, jot down your answer before moving on. Okay, suppose John Strawman takes 150 units of clothing to America to trade, how much food can he bring back to Europe? Well, because clothing cost twice as much as food in America in terms of labor requirements, John Strawman might be able to trade Europe's clothing for as much as three hundred units of food. And here's the deal, the result of trade provides up to 100 more units of food for Europe than Europe could have produced with its own labor resources alone. To put this another way, in the absence of trade, Europe can consume no more than 200 units of food. However, by trading with America, Europe can effectively push its production possibilities frontier out to 300 units with its gains from trade. This figure illustrates these possible gains from trade with the gains illustrated by the gray area. This represents an outcome whereby Europe trades freely with America rather than resorting to protectionism in the form of an outright ban on trade or possible trade tariffs or quotas. So, it should be clear here from this example that at least Europe would be better off from trading with America. What about America? Is it also better off? What do you think? So, is America better off as well from trade with Europe in our example, even though America holds an absolute advantage in both food and clothing? Suppose the American president sends a trade representative to Europe with 100 units of food and instructions to trade for as much clothing as possible, will America experience any gains from trade? And as a hint, to answer this question, try to use the same kind of production possibilities frontier and gains from trade graph we just used to illustrate the American situation. Okay, in this case, America can experience gains from trade of up to 150 units of clothing if it specializes in food production and trades with Europe for its food. Just how did we get to this result? Well, recall that in our example, the cost of producing four units of clothing in Europe is three units of food. That means an American trader could come to Europe and Exchange 100 units of food for as much as 75 units of clothing or exchange up to 600 units of food for 450 units of clothing. These gains from trade are illustrated in this figure and highlighted again by the gray area in the figure. You should see then that like Europe, America is better off by trading. And this is despite the fact that America has an absolute advantage in both food and clothing production. The broader and key point here is this: the theory of comparative advantage coupled with the gains from trade argument are two of the most important concepts in all of macroeconomics. That said, I urge you not to completely fall in love with the theory of comparative advantage or trade for trade's sake. One reason is political. Even though a nation might gain overall from trade, trade can inflict tremendous costs and harm on some segments of a nation's population. In our simple example here, if America chooses to specialize solely in farm production, clothing manufacturers in America will be harmed along with the workers in that industry. The same time, in Europe, farmers will be hurt as Europe moves to specialization in clothes production. These observations mean that the politics of trade are far more difficult to address than the economics. Note, however, that there is a second and potentially even bigger political problem with the textbook Ricardian Free Trade model. To wit, trade is only beneficial between two nations when both nations abide by the rules of free and fair trade. If, however, one nation uses unfair trade practices, that, too, can inflict great harm on other nations even as such unfair trade practices destroy any possible gains from trade for the harmed nation. In such a case, the Ricardian model of free trade, with all its gains from trade theory, can crash on the shoals of a much harsher reality. Because this is so, we must look much more closely at the intricate politics of trade. When you're ready, let's move on to the next module and a discussion of various trade barriers such as tariffs or quotas and their implications for economic efficiency.
