Lecture: International Trade & Comparative Advantage
Lecture script · about 15–20 minutes spoken · Week 13
Opening
Here's a question worth asking out loud. Why does any country trade at all?
Start with your own week. You work at one job, or you study toward one career. You don't grow your own food, sew your own clothes, or build your own phone. You spend your hours on one thing, and you trade the results for everything else. A business major pricing imported parts, a farmworker whose next season depends on crops sold abroad, and a warehouse worker moving containers at a port all live inside that same choice.
Here's where we are. In Week 1, The Macro Perspective, you met opportunity cost: the best alternative you give up. In Week 2, Measuring Output, you built gross domestic product from four kinds of spending, with net exports as exports minus imports. And in Week 12, Inflation, the Phillips Curve & Expectations, we closed the unit on money and prices. In this lecture a new unit begins: the open economy, where goods cross borders.
Here's the plan. I'll introduce two small countries and ask who makes more. Then we'll build their costs one ratio at a time, find who should make what, set a fair price for the trade, and prove that both sides gain. After that, we'll read a trade deficit calmly, and finish with an honest debate about tariffs. Every country, good, and number in this lecture is illustrative, built for this course, and not real data.
1. Who makes more? Absolute advantage
Picture two cooks in one kitchen. One chops onions faster than the other. Ask who is better at chopping, and you'd point to the faster one. That's the everyday idea behind this first term.
Now meet two countries, Northland and Southland. Each makes two goods, wheat and cloth. To compare them fairly, we measure output from the same resource: one worker-day, which is one worker's labor for one day.
In one worker-day, a Northland worker makes 4 wheat or 2 cloth. A Southland worker makes 6 wheat or 2 cloth.
Here's the term. Absolute advantage is the ability to produce more of a good than another producer can from the same resources, such as more units per worker-day.
So read the numbers. In wheat, Southland makes 6 and Northland makes 4, so Southland has the absolute advantage in wheat. In cloth, both make 2, so they tie. Put that together and Southland is at least as productive as Northland at everything.
So why would Southland ever buy from Northland? Hold on to that question.
Pause and try this. Does Southland's absolute advantage in wheat tell you which country should make the wheat?
Hold your answer until you hear what each country gives up.
Here's the answer. Not yet. Absolute advantage only asks who makes more from the same worker-day; who should make what depends on cost, which comes next.
2. The opportunity-cost table, one ratio at a time
Think back to Week 1. When you spend an evening on one thing, the cost isn't only what you pay. It's what you could have done instead. Countries face the same kind of cost. A worker-day spent on cloth is a worker-day not spent on wheat.
So in a two-good model, opportunity cost is the units of the other good given up to make one more unit of a good. Here's the rule I want you to say every time: the cost of good A equals the units of good B given up, divided by the units of good A gained.
Let's build the table one ratio at a time, saying the units first.
Northland's cloth. One worker-day makes 2 cloth or 4 wheat. To gain 2 cloth, Northland gives up 4 wheat. So one cloth costs 4 divided by 2, which is 2 wheat.
Southland's cloth. One worker-day makes 2 cloth or 6 wheat. So one cloth costs 6 divided by 2, which is 3 wheat.
Now flip the question for wheat. Northland gives up 2 cloth to gain 4 wheat, so one wheat costs 2 divided by 4, which is 0.5 cloth. Southland gives up 2 cloth to gain 6 wheat, so one wheat costs 2 divided by 6, which is one third of a cloth.
Notice that each country's two costs are flips of each other. Northland's 2 wheat per cloth turns into 0.5 cloth per wheat. That's a handy check on your work.
Pause and try this. A classmate writes that Northland's cloth costs 0.5 wheat. What went wrong?
Say the units of the question first.
Here's the answer. The ratio is upside down. The cost of one cloth, in wheat, puts the wheat on top, so it's 4 divided by 2, which is 2 wheat, not 0.5.
3. Comparative advantage: the lower cost decides
Now for the puzzle. Picture a head chef who chops onions faster than a new line cook. Should the chef do the chopping too? Every hour the chef spends chopping is an hour not spent planning the menu and running the kitchen. The line cook gives up much less to chop. So the line cook chops, and the whole kitchen gets more done.
That's the idea behind this term. Comparative advantage is the ability to produce a good at a lower opportunity cost, measured in units of the other good given up, than another producer can; it decides who should specialize in what.
Read the table one good at a time. Cloth costs Northland 2 wheat and costs Southland 3 wheat. Since 2 is less than 3, Northland has the comparative advantage in cloth. Wheat costs Northland 0.5 cloth and costs Southland one third of a cloth. Since one third is less than a half, Southland has the comparative advantage in wheat.
Here's the punchline. Southland makes at least as much of each good per worker-day, yet it still gains by letting Northland make the cloth. Absolute advantage does not decide who specializes. Opportunity cost does.
And when a country puts its resources into the good with the lower cost and gets the other good through trade, that's specialization.
The classic error is handing the comparative advantage to whoever has the absolute advantage. "Better at it" sounds like "should do it." But being faster doesn't tell you what each side gives up, and giving up less is what decides the job.
Pause and try this. Northland makes no more cloth than Southland. So why does Northland end up making the cloth?
Think about what each country gives up.
Here's the answer. Northland gives up only 2 wheat for each cloth, while Southland gives up 3. The lower opportunity cost wins the job, not the bigger output.
4. The terms of trade and the mutually beneficial range
Specializing is only half the plan. Northland makes cloth and wants wheat, so it has to swap. How much wheat should one cloth buy?
Think of two neighbors trading garden produce. If one asks too much, the other grows it at home instead. A trade happens only at a price that beats what each side can do alone.
Here's the term. The terms of trade are the rate at which one good trades for another between two trading partners, such as the units of wheat paid for one unit of cloth.
Each country checks the price against its own cost. Northland sells cloth that costs it 2 wheat, so it wants more than 2 wheat for each one. Southland buys cloth, and making its own would cost 3 wheat, so it will pay less than 3. That gives us the mutually beneficial range: the span of possible terms of trade lying between the two trading partners' opportunity costs, inside which both sides get the good more cheaply than they could make it at home. Here, it runs from 2 to 3 wheat per cloth.
The course sets the terms at 2.5 wheat per cloth. Northland gets 2.5 wheat for a cloth that cost it 2, so it gains 0.5 wheat on every cloth. Southland pays 2.5 for a cloth that would cost it 3, so it saves 0.5 wheat on every cloth. Both sides come out ahead.
Outside the range, one side loses. Below 2, Northland would rather make both goods at home; above 3, Southland would rather make its own cloth.
Pause and try this. Suppose someone offers the two countries a price of 3 wheat per cloth. Who gains nothing at that price?
Compare the price with Southland's own cost.
Here's the answer. Southland gains nothing. Making its own cloth costs 3 wheat, so paying 3 wheat for one saves it nothing at all.
5. Proving the gains from trade
Let's count. We compare what each country has before trade with what it has after.
Each country has 12 worker-days. Before trade, each splits its days to make both goods for itself. Northland puts 8 worker-days on wheat, which makes 32 wheat, and 4 on cloth, which makes 8 cloth. Southland puts 6 on wheat, which makes 36 wheat, and 6 on cloth, which makes 12 cloth.
Now each specializes. Northland puts all 12 worker-days on cloth and makes 24 cloth. Southland puts all 12 on wheat and makes 72 wheat. Then Northland sends 14 cloth and, at 2.5 wheat per cloth, receives 35 wheat.
Here's what each ends with. Northland has 35 wheat and 10 cloth, up from 32 and 8. Southland has 37 wheat and 14 cloth, up from 36 and 12. Both countries end with more of both goods.
Here's the term for that. Gains from trade are the extra goods each trading partner ends up with when both specialize by comparative advantage and trade at terms inside the mutually beneficial range, compared with making everything at home.
Where did the extra come from? Add up the world. Before trade, the two countries made 68 wheat and 20 cloth. After specializing, they made 72 wheat and 24 cloth, with the same 24 worker-days. The pie got bigger before anyone sliced it. That specialization raises total output is a positive result of the model, something you can check with arithmetic.
One honest caveat. The model counts whole countries. Inside Northland, the workers who used to grow wheat now have to make cloth, or find other work. The country gains, but not every person gains at first. We'll come back to that.
Pause and try this. Northland gains 3 wheat and Southland gains 1 wheat. How much more wheat does the world have?
Add the two gains together.
Here's the answer. The world has 4 more wheat. That matches the rise from 68 to 72, which shows the gains are new output, not something taken from either side.
6. Reading the trade balance
Now zoom out from wheat and cloth to a whole economy's books. A country sells goods abroad and buys goods from abroad, and the news often reports the gap between the two with a worried tone.
Here's the term. The trade balance is a country's exports minus its imports over a period, the same quantity as net exports; it is positive when exports are larger and negative when imports are larger.
Take the illustrative national account from Week 2, measured in billions of dollars. Exports are 100. Imports are 150. So net exports are 100 minus 150, which is negative 50. In words, imports exceeded exports by 50, in billions of dollars.
That's a trade deficit: a negative trade balance, where over the period the country's imports exceeded its exports, which describes the direction of trade flows and is not by itself a loss of national income.
Why the minus sign in GDP? In Week 2, some of the spending we counted went to goods made abroad, so we take those back out. Subtracting imports removes foreign output from the count; it doesn't erase anything made at home.
The classic misreading is to treat a trade deficit like a business posting a loss. The word "deficit" sounds like an unpaid bill. But the people in that economy bought goods, and they got the goods. So say it neutrally: imports exceeded exports.
Pause and try this. Which description is neutral: "the country lost 50 on trade," or "imports exceeded exports by 50"?
Ask which one carries a verdict.
Here's the answer. The second one is neutral. It reports the direction of trade flows without claiming the country lost income, which the number alone can't show.
7. Tariffs and trade policy, both sides at full strength
So far the model has told us what happens. Now comes a question about what a country should do, and here people disagree.
Picture a factory town facing cheaper imports. Shoppers across the country pay a little less, while the factory's workers lose their jobs. Both things are true together.
Here are the terms. A tariff is a tax a government charges on imported goods, which raises their price at home and is one kind of trade barrier. And a trade barrier is any government policy that limits or raises the cost of trade with other countries, such as a tariff on imports.
Start with the positive result. Suppose Northland and Southland put up a barrier high enough to stop their trade. Each goes back to making both goods, and world output falls back from 72 wheat and 24 cloth to 68 and 20. The extra 4 wheat and 4 cloth are gone.
Now the case for freer trade, at full strength. Specialization raises total output, as the table proved. Trade lowers prices and widens choice in every store, and those gains reach nearly every household.
And the case for protection, at full strength. The gains are spread thin across many shoppers, but the costs land hard on particular industries, regions, and workers. A worker whose plant closes may not find an equal job nearby. That loss has a name: an adjustment cost, the loss borne by particular industries, regions, and workers when trade shifts production elsewhere, such as lost jobs, closed plants, and the time and expense of retraining or moving. Some also argue for protection on strategic or national-security grounds, keeping the ability to make certain goods at home in case trade is cut off.
So separate the two kinds of claims. That specialization raises total output is positive, and both sides accept it. How to weigh a gain shared by many against a cost carried by a few is normative, a question of values. This course gives you both cases and leaves the verdict to the evidence and your own values.
Pause and try this. Is this claim positive or normative: "Protecting factory jobs is worth higher prices for everyone"?
Look for the word that weighs one good against another.
Here's the answer. It's normative. "Worth" weighs jobs against prices, and that's a value judgment the model can't settle on its own.
Closing
Let me pull it together, in the order we built it. Absolute advantage asks who makes more from the same worker-day. Opportunity cost asks what each country gives up, and you write each ratio with the good given up on top. Comparative advantage is the lower opportunity cost, and it decides who specializes, even for a country that is better at everything. The terms of trade have to sit between the two costs, here from 2 to 3 wheat per cloth. At 2.5, both countries end with more of both goods, and the world makes more from the same work. A trade deficit means imports exceeded exports, and by itself it isn't a loss. And the tariff debate shares the model while differing on how to weigh who bears the cost.
Next in this module, you'll find the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Then Week 14, Open-Economy Macro: Exchange Rates & the Balance of Payments, adds the money side of trade: what a stronger or weaker dollar does to exports and imports.
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