Comparative Advantage Continued
Free Trade Does Not Cause Massive Unemployment
NOVEMBER 01, 1999 by DWIGHT R. LEE
Filed Under : Free Trade, Competition, Opportunity Cost, Comparative Advantage
The concept of comparative advantage, which I began discussing last month, is a straightforward application of opportunity cost and is almost embarrassingly simple. Certainly people have no trouble understanding and recognizing the importance of this concept in their own personal lives. For example, if you were the best brain surgeon in town and also the best at shining shoes, you would not try to be both a brain surgeon and a shoe shiner. Compared to other shoe shiners, you would be at a tremendous disadvantage shining shoes because of the value of your time performing brain surgery.
People are very good at finding and pursuing their comparative advantages. This doesn’t mean that people are always good at what they do. We have all seen people working at jobs they can’t do well. It could be, of course, that they have made a mistake and will quickly move on to something they do better. But that clumsy waiter who keeps spilling hot soup on his customers may have a comparative advantage at being a waiter. He could be even worse at everything else. So just as you can be really good at something without having a comparative advantage in it, you can have a comparative advantage at something you don’t do very well.
While people seem to understand comparative advantage when making personal choices, they often put this understanding on hold when accepting arguments against international trade. For example, last month I explained why the widely accepted argument that countries with low-paid workers will be able to outcompete us in all goods is wrong. I shall now consider a related, and widely accepted, argument against free trade, and explain the fallacy it contains by modifying the example in last month’s column.
Being the Best May Not Be Good Enough
A common complaint by domestic producers is that foreign firms that suddenly begin outcompeting them must be selling below cost. They can often support their case by pointing out that the foreign firms were previously uncompetitive and have not improved their efficiency one bit. So how can these firms possibly be competitive now? It may seem strange that firms unable to compete earlier are suddenly able to without becoming more productive. But it is not strange at all. Foreign firms don’t have to become more productive to acquire a comparative advantage over domestic firms.
Consider the table on the next page, which contains last month’s example (ignore the number in parentheses for now). Americans have a comparative advantage only in car production even though they are absolutely more productive than Brazilians at producing both cars and computers. The opportunity cost of producing 100 cars is 666 computers in the United States and 1,000 computers in Brazil. But the other side of this coin is that Americans have a comparative disadvantage in producing computers, which means Brazilians have a comparative advantage in computer production. While it costs 150 cars to produce 1,000 computers in the United States, it costs only 100 cars in Brazil.
So, as explained last month, both countries are better off when Americans specialize in cars, Brazilians specialize in computers, and they trade with each other. Free trade moves resources into each country’s comparative advantage, thereby increasing total output.
But assume that an entrepreneur develops a better way of manufacturing computers in the United States: it now requires only 1.5 units of productive resources to produce 1,000 computers. U.S. car manufacturers are just as productive absolutely as before, and no productivity improvements are made in Brazil. But now, the comparative advantage in the United States has shifted to computers, with the absolute advantage in cars becoming a comparative disadvantage. It now costs 1,333 computers to produce 100 cars in the United States as opposed to only 1,000 in Brazil. Under free trade U.S. computer manufacturers are able to outcompete car manufacturers for resources as consumers in both countries find it cheaper to buy computers from the United States and cars from Brazil. Both countries are now better off than before, since trade allows the benefit from more efficient computer production to be fully realized.
100 cars 2 units of resources 4
1,000 computers 3 (1.5) 4
True, U.S. unemployment may increase temporarily, as workers in the declining car industry move to jobs in the expanding computer industry. And U.S. car manufacturing will lose money, an unmistakable incentive to move resources to more productive uses. So expect U.S. car manufacturers and their labor unions to complain that the competition putting them out of business cannot possibly be fair because they are still two times more productive than Brazilian car manufacturers. Obviously the Brazilians must be selling below cost—dumping cars in America. But Brazil does not have to sell cars below cost to outcompete U.S. car producers. Americans may be twice as productive manufacturing cars than Brazilians, but it is now 2.66 times more productive manufacturing computers. So the opportunity cost of producing cars in Brazil has become lower than in the United States. There is no legitimate complaint about Brazilian competition. In fact, the real competition is not coming from Brazil at all, but from other Americans. Brazil has done nothing new in our example. The competition facing U.S. car producers is coming from the more productive opportunity the U.S. computer industry is offering workers and resource owners. Car producers simply cannot afford to pay workers (and resource owners) enough to cover their increased opportunity cost given their comparative advantage in producing computers.
We can now see the self-serving silliness in the claim by industries having to lay off workers because of foreign imports that free trade will cause massive unemployment. If this were true, the opportunity cost of workers would be reduced by trade and they could be profitably re-employed at low cost by the declining industry. The problem declining industries have with free trade is that trade increases employment opportunities, not that it diminishes them.
Our discussion of international trade has ignored many real-world complexities. For example, we observe countries producing and importing the same product, as opposed to our example where countries import only what they don’t produce. To explain how both producing and importing the same product is consistent with pursuing one’s comparative advantage we will have to examine the concept of marginalism, which will be done in a subsequent column. But our discussion goes a long way to dispel common myths about the dangers of free trade.