The Economics of Trade

I was fritzing around mulling over the US Democrats who put a "Buy America" clause into their stimulus package. This shows a lack of understanding of simple economic truth that has been known for two centuries: Comparative Advantage. This is a concept developed by David Ricardo in 1817.

Here's how it works...

Suppose there are two countries Northland and Southland and each has an advantage in one industry. Northland has 100 people and Southland has 100 people. Assume that a person needs $4,500 of food per year and $1,500 of clothing per year.

• Northland needs 100*$4500 = $450,000/year in food and 100*$1500 = $150,000/year in clothing. So the GDP of Northland is $450K + $150K = $600K/year.


• Southland has exactly the same needs.

Assume that Northlanders are better agriculturists than clothiers:

• A typical Northland person can make $10,000 per year working at agriculture and only $2727.27 per year in the clothing factories.


• A typical Southlander is relatively better at clothes, they can make $5,333 per year in agriculture and $5,000 per year in clothing.

If there is no trade:

• Northland: 45 people at agriculture @ $10000 = $450K/year and 55 people at clothing @ $2727 = $150K/year. The country meets its needs! Its total GDP is $600K/year.


• Southland: 80 people at agriculture @ $5625 = $450K/year and 20 people at clothing @ $7500 = $150K/year. The country meets its needs! Its total GDP is $600K/year.

But suppose they trade, each country specializes in what it does best:

• Northland: 100 people at agriculture @ $10000 = $1000K/year.


• Southland: 100 people at clothing $7500 = $750K/year.

Previously these two countries met their needs with a combined GDP of $1.2M. But if they specialize, the total GDP is $1.75M. Northland can trade $450K of agriculture to Southland for $450K of clothing. And they end up having...

• Northland: $550K of agriculture and $450K of clothing, total GDP $1M.


• Southland: $450K of agriculture and $300K of clothing, total GDP $750K.

Both now exceed their $600K basic need, and each meets its base needs of $450K agriculture and $150K clothing. They now have surpluses! Northland has a surplus of $100K of agriculture. Southland has a surplus of $150K of clothing. Both are better off because of trade!!

If the above looks "contrived" because each has its own specialty. Consider a case where one country is clearly superior in both classes of prodcution:

Assume that Northlanders are better agriculturists than clothiers:

• A typical Northland person can make $18,000 per year working at agriculture and $9000 per year in the clothing factories.


• A typical Southlander is only half as productive, so they make $9,000 per year in agriculture and $4,500 per year in clothing.

If there is no trade, then each meets its needs, but Northland is over twice as affluent and the combined GDP is $2.088M:

• Northland: 83 people at agriculture @ $18000 = $1.494M/year and 17 people at clothing @ $9000 = $153K/year. The country meets its needs twice over! Its total GDP is $1.647M/year.


• Southland: 66 people at agriculture @ $9000 = $594K/year and 34 people at clothing @ $4500 = $153K/year. The country meets its needs! Its total GDP is $747K/year.

But suppose they trade, each country specializes in what it does best:

• Northland: 66 people at agriculture @ $18000 = $1.188M/year and 34 people at clothing @ $9000 = $306K. Total GDP: $1.494M.


• Southland: 100 people at agriculture @ $9000 = $900K/year.

Northland can trade away $150K of clothing to meet Southland's needs.

• Northland: $1.338 of agriculture and $156K of clothing, total GDP $1.494M.


• Southland: $750K of agriculture and $150K of clothing, total GDP $900K.

In this trading scenario, the combined GDP is $2.394M. This is greater than their previous $2.088M if they didn't trade.

Play with the numbers. Convince yourself that trading always leaves both parties better off if they use trade to take advantage of the "comparative advantage". This second case shows that a comparative advantage does not require an absolute advantage in some productive ability. It just means that you rationalize your production to take advantage of your trading partner. Each uses the other to advance themself, so the overall result is better for both!