Trade Specialization
Trade Specialization

So far we have considered two broad categories of goods and services and identified the reasons why countries like the United States import them. These include:

  1. Economically essential goods and services that are either not available at home or unavailable at a reasonable cost;
  2. Goods and services from abroad that may be similar in function and price to those available at home, but which differ in quality or features.

A large number of other goods and services imported by the United States and many other countries would probably fit into two additional categories:

  1. Goods and services that native companies, farms, and individuals can produce, but which foreign countries can produce more cheaply; and
  2. Goods and services that can be produced more cheaply domestically, but which native companies, farms, and individuals have chosen not to produce in favor of producing more sophisticated (and hence more expensive) goods and services.

Many items in both of these categories—indeed, a large share of the total U.S. imports—are parts, semi-finished products, components, and other items that are assembled into finished products in the United States. A quick look at these two categories of imports will help introduce the important principle of international trade specialization, which is the key to understanding not just why countries trade, but how different countries end up trading the goods and services that they do.

Country-by-country differences in the cost of producing goods and services have a major influence on the direction and content of trade. Production costs are, in turn, influenced by the national endowments of three key production inputs: labor, capital (shorthand for equipment and technology), land and natural resources.

Goods and services that mainly require low-skilled labor can be produced at a lower cost in developing countries, where such labor is abundant and, thus, cheap. (Remember the term ‘cheap labor’ from before?)Since wage levels and productivity are generally higher in the United States and other industrialized countries, it makes fiscal sense for certain goods and services to be made by workers in those countries where wage levels are lower. Additionally, the cost of transporting the goods from the developing country to the United States should not exceed the difference in the production price of the two countries.

In contrast, equipment and technology tend to be relatively scarce and expensive in developing countries. Goods and services whose production requires larger amounts of capital can be produced more cheaply in countries like the United States, where capital is more abundant and less expensive.

Comparative Advantage and the Mutual Gains from Trade

Countries have a mutual interest in specializing in the production of the goods and services that their unique combination of labor, capital, and land will enable them to produce most efficiently and cheaply. They can then trade goods and services that they are relatively well-equipped to produce for goods and services produced by other countries. Countries seek goods and services from other countries that they may not be able to produce efficiently or do not have the capacity to produce.

For example, even if U.S. companies could make both bicycles and computers more efficiently and at a lower cost than foreign firms, the theory of comparative advantage tells us that the United States should specialize more in the production of the good—in this case, computers—where its efficiency and cost advantage is greatest.

One of the most important and somewhat unexpected features of this principle of specialization is that it applies even in cases in which a particular country has an efficiency or cost advantage over other countries in all the products they are both able to manufacture. Economists call this the theory of comparative advantage.

The implication of the theory of comparative advantage is that all countries will benefit from trading with each other regardless of how well-endowed they are in labor, capital, and land, and regardless of how efficiently they can produce any particular good.

The key to securing these mutual gains from trade is for all countries to specialize as much as possible in the production of those products in which their efficiency and cost advantages are greatest. The idea, then, is that countries should devote as much of their national endowments (labor, capital, land) as they can to those things they do best. All countries should specialize in the thing they make the best, and then we can all buy one another’s best product.

 

Next: The Theory of Comparative Advantage