One of the most powerful and straightforward economic concepts is "comparative advantage." As important and simple as this concept is, however, it seldom seems to inform public discussions of international trade. Almost everyone "knows" that we can't compete with countries that have cheap labor-if we have free trade with such countries either wages will be driven down or many workers will lose their jobs. As Will Rogers once observed, "It's not what people don't know that is the problem, it is what they do know that's not true."
Understanding comparative advantage has the same effect on concerns about free trade as water had on the Wicked Witch of the West. Free trade with other countries (regardless of how much or little their workers are paid) doesn't increase unemployment or lower wages. Indeed, one of the best ways of increasing the wages of U.S. workers is by allowing them to compete with workers (even very low paid workers) in other countries through free trade.
Absolute Versus Comparative Advantage
The most straightforward case for free trade is that countries have different absolute advantages in producing goods. For example, because of differences in soil and climate, the United States is better at producing wheat than Brazil, and Brazil is better at producing coffee than the United States. Obviously both countries are better off when Americans produce wheat and exchange a portion of it for some of the coffee that Brazilians produce.
But does this mean that a country with an absolute advantage in the production of a good should always produce that good rather than import it? No, as the English economist David Ricardo first explained in the early 1800s. A country can have an absolute advantage in the production of a good without having a comparative advantage. Comparative advantage is what determines whether it pays to produce a good or import it.
Assume that there are only two goods, cars and computers, and one productive resource which is some composite of land, labor, and capital. Assume also that producing 100 cars requires two units of the productive resource (PR) in the United States and four units in Brazil, and producing 1,000 computers requires three units of PR in the United States and four in Brazil.
Americans have an absolute advantage in producing both cars and computers.
It may seem that Americans can realize no gain by trading with Brazilians. Why not produce both cars and computers here? Because it costs more to produce computers in the United States than in Brazil. All costs are opportunity costs. The cost of producing computers is the cars that could have been produced. Using the three units of PR required to produce 1,000 computers in the United States requires sacrificing the production of 150 cars. Using the four units of PR required to produce 1,000 computers in Brazil requires sacrificing only 100 cars.
So even though Americans have an absolute advantage in producing computers, Brazilians have a comparative advantage. Compared to what has to be sacrificed, Brazil produces computers for only two-thirds as much as it costs in the United States. The United States, of course, has a comparative advantage over Brazil in the production of cars. Producing 100 cars here costs 666 computers, while producing 100 cars in Brazil costs 1,000 computers.
Clearly the United States benefits from specializing in cars, which it produces more cheaply than Brazil, and trading with Brazil for some of the computers it produces more cheaply. …