Gains From Trade With Extreme Differences
The law of comparative advantage shows us that people can consume more than they would be able to produce on their own. Increasing specialization implies increasing productivity, and our ability to enjoy gains from specialization and trade is one factor that helps explain our high standards of living today. Here is another example that illustrates the logic of comparative advantage.
Suppose there are two planets, Hoth and Mustafar. Hoth is an ice planet, and Mustafar is a planet covered in lava and volcanos. On Hoth, ice is everywhere while it requires the construction of special freezers on Mustafar. On Mustafar, conditions allow them to produce steel in abundance while it is much more difficult to produce steel on the ice planet of Hoth. These planets have the following production possibilities for steel and ice: residents of Hoth can produce ten tons of steel or 100,000,000 tons of ice in a given year while residents of Mustafar can produce 100,000,000 tons of steel or 10 tons of ice per year.
Notice that for both planets, self-sufficiency is incredibly expensive. Every ton of steel that Hoth residents produce themselves costs them the opportunity to produce ten million tons of ice. Every ton of ice Mustafar residents produce themselves costs them the opportunity to produce ten million tons of steel. Conversely, every ton of ice that Hoth residents produce only costs 1/10,000,000 ton of steel, and every ton of steel that Mustafar residents produce only costs 1/10,000,000 of a ton of ice.
Trade can make residents of both worlds better off. To see this, suppose that each planet devotes half of its resources to steel production and half of its resources to ice production. Hoth produces five tons of steel and 50,000,000 tons of ice per year, and Mustafar produces 50,000,000 tons of steel and 5 tons of ice per year.
Now suppose they completely specialize and trade at a price of one ton of steel for one ton of ice. If Hoth trades until it has as much ice as it had before and Mustafar trades until it has as much steel as it did before, they each end up with 50,000,000 tons of steel and 50,000,000 tons of ice. Complete specialization and trade allows Hoth residents to enjoy as much ice as it did while spending half of its time on ice production but 49,999,995 more tons of steel. Complete specialization and trade allows Mustafar residents to enjoy the same amount of steel as they enjoyed while spending half their time on steel production but 49,999,995 more tons of ice. For Hoth residents, the ice price of steel has fallen to a tiny fraction of what it was before trade. For Mustafar residents, the return to steel production in terms of ice has increased enormously relative to what it was before trade.
But won’t trade destroy the steel industry on Hoth and the ice industry on Mustafar? Yes, but it is anything but clear that Hoth and Mustafar need steel and ice industries, respectively. Consider their comparative disadvantages of each. If leaders on Hoth were to close off trade with Mustafar to protect the domestic steel industry, they would increase the price of a ton of steel from one ton of ice to ten million tons of ice.
Further, an old cliché says that God never closes a door without opening a window. Through trade, God closes one door but opens two or three others. The contraction in the Hoth steel industry is offset by an expansion in the Hoth ice industry and the contraction in the Mustafar ice industry is offset by an expansion in the Mustafar steel industry. Opportunities to earn income by producing steel on Hoth will be eliminated, but they will be replaced by opportunities to earn income by producing ice. Since trade increases the returns to ice production, these new opportunities will be more remunerative. The same logic applies to Mustafar’s ice industry. The integration of this market also provides opportunities in the interstellar shipping industry, which I have left out of this analysis for simplicity’s sake (here’s a tongue-in-cheek treatment of “The Theory of Interstellar Trade” by Paul Krugman).
Think about it this way. If residents of Hoth agreed to give residents of Mustafar ice without asking anything in return, Mustafar residents would be much better off because they can use their resources to produce other things, like steel. Even if they don’t get it for nothing, the next best thing is to get the ice really, really cheap. Similarly, if residents of Mustafar agreed to give residents of Hoth steel without asking anything in return, Hoth residents would be much better off. “Cheap steel” from Mustafar is the next best thing.
This raises an interesting strategic objection: if Hoth loses its steel industry, won’t the planet be vulnerable to invasion? Would Hoth be unable to defend itself without a steel industry? First, increased trade is likely to reduce the potential for conflict while protection is likely to increase the potential for conflict. As Frederic Bastiat is reputed to have said, “if goods don’t cross borders, armies will.” Second, even if aggression is imminent we can expect to see profit-seeking entrepreneurs stocking up on resources like steel that are needed to make war materiel on the expectation that they will be able to sell it to the government for a higher price if a war starts. Of all the ways to prepare for possible war, protectionism is probably the most expensive.
Estimates suggest that protectionism is amazingly expensive. In the United States, the costs of protectionism are truly astounding. According to some estimates, steel protectionism in the United States was estimated to cost $750,000 per year per job saved. This means that if we completely eliminated restrictions on international trade in steel, the government could pay every steel worker who loses his or her job $700,000 per year not to work and we would still come out way ahead.
The law of comparative advantage is one of the most important ideas in economics. One of the most deceptive and pernicious myths in the world is the idea that increased market liberalization systematically makes people worse off. The law of comparative advantage shows that it is just that: a myth. Trade allows us to take advantage of our differences and cooperate to mutual advantage. In short, it allows us to produce much more wealth with the resources we have at hand.
1-I first remember hearing this point from Bob Murphy, I think.
2-Miller, Roger LeRoy, Daniel K. Benjamin, and Douglass C. North. 2005. The Economics of Public Issues, 14th Edition.Boston: Pearson/Addison-Wesley, p. 210.