Chapter 4: Efficiency and Trade (Introductory Microeconomics, June 2023)

Chapter 4 Efficiency and Trade © 1 Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM One of the greatest political and economics debates of all times is the role of agriculture in the p...

Chapter 4 Efficiency and Trade © 1 Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM One of the greatest political and economics debates of all times is the role of agriculture in the process of wealth accumulation and the improvement of the well being of an average person. In fact, many of the early great European thinkers argued that agriculture was the ultimate source of wealth. The main proponents of such a theory are known as the Physiocrats. Their conclusion was that the government should protect agriculture. In particular, it should impose tariffs and barriers on imports of agricultural products in order to protect domestic farmers. For landowners, this was a convenient theory. With an expanding population and high tariffs on imports, prices of agricultural products would rise raising the profits of the farmers. However, in many instances, farmers were not landowners. The pressure of increased demand and higher prices would entice farmers to extend cultivation to poor lands. Landowners of fertile lands extract monopoly like rents from the landless farmers until the production cost of one bushel of wheat plus the rent paid to the landowners is equalized throughout the nation. This would also raise the employment security of the farmers. Hence, landlords and farmers supported such a policy. Furthermore, the two groups argued a well developed and sound agriculture insures a nation’ self-sufficiency in food and thus contributes to national defence and security. In England, the two groups succeeded in 1812 in passing a series of laws raising the tariffs and barriers to the importation of wheat called the Corn Laws. Yet, England has always claimed to be the champion of free trade. The arguments used to win passage of the Corn Laws in England have since been used time and again in all nations of the world -except the poor ones- to justify the protection of their agricultural sector. Today we find that the most developed countries use the argument to justify the protection of their agriculture sector against imports from poor countries or other developed countries. Yet they claim they are the staunchest supporters of free trade. Among these nations we find the United States, Canada, many large European nations, and Japan. Starting with Adam Smith, economists argued that the protection of agriculture or any industry is counterproductive. David Ricardo constructed the most eloquent and complete logical argument against trade barriers and tariffs. Economists argued that the source of wealth is specialization, division of labour, trade and technological improvement. A steady rise in income per capita is possible with the division of labour, capital accumulation and improvement in know-how and technology. To promote growth a nation should specialize in order to direct its resources to the sectors in which it can use its resources most efficiently. Since then we understand that a major ingredient of efficiency is specialization of resources. We devote this chapter to the development of the concept of specialization and its main implications, the use of money and the benefits from trade. Concept of Specialization Philosophers and common people alike have long wondered about the causes of poverty and opulence. There are three main answers to this question. One of them is correct for particular individuals but not for most people. One of them is now obsolete for developed countries. The third is 1 Cartago Research and Development, 9/18/23 5:02 PM Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-2 the most important. Understanding it helps societies to produce an appropriate economic environment for a sustainable improvement of the standards of living of every member of society. Causes of poverty and opulence A common answer to the opulence poverty question is that poverty is due to laziness and indolence while opulence is due to industry and work. A second more serious answer is that poverty is a consequence of the fact that the population growth rate is an increasing function of the average level of wages. When the average level of wages increases workers multiply far more rapidly than food production causing a fall in wages, which in turn depresses wages to the subsistence level. This forces a drop of the population growth rate to a level that is sufficient to maintain the population constant. The growth rate of food production would again become greater than that of the population and wages would rise again. The process would repeat itself indefinitely insuring that in the long run workers wages remain at the subsistence level. Malthus, a famous English economist of the early nineteenth century, developed this argument and called it the Iron Law of Wages. According to this argument, poverty is a permanent feature of human societies. A third, more serious answer, is that poverty is a consequence of the chaos resulting from the selfish behaviour of human beings in a society that allows private control of resources. This argument fit well the situation of European nations at the beginning of the industrial revolution when private control of resources spread rapidly at the expense of common property and poverty become more acute. History has shown that the second reason is incorrect. In many countries agricultural output has grown much faster than population growth. Adam Smith has argued that the first reason is also incorrect for the non-agricultural sectors. In many primitive societies, people toil the whole daylong and their condition is miserable. Similarly, there are many people in modern societies who work not an hour a week and yet they are rich. Furthermore Adam Smith argued that the pursuit of self-interest does not generate chaos. To the contrary it is the driving force behind the improvement in the living conditions of all nations. Sooner or later, all nations that rely on self-interest to allocate incomes and resources will be able to eradicate poverty through continuous growth in resources and output. He asserted that it is not from the benevolence of the baker but rather from his self-interest in promoting his own well being that we get our bread. As for the claim that the pursuit of self-interest will create chaos, A. Smith argued that this is not possible because by each one of us promoting our own self- interest we end up promoting the interest of the whole society as if guided by an invisible hand. His argument is developed in his famous book "An Inquiry into the Nature and Causes of the Wealth of Nations" first published in 1776. Adam Smith argued that it is the propensity or inclination of human beings to trade and barter that is the main spring of improvement in their conditions. Among all creatures only human beings are known to engage in trades. Despite the fact that there are many different kinds of dogs, those who are agile, those who are strong, those who are swift and so on, they cannot improve their collective condition. Each dog has to provide everything it needs by itself. The propensity to trade improves the productive powers of a society because among other things it makes it possible for its members to specialize. Specialization contributes to great improvements in the productive powers of a nation, as illustrated by a simple example of a pin factory, for three different reasons. First we describe the example and then we discuss the three different reasons. Specialization is a necessary condition for an efficient allocation of resources. One worker uneducated in the business of pin making can scarcely make one pin a day. However, A. Smith, following the observations of other scholars, reported that the business of pin making in the Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-3 eighteen century has been divided into eighteen branches; each branch is a trade by itself. One worker draws the wire, another straightens it, a third cuts it, a fourth sharpens its ends, a fifth makes the head, and a sixth puts it on and so on. During a day, together they make thousands of pins. If each one of them tries to make the whole pin, they can make only 100 pins a day in total. The division of labour enables them to specialize and together they produce a 1000 fold what they can produce singly. Adam Smith used this example to show evidence of the powers of the division of labour and specialization. A nation that does not practice the division of labour such as happens in primitive societies produces little. Its economy will not be efficient since a reorganization of its resources through a division of labour would increase considerably the output of every product. According to Adam Smith, three reasons explain the powers of specialization. Specialization improves the dexterity of each worker because it permits a worker to concentrate her/his attention on a simple task. The worker learns more about that task. This allows her/him to reduce the time needed to perform the task and improve the quality of the output. Secondly, specialization permits workers to save time used to move physically or mentally from one task to another. Thirdly, specialization allows a workman to devise ways to improve on the operation of existing machinery and produce new improved machinery that would reduce the amount of effort needed to perform a given task. That is, it promotes technological progress. The application of specialization extends beyond factories to every day life. Many people specialize in various professions thereby improving their productivity. Through specialization every worker produces a lot more than what he/she needs of a given product. Through trade of the surplus, every worker will be able to obtain a lot more of all products for her/his effort than he/she could get by producing all of the products himself/herself. Following his/her self-interest and innate propensity to trade, each member of society will try to specialize and interest others in her/his wares. In this way society achieves an efficient allocation of resources and grows more opulent. Opulence would diffuse itself through the ranks of society to cover every one of its members. Poverty is explained therefore by lack of trade, lack of opportunities for specialization, and lack of skills. It does not have to be the fate of anyone. Opulence and improvement in the conveniences result from self-interest leading to an efficient allocation of resources. How to avoid chaos that would wipe out the benefits from the division of labour is the subject of the following chapters. Money and Exchange Efficiency requires specialization. In market economies with private ownership, specialization requires trade. However, trade is awkward if it is done in kind because it forces every person to be a merchant. This defeats the purpose of specialization and it is costly. If everyone can keep a stock of some product X that is acceptable to everybody else, everyone can sell the excess of the wares he/she specializes in producing in exchange for that some amount of product X and use the proceeds from the sale to purchase the products that he/she needs. Product X becomes money. In other words, the use of money enables a society based on private ownership to achieve an overall efficient allocation of resources. Money becomes an essential part of the economic systems based on private ownership, specialization, and trade. As it turned out, the products most suitable for use as money are the precious metals such as gold and silver of which the available quantity is much greater than the amounts of them that are used for producing other goods. They do not deteriorate over time easily. They are easy to transport. They are in short supply. Their quality is uniform and easily verifiable. They can be easily measured. Finally, they are easily divisible. Because without both of them, specialization cannot be carried out and Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-4 specialization is an important source of increased wealth, most people have associated the accumulation of precious metals with wealth. Even nowadays, the accumulation of gold is the ultimate goal of the rulers of most powerful and presumably most advanced countries in the world. Reasons for Specialization Since specialization is a source of growth in opulence, it is of interest to know what the reasons for specialization are. Adam Smith pointed out two reasons: extent of the market and absolute advantage. Ricardo pointed out a third reason: comparative advantage. Extent of the Market and Economies of Scale Adam Smith pointed out that the division of labour is limited by the extent of the market. If the market is small the needs are small. By specializing in the production of one good, one person can produce too much and he would not be able to sell enough to purchase all the products he needs. A porter in a village has little work but in a city he/she will have enough demand for his work that he can earn a decent living. A fall in transportation costs can enlarge the extent of markets and make it possible to specialize and benefit from it. Also, a fall in tariffs and barriers among countries can widen the extent of markets and help take advantage of specialization and drive costs down. Enlarging the extent of the market is one reason why many companies try to increase their market shares. A higher market share enables a company to increase its gains from specialization of labour and capital. Specialization and division of labour drives unit costs down allowing the firm to lower its price while keeping the profit per unit sold constant and increasing total profits. Consequently, when the sales of a company increase, the price of its shares in the stock market rises and when its sales slacken, the price of its shares fall. When an increase in the size of a company permits more specialization and a fall in per unit costs, economists say the firm is experiencing economies of scale. Another way of stating the definition of economies of scale is: There are economies of scale when output more than doubles if all inputs are doubled (thereby doubling the size of the firm). The two definitions are equivalent since the cost per unit of output is the ratio of the cost of inputs to output. When output increases faster than inputs the cost per unit falls. Existence of large economies of scale is one major reason to specialize Absolute Advantage It is reasonable to expect that if Mr. A can produce one unit of a good at a lower cost in terms of inputs than Mr. B, then Mr. A has an absolute advantage in the production of the good and should specialize in its production. This lowers unit costs and enhances efficiency. As Adam Smith pointed out absolute advantage is rarely an innate advantage. In many cases, it is actually an outcome of specialization itself. Specialization lowers unit costs or permits a worker to produce more abundantly within the same period of time precisely because it permits her/him to acquire more dexterity or know- how in the area in which he/she specializes. This view implies that specialization and division of labour is an important source of growth in opulence and reduction in poverty because it increases the stock of knowledge and the skills of workers. That is, improvement of skills is important for alleviating poverty and a nation that adopts policies that produce disincentives to work is bound to lose out in a competitive environment. Switzerland specializes in the production of watches. There is no innate advantage that the Swiss people have that others don’t have. It is by specializing in the production of watches that they Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-5 acquired and keep improving their skills of watch making. Similarly, Japan is one of the largest producers of semi-conductors in the world. Semiconductors are used in the production of mini-brains for personal computers. Japanese producers of semiconductors acquired their absolute advantage by making a deliberate decision to acquire the know-how. They improved further the skills of their workers by producing them. In 1998 they had more than 75% of the world market share because they acquired an absolute advantage in the production of semiconductors. Absolute advantage can arise also from natural sources. Brazil has an absolute advantage in producing coffee beans because of favourable climatic and soil conditions. Canada has an absolute advantage in the production of wood products such as paper pulp because it has large forests. The Maritimes have an absolute advantage in the production of fish because their shores contain one of the most fertile fish beds. The prairies have an absolute advantage in the production of wheat because of favourable soil and climatic conditions. Comparative Advantage Compared to a situation of no trade, free trade enables a country to benefit from specialization and increase its income per capita while maintaining equality between the values of its exports and imports even if all its workers are less (or more) skilled in the production of every product than the workers of another country. This occurs when countries specialize according to comparative advantage, a concept that we shall define below. Let us look at the following example of two countries Canada and Germany. For simplicity, we assume that in each country there is full employment of all factors of production, perfect competition, free movement of labour and resources, and there are constant returns to scale in the production of every product. Constant Returns to scale: There are constant returns to scale in the production of a product whenever the output of the product doubles (triples…) if the producer doubles (triples…) simultaneously the input of every factor of production. That is, there are constant returns to scale if it takes a constant additional amount of resources to produce an additional unit of a product regardless of the amount produced of it or the marginal cost is equal to a constant independent of the amount produced. Columns (2) and (3) in Table 1.a give the number of units of labour needed or the marginal cost in terms of labour to produce one additional ton of Wheat or one additional meter of Cloth in each country, assuming constant returns to scale in the production of Wheat and Cloth. The last row of Table 1.a gives the total amount of resources available to each country. Table 1.a Unit Labour Costs and Opportunity Costs Number of units of labour required to Opportunity cost of one unit of a produce a unit of a product in Country product in country Product Canada Germany Canada Germany (1) (2) (3) (4) (5) Wheat (t = ton) 4 units of labour 1 unit of labour (4/2) = (1 /1)= 2 m of Cloth / t 1 m of Cloth / t Cloth (m = meter) 2 units of labour 1 unit of labour (2/4) = 0.5 t of (1 /1) = 1 t of Wheat / m Wheat / m Total units of labour 24 8 available Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-6 Table 1.a shows that Germany has the absolute advantage in the production of both products Wheat and Cloth because in terms of labour units it is cheaper to produce each of the two products in Germany than in Canada. Thus, according to absolute advantage, Germany is better off without trade, producing its own wheat and its own cloth. However, note that the absolute advantage that Germany has is much greater in the production of Wheat than in the production of Cloth: Germany’s absolute advantage is Four to one in the production of Wheat and Two to one in the production of Cloth. In contrast, Canada has an absolute disadvantage in the production of every product. However, it has the least disadvantage in the production of Cloth. Canada’s disadvantage is Two to one in the production of Cloth But four to one in the production of Wheat We say: Germany has a comparative advantage in the production of Wheat and Canada has a comparative advantage in the production of Cloth It follows that no country has a comparative in the production of every product. Comparative advantage suggests that, if transportation costs are negligible and perfect competition prevails, at least one of the two countries would benefit from tree trade and no country would be worse off if Germany specializes in the production of Wheat where it has a comparative advantage Canada specializes in the production of Cloth where it has a comparative advantage Another way to understand comparative advantage is to compare marginal productivties of labour. Definition of Marginal Productivity: Everything else equal, the marginal productivity of a factor of production in the production of a product is the number of units of the product an additional unit of the factor of production can produce during a given unit of time. Table 1.b expresses the data given in Table 1.a in terms of marginal productivities of labour. Table 1.b Marginal Productivities and Opportunity Costs Marginal Productivity of one unit of Opportunity cost of one unit of a labour in country product in country Canada Germany Canada Germany (1) (2) (3) (4) (5) Wheat (t = ton) 0.25 t of wheat 1 t of wheat (0.5 m/0.25 t) = (1 m /1 t)= 2 m of Cloth / t 1 m of Cloth / t Cloth (m = meter) 0.5 m of Cloth 1 m of Cloth (0.25 t/0.5 m) = (1 t/1 m) = 0.5 t of Wheat / m 1 t of Wheat / m Total units of labour 24 8 available Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-7 If the marginal productivity of a factor of production is constant, independently of the number of units of the factor of production used in the production of the product, we have constant returns to that factor of production. Columns (1), (2) and (3) of Table 1.b, show clearly that a German unit of labour is more productive in the production of both Wheat and Cloth than a Canadian unit of labour. Thus, Germany has an absolute advantage in the production of both Wheat and Cloth. According to absolute advantage, Germany is better off without trade. However, the absolute advantage that Germany has is much greater in the production of Wheat than in the production of Cloth: The marginal productivity of a German worker is four times that of a Canadian worker in the production of Wheat. The marginal productivity of a German worker is only two times that of a Canadian worker in the production of Cloth. Germany has a comparative advantage in the production of Wheat. Clearly, the absolute disadvantage that Canada has is much greater in the production of Wheat than in the production of Cloth: Canada has a comparative advantage in the production of Cloth. Opportunity Costs and Comparative Advantage Suppose that both countries are operating their economies so that their resources are all fully employed. For Canada (Germany), this means that all 24 (8) units of labour that are available to the country are continuously and fully employed. To free up the required resources to produce more of one product a country must produce less of the other product. Definition: The opportunity cost of producing one more unit of Wheat in terms of Cloth is the minimum number of units of Cloth that the country must give up to produce the additional unit of Wheat. That is: Opportunity Cost of one ton of Wheat in terms of Cloth= Minimum number of meters of cloth that must be given up (1) Maximum additional number of tons of wheat that can be produced instead The opportunity cost of one unit of a product is its marginal cost in terms of other products instead of in terms of money or labour units. To calculate opportunity costs we can use the data given in either Table 1.a or Table 1.b. Using the data on marginal costs in terms of labour as given in Table 1.a or the corresponding date on marginal productivities of labour given in Table 1.b, According to the data on marginal costs in terms of labour as given in Table 1.a, if Germany wants to produce one more ton of Wheat, it must free up one unit of labour from the production of Cloth. Thus, Germany must reduce the production of Cloth by one meter to free up one worker. Using equation (1), we get In Germany, Opportunity Cost of one ton of Wheat in terms of Cloth = (one m of Cloth / one ton of wheat). = 1 m of cloth per one ton wheat. Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-8 Of course: Opportunity Cost of one meter of cloth in terms of Cloth = one meter of Cloth Thus, n Germany, Marginal Cost of Wheat in terms of Cloth = Opportunity Cost of Wheat = 1 m of cloth. Marginal Cost of Cloth in terms of Cloth = Opportunity Cost of Cloth = 1 m of cloth If Canada wants to produce one more unit of Wheat, they must free up 4 units of labour from the production Cloth. According to Table 1.a, Canada must reduce the production of Cloth by one unit to free up 2 units of labour. Thus, it must give up the production of (4/2)= 2 units of Cloth to free four units of labour and produce one more ton of Wheat. Using equation (1) and the definition of marginal cost but this time in terms of Cloth not money, we get In Canada, Marginal cost of Wheat in terms of Cloth = Opportunity cost of Wheat = 2 m of Cloth. Marginal cost of Cloth in terms of Cloth = Opportunity Cost of Cloth = 1 m of Cloth. Constant returns to scale imply that the opportunity costs and the marginal costs in terms of Cloth are all constant independent of the level of output of any product. Clearly, Germany has a lower Marginal cost of Wheat in terms of Cloth, i.e. a lower Opportunity Cost of Wheat in terms of Cloth than Canada. Thus, Germany has a comparative advantage in the production of Wheat. Conversely, In Germany Marginal cost of Cloth in terms of Wheat = Opportunity cost of Cloth in terms of wheat = One ton of Wheat. Marginal cost of Wheat in terms of Wheat = Opportunity Cost of wheat in terms of Wheat = one ton of Wheat In Canada, Marginal cost of Cloth in terms of Wheat = Opportunity cost of Cloth in terms of wheat = 0.5 t of Wheat. Marginal cost of Wheat in terms of Wheat = Opportunity Cost of wheat in terms of Wheat = one ton of Wheat Clearly, Canada has a lower Marginal cost of Cloth in terms of Wheat, i.e. a lower Opportunity Cost of Cloth in terms of wheat than Germany. Thus, Canada has a comparative advantage in the production of Cloth. Autarky = No International Trade Between Countries Canada and Germany Autarky is an economic system where there is no trade across countries. From the previous chapter on demand and supply in markets operating under perfect competition, we know that the equilibrium price of a product is equal to the marginal cost of the last unit produced. Since we assume that all markets in both countries are operating under perfect competition and there are constant returns, we conclude that under autarky: Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-9 Equilibrium price of Wheat in terms of Cloth in Germany is constant equal to its Opportunity Cost in Germany = 1 unit of Cloth. (2) Equilibrium price of Wheat in terms of Cloth in Canada is constant equal to its Opportunity Cost in Canada = 2 units of Cloth. (3) In both countries, the equilibrium price of product Cloth in terms of itself is 1 unit of Cloth. (4) Cloth plays the role of money in both countries In every country, there is equilibrium in the market of every product, but there is no trade across countries. In the following section we explain how the actual equilibrium quantities of products in each country are determined. Free trade and Zero Transportation Cost: a First Look at Comparative Advantage Now, let us allow free trade to take place between the two countries and assume zero transportation costs. According to equations (2) and (3), Germany has the lowest opportunity cost and lowest autarky equilibrium price of Wheat equal to 1 m of cloth. Suppose that producers in Germany decrease the production of Cloth by one meter. They would free up one unit of labour that they would use to produce one more ton of Wheat. If they take the additional ton of Wheat that they produced and sell it in Canada, they get for it a price equal to 2 meters of Cloth according to equation (3). They add one meter of cloth to their production of Cloth so the total amount of Cloth available for consumption in Germany and the total amount of Wheat available for consumption in Germany are the same as they were before, However, the producers are left with one more meter of Cloth. Producers in Germany would make a profit of one meter of Cloth. Germany’s producers are better off. If Canada’s producers go along and reduce their production of Wheat by unit and purchase the unit from Germany’s producers, they would free up enough workers to produce two more units of Cloth and hand them to Germany’s producers in exchange for the one unit of Wheat the latter sold to the former. Canada’s producers are neither better off nor worse off. Next, suppose that Canadian producers and consumers accept to trade with those of Germany at a price of two meters of cloth for one ton of wheat. Germany’s producers end up specializing in the production of Wheat and Canada’s producers would specialize in the production of Cloth. Each country would specialize according to its comparative advantage. Germany’s people are better off but those of Canada are no worse off than without trade. That Canada ends up not benefiting from trade is not the only outcome of free trade. It is only a consequence of our assumption that country Canada accepts to trade with Germany at a price of one ton of Wheat for two meters of Cloth, which is Canada’s opportunity cost of Wheat. Had we assumed that Germany accepts to trade with Canada at a price equal to Germany’s opportunity cost of one unit of Cloth for one unit of Wheat, Canada would collect all the benefits of trade and Germany would be no worse off and no better off. In this case we have a lopsided free trade. Unfortunately, history is replete with examples of such lopsided trade where one country or a group of countries would impose a lopsided trade on the rest of the world at prices equal to the opportunity Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-10 costs of the latter. Eventually, these lopsided trades result in trade wars and actual wars as special interest groups in powerful countries try to force by brute force other less powerful countries to trade at the latter’s opportunity costs and the other countries will retaliate later. The argument we have developed in this section ignores the effect of free trade on equilibrium prices across the two countries. To provide a stronger proof that in the absence of brute force, free trade according to comparative advantage makes everyone better off than without free trade, we need to develop the concept of production possibility frontier. Production Possibility Frontier and its Slope Every country has a production possibility frontier. The production possibility frontier illustrates the possible efficient allocations of resources among the products it produces assuming full employment. The frontier depends on the total resources and the technology available to the country. Construction of the Production Possibility Frontiers We know from Table 1.a that Canada has available to it 24 units of labour and Germany has available to it eight 8 units of labour. According to Table 1.a, when Canada allocates all its labour to produce Cloth, it can produce a 24 maximum of = 12 units of Cloth and zero tons of Wheat. Combination E in Table 2 shows this 2 allocation of resources and point E in figure 1 represents this combination. Starting from combination E, if Canada decides to produce one ton of Wheat it has to allocate 4 units of labour to do it. Only 20 units of labour are now available for the production of Cloth. The maximum number of meters of C it can produce drops now to 10 m (=20/2). Combination F in Table 2 shows this allocation of its labour resource and point F in figure 1 represents this combination. The reduction of the output of Cloth to produce one more ton of Wheat illustrates the concept of scarcity of resources when all resources are allocated efficiently and they are fully employed. As Canada continues to increase the production of wheat, it must continue to shift labour from the production of Cloth to that of Wheat. Combinations G, H, I, J and K in Table 2 illustrate this process and points G, H, I, J and K in figure 1 represent these allocations. Table 2 gives the schedule of the production possibility frontier of Canada. Straight line EK in figure 1 represents the production possibility frontier of country Canada. Table 2 Production Possibility Frontier Table 3 Production Possibility Frontier Canada Germany Total resources = 24 units of labour Total resources = 8 units of labour Combination Wheat Cloth Combination Wheat Cloth E 0 12 L 0 8 F 1 10 M 2 6 G 2 8 N 4 4 H 3 6 Y 6 2 I 4 4 Q 8 0 J 5 2 K 6 0 Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-11 Figure 2 Germany's Production Possibility Frontier Cloth 8 L Production Possibility Frontier Attainable, Effiicient 7 M 6 No Trade C and P 5 S 4 N 3 Trade P Y 2 1 Q 0 O 0 1 2 3 4 5 6 7 8 Wheat According to Table 1.a, when Germany allocates all its labour resources to produce Cloth, it can produce a maximum number of 8 meters of Cloth and zero units of Wheat. Combination L in Table 3 shows this allocation of its labour resources and point L in figure 2 represents this allocation. Starting from combination L, suppose that Germany decides to produce 2 units of Wheat it has to allocate 2 units of labour to do it. Only 6 units of labour are now available for the production of Cloth. The maximum number of meters of Cloth it can produce drops down to 6 units. Combination M in Table 3 shows this allocation of its labour resources and point M in figure 2 represents this allocation. The reduction of the output of Cloth to produce one more unit of wheat illustrates the concept of scarcity of resources when there is an efficient allocation of resources and all resources are fully employed. As Germany continues to increase the production of Wheat, it must continue to shift resources from the production of Cloth to that of Wheat. Combinations M, N, Y and Q of Table 3 and the corresponding points in figure 2 illustrate this process. Table 3 gives the schedule of the production possibility frontier of Germany. Straight line LQ in figure 2 represents its production possibility frontier of Germany. Slope of Production Possibility Frontier Consider first the production possibility frontier of Canada as given in figure 1. This production possibility frontier is a straight line with a constant slope. This slope is equal to –2 (i.e. –2 m of cloth per additional ton of wheat). Indeed, if we move along this production possibility frontier from point E with zero tons of Wheat produced and 12 meters of Cloth produced to point K with six tons of Wheat produced and zero meters of Cloth produced then 12 − 0 The opportunity cost of one ton of Wheat = = 2 meters of Cloth 6−0 Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-12 0 − 12 The slope of Canada’ production possibility frontier = = − 2 meters of Cloth 6−0 That is, the slope of the production possibility frontier is equal to the negative of the opportunity cost. The slope must be negative because the production possibility frontier is downward sloping The same is true for the production possibility frontier of Germany as given by straight line LQ in figure 2. The opportunity cost of one ton of Wheat is equal to one meter of Cloth and the slope of the production possibility frontier LQ is equal to –1 (i.e. –1 m of cloth per additional ton of wheat). All points on the production possibility frontier of a country are production efficient and they are possible to produce. To construct the production possibility frontier of a country, we assumed that full employment and efficient allocation of resources prevailed all the time. At any point on the production possibility frontier there is no way to produce more of one product without reducing the amount produced of another product. Furthermore, starting at a point such as H in figure 1, Canada cannot attain point T, which is to the right of point H. Point T has a higher output of Wheat but the same output of Cloth as H does. Point T is unattainable because starting at H, full employment and efficient allocation of resources requires a reduction of the production of Cloth to produce more of Wheat. In general points like T or R or any point north, northeast, or east of the production possibility frontier of figure 1 is unattainable. On the other hand points inside triangle OEK are possible to produce but they correspond to an inefficient allocation of resources. The production possibility frontier EK in figure 1 separates the zone OEK, but not including the production possibility frontier EK, of attainable but inefficient combinations of outputs of Wheat and Cloth from the zone of unattainable combinations. The same is true of the characteristics of the production possibility frontier LQ of Germany in figure 2. We conclude that under autarky a country’s consumption bundle must be on its production possibility frontier and it must be identical to its production bundle. Under autarky, a country must choose its production and consumption point, such as H or N in figures 1 and 2 respectively among the attainable but efficient production points located on the country’s production possibility frontier. We shall now show that free trade according to comparative advantage enlarges the set of possible consumption points of every trade partner beyond its production possibility frontier. Benefits of Free trade under Perfect Competition, No Transportation Costs, No Discriminatory Taxes, and no Bullying To appreciate the improvements of standards of living in both countries that are possible according to comparative advantage with free trade, perfect competition no transportation costs, no discriminatory taxes, and no bullying, we compare the amounts of each product that each country can consume under two arrangements: no free trade (autarky) on the one hand and specialization under comparative advantage and free trade on the other. Production and Consumption under autarky Suppose that in the absence of trade each country chose to allocate half of its resources to the production of Wheat and half to the production of Cloth. Their production of each product is equal to their consumption so that there is no trade between the two countries. We use the concept of the production possibility frontier (PPF) to illustrate the position of the two countries under autarky. Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-13 Since we assumed that in this situation, each country splits its total available labour resources evenly between the productions of the two products, Canada chooses to produce and consume combination H in figure 1, referred to in the diagram by the label “No trade C and P”. Germany chooses to produce and consume combination N in figure 2, “referred to in the diagram by the label “No trade C and P”. Production with Specialization and Free Trade Since Germany has the greatest advantage in the production of Wheat, it follows that if Germany produces one meter less of Cloth it could produce a lot more additional tons of Wheat than Canada would if it produced one meter less of Cloth. It also follows that if Germany produced one unit less of Wheat it would produce much less additional meters of Cloth than Canada would if it did the same. It follows that The marginal cost (= opportunity cost) of Wheat in terms of Cloth is significantly lower in Germany than in Canada, The marginal cost (= opportunity cost) of Cloth in terms of Wheat is significantly higher in Germany than in Canada, The marginal cost (= opportunity cost) of Cloth in terms of Wheat is significantly lower in Canada than in Germany, Indeed, Table 1.a shows that Canada’s opportunity cost of producing one additional ton of Wheat is 2 meters of Cloth, higher than Germany’s opportunity cost of producing one additional ton of Wheat which is equal to 1 meter of Cloth Canada’s opportunity cost of producing one additional meter of Cloth is ½ ton of wheat, lower than Germany’s opportunity cost of producing one additional ton of Wheat which is equal to 1 meter of Cloth. Recall that under perfect competition, the price of one unit of a product in a country is equal to its marginal cost. Based on the data of Table 1.a, it follows that under autarky and perfect competition, equations (2), (3), and (4) for equilibrium prices within every country, which we reproduce below, hold true. Equilibrium price of Wheat in terms of Cloth in Germany is constant equal to its Opportunity Cost in Germany = 1 unit of Cloth. (2) Equilibrium price of Wheat in terms of Cloth in Canada is constant equal to its Opportunity Cost in Canada = 2 units of Cloth. (3) In both countries, the equilibrium price of Cloth in terms of itself is 1 unit of Cloth. (4) Cloth plays the role of money in both countries We have seen above that, once we allow for free trade with zero transportation cost, these facts imply that if Germany’s producers would produce one meter less of Cloth, they could produce one more ton Wheat. When they export the additional ton of Wheat to Canada in exchange for more than one meter of Cloth, they make a positive profit if transportation costs are equal to zero. The argument works for producers of Canada also. Their opportunity cost (marginal cost) of producing one more meter of Cloth is 0.5 ton of Wheat. However, the equilibrium price of Cloth in terms of Wheat in Germany under autarky is one ton of Wheat. Thus, the marginal cost of Cloth in Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-14 terms of Wheat in Canada is less than the autarky equilibrium price of Cloth in terms of Wheat in Germany. Canadian producers would make a positive profit if transportation costs are equal to zero Let Canada’s producers produce half unit less of Wheat then they could produce one more unit of Cloth. If country’s Canada producers export the additional unit of Cloth to Germany they would get in exchange one unit of Wheat (the equilibrium price under autarky). Thus, they would make a profit of a half unit of Wheat since they gave up the production of only half a unit of Wheat. This argument implies that due to constant returns to scale perfect competition and free trade if the equilibrium price of Wheat in Canada remains higher than its constant marginal cost in Germany and the equilibrium price of Cloth in Germany remains higher than its constant marginal cost in Canada (all expressed in terms of Cloth) then, the pursuit of self-interest would entice Germany’s producers to continue to reduce their output of Cloth and increase their output of Wheat and Canada’s producers would continue to produce more of Cloth and less of Wheat, and Eventually, each country would specialize in the production of that product in which it has the lowest opportunity cost. o Germany specializes in the production of Wheat in which it has a comparative advantage since it has the lowest opportunity cost (one m of cloth) of producing one unit of Wheat. Germany produces combination Q in figure 2, referred to by the label “trade P”. o Canada specializes in the production of Cloth in which it has a comparative advantage since it has the lowest opportunity cost (0.5 tons of wheat) of producing one meter of Cloth. Canada produces combination E in figure 1, referred to by the label “trade P”. Terms of trade When the two countries specialize according to comparative advantage, they need to trade with each other. Trade needs common markets to determine prices valid inside and outside each country at which products will be traded freely against each other. Equation (4) is still valid under free trade. As free trade and specialization are allowed to take place, the autarky equilibrium prices as given in equations (2) and (3) are not anymore valid. At those prices and with free trade, there will be excess supply of Cloth in Germany and excess supply of Wheat in Canada. We know from chapter 2 on demand and supply that under perfect competition an excess supply in the market of a product will make out of market participants price makers because the market is not at equilibrium. Suppliers and demanders will bid the price down to encourage demanders to increase their quantity demanded and the suppliers to reduce the quantity supplied. Thus, In Canada, the price of Wheat in terms of Cloth will decrease below its opportunity cost in Canada = 2 m of Cloth In Germany, the price of Cloth in terms of Wheat will fall. That is The price of Wheat in terms of Cloth will increase above its opportunity cost in Germany = 1 m of Cloth We define the terms of trade as follows: The terms of trade is the equilibrium price of Wheat in terms of Cloth at which trade takes place between the two countries under free trade Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-15 Under free trade and perfect competition, Consumers in Canada will never accept to pay more than 2 m of Cloth for one unit of Wheat because Canada’s producers can produce one unit of Wheat at an opportunity cost of 2 m of Cloth. Producers in Germany will never accept to exchange one ton of Wheat for less than one 1 m of Cloth since this means that the price of Wheat will not cover its marginal cost or opportunity cost which is equal to 1 m of Cloth in Germany. Thus, Opportunity Cost of Wheat in Germany < Terms of trade < Opportunity Cost of Wheat in Canada The data in Table 1.a imply that under free trade, 1 m of cloth < Terms of trade < 2 m of Cloth (5) We assume that the terms of trade are determined by equilibrium under perfect competition in the markets of Wheat and Cloth. We note that under free trade, the demand curves are the sum of demand curves of the consumers of all countries and the supply curves are the sum of the supply curves of the producers of all countries. The details of how the terms of trade are exactly determined are beyond the scope of this course. Let us suppose that under perfect competition and free trade we have equilibrium in every product market such that Equilibrium under Free trade is achieved when total quantity demanded by consumers of all countries of every product is equal to the corresponding total quantity produced and supplied by all countries producers. Let us suppose that at this equilibrium the terms of trade settle at Terms of Trade = 1.5 units of Cloth for one unit of Wheat These terms of trade satisfy equation (5). By definition, Price of Wheat in terms of Cloth = 1.5 units of Cloth Obviously, Price of Cloth in terms of Cloth = 1 unit of Cloth We now use these terms of trade to show that both countries benefit from trade in the absence of coercion, bullying, brute power manipulation exercised by one country against the other, no transportation cost and no discriminatory taxes. Free Trade under Perfect Competition Improves the Average Standard of Living In Both Countries by expanding the set of consumption bundles available to every country First, we show the benefits of free trade by comparing the sets of possible consumption bundles that each country may enjoy consuming under autarky and under free trade. Every citizen of any country is a consumer and owner of some factor of production: in case of Table 1.a he/she owns labour. Producers use all their revenue from the sale of their production to pay wages. The total income of consumers is equal to the total revenue obtained from the sale of all the output of every product produced in the country. Each country’s consumers use their total earned income to purchase products. They have a demand curve for each product. Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-16 Budget constraint and Production Possibility Frontier of Canada Under autarky, Canada produces combination H = (3 t of Wheat, 6 m of Cloth). Since under autarky the price of Wheat is equal to 2 units of Cloth and the price of Cloth in terms of Cloth is equal to 1 m of Cloth, it follows that in Canada, Total income of all consumers = Value of the output of Wheat + value of the output of Cloth = (Price of Wheat x output of Wheat) + (price of Cloth x output of Cloth) = (2 m of Cloth x 3 t of Wheat) + (1 m of Cloth x 6 units of Cloth) = 12 m of Cloth Thus, Total income of all consumers in Canada = 12 m of Cloth, Furthermore, the consumers of Canada cannot spend more than their total income and they would not spend less. It follows that under autarky the consumers of Canada have a budget constraint composed of the set of all combinations of the possible quantities of Wheat and Cloth that they can purchase and consume. The equation for this budget constraint is (2 m of Cloth x quantity consumed of Wheat) + 1 m of Cloth x quantity consumed of Cloth = (8) Total income under autarky = 12 units of Cloth We can easily verify that any point on the production possibility frontier curve EK in figure 3, such as points E, H, and K, represents a combination of amounts of Wheat and Cloth that the consumers of Canada can afford to consume without violating their budget constraint (8). Under autarky the production possibility frontier is also the budget constraint of all Consumers. Next, under free trade, Canada specializes in the production of Cloth. It produces 0 units of Wheat and 12 units of Cloth and free trade equilibrium price of Wheat in terms of Cloth is 1.5 m of Cloth but the price of Cloth in terms of Cloth is 1m of Cloth. It follows that: Under free trade, total income of Canada’s consumers = 12 units of Cloth. Thus Budget constraint of all Canada’s consumers under free trade: (1.5 m of Cloth x quantity consumed of Wheat) + (1 m of Cloth x quantity consumed of Cloth = (9) Total income under free trade = 12 units of Cloth We can easily verify that any point on straight line EU in figure 3, such as points E, R, and Y, represents a combination of amounts of Wheat and Cloth that the consumers of Canada can afford to consume under free trade without violating their budget constraint (9). Under free trade, straight line EU represents the budget constraint of Canada’s consumers. Under free trade the production possibility frontier curve EK of Canada is the same as under autarky but under free trade its production possibility frontier EK lies to the left of and below its consumers’ budget constraint EU. It follows that under free trade the budget constraint EU of Canada’s consumers lies to the right of their budget constrain EK under autarky as Figure 3 shows. Thus, free trade under perfect competition expands substantially the range of consumption choices open to the consumers of Canada. Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-17 Figure 3 Canada’s Gains from Trade Figure 4 Germany’s Gains from Trade Cloth Trade P Budget Constraint under E Free trade Cloth 12 B udget C ons t ra int V unde r F re e T rade 9 11 Budget Constraint under autarky 8 Q 10 B udget C ons t ra int unde r A ut ark y 9 Trade C 7 7.5 8 6 5.25 A T ra de C S 7 R 5 6 H 4 6.75 N 5 3 T ra de P 4 No Trade C and P N o T rade C a nd 3 2 P U 2 1 4.5 3.5 L 1 K 0 0 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 Wheat Wheat Consumers of Canada are better off under free trade than under autarky. For example they can afford to consume bundle R on the free trade budget constraint EU, which they could not afford to consume under autarky. Budget constraint and Production Possibility Frontier of Germany Under autarky, Germany produces combination N = (4 t of Wheat, 4 m of Cloth) as in figure 3. Since under autarky the price of Wheat is equal to 1 m of Cloth and the price of Cloth in terms of itself is equal to 1 m of cloth, it follows that Total income of all consumers = Value of the output of Wheat + value of the output of Cloth = (Price of Wheat x output of Wheat) + (price of Cloth x output of Cloth) = (1 m of Cloth x 4 t of Wheat) + (1 m of Cloth x 4 m of Cloth) = 8 m of Cloth Thus, Total income of all consumers in Germany = 8 m of Cloth, Furthermore, the consumers of Germany cannot spend more than their total income and they would not spend less. It follows that under autarky the consumers of Germany have a budget constraint composed of the set of all combinations of the possible quantities of Wheat and Cloth that they can purchase and consume. The equation for this budget constraint is Budget constraint of Germany’s consumers under autarky: (1 m of Cloth x quantity consumed of Wheat) + 1 m of Cloth x quantity consumed of Cloth = (10) 8 units of Cloth Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-18 We can easily verify that any point on the production possibility frontier curve LQ in figure 4, such as points Q, N, and L, each represents a combination of amounts of Wheat and Cloth that the consumers of Germany can afford to consume under autarky without violating their budget constraint as given in equation (10). Under autarky the production possibility frontier is also the budget constraint. Under free trade and perfect competition Germany’s producers specialize in the production of Wheat. They would now produce 8 units of Wheat and zero meters of Cloth. The total value of their output = total value of their sales = (1.5 m of Cloth) x (total output of Wheat = 8 tons of Wheat) + (1 m of Cloth) x (total output of Cloth = 0) = 12 units of Cloth. Germany’s producers would distribute this amount as incomes to the consumers of the country as either workers or owners of factories. Thus, the total income of the consumers of Germany is equal to 12 units of Cloth. Germany’s consumers spend this income to purchase Wheat and Cloth for consumption. The total value of their purchases must be equal to their total income. Thus, their choices of how much to consume of Wheat and Cloth are constrained by the following budget constraint: Under free trade, total income of Germany’s consumers = 12 units of Cloth. Thus Budget constraint of Germany’s consumers under free trade: (1.5 m of Cloth x quantity consumed of Wheat) + (1 unit of Cloth x quantity consumed of (11) Cloth = 12 units of Cloth We can easily verify that any point on straight line LV in figure 4, such as points L, S, and V, represents a combination of amounts of Wheat and Cloth that the consumers of Germany can afford to consume under free trade without violating their budget constraint (11). Straight line LV represents the budget constraint of Germany’s consumers. Under free trade the production possibility frontier curve LQ of Germany in figure 4 is the same as under autarky. However, under free trade, Germany’s production possibility frontier LQ lies to the left or below Germany’s budget constraint LV. It follows that under free trade the budget constraint LV of Germany’s consumers lies to the right of their budget constraint LQ under autarky. Thus, free trade under perfect competition expands substantially the range of consumption choices open to the consumers of Germany. Consumers of Germany are better off under free trade than under autarky. For example, they can afford to consume bundle S on the free trade budget constraint LV, which they could not afford to consume under autarky. We now know: If the terms of trade are equal to the average of the opportunity costs, then free trade, under perfect competition and no transportation costs, allows every country’s consumers to consume more of both products. Suppose that at the given equilibrium terms of trade of 1.5 m of Cloth for 1 t of Wheat, the consumers of Germany choose to consume 4.5 units of Wheat. Thus, Germany’s producers would export 3.5 units of Wheat to Canada. The total value of their exports is (1.5 m of Cloth) x (3.5 units of Wheat) = 5.25 m of Cloth. Thus, Germany can import 5.25 m of Cloth from Canada and its consumers’ total consumption of Cloth is equal to Germany’s imports of 5.25 m of Cloth at a price of 1 m of Cloth. Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-19 We can verify easily that the consumption bundle 4.5 t of Wheat and 5.25 m of Cloth satisfies the free trade budget constraint (11) of Germany’s consumers. Indeed, (1.5 m of Cloth x 4.5 t of wheat) + (1 m of Cloth x 5.25 m of Cloth) = 12 m of Cloth = Germany’s National Income under free trade We conclude that Germany’s consumers can now consume 4.5 t of Wheat and 5.25 m of Cloth as indicated by point S in figure 4, referred to in the diagram by the label “Trade C”. German Consumers can consume more of both products under free trade and specialization according to comparative advantage than under autarky. Germany citizens are better off. Under free trade and perfect competition Canada’s producers specialize in the production of Cloth. They produce 12 m of Cloth and zero ton of Wheat. The country would import, and its consumers would consume 3.5 t of wheat, an amount equal to the amount of Wheat exported by Germany, for which Canadian Consumers pay 5.25 m of Cloth (= 1.5 m of Cloth x 3.5 t of Wheat. Thus, Canada must export 5.25 m of Cloth. Since its producers produce 12 m of Cloth, Canada’s consumers would consume 6.75 m of Cloth. We can verify easily that the consumption bundle of 3.5 tons of Wheat and 6.75 m of Cloth satisfies the free trade budget constraint (10) of Canada’s consumers. We conclude that the consumers of Canada can now consume 3.5 units of Wheat and 6.75 m of Cloth as indicated by point R on the free trade budget constraint EU in figure 3 of Canada consumers, referred to in the diagram by the label “trade C”. Table 4 summarizes and compares the situations under autarky and free trade. The consumption columns (5) and (6) of the table show that people in both countries enjoy more consumption of each product when they specialize according to comparative advantage compared to what they consume under autarky or no specialization and no trade. We can get the same conclusion by visually comparing points H and R in figure 3 for Canada and points N and S in figure 4 for Germany. Table 4 Production and Consumption and Trade Balances Production Consumption Before With Before With Imports Exports Trade Trade Trade Trade (1) (2) (3) (4) (5) (6) (7) (8) Germany Wheat 4 8 4 4.5 0 3.5 Cloth 4 0 4 5.25 5.25 0 Value in cloth terms 5.25 (3.5) x (1.5)= 5.25 Canada Wheat 3 0 3 3.5 3.5 0 Cloth 6 12 6 6.75 0 5.25 Value in Cloth terms (3.5) x (1.5) =5.25 5.25 World Wheat 4 +3= 7 8 + 0=8 7 8 Cloth 6 +4=10 12+0=12 10 12 Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-20 Another indicator that free trade is better than autarky is the higher value of the world output of each product under free trade than under autarky. Clearly, world output of a product = sum of the outputs of the two country’s output of the product. Table 4 shows that: World output of Wheat under autarky = 3 t of Wheat + 4 t of Wheat = 7 t of Wheat and. World output of Wheat under free trade = 0 t of Wheat + 8 t of Wheat = 8 t of Wheat World output of Cloth under autarky = 6 m of Cloth + 4 m of Cloth = 10 m of Cloth and World output of Wheat under free trade = 12 m of Cloth + 0 m of Cloth = 12 m of Cloth Clearly, the world output of every product is greater under free trade than under autarky. The trade balances are balanced: That is the value of exports for each country is equal to the value of its imports equal to 5.25 m of Cloth, yet both countries benefit from trade. Contrary to the mercantilism doctrine, free trade under perfect competition is not a zero-sum game if no country’s government exercises brute force, bullying, lying, or otherwise exercise trade manipulation or prices of services of factors of production to intimidate or destroy the industry of the other country. Of course, for free trade to benefit everyone, there should be no tariffs on imports and exports, no restriction on the diffusion across countries of information, including technological know-how, no war material produced, exported, or imported by any country, and no country with intentions to wage wars against the others. In the real world, specialization is not easy because it is costly for factors of production such as skilled labour to move from one sector to another to achieve specialization. Those who must move may incur heavy costs. Thus, free trade requires that in the same country those who benefit must compensate those who lose. Applications Japan after World War II After World War II, Japan was a devastated country without any significant natural resources. It had to import a lot of its raw material and manufactured products. However, its population was well educated and they were experienced in manufacturing. The Japanese people realized that their salvation lies in exporting to earn the necessary foreign exchange to buy what they need of imports. Even though they were not as skilled as the American workers were at that time, the Japanese workers had a comparative advantage in many manufactured products, including textiles. Hence, they specialized in the production of these products. Soon, they improved their skills and know-how. Now they export and import all kinds of products. For example, in the 1980's Japan become a major player and a formidable competitor in international trade thanks to Free Trade. Textile Industry Before World War II, Western countries dominated the textile trade. After the liberalization of trade, many relatively poor countries of Asia, including Japan, Singapore, and Taiwan realized that their productivity was lower than in western industrialized countries. Western industrialized countries had an absolute advantage in all products including textiles. However, the East Asian countries realized that they have a comparative advantage in textiles because it is in this sector where their absolute disadvantage was least. They learned the trade, attracted capital from the western industrialized Chapter 4, Specialization and Trade, Introductory Microeconomics, June 2023, 18/09/2023 5:02 PM 4-21 countries and specialized in the production of textiles. More Asian and non-Asian countries followed their example. Today there is little production of textiles in western industrialized countries.