Chapter 32
Comparative Advantage and the Open Economy
◼ Overview
The most important objective of this chapter is to demonstrate how international trade based on comparative
advantage arises and its benefits. International trade is shown to be important, even to a country such as
the United States, in which the ratio of exports and imports to GDP is relatively small but growing. The
◼ Learning Objectives
After studying this chapter, students should be able to:
• 32.1 Explain why nations can gain from specializing in production and engaging in international trade
• 32.2 Understand common arguments against free trade
• 32.3 Describe the ways that nations restrict foreign trade
• 32.4 Identify key international agreements and organizations that adjudicate trade disputes among
nations
◼ Outline
I. Why We Trade: Comparative Advantage and Mutual Gains from Exchange
A. The Worldwide Importance of International Trade: World trade has increased to more than
B. The Output Gains from Specialization: If specialization and trade occur along the lines of
comparative advantage, then production increases above what would be otherwise possible.
1. The Situation with No Trade: A two-person numerical example is presented.
2. Specialization and Trade: If each person specializes in doing one job task, their
Chapter 32 Comparative Advantage and the Open Economy 483
C. Specialization among Nations: A two-country numerical example is presented.
1. Production and Consumption Capabilities in a Two-Country, Two-Good World
(See Table 32-1.)
2. Comparative Advantage: Comparative advantage is the ability to produce a good or
7. Specialization Is the Key: Trade along the lines of comparative advantage allows increases
in production and consumption.
a. Why Specialization Yields Gains from Trade: Specialization along the lines of
industries will disappear, and so their firms will be worse off.
D. Other Benefits from International Trade: The Transmission of Ideas: Ideas are transmitted
E. The Relationship between Imports and Exports: In the long run, imports are paid for by
F. International Competitiveness: This term is hard to define precisely because countries do
II. Arguments Against Free Trade: Arguments against free trade point out the costs of trade. They
A. The Infant Industry Argument: Tariffs should be imposed to protect an industry that is
trying to get started from import competition. After the industry becomes technologically
efficient, the tariff can be lifted.
1. Basis of the Argument: The protected industry will experience improvements in
2. Problems with Infant Industry Protection: Often the import-restricting arrangements
B. Countering Foreign Subsidies and Dumping: When a foreign government subsidizes its
484 Miller • Economics Today, Nineteenth Edition
1. Proposed Benefits of Domestic Jobs Protection: Economists found no causal link
2. Costs of Protecting Domestic Jobs: A study found that U.S. consumers pay $9 billion a
III. Ways to Restrict Foreign Trade
A. Quotas: Quotas are government-imposed restrictions on the quantity of a specific good that
another country is allowed to sell in the United States. Quotas restrict imports. These
restrictions are usually applied to a specific country or countries. (See Figure 32-3.)
1. Voluntary Quotas: A voluntary restraint agreement (VRA) is where a country agrees to
B. Tariffs: A tariff is a tax on imported goods. A protective tariff is such that no similar tax is
applied to identical domestic goods. (See Figure 32-4.)
1. Tariffs in the United States: Tariffs on all imported goods have varied widely. The
2. Current Tariff Laws: The Trade Expansion Act of 1962 permitted the president to
reduce tariffs by up to 50 percent. The Trade Reform Act of 1974 and the Trade and
IV. International Trade Organizations: Widespread efforts to reduce tariffs around the world have
led to a growth of international trade organizations.
A. The World Trade Organization (WTO): The most important international trade organization
B. Regional Trade Agreements: Other international trade organizations such as the European
1. Do Regional Trade Blocs Simply Divert Trade? Trade diversion is shifting international
2. The Trade Deflection Issue: Moving partially assembled products into a member nation
◼ Points to Emphasize
The Argument over International Trade
Many people have stronger opinions about international trade than about any other economic topic. Some
claim that exports make a country worse off because, by sending goods abroad, fewer are left for domestic
consumption, forcing domestic prices higher. Next, they point out that imports are harmful, too, because
they destroy domestic jobs, that is, imported goods could have been produced by domestic workers. There
is some truth to these positions. Turn these arguments upside down. If U.S. exports raise domestic prices,
then imports will lower domestic prices. If U.S. imports destroy domestic jobs, do U.S. exports create
domestic jobs? The implications of the antitrade arguments sow the seeds of a pro-trade argument,
specifically that imports lower domestic prices and exports create domestic jobs.
The Purpose of Trade Restrictions
Trade restrictions will increase the price of the protected good. Students will certainly understand that a
tax on an imported good will increase its price. What they do not often see is that the price charged by the
U.S. producers of that product will also increase. For example, in 2001, the U.S. steel industry
successfully petitioned the International Trade Commission (ITC) to provide tariff protection from low
486 Miller • Economics Today, Nineteenth Edition
The Government and Trade
When trade is carried on privately, people have an incentive to be efficient in the use of resources. Using
the price system, people will import a good when foreigners can produce it more cheaply than domestic
producers can, and buy that same good domestically when domestic producers can produce it more cheaply
than foreigners can.
During the 1950s and 1960s, when foreign oil was very cheap compared to domestic oil, the U.S.
◼ For Those Who Wish to Stress Theory
Comparative and Absolute Advantage
In analyzing the comparative advantage model, it is important to emphasize that the amount of time it
takes two different countries (or people) to produce a given commodity is irrelevant. To know that a unit
of commodity X takes one hour to produce in Country 1 and two hours to produce in Country 2 is
essentially useless information by itself. Rather, it is important to determine which country has a
comparative advantage in production of commodity X. This is done by looking at each country’s
opportunity cost of producing a unit of commodity X. If Country 1 and Country 2 both have the same
opportunity cost for producing a unit of commodity X, then neither has a comparative advantage in
producing X, and no cost basis for trade exists. Now, if Country 2 has an opportunity cost of 3 units of
commodity Y (one unit of commodity X costs 3 units of commodity Y in Country 2) and Country 1 has
an opportunity cost of 4 units of commodity Y (one unit of X costs 4 units of Y in Country 1), then
Country 2 has the comparative advantage in the production of commodity X, while Country 1 will have
the comparative advantage in producing commodity Y. This conclusion is true despite the fact that it
takes more time to produce commodity X in Country 2 than in Country 1.
This is important because different countries have different tastes, climates, and relative resource
Exploitation—International Trade
Some people argue that the distribution of gains from international trade between countries is such that
exploitation of some countries occurs. If international trade is voluntary, exploitation is unlikely to occur. As
long as individuals in one nation exchange voluntarily with individuals in another, both groups will perceive
a benefit, or trade would not arise. Unless both groups actually receive benefits, trade will not continue.
Some argue that “exploitation” can be viewed as the “deterioration of the terms of trade.” If the ratio
between a nation’s export price index and its import price index falls, its terms of trade are said to have
deteriorated. It is alleged that less-developed countries produce agricultural goods in exchange for industrial
Chapter 32 Comparative Advantage and the Open Economy 487
◼ Further Questions for Class Discussion
1. It is instructive to look at the effects of tariffs on the speed of industrialization. Many people
believe that domestic industry can grow rapidly only if protected from foreign competition. Is this
necessarily true? As shown in Figure 32-5, tariffs fell almost continuously from 1828 until the
Civil War. This was a period of rapid industrialization. Falling tariffs were associated with rising
2. In the past few years, the WTO has had meetings of member nations attempting to negotiate
lower tariffs and other trade barriers as well as subsidies by governments in the developed world
to their farmers. The developing countries want developed countries to eliminate or reduce
subsidies to their farmers. Is it likely that the developed countries have comparative advantage in
producing these subsidized agricultural products? Explain what would happen if agricultural
3. Mexican pork farmers were reported to be unable to compete with U.S. pork imports because the
price of pork had fallen to a level that made it unprofitable to raise pigs for slaughter in Mexico.
The issue was not that U.S. pork farmers were raising pigs at a lower cost than could Mexican
4. Can tariffs reduce the international competitiveness of other domestic industries? Yes. A tariff
5. A study by the Economic Policy Institute, U.S. China–Trade, 1989–2003, at
http://www.epinet.org/, argues that trade with China during that period “cost” the United States
◼ Answers to Questions for Critical Analysis
How African Nations Are Developing Comparative Advantages in Agriculture
(p. 716)
Why do you think that increased specialization in specific agricultural products has accompanied
growth in African exports of those products?
Why European Firms View Chinese Tourists’ Parallel Imports as a Threat (p. 719)
Why do you suppose that infant-industry firms that have developed novel products often implore
their governments to enact policies aimed at restraining parallel imports?
Has Greater Financial Uncertainty Become an Argument against Trade? (p. 721)
Why do you think that heightened risk about gains or losses from market transactions is less likely
than increased uncertainty to induce people to abandon activities in the affected market?
Chapter 32 Comparative Advantage and the Open Economy 489
Ending the U.S. Oil Export Ban (p. 722)
Why was it more efficient to end the quota? (Hint: Why do you think that people usually accept
money in exchanges instead of engaging in barter of one good for another every time they trade?)
◼ You Are There
Argentina Specializes in Oil Production to Protect Domestic Jobs (p. 726)
1. Why do you suppose that Argentina’s oil market has been experiencing surpluses as a result
of the government’s policy action? (Hint: How does a price control that establishes a price
above the market clearing level affect the quantities demanded and supplied?)
2. What entity do you think has been buying surplus oil to maintain the government’s
controlled oil price, and who do you suppose ultimately is paying for those oil purchases?
◼ Issues and Applications
Drought Induces California Farmers to Double Down on a Comparative
Advantage (p. 726–727)
1. Why do you suppose that soil, climate, and water conditions are among the key
determinants of a region’s or nation’s comparative advantage in production of agricultural
corps? (Hint: Keep in mind that the main determinant of comparative advantage is relative
opportunity costs of producing alternative items.)
2. What other elements besides soil, climate, and water conditions do you suppose influence
whether a region or nation develops a comparative advantage in an agricultural product?
(Hint: What other factors of production are involved in producing agricultural goods?)
490 Miller • Economics Today, Nineteenth Edition
◼ Research Project
1. Find out more about California’s top agricultural export crops in the Web Links in MyEconLab.
◼ Answers to Problems
32-1. To answer the questions below, consider the following table for the neighboring nations of
Northland and West Coast. The table lists maximum feasible hourly rates of production of
pastries if no sandwiches are produced and maximum feasible hourly rates of production of
sandwiches if no pastries are produced. Assume that the opportunity costs of producing
these goods are constant in both nations.
Product
Northland
West Coast
Pastries (per hour)
50,000
100,000
Sandwiches (per hour)
25,000
200,000
a. What is the opportunity cost of producing pastries in Northland? Of producing
sandwiches in Northland?
b. What is the opportunity cost of producing pastries in West Coast? Of producing
sandwiches in West Coast?
32-2. Based on your answers to Problem 32-1, which nation has a comparative advantage in
producing pastries? Which nation has a comparative advantage in producing sandwiches?
32-3. Suppose that the two nations in Problems 32-1 and 32-2 choose to specialize in producing
the goods for which they have a comparative advantage. They agree to trade at a rate of
exchange of 1 pastry for 1 sandwich. At this rate of exchange, what are the maximum
possible numbers of pastries and sandwiches that they could agree to trade?
32-4. Residents of the nation of Border Kingdom can forgo production of digital televisions and
utilize all available resources to produce 300 bottles of high-quality wine per hour.
Alternatively, they can forgo producing wine and instead produce 60 digital TVs per hour.
In the neighboring country of Coastal Realm, residents can forgo production of digital TVs
and use all resources to produce 150 bottles of high-quality wine per hour, or they can forgo
wine production and produce 50 digital TVs per hour. In both nations, the opportunity
costs of producing the two goods are constant.
Chapter 32 Comparative Advantage and the Open Economy 491
a. What is the opportunity cost of producing digital TVs in Border Kingdom? Of
producing bottles of wine in Border Kingdom?
b. What is the opportunity cost of producing digital TVs in Coastal Realm? Of producing
bottles of wine in Coastal Realm?
32-5. Based on your answers to Problem 32-4, which nation has a comparative advantage in
producing digital TVs? Which nation has a comparative advantage in producing bottles of
wine?
32-6. Suppose that the two nations in Problem 32-4 decide to specialize in producing the good for
which they have a comparative advantage and to engage in trade. Would residents of both
nations find a rate of exchange of 4 bottles of wine for 1 digital TV potentially agreeable?
Why or why not?
To answer Problems 32-7 and 32-8, refer to the following table, which shows possible
combinations of hourly outputs of modems and flash memory drives in South Shore and
neighboring East Isle, in which opportunity costs of producing both products are constant.
South Shore
East Isle
Modems
Flash Drives
Modems
Flash Drives
75
0
100
0
60
30
80
10
45
60
60
20
30
90
40
30
15
120
20
40
0
150
0
50
Residents of Border Kingdom will be willing to trade bottles of wine for digital TVs produced in
Coastal Realm as long as the rate of exchange is less than its own opportunity cost of producing
32-7. Consider the above table and answer the questions that follow.
a. What is the opportunity cost of producing modems in South Shore? Of producing flash
memory drives in South Shore?
b. What is the opportunity cost of producing modems in East Isle? Of producing flash
memory drives in East Isle?
c. Which nation has a comparative advantage in producing modems? Which nation has a
comparative advantage in producing flash memory drives?
32-8. Refer to your answers to Problem 32-7 when answering the following questions.
a. Which one of the following rates of exchange of modems for flash memory drives will be
acceptable to both nations: (i) 3 modems for 1 flash drive; (ii) 1 modem for 1 flash drive;
or (iii) 1 flash drive for 2.5 modems? Explain.
b. Suppose that each nation decides to use all available resources to produce only the good
for which it has a comparative advantage and to engage in trade at the single feasible
rate of exchange you identified in part (a). Prior to specialization and trade, residents of
South Shore chose to produce and consume 30 modems per hour and 90 flash drives per
hour, and residents of East Isle chose to produce and consume 40 modems per hour and
30 flash drives per hour. Now, residents of South Shore agree to export to East Isle the
same quantity of South Shore’s specialty good that East Isle residents were consuming
prior to engaging in international trade. How many units of East Isle’s specialty good
does South Shore import from East Isle?
c. What is South Shore’s hourly consumption of modems and flash drives after the nation
specializes and trades with East Isle? What is East Isle’s hourly consumption of
modems and flash drives after the nation specializes and trades with South Shore?
d. What consumption gains from trade are experienced by South Shore and East Isle?
a. A rate of exchange of 3 modems for 1 flash drive is higher than South Shore’s opportunity
cost of producing modems, so its residents will not accept this rate of exchange. A rate of
32-9. Critics of the North American Free Trade Agreement (NAFTA) suggest that much of the
increase in exports from Mexico to the United States now involves goods that Mexico
otherwise would have exported to other nations. Mexican firms choose to export the goods
to the United States, the critics argue, solely because the items receive preferential
treatment under NAFTA tariff rules. What term describes what these critics are claiming is
occurring with regard to U.S.-Mexican trade as a result of NAFTA? Explain your
reasoning.
32-10. Some critics of the North American Free Trade Agreement (NAFTA) suggest that firms
outside NAFTA nations sometimes shift unassembled inputs to Mexico, assemble the inputs
into final goods there, and then export the final product to the United States in order to take
advantage of Mexican trade preferences. What term describes what these critics are
claiming is occurring with regard to U.S.-Mexican trade as a result of NAFTA? Explain
your reasoning.
32-11. How could multilateral trade agreements established for all nations through the World
Trade Organization help to prevent both trade diversion and trade deflection that can
occur under regional trade agreements, thereby promoting more overall international
trade?
32-12. Consider the data in Table 32-1. Would U.S. residents gain from trade of U.S. tablets for
Indian apps if the rate of exchange of tablet devices for digital apps happened to be 3 tablets
per app?
32-13. Take a look at the data in Table 32-1. Would Indian residents gain from trade of Indian
apps for U.S. tablets if the rate of exchange of tablet devices for digital apps happened to be
0.75 tablets per app?
32-14. Take a look at Figure 32-3. What is the effect on foreign textile importers’ total revenues of
the imposition of the quota that generates a movement from point E1 to point E2?
Prior to imposition of the quota, at point E1, the total revenues of foreign textile importers were
32-15. Consider Figure 32-3. What is the effect on U.S. textile consumers’ total expenditures of the
imposition of the quota that generates a movement from point E1 to point E2?
Prior to imposition of the quota, at point E1, the total expenditures of U.S. textile consumers were
32-16. Take a look at panel (a) of Figure 32-4. On a per-unit basis, how much of the $50-per-unit
tariff on imported tablet devices is paid by U.S. consumers? On a per-unit basis, how much
of the $50-per-unit tariff is paid by Chinese tablet-producing firms?
32-17. Based on your answer to Problem 32-16, what are the total tariff revenues of the U.S.
government? What percentage do U.S. consumers ultimately pay because of a higher price
generated by the tariff?
Chapter 32 Comparative Advantage and the Open Economy 495
◼ Selected References
Carbaugh, Robert J., International Economics, 4th ed., Belmont, CA: Wadsworth, 1992.
Dillard, Dudley, The Economic Development of the North Atlantic Community, Englewood Cliffs,
NJ: Prentice-Hall, 1967.