By the end of this section, you will be able to:
- Define the term comparative advantage.
- Explain the terms and conditions of trade from an orthodox economic perspective.
If ever there was a sacrosanct idea within orthodox economic thought, it is the belief, faith even, that orthodox economists have regarding the merits and benefits of economic actors being free to trade. The basis for the orthodox economists’ faith has much to do with the theoretical explanation orthodox economists utilize to explain how trade works and why it is beneficial. Consider the ideas presented in the chapter entitled International Trade.
As presented, orthodox economics organizes its free trade story around several assumptions. The assumptions are designed to constrain the scope of the analysis so as to simplify the story. In the typical introductory textbook presentation, orthodox economists utilize production possibilities frontiers to depict their story.
In support of the production possibilities frontier presentation, orthodox economists apply eight assumptions. The following represents the eight, most common, assumptions.
- Two producers
- Two products
- Fixed resources.
- Fixed technology.
- Full resource utilization.
- Zero transactions costs
- No external costs or benefits
Let’s take a moment to reflect upon these assumptions and what they mean. For starters, it is typically to assume that the two producers in the model will be countries. Within the two countries, only two products will be produced. Each country will have a fixed number of resources available to produce those products. Limited resources will subsequently limit the amount of production of the two products that is possible within the two countries. Additionally, the fixed technology assumption further limits the extent of possible production. Given the limits to production, all resources and technology are assumed to be used, fully utilized, meaning that production will take place at some point on the production possibilities frontier. Once products are produced, if the two countries seek to trade with one another, there will be no transactions costs associated with trade. Transactions costs are costs such as the legal costs of creating contracts or the transportation costs associated with shipping a product from one part of the world to another. In addition to no transactions costs, external costs or benefits are assumed to be absent. As a reminder, external costs or benefits are the possible spillover effects that occur as a result of economic activity such as production or consumption. As one can imagine, because trade requires transportation, the social costs associated with the wastes generated by transportation are very real. However, for the sake of simplicity, the model assumes the costs and/or benefits of externalities are zero. Finally, autarky means that each producer is self-sufficient. Self-sufficient producers do not require trade in order to survive. If trade is a luxury rather than a necessity, then when trade occurs it is voluntary trade and only to the benefit of the trading partners.
Given the model’s assumptions, the orthodox free trade story then showcases three essential components to the trade story. First, the initial step in facilitating trade is for producers to identify their comparative advantage. Recall, comparative advantage means that producers are capable of producing some product(s) at a lower opportunity cost than another producer is capable of producing the same product(s). As a producer, regardless of whether the producer is an individual, firm, or nation, as long as the producer is producing the product at a lower opportunity cost than the other producer, the producer with the lower opportunity cost has a comparative advantage. The second step in the trade story is the specialization of production. Upon identifying its comparative advantage, orthodox economics argues that a producer should specialize in the production of the product that which it has a comparative advantage. Specialization means that a producer should direct their available resources toward the production of a specific product. The third component of the trade story is, trade. Specialized producers, producing a product of which they have a comparative advantage, should now seek to identify trading partners that are also specialized producers of desirable products.
1 → 2 → 3
Producer Producer Specializes in Trade with
Identifies its the Production other Producers
Comparative of the Comparatively of other
Advantage Advantageous Product Products
The Benefits of Trade
Orthodox economics sees the outcomes of trade as having predominantly positive impacts for the economic well-being of those people participating in the trade. Trade is deemed beneficial for several reasons. Orthodox economics concludes that trade will not only stimulate economic growth, increase efficiency, and enhance economic development, but that trade is also the best path toward pursuing those goals.
The story of growth is relatively straightforward. The economic growth, when examined more specifically, such as in the case of international trade as producers get access to consumers beyond their domestic borders, the number of available consumers should grow. In the face of a larger potential consumer market place, domestic producers will seek to expand their productive capacities, otherwise known as growth, in order to produce more in an effort to take advantage of having more potential consumers.
The story of efficiency is less obvious, but is still relatively straightforward, particularly if viewed through the lens of international trade. In an international trade environment, producers that may have otherwise been subject to their own country’s domestic competition, are now confronted by international competition. Given more competition, producers are forced to seek ever more efficient ways to produce products or risk being driven out of business. More trade equates to more competition and, through the eyes of an orthodox economist, increased efficiency.
Finally, in the case of the economic development story, the relationship between trade and development is a bit murky but still evident. By focusing on the specialized production product(s) that producers are comparatively good at producing, the total amount of available products should grow. As two or more parties trade, each producer’s relative abundance of production becomes available to more people to be consumed. Essentially, with the growth of products comes an increased ability to meet people’s wants. As more wants are met, facilitated by trade, the sum total of utility grows for all and everyone is made better off. In this case, economic development is being defined as raised living standards by virtue of access to consumer products.