Account for the economic reasons/explanations/assumptions behind the structure of the diagrams in the article.Are there any other interpretations for the diagrams?

SCHOOLS BRIEF of Africa, or Britain, or wherever, prosper through trade regardless that it has no comparative ad- of how inefficient, in absolute vantage in anything, they are terms, they may be in their cho simply confusing absolute ad- sen speciality. vantage (for which their claim At first sight this is an implau The miracle of trade may or may not be true) with sible, not to say miraculous, find- comparative advantage (for ing. In economics, it stands The most popular and most dangerous of all elementary eco- which it is certainly false). apart. One distinguished practi Why does this confusion over tioner has even called the princi- nomic fallacies is the claim that an unproductive economy may be harmed by free trade. This view misunderstands one of the terms matter? Because the case ple of comparative advantage the sublest but most powerful deductions in economic theory: the for free trade is often thought to depend on the existence of abso- only result in economic theory that is neither trivial nor false. principle of comparative advantage lute advantage- and is therefore That may be a little hard on the DOP economists of even the . feriority, however impressive, is thought to collapse whenever ab- solute advantage is absent. But rest of economics, but it does sug smallest pretension claim an . presumably smaller. Conversely, intimate acquaintance with the economics (thanks to David Ri- gest that the principle is worth Mr Lewis's comparative advan- . cardo in the 19th century, not . derstand it. . the small effort required to un- principle of comparative advan- tage-usually pointing out, tage is in sprinting, in which his Adam Smith in the 18th) shows Speaking of which wrongly, that it dates back to margin of superiority is greater. that gains from trade follow, in Adam Smith. Understanding Across. any range of athletic fact, from comparative advan- Imagine a global economy com- events, Mr Clinton would have why it is wrong to credit Smith " no comparative advantage with tage: Since comparative advan- prising two countries, North and with this crucial idea takes you a tage is never absent, this gives the respect to Mr Lewis only in the theory far broader scope than South. Each makes two goods, good way towards understand- . all-but-impossible circumstances. most popular critics suppose. bread and wine; each has 100 ing the idea itself. .-. workers, and no input but labour Smith was much concerned . that his margin of inferiority were' exactly the same in each : In particular, it shows that is required for production. As- even countries which are desper-" sume that they are market econo- with the gains to be made from sport. As long as he is, as it were, . ately bad at making everything mies but, to begin with, closed to specialising. Hence his interest relatively less bad at something, can expect to gain from intema- foreign trade. in trade among people and na-. he is bound to have a compara- tional competition. If countries To proceed, an assumption tions: specialisation both re- . tive advantage in that activity. specialise according to their com- quires and promotes trade. But . about technology is required. North, it seems, could make 100 what Smith said about special- : Accordingly, when people say parative advantage, they can isation was implicitly based on loaves a day if it devoted all its the idea of absolute, as opposed The geometry of geography manpower to bread, and 100 bot- to comparative, advantage. NORTH SOUTH les a day if it devoted all its man- Bread power to wine, with all interme- It is mere common sense that : 2. ... if one country is very good at" diate : combinations (50 loaves making hats, say, and another is and 50 bottles, say) in propo:- very good at making shoes, then tion. is production choices are ". . .. . . ... total output can be increased by 70 therefore shown by the line, arranging for the first country to which is called a production-pos- concentrate on making hats and sibility frontier, in chart 1. Ex- the second .on making shoes. actly how much of each good it Then, through trade in both chooses to produce depends on Wine the relative demand in North for goods, more of each can be con- sumed in both places. 30 'S.;100 ... ..30. 90' Wine bread and wine. Suppose de- That is a tale of absolute ad- mand is such that the economy vantage, such as Adam Smith Broad .9. : Bread chooses point A: 70 loaves and might have told. Each country is 30 bottles. better than the other at making a 100 South is less efficient at mak- certain good, and so profits from ing both goods. At one extreme, it specialisation and trade. Com- Slope=1:2 could make 30 loaves a day; at parative advantage-is different: a the other, 90 bottles of wine. Sup- country will have it despite being pose demand is such that it pro- 30 Slopeali bad at the activity concerned. In- . Slope=1:1 duces 20 loaves and 30 bottles- deed, it can have a comparative point A in chart 2. advantage in making a certain Wine Slope=1:3 With these facts, the rate at good even if it is worse at making 100 7. 3.7:. 30. . Lia so Wine which bread will be exchanged that good than any other country. for wine in each economy is ": This is not economic theory, known. In North this rate is 100 but a straightforward matter of Imports. Bread ..' 1 0 loaves to 100 bottles (that is, 1:1). definition: a country has a com- of wine parative advantage where its 100 0727 In South it is 30 loaves to-90 bot- tles (1:3). These rates, which are margin of superiority is greater, of bread the relative prices of bread and or its margin of inferiority small- wine in the two economies, are er. Carl Lewis, one imagines, is xpon shown by the slopes of the lines better than Bill Clinton at both of wine in charts I and 2. sprinting and tennis-that is, he Now suppose that the econo- has an absolute advantage in Win Imports of bread mies are allowed to trade with both. Even so, the president has a 30 50 100 30 40 B- 90 Wine each other. What happens? Cer- comparative advantage in ten- tainly, North is going to offer nis, in which his margin of in- South some bread in exchange 1996 THE ECONOMIST JANUARY 27TH 1996 for wine. In North, a loaf sells for 61just one bottle of wine; across the border, it fetches It's all comparative .-balance the flows of goods, three. Once trade is possi- each economy trades along ble, consumers in the Exchange Bread Breed kits (shifting) consumption North will no longer be imported ( Wine " produced. consumed exported (+) produced consumed exp frontier to point C. There, happy: at these prices, they Before trade equilibrium is achieved at a can improve their position North 1:1 70 price of 1:2, with both econ- 70 30 through trade South omies consuming more of 60 both goods than before. Consumers in the South World . none 190 90 will be happy to go along. For greater clarity, the They will be keen to sell After trade numbers in charts 5 and 6 North some wine. At home, a bot- 1:2 100 are also set out in the table. le sells for one-third of a South The highlighted numbers loaf; in the North, the same . World 1:2 100 100 90 are what really matter. Be- bottle sells for a full loaf. Gains from trade cause of trade, North con- Here then is the auto- North +30 .30 +20 sumes five more loaves and South 20 more bottles of wine matic connection between than before. Unproductive comparative . advantage World +10 +10 OCT Loaves of bread for bortles of wine South consumes five more. and trade. In North, bread loaves. and ten more bottles is cheap in relation to wine; in South, bread is dear in rela- .A. At such points, North would tion to wine. That difference-.. None of this depends on the of wine. There you have it: the gains from trade. the difference between the slopes consume more of both goods, particular price set in the market. of the lines in chants 1 and 2- and therefore be unambiguously . That will be determined by the Free, and fair trade Those suspecting sleight of hand gives North its comparative ad- better off than it was at; A. pattern of trade in bread and wine. . The price. will settle at may still find it confusing that vantage in bread, and South its If. North chose to produce at any point on its production-pos- whatever level is needed to bal- South can sell wine in compe- comparative advantage in wine. The same difference creates the sibility. frontier other than B, : ance North's exports (South's im- - tition with North, even though opportunity for trades that will opportunities to do better by . ports) of bread with North's im- North makes wine more effi- making more bread and;- less : ports (South's exports) of wine. ciently. The answer to this puz- make both sides better off. . wine (thus shifting the consump-. tion . frontier. 'upwards) would . .We know that this value will lie , zle, embedded: in the foregoing Between the lines between 1:1 and 1:3. For illustra- analysis, is wages. How does this process work itself again be left-unexploited. In this . tive purposes, suppose the price out? Once the pattern of trade be- simple model of a market econ-: does turn out to be 1:2, as. in : Recall: that, after trade, South's 100 workers make 90 bot- omy, that cannot happen, North charts 3 and 4. Then charts 5 and . thes of wine a day. So their daily tween North and South has set- does as well as it can, and spe- . 6 show a possible outcome..... wage must be nine-tenths of a tled down, we can be sure of one cialises entirely in bread: By ex-Each economy moves from its - bottle. (By assumption, there are thing: the relative price of bread actly the same reasoning, South initial production at A. to com-.- no other factors of production: and wine will be the same in workers receive all output as both countries. Otherwise, the specialises entirely in wine, at plete specialisation at B. From point B in chart 4. there, with prices changing to . -wages.). North's, workers make pattern of trade will shift again as 100 loaves, so they each earn one buyers and sellers engage in fur- Reality calling loaf a day; at the after-trade price, ther cross-border. ."arbitrage" be- that is equivalent to two bottles tween the two goods. : . of wine. In other words, wages in Where- will -the price settle? IN THE real world, the power of comparative advantage seems South are less than half of wages This cannot be deduced from the I weaker than the simple model of trade-implies. For instance, in North. . existing assumptions: it depends ... .That difference is enough to on the pattern of demand in countries specialise less than you would expect. There is lots of North and South. All we know is "intra-industry" trade-France sells cars to Germany and vice offset South's low productivity in versa. And competition from foreign suppliers does sometimes wine, making it a "competitive" that the free-trade price will lie lower wages in the importing countries. supplier. But the difference is not between the initial prices in More complicated versions of the model account for these enough to offset South's low pro- North and South. duetivity in bread. This is just an- Given only this, however, it is apparent anomalies. Moving from two goods and countries to other way of saying that North possible to say exactly what and many greatly complicates the maths, but otherwise changes lit- how much North and South will tle. A bigger point is that in the real world labour is not the only has . comparative advantage in factor of production: it works with capital (and maybe other fac- bread, and South in wine. produce. At any price even frac- .Unequal wages may be an ef- tionally above 1:1, North will spe ors too). As a result, diminishing returns (extra inputs yield ever ficient basis for trade, but are cialise entirely in the production smaller additions to output) must be taken seriously. It follows of bread. That is because by mak- that the production-possibility frontier is not in general a they a just one? It is often argued : that such trade is unfair on ing only bread, and trading some straight line, but a curve bending outwards in the middle. This in tum implies that complete specialisation is unlikely. As the North, because its suppliers are of it for wine, it can achieve its highest possible consumption of consumption frontier moves upwards (see charts 3 and 4), the being .. undercut by Southern sweatshop labour. The same both goods. This is shown in country shifts production in accordance with comparative ad- chart. 3. . vantage-but gently, not abruptly to point B. .logic, slightly twisted, yields the At a price of 1:2, say, North The other big change is that, with two or more factors to re- opposite complaint: trade is un- ward, the distribution of income matters. As trade shifts re-. fair on South, because its workers produces at point B, and can are being exploited. then, in effect, trade along its sources, this distribution is likely to alter. If an industry that uses . The best answer to both argu- new price line to any of a range lots of labour shrinks and one that uses lots of capital grows, of points. This new price line is a payments to labour will fall relative to payments to capital-per- ments is simply to point out that, consumption-possibility (as op- haps enough to lower real wages. But remember that in each "fair" or not, trade raises in- posed to production-possibility) country trade will still raise incomes in the aggregate, making it comes in both countries. Victims frontier. It includes many points possible for losers to be compensated, with net gains all round. of .injustice and exploitation that are above and to the right of should always be so lucky. 62 THE ECONOMIST JANUARY 27TH 1996