Gains from Trade

Many of the important ideas in economics were first worked out by analyzing international trade. Economists argue that free trade enhances efficiency.

In running our personal affairs, virtually all of us exploit the advantages of free trade and comparative advantage without thinking twice. For example, many of us have our shirts laundered at professional cleaners rather than wash and iron them ourselves. Anyone who advised us to "protect" ourselves from the "unfair competition" of low-paid laundry workers by doing our own wash would be thought looney. --Alan Blinder, "Free Trade," The Concise Encyclopedia of Economics

Here is an example from David Friedman's Hidden Order: The Economics of Everyday Life.

There are two ways we can produce automobiles. We can build them in Detroit or we can grow them in Iowa. Everyone knows how we build automobiles. To grow automobiles, we first grow the raw material from which they are made--wheat. We put wheat on shhips and send the ships out into the Pacific. They come back with Hondas on them.

As this example illustrates, trade is a way of transforming our output into different output. Using trade, we can produce more goods where we have a comparative advantage, and trade them for goods where another country has a comparative advantage. Indeed, the concept of comparative advantage first was developed almost 200 years ago by David Ricardo in the context of analyzing international trade.

The Ricardian Model

Suppose that the United States can produce 6 cars per worker per year, and 90 tons of wheat per worker per year. Suppose that the rest of the world can produce 4 cars per worker per year, and 50 tons of wheat per worker per year. The United States is more productive in both industries, which means that the U.S. has an absolute advantage in both. The naive view is that the United States cannot gain from trade, because we are more efficient. But we can show that this view is wrong.

Suppose that Americans like to spend half of their income on cars and half their income on wheat, and that we have 100 workers. If we do not trade, then half of our workers will make cars and half will produce wheat. With 50 workers producing cars, we produce 300 cars. With 50 workers producing wheat, we produce 4500 tons of wheat.

Next, suppose that we can trade. We can specialize in producing wheat, so that 100 workers produce 9000 tons of wheat. Then, we keep 4500 tons of wheat and trade 4500 tons of wheat in the world market.

In the world market, 50 tons of wheat can trade for 4 cars. If a car costs $10,000, then a ton of wheat will cost $800. So our 4500 tons of wheat can trade for 360 cars.

With no trade, we produce and consume 4500 tons of wheat and 300 cars. With trade, we produce 9000 tons of wheat, but we consume 4500 tons of wheat and 360 cars. We export 4500 tons of wheat and import 360 cars. The opportunity to trade increases our ability to consume by 60 cars compared with no trade.

Trade with diminishing returns

The Ricardian model is useful for illustrating comparative advantage. However, it violates the law of diminishing returns. As a result, it has some peculiar features, particularly the implication that once trade opens up, a country will completely specialize in producing its exportable good.

Here is an example with diminishing returns. Suppose that everyone consumes tacos, which consist of hamburger meat and tortillas. If you multiply the number of ounces of hamburger meat times the number of tortillas, you have a measure of consumer happiness, which we will call the index of satisfaction.

The United States has 100 units of labor, which can be allocated either to producing hamburger meat or producing tortillas. If we allocate 25 units to producing meat and 75 units to producing tortillas, then we obtain 22 ounces of meat and 66 tortillas. Multiplying 22 by 66 gives a total satisfaction index of 1452. Below is a table that gives consumption possibilities for different allocations of labor.

The U.S. economy without trade

Labor Producing MeatLabor Producing TortillasOunces of Meat Produced Tortillas ProducedIndex of Satisfaction

What is the allocation of labor that produces the highest level of satisfaction?

In moving from 50 units of labor producing meat to 75 units of labor producing meat, how much more meat is produced? How many fewer tortillas are produced?

Because the trade-off between meat and tortillas is one for one, if the price of a tortilla is 10 cents, then the price of an ounce of meat will also be 10 cents. (All we really know about prices in this economy is the relative price of meat in terms of tortillas. That is, we know that the price of an ounce of meat is the same as the price of a tortilla, because the cost trade-off between the two is one for one. However, the price of ten cents is arbitrary. We could have fixed the price of a tortilla at $5, in which case the price of an ounce of meat would be $5.)

Next, consider another economy, Mexico, that also does not trade. It has the same amount of labor as the United States, but labor is not as productive in either the meat industry or the tortilla industry.

The Mexican economy without trade

Labor Producing MeatLabor Producing TortillasOunces of Meat Produced Tortillas ProducedIndex of Satisfaction

What is the allocation of labor that produces the highest level of satisfaction?

In moving from 50 units of labor producing meat to 75 units of labor producing meat, how much more meat is produced? How many fewer tortillas are produced?

In Mexico, giving up one ounce of meat means that they can produce two more tortillas. Therefore, in Mexico, if the price of a tortilla is 10 cents, then the price of an ounce of meat will be 20 cents.

Note that the United States has higher productivity in terms of both tortillas and meat. The United States has an absolute advantage in both goods. However, the gains from trade come from comparative advantage, not absolute advantage.

The key to this entire example is the fact that the United States has to give up one tortilla for one ounce of meat, while Mexico only has to give up two tortillas for one ounce of meat. This means that the relative cost of meat will be higher in Mexico, so that Mexico will have a comparative advantage in producing tortillas.

Prior to trade, prices are different in the two countries. A tortilla costs 10 cents in each country, but an ounce of meat costs 10 cents in the United States and 20 cents in Mexico. When trade opens up, Mexico will want to import cheap meat from the United States, which means that it will have to export tortillas. Eventually, free trade leads to a new price of meat that is the same in both countries.

When identical goods trade for different prices in two places, speculators can buy the goods where they are cheap and sell them where they are expensive. This is known as arbitrage. If the price of meat were 10 cents in the United States and 20 cents in Mexico, what would arbitrageurs do?

When trade opens up between the two countries, Mexico will shift 25 workers from meat to tortillas, so that it produces 57 tortillas and 15 ounces of meat. The United States will shift 25 workers from tortillas to meat, so that it produces 57 ounces of meat and 34 tortillas. Total production will be 72 ounces of meat and 91 tortillas.

Assuming that the price of tortillas stays fixed at ten cents, the price of an ounce of meat will settle at something like 12 cents. Mexico will trade 18 tortillas to the U.S. for 15 ounces of meat. This is balanced trade, because 15 ounces times 12 cents/ounce is equal to 18 tortillas times 10 cents/tortilla. Taking into account production, imports, and exports, Mexico will consume 39 tortillas and 30 ounces of meat, for a total satisfaction index of 1170.

After trading 15 ounces of meat for 18 tortillas, the United States consumes 42 ounces of meat and 52 tortillas, for a total satisfaction index of 2184. Thus, both countries are better off with trade.

Key Points

  1. Beneficial trade is possible whenever there is comparative advantage. A country does not have to be absolutely more productive in an industry in order to export goods in that industry.

  2. Without trade, relative prices between goods can differ in two countries. These relative prices are what indicate comparative advantage. A country will export the goods that are relatively more expensive abroad than at home.

  3. With trade, the relative prices of goods will be equalized. Arbitrage helps to ensure that this is the case.

  4. With trade, both countries are better off. Each country will produce more of the good where it has a comparative advantage, and trade some of that good for the other good.

Tariffs and Quotas

Suppose that the United States imports cocaine from Columbia. Suppose that the cost of producing and shipping cocaine is $5 a kilo, and that the demand for cocaine is

Q = 17,000 - 15P

where Q is the quantity of kilos consumed and P is the price of cocaine.

In the absence of any restrictions on trade, the equilibrium price will be $5, and the equilibrium quantity that the U.S. will import and consume will be 16,925 kilos.

Next, suppose that the United States decides to restrict imports of cocaine by the means of a drug war. The result is to reduce the quantity of cocaine to 2000 kilos. We can use the demand equation to solve for the equilibrium price when there are only 2000 kilos.

2000 = 17,000 - 15P; P = $1000. The price of a kilo rises to $1000.

Instead of the drug war, the United States could impose an import tariff on cocaine of $995 a kilo. This would raise the price to $1000, and lead to a quantity consumed of 2000 kilos.

When countries want to restrict imports, sometimes they impose quotas and sometimes they impose tariffs. Either way, the cost to consumers rises and consumers are hurt. However, with a tariff, some of what consumers lose is collected by the government in the form of taxes. With a quota, some of what the consumers lose is collected by the suppliers who are fortunate enough to have their product shipped as part of the quota. In the case of the cocaine drug war, the steep price of cocaine that consumers face is a source of profits to successful criminal enterprises.

You can tell from this discussion that economists tend to view drug policy in terms of tariffs and quotas. From this perspective, legalization with high taxes, as we do with cigarettes and alcohol, is equivalent to a tariff. The drug war is equivalent to a quota. Economists tend to prefer the tariff approach, which means that they tend to support legalization of drugs.

For goods and services that are less controversial than cocaine, economists tend to oppose both tariffs and quotas. That is because tariffs and quotas interfere with the potential gains from trade that come from comparative advantage.

An individual industry can benefit from a tariff or quota. If you are a farmer in France, then you would like a tariff on foreign farm products, because you want the price of farm products to be high in France. France as a whole would be better off with lower food prices and fewer farmers, but it is hard to get the French farmers to see it that way--particularly when they vote. American steel producers and textile producers are similarly in favor of tariffs and quotas.

The Problem of Monopoly

The classic problem of monopoly is that it sets a higher price than marginal cost, which distorts the trade-offs in the economy and moves it away from Pareto efficiency. We will discuss this problem here. However, other problems with monopoly may be more important. For example, the fact that a monopoly does not face the discipline of competition means that the monopoly may operate inefficiently without being corrected by the marketplace.

A competitive firm confronts demand that is infinitely elastic. For example, suppose that you grow wheat. If you charge a price for your wheat that is one penny above the market price, then you will sell no wheat. Conversely, if you charge a price that is one penny below the market price, people will want to buy more wheat than you can possibly produce. An individual wheat farmer faces infinitely elastic demand. If the marginal cost of producing a bushel of wheat is $100, then the competitive price of wheat will be $100 a bushel.

Suppose that you could establish a monopoly in wheat production. Then the demand curve that you would face would be the market demand curve, which might be

Q = 10,000 - 20P

where Q is bushels of wheat and P is the price of wheat. In a competitive market, the price would be $100 a bushel, and 8000 bushels would be consumed. For a competitive firm in this market, the revenue function is

R = PQ = $100Q for P less than or equal to $100, 0 otherwise.

If the competitor tries to charge a price above the competitive price, it sells no wheat.

A monopolist faces the entire demand curve. For the monopolist, revenue is given by

R = PQ = P(100,000 - 20P)

Let us look at total revenue and total cost for various prices charged by the monopolist.

PriceQuantity SoldRevenueCost

Which price should the monopolist pick in order to maximize profits?

How much do consumers lose in moving from a competitive price to a monopoly price?

At the competitive price, consumers earn a surplus equal to one half times Q times the difference betwen P and the point at which P chokes off demand, which is when P = $500. The difference between $500 and the competitive price of $100 is $400. So we have (1/2)(8000)($400) = $1.6 million in consumers' surplus at the competitive price.

At the monopoly price of $300, the difference with the choke-off price is only $200, and consumers only buy 4000 bushels. So consumers' surplus is (1/2)(4000)($200) = $400,000.

Now, we can do a complete accounting of what happens when we go from competition to monopoly. The consumers' surplus falls by $1.2 million. Producer profits rise from zero to $800,000. What happens to the remaining $400,000 of consumers' surplus that is not transferred to consumers? The remaining $400,000 is lost to the economy completely. It is the "deadweight loss" from the monopoly.

Note that if the industry were competitive and the government imposed a $200 per-bushel tax on wheat, the result for the consumer would be the same. There is the same "deadweight loss" for the economy. The only difference between a government tax and the monopoly "tax" is that the "profits" accrue to the government.

There is a disconnect between the public perception of the problem of monopoly and economists' perception of the problem of monopoly. To the public, the profits of monopolists are a measure of the problem. To economists, it is only the "deadweight loss" that matters. The profits of the monopolist represent a transfer of income, not a loss of of income. Economists cannot say whether or not a transfer of income is socially desirable. What if the monopolist were owned by sweet little old ladies and the consumers were a bunch of rich cads?

Public Goods

Sometimes, I can enjoy a good without having to pay for it. If my neighbors pay to have a security guard, then I may benefit from that security guard, even though I do not pay. In that case, I am a "free rider," and economists call this the "free-rider problem."

Certain types of goods naturally impose free-rider problems. National defense is an example.

Another example of a public good is environmental quality. With the environment, it is polluters who are "free riders," imposing a cost on others that the polluters themselves do not have to bear. If I drive a high-pollution automobile, the cost of the pollution is spread among everyone in the area in which I drive. If a company dumps toxic waste into a stream, the cost is borne by people downstream.

We could think of pollution as a "public bad," which is the opposite of a public good. However, the more common terminology is to say that pollution is a "negative externality." This term "externality" means an economic consequence that is not taken into account by the producer, because the producer does not absorb the benefit or cost. When the externality imposes a cost, it is a negative externality. When the externality provides a benefit, it is a positive externality. When I was in graduate school, my roommate and I used to pass the factory that made Necco Wafers on the way to class. The smell from the factory was like candy--a positive externality. But we did not have to pay Necco for the pleasure that we got out of walking by the factory.

Not everything that is good for the public is a public good. For example, education is good for the public. However, an individual benefits from his or her own education. Education is only a public good to the extent that I enjoy "free-rider" benefits when you are educated. If individual incentives are sufficient to achieve the optimal production of something, then it is not a public good.

An economic principle known as the Coase Theorem (for Ronald Coase) states that the inefficiencies of public goods can be mitigated when it is possible to clarify property rights. For example, take the case of the company that pollutes a stream. If it is clear who owns the downstream water, then the downstream owner can pay the company to reduce its pollution, or the company can pay the downstream owner for the right to pollute.

The use of property rights to resolve environmental problems can be counter-intuitive. Consider the issue of killing elephants to obtain their tusks for ivory. Some activists have argued that in order to save elephants from extinction, we need to ban ivory. Economists, on the other hand, suggest giving farmers property rights to elephant herds. If I own an elephant herd, then I will want to maximize its long-term value, which means making sure that the herd expands rather than contracts. The argument goes that ownership of elephant herds would ensure the survival of elephants in the same way that the ownership of egg farms ensures that farmers have an incentive to maintain the supply of chickens.

When the problem of a public good or externality cannot be resolved by assigning property rights, only government intervention can mitigate the deadweight loss. For example, the government can regulate pollution or tax polluters. Regulation is like a quota, and a tax is like a tariff.

In the case of national defense, the government provides the public good. Everyone is taxed to help pay for national defense. The government has to decide how much social benefit is provided by national defense, and in theory it should try to maximize the benefits relative to the costs.

Game Theory and Public Goods

Economists use game theory to spell out the problem of public goods. Game theory is the branch of economics in which John Nash ("A Beautiful Mind") earned his Nobel Prize.

Game theory looks at how people will behave when they take into account other people's strategies. A simple example is the payoff matrix for the game known as "prisoner's dilemma." Suppose that a judge has two prisoners that are accused of a crime. The judge tells each prisoner that if one confesses but the other does not, the confessor will serve 1 year, and the other prisoner will serve 10 years. If both confess, they each will serve 5 years. If neither confesses, both will serve three years on a lesser charge. The prisoners will be making their decisions separately in separate hearings.

Here is what the payoff matrix looks like for one of the prisoner, depending on the choice made by the other prisoner.

First Prisoner's StrategiesSecond Prisoner Does Not ConfessSecond Prisoner Confesses
Do Not Confessserves 3 yearsserves 10 years
Confessserves 1 yearserves 5 years

If the second prisoner confesses, is the first prisoner better off confessing or not confessing? If the second prisoner does not confess, is the first prisoner better off confessing or not confessing? What would we predict that the first prisoner will do? What will be the outcome of the game? How does this compare with the best outcome from the perspective of the prisoners?

The problem of congestion on the Beltway at rush hour is like a prisoner's dilemma game. If many drivers would exercise discretion to take trips at off-peak times, everyone might be better off. However, as a driver, taking other drivers' choices as given, my indivudal "payoff matrix" says that I am better off driving at rush hour than moving my trip to a different time.

Construct a pay-off matrix for the Beltway congestion game that leads to the result that everyone chooses to drive at rush hour, even though they would be better off if many people would drive at off-peak times.
Some Classic Policy Issues

There are some types of policy issues where economists believe strongly in a policy that may or may not appeal to the general public. For example, economists believe that we benefit from free trade, even though the public sometimes resents foreign imports. Here are some classic policy issues where economists tend to have a consensus opinion.

Ticket Scalping

Economists are in favor of ticket scalping. When the price of a ticket is fixed, the price may be too low, and there are more people who want to attend the event than the number of seats available at that price. In that case, the equilibrium price would be higher. Scalpers help to raise the price to the right level. If the market-clearing price is $50, then someone who only wants to pay $40 should miss the event. Scalpers help take tickets from people who do not want to pay the market-clearing price and put tickets in the hands of people who most want to attend the event.

Rent Control

Cities sometimes adopt rent controls, where they place a ceiling on rents for apartments. Economists believe that a price ceiling will create a shortage. In fact, cities that have rent control find that apartments are in short supply. This leads to a "black market" in which one renter might pay another in order to live in a scarce rent-controlled apartment.

Rent controls provide a short-term benefit to some lucky renters. However, other would-be renters are unable to get housing entirely. Moreover, apartment owners let their buildings deteriorate, because with rent control they are unable to raise rents to recover the costs of maintenance and improvement. Thus, if rent controls are kept in place for a long time, they can lower the quality of life for everyone.

Minimum Wage Laws

Montgomery County passed a "living wage" law, requiring that workers who provide government services must be paid at least a minimum amount per hour. Minimum wage laws tend to be harmful, even for the poor people that they are intended to help.

If the minimum wage is higher than the marginal productivity of an an individual, then the result of the minimum wage law is to make it uneconomical to hire that person. Instead of earning a sub-minimum market wage, the person is unemployed. Instead of hiring unskilled workers at the minimum wage and losing money, employers subsitute capital and highly-skilled workers for low-skilled workers.

Montgomery County's "living wage" law applies to workers who provide government services. It will raise the cost of those services, which will reduce the capacity of the government to provide them. Since many government services go to aid the poor, the "living wage" law will have the same effect on the poor as a broad-based budget cut.

Fuel Economy Regulation

When people decide to buy cars, they have to decide between fuel economy and other features. It is argued that there is a "public good" issue because high fuel consumption causes pollution and also adversely impacts our ability to conduct foreign policy free from the influence of oil-producing countries.

A policy response has been Corporate Average Fuel Economy, or CAFE standards. These require auto manfacturers to achieve certain average standards for fuel economy. Economists think that this approach is ineffective, for a number of reasons.

  1. Improved fuel economy lowers the cost of driving. People who use more fuel-efficient cars to drive more miles are not reducing their fuel consumption and pollution. They may even increase it.

  2. The standards create incentives for companies to work around them. Most notoriously, SUV's are exempt from CAFE standards.

  3. The standards raise the cost of new cars relative to old cars. This keeps old, gas-guzzling, high-pollution cars on the road longer.

Instead of fuel economy standards, economists would prefer to raise the tax on gasoline. A higher gasoline tax would directly discourage gasoline consumption. It would allow consumers to choose the most efficient means to economize on fuel, which might be obtaining newer cars, driving fewer miles, or switching to cars with better fuel economy.

Tradable Pollution Rights

Suppose that we want to reduce the amount of an airborne pollutant that comes from industrial smokestacks. One approach is to regulate the amount of emissions allowed from each plant. However, such regulatory limits impose very different costs in different industries.

The approach that economists recommend involves tradable pollution rights. The government can auction off the right to emit a certain level of pollution. A firm is only allowed to emit as much pollution as it has acquired the right to emit, either through the auction or by trading with other firms. This allows for greater substitution and flexibility in meeting a given national goal for pollution control. For example, some firms might find it cheapest simply to shut down certain plants and build new ones, and they can sell pollution rights to firms that would find it expensive to undertake a short-run conversion.

The Principle of Substitution

Perhaps the most common thread in these policies issues is that economists are focused on the principle of substitution. That principle says that individuals will respond to incentives by substituting low-cost methods for high-cost methods. If you want the principle of substitution to work for you, then you should apply taxes directly to the activity that you want to discourage. If you want to discourage gasoline consumption, then tax gasoline.

Policies that do not permit substitution are inefficient. For example, forcing a pollution limit on every industrial plant is less efficient than allowing plants to trade rights to produce the same aggregate amount of pollution.

The most ineffective policies are policies that will be undermined by the principle of substitution. If you impose a minimum wage, then businesses will substitute away from low-skilled workers. If you try to regulate fuel economy, people will substitute exempt cars (such as old automobiles) and drive more miles.

When I decide to get on the Beltway at rush hour, I add to the congestion. My decision to take the Beltway does not take into account the cost to others of the additional congestion that I cause.

  1. This can be thought of as a situation involving public goods. What is the public good in this case?

  2. Economists would argue that if tolls can be collected costlessly (by electronic tolltakers, rather than toll booths), then tolls are the best solution for road congestion. Explain how tolls use the principle of substitution. List three alternatives to tolls for relieving road congestion, and describe how the effectiveness of those alternatives would be affected by substitution.

Money vs. Barter

In the next main topic of this course, macroeconomics, money is one of the important concepts. This section talks about money from the perspective of microeconomics.

When people exchange goods and services without using money, this is called barter. "I'll cook dinner if you'll do the dishes" is an example of barter.

Imagine an economy in which I can sell services as a consultant to banks, but what I want is to buy a new suit. The clothing store that sells suits does not have any use for my services as a banking consultant. The bank does not sell suits. How can barter work?

One can imagine a computer system that finds a bank that wants my consulting services, a clothing store that needs banking services, and then arranges a three-way trade where I get my suit in exchange for consulting services. As the economy gets more complex, the computer system has to arrange barter trades that are more and more elaborate.

Instead of a computerized bartering system, we use money to implement complex exchanges. I sell consulting services for money, and I buy a suit using money. Money serves as a medium of exchange.

Using money, my exchange of consulting services for a new suit is not simultaneous. The transactions take place at different points in time. For this to work, money must hold its value over time. Thus, money also acts as a store of value. I can hold onto money for a few days without having it lose value.

When money is established as a medium of exchange, people get used to calculating value in terms of money. Thus, money becomes a unit of account. Using money as a unit of account breaks down if we are doing cross-country comparisons. A Canadian dollar and a U.S. dollar are not the same.

Commodity Money and Fiat Money

Commodity money consists of objects that have value but which are used as a medium of exchange. Pretty shells could serve as commodity money. Gold jewelry can serve as commodity money. Among prisoners, cigarettes often serve as commodity money.

As a practical matter, money is anything that is widely accepted in exchange. With commodity money, people will want to hold onto valuable samples and to use the least valuable samples for payment. Thus, among prisoners, the least popular cigarettes will end up being used as currency. This tendency for the least valuable currency to circulate is known as Gresham's Law.

Fiat money is something that has no intrinsic value, but which the government declares by fiat to be money. If you look at a dollar bill, you will see the phrase "legal tender for all debts, public and private." What that means is that if someone sells you something and you "tender" the currency (offer the currency as payment), you have legally paid, whether or not the seller accepts your currency. By making U.S. currency legal tender in this country, the government forces people to accept it as a medium of exchange.


With the concept of fiat money, the government can turn worthless pieces of paper into something of value. The reason that people value money is that it allows for complex exchanges to take place more easily than using barter.

The difference between the value of goods and services that a dollar can buy and the cost of printing the dollar represents a profit to the government, or a form of taxation. This tax is called seignorage.