4.2 Why Do Nations Trade?

Why does Canada import automobiles, steel, digital phones, and apparel from other countries? Why don’t we just make them ourselves? Why do other countries buy wheat, chemicals, machinery, and lumber products from us? Because no national economy produces all the goods and services that its people need. Countries are importers when they buy goods and services from other countries; when they sell products to other nations, they’re exporters (we’ll discuss importing and exporting in greater detail later in the chapter). The monetary value of international trade is enormous. In 2016, the total value of worldwide trade in merchandise and commercial services was $20.208 trillion.^[1]

Absolute and Comparative Advantage

To understand why certain countries import or export certain products, you need to realize that every country (or region) can’t produce the same products. The cost of labour, the availability of natural resources, and the level of know-how vary greatly around the world. Most economists use the concepts of absolute advantage and comparative advantage to explain why countries import some products and export others.

Absolute Advantage

A nation has an absolute advantage if (1) it’s the only source of a particular product or (2) it can make more of a product using fewer resources than other countries. Because of climate and soil conditions, for example, France had an absolute advantage in winemaking until its dominance of worldwide wine production was challenged by the growing wine industries in Italy, Spain, the United States, and more recently, Canada. Unless an absolute advantage is based on some limited natural resource, it seldom lasts. That’s why there are few, if any, examples of absolute advantage in the world today.

Comparative Advantage

How can we predict, for any given country, which products will be made and sold at home, which will be imported, and which will be exported? This question can be answered by looking at the concept of comparative advantage, which exists when a country can produce a product at a lower opportunity cost compared to another nation. But what’s an opportunity cost?

Opportunity costs

Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that is desired. A fundamental principle of economics is that every choice has an opportunity cost.

• If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss.
• If you spend your income on video games, you cannot spend it on movies.
• If you choose to marry one person, you give up the opportunity to marry anyone else.

In short, opportunity cost is all around us.

The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else; in short, opportunity cost is the value of the next best alternative.

Since people and businesses must choose, they inevitably face trade-offs in which they have to give up things they desire to get other things that they desire more.

Opportunity Cost and Individual Decisions

In some cases, recognizing the opportunity cost can alter personal behaviour. Imagine, for example, that you spend $10 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $7 each day (that is, the $10 that buying lunch costs minus the $3 your lunch from home would cost). Ten dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 workdays a year × $10 per day equals $2 500—it is the cost, perhaps, of a decent vacation. If the opportunity cost were described as “a nice vacation” instead of “$10 a day” you might make different choices.

Another situation many businesses and individuals face is having to choose between producing one product versus another product. There is only a finite amount of time each day, so companies have to decide which product they wish to focus their resources on (product A or product B). If you choose to produce product A, the opportunity cost is the value of the alternative product (product B) that you gave up in order to produce product A. Let’s look at an example.

Say you work for a company that produces dinnerware. It takes longer for you to make a bowl than it does a plate, so in a day you could produce either 10 bowls or 30 plates. To find the opportunity cost per item produced, you need to calculate how many plates you must give up in order to produce 1 bowl. In this case, you are losing 3 plates for every bowl (30 plates divided by 10 bowls). Therefore, your opportunity cost for producing 1 bowl is 3 plates.

Opportunity Cost and Societal Decisions

Opportunity cost also comes into play with societal decisions. Universal health care would be nice, but the opportunity cost of such a decision would be less housing, environmental protection, or national defense. These trade-offs also arise with government policies. For example, after the terrorist plane hijackings on September 11, 2001, many proposals, such as the following, were made to improve air travel safety:

• The federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year.
• Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million.
• Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face-recognition software, would cost another $2 billion.

Lost time can be a significant component of opportunity cost.

However, the single biggest cost of greater airline security does not involve money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation, more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travellers are relatively highly paid business people, conservative estimates set the average “price of time” for air travellers at $20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × $20/hour—or, $8 billion per year. Clearly, the opportunity costs of waiting time can be just as substantial as costs involving direct spending.

Benefits of Globalization

A closer look reveals that globalization has been the engine that creates jobs and wealth. Benefits of global trade include the following:

• Productivity grows more quickly when countries produce goods and services in which they have a comparative advantage. Living standards can increase faster. One problem is that big G20 countries have added more than 1,200 restrictive export and import measures since 2008.
• Global competition and cheap imports keep prices down, so inflation is less likely to stop economic growth. However, in some cases, this is not working because countries manipulate their currency to get a price advantage.
• An open economy spurs innovation with fresh ideas from abroad.
• Through the infusion of foreign capital and technology, global trade provides poor countries with the chance to develop economically by spreading prosperity.
• More information is shared between two trading partners that may not have much in common initially, including insight into local cultures and customs, which may help the two nations expand their collective knowledge and learn ways to compete globally.¹⁷