Notes

In dollar terms, our imports in 2016 exceeded $2.7 trillion. These imports included the consumer items mentioned earlier as well as capital equipment, raw materials, and food. Table 19.1 represents the goods and services we purchase from foreign suppliers.Page 405

While we’re buying goods (merchandise) and services from the rest of the world, global consumers are buying our exports. In 2016 we exported $1.5 trillion of goods, including farm products (wheat, corn, soybeans), tobacco, machinery (computers), aircraft, automobiles and auto parts, raw materials (lumber, iron ore), and chemicals (see Table 19.1 Page 406for a sample of U.S. merchandise exports). We also exported $750 billion of services (movies, software licenses, tourism, engineering, financial services, etc.).

Although we export a lot of products, we usually have an imbalance in our trade flows. The trade balance is the difference between the value of exports and imports:

Trade balance = Exports − Imports

During 2016 we imported much more than we exported and so had a negative trade balance. A negative trade balance is called a trade deficit.


When the United States has a trade deficit with the rest of the world, other countries must have an offsetting trade surplus. On a global scale, imports must equal exports because every good exported by one country must be imported by another. Hence any imbalance in America’s trade must be offset by reverse imbalances elsewhere.

When countries trade goods and services, they are doing the same thing—specializing in production and then trading for other desired goods. Why do they do this? Because specialization increases total output.

To see how nations benefit from trade, we’ll examine the production possibilities of two countries. We want to demonstrate that two countries that trade can together produce more output than they could in the absence of trade. If they can, the gain from trade is increased world output and a higher standard of living in all trading countries. This is the essential message of the theory of comparative advantage.

Consider the production and consumption possibilities of just two countries—say, the United States and France. For the sake of illustration, assume that both countries produce only two goods: bread and wine. Let’s also set aside worries about the law of diminishing returns and the substitutability of resources, thus transforming the familiar production possibilities curve into a straight line, as in Figure 19.1.

A nation that doesn’t trade with other countries is called a closed economy. In the absence of contact with the outside world, the production possibilities curve for a closed economy also defines its consumption possibilities. Without imports, a country cannot consume more than it produces. Thus the only immediate issue in a closed economy is which mix of output to choose—what to produce and consume—out of the domestic choices available.

Assume that Americans choose point D on their production possibilities curve, producing and consuming 40 zillion loaves of bread and 30 zillion barrels of wine. The French, on the other hand, prefer the mix of output represented by point I on their production Page 409possibilities curve.

This is our first clue as to how specialization and trade can benefit an open economy—a nation that engages in international trade.

Table 19.4 recaps the gains from trade for both countries. Notice that U.S. imports match French exports and vice versa. Also notice how the trade-facilitated consumption in each country exceeds no-trade levels.

Each country produces those goods it makes best and then trades with other countries to acquire the goods it desires to consume.

The resultant specialization increases total world output. In the process, each country is able to escape the confines of its own production possibilities curve, to reach beyond it for a larger basket of consumption goods. When a country engages in international trade, its consumption possibilities always exceed its production possibilities.

The decision to export bread is based on comparative advantage—that is, the relative cost of producing different goods. Recall that we can produce a maximum of 100 zillion loaves of bread per year or 50 zillion barrels of wine. Thus the domestic opportunity cost of producing 100 zillion loaves of bread is the 50 zillion barrels of wine we forsake in order to devote all our resources to bread production. In fact, at every point on the U.S. production possibilities curve (Figure 19.2a), the opportunity cost of a loaf of bread is ½ barrel of wine. We’re effectively paying half a barrel of wine to get a loaf of bread.

Comparative advantage refers to the relative (opportunity) costs of producing particular goods.

A country should specialize in what it’s relatively efficient at producing—that is, goods for which it has the lowest opportunity costs. In this case, the United States should produce bread because its opportunity cost (½ barrel of wine) is less than France’s (4 barrels of wine). Were you the production manager for the whole world, you’d certainly want each country to exploit its relative abilities, thus maximizing world output. Each country can arrive at that same decision itself by comparing its own opportunity costs to those prevailing elsewhere. World output, and thus the potential gains from trade, will be maximized when each country pursues its comparative advantage. To do so, each country

Exports goods with relatively low opportunity costs.

Imports goods with relatively high opportunity costs.

We’re clever traders; but beyond that, is there any way to determine the terms of trade—the quantity of good A that must be given up in exchange for good B? In our previous illustration, the terms of trade were very favorable to us; we exchanged only 6 zillion loaves of bread for 20 zillion barrels of wine (Table 19.4). The terms of trade were thus 6 loaves = 20 barrels.


If we’re to make sense of trade policies, then, we must recognize one central fact of life: Some producers have a vested interest in restricting international trade. In particular, workers and producers who compete with imported products—who work in import-competing industries—have an economic interest in restricting trade. This helps explain why GM, Ford, and Chrysler are unhappy about auto imports and why shoe workers in Massachusetts want to end the importation of Italian shoes. It also explains why textile producers in South Carolina think China is behaving irresponsibly when it sells cheap cotton shirts and dresses in the United States.

Export Industries

Although imports typically mean fewer jobs and less income for some domestic industries, exports represent increased jobs and income for other industries. Producers and workers in export industries gain from trade. Thus on a microeconomic level there are identifiable gainers and losers from international trade. Trade not only alters the mix of output but also redistributes income from import-competing industries to export industries. This potential redistribution is the source of political and economic friction.