Question

Discuss the rationale for international trade using comparative and absolute advantage theories

Provide an example of how to resolve macroeconomic challenges like income distribution

Answer 1

International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.

A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.

Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.

A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs.

A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.

Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.

Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players. Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.

Income is a flow of money received, often measured on a monthly or an annual basis; wealth is the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home. In calculating wealth all debts must be subtracted, such as debt owed on a home mortgage and on credit cards. A retired person, for example, may have relatively little income in a given year, other than a pension or Social Security. However, if that person has saved and invested over time, the person’s accumulated wealth can be quite substantial.

In the United States, the wealth distribution is more unequal than the income distribution, because differences in income can accumulate over time to make even larger differences in wealth. However, the degree of inequality in the wealth distribution can be measured with the same tools we use to measure the inequality in the income distribution, like quintile measurements.

Redistribution means taking income from those with higher incomes and providing income to those with lower incomes. Earlier in this chapter, we considered some of the key government policies that provide support for the poor: the welfare program TANF, the earned income tax credit, SNAP, and Medicaid. If a reduction in inequality is desired, these programs could receive additional funding.

The programs are paid for through the federal income tax, which is a progressive tax systemdesigned in such a way that the rich pay a higher percent in income taxes than the poor. Data from household income tax returns in 2009 shows that the top 1% of households had an average income of $1,219,700 per year in pre-tax income and paid an average federal tax rate of 28.9%. The effective income tax, which is total taxes paid divided by total income (all sources of income such as wages, profits, interest, rental income, and government transfers such as veterans’ benefits), was much lower. The effective tax paid by the top 1% of householders was 20.4%, while the bottom two quintiles actually paid negative effective income taxes, because of provisions like the earned income tax credit. News stories occasionally report on a high-income person who has managed to pay very little in taxes, but while such individual cases exist, according to the Congressional Budget Office, the typical pattern is that people with higher incomes pay a higher average share of their income in federal income taxes.

Of course, the fact that some degree of redistribution occurs now through the federal income tax and government antipoverty programs does not settle the questions of how much redistribution is appropriate, and whether more redistribution should occur.