Here’s a letter to a sympathetic correspondent. I apologize for its wonkiness.
Mr. W__:
Thanks for your e-mail.
In response to my piece on microchips and potato chips, you ask “But what happens when they [foreigners] not only make [micro]chips cheaper than we can but also make potato chips and everything else cheaper than we do?”
The answer to your question is indisputable: The outcome you describe is, because of the principle of comparative advantage, impossible. Explaining why, alas, requires an unusually long letter, for which, I trust, you’ll forgive me. (You can also consult here, here, here, and here.)
Suppose China can produce microchips at a lower cost than we Americans can. This fact means that the value of other goods and services that China gives up – the value of other goods and services that China does not produce – as a consequence of producing microchips is less than is the value of other goods and services that we give up were we to produce microchips.
To offer a concrete hypothetical, suppose that each week China can produce $1,000,000 worth of microchips or $1,000,000 worth of other goods and services – “widgets.” This fact means that for each dollar’s worth of microchips that China produces, it sacrifices – it doesn’t produce – $1 worth of widgets. As for us, suppose that each week we can, like China, produce $1,000,000 worth of microchips. But the amount of widgets we can produce each week is $2,000,000 worth. Our cost of producing one dollar’s worth of microchips is thus $2 worth of widgets – twice as high as is China’s cost of producing microchips. China produces microchips at a lower cost than we do.
But these numbers also mean that we produce widgets at a lower cost than does China. Producing $2,000,000 worth of widgets requires that we sacrifice the production of $1,000,000 worth of microchips – meaning that each dollar’s worth of widgets that we produce cost us only $0.50 in foregone microchip production.
In this example, China is the low-cost producer of microchips (and so has a comparative advantage at producing microchips). America is the low-cost producer of widgets (and so has a comparative advantage at producing widgets).
Now suppose that Beijing decides that it wants China to produce both microchips and widgets at lower costs than America produces these outputs. In pursuit of this goal, Beijing strives – say, using industrial policy – to improve China’s ability to produce widgets. Suppose Beijing succeeds spectacularly. Each week China can now produce, not merely the $1,000,000 worth of widgets that it could produce earlier, but $4,000,000 worth of widgets. Nothing, however, has happened to China’s ability to produce microchips; it can still, as before, produce each week $1,000,000 worth of microchips.
Because China can now, in a week, produce $4,000,000 worth of widgets, its cost of producing each dollar’s worth of widgets now is $0.25 worth of microchips – down from $1 worth of microchips. BUT – and here’s the kicker – this fact means that China’s cost of producing a dollar’s worth of microchips has risen from $1 worth of widgets to $4 worth of widgets. (By making itself an economically better producer of widgets, China necessarily makes itself an economically worse producer of microchips.) Yet America’s cost of producing a dollar’s worth of microchips remains at $2 worth of widgets – now only half of China’s new, higher ($4) cost of producing a dollar’s worth of microchips.
In short, it’s impossible for a country to gain a comparative advantage in the production of output W by lowering its cost of producing output W without simultaneously increasing its cost of producing other outputs (such as output M) and thereby ensuring that other countries come to have a comparative advantage at producing output M.
In our world of inescapable resource scarcity, what matters for determining trade patterns is not how many resources are used in country A to produce output W and to produce output M compared to how many resources are used in country B to produce output W and to produce output M. What does matters is how much of output W is sacrificed in country A to produce a unit of output M compared to how much of output W is sacrificed in country B to produce a unit of output M. As long as countries A and B sacrifice different amounts of value of output W to produce $1 worth of output M, one country will be the low-cost producer of output W while the other country will be the low-cost producer of output M. And the peoples of these countries can gain from freely trading with each other. (If both countries sacrifice the same amount of output W to produce a unit of output M, then both countries have the same cost of producing both outputs. In such an unlikely circumstance, there would be no need for government to obstruct trade between countries because there would be no incentive for people in these countries to trade with each other to begin with.)
Comparative advantage is one of the most counterintuitive concepts in all of economics. Economists have struggled for more than 200 years, with various degrees of success, to explain it clearly. I keep striving for clarity, but I’m painfully aware that I always come up waaaaay short. But please don’t be misled by my obtuseness: Once the concept of comparative advantage is grasped, it forever deepens and sharpens a person’s understanding of economics generally and of trade specifically. And this concept makes clear that it’s impossible for one country (or person, or firm, or you-name-the-economic-entity) to be the low-cost producer of everything.
Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030
