Canada's Trading Patterns with Developed and Developing Countries
The third and final part in a series on absolute advantage, comparative advantage, and gains from trade
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Now onto the show.
Introduction
In the first part of this series, I explained why free trade between two jurisdictions can lead to gains from trade on both sides of the deal; although there are indeed winners and losers in each jurisdiction, the gains will outweigh the losses. I also compared these conclusions to historical views on the gains from trade from Plato and Aristotle to the mercantalists of the 18th century.
I then relied on the theories of absolute advantage and comparative advantage to demonstrate why economists have been so enamoured with increased economic integration with China. I also argued why our expectations of China might have been so far off the mark, even though our faith in comparative advantage was not totally misguided — it was just too limited.
Today, I want to finish this series by showing comparative advantage still exists when we ditch the assumption of a barter economy, as well as when we do not focus solely on labour as our only factor of production. I will show there can be mutual gains from trade regardless of the relative value of currencies, and that gains from trade can be dynamic, meaning they become more significant over time.
Finally, I will use what I have taught to counterargue three “myths” of international trade introduced last Monday, and in the process provide evidence that Canada primarily trades with other developed countries like the U.S., despite the low wages being paid in developing countries like China. Some of the trade statistics shown will relate specifically to oil and gas, which provides a nice transition to my next post — to be published on Thursday — which will focus on differences between export taxes and import tariffs.
Comparative Advantage with Money
I first want to show that the theory of comparative advantage is just as valuable whether we assume a barter economy or one where we exchange stuff with money. To do so, I make the following assumptions based on current, real-world data:
Hourly wage rates: 16.1 yuan (Guangdong province, China) and $17.30 (Canada)
Exchange rate: CDN$1 = 5.10 yuan
Therefore, the Chinese minimum wage rate is 16.1 / 5.10 = $3.16 per hour
For simplicity, I also assume businesses make zero economic profits, meaning price equals marginal cost.1 Therefore, using the same labour productivity numbers from last Thursday’s issue of this newsletter, we can calculate the Canadian dollar prices of one unit of each good as shown in Table 1 below.
For example, since one hour of labour can produce 10 units of lumber, and since we assume one hour of labour costs $17.30, it will cost $1.73 to produce one unit of lumber.
In summary, even though China has much lower labour costs than Canada, Canada is so much more efficient in the production of lumber that we can still produce it for a lower cost here — and that does not even take transportation costs into account, which would make importing lumber from China even more expensive. Therefore, we will devote our labour to producing lumber, and import sweatshirts since China has a comparative advantage in that industry.
More generally, as long as the Chinese wage rate is between 10% and 50% of the Canadian wage rate — the same as the productivity differences for the two goods —then mutually beneficial trade is possible. Later in this post, I will demonstrate that despite the relative wage rates between Canada and China, we still export plenty to that country.
Comparative Advantage and Exchange Rates
While on the subject of money, our dollar does not have to be worth less than the U.S. dollar for there to be gains from trade on both sides. Case in point with the following chart, where our dollar was worth more than the U.S. dollar whenever the value was above the red line:
Regardless of whether our dollar was worth more or less than the U.S. dollar, Canada not only exported billions of dollars worth of stuff to the U.S., but we ran a trade surplus every year.
