Comparative Advantage and Manufacturing Subsidies

President Obama, Republican presidential candidate Rick Santorum and many other politicians have proposed granting tax cuts for domestic manufacturers to recapture markets lost in competition with foreign producers. Beginning with Adam Smith, economists have favored free trade domestically and internationally including freedom from tax distortions. This post uses the first trade model presented in introductory classes that was first developed by Adam Smith and improved by David Ricardo to demonstrate that, given a set of assumptions, trade results in higher national well-being than a policy of no international trade or autarky. The model will be exploited to show that tax distortions that promote domestic production lower a country’s well-being.

The model assumes two countries, the United States and China. Both produce two goods, cars—a manufactured good, and fruit—an agricultural good. The models are depicted in two graphs and a table. The first graph depicts the movement from autarky to free trade, and the second, from free trade to trade distorted by taxes and subsidies. The red lines are the production possibilities frontiers (PPF) and show the output combinations of the two goods that maximize the output that can be achieved with the country’s resources. Resources move costlessly from the production of one good to the other. The slope of the PPF gives the physical tradeoff between the two goods; the tradeoff is the opportunity cost of cars in terms of fruit. The slope in the United States is 3 implying that the country gives up three tons of fruit to produce 1 car. The slope in China is 1, implying that China gives up 1 ton of fruit to produce 1 car.

	U.S.		China
	Cars	Fruit	Cars	Fruit
Autarky
Production=Consumption	8	24	8	8
With Trade
Production	4	36	16	0
Trade	5	-10	-5	10
Consumption	9	26	11	10
Gains from Trade	1	2	3	2
With Tax Distortions
Production	12	12	0	16
Trade	-9	6	9	-6
Consumption	3	18	9	10
Grains from Trade
Compared to Autarky	-5	-6	1	2
Compared to Free Trade	-6	-8	-2	0

Without international trade, a country consumes what it produces. The model does not set production levels or trade prices for each good making a little story telling necessary. The story does not detract from the outcome. Through the interaction of economic agents in markets, the United States produces and consumes 8 cars and 24 tons of fruit (P1=C1(8, 24)). China produces and consumes 8 cars and 8 tons of fruit (P1=C1(8, 8)). 

Trade increases the well-being of a country because it promotes specialization. The United States and China decide to trade. Because the United States gives up 3 tons of fruit to make a car, it specializes in the production of fruit. Because the China gives up only one ton of fruit to make a car, it specializes in the manufacture of cars. China has the comparative advantage in the manufacture of cars and the United States, in the production of fruit. 

Through the interaction of economic agents in international markets, the price settles at two tons of fruit per car. The United States increases its production to 36 tons of fruit while cutting car manufacture to 4. China specializes completely in the manufacture of cars producing 16 cars and no fruit (P2(16, 0)). Economic agents in the United States trade 10 tons of fruit for 5 cars and Chinese economic agents make the opposite trade, getting 10 tons of fruit for 5 cars. The blue arrows are the trade paths; both have a slope of -2 but the arrows point in different directions. They connect the second production points to the second consumptions points. After trade, both countries consume more than they did prior to trade as summarized in the graph and table. The United States consumes 9 cars and 24 tons of fruit (C2(9, 264)) and China, 11 cars and 10 tons of fruit (C2(11,10)). The United States gains 1 car and 2 tons of fruit. China gains 3 cars and 2 tons of fruit. 

The United States government decides that more economic agents should specialize in the production of the manufactured good, cars.  To accomplish its goal, it taxes production of fruit and subsidizes the manufacture of cars.  The international price changes to 2 tons of fruit for 3 cars.  In response to the incentives, production in the United States shifts to 12 cars and 12 tons of fruit (P3(12, 12)).  In response to the change in the international price, China specializes completely in the production of fruit (P3(0, 16).  When the Unites States subsidizes the manufacture of cars it changes the allocation of resources and the international price in both countries. 

The new trade path is represented by the green arrows in the graphs of each country.  It demonstrates how the tax distortion harms the United States but allows China to consume above its PPF.  Rather than set the international price between the countries by the slopes of the two country’s production possibilities frontiers, their trade is determined by the tax distorted price in international markets and the opportunity cost in China.  The distortions move specialization in the wrong direction in the United States.  Because the slope of the trade path is greater than slope of the PPF (-2/3 > -3) in the United States and because the United States is specializing in cars, trade moves to the interior of the PPF.  It consumes 3 cars and 18 tons of fruit (C3(3, 18)). 

The United States would be better off not trading than subsidizing the manufacture of cars.  It loses 5 cars and 6 tons of fruit compared to autarky and losses 6 cars and 8 tons of fruit compared to free trade.  Because China has not distorted its markets and shifts market production according to the relationship of the slope of its PPF, its opportunity cost and the international price, it again consumes above its PPF but its net gain is 1 car and 2 tons of fruit compared to autarky and -2 cars and 0 tons of fruit when compared to free trade.  Although China is better off even with distortions in the international markets caused by tax policy, it is worse off than under a free trade.  Compared to autarky, it gained 1 car and 2 tons of fruit but compared to free trade it lost 2 cars.