Chapter 33: International Trade
As Benjamin Franklin wrote, “No nation was ever ruined by trade.” International trade has accompanied economic growth around the world. This chapter develops the key concepts — absolute advantage, comparative advantage, intra-industry trade, and economies of scale — that explain why nations trade and why it benefits all participants.
Table of Contents
1. Absolute and Comparative Advantage
1.1 Core Definitions
Absolute advantage: A country can produce more of a good than another country — it has more resources, more productive resources, or a natural endowment. Example: Saudi Arabia has an absolute advantage in oil because extracting it is essentially “drilling a hole,” while other countries require costly exploration and extraction technologies.
Comparative advantage: A country can produce a good at a lower opportunity cost in terms of other goods. The question: “What do we give up to produce this good?”
David Ricardo articulated this insight in On the Principles of Political Economy and Taxation (1817): specialization and free trade benefit all trading partners, even those that may be relatively inefficient.
1.2 Numerical Example: Saudi Arabia and the United States
| Country | Oil (hours per barrel) | Corn (hours per bushel) |
|---|---|---|
| Saudi Arabia | 1 | 4 |
| United States | 2 | 1 |
- Saudi Arabia has an absolute advantage in oil (1 hour vs. 2 hours)
- United States has an absolute advantage in corn (1 hour vs. 4 hours)
With 100 worker hours each:
| Country | Max Oil (barrels) | Max Corn (bushels) |
|---|---|---|
| Saudi Arabia | 100 | or 25 |
| United States | 50 | or 100 |
1.3 Calculating Opportunity Costs
| Country | Opportunity Cost of 1 Barrel of Oil | Opportunity Cost of 1 Bushel of Corn |
|---|---|---|
| Saudi Arabia | ¼ bushel of corn | 4 barrels of oil |
| United States | 2 bushels of corn | ½ barrel of oil |
- Saudi Arabia has comparative advantage in oil (gives up only ¼ bushel of corn per barrel)
- United States has comparative advantage in corn (gives up only ½ barrel of oil per bushel)
Key Insight on PPF Slope: The production possibility frontier slope equals the opportunity cost. Saudi Arabia: slope = 25/100 = ¼ (corn per oil). United States: slope = 100/50 = 2 (corn per oil). The PPFs in trade examples are drawn as straight lines (constant opportunity costs) to simplify calculations, though in reality opportunity costs are usually increasing (bowed-out PPF).
1.4 Gains from Trade
Before trade (producing at points C and C’):
| Country | Oil (barrels) | Corn (bushels) |
|---|---|---|
| Saudi Arabia | 60 | 10 |
| United States | 20 | 60 |
| Total World | 80 | 70 |
After 100% specialization:
| Country | Oil (barrels) | Corn (bushels) |
|---|---|---|
| Saudi Arabia | 100 | 0 |
| United States | 0 | 100 |
| Total World | 100 | 100 |
Specialization increases total world production from (80 oil, 70 corn) to (100 oil, 100 corn) — a gain of 20 barrels of oil and 30 bushels of corn.
The key formulas for calculating comparative advantage:
\[\text{Opportunity Cost of Good A} = \frac{\text{Max production of Good B}}{\text{Max production of Good A}}\] \[\text{Comparative Advantage in A} \Rightarrow \text{Country with lowest opportunity cost of A}\]1.5 Range of Mutually Beneficial Trades
| The U.S. benefits if it: | Saudi Arabia benefits if it: |
|---|---|
| Exports no more than 60 bushels of corn | Imports at least 10 bushels of corn |
| Imports at least 20 barrels of oil | Exports less than 60 barrels of oil |
Even Without Full Specialization: If the U.S. exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil, Saudi Arabia moves from consuming (60 oil, 10 corn) to (40 oil, 30 corn) — a point beyond its PPF. The “trading price” (20 oil for 20 corn) is better than Saudi Arabia’s domestic opportunity cost (1 oil for ¼ corn), so Saudi Arabia gains from trade.
2. When a Country Has an Absolute Advantage in All Goods
The remarkable insight of comparative advantage: even when one country has an absolute advantage in ALL goods, both countries still benefit from trade.
2.1 Example: United States vs. Mexico
| Country | Workers for 1,000 Shoes | Workers for 1,000 Refrigerators |
|---|---|---|
| United States | 4 | 1 |
| Mexico | 5 | 4 |
The U.S. has an absolute advantage in both goods (fewer workers needed). But comparative advantage differs:
- U.S. is 4/5 as productive as Mexico in shoes (4 vs. 5 workers) but 4 times as productive in refrigerators (1 vs. 4 workers)
- U.S. comparative advantage is in refrigerators (where its absolute advantage is relatively greatest)
- Mexico’s comparative advantage is in shoes (where its absolute disadvantage is relatively smallest)
2.2 Production With 40 Workers Each
Before trade (point A):
| Country | Shoes | Refrigerators |
|---|---|---|
| United States | 5,000 | 20,000 |
| Mexico | 4,000 | 5,000 |
| Total | 9,000 | 25,000 |
After shifting toward comparative advantage:
- U.S. transfers 6 workers from shoes → refrigerators: shoes −1,500, refrigerators +6,000
- Mexico transfers 10 workers from refrigerators → shoes: shoes +2,000, refrigerators −2,500
| Country | Shoes | Refrigerators |
|---|---|---|
| United States | 3,500 | 26,000 |
| Mexico | 6,000 | 2,500 |
| Total | 9,500 | 28,500 |
Result: Combined world production rises from (9,000 shoes, 25,000 refrigerators) to (9,500 shoes, 28,500 refrigerators) — 500 more shoes and 3,500 more refrigerators — even though the U.S. has an absolute advantage in everything!
2.3 Opportunity Cost Sets the Boundaries of Trade
| The U.S. benefits if it: | Mexico benefits if it: |
|---|---|
| Exports fewer than 6,000 refrigerators | Imports at least 2,500 refrigerators |
| Imports at least 1,500 pairs of shoes | Exports no more than 2,000 pairs of shoes |
A trade of 4,000 refrigerators for 1,800 pairs of shoes would benefit both sides.
The Camping Analogy (Jethro): Imagine a camping group where Jethro has an absolute advantage in everything — faster at carrying packs, gathering firewood, cooking, etc. Should he do all the work? Of course not! If Jethro is 80% faster at cooking but only 10% faster at setting up tents, he should focus on cooking while others set up tents. Everyone specializes in their comparative advantage — where their productivity disadvantage is least — and the whole group benefits.
2.4 Worked Example: Canada vs. Venezuela
| Country | Oil (barrels per worker) | Lumber (tons per worker) |
|---|---|---|
| Canada | 20 | or 40 |
| Venezuela | 60 | or 30 |
Step-by-step:
- Absolute advantage: Venezuela in oil (60 > 20), Canada in lumber (40 > 30)
- Opportunity cost of 1 oil: Canada: 40/20 = 2 lumber; Venezuela: 30/60 = ½ lumber → Venezuela has comparative advantage in oil
- Opportunity cost of 1 lumber: Canada: 20/40 = ½ oil; Venezuela: 60/30 = 2 oil → Canada has comparative advantage in lumber
- Canada exports lumber, imports oil; Venezuela exports oil, imports lumber
3. Intra-Industry Trade between Similar Economies
3.1 The Puzzle
Comparative advantage theory predicts trade between economies with large differences in opportunity costs. But in practice:
- ~50% of U.S. trade is with similar high-income economies (Japan, Canada, EU)
- Biggest U.S. trading partners: Canada (17.6% of exports) and Mexico (15.8%)
- ~60% of both U.S. and European trade is intra-industry trade
Intra-industry trade: International trade of goods within the same industry. Example: The U.S. exports $131 billion in autos AND imports $317 billion in autos (2021). Both exporting and importing the same category of goods.
| Category | U.S. Exports ($ billions) | U.S. Imports ($ billions) |
|---|---|---|
| Autos | $131 | $317 |
| Food & beverages | $147 | $167 |
| Capital goods | $474 | $695 |
| Consumer goods | $201 | $699 |
| Industrial supplies | $578 | $589 |
| Other transportation | $63 | $113 |
3.2 Two Sources of Gains
Reason 1: Specialization and Learning
The division of labor leads to learning, innovation, and unique skills even among similarly skilled economies. Specialization can be very finely split:
Splitting up the value chain: The different stages of producing a good happen in different geographic locations. The value chain describes how a good is produced in stages.
iPhone Example: Design and engineering in the U.S. → component production in Korea (Samsung supplies displays and cameras) → assembly in China and India (Foxconn) → marketing globally. International trade often involves shipping specialized components (automobile dashboards, refrigerator shelving) rather than whole finished products.
Reason 2: Economies of Scale, Competition, and Variety
Economies of scale: As the scale of output increases, average costs of production decline — at least up to a point.
Toaster Oven Factory Example:
| Plant | Output (units) | Average Cost |
|---|---|---|
| S (Small) | 30 | $30 each |
| M (Medium) | 50 | $20 each |
| L (Large) | 150 | $10 each |
| V (Very Large) | 200 | $10 each |
Plants S and M cannot compete with L or V. Economies of scale operate up to point L (150 units), beyond which additional scale doesn’t further reduce costs.
Why this matters for trade:
- A single large factory could supply all cars for a small economy like Belgium
- But with only one domestic producer → little consumer choice, no competition
- International trade combines economies of scale with competition and variety — consumers choose from Toyota, Honda, Volkswagen, BMW, Hyundai, Ford, GM, etc.
- Greater competition drives innovation: “America’s car producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure”
3.3 Dynamic Comparative Advantage
Important: Comparative advantage is not fixed — it is dynamic and can evolve over time as countries develop new skills and manufacturers split the value chain in new ways. Countries are not destined to have the same comparative advantage forever and must be flexible in response to ongoing changes.
In intra-industry trade, climate or geography don’t determine worker productivity. Instead, how firms engage in specific learning about specialized products — including taking advantage of economies of scale — determines productivity levels.
4. The Benefits of Reducing Barriers to International Trade
4.1 Tariffs and Trade Barriers
Tariffs: Taxes that governments place on imported goods for various reasons — protecting sensitive industries, humanitarian reasons, and protection against dumping (selling below “fair value”).
4.2 The World Trade Organization (WTO)
The WTO facilitates negotiations to lower trade barriers through “rounds”:
- Doha Round (launched November 2001 in Doha, Qatar): Focus on market access and reform of agricultural subsidies
- Estimated potential gain: $121–$202 billion added to the world economy
- Against a global economy producing >$80 trillion/year, this is <1% — but:
- Hundreds of billions of dollars per year, persisting every year
- Gains are likely understated: hard to measure consumer variety benefits and knowledge transfer (production skills, technology, management, finance, law)
4.3 Who Benefits Most?
Low-income countries benefit more from trade than high-income countries. The giant U.S. economy already benefits from internal trade across its states. Smaller economies in Latin America, Africa, the Middle East, and Asia have much more limited internal possibilities for trade and therefore gain more from international trade through:
- Comparative advantage
- Splitting up the value chain
- Economies of scale
- Greater competitive pressure on domestic firms
4.4 The History of Globalization
| Period | What Happened |
|---|---|
| 1820–1913 (First Wave) | Global exports rose from <1% to 9% of GDP; Suez Canal and Union Pacific Railroad completed 1869; submarine telegraph cable across Atlantic 1858 |
| 1914–1945 | WWI severed economic connections; Great Depression: nations tried to fix economies by reducing trade; WWII further hindered trade |
| Post-WWII | Slow rebuilding of global flows; not until early 1980s that trade became as important as pre-WWI |
| Today | ~$20 trillion in goods and services moving globally; U.S. trade (imports + exports) went from 11% of GDP (1970) to 32% today |
4.5 From Interpersonal to International Trade
The benefits of trade apply at every level — individual, community, state, and international — for the same three reasons:
- Workers with different characteristics can specialize where they have comparative advantage
- Learning and practice make specialized workers and firms more productive
- Economies of scale reduce average costs
No exemptions: “There is no modern example of a country that has shut itself off from world trade and yet prospered.” Trade of $20 trillion worth of goods and services inevitably causes disruption and controversy, but the economic benefits case is strong.
5. Key Takeaways
- Absolute advantage means producing more with the same resources; comparative advantage means producing at a lower opportunity cost — trade is driven by comparative advantage
- Even when one country has an absolute advantage in all goods, both countries benefit from specialization and trade based on comparative advantage
- Specialization increases total world production, moving countries beyond their individual PPFs through trade
- The range of mutually beneficial trades is bounded by each country’s opportunity costs — both countries must get a better deal than their domestic alternative
- About 60% of U.S. and European trade is intra-industry trade — importing and exporting goods from the same industry — driven by specialized learning and economies of scale
- Splitting up the value chain across countries allows very fine specialization (components rather than finished products)
- Comparative advantage is dynamic — it evolves with new skills, technologies, and production methods
- Reducing trade barriers through the WTO produces gains of hundreds of billions of dollars per year, with low-income countries benefiting proportionally more
- International trade brings the same economic benefits as interpersonal trade: specialization, learning, and economies of scale
6. Practice Questions
Q1. Country A can produce 30 tons of steel or 60 tons of rice with one worker. Country B can produce 20 tons of steel or 80 tons of rice with one worker. (a) Who has the absolute advantage in each good? (b) Calculate the opportunity costs and determine comparative advantage.
Answer
(a) Country A has absolute advantage in steel (30 > 20). Country B has absolute advantage in rice (80 > 60). (b) Opportunity costs: - **Country A:** 1 steel = 60/30 = 2 rice; 1 rice = 30/60 = ½ steel - **Country B:** 1 steel = 80/20 = 4 rice; 1 rice = 20/80 = ¼ steel Country A has comparative advantage in **steel** (gives up only 2 rice vs. 4 rice). Country B has comparative advantage in **rice** (gives up only ¼ steel vs. ½ steel). Country A should specialize in steel and Country B in rice.Q2. Explain why Saudi Arabia’s comparative advantage in oil rests on opportunity cost rather than just having lots of oil.
Answer
Absolute advantage (having lots of oil) explains why Saudi Arabia *can* produce oil cheaply, but comparative advantage explains why it *should* specialize in oil. The key is opportunity cost: for every barrel of oil Saudi Arabia produces, it gives up only ¼ bushel of corn, while the U.S. gives up 2 bushels. Even if Saudi Arabia could produce corn efficiently, its low opportunity cost in oil means it benefits more by producing oil and trading for corn. Comparative advantage is about what you give up, not just what you can produce.Q3. The United States has an absolute advantage over Mexico in both shoes and refrigerators. Explain why both countries still benefit from trade, using the concept of comparative advantage.
Answer
Even though the U.S. is more productive in both goods, its advantage is not equal: the U.S. is 4 times more productive than Mexico in refrigerators (1 vs. 4 workers) but only 1.25 times more productive in shoes (4 vs. 5 workers). The U.S. has a comparative advantage in refrigerators (where its edge is greatest), and Mexico has a comparative advantage in shoes (where its disadvantage is least). When each specializes and they trade, total world production of **both** goods increases — from (9,000 shoes, 25,000 refrigerators) to (9,500 shoes, 28,500 refrigerators). Both countries can consume more than they could produce alone.Q4. Japan produces 5 tons of rubber or 80 radios per worker. Malaysia produces 10 tons of rubber or 40 radios per worker. (a) Who has absolute advantage in each? (b) Calculate comparative advantages. (c) Does absolute advantage equal comparative advantage here?
Answer
(a) Malaysia has absolute advantage in rubber (10 > 5). Japan has absolute advantage in radios (80 > 40). (b) Opportunity costs: - **Japan:** 1 rubber = 80/5 = 16 radios; 1 radio = 5/80 = 1/16 rubber - **Malaysia:** 1 rubber = 40/10 = 4 radios; 1 radio = 10/40 = ¼ rubber Japan has comparative advantage in **radios** (gives up 1/16 rubber vs. ¼ rubber). Malaysia has comparative advantage in **rubber** (gives up 4 radios vs. 16 radios). (c) Yes — in this example, absolute and comparative advantage align: Malaysia has both in rubber, Japan has both in radios. But this symmetry is not always the case.Q5. Explain how the United States can both export and import automobiles. Why does this intra-industry trade make economic sense?
Answer
Intra-industry trade occurs because of two forces: (1) **Specialized learning** — different car manufacturers in different countries develop unique expertise on particular vehicle types, features, and designs. The U.S. might export trucks and SUVs while importing compact cars and luxury sedans. (2) **Economies of scale** — large factories producing specific models can achieve lower average costs than trying to produce all car types domestically. International trade combines these scale economies with greater **competition and variety** for consumers. American car producers make far better cars today partly because of competitive pressure from Toyota, Honda, BMW, Hyundai, and others.Q6. What is “splitting up the value chain”? Use the iPhone as an example to explain how it relates to international trade.
Answer
Splitting up the value chain means that different stages of producing a good happen in different geographic locations. The **value chain** is the sequence of stages from raw materials to finished product. For the iPhone: Apple designs and engineers the phone in the U.S. (comparative advantage in design and marketing); Samsung in Korea supplies key components like displays and cameras (comparative advantage in electronic components through scale and innovation); Foxconn assembles the phone in China and India (comparative advantage in skilled manufacturing labor). This means modern international trade often involves shipping specialized components rather than whole finished products, enabling very fine-grained specialization that maximizes efficiency at each stage.Q7. A semiconductor factory has the following cost structure: 10,000 units at $8 each, 20,000 at $5, 30,000 at $3, 40,000 at $2, and 100,000 at $2. A small country demands only 30,000 semiconductors. How does international trade help this country take advantage of economies of scale?
Answer
With domestic demand of only 30,000 units, a local factory could produce at $3 each. But economies of scale show that producing 40,000+ would lower cost to $2 each. Without trade, the country can't reach this scale because domestic demand is insufficient. With international trade, the factory can produce 40,000+ units — selling 30,000 domestically and exporting the surplus — achieving the $2 average cost. Additionally, the country can import semiconductors from foreign factories already operating at scale, benefiting from their lower costs. Trade also introduces competition from multiple producers, giving consumers more choice and incentivizing innovation, rather than being stuck with a single domestic monopolist.Q8. Explain why comparative advantage is described as “dynamic” rather than permanent. What implications does this have for economic policy?
Answer
Comparative advantage is dynamic because it evolves over time as countries develop new skills, invest in human and physical capital, innovate, and split up value chains in new ways. South Korea, for example, shifted from comparative advantage in low-skill manufacturing in the 1960s to high-tech electronics and automobiles today. This has important policy implications: (1) Countries should not assume their current comparative advantage is permanent — they must invest in education, technology, and infrastructure to develop new advantages; (2) Protectionist policies that lock in current industries may prevent adaptation; (3) Flexibility and openness to changing trade patterns are essential for long-term prosperity.Q9. Why do low-income countries benefit proportionally more from international trade than the United States?
Answer
The U.S. economy is so large that it can already achieve many benefits of trade internally — firms can specialize across states, reach economies of scale with 330 million consumers, and face competition from many domestic firms. Smaller, low-income economies have much more limited internal possibilities: fewer consumers (can't achieve scale), fewer competitors (less incentive to innovate), and less specialization. International trade gives small economies access to: (1) the world's consumers — enabling economies of scale; (2) global competitors — forcing innovation; (3) comparative advantage opportunities — specializing in what they do best; (4) value chain participation — even producing components rather than whole products. Without trade, small economies cannot grow through these channels.Q10. Paul Krugman described globalization’s first wave (1820–1913) as reaching an “impressive degree of integration.” What caused this wave, what ended it, and how does it compare to today?
Answer
**Causes of the first wave:** Technological innovations — steamships, railroads (Union Pacific completed 1869), the Suez Canal (1869), and submarine telegraph cables (first transatlantic cable 1858). By 1900, all major economic regions could communicate instantaneously. Global exports rose from <1% of GDP in 1820 to 9% by 1913. **What ended it:** World War I severed economic connections; the Great Depression saw nations mistakenly restrict trade to protect their economies; World War II further disrupted flows. **Comparison to today:** It took until the early 1980s for trade to regain its pre-WWI importance relative to the world economy. Today, ~$20 trillion in trade flows annually; U.S. trade went from 11% of GDP (1970) to 32%. While the absolute scale is vastly larger, the lesson is that globalization is not inevitable — it can be reversed by war, protectionism, and political choices.Q11. Country X can produce 100 widgets or 200 gadgets with its workforce. Country Y can produce 80 widgets or 40 gadgets. (a) Country X has absolute advantage in both goods. Does it still benefit from trade? (b) Calculate the range of mutually beneficial trades if each country fully specializes.
Answer
(a) Yes, Country X still benefits from trade through comparative advantage. Opportunity costs: - **Country X:** 1 widget = 200/100 = 2 gadgets; 1 gadget = 100/200 = ½ widget - **Country Y:** 1 widget = 40/80 = ½ gadget; 1 gadget = 80/40 = 2 widgets Country X has comparative advantage in **gadgets** (½ widget vs. 2 widgets). Country Y has comparative advantage in **widgets** (½ gadget vs. 2 gadgets). (b) With full specialization: X produces 200 gadgets, Y produces 80 widgets. For mutually beneficial trade, the exchange rate must be between each country's opportunity costs: - For widgets: between ½ gadget (Y's cost) and 2 gadgets (X's cost) per widget - Equivalently, for gadgets: between ½ widget (X's cost) and 2 widgets (Y's cost) per gadget Any trade where X gives fewer than 2 gadgets per widget received, and Y gives fewer than 2 widgets per gadget received, benefits both.Q12. Three countries have the following production capabilities per 1,000 workers:
| Country | Cars | Textiles (tons) |
|---|---|---|
| Germany | 500 | or 200 |
| Bangladesh | 20 | or 100 |
| Brazil | 100 | or 250 |
(a) Calculate all six opportunity costs.
(b) Which country has comparative advantage in cars? In textiles?
(c) If Germany and Bangladesh fully specialize and trade, show that total production increases compared to each producing half of its capacity in each good.
Answer
**(a)** Opportunity costs: | Country | OC of 1 Car | OC of 1 Textile | |---|---|---| | Germany | $200/500 = 0.4$ textiles | $500/200 = 2.5$ cars | | Bangladesh | $100/20 = 5$ textiles | $20/100 = 0.2$ cars | | Brazil | $250/100 = 2.5$ textiles | $100/250 = 0.4$ cars | **(b)** Comparative advantage in **cars**: Germany (0.4 textiles per car is lowest). Comparative advantage in **textiles**: Bangladesh (0.2 cars per textile is lowest). Brazil is in between on both. **(c)** Half-and-half production: - Germany: 250 cars + 100 textiles - Bangladesh: 10 cars + 50 textiles - Total: 260 cars + 150 textiles Full specialization (Germany → cars, Bangladesh → textiles): - Germany: 500 cars + 0 textiles - Bangladesh: 0 cars + 100 textiles - Total: 500 cars + 100 textiles **Wait — textiles fell!** This is because Bangladesh alone can't produce as many textiles as both combined at half-capacity. The better approach: Germany produces mostly cars (say 450 cars, using 900 workers, remaining 100 workers produce 20 textiles). Bangladesh fully specializes in textiles (100). - Total: 450 cars + 120 textiles vs. 260 cars + 150 textiles. The gains from trade are larger in cars (+190) with a smaller loss in textiles (−30). Total value increases if the price ratio is reasonable (1 car > 0.16 textiles, which it almost certainly is). The key insight: gains from specialization are greatest when opportunity cost differences are large.Q13. The toaster oven factory has these average costs: Small (30 units, $30/each), Medium (50, $20), Large (150, $10), Very Large (200, $10). A country has domestic demand of only 40 units.
(a) Without trade, what is the lowest average cost achievable? What is total consumer spending?
(b) With trade (access to a global market of 300 units), what average cost can a domestic factory achieve? What are consumer savings?
(c) What is the trade-off between economies of scale and competition if only one factory can serve the domestic market?
Answer
**(a)** The factory can produce 40 units (between S=30 and M=50). Interpolating between cost curves, average cost ≈ $25/unit. Total spending = $40 \times 25 = \$1{,}000$. Alternatively, with the Medium factory (50 units), cost is $20/each but 10 units go unsold. If selling 40 at $20: total spending = $40 \times 20 = \$800$. **(b)** With global demand of 300 units, the factory operates at Large scale (150+ units) at $10/each. Domestic consumers pay $40 \times 10 = \$400$. **Savings = \$800 - \$400 = \$400** (50% reduction). **(c)** Without trade, one domestic factory means **monopoly** — low average cost from scale but no competitive pressure on price, quality, or innovation. With trade, consumers access products from **multiple** large-scale factories worldwide (Toyota, Honda, VW, Ford, etc.), combining economies of scale with competition and variety. Trade solves the small-country dilemma of choosing between scale and competition.Q14. Case Study — iPhone Value Chain:
An iPhone retails for $999 in the U.S. Apple’s approximate cost breakdown:
- Design & engineering (U.S.): $150
- Display & camera (Samsung, South Korea): $110
- Processor (TSMC, Taiwan): $50
- Memory & storage (Japan/Korea): $45
- Assembly (Foxconn, China): $25
- Other components (global): $120
- Apple’s profit margin: ~$499
(a) When the U.S. imports an iPhone from China (where it is assembled), the full $999 is recorded as a Chinese export. Why is this misleading about the actual trade balance?
(b) Calculate China’s actual share of the value added. Compare it to Apple’s share.
(c) Explain how this example illustrates splitting up the value chain and why it complicates trade policy (e.g., tariffs on Chinese imports).
Answer
**(a)** Only **\$25 of the \$999** represents Chinese value added (assembly labor). The display, processor, memory, and design are produced elsewhere. Recording the full $999 as a Chinese export dramatically overstates China's trade surplus and the U.S. trade deficit. The iPhone is really a product of 5+ countries, not just China. **(b)** China's value added: $\frac{25}{999} = 2.5\%$. Apple's share (design + profit): $\frac{150 + 499}{999} = \frac{649}{999} = 65\%$. Apple captures 26× more value than China from each iPhone. The real beneficiary of iPhone trade is **the United States** (Apple's design/IP + profits), not China. **(c)** Modern products are assembled from globally sourced components — “splitting up the value chain.” A 25% tariff on Chinese-assembled iPhones taxes the full $999, even though only $25 of value was created in China. This means: (1) 97.5% of the tariff falls on non-Chinese value (including American design work); (2) Apple might move assembly to Vietnam or India to avoid the tariff, but this doesn't change the fundamental economics — it just reshuffles the final assembly location; (3) Tariffs on intermediate goods raise costs for downstream industries, potentially reducing U.S. competitiveness. The value chain makes bilateral trade statistics and tariff policies increasingly misleading.7. Glossary
| Term | Definition |
|---|---|
| Absolute advantage | When a country can produce more of a good than another country, due to more resources, more productive resources, or natural endowment |
| Comparative advantage | When a country can produce a good at a lower opportunity cost in terms of other goods than another country |
| Doha Round | Current round of WTO negotiations, launched in 2001 in Doha, Qatar, focused on market access and agricultural subsidy reform |
| Dumping | Selling goods in foreign markets at “less than fair value,” often used as a basis for anti-dumping tariffs |
| Dynamic comparative advantage | The idea that comparative advantage evolves over time as countries develop new skills and production methods |
| Economies of scale | As the scale of output increases, average costs of production decline (at least up to a point) |
| Gain from trade | When a country can consume more than it could produce alone as a result of specialization and trade |
| Intra-industry trade | International trade of goods within the same industry (e.g., both exporting and importing automobiles) |
| Opportunity cost | What a country gives up to produce one more unit of a good; the basis for comparative advantage |
| Production possibility frontier (PPF) | Graph showing the maximum amount of goods a country can produce given its limited resources and technology |
| Specialization | When a country shifts resources to focus on producing the good in which it has a comparative advantage |
| Splitting up the value chain | Different stages of producing a good happening in different geographic locations across countries |
| Tariffs | Taxes that governments place on imported goods |
| Value chain | The sequence of stages through which a good is produced, from raw materials to finished product |
| World Trade Organization (WTO) | International organization committed to lowering barriers to trade through multilateral negotiations |