THE ISSUES

This chapter introduces the main methods of trade theory and uses them to study three basic issues:

• Why countries trade and how they gain from trade.

• How trade affects the allocation of domestic resources in each trading country.

• How tariffs and other trade barriers affect the gains from trade and modify the allocation of resources.

The chapter begins by using demand and supply curves to analyze the principal effects of trade, then introduces more powerful techniques.

PRICES AND TRADE PATTERNS

Differences in prices from country to country are the basic cause of trade. They reflect differences in costs of production. Trade serves in turn to minimize the real resource costs of worldwide production, which is the same as saying that trade serves to maximize the real value of production by allocating worldwide resources most efficiently. It does so by permitting and encouraging producers in each trading country to specialize in those economic activities that make the best use of their country's physical and human resources.

Why should costs differ from country to country? How can Japan produce cars, cameras, and computers more cheaply than the United States? Many people would reply that Japan has lower costs because it has lower wage rates, and wages are important costs. This explanation sounds plausible enough, but it is inadequate. If wage rates were decisive for cost differences and trade, Japan would undersell the United States in every product line and market.