Thursday, October 05, 2006

Can growth in China be bad for the U.S.?

An economics instructor emails me a question about a problem in Chapter 3 of my principles text. Here is the problem:

7. Suppose that in a year an American worker can produce 100 shirts or 20 computers, while a Chinese worker can produce 100 shirts or 10 computers.

a. Graph the production possibilities curve for the two countries. Suppose that without trade the workers in each country spend half their time producing each good. Identify this point in your graph.

b. If these countries were open to trade, which country would export shirts? Give a specific numerical example and show it on your graph. Which country would benefit from trade? Explain.

c. Explain what price of computers (in terms of shirts) trade between the two countries might take place.

d. Suppose that China catches up with American productivity, so that a Chinese worker can produce 100 shirts or 20 computers. What pattern of trade would you predict now? How does this advance in Chinese productivity affect the economic well-being of the citizens of the two countries?

The problem generates this email:

Question 7 asks students to do a comparative advantage analysis of trade potential between China and the US.

In this problem regarding comparative advantage and trade the answer to part d provides fuel for a zero-sum outlook. When my students crunch the numbers they see that the gain in China's productivity eliminates the incentive for trade. Indeed, it appears that while China gains in productivity the US loses both the opportunity to buy shirts for a relatively lower price (creating inflation pressure within the US?) and the opportunity to "profit" by selling computers to China. I confirmed that result in your on-line answer key.

Yet, the numeric answer doesn't make intuitive sense. I often follow your suggestion in teaching trade by asking students to think about trade between two cities in the same state or two states in the same country. We learn about how the bias of nationalism creeps into and can cloud our judgement about the impact of trade. Am I mistaken in suggesting that just as a a gain in productivity in one part of the US shouldn't reduce the standard of living elsewhere, nor should a gain in productivity anywhere in the world lower the overall material standard of living. But the numbers in 7d either challenge that statement or do not make that clear.

Perhaps this is a simplistic question with an obvious answer, but I am curious about how you teach this problem and what suggestions might you make?

I added this problem in the new edition after reading an article by Paul Samuelson in the Journal of Economic Perspectives (Summer 2004). Part d uses the tools available to ec 10 students to illustrate the essential point of the Samuelson article: Growth in China can make the United States worse off.

When it came out, the Samuelson article was widely misinterpreted as showing that outsourcing and trade with China were bad for the United States. In fact, what Samuelson and my textbook problem illustrate is that, while trade is beneficial for both countries, growth in China could be bad for the United States because it could cause us to lose some of those gains from trade. In the example, growth in the Chinese computer industry causes the two countries to become identical, so trade based on comparative advantage disappears. (The Samuelson paper and the public reaction to it are discussed more fully on pages 18 to 20 in my paper with Phill Swagel on outsourcing.)

I wouldn't describe this result as zero-sum: China is certainly better off from the productivity growth, and those gains need not equal U.S. losses. But the example does illustrate the principle that growth in one part of the world can create losers in another part. (Still not convinced? Here is a clear example: If New Zealand figured out a way to make a cheap gasoline substitute from sheep dung, the New Zealand economy would boom, but Saudi Arabian incomes would surely suffer.)

Although this textbook problem is useful as a theoretical exercise, one should not overstate its practical relevance (as I believe Paul mistakenly did in his paper). In the example, the United States is made worse off by growth in China because our trade with China dries up, so we lose the gains from trade. This theoretical result has minimal application to the world as we see it today. World trade is booming, not shrinking.