International Trade Theory and Policy
by Steven M. Suranovic

Trade 5-5C

Lesson 5C

A country may benefit from free trade even if it is less efficient than all other countries in every industry.

It makes sense that one firm would be more successful than another firm in a local market if it could produce its output more efficiently - that is at lower cost - than the second firm. If the two firms produce identical products, then the less efficient firm is likely to be driven out of business, generating losses. If we extend this example to an international market then it would also make sense that a more efficient foreign firm would absorb business from a less efficient domestic firm. Finally, suppose all firms in all industries domestically were less efficient than all firms in all industries in the foreign countries. It would then seem logically impossible for any domestic firms to succeed in competition in the international market with the foreign firms. International competition would seemingly have only negative effects upon the less efficient domestic firms and the domestic country.

This seemingly logical conclusion is refuted by the Ricardian model of comparative advantage. Ricardo demonstrated the surprising result that less efficient firms in a country can indeed compete with foreign firms in international markets. In addition, by moving to free trade, the less efficient country can generate welfare improvements for everybody in the country. Free trade can even benefit a country that is less efficient at producing everything (See page 40-9).

What's more, in a free market system, differences in prices and profit-seeking behavior are all that is needed to induce countries to produce and export the "right" goods and trade to their national benefit. (see especially 40-8)

International Trade Theory and Policy - Chapter 5-5C: Last Updated on 6/13/06