The Cost of Production 245certain goods and services, and another country specialize in others? Important
reasons for varying patterns of specialization include different resource endow-
ments, differences in the amount and productivity of labor, and differences in
capital. For instance, a nation with abundant agricultural resources, predomi-
nantly unskilled labor, and little capital is likely to specialize in production of
basic foods. By contrast, a nation, such as Japan, with a highly educated popula-
tion and abundant capital but with relatively few natural resources, has an advan-
tage in manufactured goods. Many observers believe that the United States’
competitive advantage lies in high-tech goods and services. Relying on their
research expertise and innovative ability, American firms excel in the develop-
ment of technologically advanced goods and services. As these markets grow and
mature, however, one would expect high-tech goods to evolve into commodity
items, assembled and produced in large-scale facilities. It is not surprising that
production of these goods tends to shift to other parts of the world over time.
To understand the basis for mutually beneficial trade, it is important to grasp
the notion of comparative advantage. The easiest way to explain this concept is
with a simple example. Table 6.2 offers a stylized depiction of trade involving two
goods, digital electronic watches and pharmaceutical products, and two coun-
tries, the United States and Japan. Part (a) of the table shows the productivity of
labor (that is, output per hour) in each country for each good. For instance, on
average U.S. workers produce 4 bottles of pills and 1 digital watch per labor-hour;
their Japanese counterparts produce 2 bottles and .8 watches per labor-hour.
According to the table, the United States is a more efficient manufacturer of
both items; that is, U.S. workers are more productive in both sectors.
However, labor productivity is only one factor influencing the cost of pro-
duction. The other determinant is the price of the input, in this case, the price
of labor. To compute the labor cost per unit of output, we need to know the
prevailing hourly wage in each country. To keep things simple, suppose the
U.S. wage in both sectors is $15 per hour, whereas the Japanese wage in both
sectors is 1,000 yen (¥) per hour. Naturally, the Japanese wage is denominated
in that country’s currency, the yen. Now consider the labor cost per unit of
each good in each country. For the U.S. pharmaceutical sector, this labor cost
is simply ($15 per hour)/(4 bottles per hour) $3.75 per bottle, using
Equation 6.1. Part (b) of the table lists these costs for each country. For Japan,
the cost in yen is shown in parentheses. For example, the labor cost per digital
watch is 1,000/.8 ¥1,250.
Finally, to make cross-country cost comparisons, we need one additional
piece of information: the prevailing exchange rate between the two curren-
cies. As its name suggests, the exchange rate denotes the amount of one coun-
try’s currency that exchanges for a unit of another country’s. Again, keeping
things simple, suppose the current exchange rate in round numbers is 100 yen
per dollar. (Furthermore, we suppose that this rate is expected to remain
unchanged.) Using this exchange rate, it is a simple matter to convert the coun-
tries’ costs per unit into a common currency, in this case the dollar. Japan’sc06CostAnalysis.qxd 9/29/11 1:46 PM Page 245