LECTURE 7: INTERNATIONAL TRADE COMPARATIVE ADVANTAGE AND PROTECTIONISM

International Trade

All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders.

The “internationalization” or “globalization” of the U.S. economy has occurred in the private and public sectors, in input and output markets, and in business firms and households.

Trade Surpluses and Deficits

U.S. Balance of Trade (Exports Minus Imports), 1929 – 1999 (Billions of Dollars)U.S. Balance of Trade (Exports Minus Imports), 1929 – 1999 (Billions of Dollars)

EXPORTS MINUS IMPORTSEXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTSEXPORTS MINUS IMPORTS

19291929 + 0.4+ 0.4 19841984 – – 102.0102.0

19331933 + 0.1+ 0.1 19851985 – – 114.2114.2

19451945 – – 0.9 0.9 19861986 – – 131.9131.9

19551955 + 0.4+ 0.4 19871987 – – 142.3142.3

19601960 + 2.4+ 2.4 19881988 – – 106.3106.3

19651965 + 3.9+ 3.9 19891989 – – 80.780.7

19701970 + 1.2+ 1.2 19901990 – – 71.471.4

19751975 + 13.6+ 13.6 19911991 – – 20.720.7

19761976 – – 2.32.3 19921992 – – 27.927.9

19771977 – – 23.723.7 19931993 – – 60.560.5

19781978 – – 26.126.1 19941994 – – 87.187.1

19791979 – – 24.024.0 19951995 – – 84.384.3

19801980 – – 14.914.9 19961996 – – 89.089.0

19811981 – – 15.0 15.0 19971997 – – 89.389.3

19821982 – – 20.520.5 19981998 – – 151.5151.5

19831983 – – 51.751.7 19991999 – – 254.0254.0

The Economic Basis for Trade: Comparative Advantage

Corn Laws were the tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain.

David Ricardo’s theory of comparative advantage , which he used to argue against the corn laws, states that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

Absolute Advantage Versus Comparative Advantage

A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does.

A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower cost in terms of other goods.

Mutual Absolute Advantage

YIELD PER ACRE OF WHEAT AND COTTONYIELD PER ACRE OF WHEAT AND COTTONNEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 6 bushels6 bushels 2 bushels2 bushels

CottonCotton 2 bales2 bales 6 bales6 bales

• In this example, New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton. We say that the two countries have mutual absolute advantage.

Mutual Absolute Advantage

TOTAL PRODUCTION OF WHEAT AND COTTON TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE, MUTUAL ABSOLUTE ASSUMING NO TRADE, MUTUAL ABSOLUTE ADVANTAGE, AND 100 AVAILABLE ACRESADVANTAGE, AND 100 AVAILABLE ACRES

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 25 acres x 6 bushels/acre25 acres x 6 bushels/acre150 bushels150 bushels

75 acres x 2 bushels/acre75 acres x 2 bushels/acre150 bushels150 bushels

CottonCotton 75 acres x 2 bales/acre75 acres x 2 bales/acre150 bales150 bales

25 acres x 6 bales/acre25 acres x 6 bales/acre150 bales150 bales

• Suppose that each country divides its land to obtain equal units of cotton and wheat production.

Production Possibility Frontiers for Australia and New Zealand Before Trade

Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.

Gains from Specialization

An agreement to trade 300 bushels of wheat for 300 bales of cotton would double both wheat and cotton consumption in both countries.

PRODUCTION AND CONSUMPTION OF WHEATPRODUCTION AND CONSUMPTION OF WHEATAFTER SPECIALIZATIONAFTER SPECIALIZATION

PRODUCTIONPRODUCTION CONSUMPTIONCONSUMPTION

NEW NEW ZEALANDZEALAND AUSTRALIAAUSTRALIA NEW NEW

ZEALANDZEALAND AUSTRALIAAUSTRALIA

WheatWheat 100 acres x 6 bu/acre100 acres x 6 bu/acre600 bushels600 bushels

75 acres x 2 bu/acre75 acres x 2 bu/acre150 bushels150 bushels

300 bushels300 bushels 300 bushels300 bushels

CottonCotton 0 acres0 acres00

100 acres x 6 bales/acre100 acres x 6 bales/acre600 bales600 bales

300 bales300 bales 300 bales300 bales

Gains from Specialization

Gains from Comparative Advantage Even if a country had a considerable

absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial.

When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.

Gains from Comparative Advantage

The real cost of producing cotton is the wheat that must be sacrificed to produce it.

A country has a comparative advantage in cotton production if its opportunity cost, in terms of wheat, is lower than the other country.

Gains from Comparative Advantage

Gains from Comparative Advantage

To illustrate the gains from comparative advantage, assume (again) that in each country people want to consume equal amounts of cotton and wheat. Now, each country is constrained by its domestic production possibilities curve, as follows:

YIELD PER ACRE OF WHEAT AND COTTONYIELD PER ACRE OF WHEAT AND COTTON

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 6 bushels6 bushels 1 bushel1 bushel

CottonCotton 6 bales6 bales 3 bales3 bales

Gains from Comparative Advantage

The gains from trade in this example can be demonstrated in three stages.

TOTAL PRODUCTION OF WHEAT AND COTTON TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND 100 AVAILABLE ACRESASSUMING NO TRADE AND 100 AVAILABLE ACRES

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 50 acres x 6 bushels/acre50 acres x 6 bushels/acre300 bushels300 bushels

75 acres x 1 bushels/acre75 acres x 1 bushels/acre75 bushels75 bushels

CottonCotton 50 acres x 6 bales/acre50 acres x 6 bales/acre300 bales300 bales

25 acres x 3 bales/acre25 acres x 3 bales/acre75 bales75 bales

Gains from Comparative Advantage

Stage 1: Australia transfers all its land into cotton production. New Zealand cannot completely specialize in wheat because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat).

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGEHAS A DOUBLE ABSOLUTE ADVANTAGE

STAGE 1STAGE 1

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 50 acres x 6 bushels/acre50 acres x 6 bushels/acre300 bushels300 bushels

0 acres0 acres00

CottonCotton 50 acres x 6 bales/acre50 acres x 6 bales/acre300 bales300 bales

100 acres x 3 bales/acre100 acres x 3 bales/acre300 bales300 bales

Gains from Comparative Advantage

Stage 2: New Zealand transfers 25 acres out of cotton and into wheat.

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGEHAS A DOUBLE ABSOLUTE ADVANTAGE

STAGE 2STAGE 2

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

WheatWheat 75 acres x 6 bushels/acre75 acres x 6 bushels/acre450 bushels450 bushels

0 acres0 acres00

CottonCotton 25 acres x 6 bales/acre25 acres x 6 bales/acre150 bales150 bales

100 acres x 3 bales/acre100 acres x 3 bales/acre300 bales300 bales

Gains from Comparative Advantage

Stage 3: Countries tradeREALIZING A GAIN FROM TRADE WHEN ONE COUNTRY REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY

HAS A DOUBLE ABSOLUTE ADVANTAGEHAS A DOUBLE ABSOLUTE ADVANTAGE

STAGE 3STAGE 3

NEW ZEALANDNEW ZEALAND AUSTRALIAAUSTRALIA

100 bushels (trade)100 bushels (trade)

WheatWheat 350 bushels350 bushels 100 bushels100 bushels

(after trade)(after trade)

200 bushels (trade)200 bushels (trade)

CottonCotton 350 bales350 bales 100 bales100 bales

(after trade)(after trade)

Gains from Comparative Advantage

Both countries are better off than they were before trade. Both have moved beyond their own production possibility frontiers.

Exchange Rates

When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms.

To understand these patterns we must know something about the factors that determine exchange rates.

Exchange Rates

An exchange rate is the ratio at which two currencies are traded. The price of one currency in terms of another.

For any pair of countries, there is a range of exchange rates that can lead automatically to both countries realizing the gains from specialization and comparative advantage.

Exchange rates determine the terms of trade.

Exchange Rates

The option of buying at home or importing will depend on the exchange rate.

Domestic Prices of Timber (Per Foot) and Rolled Domestic Prices of Timber (Per Foot) and Rolled Steel (Per Meter) in the United States and BrazilSteel (Per Meter) in the United States and Brazil

UNITED STATESUNITED STATES BRAZILBRAZIL

TimberTimber $1$1 3 Reals3 Reals

Rolled steelRolled steel $2$2 4 Reals4 Reals

Exchange Rates

Trade Flows Determined by Exchange RatesTrade Flows Determined by Exchange Rates

EXCHANGE EXCHANGE RATERATE

PRICEPRICEOF REALOF REAL RESULTRESULT

$1 = 1 R$1 = 1 R $1.00$1.00 Brazil imports timber and steelBrazil imports timber and steel

$1 = 2 R$1 = 2 R .50.50 Brazil imports timberBrazil imports timber

$1 = 2.1 R$1 = 2.1 R .48.48 Brazil imports timber; United Brazil imports timber; United States imports steelStates imports steel

$1 = 2.9 R$1 = 2.9 R .34.34 Brazil imports timber; United Brazil imports timber; United States imports steelStates imports steel

$1 = 3 R$1 = 3 R .33.33 United States imports steelUnited States imports steel

$1 = 4 R$1 = 4 R .25.25 United States imports timber and United States imports timber and steelsteel

Exchange Rates

If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage.

Only those products in which a country has a comparative advantage will be competitive in world markets.

The Sources ofComparative Advantage Factor endowments refer to the

quantity and quality of labor, land, and natural resources of a country.

Factor endowments seem to explain a significant portion of actual world trade patterns.

The Sources ofComparative Advantage

The Heckscher-Ohlin theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments.

According to the theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

The Sources ofComparative Advantage

Product differentiation is a natural response to diverse preferences within an economy, and across economies.

Some economists also distinguish between acquired comparative advantage and natural comparative advantages.

Economies of scale may be available when producing for a world market that would not be available when producing for a limited domestic market.

Trade Barriers: Tariffs,Export Subsidies, and Quotas

Protection is the practice of shielding a sector of the economy from foreign competition.

A tariff is a tax on imports. Export subsidies are government

payments made to domestic firms to encourage exports. Closely related to subsidies is dumping. A firm or industry sells products on the world market at prices below the cost of production.

A quota is a limit on the quantity of imports.

Trade Barriers: Tariffs,Export Subsidies, and Quotas

The Smoot-Hawley tariff was the U.S. tariff law of the 1930s, which set the highest tariff in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s.

The General Agreement on Tariffs and Trade (GATT) is an international agreement singed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade.

Economic Integration

Economic integration occurs when two or more nations join to form a free-trade zone.

The European Union (EU) is the European trading bloc composed of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

Economic Integration

The U.S.-Canadian Free-Trade Agreement is an agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1988.

The North American Free-Trade Agreement (NAFTA) is an agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all of North America as a free-trade zone.

The North American Free-Trade Agreement (NAFTA) The U.S. Department of Commerce has

estimated that as a result of NAFTA trade between the United States and Mexico increased by nearly $16 billion in 1994.

In addition, exports from the United States to Mexico outpaced imports from Mexico.

By 1998, a general consensus emerged among economists that NAFTA had led to expanded employment opportunities on both sides of the border.

The Case for Free Trade

The case for free trade is based on the theory of comparative advantage. When countries specialize and trade based on comparative advantage, consumers pay less and consume more, and resources are used more efficiently.

When tariffs and quotas are imposed, some of the gains from trade are lost.

The Gains from Trade

When world price is $2, domestic quantity demanded rises, and quantity supplied falls. U.S. supply drops and resources are transferred to other sectors.

The Losses from theImposition of a Tariff

The loss of efficiency from a $1 tariff has two components:1. Consumers must

pay a higher price for goods that could be produced at a lower cost.

2. Marginal producers are drawn into textiles and away from other goods, resulting in inefficient domestic production.

• Government revenue equals the shaded area.

The Case for Protection

Protection saves jobs Some countries engage in unfair trade

practices Cheap foreign labor makes competition

unfair Protection safeguards national security Protection discourages dependency Protection safeguards infant industries

Helpful Reading

Economics. Samuelson, & Nordhaus (2005) Ch. 35