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© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

International Trade, International Trade, Comparative Advantage, and Comparative Advantage, and

ProtectionismProtectionism


International TradeInternational Trade

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

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


Trade Surpluses and DeficitsTrade 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: The Economic Basis for Trade: Comparative AdvantageComparative Advantage

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

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


Absolute Advantage Versus Absolute Advantage Versus Comparative AdvantageComparative Advantage

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

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


Mutual Absolute AdvantageMutual 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 AdvantageMutual 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 Production Possibility Frontiers for Australia and New Zealand Before Tradeand 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 SpecializationGains from Specialization

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


300 bales300 bales 300 bales300 bales


Gains from SpecializationGains from Specialization


Gains from Comparative AdvantageGains from Comparative Advantage

• Even if a country had a considerable Even if a country had a considerable absolute advantage in the production of absolute advantage in the production of both goods, Ricardo would argue that both goods, Ricardo would argue that specialization and trade are still mutually specialization and trade are still mutually beneficialbeneficial..

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



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

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





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

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


WheatWheat 6 bushels6 bushels 1 bushel1 bushel




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



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





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



0 acres0 acres00





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


STAGE 2STAGE 2



0 acres0 acres00





• Stage 3: Countries tradeStage 3: Countries trade


STAGE 3STAGE 3


100 bushels (trade)100 bushels (trade)

WheatWheat 350 bushels350 bushels 100 bushels100 bushels

(after trade)(after trade)

200 bushels (trade)200 bushels (trade)


(after trade)(after trade)



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


Exchange RatesExchange Rates

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

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



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

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

• Exchange rates determine the terms of Exchange rates determine the terms of trade.trade.



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



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



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

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


The Sources ofThe Sources ofComparative AdvantageComparative Advantage

• Factor endowmentsFactor endowments refer to the quantity refer to the quantity and quality of labor, land, and natural and quality of labor, land, and natural resources of a country.resources of a country.

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



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

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



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

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

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


Trade Barriers: Tariffs,Trade Barriers: Tariffs,Export Subsidies, and QuotasExport Subsidies, and Quotas

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

• A A tarifftariff is a tax on imports. is a tax on imports.

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

• A A quotaquota is a limit on the quantity of imports. is a limit on the quantity of imports.


Trade Barriers: Tariffs,Trade Barriers: Tariffs,Export Subsidies, and QuotasExport Subsidies, and Quotas

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

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


Economic IntegrationEconomic Integration

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

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


Economic IntegrationEconomic Integration

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

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


The North American Free-Trade The North American Free-Trade Agreement (NAFTA)Agreement (NAFTA)

• The U.S. Department of Commerce has The U.S. Department of Commerce has estimated that as a result of NAFTA trade estimated that as a result of NAFTA trade between the United States and Mexico between the United States and Mexico increased by nearly $16 billion in 1994.increased by nearly $16 billion in 1994.

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

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


The Case for Free TradeThe Case for Free Trade

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

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


The Gains from TradeThe Gains from Trade

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


The Losses from theThe Losses from theImposition of a TariffImposition of a Tariff

• The loss of efficiency The loss of efficiency from a $1 tariff has two from a $1 tariff has two components:components:

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

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

• Government revenue equals the shaded area.


The Case for ProtectionThe Case for Protection

• Protection saves jobsProtection saves jobs

• Some countries engage in unfair trade Some countries engage in unfair trade practicespractices

• Cheap foreign labor makes competition Cheap foreign labor makes competition unfairunfair

• Protection safeguards national securityProtection safeguards national security

• Protection discourages dependencyProtection discourages dependency

• Protection safeguards infant industriesProtection safeguards infant industries

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Documents

bales cotton

bales of cotton

cotton production

bushels of wheat

wheat production

acres x

bushels australia

cotton consumption