Copyright ©2014 Pearson Education, Inc. All rights reserved.3-1 1 Chapter 3 Lecture - Comparative Advantage and the Gains from Trade.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-1 1

Chapter 3 Lecture - Comparative Advantage and the Gains from

Trade


Learning Objectives• Analyze numerical examples of absolute and

comparative advantage.

• Draw a diagram showing gains from trade.

• Define and state the differences between the concepts of absolute advantage, comparative advantage, and competitiveness.

• Discuss the economic and ethical considerations of economic restructuring caused by international trade.


Introduction: The Gains from Trade

• The improvement in national welfare is known as the gains from trade


Historical Development ofModern Trade Theory

• The Mercantilists, 1500-1800• A country’s wealth is measured by its holdings

of precious metals (specie).• International trade is a zero sum game. (One

country’s gain is the loss for the trading partner)

• A country should maintain a positive trade balance (that is, export more than it imports).

• A country with positive trade balance would increase its wealth through acquisiton of precious metals.

• Static view of the world economy


Historical Development ofModern Trade Theory

• Criticisms of Mercantilism– David Hume’s price-specie-flow doctrine

• A favorable trade balance is possible only in the short run

– Adam Smith, The Wealth of Nations (1776)• World’s wealth is not a fixed quantity• International trade increases general level of productivity within a country as well as increases world output


David Hume’s Price Specie-Flow Mechanism

If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level.

Initially, Spain piles up gold, from the New World (mercantilism).


Hume’s Price Specie-Flow Mechanism

If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally.

continued


Implications of Adam Smith’s Theory

Access to foreign markets helps create wealth

– If no nation imports, every company will be limited by the size of its home country market

– Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs

– Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation


Why Countries Trade• Price differences

– If prices differ by more than transport costs• Buyers in high-price country will import• Sellers in low-price country will export• Anybody in any country can profit by doing both:

– Buying in low-price country and

– Selling in high-price country– Thus, in all cases:

imports exports is,that

trade: toleadmay

BABAPP BA


Consumer and Producer Surplus Consumer surplus: value received by consumers in excess of the

price they pay (can be measured only if the demand curve is known)

Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce (can be measured only if the supply curve is known)


Why Countries Trade: Supply and Demand

Country BP

Q

Country AP

Q

DA

DB

SB

SA

PA

PB

“Autarky” = No trade

Autarky price in country A

Autarky price in country B

PB

Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example


Country BP

Q

Country AP

Q

DA

DB

SB

SA

PA

PB

PF

Exp

Imp

Why Countries Trade: Supply and Demand

Free Trade = No barriers to trade

PF is defined by these two distances being equal.Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example


Country BP

Q

Country AP

Q

DA

DB

SB

SA

PA

PB

PF

Exp

Impa

c

b

d

Use areas to measure gains and losses.



A’s demanders lose -a

Gains and losses from trade:

Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd

Loss of Consumer

Surplus



A’s demanders lose -aA’s suppliers gain +(a+b)


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd

Gain of Producer Surplus




→Country A gains +b


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd




Country A gains +bB’s demanders gain+(c+d)


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd

Gain of Consumer

Surplus




Country A gains +bB’s demanders gain+(c+d)B’s suppliers lose -c


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd

Loss of Producer Surplus





→Country B gains +d


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Impac

bd





Country B gains +d → World gains +(b+d)


Country BP

Q

Country AP

QDA

DB

SBSA

PA

PBPF

Exp

Imp

cb

d



What Determines Prices, and Thus Trade?

• Prices determined by– Productivity of labor (and other factors)– Price of labor (w=wage)– Exchange rate (E) (i.e., prices of currencies)

• Since w and E are largely common to all sectors– The main determinant of how individual

sectors trade (i.e., whether they export or import) is Productivity in sectors

– High (relative) productivity, i.e., output per worker• Implies low (relative) price• And hence export


Adjustment Mechanism

• What if all of a country’s prices are too high for it to export at all?

Then either:– Exchange rate (value of currency) will fall

• Because otherwise nobody would buy its currency,

Or:– Wages will fall

• Because nobody would hire its laborEither of these will lower the country’s

prices


A Simple Model of Production and Trade

• A basic model, often referred to as the Ricardian model, named after economist David Ricardo (1772-1823)

• Assumptions– Markets are competitive: Firms are price

takers– Static world: Technology is constant and

there are no learning effects– Labor is perfectly mobile: It can easily move

back and forth between industries but perfectly immobile across national borders.


Assumptions of the Simple Ricardian Trade Model

See Handout – Absolute and Comparative Advantage.


Comparative Advantage and “Competitiveness”

• Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity

• Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs

-Imbalances result from government policies, such as subsidies or protection


Economic Restructuring

Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear

– In the Ricardian model, trade opening moved labor from bread to steel production: restructuring improved U.S. overall economic welfare but made its bread industry disappear

– If trade results in net gain (in an increase of the consumption bundle), a country will be better off by trading; however, some sectors may still lose


Economic Restructuring

• Given that some lose due to economic restructuring, the government can seek to get the winners from trade and restructuring to compensate the losers – Trade adjustment assistance (TAA) helps

losers by providing extended unemployment benefits, worker retraining, and temporary tax on imports

– For example, the U.S. government created a special program for workers laid off because of NAFTA; in 1994, 17,000 workers qualified for the program


Low-Cost and High-Cost Cotton Producers


Gain from Trade in General• What trade does not do:

– Trade does not help everybody• There are losers from trade

– (We’ll see later in the course who they are)– Trade does not reduce inequality

• At least not necessarily; it could, in some cases• But there are also good reasons why it may

increase inequality– Trade may not cause countries to grow faster

(There is debate on that)– Trade certainly does not fix all problems

• Weak or corrupt government• Failure to save• Poor technology


Gain from Trade in General

• Implications for Trade Policies• Autarky is not realistic, but “protection” (i.e.,

tariffs, quotas, etc.) is very realistic• Result that there is gain from trade does

extend to reducing protection– There are exceptions – we’ll see later– But in most cases, countries (as a whole) do

gain from reducing their tariffs• Even if other countries do not reduce

tariffs– Countries also gain when other countries

liberalize


Criticism• Comparative-advantage theory of trade

focuses on technology or resource productivity differences as a production-side basis for trade / comparative advantage.

• According to comparative-advantage theory, nations that are similar in their production-side capabilities (and in their general demand patterns) should trade little with each other.

• In reality, we observe the opposite.• Industrialized countries (which are similar in

many aspects in their technologies, technological capabilities, and factor endowment) trade extensively with each other.


• Trade between industrialized countries is nearly half of all world trade.

• Over 70% of the exports of industrialized countries go to other industrialized countries, and about 4/5 of these exports are nonfood manufactured products.

• These facts appear to be inconsistent with comparative-advantage theory.

• Furthermore, technology quickly spreads internationally because it is difficult for a country to keep its technology secret. Hence, many countries usually have access to the same technologies for production and are capable of achieving similar levels of resource productivity.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-1 1 Chapter 3 Lecture - Comparative Advantage and the Gains from Trade.

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