20

RETP A HC

International Trade, Comparative Advantage, and Protectionism

Prepared by: Fernando Quijano and Yvonn Quijano

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

International Trade

All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

2 of 47

International Trade

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

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.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

3 of 47

Trade Surpluses and Deficits

When a country exports more than it imports, it runs a trade surplus. A trade deficit is the situation when a country imports more than it exports.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

4 of 47

Trade Surpluses and Deficits

U.S. Balance of Trade (Exports Minus Imports), 19292002 (Billions of Dollars) EXPORTS MINUS IMPORTS
1929 1933 1945 1955 1960 1965 1970 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 + 0.4 + 0.1 0.9 + 0.4 + 2.4 + 3.9 + 1.2 + 13.6 2.3 23.7 26.1 24.0 14.9 15.0 20.5 51.7 102.0 114.2 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

EXPORTS MINUS IMPORTS

131.9 142.3 106.3 80.7 71.4 20.7 27.9 60.5 87.1 84.3 89.0 89.3 151.7 249.9 365.5 348.9 423.6

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

5 of 47

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

6 of 47

The Economic Basis for Trade: Comparative Advantage

David Ricardos 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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

7 of 47

Absolute Advantage versus Comparative Advantage

A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

8 of 47

Absolute Advantage versus Comparative Advantage

A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

9 of 47

Gains from Mutual Absolute Advantage

Yield Per Acre Of Wheat And Cotton NEW ZEALAND AUSTRALIA

Wheat Cotton

6 bushels 2 bales

2 bushels 6 bales

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

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.
Principles of Economics, 7/e Karl Case, Ray Fair 10 of 47

2004 Prentice Hall Business Publishing

Gains from Mutual Absolute Advantage

Suppose that each country divides its land to obtain equal units of cotton and wheat production as shown below:
Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres NEW ZEALAND
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

AUSTRALIA
75 acres x 2 bushels/acre 150 bushels 25 acres x 6 bales/acre 150 bales

Wheat Cotton

25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bales/acre 150 bales

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

11 of 47

Production Possibility Frontiers for Australia and New Zealand Before Trade

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

12 of 47

Gains from Mutual Absolute Advantage

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 Wheat and Cotton after Specialization

PRODUCTION
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

CONSUMPTION
New Zealand
300 bushels 300 bales

New Zealand

Australia
0 acres 0

Australia
300 bushels 300 bales

Wheat Cotton

100 acres x 6 bu/acre 600 bushels 0 acres 0

100 acres x 6 bales/acre 600 bales

Principles of Economics, 7/e

2004 Prentice Hall Business Publishing

Karl Case, Ray Fair

13 of 47

Expanded Possibilities after Trade

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.
Principles of Economics, 7/e Karl Case, Ray Fair 14 of 47

2004 Prentice Hall Business Publishing

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.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

15 of 47

Gains from Comparative Advantage

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

16 of 47

Gains from Comparative Advantage

Assume that people in each country want to consume equal amounts of cotton and wheat, and that each country is constrained by its domestic production possibilities curve, as follows:
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Yield Per Acre of Wheat and Cotton

Wheat Cotton NEW ZEALAND AUSTRALIA

6 bushels 6 bales

1 bushel 3 bales
17 of 47

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

Gains from Comparative Advantage

Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres Wheat NEW ZEALAND
50 acres x 6 bushels/acre 300 bushels

AUSTRALIA
75 acres x 1 bushels/acre 75 bushels 25 acres x 3 bales/acre 75 bales

Cotton
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

50 acres x 6 bales/acre 300 bales

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

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

18 of 47

Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 1: Countries specialize
Wheat New Zealand
50 acres x 6 bushels/acre 300 bushels

STAGE 1 Australia
0 acres 0 100 acres x 3 bales/acre 300 bales

Cotton
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

50 acres x 6 bales/acre 300 bales

Australia transfers all its land into cotton production. New Zealand cannot completely specialize in wheat production 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).
Principles of Economics, 7/e Karl Case, Ray Fair 19 of 47

2004 Prentice Hall Business Publishing

Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 2:
Wheat New Zealand
75 acres x 6 bushels/acre 450 bushels

STAGE 2 Australia
0 acres 0 100 acres x 3 bales/acre 300 bales

Cotton
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

25 acres x 6 bales/acre 150 bales

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

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

20 of 47

Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 3: Countries trade
STAGE 3 New Zealand Wheat
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Australia
100 bushels (after trade)

100 bushels (trade) 350 bushels

200 bales (trade)

Cotton

350 bales (after trade)

100 bales

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

21 of 47

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

22 of 47

Comparative Advantage Means Lower Opportunity Cost

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton to wheat.
Principles of Economics, 7/e Karl Case, Ray Fair 23 of 47

2004 Prentice Hall Business Publishing

Terms of Trade
The ratio at which a country can trade domestic products for imported products is the terms of trade. The terms of trade determine how the gains from trade are distributed among trading partners.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

24 of 47

Exchange Rates
When trade is freeunimpeded 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 learn about exchange rates.
Principles of Economics, 7/e Karl Case, Ray Fair 25 of 47

2004 Prentice Hall Business Publishing

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Exchange Rates
An exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

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.
Principles of Economics, 7/e Karl Case, Ray Fair 26 of 47

2004 Prentice Hall Business Publishing

Trade and Exchange Rates in a Two-Country/Two-Good World

Exchange rates determine the terms of trade.
Domestic Prices of Timber (Per Foot) and Rolled Steel (Per Meter) in the United States and Brazil
UNITED STATES
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

BRAZIL

Timber Rolled steel

$1 $2

3 Reals 4 Reals

The option of buying at home or importing will depend on the exchange rate.
Principles of Economics, 7/e Karl Case, Ray Fair 27 of 47

2004 Prentice Hall Business Publishing

Trade and Exchange Rates in a Two-Country/Two-Good World

Trade Flows Determined by Exchange Rates
EXCHANGE RATE PRICE OF REAL RESULT

$1 = 1 R $1 = 2 R $1 = 2.1 R
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

$1.00 Brazil imports timber and steel .50 Brazil imports timber .48 Brazil imports timber; United States
imports steel imports steel

$1 = 2.9 R $1 = 3 R $1 = 4 R

.34 Brazil imports timber; United States .33 United States imports steel .25 United States imports timber and
steel
Principles of Economics, 7/e Karl Case, Ray Fair 28 of 47

2004 Prentice Hall Business Publishing

Exchange Rates and Comparative Advantage

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.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Only those products in which a country has a comparative advantage will be competitive in world markets.
Principles of Economics, 7/e Karl Case, Ray Fair 29 of 47

2004 Prentice Hall Business Publishing

The Sources of Comparative 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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

30 of 47

The Heckscher-Ohlin Theorem

The Heckscher-Ohlin theorem is a theory that explains the existence of a countrys comparative advantage by its factor endowments.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

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.
Principles of Economics, 7/e Karl Case, Ray Fair 31 of 47

2004 Prentice Hall Business Publishing

Other Explanations for Observed Trade Flows

Product differentiation is a natural response to diverse preferences within an economy, and across economies.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Some economists also distinguish between gains from acquired comparative advantage and gains from natural comparative advantages.
Principles of Economics, 7/e Karl Case, Ray Fair 32 of 47

2004 Prentice Hall Business Publishing

Other Explanations for Observed Trade Flows

Economies of scale may be available when producing for a world market that would not be available when producing for a limited domestic market.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

33 of 47

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.
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

A quota is a limit on the quantity of imports.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

34 of 47

Trade Barriers: Tariffs, Export Subsidies, and Quotas

Export subsidies are government payments made to domestic firms to encourage exports. Dumping refers to a firm or industry that sells products on the world market at prices below the cost of production.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

35 of 47

U.S. Trade Policies and GATT

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

36 of 47

U.S. Trade Policies and GATT

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

37 of 47

Economic Integration
Economic integration occurs when two or more nations join to form a free-trade zone. The European Union (EU) and the North American Free-Trade Agreement NAFTA are examples of economic integration.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

38 of 47

Economic Integration
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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

39 of 47

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

40 of 47

Economic Integration
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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

41 of 47

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.
Principles of Economics, 7/e Karl Case, Ray Fair 42 of 47

2004 Prentice Hall Business Publishing

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

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.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

43 of 47

The Losses from the Imposition of a Tariff

The loss of efficiency from a $1 tariff:
1. Consumers must pay a

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

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2. Marginal producers are

Government revenue equals the shaded area.

drawn into textiles and away from other goods, resulting in inefficient domestic production.
Karl Case, Ray Fair 44 of 47

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

The Case for Protection

Protection saves jobs Some countries engage in unfair trade practices Cheap foreign labor makes competition unfair
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

Protection safeguards national security Protection discourages dependency Protection safeguards infant industries
Principles of Economics, 7/e Karl Case, Ray Fair 45 of 47

2004 Prentice Hall Business Publishing

The Case for Protection

An infant industry is a young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage.

ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

46 of 47

Review Terms and Concepts

absolute advantage General Agreement on Tariffs and Tradetariff Smoot-Hawley (GATT)

comparative advantage Heckscher-Ohlin theorem tariff Corn Laws dumping economic integration
ap m H,C dar Tl ano t an e n o PA C e i r t I mi no t c e o P dna s i t r

infant industry

terms of trade

North American Free-Trade Agreement (NAFTA) theory of comparative ad protection quota trade deficit trade surplus

European Union (EU) exchange rate export subsidies factor endowments

U.S.-Canadian Free- Tra

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

47 of 47