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Ch. 17 International Trade and Comparative Advantage: Understanding Trade Flows

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Title: Ch. 17 International Trade and Comparative Advantage: Understanding Trade Flows


1
Ch. 17 International Trade and Comparative
Advantage Understanding Trade Flows
  • 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.

2
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) 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 IMPORTS EXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTS
1929 0.4 1984 102.0
1933 0.1 1985 114.2
1945 0.9 1986 131.9
1955 0.4 1987 142.3
1960 2.4 1988 106.3
1965 3.9 1989 80.7
1970 1.2 1990 71.4
1975 13.6 1991 20.7
1976 2.3 1992 27.9
1977 23.7 1993 60.5
1978 26.1 1994 87.1
1979 24.0 1995 84.3
1980 14.9 1996 89.0
1981 15.0 1997 89.3
1982 20.5 1998 151.5
1983 51.7 1999 254.0
3
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 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.
  • 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.

4
Mutual Absolute Advantage
YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON
NEW ZEALAND AUSTRALIA
Wheat 6 bushels 2 bushels
Cotton 2 bales 6 bales
New Zealand has an absolute advantage in Wheat
because one acre of land in New Zealand can
produce 6 bushels of wheat whereas an acre in
Australia can produce only 2 bushels of
wheat. Australia has an absolute advantage in
Cotton because one acre of land in Australia can
produce 6 bales of cotton whereas an acre in New
Zealand can produce only 2 bales of
cotton. Since each country has an absolute
advantage, we say it is mutual.
5
Mutual Absolute Advantage with No Trading
Suppose that each country has 100 acres of land
and divides its land to obtain equal units of
cotton and wheat production. (An assumption about
preferences)
TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE, MUTUAL ABSOLUTE ADVANTAGE, AND 100 AVAILABLE ACRES TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE, MUTUAL ABSOLUTE ADVANTAGE, AND 100 AVAILABLE ACRES TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE, MUTUAL ABSOLUTE ADVANTAGE, AND 100 AVAILABLE ACRES
NEW ZEALAND AUSTRALIA
Wheat 25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bushels/acre 150 bushels
Cotton 75 acres x 2 bales/acre 150 bales 25 acres x 6 bales/acre 150 bales
6
Production Possibility Frontiers for Australia
and New Zealand with No Trading
  • Because both countries have an absolute
    advantage in the production of one product,
    specialization and trade will benefit both.

7
With Trade The Gains from Specialization
  • With Trade each country uses all of its land to
    produce the good for which it has an 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 AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION
PRODUCTION PRODUCTION PRODUCTION PRODUCTION CONSUMPTION CONSUMPTION
NEW ZEALAND AUSTRALIA AUSTRALIA AUSTRALIA NEW ZEALAND AUSTRALIA
Wheat 100 acres x 6 bu/acre 600 bushels 100 acres x 6 bu/acre 600 bushels 100 acres x 6 bu/acre 600 bushels 75 acres x 2 bu/acre 150 bushels 300 bushels 300 bushels
Cotton 0 acres 0 0 acres 0 100 acres x 6 bales/acre 600 bales 100 acres x 6 bales/acre 600 bales 300 bales 300 bales
8
With Trade The Gains from Specialization
Each country can consume beyond its PPF due to
specialization and trade. Trade is good for all
parties involved
9
What If There is No Mutual Absolute Advantage
Gains from Comparative Advantage
  • Sometimes, resources and abilities arent as
    evenly balanced as in the previous example.
  • Suppose a country had a considerable absolute
    advantage in the production of both goods
    Ricardo would argue that specialization and trade
    are still mutually beneficial.
  • Countries should specialize in producing the
    goods in which they have a comparative advantage.
    We will see that they maximize their combined
    output and allocate their resources more
    efficiently when they do so.

10
Gains from Comparative Advantage
  • Comparative Advantage uses the idea of
    opportunity cost
  • The real (opportunity) cost of producing cotton
    is the wheat that must be sacrificed to produce
    it.
  • The real (opportunity) cost of producing wheat is
    the cotton that must be sacrificed to produce it.
  • A country has a comparative advantage in cotton
    production if its opportunity cost of cotton, in
    terms of wheat, is lower than the other country.
  • A country has a comparative advantage in wheat
    production if its opportunity cost of wheat, in
    terms of cotton, is lower than the other country.

11
Gains from Comparative Advantage
YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON
NEW ZEALAND AUSTRALIA
Wheat 6 bushels 1 bushel
Cotton 6 bales 3 bales
  • Here, Australias land is less productive than
    New Zealands in the production of both goods
  • For Wheat one acre of land in NZ produces 6
    bushes, whereas one acre of land in AUS produces
    only 1 bushel.
  • For Cotton one acre of land in NZ produces 6
    bales, whereas one acre of land in AUS produces
    only 3 bales.
  • NZ has an absolute advantage in the production of
    both goods.
  • We will see that the countries can still gain
    from specialization and trade.

12
Gains from Comparative Advantage Calculating
Opportunity Cost
  • To illustrate the gains from comparative
    advantage, assume (again) that in each country
    people want to consume equal amounts of cotton
    and wheat.

YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON YIELD PER ACRE OF WHEAT AND COTTON
NEW ZEALAND AUSTRALIA
Wheat 6 bushels 1 bushel
Cotton 6 bales 3 bales
Wheat NZ 6 bushels cost 6 bales of cotton
? 1 bushel costs 1 bale AUS 1 bushels cost
3 bales of cotton ? 1 bushel costs 3
bale Cotton NZ 6 bales cost 6 bushels of
wheat ? 1 bale costs 1 bushel AUS 3 bales
cost 1 bushel of wheat ? 1 bale costs 1/3
bale
13
Before Trade
TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND 100 AVAILABLE ACRES TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND 100 AVAILABLE ACRES TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND 100 AVAILABLE ACRES
NEW ZEALAND AUSTRALIA
Wheat 50 acres x 6 bushels/acre 300 bushels 75 acres x 1 bushels/acre 75 bushels
Cotton 50 acres x 6 bales/acre 300 bales 25 acres x 3 bales/acre 75 bales
  • In the next few slides, we will show that both
    countries can be better off by specializing and
    then trading with each other

14
Terms of Trade
  • Terms of Trade the ratio at which a country can
    trade domestic products for imported products
  • NZ and AUS need to decide the terms of their
    trade.
  • AUS is going to sell cotton to NZ. In return, NZ
    is going to sell wheat to AUS, but how much
    cotton for how much wheat?
  • As the buyer of cotton, NZ wont offer more
    than 1 wheat for 1 cotton.
  • As the seller of cotton, AUS wont accept less
    than 1/3 of a wheat for 1 cotton ? They will
    agree to a ratio between 1 and 1/3.
  • As the buyer of wheat, AUS wont offer more
    than 3 cottons for 1 wheat.
  • As the seller of wheat, NZ wont accept less
    than 1 of cotton for 1 wheat ? They will agree to
    a ratio between 1 and 3.
  • Lets pick ½ of a wheat for 1 cotton (or 2
    cottons for 1 wheat) as the terms of trade.

15
With Trade 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 HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE
STAGE 1 STAGE 1
NEW ZEALAND AUSTRALIA
Wheat 50 acres x 6 bushels/acre 300 bushels 0 acres 0 bushels
Cotton 50 acres x 6 bales/acre 300 bales 100 acres x 3 bales/acre 300 bales
16
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 HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE
STAGE 2 STAGE 2
NEW ZEALAND AUSTRALIA
Wheat 75 acres x 6 bushels/acre 450 bushels 0 acres 0
Cotton 25 acres x 6 bales/acre 150 bales 100 acres x 3 bales/acre 300 bales
17
Gains from Comparative Advantage
  • Stage 3 Countries trade

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE
STAGE 3 STAGE 3
NEW ZEALAND AUSTRALIA

Wheat 450 Bushels (before) 100 bushels (trade)? 350 bushels (after) 0 Bushels (before) 100 bushels (after)


Cotton 150 bales (before) 350 bales (after) 300 bales (before) ?200 bushels (trade) 100 bales (after)

18
Gains from Comparative Advantage
  • Both countries are better off than they were
    before trade. Both have moved beyond their own
    production possibility frontiers.

19
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.
  • The Heckscher-Ohlin theorem is a theory that
    explains the existence of a countrys 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

20
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.
  • 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.

21
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.
  • 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.

22
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.

23
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.

24
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.

25
The Losses from the Imposition of a Tariff
  • The loss of efficiency from a 1 tariff has two
    components
  • Consumers must pay a higher price for goods that
    could be produced at a lower cost.
  • Marginal producers are drawn into textiles and
    away from other goods, resulting in inefficient
    domestic production.

Government revenue equals the shaded area.
26
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
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