32 prepared by: fernando quijano and yvonn quijano © 2004 prentice hall business...

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Prepared by: Fernando QuijanoPrepared by: Fernando Quijanoand Yvonn Quijanoand Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

International Trade, Comparative Advantage,

and Protectionism

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2 of 47© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl 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.

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International Trade

• 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.

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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.

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Trade Surpluses and Deficits

U.S. Balance of Trade (Exports Minus Imports), 1929–2002 (Billions of Dollars)

EXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTS

1929 + 0.4 1986 – 131.9

1933 + 0.1 1987 – 142.3

1945 – 0.9 1988 – 106.3

1955 + 0.4 1989 – 80.7

1960 + 2.4 1990 – 71.4

1965 + 3.9 1991 – 20.7

1970 + 1.2 1992 – 27.9

1975 + 13.6 1993 – 60.5

1976 – 2.3 1994 – 87.1

1977 – 23.7 1995 – 84.3

1978 – 26.1 1996 – 89.0

1979 – 24.0 1997 – 89.3

1980 – 14.9 1998 – 151.7

1981 – 15.0 1999 – 249.9

1982 – 20.5 2000 – 365.5

1983 – 51.7 2001 – 348.9

1984 – 102.0 2002 – 423.6

1985 – 114.2Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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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.

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The Economic Basis for Trade: Comparative Advantage

• 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.

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Absolute Advantageversus 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.

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Absolute Advantageversus 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.

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Gains from Mutual Absolute Advantage

Yield Per Acre Of Wheat And Cotton

NEW ZEALAND AUSTRALIA

Wheat 6 bushels 2 bushels

Cotton 2 bales 6 bales

• 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.

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Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres


Wheat 25 acres x 6 bushels/acre150 bushels

75 acres x 2 bushels/acre150 bushels

Cotton 75 acres x 2 bales/acre150 bales

25 acres x 6 bales/acre150 bales

• Suppose that each country divides its land to obtain equal units of cotton and wheat production as shown below:


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Production Possibility Frontiers for Australia and New Zealand Before Trade

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• 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 CONSUMPTION

New Zealand AustraliaNew

ZealandAustralia

Wheat 100 acres x 6 bu/acre600 bushels

0 acres0

300 bushels 300 bushels

Cotton 0 acres0


300 bales 300 bales

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Expanded Possibilities after Trade

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

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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.

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• 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.

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• 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:

Yield Per Acre of Wheat and Cotton

Wheat


6 bushels 1 bushelCotton 6 bales 3 bales

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

Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres

Wheat

NEW ZEALAND AUSTRALIA50 acres x 6 bushels/acre

300 bushels75 acres x 1 bushels/acre

75 bushels



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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage

Stage 1: Countries specialize

Wheat

STAGE 1

New Zealand Australia50 acres x 6 bushels/acre

300 bushels0 acres

0



• 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).

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Stage 2:

Wheat

STAGE 2

New Zealand Australia75 acres x 6 bushels/acre

450 bushels0 acres

0



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

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Stage 3: Countries trade

STAGE 3

New Zealand Australia100 bushels (trade)

Wheat 350 bushels 100 bushels

(after trade)

200 bales (trade)

Cotton 350 bales 100 bales

(after trade)

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• 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.

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Comparative AdvantageMeans Lower Opportunity Cost

• Both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton to wheat.

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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.

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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 learn about exchange rates.

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Exchange Rates

• An exchange rate is the ratio at which two currencies are traded, or 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.

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Trade and Exchange Ratesin a Two-Country/Two-Good World

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

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

UNITED STATES BRAZIL

Timber $1 3 Reals

Rolled steel $2 4 Reals

• Exchange rates determine the terms of trade.

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Trade and Exchange Ratesin a Two-Country/Two-Good World

Trade Flows Determined by Exchange RatesEXCHANGE

RATEPRICE

OF REAL RESULT

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

$1 = 2 R .50 Brazil imports timber

$1 = 2.1 R .48 Brazil imports timber; United States imports steel

$1 = 2.9 R .34 Brazil imports timber; United States imports steel

$1 = 3 R .33 United States imports steel

$1 = 4 R .25 United States imports timber and steel

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Exchange Ratesand 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.

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

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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.

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The Heckscher-Ohlin Theorem

• 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.

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Other Explanations forObserved Trade Flows

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

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

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Other Explanations forObserved 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.

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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.

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

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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.

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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.

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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.

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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.

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• 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.

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• 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.

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• 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.

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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.

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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.

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The Losses from theImposition 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.

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

the shaded area.

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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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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.

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Review Terms and Concepts

absolute advantage

comparative advantage

Corn Laws

dumping

economic integrationeconomic integration

European Union (EU)European Union (EU)

exchange rateexchange rate

export subsidiesexport subsidies

factor endowmentsfactor endowments

General Agreement General Agreement on Tariffs and on Tariffs and Trade (GATT)Trade (GATT)

Heckscher-Ohlin Heckscher-Ohlin theoremtheorem

infant industryinfant industry

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

protectionprotection

quotaquota

Smoot-Hawley tariff Smoot-Hawley tariff

tarifftariff

terms of tradeterms of trade

theory of comparative theory of comparative advantageadvantage

trade deficittrade deficit

trade surplustrade surplus

U.S.-Canadian Free- U.S.-Canadian Free- Trade AgreementTrade Agreement

32 prepared by: fernando quijano and yvonn quijano © 2004 prentice hall business...

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