chapter 33 comparative advantage and the open economy

Chapter 33

Comparative Advantage and the Open Economy

Introduction

Why do nations enter into agreements aimed at promoting bilateral or multilateral trade of goods and services?

In this chapter, you will learn about how nations can gain from trade.

Learning Objectives

• Discuss the worldwide importance of international trade

• Explain why nations can gain from specializing in production and engaging in international trade

• Understand common arguments against free trade

• Describe ways that nations restrict foreign trade

• Identify key international agreements and organizations that adjudicate trade disputes among nations

Chapter Outline

• The Worldwide Importance of International Trade

• Why We Trade: Comparative Advantage and Mutual Gains from Exchange

• The Relationship Between Imports and Exports

• International Competitiveness

• Ways to Restrict Foreign Trade

Did You Know That...

• U.S. residents spend about $24 billion on imports from Scandinavian nations each year?

• The U.S. tariff rate on products imported from Scandinavian countries is less than 1%?

The Worldwide Importance of International Trade

• World GDP is nearly nine times greater than it was at the end of World War II.

• World trade has increased to more than 26 times what it was in 1950.

The Worldwide Importance of International Trade (cont'd)

• The United States has figured prominently in this expansion of world trade.

Imports added up to barely 4% of annual U.S. GDP in 1950.

Today they account for almost 17%.

Source: Steven Husted and Michael Melvin, International Economics, 3rd ed. (New York: HarperCollins, 1995), p. 11, used with permission; World Trade Organization; Federal Reserve System; U.S. Department of Commerce.

Figure 33-1 The Growth of World Trade, Panel (a)

Figure 33-1 The Growth of World Trade, Panel (b)

Source: Steven Husted and Michael Melvin, International Economics, 3rd ed. (New York: HarperCollins, 1995), p. 11, used with permission; World Trade Organization; Federal Reserve System; U.S. Department of Commerce.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange

• We have learned about the concept of specialization and the mutual gains from trade.

• We can understand gains from trade among nations by understanding output gains from specialization between individuals.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd)

• Scenario (8-hour day)

Ad specialist 2 pages of ad copy/hour

1 art rendering/hour

Computer artist1 page of ad copy/hour

1 art rendering/hour

Without Trade(8-hour day)

Ad Specialist Computer Artist

Renderings

4 hrs 2 = 8

4 hrs 1 = 4

Ad copy outputincreases by 4pages per day

With Trade(8-hour day)

Ad Specialist Computer Artist

Renderings

8 hrs 2 = 16

8 hrs 1 = 8

• Comparative Advantage

The ability to produce a good or service at a lower opportunity cost compared with producers

International Example: Kenya’s Green Thumb in Exporting Green Beans

• The opportunity cost of producing many packaged vegetables is lower in Kenya than in many European countries.

• This gives Kenya a comparative advantage in producing such goods.

• Specialization among nations

To demonstrate the concept of comparative advantage, consider a simple two-country, two-good world.

• Production and consumption capabilities in a two-country, two-good world

We show maximum feasible quantities of software and PCs.

Using all resources—land, labor, capital, and entrepreneurship.

• U.S. residents can utilize all their resources to produce 90 units of software or 225 PCs per hour.

• Residents of India are able to utilize all their resources to produce either 100 units of software or 50 PCs per hour.

Table 33-1 Maximum Feasible Hourly Production Rates of Either Commercial Software or Personal Computers Using All Available Resources

• Comparative advantage The opportunity cost of producing a PC is

lower in the United States than in India.1 PC = 0.4 units of software1 unit of software = 2.5 PCs

The opportunity cost of producing software is lower in India than the United States.1 PC = 2 units of software1 unit of software = 0.5 PC

• Production without trade

Table 33-2 tabulates two possible production choices.

“World” output is 55 units of software and 187.5 PCs (per hour).

Table 33-2 U.S. and Indian Production and Consumption Without Trade

• The United States and India will specialize in activities with which they experience a lower opportunity cost.

• In other words, they will specialize in the activity in which they have a comparative advantage.

• Specialization in production

United States will specializeProduce 225 PCs, and no software

India will specializeProduce 100 software units, no PCs

• Consumption with specialization and trade

United States willing to buy 1 unit of Indian software as long as they provide in exchange no more than 2.5 PCs.

This is the United States’ opportunity cost of producing 1 unit of software at home.

• Consumption with specialization and trade

India buys a PC from the United States in exchange for no more than 2 units of software.

This is India’s opportunity cost of producing a PC at home.

• Residents of the two nations agree to a rate of exchange of 1 PC for 1 unit of software.

Proceed to trade 75 U.S. PCs for 75 units of Indian software.

Table 33-3 U.S. and Indian Production and Consumption with Specialization and Trade

• By specializing and engaging in trade

United States consumes 75 units of software imported from India and consumes 150 PCs produced at home.

Indian residents consume 25 units of software produced at home and import 75 PCs from the United States.

• Gains from trade

United States’ gain from specialization and trade is 45 units of software.

India can consume 37.5 more PCs.

These are net gains.

Table 33-4 National and Worldwide Gains from Specialization and Trade

• Specialization is the key

Specializing in producing goods for which a nation has a comparative advantage allows for greater efficiency.

Production capabilities increase, making possible greater worldwide consumption through international trade.

• Observations on specialization and trade

Not everyone gains from trade.

Cannot “run out of exports”

Every country will always have a comparative advantage in something.

Figure 33-2 World Trade Flows

International Example: Japan Loses Its Electronics Advantage to the U.S.

• From the 1950s until the late 1990s, companies based in Japan—Sony, Panasonic, Pioneer—made the nation a major exporter of electronic devices.

• Since the 1990s, U.S. companies—Apple, Microsoft, palmOne—have elbowed out Japanese firms.

• The United States has developed a comparative advantage over Japan in producing a number of modern electronic products.

• Other benefits from international trade: the transmission of ideas

New goods, services spread

New processes transmitted

Intellectual property introduced

The Relationship Between Exports and Imports

• In the long run, imports are paid for by exports.

• Any restrictions on imports ultimately reduce exports.

• When a country engages in trade, it is not competing against the other countries.

• All nations stand to benefit from trade.

International Competitiveness

• Questions

Is the United States falling behind?

Do we need to stay competitive internationally?

What does global competitiveness really mean?

International Competitiveness (cont'd)

• Answers

United States leads in overall productive efficiency

According to the Institute for Management Development in Lausanne, Switzerland

International Competitiveness (cont'd)

• Reasons for ranking

Widespread entrepreneurship

Economic restructuring

Investment in information-technology

Sophisticated financial system

Large investments in scientific research

Arguments Against Free Trade

• Infant Industry Argument

The contention that tariffs should be imposed to protect from import competition an industry that is trying to get started

Presumably, after the industry becomes technologically efficient, the tariff can be lifted.

Arguments Against Free Trade (cont'd)

• Countering foreign subsidies and dumping

• Dumping Selling a good or a service abroad below

the price charged in the home market or at a price below its cost of production

• Protecting domestic jobs

Do imports reduce jobs?No empirical evidence

In half of the cases studied, when imports rose, unemployment fell.

• The cost of protecting U.S. jobs

Restrictions on textiles and apparel goods cost U.S. consumers $9 billion a year.Cost $50,000 a year for each $20,000

job saved

Restriction on imports of Japanese cars Cost $160,000 per year for each job saved in

the auto industry

• The cost of protecting U.S. jobs

Glass industry restrictionsCost $200,000 per year per job saved

Steel industry restrictionsCost $750,000 per year per job saved

Emerging Arguments Against Free Trade

• Environmental concerns Genetic engineering

New diseases

• National defense Exports of new technology

Ways to Restrict Foreign Trade

• Quota System

A government-imposed restriction on the quantity of a specific good that another country is allowed to sell in the United States

In other words, quotas are restrictions on imports, usually applied to one or several specific countries.

Figure 33-3 The Effect of Quotas on Textile Imports

Equilibrium with restrictions

Equilibrium without restrictions

Ways to Restrict Foreign Trade

• Voluntary quotas

Voluntary Restraint Agreement (VRA)An official agreement with another country that

“voluntarily” restricts the quantity of its exports

Voluntary Import Expansion (VIE)An official agreement with another country

in which it agrees to import more from the United States

Ways to Restrict Foreign Trade (cont'd)

• Tariffs

Tax on imported goods

Benefits import-competing industries

Harms consumers by raising prices

Figure 33-4 The Effect of a Tariff on Japanese-Made Laptop Computers, Panel (a)

Japanese-madenotebook computers

Figure 33-4 The Effect of a Tariff on Japanese-Made Laptop Computers, Panel (b)

American-made notebook computers

• Tariffs in the United States

Have varied widely on imported goods

Highest rates in twentieth century occurred with passage of Smoot-Hawley Tariff in 1930

Figure 33-5 Tariff Rates in the United States Since 1820

Source: U.S. Department of Commerce

• Current tariff laws

Trade Expansion Act of 1962

Trade Reform Act of 1974

Trade and Tariff Act of 1984

General Agreement on Tariffs and Trade

World Trade Organization

International Trade Organizations

• General Agreement on Tariffs and Trade

An international agreement established in 1947 to further world trade by reducing barriers and tariffs

GATT was replaced by the World Trade Organization in 1995.

International Trade Organizations (cont'd)

• World Trade Organization (WTO)

The successor organization to GATT that handles trade disputes among its member nations

International Trade Organizations (cont'd)

• The World Trade Organization (WTO)

Most important international trade organization, with largest membership

Fostered most important and far-reaching global trade agreement covering

Financial institutions; including banks, insurers and investment companies

International Policy Example: Twin Growth Paths in World Trade

• Its champions credit the WTO with boosting world trade.

• Doubters claim gains from trade are fueling membership.

• In any event, growth in world trade takes place alongside the WTO.

Figure 33-6 Growth in the World Trade Organization’s Membership and in Global Trade

• Regional Trade Bloc

A group of nations that grants members special privileges

Examples include the European Union, NAFTA, and the Association of Southeast Asian Nations

• Some economists worry regional blocs could lead to a reduction in members’ trade with nations outside their blocs.

• Most evidence indicates regional trade blocs have promoted trade instead of hindering it.

• Numerous studies have found that as countries from around the world have become more open to trade, they have tended to join regional trade blocs that promote even more openness.

Issues and Applications: Do Regional Trade Blocs Encourage “Trade Deflection”?

• Trade diversion versus trade deflection.

• Is trade deflection “bad”?

• Is the solution to the trade deflection worse than the problem?

Figure 33-7 The Percentage of World Trade Within Regional Trade Blocs

Summary Discussion of Learning Objectives

• Worldwide importance of international trade World trade has grown faster than total

world GDP.

• Why nations can gain from specializing in production and engaging in trade Comparative advantage

Summary Discussion of Learning Objectives (cont'd)

• Arguments against free trade Infant industry Dumping Environmental concerns National defense

• Ways that nations restrict foreign trade Tariffs Quotas

Summary Discussion of Learning Objectives (cont'd)

• Key international agreements and organizations

More than 230 regional trade blocsNAFTA

European Union

End of Chapter 33

Comparative Advantage and the Open Economy

chapter 33 comparative advantage and the open economy

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