17.1Ch. 17 International Trade and Comparative

Advantage: Understanding Trade Flows

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

• David Ricardo’s theory of comparative advantage 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.

17.2Trade Surpluses and Deficits

U.S. Balance of Trade (Exports Minus Imports), 1929 – 1999 (Billions of Dollars)

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

17.3Mutual Absolute Advantage

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.

17.4Production Possibility Frontiers for Australia and New

Zealand 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)

17.5Mutual Absolute Advantage with No Trading

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/acre150 bushels

75 acres x 2 bushels/acre150 bushels

Cotton 75 acres x 2 bales/acre150 bales

25 acres x 6 bales/acre150 bales

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

17.6With 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 WHEATAFTER SPECIALIZATION

PRODUCTION CONSUMPTION

NEW ZEALAND AUSTRALIANEW

ZEALANDAUSTRALIA

Wheat 100 acres x 6 bu/acre600 bushels

0 acres0 bushels

300 bushels 300 bushels

Cotton 0 acres0

100 acres x 6 bales/acre600 bales

300 bales 300 bales

17.7With Trade: The Gains from Specialization

Each country can consume beyond its PPF due to specialization and trade. “Trade is good for all parties involved”

17.8What If There is No Mutual Absolute Advantage?

Gains from Comparative Advantage

• Sometimes, resources and abilities aren’t 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.

17.9Gains from Comparative Advantage

Comparative Advantage uses the idea of opportunity cost

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.

17.10Gains from Comparative Advantage

YIELD PER ACRE OF WHEAT AND COTTON

NEW ZEALAND AUSTRALIA

Wheat 6 bushels 1 bushel

Cotton 6 bales 3 bales

Here, Australia’s land is less productive than New Zealand’s 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.

17.11Gains 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

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 baleAUS: 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 bushelAUS: 3 bales “cost” 1 bushel of wheat 1 bale costs 1/3 bale

17.12No Trade

In the next few slides, we will show that both countries can be better off by specializing and then trading with each other

TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND 100 AVAILABLE ACRES

NEW ZEALAND AUSTRALIA

Wheat 50 acres x 6 bushels/acre300 bushels

75 acres x 1 bushels/acre75 bushels

Cotton 50 acres x 6 bales/acre300 bales

25 acres x 3 bales/acre75 bales

17.13Terms 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? (what are the “terms of trade”?)

As the “buyer” of cotton, NZ won’t offer more than 1 wheat for 1 cotton. As the “seller” of cotton, AUS won’t accept less than 1/3 of a wheat for 1 cotton

They will agree that 1 cotton is worth between 1/3 and 1 Wheat.

As the “buyer” of wheat, AUS won’t offer more than 3 cottons for 1 wheat. As the “seller” of wheat, NZ won’t accept less than 1 of cotton for 1 wheat

They will agree that 1 Wheat is worth between 1 and 3 cottons.

Let’s pick a “price”: 1 cotton “costs” ½ of a wheat (or, equivalently) 1 wheat “costs” 2 cotton. These are the terms of trade.

17.14With Trade: Gains from Comparative Advantage

Stage 1: Australia transfers all its land into cotton production. Stage 2: New Zealand cannot completely specialize in wheat because it will not

be able to get enough cotton from Australia in exchange (if countries are to consume equal amounts of cotton and wheat). NZ will devote ¾ of its land to Wheat (75 acres) and ¼ to Cotton (25 acres)

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE

NEW ZEALAND AUSTRALIA

Wheat 75 acres x 6 bushels/acre450 bushels

0 acres0

Cotton 25 acres x 6 bales/acre150 bales

100 acres x 3 bales/acre300 bales

17.15Gains from Comparative Advantage

Stage 3: Countries trade

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE

STAGE 3

NEW ZEALAND AUSTRALIA

Wheat 450 Bushels (production) - 100 bushels (trade)

= 350 bushels (after)

0 Bushels (production)+100(trade)

=100 bushels (after)

Cotton 150 bales (production)+200 (trade)

=350 bales (after)

300 bales (production)-200 bushels (trade)= 100 bales (after)

17.16Gains from Comparative Advantage

Both countries are better off than they were before trade. Both have moved beyond their own production possibility frontiers.

17.17The 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. 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

17.18Trade 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.

17.19Economic 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 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.

• The U.S. Department of Commerce has estimated that as a result of NAFTA, trade between the U.S. and Mexico increased by nearly $16 billion in 1994.

• Exports from the United States to Mexico outpaced imports from Mexico.

17.20The 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.

Now let the gov’t impose a $1 tariff. What is the loss in surplus?