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

1. Ch. 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.

2. Trade Surpluses and Deficits

3. Mutual Absolute Advantage 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.

4. Production 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)

5. Mutual Absolute Advantage with No Trading Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.

6. 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.

7. 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”

8. What 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.

9. Gains 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.

10. Gains from Comparative Advantage • 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.

11. 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. 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

12. No Trade In the next few slides, we will show that both countries can be better off by specializing and then trading with each other

13. 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? (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.

14. With 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)

15. Gains from Comparative Advantage Stage 3: Countries trade

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

17. 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. 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

18. 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.

19. 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 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.

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