Ch 17 International Trade and Comparative Advantage Understanding

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

Trade Surpluses and Deficits 17. 2 U. S. Balance of Trade (Exports Minus Imports), 1929 – 1999 (Billions of Dollars) 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

Mutual Absolute Advantage 17. 3 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.

Production Possibility Frontiers for Australia and New Zealand with No Trading Suppose that each country has 100 acres of land divides its land to obtain equal units of cotton and wheat production. (An assumption about preferences) 17. 4

Mutual Absolute Advantage with No Trading 17. 5 Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both. 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

With Trade: The Gains from Specialization 17. 6 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 NEW ZEALAND Wheat Cotton 100 acres x 6 bu/acre 600 bushels 0 acres 0 CONSUMPTION AUSTRALIA 0 acres 0 bushels 100 acres x 6 bales/acre 600 bales NEW ZEALAND AUSTRALIA 300 bushels 300 bales

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” 17. 7

What If There is No Mutual Absolute Advantage? 17. 8 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.

Gains from Comparative Advantage 17. 9 Comparative Advantage uses the idea of opportunity cost Ø 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. Ø 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.

Gains from Comparative Advantage 17. 10 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.

Gains from Comparative Advantage: Calculating Opportunity Cost 17. 11 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: AUS: 6 bushels “cost” 6 bales of cotton 1 bushel costs 1 bale 1 bushels “cost” 3 bales of cotton 1 bushel costs 3 bale NZ: AUS: 6 bales “cost” 6 bushels of wheat 1 bale costs 1 bushel 3 bales “cost” 1 bushel of wheat 1 bale costs 1/3 bale Cotton:

No Trade 17. 12 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

Terms of Trade 17. 13 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.

With Trade: Gains from Comparative Advantage 17. 14 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/acre 450 bushels 0 acres 0 Cotton 25 acres x 6 bales/acre 150 bales 100 acres x 3 bales/acre 300 bales

Gains from Comparative Advantage Stage 3: Countries trade REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE ABSOLUTE ADVANTAGE STAGE 3 NEW ZEALAND Cotton 450 Bushels (production) - 100 bushels (trade) 0 Bushels (production) +100(trade) = 350 bushels (after) Wheat AUSTRALIA =100 bushels (after) 150 bales (production) +200 (trade) =350 bales (after) 300 bales (production) -200 bushels (trade) = 100 bales (after) 17. 15

Gains from Comparative Advantage 17. 16 Both countries are better off than they were before trade. Both have moved beyond their own production possibility frontiers.

The Sources of Comparative Advantage 17. 17 • 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

Trade Barriers: Tariffs, Export Subsidies, and Quotas 17. 18 • 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 1930 s, 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 1930 s. • 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.

Economic Integration 17. 19 • Economic integration occurs when two or more nations join to form a freetrade 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.

The Gains from Trade 17. 20 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?