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Chapter 15 - Comparative Advantage and the Gains from


									    Comparative Advantage and the
     Gains from International Trade
• Consumers love bargains
• Should we let these bargain goods into the
• Do cheap foreign goods threaten the jobs of
  American workers and the profits of American
• Over the post-World War II period, there has
  been a worldwide movement toward a policy of
  free trade

Hall & Leiberman;                                1
Economics: Principles
    Comparative Advantage and the
     Gains from International Trade
• While many barriers have come down, others
  are being put up
• Poor countries have imposed tariffs on
  computers, semiconductors, and software
  exported by rich countries
• Rich countries have announced their intention to
  maintain existing quotas on textiles and clothing
  sold by poor countries
• Is free international trade a good thing that
  makes us better off

Hall & Leiberman;                                     2
Economics: Principles
            The Logic of Free Trade
• Many of us like the idea of being self-reliant

• Defects of self-sufficiency explain why most people do
  not choose it

• Principle applies not just to individuals, but also to
  groups of individuals

• What would happen if residents of your state switched
  from a policy of open trading with other states to one of

Hall & Leiberman;                                             3
Economics: Principles
            The Logic of Free Trade
• It would make no sense to insist on the economic self-
  sufficiency of each of the 50 states

• What is true for states is also true for entire nations

• Long-term goal of WTO is to remove all barriers to
  exports and imports

Hall & Leiberman;                                           4
Economics: Principles
          The Theory of Comparative
•   Economists who first considered the benefits of international trade
    focused on a country’s absolute advantage
     – A country has an absolute advantage in a good when it can produce it
       using fewer resources than another country

•   In 1817, however, British economist David Ricardo disagreed
     – A nation has a comparative advantage in producing a good if it can
       produce it at a lower opportunity cost than some other country

•   Mutually beneficial trade between any two countries is possible
    whenever one country is relatively better at producing a good than
    the other country
     – Being relatively better means having ability to produce a good at a lower
       opportunity cost

Hall & Leiberman;                                                              5
Economics: Principles
 Opportunity Cost and Comparative
• To illustrate Ricardo’s insight, let’s consider a
  hypothetical world of two countries—China and
  United States
• Both countries can gain from trade
     – If China could be persuaded to produce more suits
       and United States more computers
          • World’s total production of goods will increase
     – Each country can come out ahead by trading with the

Hall & Leiberman;                                             6
Economics: Principles
              Specialization and World
• Additional production lies behind the
  substantial benefits countries enjoy from
  free trade
• If countries specialize according to
  comparative advantage, a more efficient
  use of given resources occurs
          • That is, with the same resources, the world can
            produce more of at least one good
                – Without decreasing production of any other good

Hall & Leiberman;                                                   7
Economics: Principles
                  The Terms of Trade
• Exchange ratio is known as the terms of trade
     – Quantity of one good that is exchanged for a unit of
       the other

• Determine how gains from international trade
  are distributed among countries

Hall & Leiberman;                                             8
Economics: Principles
       How Potential Gains Turn Into
              Actual Gains
• Within framework of WTO, government officials
  are supposed to create environment for free
     – But they do not decide who has a comparative
       advantage in what, or what should be produced in this
       or that country
     – In today’s market economies around the world, it is
       individual consumers and firms who decide to buy
       things—at home or abroad
• What makes China shift resources into its
  comparative advantage good?
      – And what makes the U.S. shift resources in the other
Hall & Leiberman;                                              9
Economics: Principles
          • Prices
       How Potential Gains Turn Into
              Actual Gains
• When consumers are free to buy at the lowest prices
     – They will naturally buy a good from the country that has a
       comparative advantage in producing it
          • That country’s industries respond by producing more of that good
            and less of other goods
          • Countries naturally move toward specializing in those goods in
            which they have a comparative advantage
• Conclusion applies even beyond simple example we’ve
  been considering
     – Applies when there are many countries and many goods
     – Applies when countries use a variety of resources to produce
       goods, rather than just labor

Hall & Leiberman;                                                              10
Economics: Principles
          Some Important Provisos
•   Following real-world considerations can lead to reduced trade or
    incomplete specialization
     – Costs of Trading
          • If there are high transportation costs or high costs of making deals across
            national boundaries
                – Trade may be reduced and even become prohibitively expensive
     – Sizes of Countries
          • Sometimes a very large country trades with a very small one
                – If the smaller country specialized completely, its output would be insufficient to
                  fully meet demand of the larger one
     – Increasing Opportunity Cost
          • Have assumed opportunity cost remains constant as production changes
          • More typically, opportunity cost of a good rises as more of it is produced
          • In the end, while trading will occur, there will not be complete specialization
     – Government Barriers to Trade

Hall & Leiberman;                                                                                      11
Economics: Principles
         The Sources of Comparative
• What determines comparative advantage in the
  first place?
     – A country that has relatively large amounts of a
       particular resource at its disposal
          • Will tend to have a comparative advantage in goods that
            make heavy use of that resource
• Countries often develop strong comparative
  advantage in the goods they have produced in
  the past
     – Regardless of why they initially began producing
       those goods
Hall & Leiberman;                                                     12
Economics: Principles
  Why Some People Object to Free
• Given the clear benefits that nations can derive
  by specializing and trading
     – Why would anyone ever object to free international
• Despite benefit to nation as a whole, some
  groups within the country, in short-run, are likely
  to lose from free trade
     – Even while others gain a great deal more
• Instead of finding ways to compensate the losers
     – Often allow them to block free-trade policies
Hall & Leiberman;                                           13
Economics: Principles
    Figure 1: The Impact of Trade
                   China                                   United States
  Price                                         Price
(Dollars)                                     (Dollars)              Supply

                                                    $500         F
                                                           C             D
   $350                                             $350
               A               B                               Imports
   $250                                                                       Demand
                                      Thousand                                Thousands
                  200 300              s of Suits             250 310            of Suits
               150                    per Month            160                 per Month

 Hall & Leiberman;                                                                      14
 Economics: Principles
           The Impact of Trade in the
          Exporting/Importing Country
• When opening of trade results in increased
  exports of a good
     – Producers of the good are made better off
     – Consumers of the good in exporting country will be
       made worse off
• When opening of trade results in increased
  imports of a product
     – Domestic producers of the product are made worse
     – Consumers of the good in importing country are better
Hall & Leiberman;                                           15
Economics: Principles
    Attitudes and Influence on Trade
      Policy: The Anti-Trade Bias
• Distribution of gains and losses create a
  policy-bias against free trade
     – Those who benefit from trade in a specific
       product either have little incentive to lobby for
       it (consumers of imports)
          • Or have limited power to influence policy
            (producers of exports)
     – But one constituency harmed by trade has
       both a powerful incentive to lobby and ability
       to influence policy
          • Domestic producers threatened by imports
Hall & Leiberman;                                       16
Economics: Principles
    Attitudes and Influence on Trade
      Policy: The Anti-Trade Bias
• Antidotes to this policy bias
     – Multilateral Agreements
          • Two or more countries agree to trade freely in many goods—
            or even all goods—simultaneously
     – World Trade Organization
          • By setting standards for acceptable and unacceptable trade
            restrictions, and making rulings in specific cases, WTO has
            some power to influence nations’ trade policies
     – Industries as Consumers
          • Term can apply to any buyer of a product, including a firm
            that uses it as an input

Hall & Leiberman;                                                         17
Economics: Principles
    Figure 2: The Effect of a Tariff on
                   China                                United States
  Price                                       Price
(Dollars)                                   (Dollars)                   Supply

                                                             K      L
                                                        C    Imports      D
   $350                                         $350
               A    Exports        B
                   H          J

                           Demand                                             Demand

               150         250300      Thousand          160 205   280  Thousands
                                        s of Suits                         of Suits
                  175                  per Month                     310 per Month

 Hall & Leiberman;                                                                18
 Economics: Principles
    How Free Trade Is Restricted
• When government decides to accommodate
  opponents of free trade
     – It is apt to use tariffs or quotes to restrict trade
• Tariffs
     – Tax on imported goods
          • Can be a fixed dollar amount per physical unit or a
            percentage of good’s value
          • In either case, effect in tariff-imposing country is similar
                – Both countries, as a whole, are worse off
                    » Tariffs reduce volume of trade and raise domestic prices of
                      imported goods
                    » In the country that imposes the tariff, producers gain and
                      consumers lose
                    » World as a whole loses, because tariffs decrease volume
                      of trade and therefore decrease gains from trade
Hall & Leiberman;                                                              19
Economics: Principles
        How Free Trade Is Restricted
• Quotas
     – Government decree limiting imports of a good to a
       specified maximum physical quantity
     – Because goal is to restrict imports, a quota is set
       below the level of imports that would occur under free
     – General effects are same as a tariff
          • Reduce quantity of imports and raise domestic prices
• While both tariffs and quotas help domestic
     – They reduce benefits of trade to the nation as a whole
• However, a tariff has one saving grace
     – Increased government revenue
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Economics: Principles
•   Groups who suffer from trade with other nations have developed a
    number of arguments against free trade
     – Together, these arguments form a position known as protectionism
          • Belief that a nation’s industries should be protected from free trade with
            other nations
•   Myths about international trade
     – A high-wage country cannot afford free trade with a low-wage country
          • High-wage country will either be undersold in everything and lose all of its
            industries, or else its workers will have to accept equally low wages and
            equally low living standards
     – Low-productivity country cannot afford free trade with a high-productivity
          • Former will be clobbered by latter and lose all of its industries
     – In recent times, America’s unskilled workers have suffered because of
       ever-expanding trade between United States and other countries

Hall & Leiberman;                                                                          21
Economics: Principles
         Sophisticated Arguments for
•   Strategic trade policy and support for infant industries are
•   Opponents stress three problems
     – Once government assistance to an industry is accepted
          • Special interest groups of all kinds will lobby to get the assistance
                – Whether it benefits general public or not
     – When one country provides assistance to an industry by keeping out
       foreign goods, other nations may respond in kind
          • If they respond with tariffs and quotas of their own, result is a shrinking
            volume of world trade and falling living standards
          • If subsidies are used to support a strategic industry, and another country
            responds with its own subsidies, then both governments lose revenue
                – Neither gains the sought-after profits
     – Strategic trade policy assumes that government has information to
       determine which industries, infant or otherwise, are truly strategic and
       which are not
Hall & Leiberman;                                                                         22
Economics: Principles
         Sophisticated Arguments for
• Arguments help to remind us of conditions under
  which free trade is most beneficial to a nation
     – Production is most likely to reflect principle of
       comparative advantage
          • When firms can obtain funds for investment projects
          • When they can freely enter industries that are profitable
     – Thus, free trade, without government intervention,
       works best when markets are working well
• May partly explain why United States has for
  decades been among the strongest supporters
  of free trade ideal
Hall & Leiberman;                                                       23
Economics: Principles
  Protectionism in the United States
• U.S. consumers have suffered and U.S. producers have
  gained, from some persistent barriers to trade
• Protection is costly
• In some cases, cost per job saved is staggering
• In addition to the dozens of industries in U.S.
  permanently protected from foreign competition
     – Dozens more each year are granted temporary protection when
       the U.S. government finds a foreign producer or industry guilty of
          • Selling their products in U.S. at “unfairly” low prices that harm a U.S.
     – Most economists believe that these low prices are most often the
       result of comparative advantage
          • U.S. as a whole would gain from importing the good
Hall & Leiberman;                                                                 24
Economics: Principles
 Using the Theory: The U.S. Sugar
• United States has protected U.S. sugar producers from
  foreign competition since 1930s
     – Since 1980s protection has been provided in the form of a price
          • If U.S. sugar prices fall below 22¢, government will buy the sugar at
            that price
• May not sound like a lot
     – But in the rest of the world, people and businesses can buy
       sugar for a lot less
• Government decides how much foreign sugar it will allow
  in each year free of any tariff
     – All sugar beyond the allowed amount faces a heavy tariff of
       about 16¢ a pound
• Sugar producers benefit
     – Sugar consumers are hurt substantially
Hall & Leiberman;                                                              25
Economics: Principles
 Using the Theory: The U.S. Sugar
• Taxpayers pay a cost for the sugar quota
     – Because as part of its price support program, U.S.
       government must occasionally buy excess sugar from
• Hurts the poorest countries in the world that rely
  on sugar as an important source of export
     – Sugar quota’s harm to these countries has been
       estimated at about $1.5 billion per year
• Why do we bear these costs?
     – Because of lobbying by groups who enjoy highly
       concentrated benefits
Hall & Leiberman;                                       26
Economics: Principles

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