Comparative Advantage and the Gains from International Trade

Comparative Advantage and the Gains from International Trade Slides by: John & Pamela Hall ECONOMICS: Principles and Applications 3 e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing

Comparative Advantage and the Gains from International Trade • Consumers love bargains • Should we let these bargain goods into the country? – Do cheap foreign goods threaten the jobs of American workers and the profits of American producers? • Over the post-World War II period, there has been a worldwide movement toward a policy of free trade – In 1995 a new international body was created • World Trade Organization (WTO) 2

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 – Or is it bad and something that should be kept in check? 3

The Logic of Free Trade • Many of us like the idea of being self-reliant – But consider the defects of self-sufficiency • If you lived all by yourself, you would be poor • Defects of self-sufficiency explain why most people do not choose it • Principle applies not just to individuals, but also to groups of individuals – Such as those living within boundaries that define cities, countries, states, or nations • What would happen if residents of your state switched from a policy of open trading with other states to one of self-sufficiency – Refusing to import anything from “foreign states” or to export anything to them 4

The Logic of Free Trade • It would make no sense to insist on the economic selfsufficiency of each of the 50 states – Founders of United States placed prohibitions against tariffs, quotas, and other barriers to interstate commerce in U. S. Constitution • What is true for states is also true for entire nations – Members of WTO have carried argument to its ultimate conclusion • National specialization and exchange can expand world living standards through free international trade • Long-term goal of WTO is to remove all barriers to exports and imports – In order to encourage among nations specialization and trade that have been successful within nations 5

The Theory of Comparative Advantage • 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 • At a lower sacrifice of other goods foregone 6

Opportunity Cost and Comparative Advantage • 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 other 7

Specialization and World Production • Additional production is the kind of gain that, multiplied a million times, 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 8

How Each Nation Gains From International Trade • By trading some of its comparative advantage good for the other good, each country can consume more of both goods • As long as such benefits continue, a country can gain even greater benefits by shifting more and more of its resources toward its comparative advantage good – As long as opportunity costs differ, specialization and trade can be beneficial to all involved • Remains true regardless of whether parties are different nations, different states, different countries, or different individuals • Remains true even if one party has an all-round absolute advantage or disadvantage 9

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 – For the world as a whole, gains from international trade are due to increased production as nations specialize according to comparative advantage • How those world gains are distributed among specific countries depends on terms of trade 10

How Potential Gains Turn Into Actual Gains • Within framework of WTO, government officials are supposed to create environment for free trade – 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 direction? • Prices 11

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 12

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 13

The Sources of Comparative Advantage • 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 14

Why Some People Object to Free Trade • Given the clear benefits that nations can derive by specializing and trading – Why would anyone ever object to free international trade? • 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 15

Figure 1: The Impact of Trade 16

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 off – Consumers of the good in importing country are better off 17

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 18

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 19

Figure 2: The Effect of a Tariff on Suits 20

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 21

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 trade – General effects are same as a tariff • Reduce quantity of imports and raise domestic prices • While both tariffs and quotas help domestic producers – They reduce benefits of trade to the nation as a whole • However, a tariff has one saving grace – Increased government revenue 22

Protectionism • 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 country • 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 23

Sophisticated Arguments for Protection • Strategic trade policy and support for infant industries are controversial • 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 24

Sophisticated Arguments for Protection • 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 25

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 dumping • Selling their products in U. S. at “unfairly” low prices that harm a U. S. industry – 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 26

Using the Theory: The U. S. Sugar Quota • United States has protected U. S. sugar producers from foreign competition since 1930 s – Since 1980 s protection has been provided in the form of a price guarantee • 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 27

Using the Theory: The U. S. Sugar Quota • 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 producers • Hurts the poorest countries in the world that rely on sugar as an important source of export revenue – 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 28