Comparative Advantage and the Gains from International Trade

Chapter 8

Relative Importance of International Trade to US Economy

YEAR GDP(mill) EX +IM (mill)X M/GDP1970 993 125 12.61975 1,549 283 18.31980 2,632 654 24.81990 5,463 1,379 25.21995 7,265 1,691 23.32000 9,810.20 1,999 20.42005 12,915.60 $3,492 27.02009 14,463.40 3,766 20.42010 14,581.70 4,364 292011 14,887.50 4,764 32

1. Why Do Nations Trade?

Trade is a means of getting some vital resources (Chromium-for surgical instruments )

Trade helps nations to focus on what do best (Brazilian coffee, American airplanes; Saudi Arabian oil; Cuban cigars, etc. )

Trade increases total world production and consumption due to specialization

2. The Law of Comparative Advantage

Trade is based on the concept of comparative advantage.“The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing the good.”

3. Why Trade?

There are mutual gains from tradeTrade increases total world

production and consumptionTrade improves the standard of

living of trading partnersTrade helps the transfer of technical

know-how

4. Determinants of International Trade

The world price of goodsThe domestic price of goods; or simply, The difference in the relative price of one

good in terms of another => comparative advantage

If the world price > the domestic price, then producers have the incentive to export the good.

If the world price< the domestic price, then consumers will import the good from abroad

5. Equilibrium without Trade

Assume:A country that is isolated from rest of the

world and produces steel.The market for steel consists of the

buyers and sellers of the country.Suppose the country is Korea.Show the Consumer Surplus, Producer

Surplus, and the Total Surplus before trade.

5. Equilibrium Without Trade

DomesticSupply

Domestic Demand

Quantity

Pri

ceSteel Market

Consumer Surplus

Producer SurplusPe

Qe

5. Equilibrium without Trade

Domestic Price adjusts to balance Demand and Supply.

The sum of consumer and producer surplus measures the total benefits.

5a. The welfare effect of trade on an exporter of steel-KoreaIf a country has a comparative

advantage, its domestic price will be below the world price, and it will be an exporter of the good.

If other countries (the rest of the world) have a comparative advantage, then the domestic price in a given country will be higher than the world price and it will be an importer of the good.

5a. International Trade Example – ExporterDomestic

Supply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

PD

QD

5a. International Trade Example - ExporterDomestic

Supply

Domestic Demand

Quantity

Pri

ceSteel Market

World PricePrice w/trade

QD QS

Exports

5a. International Trade Example - Exporter

When an exporter sells on the world market, its price rises to the world price.

At the world price, there is an excess supply. Domestic producers produce more than domestic buyers want to buy at that price.

The excess supply is exported.

5a. International Trade Example - ExporterDomestic

Supply

Domestic Demand

Quantity

Pri

ceSteel Market

World PricePrice w/trade

ExportsA

B

C

D

5a. International Trade Example - Exporter

BeforeTrade

AfterTrade

ConsumerSurplus

A+B A

ProducerSurplus

C B+C+D

TotalSurplus

A+B+C A+B+C+D

5a. Gains and Losses From Trade of an exporter-KoreaDomestic consumers of the exported

good may be worse off from trade. Consumer surplus declined from A+B to A.

Domestic producers of the exported good will be better off as a result of trade. Producer surplus increased from C to B+C+D.

Collectively, the exporting country is better off. Total surplus increased from A+B+C to A+B+C+D.

5b. International Trade Example – Importer-US

When the domestic price is higher than the world price and the country will be an importer of the good.

5b. International Trade Example - Importer-US

DomesticSupply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

PD

QD

5b. International Trade Example - Importer-US

DomesticSupply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

QDQS

Quantity Imported

5b. International Trade Example - Importer-US

When US buys on the world market its price falls to the world price.

At the world price, there is an excess demand. Domestic producers produce less than domestic consumers want to buy at that price.

The excess demand is imported.

5b. International Trade Example - Importer-US

DomesticSupply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

QDQS

PD

A

B

C

D

imports

5b. International Trade Example - Importer.

BeforeTrade

AfterTrade

ConsumerSurplus

A A+B+D

ProducerSurplus

B+C C

TotalSurplus

A+B+C A+B+C+D

5b. Gains and Losses From TradeDomestic consumers of the imported

good will be better off from trade. Consumer surplus increased from A to A+B+D.

Domestic producers of the imported good will be worse off as a result of trade. Producer surplus decreased from B+C to C.

Collectively, the importing country is better off. Total surplus increased from A+B+C to A+B+C+D.

6. Barriers to Trade

a.Tariffs

A tariff [is] a tax on imported goods

[HO, p. 238]

6a. Examples of U.S. Tariffs

Brooms 32 cents eachFishing reels 24 cents eachElectrical motors 2.4% of value Automobiles 2.9% of value Bicycles 5.5% of value

a. Examples of U.S. Tariffs

tariff code product amount 2202.9 chocolate

milk 19.5 cents per liter

2203.0 beer made from malt

1.4 cents per plus $16 per bbl excise tax

2204.2 wine of fresh grapes in bottles < 2 liters which is effervescent

29 cents per liter plus $1.07 per gallon excise tax (under 14 proof)

a. The Impact of a Tariff

Suppose the government imposes a tariff on imported steel.

Recall from Chapter 4 that a tax raises prices consumers pay. Consumers buy less of the good. Consumer surplus declines.

a. The Impact of a Tariff

A tariff reduces the price that exporting producers receive for their products and the quantity they sell.

In this case, the tariff raises the price for domestic producers which import the product allowing them to increase their output.

Consumer surplus falls, producer surplus rises.

a.The Welfare Effects of a TariffDomestic

Supply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

Tariff

}

a.The Welfare Effects of a TariffDomestic

Supply

Domestic Demand

Quantity

Pri

ceSteel Market

World Price

Tariff

}

a. The Welfare Effects of a Tariff

The net effect of the tariff is that total surplus declines.

Like the taxes considered in Chap. 4, there is a deadweight loss resulting from the imposition of the tariff.

b. Quotas

An import quota [is] a limit on the quantity of an imported good [HO, p.

251]

Examples: Quota on sugar import; Quota on lumber import; Quota on steel import

b. Impact of an Import Quota

The import quota restricts supply with the result that the domestic price increases.

At the higher price, domestic consumers buy less. Consumer surplus declines.

At the higher price, domestic producers increase production and producer surplus increases.

6b. Impact of an Import Quota

Just as in the case of the tariff, import quotas result in a deadweight loss (perhaps even greater loss).

One important difference in the impacts of tariffs and quotas is that there is a transfer of income (consumer surplus) from consumers to the holders of import quota license holders.

7.Tariffs Versus Quotas

In the case of tariffs, some of the increased revenues go to the government of the importing country. Governments have always regarded tariffs as a legitimate means of raising tax revenues.

Tariffs impose the highest penalty on the least efficient foreign producers. Quotas, on the other hand, do not guarantee that result.

8. Arguments Against Free Trade (Protectionism)

The Jobs Loss argument (saving jobs) –NAFTA as ”Giant sucking sound,” - Ross Perot 1994 election.

The National Security Argument – Be selective of exports.

The Infant Industry Argument (HDTV)The Unfair-Competition Argument -

Retaliate against those who restrict their own trade.

Antidumping - Dumping is selling a product below its cost of production in another country.

9. Has NAFTA been a Success or a Failure?

NAFTA is A trilateral trade which increased US exports to Mexico by 90% and Mexican exports to US by 140% (1994-2000)

Mexico lowered duties on US exports to 1.6% from 10%. US lowered duties on Mexican goods from 4% to .4% (1994-2000)

US exports to Canada increased by 55% and US imports from Canada increased by 56%

There are arguments about job losses in the US, Canada, and Mexico, however.

10a. General Agreements on Tariffs and Trade (GATT)

First signed in 1947 among 10 countries Designed to provide an international

forum that would encourage free trade by:

-regulating and reducing tariffs -providing a common mechanism for resolving disputes - environmental, intellectual property rights, subsidies, etc.

10b. World Trade Organization (WTO)

An international organization dealing with rules of trade among nations

Created in 1995 by the Uruguay round of negotiations (86-94) by 146 countries

Functions are: Administering trade agreements Providing forum for trade negotiations Monitoring national trade policies Handling trade disputes Giving technical assistance and training for

developing countries to improve trade relations