Comparative Advantage and the Gains from Trade © 2003 South-Western/Thomson Learning

The Logic of Free Trade Exports Goods and services produced domestically, but sold abroad

The Logic of Free Trade Imports Goods and services produced abroad, but consumed domestically

The Theory of Comparative Advantage Opportunity Cost and Comparative AdvantageOpportunity Cost and Comparative Advantage Specialization and World ProductionSpecialization and World Production Gains from International TradeGains from International Trade The Terms of TradeThe Terms of Trade

The Theory of Comparative Advantage Absolute Advantage The ability to produce a good using fewer resources than another country

The Theory of Comparative Advantage Comparative Advantage The ability to produce a good at a lower opportunity cost than another country

The Theory of Comparative Advantage Mutually beneficial trade between any two countries is possible when one is relatively better at producing a good than the other. Being relatively better means having the ability to produce a good at a lower opportunity cost – that is, at a lower sacrifice than other goods foregone.

Specialization and World Production If countries specialize according to comparative advantage, with the same resources the world can produce more of at least one good the world can produce more of at least one good without decreasing production of any other good.without decreasing production of any other good.

Gains from International Trade As long as opportunity costs differ, specialization and trade can be beneficial to all involved, regardless of whether the parties are nations nations statesstates countries, orcountries, or individualsindividuals even if one party has an absolute advantage or disadvantage.

The Terms of Trade Terms of Trade The ratio at which a country can trade domestically produced products for foreign-produced products

Turning Potential Gains Into Actual Gains Exchange Rate The amount of one currency that is traded for one unit of another currency

Turning Potential Gains Into Actual Gains When consumers are free to buy at the lowest prices, they will naturally buy a good from the country that has the comparative advantage.

Important Provisos Costs of TradingCosts of Trading Size of CountriesSize of Countries Increasing Opportunity CostIncreasing Opportunity Cost Government Barriers to TradeGovernment Barriers to Trade

The Sources of Comparative Advantage Countries often specialize in products based on their own particular endowments of natural resources. But natural resources are not the only basis for comparative advantage.

The Sources of Comparative Advantage Countries often develop strong comparative advantages in the goods they have produced in the past, regardless of why they began producing those goods in the first place.

Objections to Free Trade The Impact of Trade in the Exporting CountryThe Impact of Trade in the Exporting Country The Impact of Trade in the Importing CountryThe Impact of Trade in the Importing Country Attitudes Toward Free Trade: A SummaryAttitudes Toward Free Trade: A Summary

Objections to Free Trade a a aa Quantity of Suits Price (Dollars) P ' N P T Q’ 2 N 3 Demand China United States Supply Quantity of Suits Price (Dollars) P N P T Q 2 Q N Q 3 Supply Demand B A F E CD

Impact of Trade in the Exporting Country When the opening of trade results in increased exports of a good, the producers of the good are made better off and will support increased trade. Consumers of the good will be made worse off and will oppose increased trade.

Impact of Trade in the Importing Country When the opening of trade results in increased imports of a product, the domestic producers of the product are made worse off and will oppose the increased trade. Consumers are better off and will favor the increased trade.

How Free Trade Is Restricted TariffsTariffs QuotasQuotas

How Free Trade Is Restricted Tariff A tax on imports that: reduces the volume of tradereduces the volume of trade raises the domestic prices of imported goodsraises the domestic prices of imported goods

Tariffs In the country that imposes the tariff, producers gain and consumers lose: –tariffs decrease the volume of trade and –therefore decrease the gains from trade

Tariffs a a a China United States Quantity of Suits Price (Dollars) P 3 P T Supply Demand KL CD Quantity of Suits Price (Dollars) P 2 P T Supply Demand A HJ B

Quotas Quota A limit on the physical volume of imports that reduces the volume of tradereduces the volume of trade raises the domestic prices of imported goodsraises the domestic prices of imported goods

How Free Trade Is Restricted While both tariffs and quotas help domestic producers, they reduce the benefits of trade to the nation as a whole.

Protectionism Myths About Free TradeMyths About Free Trade Sophisticated Arguments for ProtectionSophisticated Arguments for Protection

Protectionism Protectionism The belief that a nation’s industries should be protected from foreign competition

Myths About Free Trade “A high-wage country cannot afford free trade with a low-wage country.”“A high-wage country cannot afford free trade with a low-wage country.” “A low-productivity country cannot afford free trade with a high-productivity country.”“A low-productivity country cannot afford free trade with a high-productivity country.” “In recent times, America’s unskilled workers have suffered because of ever- expanding international trade.”“In recent times, America’s unskilled workers have suffered because of ever- expanding international trade.”

Arguments for Protection According to strategic trade policy, a nation can gain in some circumstances by assisting certain “strategic” industries that benefit society as a whole, but that may not thrive in an environment of free trade.

Infant Industries Infant industries in developing nations need initial government assistance: Three Problems

Infant Industries 1.Special interest groups will lobby for assistance, regardless of who benefits. 2.When one country provides assistance by keeping out competing goods, others may impose tariffs and quotas. 3.Assumption is that government knows which industries are strategic and which are not.

Arguments for Protection Production is most likely to reflect the principle of comparative advantage when firms can obtain funds for investment projects and when they can freely enter industries that are profitable.