11 International Trade and Comparative Advantage

●Why Trade? ●International versus Intranational Trade ●The Law of Comparative Advantage ●Why Trade? ●International versus Intranational Trade ●The Law of Comparative Advantage Outline

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Puzzle: How Can Americans Compete with “Cheap Foreign Labor”? ●Why do Americans want government to limit or prevent import-competition? ♦Common belief that imports ↓ U.S. jobs and wages. ♦“Cheap foreign L” steals jobs from U.S. L and puts pressure on U.S. firms to cut wages. ●Why do Americans want government to limit or prevent import-competition? ♦Common belief that imports ↓ U.S. jobs and wages. ♦“Cheap foreign L” steals jobs from U.S. L and puts pressure on U.S. firms to cut wages.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. “Cheap Foreign Labor” ●Empirical evidence doesn’t support this view. ♦↑wages in industrialized countries that X to U.S. over past 30 years. ♦Wages in Britain rose from ½ U.S. standards to above U.S. levels. ♦Wages in South Korea have dramatically increased from just 5% of U.S. wages to nearly 60% –all during a time when X of textiles, toys, and consumer electronics soared. ♦Clearly, cheap L abroad does not explain our ↑ trade deficit. ●Empirical evidence doesn’t support this view. ♦↑wages in industrialized countries that X to U.S. over past 30 years. ♦Wages in Britain rose from ½ U.S. standards to above U.S. levels. ♦Wages in South Korea have dramatically increased from just 5% of U.S. wages to nearly 60% –all during a time when X of textiles, toys, and consumer electronics soared. ♦Clearly, cheap L abroad does not explain our ↑ trade deficit.

TABLE 1. Labor Costs in Industrialized Countries France73%104% United Kingdom54109 Spain4175 Japan4892 South Korea557 Taiwan627 Mexico2411 Canada99101 Note: Labor costs in industrialized countries as a percentage of U.S. Labor Costs

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Trade? ●Differences in resources ♦U.S. can produce coal and wheat but relies on rest of the world for rubber and oil. ♦Saudi Arabia has poor farming T but sits on a massive pool of oil. ●Differences in climate ♦Bananas and coffee are more efficiently grown in Latin America. ●Differences in resources ♦U.S. can produce coal and wheat but relies on rest of the world for rubber and oil. ♦Saudi Arabia has poor farming T but sits on a massive pool of oil. ●Differences in climate ♦Bananas and coffee are more efficiently grown in Latin America.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Trade? ●Differences in labor skills ♦New Zealand has skilled sheep farmers, while Singapore has skilled manufacturing workers. ●Economies of Scale ♦Small country that tried to produce everything for itself would end up with many industries whose scale of operation was too small to benefit from mass-scale production techniques. ♦Argentina does not have enough domestic consumers to support 1 efficient scale automobile producer. ●Differences in labor skills ♦New Zealand has skilled sheep farmers, while Singapore has skilled manufacturing workers. ●Economies of Scale ♦Small country that tried to produce everything for itself would end up with many industries whose scale of operation was too small to benefit from mass-scale production techniques. ♦Argentina does not have enough domestic consumers to support 1 efficient scale automobile producer.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Late 1700s, Adam Smith and David Ricardo argued that 2 countries must gain from voluntary exchange. If not, they would refuse to trade. ●Exchange of goods ↑ welfare of two parties, even though no goods are created in the act of trading. ♦U.S. and Mexico are both better off if Mexico ships fruits and vegetables in exchange for telecommunications equipment. ●Late 1700s, Adam Smith and David Ricardo argued that 2 countries must gain from voluntary exchange. If not, they would refuse to trade. ●Exchange of goods ↑ welfare of two parties, even though no goods are created in the act of trading. ♦U.S. and Mexico are both better off if Mexico ships fruits and vegetables in exchange for telecommunications equipment. Mutual Gains from Trade

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●50 states in U.S. with no trade barriers shows the incredible gains from specialization and trade. ♦California –movies and computer chips ♦Wisconsin –beer and cheese ♦Michigan –cars ♦Nebraska –corn ♦Florida –oranges ♦New York –financial services ●Your standard of living would be much lower if you were only allowed to purchase goods made in CA. ●50 states in U.S. with no trade barriers shows the incredible gains from specialization and trade. ♦California –movies and computer chips ♦Wisconsin –beer and cheese ♦Michigan –cars ♦Nebraska –corn ♦Florida –oranges ♦New York –financial services ●Your standard of living would be much lower if you were only allowed to purchase goods made in CA. Intranational Trade

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Political factors ♦Domestic trade occurs under one government. ♦U.S. Constitution prohibits trade restrictions across states. ●Many currencies ♦Trade in U.S. (or EU) is carried out with same currency. ●Restrictions on L and K mobility ♦No immigration laws restrict flow of L across state borders. ♦Many countries have laws that restrict foreign ownership of domestic assets. ♦K invested abroad faces greater risks of expropriation. ●Political factors ♦Domestic trade occurs under one government. ♦U.S. Constitution prohibits trade restrictions across states. ●Many currencies ♦Trade in U.S. (or EU) is carried out with same currency. ●Restrictions on L and K mobility ♦No immigration laws restrict flow of L across state borders. ♦Many countries have laws that restrict foreign ownership of domestic assets. ♦K invested abroad faces greater risks of expropriation. International versus Intranational Trade

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Law of Comparative Advantage ●Gains from trade are obvious when 1 country is better at producing 1 good and its trading partner is better at producing another. ♦U.S. X aircraft to Columbia in exchange for coffee. ♦U.S. has more K equipment and experience with aircraft production and Columbia has cheaper L and a warmer climate. ♦U.S. has an absolute advantage in aircraft production and Columbia has an absolute advantage in coffee production. ●Gains from trade are obvious when 1 country is better at producing 1 good and its trading partner is better at producing another. ♦U.S. X aircraft to Columbia in exchange for coffee. ♦U.S. has more K equipment and experience with aircraft production and Columbia has cheaper L and a warmer climate. ♦U.S. has an absolute advantage in aircraft production and Columbia has an absolute advantage in coffee production.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Law of Comparative Advantage ●Less obvious: if 1 country is better at producing everything, then 2 countries can gain from trade. ♦E.g., Top neurosurgeon who is the best car mechanic. Should she repair her own car? No! Even though she’s a better car mechanic, she should concentrate on surgery and leave car repair to a lower skilled (and lesser paid) auto mechanic. Opportunity cost of 1 hour devoted to car repair is 1 less hour spent in brain surgery which is higher paying. ●Comparative advantage is at work here. Surgeon specializes in medicine despite her absolute advantage in car repair because she has an even greater absolute advantage as a doctor. ●Less obvious: if 1 country is better at producing everything, then 2 countries can gain from trade. ♦E.g., Top neurosurgeon who is the best car mechanic. Should she repair her own car? No! Even though she’s a better car mechanic, she should concentrate on surgery and leave car repair to a lower skilled (and lesser paid) auto mechanic. Opportunity cost of 1 hour devoted to car repair is 1 less hour spent in brain surgery which is higher paying. ●Comparative advantage is at work here. Surgeon specializes in medicine despite her absolute advantage in car repair because she has an even greater absolute advantage as a doctor.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Law of comparative advantage: even if one country is worse at producing every good, relative to another country, it has a comparative advantage in making the good at which it is the least inefficient. ●A country can gain importing a good, even if that good could be produced at home more efficiently than it could be produced abroad. These imports allow the country to specialize in goods at which it is even more efficient. ●Law of comparative advantage: even if one country is worse at producing every good, relative to another country, it has a comparative advantage in making the good at which it is the least inefficient. ●A country can gain importing a good, even if that good could be produced at home more efficiently than it could be produced abroad. These imports allow the country to specialize in goods at which it is even more efficient. The Law of Comparative Advantage

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Arithmetic of Comparative Advantage ●Trade Model: 2 countries –U.S. and Japan; 1 input –L; and 2 goods –computers and televisions ●Assume U.S. has absolute advantage in producing both goods. It still pays for U.S. to trade with Japan. ●In Table 2, U.S. has a comparative advantage in PCs and Japan has a comparative advantage in TVs. ●U.S. is 5 times more efficient in PCs and 1.25 times as efficient in TVs. ●Trade Model: 2 countries –U.S. and Japan; 1 input –L; and 2 goods –computers and televisions ●Assume U.S. has absolute advantage in producing both goods. It still pays for U.S. to trade with Japan. ●In Table 2, U.S. has a comparative advantage in PCs and Japan has a comparative advantage in TVs. ●U.S. is 5 times more efficient in PCs and 1.25 times as efficient in TVs.

TABLE 2. Alternative Outputs from One Year of Labor Input

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Graph of Comparative Advantage ●Assume U.S. and Japan have same amount of L –1 million person years. ♦Actual graph for U.S. would be even further out from Japan because U.S. has more L. Here we want to highlight the differences in L efficiency. ●Absolute advantage is shown by PPF of U.S. lies outside PPF for Japan. ♦U.S. can produce more of both goods using same amount of L. ●Assume U.S. and Japan have same amount of L –1 million person years. ♦Actual graph for U.S. would be even further out from Japan because U.S. has more L. Here we want to highlight the differences in L efficiency. ●Absolute advantage is shown by PPF of U.S. lies outside PPF for Japan. ♦U.S. can produce more of both goods using same amount of L.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Graph of Comparative Advantage ●Comparative advantage is shown by the relative slopes of PPFs. ♦Slope of PPF = ∆Y/∆X = opportunity cost of producing the good on X-axis. ♦Slope of U.S. PPF = 1 = (50/50) → U.S. must give up 1 TV to get 1 PC, so opportunity cost of 1 PC = 1 TV. ♦Slope of Japan PPF = 4 = (40/10) → Japan must give up 4 TVs to get 1 PC, so opportunity cost of 1 PC = 4 TVs. ●Because opportunity costs differ across 2 countries, it is possible for both to gain from trade. ●Comparative advantage is shown by the relative slopes of PPFs. ♦Slope of PPF = ∆Y/∆X = opportunity cost of producing the good on X-axis. ♦Slope of U.S. PPF = 1 = (50/50) → U.S. must give up 1 TV to get 1 PC, so opportunity cost of 1 PC = 1 TV. ♦Slope of Japan PPF = 4 = (40/10) → Japan must give up 4 TVs to get 1 PC, so opportunity cost of 1 PC = 4 TVs. ●Because opportunity costs differ across 2 countries, it is possible for both to gain from trade.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Graph of Comparative Advantage ●It is cheaper to purchase PCs in U.S. than in Japan. ♦U.S. → give up 1 TV to get 1 PC versus Japan → give up 4 TVS to get 1 PC. ●It is cheaper to purchase TVs in Japan than in U.S. ♦U.S. → give up 1 PC to get 1 TV versus Japan → give up 1/4 PC to get 1 TV. ●If opportunity costs are the same across 2 countries, then no gains from trade are possible. ●Gains occur because the countries are different. ●It is cheaper to purchase PCs in U.S. than in Japan. ♦U.S. → give up 1 TV to get 1 PC versus Japan → give up 4 TVS to get 1 PC. ●It is cheaper to purchase TVs in Japan than in U.S. ♦U.S. → give up 1 PC to get 1 TV versus Japan → give up 1/4 PC to get 1 TV. ●If opportunity costs are the same across 2 countries, then no gains from trade are possible. ●Gains occur because the countries are different.

FIGURE 1. Per-Capita PPFs for Two Countries 60 U.S. production possibilities frontier SN J Japanese production possibilities frontier Television Sets (millions) Computers (millions) U

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Gains From Trade ●Gains from trade depend on prices that emerge from trade. ●When trade opens: 1 TV < price of PC < 4 TVs. ♦Why? If 1 PC costs ½ of a TV → U.S. will refuse to trade. Why should U.S. give up 2 PCs to get 1 TV? ♦If 1 PC costs 5 TVs → Japan will refuse to trade. Why should Japan give up 5 TVs to get 1 PC? ●Assume traded price of 1 PC = 2 TVs. ●Gains from trade depend on prices that emerge from trade. ●When trade opens: 1 TV < price of PC < 4 TVs. ♦Why? If 1 PC costs ½ of a TV → U.S. will refuse to trade. Why should U.S. give up 2 PCs to get 1 TV? ♦If 1 PC costs 5 TVs → Japan will refuse to trade. Why should Japan give up 5 TVs to get 1 PC? ●Assume traded price of 1 PC = 2 TVs.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Gains From Trade ●We can show gains from trade graphically in Figure 2. ♦CPF with trade > PPF = CPF without trade ●Labor is twice as productive with trade: ♦U.S. gets 2 TVs for every PC (instead of 1 TV before trade). ♦Japan gets ½ PC for every TV (instead of ¼ PC before trade). ♦Thus, L in both countries has become twice as productive after trade. ●We can show gains from trade graphically in Figure 2. ♦CPF with trade > PPF = CPF without trade ●Labor is twice as productive with trade: ♦U.S. gets 2 TVs for every PC (instead of 1 TV before trade). ♦Japan gets ½ PC for every TV (instead of ¼ PC before trade). ♦Thus, L in both countries has become twice as productive after trade.

FIGURE 2. The Gains from Trade U U.S. production possibilities A U.S. consumption possibilities S 300 Television Sets Computers (b) United States Japanese production possibilities J Japanese consumption possibilities PN 300 Television Sets Computers (a) Japan

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Comparative Advantage: “Cheap Foreign Labor” ●In our example, U.S. workers are more productive than Japanese workers, so their wages must be higher (wage = MRP L ). ●U.S. workers will complain about competing with cheap Japanese L. And Japanese workers will worry about competing with productive American L. ●Law of Comparative Advantage says these fears are unfounded. ●Workers in both countries will earn higher wages after trade because of ↑ productivity from specialization. ●After trade, workers in both countries will have higher real wages and improved living standards. ●In our example, U.S. workers are more productive than Japanese workers, so their wages must be higher (wage = MRP L ). ●U.S. workers will complain about competing with cheap Japanese L. And Japanese workers will worry about competing with productive American L. ●Law of Comparative Advantage says these fears are unfounded. ●Workers in both countries will earn higher wages after trade because of ↑ productivity from specialization. ●After trade, workers in both countries will have higher real wages and improved living standards. ?