2 2 International Trade and Comparative Advantage No nation was ever ruined by trade. BENJAMIN FRANKLIN International Trade and Comparative Advantage No nation was ever ruined by trade. BENJAMIN FRANKLIN

●Why Trade? ●International versus Intranational Trade ●The Law of Comparative Advantage ●Tariffs, Quotas, and Other Interferences with Trade ●Guest Lecture: Turkey's Comparative Advantage in Trade ●Why Trade? ●International versus Intranational Trade ●The Law of Comparative Advantage ●Tariffs, Quotas, and Other Interferences with Trade ●Guest Lecture: Turkey's Comparative Advantage in Trade Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why Trade? ●Reasons countries benefit from foreign trade ♦They can import resources they lack at home. ♦They can import goods for which they are a relatively inefficient producer. ♦Specialization sometimes permits economies of large-scale production. ●Reasons countries benefit from foreign trade ♦They can import resources they lack at home. ♦They can import goods for which they are a relatively inefficient producer. ♦Specialization sometimes permits economies of large-scale production.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Mutual Gains from Trade ♦When trade is voluntary: ■Both sides must expect to gain from it ■Otherwise, they would not trade ●Mutual Gains from Trade ♦When trade is voluntary: ■Both sides must expect to gain from it ■Otherwise, they would not trade Why Trade?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Why international trade is studied separately: ♦Countries are governed by separate governments ♦International trade involves the exchange of national currencies ♦Labor and capital are less mobile internationally than they typically are within a country ●Why international trade is studied separately: ♦Countries are governed by separate governments ♦International trade involves the exchange of national currencies ♦Labor and capital are less mobile internationally than they typically are within a country International versus Intranational Trade

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Absolute Advantage ●One country has an absolute advantage over another in the production of a particular good if it can produce that good using smaller quantities of resources than can the other country.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●One country has a comparative advantage over another in the production of a particular good if it produces that good less inefficiently than the other country. ●Less inefficiently = with lower opportunity costs ●One country has a comparative advantage over another in the production of a particular good if it produces that good less inefficiently than the other country. ●Less inefficiently = with lower opportunity costs The Law of Comparative Advantage

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Law of Comparative Advantage ●The law of comparative advantage applies even if one country is at an absolute disadvantage relative to another country in the production of every good. ●Both countries gain from trade even if one of them is more efficient than the other in producing everything. ●The law of comparative advantage applies even if one country is at an absolute disadvantage relative to another country in the production of every good. ●Both countries gain from trade even if one of them is more efficient than the other in producing everything.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Law of Comparative Advantage ●The Arithmetic of Comparative Advantage ♦When countries differ in the relative efficiency with which they produce different goods: ■Both world output and the welfare of each country can be increased if: ●Each country specializes in producing the goods for which it has a relative advantage; ●And then trades with the other. ●The Arithmetic of Comparative Advantage ♦When countries differ in the relative efficiency with which they produce different goods: ■Both world output and the welfare of each country can be increased if: ●Each country specializes in producing the goods for which it has a relative advantage; ●And then trades with the other.

TABLE 2: Alternative Outputs from One Year of Labor Input Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Gains from Trade: An Example Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Table 3 Example of the Gains from Trade U.S.JapanTotal Computers + 25− Televisions − ●Suppose U.S. produce only Televisions ♦Then there are 50 made ●And Japan only produces Computers ♦So there is a total of 10 ●Now they reallocate production: ♦U.S. produce 25 TVs and 25 PCs ♦Japan produces 40 TVs and 0 PCs ●What happens with total production? ●Suppose U.S. produce only Televisions ♦Then there are 50 made ●And Japan only produces Computers ♦So there is a total of 10 ●Now they reallocate production: ♦U.S. produce 25 TVs and 25 PCs ♦Japan produces 40 TVs and 0 PCs ●What happens with total production?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Calculating Opportunity Costs for U.S. ●Suppose U.S. produce only TVs ♦If so, they produce 50 ●Now they want 1 PC ●How many televisions must give up producing? ♦Exactly 1, so now produce 1 PC and 49 TVs ●Costs of making 1 PC is 1 TV that we don’t produce – that’s opportunity costs! ●Suppose U.S. produce only TVs ♦If so, they produce 50 ●Now they want 1 PC ●How many televisions must give up producing? ♦Exactly 1, so now produce 1 PC and 49 TVs ●Costs of making 1 PC is 1 TV that we don’t produce – that’s opportunity costs!

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Calculating Opportunity Costs for Japan ●Suppose Japan produces only TVs ♦If so, they produce 40 ●Now they want 1 PC ●How many TVs must give up producing? ♦4, so now produce 36 TVs and 1 PC ●Costs of making 1 PC is 4 TV sets they do not produce – that’s opportunity costs! ●Suppose Japan produces only TVs ♦If so, they produce 40 ●Now they want 1 PC ●How many TVs must give up producing? ♦4, so now produce 36 TVs and 1 PC ●Costs of making 1 PC is 4 TV sets they do not produce – that’s opportunity costs!

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Opportunity Costs Computed Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Table 4 Opportunity Costs U.S.Japan Computers 1 unit of TVs 4 units of TVs Televisions 1 unit of PCs¼ units of PCs

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Exchange Price ●What (relative) price will prevail? ♦Need a more complicated model to answer ♦But can say something here! ●Let p be the relative price of PCs ♦If p < 1, U.S. won’t sell PCs ♦If p > 4, Japan won’t buy PCs ●So p is between 1 and 4 ●Assume p =2 ●What (relative) price will prevail? ♦Need a more complicated model to answer ♦But can say something here! ●Let p be the relative price of PCs ♦If p < 1, U.S. won’t sell PCs ♦If p > 4, Japan won’t buy PCs ●So p is between 1 and 4 ●Assume p =2

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Law of Comparative Advantage ●The Graphics of Comparative Advantage ♦Production possibilities frontiers for two countries can show: ■Different opportunity costs ■The potential gains from trade ●The Graphics of Comparative Advantage ♦Production possibilities frontiers for two countries can show: ■Different opportunity costs ■The potential gains from trade

FIGURE 1: Per-Capita PPFs for Two Countries Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 60 U.S. production possibilities frontier SN J Japanese production possibilities frontier Television Sets (millions) Computers (millions) U

FIGURE 2: The Gains from Trade Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 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 D

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tariffs, Quotas, and Other Interferences with Trade ●Countries can reduce imports by setting tariffs or quotas. ♦Tariff – like a per-unit tax on the good traded ♦Quota – limit on the quantity traded ●They can promote exports by subsidizing export goods. ●Countries can reduce imports by setting tariffs or quotas. ♦Tariff – like a per-unit tax on the good traded ♦Quota – limit on the quantity traded ●They can promote exports by subsidizing export goods.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Reasons why countries may restrict trade: ♦Gain a price advantage ♦Protect particular industries (infant industry argument) ♦National defense and other non-economic reasons ●Reasons why countries may restrict trade: ♦Gain a price advantage ♦Protect particular industries (infant industry argument) ♦National defense and other non-economic reasons Why Inhibit Trade?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. TABLE 4: Estimated Costs of Protectionism to Consumers Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Trade is Beneficial ●Under most circumstances, international trade enhances our standard of living. ●There are always winners and losers ♦But winners usually win more than losers lose ●So trade is beneficial ●Under most circumstances, international trade enhances our standard of living. ●There are always winners and losers ♦But winners usually win more than losers lose ●So trade is beneficial

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The End ???