Comparative Advantage and the Gains from International Trade Chapter 8

Relative Importance of International Trade to US Economy

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 trade Trade increases total world production and consumption Trade improves the standard of living of trading partners Trade helps the transfer of technical know-how

4. Determinants of International Trade The world price of goods The 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 Steel Market Domestic Supply Price Consumer Surplus Pe Producer Surplus Domestic Demand Qe Quantity

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-Korea If 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 – Exporter Steel Market Domestic Supply Price World Price PD Domestic Demand Quantity QD

5a. International Trade Example - Exporter Steel Market Domestic Supply Exports Price w/trade World Price Price Domestic Demand QD QS Quantity

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 - Exporter Steel Market Domestic Supply A Exports Price w/trade World Price D B Price C Domestic Demand Quantity

5a. International Trade Example - Exporter

5a. Gains and Losses From Trade of an exporter-Korea Domestic 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 Steel Market Domestic Supply Price PD World Price Domestic Demand Quantity QD

5b. International Trade Example - Importer-US Steel Market Domestic Supply Price Quantity Imported World Price Domestic Demand Quantity QD QS

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 Steel Market Domestic Supply Price A PD B D World Price C imports Domestic Demand Quantity QD QS

5b. International Trade Example - Importer.

5b. Gains and Losses From Trade Domestic 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 each Fishing reels 24 cents each Electrical motors 2.4% of value Automobiles 2.9% of value Bicycles 5.5% of value

a. Examples of U.S. Tariffs

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 Tariff Tariff Steel Market Price Quantity Domestic Supply Price Tariff } World Price Domestic Demand Quantity

} a.The Welfare Effects of a Tariff Tariff Steel Market Price Quantity Domestic Supply Price Tariff } World Price Domestic Demand Quantity

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