Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 33 The Gains from International Trade

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Explain why the gains from trade depend on the pattern of comparative advantage. 2. Describe the effects of factor endowments and climate on a country’s comparative advantage. 4. Describe some of the reasons why countries export certain goods and import others. 3. Explain the relationship between the law of one price and trade patterns.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.1 The Growth in World Trade, 1950–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.2 U.S. Exports and Imports of Goods by Industry, 2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Interpersonal, Interregional, and International Trade Without trade, people must be self-sufficient. With trade, people can specialize efficiently and satisfy other needs by trading. This basic principle is true for individuals, regions, and countries:  the gains from trade The Gains from Trade

Copyright © 2008 Pearson Addison-Wesley. All rights reserved One country has an absolute advantage in the production of a specific product if, relative to another country, it can produce one unit of the product using fewer resources. Illustrating the Gains from Trade Table 33.1 Absolute Costs and Absolute Advantage

Copyright © 2008 Pearson Addison-Wesley. All rights reserved One country has a comparative advantage in the production of a specific product if, relative to another country, its opportunity cost for producing the product is lower. Table 33.2 Opportunity Costs and Comparative Advantage

Copyright © 2008 Pearson Addison-Wesley. All rights reserved World production of all products can be increased if each country specializes in producing the goods for which it has a comparative advantage. Table 33.3 The Gains from Specialization

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.3 The Gains from Trade with Constant Opportunity Costs Canada specializes in wheat, the EU specializes in cloth.  consumption possibilities increase in both countries

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Conclusions about Gains from Trade 1.If Country A has a comparative advantage in one product then it must have a comparative disadvantage in another. 2. The opportunity cost of one product is not its absolute cost, but the amount of output of other products that must be sacrificed. 3. When opportunity costs are the same in all countries, there are no gains from specialization and trade. 4. When opportunity costs differ across both countries, global production can be increased by reallocating resources.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved EXTENSIONS IN THEORY 33.1 The Gains from Trade Without Complete Specialization Gains from Trade Without Complete Specialization

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Gains from Trade with Variable Costs Additional gains from trade may be possible: Economies of scale: International trade allows small countries to produce high enough levels of output to reap the available scale economies. Learning by doing: Costs may fall as production experience increases.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.4 Economics of Scale versus Learning by Doing Scale economies are shown by the downward sloping LRAC curve. Learning by doing implies that LRAC curves shift down as experience increases.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Sources of Comparative Advantage Factor endowments. Countries have the CA in products that use their abundant resources relatively intensively. Climate. Variation in national climates affects comparative advantages. Climate can be considered a “special” factor of production. Acquired. Comparative advantage can be acquired or lost over time. It is a dynamic concept.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Contrasting Views The traditional view: A government should encourage specialization of production in goods for which it currently has a comparative advantage. each country should specialize in a relatively narrow range of distinct products. The modern view: If comparative advantage can be acquired, it can also be lost. each country should innovate and adopt the latest technologies

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Determination of Trade Patterns The Law of One Price - when an easily transported product is internationally traded, arbitrage guarantees a single world price Compare the world price with the U.S. domestic price: 1. If p w > p d  U.S. exports the product 2. If p w < p d  U.S. imports the product

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.5 An Exported Good Countries export goods whose world price exceeds the domestic price.  Countries export the goods for which they are low-cost producers.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.6 An Imported Good Countries import products whose world price is less than the domestic price.  Countries import goods for which they are high-cost producers.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Is Comparative Advantage Obsolete? The theory that comparative advantage determines trade flows is not obsolete. But the idea that comparative advantage is completely determined by forces beyond the reach of public policy has been discredited. Although governments may influence patterns of comparative advantage, it is not necessarily advisable: - compare the costs of trade-related policies with their likely benefits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The division of the gains from trade depends on the terms of trade. The terms of trade are measured by the ratio of the price of exports to the price of imports. The Terms of Trade Terms of Trade = Index of Export Prices Index of Import Prices x 100

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.7 A Change in the Terms of Trade

Copyright © 2008 Pearson Addison-Wesley. All rights reserved A rise in the index:  country gets more imports per unit of exports  a favorable change for the country A fall in the index:  country gets fewer imports per unit of exports  an unfavorable change for the country A Change in the Terms of Trade

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 33.8 U.S. Terms of Trade, 1961–2006