1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 33 Chapter PART VII THE WORLD ECONOMY International Trade, Comparative Advantage, and Protectionism

2. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 29 Chapter Outline 33 International Trade, Comparative Advantage, and Protectionism PART IV THE WORLD ECONOMY Trade Surpluses and Deficits The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Terms of Trade Exchange Rates The Sources of Comparative Advantage The Heckscher-Ohlin Theorem Other Explanations for Observed Trade Flows Trade Barriers: Tariffs, Export Subsidies, and Quotas Free Trade or Protection? The Case for Free Trade The Case for Protection An Economic Consensus

3. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 29 INTERNATIONAL TRADE, COMPARATIVE ADVANTAGE, AND PROTECTIONISM All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. The “internationalization” or “globalization” of the U.S. economy has occurred in the private and public sectors, in input and output markets, and in business firms and households.

4. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 29 TRADE SURPLUSES AND DEFICITS trade surplus The situation when a country exports more than it imports. trade deficit The situation when a country imports more than it exports.

5. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 29 TRADE SURPLUSES AND DEFICITS TABLE 18.1 U.S. Balance of Trade (Exports Minus Imports), 1929–2004 (Billions of Dollars) EXPORTS MINUS IMPORTS 1929 + 0.4 1986– 132.7 1933 + 0.1 1987– 148.2 1945 – 0.8 1988– 110.4 1955 + 0.5 1989– 88.2 1960 + 4.2 1990– 78.0 1965 + 5.6 1991– 27.5 1970 + 4.0 1992– 33.2 1975 + 16.0 1993– 65.0 1976 – 1.6 1994– 93.6 1977 – 23.1 1995– 91.4 1978 – 25.4 1996– 96.2 1979 – 22.5 1997– 101.6 1980 – 13.1 1998– 159.9 1981 – 12.5 1999– 260.5 1982 – 20.0 2000– 379.5 1983 – 51.7 2001– 367.0 1984 – 102.7 2002– 424.4 1985 – 115.2 2003– 500.9 2004– 624.4 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

6. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE Corn Laws The tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain. theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers. Specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

7. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE absolute advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does. comparative advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country. ABSOLUTE ADVANTAGE VERSUS COMPARATIVE ADVANTAGE

8. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE Gains from Mutual Absolute Advantage TABLE 18.2 Yield Per Acre of Wheat and Cotton NEW ZEALANDAUSTRALIA Wheat6 bushels2 bushels Cotton2 bales6 bales TABLE 18.3 Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage, and 100 Available Acres NEW ZEALANDAUSTRALIA Wheat 25 acres x 6 bushels/acre 150 bushels 75 acres x 2 bushels/acre 150 bushels Cotton 75 acres x 2 bales/acre 150 bales 25 acres x 6 bales/acre 150 bales

9. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE FIGURE 18.1 Production Possibility Frontiers for Australia and New Zealand before Trade

10. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE TABLE 18.4 Production and Consumption of Wheat and Cotton after Specialization PRODUCTIONCONSUMPTION New ZealandAustralia New Zealand Australia Wheat 100 acres x 6 bushels/acre 600 bushels 0 acres 0 300 bushels Cotton 0 acres 0 100 acres x 6 bales/acre 600 bales 300 bales

11. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE FIGURE 18.2 Expanded Possibilities after Trade Trade enables both countries to move beyond their previous resource and productivity constraints.

12. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE TABLE 18.5 Yield Per Acre of Wheat and Cotton NEW ZEALANDAUSTRALIA Wheat6 bushels1 bushel Cotton6 bales3 bales Gains from Comparative Advantage TABLE 18.6 Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres NEW ZEALANDAUSTRALIA Wheat 50 acres x 6 bushels/acre 300 bushels 75 acres x 1 bushels/acre 75 bushels Cotton 50 acres x 6 bales/acre 300 bales 25 acres x 3 bales/acre 75 bales

13. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE TABLE 18.7 Realizing a Gain from Trade When One Country Has a Double Absolute Advantage STAGE 1STAGE 2 New ZealandAustraliaNew ZealandAustralia Wheat 50 acres x 6 bushels/acre 300 bushels 0 acres 0 75 acres x 6 bushels/acre 450 bushels 0 acres 0 Cotton 50 acres x 6 bales/acre 300 bales 100 acres x 3 bales/acre 300 bales 25 acres x 6 bales/acre 150 bales 100 acres x 3 bales/acre 300 bales STAGE 3 New ZealandAustralia 100 bushels (trade) Wheat350 bushels100 bushels (after trade) 200 bales (trade) Cotton350 bales100 bales (after trade)

14. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE Why Does Ricardo’s Plan Work? When countries specialize in producing goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. FIGURE 18.3 Comparative Advantage Means Lower Opportunity Cost

15. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE TERMS OF TRADE terms of trade The ratio at which a country can trade domestic products for imported products.

16. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE EXCHANGE RATES exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms. First, for any pair of countries, there is a range of exchange rates that can lead automatically to both countries’ realizing the gains from specialization and comparative advantage. Second, within that range, the exchange rate will determine which country gains the most from trade. In short, exchange rates determine the terms of trade.

17. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE Trade and Exchange Rates in a Two- Country/Two-Good World TABLE 18.8 Domestic Prices of Timber (Per Foot) and Rolled Steel (Per Meter) in the United States and Brazil UNITED STATESBRAZIL Timber$13 Reals Rolled steel$24 Reals

18. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 29 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE TABLE 18.9 Trade Flows Determined by Exchange Rates EXCHANGE RATE PRICE OF REAL RESULT $1 = 1 R$1.00Brazil imports timber and steel $1 = 2 R.50Brazil imports timber $1 = 2.1 R.48Brazil imports timber; United States imports steel $1 = 2.9 R.34Brazil imports timber; United States imports steel $1 = 3 R.33United States imports steel $1 = 4 R.25United States imports timber and steel Exchange Rates and Comparative Advantage If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only those products in which a country has a comparative advantage will be competitive in world markets.

19. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 29 THE SOURCES OF COMPARATIVE ADVANTAGE factor endowments The quantity and quality of labor, land, and natural resources of a country. THE HECKSCHER-OHLIN THEOREM Heckscher-Ohlin theorem A theory that explains the existence of a country’s comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

20. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 29 OTHER EXPLANATIONS FOR OBSERVED TRADE FLOWS Some theories argue that comparative advantage can be acquired. Just as industries within a country differentiate their products to capture a domestic market, so too do they differentiate their products to please the wide variety of tastes that exists worldwide. This theory is consistent with the theory of comparative advantage.

21. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 29 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS protection The practice of shielding a sector of the economy from foreign competition. tariff A tax on imports. export subsidies Government payments made to domestic firms to encourage exports. dumping A firm or industry’s sale of products on the world market at prices below the cost of production. quota A limit on the quantity of imports.

22. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 29 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS Smoot-Hawley tariff The U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s. U.S. Trade Policies and GATT General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade.

23. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 29 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS economic integration Occurs when two or more nations join to form a free-trade zone. Economic Integration European Union (EU) The European trading bloc composed of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

24. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 29 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS U.S.-Canadian Free Trade Agreement An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1998. North American Free Trade Agreement (NAFTA) An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a free-trade zone.

25. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 29 FREE TRADE OR PROTECTION? THE CASE FOR FREE TRADE Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. FIGURE 18.4 The Gains from Trade and Losses from the Imposition of a Tariff

26. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 29 FREE TRADE OR PROTECTION? THE CASE FOR PROTECTION Protection Saves Jobs Some Countries Engage in Unfair Trade Practices Cheap Foreign Labor Makes Competition Unfair Protection Safeguards National Security Protection Discourages Dependency

27. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 29 FREE TRADE OR PROTECTION? Protection Safeguards Infant Industries infant industry A young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage.

28. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 29 AN ECONOMIC CONSENSUS Foreign trade and full employment can be pursued simultaneously. Although economists disagree about many things, the vast majority of them favor free trade. Critical to our study of international economics is the debate between free traders and protectionists.

29. CHAPTER 33: International Trade, Comparative Advantage, and Protectionism © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 29 absolute advantage comparative advantage Corn Laws dumping economic integration European Union (EU) exchange rate export subsidies factor endowments General Agreement on Tariffs and Trade (GATT) Heckscher-Ohlin theorem infant industry REVIEW TERMS AND CONCEPTS North American Free Trade Agreement (NAFTA) protection quota Smoot-Hawley tariff tariff terms of trade theory of comparative advantage trade deficit trade surplus U.S.-Canadian Free Trade Agreement