1. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-1 1 Chapter 3 Lecture - Comparative Advantage and the Gains from Trade

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-2 2 Learning Objectives Analyze numerical examples of absolute and comparative advantage. Draw a diagram showing gains from trade. Define and state the differences between the concepts of absolute advantage, comparative advantage, and competitiveness. Discuss the economic and ethical considerations of economic restructuring caused by international trade.

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-3 3 Introduction: The Gains from Trade The improvement in national welfare is known as the gains from trade

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-4 4 Historical Development of Modern Trade Theory The Mercantilists, 1500-1800 A country’s wealth is measured by its holdings of precious metals (specie). International trade is a zero sum game. (One country’s gain is the loss for the trading partner) A country should maintain a positive trade balance (that is, export more than it imports). A country with positive trade balance would increase its wealth through acquisiton of precious metals. Static view of the world economy

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-5 5 Historical Development of Modern Trade Theory Criticisms of Mercantilism –David Hume’s price-specie-flow doctrine A favorable trade balance is possible only in the short run –Adam Smith, The Wealth of Nations (1776) World’s wealth is not a fixed quantity International trade increases general level of productivity within a country as well as increases world output

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-6 6 David Hume’s Price Specie-Flow Mechanism If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level. Initially, Spain piles up gold, from the New World (mercantilism).

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-7 7 Hume’s Price Specie-Flow Mechanism If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. continued

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-8 8 Implications of Adam Smith’s Theory Access to foreign markets helps create wealth –If no nation imports, every company will be limited by the size of its home country market –Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs –Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-9 9 Why Countries Trade Price differences –If prices differ by more than transport costs Buyers in high-price country will import Sellers in low-price country will export Anybody in any country can profit by doing both: –Buying in low-price country and –Selling in high-price country –Thus, in all cases:

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-10 10 Consumer and Producer Surplus  Consumer surplus: value received by consumers in excess of the price they pay (can be measured only if the demand curve is known)  Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce (can be measured only if the supply curve is known)

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-11 11 Why Countries Trade: Supply and Demand Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB “Autarky” = No trade Autarky price in country A Autarky price in country B PBPB Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-12 12 Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp Why Countries Trade: Supply and Demand Free Trade = No barriers to trade P F is defined by these two distances being equal. Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-13 13 Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Use areas to measure gains and losses. Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-14 14 A’s demanders lose-a Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Loss of Consumer Surplus Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-15 15 A’s demanders lose-a A’s suppliers gain+(a+b) Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Gain of Producer Surplus Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-16 16 A’s demanders lose-a A’s suppliers gain+(a+b) → Country A gains+b Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-17 17 A’s demanders lose-a A’s suppliers gain+(a+b) Country A gains+b B’s demanders gain+(c+d) Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Gain of Consumer Surplus Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-18 18 A’s demanders lose-a A’s suppliers gain+(a+b) Country A gains+b B’s demanders gain+(c+d) B’s suppliers lose-c Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Loss of Producer Surplus Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-19 19 A’s demanders lose-a A’s suppliers gain+(a+b) Country A gains+b B’s demanders gain+(c+d) B’s suppliers lose-c → Country B gains+d Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp a c b d Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-20 20 A’s demanders lose-a A’s suppliers gain+(a+b) Country A gains+b B’s demanders gain+(c+d) B’s suppliers lose-c Country B gains+d → World gains+(b+d) Gains and losses from trade: Country B P Q Country A P Q DADA DBDB SBSB SASA PAPA PBPB PFPF Exp Imp c b d Thank you to Dr. Alan Deardorff (UMICH) for permission to use this example

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-21 21 What Determines Prices, and Thus Trade? Prices determined by –Productivity of labor (and other factors) –Price of labor (w=wage) –Exchange rate (E) (i.e., prices of currencies) Since w and E are largely common to all sectors –The main determinant of how individual sectors trade (i.e., whether they export or import) is Productivity in sectors –High (relative) productivity, i.e., output per worker Implies low (relative) price And hence export

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-22 22 Adjustment Mechanism What if all of a country’s prices are too high for it to export at all? Then either: –Exchange rate (value of currency) will fall Because otherwise nobody would buy its currency, Or: –Wages will fall Because nobody would hire its labor  Either of these will lower the country’s prices

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-23 23 A Simple Model of Production and Trade A basic model, often referred to as the Ricardian model, named after economist David Ricardo (1772-1823) Assumptions –Markets are competitive: Firms are price takers –Static world: Technology is constant and there are no learning effects –Labor is perfectly mobile: It can easily move back and forth between industries but perfectly immobile across national borders.

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-24 24 Assumptions of the Simple Ricardian Trade Model See Handout – Absolute and Comparative Advantage.Absolute and Comparative Advantage.

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-25 25 Comparative Advantage and “Competitiveness” Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs -Imbalances result from government policies, such as subsidies or protection

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-26 26 Economic Restructuring Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear –In the Ricardian model, trade opening moved labor from bread to steel production: restructuring improved U.S. overall economic welfare but made its bread industry disappear –If trade results in net gain (in an increase of the consumption bundle), a country will be better off by trading; however, some sectors may still lose

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-27 27 Economic Restructuring Given that some lose due to economic restructuring, the government can seek to get the winners from trade and restructuring to compensate the losers –Trade adjustment assistance (TAA) helps losers by providing extended unemployment benefits, worker retraining, and temporary tax on imports –For example, the U.S. government created a special program for workers laid off because of NAFTA; in 1994, 17,000 workers qualified for the program

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-28 28 Low-Cost and High-Cost Cotton Producers

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-29 29 Gain from Trade in General What trade does not do: –Trade does not help everybody There are losers from trade –(We’ll see later in the course who they are) –Trade does not reduce inequality At least not necessarily; it could, in some cases But there are also good reasons why it may increase inequality –Trade may not cause countries to grow faster (There is debate on that) –Trade certainly does not fix all problems Weak or corrupt government Failure to save Poor technology

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-30 30 Gain from Trade in General Implications for Trade Policies Autarky is not realistic, but “protection” (i.e., tariffs, quotas, etc.) is very realistic Result that there is gain from trade does extend to reducing protection –There are exceptions – we’ll see later –But in most cases, countries (as a whole) do gain from reducing their tariffs Even if other countries do not reduce tariffs –Countries also gain when other countries liberalize

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-31 31 Criticism Comparative-advantage theory of trade focuses on technology or resource productivity differences as a production-side basis for trade / comparative advantage. According to comparative-advantage theory, nations that are similar in their production-side capabilities (and in their general demand patterns) should trade little with each other. In reality, we observe the opposite. Industrialized countries (which are similar in many aspects in their technologies, technological capabilities, and factor endowment) trade extensively with each other.

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.3-32 32 Trade between industrialized countries is nearly half of all world trade. Over 70% of the exports of industrialized countries go to other industrialized countries, and about 4/5 of these exports are nonfood manufactured products. These facts appear to be inconsistent with comparative-advantage theory. Furthermore, technology quickly spreads internationally because it is difficult for a country to keep its technology secret. Hence, many countries usually have access to the same technologies for production and are capable of achieving similar levels of resource productivity.