1. Chapter Seventeen The Gains from International Trade

2. 17 | 2 Copyright © Houghton Mifflin Company. All rights reserved. Gains from trade – improvements in income, production, or satisfaction owing to the exchange of goods or services. International Trade – the exchange of goods and services between people or firms in different nations. Recent Trends in International Trade

3. 17 | 3 Copyright © Houghton Mifflin Company. All rights reserved. Recent Trends in International Trade (cont’d) Tariff – a tax on imports Quota – a governmental limit on the quantity of a good that may be imported or sold Commerce Clause – the clause in the U.S. Constitution that prohibits restraint of trade between states

4. 17 | 4 Copyright © Houghton Mifflin Company. All rights reserved. Figure 29.1 illustrates the rapid expansion of trade worldwide as a result of the decrease in trade restrictions and the decrease in the transportation costs. By 2002, international trade accounted for 24 percent of GDP. Recent Trends in International Trade (cont’d)

5. 17 | 5 Copyright © Houghton Mifflin Company. All rights reserved. Recent Trends in International Trade (cont’d) Figure 29.1

6. 17 | 6 Copyright © Houghton Mifflin Company. All rights reserved. Comparative Advantage Comparative advantage – a situation in which a person or country can produce one good at a lower opportunity cost than another person or country. Absolute advantage – a situation in which a person or country is more efficient at producing a good in comparison with another person or country.

7. 17 | 7 Copyright © Houghton Mifflin Company. All rights reserved. Opportunity Cost – the value of the next best forgone alternative that was not chosen because something else was chosen. Comparative Advantage (cont’d)

8. 17 | 8 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade Table 29.1 provides an example of productivity differences of two goods, TV sets and vaccines, between two countries, the United States and Korea. The productivity is measured by the amount of each good that can be produced by a worker, per day of work.

9. 17 | 9 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade (cont’d)

10. 17 | 10 Copyright © Houghton Mifflin Company. All rights reserved. According to Table 29.1, one worker in the US can produce 6 vials of vaccine per day or 3 TV sets per day. One worker in Korea can produce 1 vial of vaccine per day and 2 TV sets per day. Note that in both goods, the US has absolute advantage in the production of both goods, as its workers can produce more vaccine and more TV sets than Korea per worker in one day. Gains from Trade (cont’d)

11. 17 | 11 Copyright © Houghton Mifflin Company. All rights reserved. Which country has the comparative advantage in the production of vaccines and TV sets? For vaccines, the US opportunity cost of one vaccine is ½ TV set, while the opportunity cost for Korea is 2 TV sets. The US has a lower opportunity cost, and hence, the comparative advantage in vaccine production. For TV sets, the US opportunity cost of one TV set is 2 vaccines, while the opportunity cost for Korea is ½ vaccine. Korea has a lower opportunity cost, and hence, the comparative advantage in TV set production. Gains from Trade (cont’d)

12. 17 | 12 Copyright © Houghton Mifflin Company. All rights reserved. If the countries choose not to trade with each other, the exchange between vaccines and TV sets will be the opportunity cost of production in each country. A TV in the US will sell for 2 vaccines, while a TV set in Korea will sell for ½ vaccines. Similarly, a vaccine in the US will sell for ½ a TV set, while a vaccine in Korea will sell for 2 TV sets. Gains from Trade (cont’d)

13. 17 | 13 Copyright © Houghton Mifflin Company. All rights reserved. If the relative price is going to be the same in both countries, then we know the price must be somewhere between the prices in the two countries before trade. Trade price for one vaccine: between ½ TV set – 2 TV sets. Trade price for one TV set: between ½ vaccine – 2 vaccines. The calculation of the trade price is summarized in Table 29.2. Gains from Trade (cont’d)

14. 17 | 14 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade (cont’d)

15. 17 | 15 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Trade Suppose that there are 10 workers in the US and 30 workers in Korea. To exploit their comparative advantage, US workers will produce vaccines only (total = 60 vaccines) while Korea will produce TV sets only (total = 60 TV sets). Both will trade at a price of 1 vaccine = 1 TV set.

16. 17 | 16 Copyright © Houghton Mifflin Company. All rights reserved. Table 29.3 illustrates the gains from trade due to comparative advantage for the US and Korea. By moving US workers out of TV set production and into vaccine production, the maximum US gain from trading is 30 TV sets, with a trade price of 1 vaccine = 1 TV set. Similarly, by moving Korean workers out of vaccine production and into manufacturing TV sets, the maximum gain by Korea from trading is 30 vaccines. Measuring the Gains from Trade (cont’d)

17. 17 | 17 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Trade (cont’d) Table 29.3

18. 17 | 18 Copyright © Houghton Mifflin Company. All rights reserved. The gains from trade due to comparative advantage can also be found graphically with production possibilities curves, as shown in Figure 29.2. The gain from trade is illustrated as a shift out in the production possibilities curve, allowing both countries to consume more TV sets and vaccines than if they chose not to trade. Measuring the Gains from Trade (cont’d)

19. 17 | 19 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Trade (cont’d) Figure 29.2

20. 17 | 20 Copyright © Houghton Mifflin Company. All rights reserved. Principle of Comparative Advantage: By specializing in products in which they have comparative advantage, countries can increase the amount of goods available for consumption. Measuring the Gains from Trade (cont’d)

21. 17 | 21 Copyright © Houghton Mifflin Company. All rights reserved. One last note: In our example, the opportunity costs in the production of vaccines and TV sets were constant (and the production possibilities curves are linear). As a result, both countries completely specialized in the production of one good only. In the real world, opportunity costs are increasing and the production possibilities curves are bowed out. In this scenario, incomplete specialization occurs and both countries produce both goods. Measuring the Gains from Trade (cont’d)

22. 17 | 22 Copyright © Houghton Mifflin Company. All rights reserved. No Gains From Trade: An Example Using our example of vaccines and TV sets, we can identify one scenario in which two countries, the US and Japan, cannot benefit from specialization and trade. Suppose that Table 29.1A illustrates the production differences between the two countries in the production of TV sets and vaccines.

23. 17 | 23 Copyright © Houghton Mifflin Company. All rights reserved. No Gains From Trade: An Example (cont’d) VaccinesTV Sets US63 Japan42 Table 29.1A Production of TV sets and Vaccines by one worker in one day.

24. 17 | 24 Copyright © Houghton Mifflin Company. All rights reserved. No Gains From Trade: An Example (cont’d) In producing vaccines, the US opportunity cost of one vaccine is ½ TV set, while the opportunity cost for Japan is also ½ TV set. In producing TV sets, the US opportunity cost of one TV set is 2 vaccines, while the opportunity cost for Japan is also 2 vaccines. Which country has the comparative advantage in the production of vaccines and TV sets? Neither country has the comparative advantage in the production of either good.

25. 17 | 25 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade If the countries choose to trade, the price must be somewhere between the prices in the two countries before trade. Trade price for one vaccine: between ½ TV set (US domestic price) – ½ TV sets (Japan’s domestic price). Trade price for one TV set: between 2 vaccines US domestic price) – 2 vaccines (Japan’s domestic price).

26. 17 | 26 Copyright © Houghton Mifflin Company. All rights reserved. Since the relative trade price between TV sets and vaccines should be between the domestic price of TV sets and vaccines of the two countries, then no trade price will give the countries a mutual gain from trade. There is no incentive for either country to stop trading at home and start trading with the other country. No Gains From Trade: An Example (cont’d)

27. 17 | 27 Copyright © Houghton Mifflin Company. All rights reserved. One final note: there will be no gains from trade in this example only if the production costs are constant, i.e., there are no economies of scale. We will get back to this later in the chapter, when we discuss gains from trade through expanded markets. No Gains From Trade: An Example (cont’d) © Royalty-Free, Photodisc/Getty Images

28. 17 | 28 Copyright © Houghton Mifflin Company. All rights reserved. One reason why some countries have comparative advantage over other countries is because some countries have a higher amount of the input that is used more intensively in the production of one good. Reasons for Comparative Advantage

29. 17 | 29 Copyright © Houghton Mifflin Company. All rights reserved. Reasons for Comparative Advantage (cont’d) Capital abundant – a higher level of capital per worker in one country relative to another. Labor abundant – a lower level of capital per worker in one country relative to another. Capital intensive – production that uses a high level of capital per worker. Labor intensive – production that uses a low level of capital per worker.

30. 17 | 30 Copyright © Houghton Mifflin Company. All rights reserved. The Effect of Trade on Wages Factor price equalization – the equalization of the price of labor and the price of capital across countries when they are engaging in free trade. Intuition: trade tends to increase the demand for the factor that is relatively abundant in a country and decrease demand for the factor that is relatively scarce. Hence, if a country is selling a labor intensive good to another country, the wage increases in the country with lots of labor and drops in the country with less labor.

31. 17 | 31 Copyright © Houghton Mifflin Company. All rights reserved. Factor price equalization can explain one particular trend in US wages: the rise of wages for the skilled workers over unskilled workers over the last 20 years. The demand for goods and services produced by skilled workers increased over the past 25 years, resulting in an increase in the demand for these workers and an increase in their wages. The Effect of Trade on Wages (cont’d)

32. 17 | 32 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade Through Expanded Markets The top panel in Figure 29.3 illustrates a situation where two countries, the US and Germany, have the same technology and can produce the same number of MRI equipment and ultrasound equipment with a given amount of resources. Both countries also produce both goods at the same cost, i.e., $300,000 for an MRI machine and $200,000 for an ultrasound scanner.

33. 17 | 33 Copyright © Houghton Mifflin Company. All rights reserved. Gains from Trade Through Expanded Markets (cont’d) Figure 29.3

34. 17 | 34 Copyright © Houghton Mifflin Company. All rights reserved. The bottom panel in Figure 29.3 shows that if the US produces 2,000 machines (instead of 1,000), it can significantly lower the cost of production to $150,000 per machine. Similarly, if Germany produces 2,000 ultrasound machines (instead of 1,000), it can produce at a cost of only $150,000 per machine, down from $200,000. Gains from Trade Through Expanded Markets (cont’d)

35. 17 | 35 Copyright © Houghton Mifflin Company. All rights reserved. Intraindustry trade – trade between countries in goods from the same or similar industries. Example: ultrasound machines and MRI machines Interindustry trade – trade between countries in goods from different industries. Example: TV sets and vaccines Gains from Trade Through Expanded Markets (cont’d)

36. 17 | 36 Copyright © Houghton Mifflin Company. All rights reserved. Figure 29.4 illustrates the relationship between the number of firms in the market and the cost of producing each unit. Comparing the graph on the left side with that on the right side of Figure 29.4, we can see that in a larger market, the cost per unit of producing a good is lower than in a small market. Another observation in Figure 29.4 is that regardless of the size of the market, the cost per unit declines as the number of firms increases. Gains from Trade Through Expanded Markets (cont’d)

37. 17 | 37 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Expanded Markets Figure 29.4

38. 17 | 38 Copyright © Houghton Mifflin Company. All rights reserved. Figure 29.5 illustrates the relationship between the number of firms in a market and the cost of production per unit. With the same-sized market, a larger number of firms will result in a higher cost per unit. However, as the market size becomes larger, the curve shifts down, representing lower costs per unit with a larger market. Measuring the Gains from Expanded Markets (cont’d)

39. 17 | 39 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Expanded Markets (cont’d) Figure 29.5

40. 17 | 40 Copyright © Houghton Mifflin Company. All rights reserved. As the number of firms in the market increases, the market becomes more competitive, and the price that each firm charges for the good decreases and moves toward the cost of production. Figure 29.6 illustrates the relationship between the price and the number of firms. Measuring the Gains from Expanded Markets (cont’d)

41. 17 | 41 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Expanded Markets (cont’d) Figure 29.6

42. 17 | 42 Copyright © Houghton Mifflin Company. All rights reserved. Figure 29.7 illustrates the long-run equilibrium number of firms and cost per unit in the market. The equilibrium is determined by the intersection between the cost per unit curve and the price in the market curve. Measuring the Gains from Expanded Markets (cont’d)

43. 17 | 43 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Expanded Markets (cont’d) Figure 29.7

44. 17 | 44 Copyright © Houghton Mifflin Company. All rights reserved. Figure 29.8 illustrates the gains from trade due to a larger market. When trade occurs, the market increases from the size of the market in one country to the combined size of the markets in two or more countries. This larger market shifts the upward-sloping line down because cost per unit for each firm is lower when the market is bigger. This brings about a new intersection and a long-run equilibrium at a lower price. Measuring the Gains from Expanded Markets (cont’d)

45. 17 | 45 Copyright © Houghton Mifflin Company. All rights reserved. Measuring the Gains from Expanded Markets (cont’d) Figure 29.8

46. 17 | 46 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms Tariff Quota Commerce clause Absolute advantage Comparative advantage Capital abundant Labor abundant Capital intensive Labor intensive Factor price equalization