International Trade

Greater choice of products for consumers There are potentially many gains in economic welfare to be achieved through free trade: Greater choice of products for consumers Increased competition for producers Other countries can supply certain products more efficiently Trade speeds up the pace of technological progress and innovation Political benefits from expansion of global trade

Absolute Advantage: When a country can produce a good using fewer resources than another country can to produce that good.

For example if one unit of labor in Scotland can produce 80 units of wool or 20 units of wine; while in Spain one unit of labor makes 50 units of wool or 75 units of wine, then Scotland has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine.

Comparative Advantage: Ability to produce a good at a lower relative cost than another country

Law of Comparative Advantage: Nations are better off when they produce goods they have a comparative advantage in supplying

Here’s an example that explains comparative advantage….

Two men live alone in an isolated island.

To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction (and maintenance).

The first man is young, strong, and educated and is faster, better, more productive at everything.

He has an absolute advantage in all activities.

The second man is old, weak, and uneducated.

He has an absolute disadvantage in all economic activities.

In some activities the difference between the two is great; in others it is small.

Is it in the interest of either of them to work in isolation?

No.

Specialization and exchange (trade) can benefit both of them.

How should they divide the work?

According to comparative advantage, not absolute advantage

The young man must spend more time on the tasks in which he is much better and the old man must concentrate on the tasks in which he is only a little worse.

Such an arrangement will increase total production and/or reduce total labor.

It will make both of them richer.

Here’s another example of how comparative advantage works…

Imagine a city where the best lawyer happens also to be the best secretary, that is he would be the most productive lawyer and he would also be the best secretary in town.

However it is quite clear that this lawyer would focus on the task of being an attorney by employing a secretary instead of doing all the paperwork by himself.

This can easily be explained with the concept of comparative advantage

He is the best secretary and the best lawyer, however by comparing what he can earn as a secretary with the income he could earn by running a law firm and employing a secretary one can clearly see that the latter option is the better one.

Now, let’s apply this principle to trade between two countries…

Suppose we have two countries of equal size, Northland and Southland, that both produce and consume two goods, Food and Clothes.

If both countries devoted all their resources to food production, output would be as follows: Northland: 100 units Southland: 200 units

If all the resources of the countries were allocated to the production of clothes, output would be: Northland: 100 units Southland: 100 units

Southland has an absolute advantage over Northland in the production of Food. Both countries are equally efficient in the production of clothes.

Southland has a comparative advantage in Food production, because of its lower opportunity cost of production with respect to Northland.

Southland's opportunity cost of one unit of Food is 0 Southland's opportunity cost of one unit of Food is 0.5 unit of Clothes. The opportunity cost of one unit of Clothes is 2 units of Food.

Northland’s opportunity costs of one unit of Food is 1 unit of clothes Northland’s opportunity costs of one unit of Food is 1 unit of clothes. The opportunity cost of one unit of Clothes is 1 unit of Food.

Northland has a comparative advantage over Southland in the production of clothes

Each country should specialize in that good in which it has a comparative advantage

Production and consumption before trade Food Clothes Northland 50 Southland 100 World total 150

Production after trade Food Clothes Northland 100 Southland 200 World total

Consumption after trade Food Clothes Northland 75 50 Southland 125 World total 200 100

Both Northland and Southland benefited from trade

People don’t trade unless both sides expect to benefit

Exports: Goods and services sold by domestic citizens to other nations

Imports: Goods and services that are bought by domestic citizens and are produced by other nations

Imports are what a nation gets back in exchange for giving away exports

The cheaper imports are, the more a nation gets back in trade

Relative price (as compared with the other nations’ relative prices) determines which goods to produce and export and which goods to import

A nation should produce more of the good that it has a lower relative price of producing and should export that good

A nation should produce less of the good that it has a higher relative price of producing and should import that good

Each country should produce more of the good that it has a lower relative price of producing

World output will be increased when all nations produce those goods that they have a comparative advantage in producing

By trading, two countries can both end up with more than they had before trade

Without trade, a nation can consume only along its production possibility curve

With trade, a nation will specialize in producing one good With trade, a nation will specialize in producing one good. It will export that good, and import the other

A tariff raises domestic prices, reduces consumption, increases domestic production, and reduces imports.

Consumers lose more than others gain.

A quota can have the same effect as a tariff, except that the government does not collect any tax revenues.

Tariffs are a very expensive form of job protection.

There are far cheaper ways to help workers in the transition between jobs.

The only two possibly valid reasons tariffs are to protect infant industries and to better the world terms of trade.

But both reasons apply only in limited circumstances.