© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Interdependence and the Gains from Trade E conomics P R I N C I P L E S O F

In this chapter, look for the answers to these questions:  Why do people choose to trade?  What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different? 1

2 Our Example  Two countries: the U.S. and Japan  Two goods: computers and wheat  One resource: labor, measured in hours  We will look at how much of both goods each country produces and consumes  if the country chooses to be self-sufficient  if it trades with the other country

3 Production Possibilities:  The U.S. has 50,000 hours of labor available for production, per month.  Producing one computer requires 100 hours of labor.  Producing one ton of wheat requires 10 hours of labor.  Japan has 30,000 hours of labor available for production, per month.  Producing one computer requires 125 hours of labor.  Producing one ton of wheat requires 25 hours of labor

4 4, ,000 2,000 1,000 3, Computers Wheat (tons) The U.S. PPF The U.S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF. Where will American’s choose to consume without trade?

INTERDEPENDENCE AND THE GAINS FROM TRADE 5 Computers Wheat (tons) 2,000 1, Japan’s PPF Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF.

6 4, ,000 2,000 1,000 3, Computers Wheat (tons) U.S. Production With Trade

INTERDEPENDENCE AND THE GAINS FROM TRADE 7 Japan’s Production With Trade Producing 240 computers requires all of Japan’s 30,000 labor hours. Computers Wheat (tons) 2,000 1, So, Japan would produce 0 tons of wheat.

A C T I V E L E A R N I N G 3 Consumption under trade 8  How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF.  How much of each good is consumed in Japan? Plot this combination on Japan’s PPF. Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan. (So, Japan imports 700 tons wheat and exports 110 computers.)

INTERDEPENDENCE AND THE GAINS FROM TRADE 9 4, ,000 2,000 1,000 3, Computers Wheat (tons) U.S. Consumption With Trade = amount consumed imported 7000– exported produced wheatcomputers

INTERDEPENDENCE AND THE GAINS FROM TRADE 10 Japan’s Consumption With Trade Computers Wheat (tons) 2,000 1, = amount consumed imported 0110– exported 0240produced wheatcomputers

INTERDEPENDENCE AND THE GAINS FROM TRADE 11 Trade Makes Both Countries Better Off 2002,7002,500wheat computers gains from trade consumption with trade consumption without trade U.S wheat computers gains from trade consumption with trade consumption without trade Japan

INTERDEPENDENCE AND THE GAINS FROM TRADE 12 Where Do These Gains Come From?  Absolute advantage: the ability to produce a good using fewer inputs than another producer  The U.S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan.  If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.

INTERDEPENDENCE AND THE GAINS FROM TRADE 13 Where Do These Gains Come From?  Which country has an absolute advantage in computers?  Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S.  The U.S. has an absolute advantage in both goods! So why does Japan specialize in computers? Why do both countries gain from trade?

INTERDEPENDENCE AND THE GAINS FROM TRADE 14 Two Measures of the Cost of a Good  Two countries can gain from trade when each specializes in the good it produces at lowest cost.  Absolute advantage measures the cost of a good in terms of the inputs required to produce it.  Recall: Another measure of cost is opportunity cost.  In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.

INTERDEPENDENCE AND THE GAINS FROM TRADE 15 Opportunity Cost and Comparative Advantage  Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer  Which country has the comparative advantage in computers?  To answer this, must determine the opp. cost of a computer in each country.

INTERDEPENDENCE AND THE GAINS FROM TRADE 16 Opportunity Cost and Comparative Advantage  The opp. cost of a computer is  10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat.  5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat.  So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage!

17 Comparative Advantage and Trade  Gains from trade arise from comparative advantage (differences in opportunity costs).  When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.

Argentina and Brazil each have 10,000 hours of labor per month. In Argentina,  producing one pound coffee requires 2 hours  producing one bottle wine requires 4 hours In Brazil,  producing one pound coffee requires 1 hour  producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine? A C T I V E L E A R N I N G 4 Absolute & comparative advantage 18

Brazil has an absolute advantage in coffee:  Producing a pound of coffee requires only one labor-hour in Brazil, but two in Argentina. Argentina has a comparative advantage in wine:  Argentina’s opp. cost of wine is two pounds of coffee, because the four labor-hours required to produce a bottle of wine could instead produce two pounds of coffee.  Brazil’s opp. cost of wine is five pounds of coffee. A C T I V E L E A R N I N G 4 Answers 19

THE DETERMINANTS OF TRADE  Equilibrium Without Trade  Assume:  A country is isolated from rest of the world and produces steel.  The market for steel consists of the buyers and sellers in the country.  No one in the country is allowed to import or export steel.

Figure 1 The Equilibrium without International Trade Consumer surplus Producer surplus Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Equilibrium price Equilibrium quantity

The World Price and Comparative Advantage  If the country decides to engage in international trade, will it be an importer or exporter of steel?  The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the price that prevails in the world market for that good.

The World Price and Comparative Advantage  If a country has a comparative advantage, then  the domestic price will be below the world price, and  the country will be an exporter of the good.  If the country does not have a comparative advantage, then  the domestic price will be higher than the world price, and  the country will be an importer of the good.

Figure 2 International Trade in an Exporting Country Price of Steel 0 Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Domestic quantity demanded Domestic quantity supplied

Figure 2 International Trade in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Producer surplus before trade Consumer surplus before trade C Consumer surplus after trade B Producer surplus after trade

How Free Trade Affects Welfare in an Exporting Country

THE WINNERS AND LOSERS FROM TRADE  The analysis of an exporting country yields two conclusions:  Domestic producers of the good are better off, and domestic consumers of the good are worse off.  Trade raises the economic well-being of the nation as a whole.

The Gains and Losses of an Importing Country  International Trade in an Importing Country  If the world price of steel is lower than the domestic price,  the country will be an importer of steel when trade is permitted.  domestic consumers will want to buy steel at the lower world price.  domestic producers of steel will have to lower their output because the domestic price moves to the world price.

Figure 3 International Trade in an Importing Country C B D A Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price after trade World price Imports Price before trade Consumer surplus before trade Producer surplus before trade

Figure 3 International Trade in an Importing Country C B D A Price of Steel 0 Quantity of Steel Price after trade World price Producer surplus after trade Consumer surplus after trade D B Domestic demand Domestic supply Imports Price before trade

How Free Trade Affects Welfare in an Importing Country

The Gains and Losses of an Importing Country  How Free Trade Affects Welfare in an Importing Country  The analysis of an importing country yields two conclusions:  Domestic producers of the good are worse off, and domestic consumers of the good are better off.  Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

The Effects of a Tariff  A tariff is a tax on goods produced abroad and sold domestically.  Tariffs raise the price of imported goods above the world price by the amount of the tariff.

Figure 4 The Effects of a Tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Equilibrium without trade Price without tariff World price Imports with tariff Q S Q S Q D Q D

Figure 4 The Effects of a Tariff C G A EDF B Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Price without tariff World price Imports with tariff Q S Q S Q D Q D Deadweight Loss Consumer surplus Producer surplus

The Effects of a Tariff  A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade.  With a tariff, total surplus in the market decreases by an amount referred to as a deadweight loss.

FYI: Import Quotas: Another Way to Restrict Trade  The Effects of an Import Quota  An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically.  Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off.  License holders are better off because they make a profit from buying at the world price and selling at the higher domestic price.

The Effects of an Import Quota A E' C B G D E" F Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand Isolandian price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S Consumer surplus after quota Producer surplus after quota Surplus for firms with licenses

FYI: Import Quotas: Another Way to Restrict Trade  With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss.  The quota can potentially cause an even larger deadweight loss, if a mechanism such as lobbying is employed to allocate the import licenses.

The Lessons for Trade Policy  Both tariffs and import quotas...  raise domestic prices.  reduce the welfare of domestic consumers.  increase the welfare of domestic producers.  cause deadweight losses.

The Lessons for Trade Policy  Other Benefits of International Trade  Increased variety of goods  Lower costs through economies of scale  Increased competition  Enhanced flow of ideas

THE ARGUMENTS FOR RESTRICTING TRADE  Jobs Argument  National-Security Argument  Infant-Industry Argument  Unfair-Competition Argument  Protection-as-a-Bargaining-Chip Argument