Comparative Advantage and the Open Economy Chapter 33 Comparative Advantage and the Open Economy

Introduction Why do nations enter into agreements aimed at promoting bilateral or multilateral trade of goods and services? In this chapter, you will learn about how nations can gain from trade. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Learning Objectives Discuss the worldwide importance of international trade Explain why nations can gain from specializing in production and engaging in international trade Understand common arguments against free trade Describe ways that nations restrict foreign trade Identify key international agreements and organizations that adjudicate trade disputes among nations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Chapter Outline The Worldwide Importance of International Trade Why We Trade: Comparative Advantage and Mutual Gains from Exchange The Relationship Between Imports and Exports International Competitiveness Ways to Restrict Foreign Trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Did You Know That... U.S. residents spend about $24 billion on imports from Scandinavian nations each year? The U.S. tariff rate on products imported from Scandinavian countries is less than 1%? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Worldwide Importance of International Trade World GDP is nearly nine times greater than it was at the end of World War II. World trade has increased to more than 26 times what it was in 1950. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Worldwide Importance of International Trade (cont'd) The United States has figured prominently in this expansion of world trade. Imports added up to barely 4% of annual U.S. GDP in 1950. Today they account for almost 17%. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-1 The Growth of World Trade, Panel (a) Source: Steven Husted and Michael Melvin, International Economics, 3rd ed. (New York: HarperCollins, 1995), p. 11, used with permission; World Trade Organization; Federal Reserve System; U.S. Department of Commerce. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-1 The Growth of World Trade, Panel (b) Source: Steven Husted and Michael Melvin, International Economics, 3rd ed. (New York: HarperCollins, 1995), p. 11, used with permission; World Trade Organization; Federal Reserve System; U.S. Department of Commerce. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange We have learned about the concept of specialization and the mutual gains from trade. We can understand gains from trade among nations by understanding output gains from specialization between individuals. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Scenario (8-hour day) Ad specialist 2 pages of ad copy/hour 1 art rendering/hour Computer artist 1 page of ad copy/hour Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Without Trade (8-hour day) Ad Specialist Computer Artist Copy Renderings 4 hrs  2 = 8 4 hrs  1 = 4 Total 12 8 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) With Trade (8-hour day) Ad Specialist Computer Artist Copy Renderings Total 8 hrs  2 = 16 8 hrs  1 = 8 16 8 Ad copy output increases by 4 pages per day Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Comparative Advantage Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Comparative Advantage The ability to produce a good or service at a lower opportunity cost compared with producers Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Example: Kenya’s Green Thumb in Exporting Green Beans The opportunity cost of producing many packaged vegetables is lower in Kenya than in many European countries. This gives Kenya a comparative advantage in producing such goods. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Specialization among nations Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Specialization among nations To demonstrate the concept of comparative advantage, consider a simple two-country, two-good world. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Production and consumption capabilities in a two-country, two-good world We show maximum feasible quantities of software and PCs. Using all resources—land, labor, capital, and entrepreneurship. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) U.S. residents can utilize all their resources to produce 90 units of software or 225 PCs per hour. Residents of India are able to utilize all their resources to produce either 100 units of software or 50 PCs per hour. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 33-1 Maximum Feasible Hourly Production Rates of Either Commercial Software or Personal Computers Using All Available Resources Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Comparative advantage Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Comparative advantage The opportunity cost of producing a PC is lower in the United States than in India. 1 PC = 0.4 units of software 1 unit of software = 2.5 PCs The opportunity cost of producing software is lower in India than the United States. 1 PC = 2 units of software 1 unit of software = 0.5 PC Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Production without trade Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Production without trade Table 33-2 tabulates two possible production choices. “World” output is 55 units of software and 187.5 PCs (per hour). Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 33-2 U.S. and Indian Production and Consumption Without Trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) The United States and India will specialize in activities with which they experience a lower opportunity cost. In other words, they will specialize in the activity in which they have a comparative advantage. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Specialization in production Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Specialization in production United States will specialize Produce 225 PCs, and no software India will specialize Produce 100 software units, no PCs Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Consumption with specialization and trade Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Consumption with specialization and trade United States willing to buy 1 unit of Indian software as long as they provide in exchange no more than 2.5 PCs. This is the United States’ opportunity cost of producing 1 unit of software at home. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Consumption with specialization and trade Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Consumption with specialization and trade India buys a PC from the United States in exchange for no more than 2 units of software. This is India’s opportunity cost of producing a PC at home. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Residents of the two nations agree to a rate of exchange of 1 PC for 1 unit of software. Proceed to trade 75 U.S. PCs for 75 units of Indian software. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 33-3 U.S. and Indian Production and Consumption with Specialization and Trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

By specializing and engaging in trade Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) By specializing and engaging in trade United States consumes 75 units of software imported from India and consumes 150 PCs produced at home. Indian residents consume 25 units of software produced at home and import 75 PCs from the United States. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Gains from trade United States’ gain from specialization and trade is 45 units of software. India can consume 37.5 more PCs. These are net gains. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Table 33-4 National and Worldwide Gains from Specialization and Trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Specialization is the key Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Specialization is the key Specializing in producing goods for which a nation has a comparative advantage allows for greater efficiency. Production capabilities increase, making possible greater worldwide consumption through international trade. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Observations on specialization and trade Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Observations on specialization and trade Not everyone gains from trade. Cannot “run out of exports” Every country will always have a comparative advantage in something. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-2 World Trade Flows Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Example: Japan Loses Its Electronics Advantage to the U International Example: Japan Loses Its Electronics Advantage to the U.S. From the 1950s until the late 1990s, companies based in Japan—Sony, Panasonic, Pioneer—made the nation a major exporter of electronic devices. Since the 1990s, U.S. companies—Apple, Microsoft, palmOne—have elbowed out Japanese firms. The United States has developed a comparative advantage over Japan in producing a number of modern electronic products. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Other benefits from international trade: the transmission of ideas Why We Trade: Comparative Advantage and Exhausting Mutual Gains From Exchange (cont'd) Other benefits from international trade: the transmission of ideas New goods, services spread New processes transmitted Intellectual property introduced Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Relationship Between Exports and Imports In the long run, imports are paid for by exports. Any restrictions on imports ultimately reduce exports. When a country engages in trade, it is not competing against the other countries. All nations stand to benefit from trade. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Competitiveness Questions Is the United States falling behind? Do we need to stay competitive internationally? What does global competitiveness really mean? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Competitiveness (cont'd) Answers United States leads in overall productive efficiency According to the Institute for Management Development in Lausanne, Switzerland Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Competitiveness (cont'd) Reasons for ranking Widespread entrepreneurship Economic restructuring Investment in information-technology Sophisticated financial system Large investments in scientific research Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Arguments Against Free Trade Infant Industry Argument The contention that tariffs should be imposed to protect from import competition an industry that is trying to get started Presumably, after the industry becomes technologically efficient, the tariff can be lifted. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Arguments Against Free Trade (cont'd) Countering foreign subsidies and dumping Dumping Selling a good or a service abroad below the price charged in the home market or at a price below its cost of production Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Arguments Against Free Trade (cont'd) Protecting domestic jobs Do imports reduce jobs? No empirical evidence In half of the cases studied, when imports rose, unemployment fell. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Arguments Against Free Trade (cont'd) The cost of protecting U.S. jobs Restrictions on textiles and apparel goods cost U.S. consumers $9 billion a year. Cost $50,000 a year for each $20,000 job saved Restriction on imports of Japanese cars Cost $160,000 per year for each job saved in the auto industry Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Arguments Against Free Trade (cont'd) The cost of protecting U.S. jobs Glass industry restrictions Cost $200,000 per year per job saved Steel industry restrictions Cost $750,000 per year per job saved Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Emerging Arguments Against Free Trade Environmental concerns Genetic engineering New diseases National defense Exports of new technology Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade Quota System A government-imposed restriction on the quantity of a specific good that another country is allowed to sell in the United States In other words, quotas are restrictions on imports, usually applied to one or several specific countries. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-3 The Effect of Quotas on Textile Imports Equilibrium with restrictions Equilibrium without restrictions Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade Voluntary quotas Voluntary Restraint Agreement (VRA) An official agreement with another country that “voluntarily” restricts the quantity of its exports Voluntary Import Expansion (VIE) An official agreement with another country in which it agrees to import more from the United States Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Tariffs Tax on imported goods Benefits import-competing industries Harms consumers by raising prices Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-4 The Effect of a Tariff on Japanese-Made Laptop Computers, Panel (a) notebook computers Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-4 The Effect of a Tariff on Japanese-Made Laptop Computers, Panel (b) American-made notebook computers Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Tariffs in the United States Have varied widely on imported goods Highest rates in twentieth century occurred with passage of Smoot-Hawley Tariff in 1930 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-5 Tariff Rates in the United States Since 1820 Source: U.S. Department of Commerce Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Current tariff laws Trade Expansion Act of 1962 Trade Reform Act of 1974 Trade and Tariff Act of 1984 General Agreement on Tariffs and Trade World Trade Organization Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Trade Organizations General Agreement on Tariffs and Trade An international agreement established in 1947 to further world trade by reducing barriers and tariffs GATT was replaced by the World Trade Organization in 1995. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Trade Organizations (cont'd) World Trade Organization (WTO) The successor organization to GATT that handles trade disputes among its member nations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Trade Organizations (cont'd) The World Trade Organization (WTO) Most important international trade organization, with largest membership Fostered most important and far-reaching global trade agreement covering Financial institutions; including banks, insurers and investment companies Copyright © 2008 Pearson Addison Wesley. All rights reserved.

International Policy Example: Twin Growth Paths in World Trade Its champions credit the WTO with boosting world trade. Doubters claim gains from trade are fueling membership. In any event, growth in world trade takes place alongside the WTO. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-6 Growth in the World Trade Organization’s Membership and in Global Trade Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Regional Trade Bloc A group of nations that grants members special privileges Examples include the European Union, NAFTA, and the Association of Southeast Asian Nations Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Some economists worry regional blocs could lead to a reduction in members’ trade with nations outside their blocs. Most evidence indicates regional trade blocs have promoted trade instead of hindering it. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Ways to Restrict Foreign Trade (cont'd) Numerous studies have found that as countries from around the world have become more open to trade, they have tended to join regional trade blocs that promote even more openness. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Trade diversion versus trade deflection. Is trade deflection “bad”? Issues and Applications: Do Regional Trade Blocs Encourage “Trade Deflection”? Trade diversion versus trade deflection. Is trade deflection “bad”? Is the solution to the trade deflection worse than the problem? Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Figure 33-7 The Percentage of World Trade Within Regional Trade Blocs Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives Worldwide importance of international trade World trade has grown faster than total world GDP. Why nations can gain from specializing in production and engaging in trade Comparative advantage Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Arguments against free trade Infant industry Dumping Environmental concerns National defense Ways that nations restrict foreign trade Tariffs Quotas Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Summary Discussion of Learning Objectives (cont'd) Key international agreements and organizations GATT WTO More than 230 regional trade blocs NAFTA European Union Copyright © 2008 Pearson Addison Wesley. All rights reserved.

Comparative Advantage and the Open Economy End of Chapter 33 Comparative Advantage and the Open Economy