The Case for Trade  So far we have determined what Canada trades and with whom  We haven’t yet answered the question, why trade?  There are many benefits which all bring significant economic gain:  Increases product variety for consumers  Promotes competition in each country’s markets  Adds to output by allowing countries to specialize in commodities in which they are internationally competitive

Gains from Trade  Product Variety: adding imports to domestic products gives you greater choice  Competition: more competition means lower prices for consumers since it encourages all businesses to produce goods as efficiently as possible  Specialization: most important gain from trade  Without specialization, every country would have to make everything its citizens need  With specialization, each country can specialize in the products it makes most efficiently  The money made from exporting specialized products can pay for importing products that the country does not specialize in

Absolute Advantage  Case Study:  A lawyer wants custom-made furniture  A carpenter wants to prepare a will  The lawyer could build the furniture herself in 20 hours, or hire carpenter to build it in 5 hours  The carpenter could prepare the will himself in 10 hours, or hire a lawyer to do it in 2 hours  The lawyer and carpenter each have an absolute advantage  Each trading partner is able to produce one product using fewer resources than would other producers  As a result, living standard for both increase

Comparative Advantage  Different countries have different strengths however  Case Study: Both Canada and Mexico can produce paper and computers, but Canada has an absolute advantage over Mexico in both products  Using an equal amount of resources, Canada can produce 12 tonnes of paper/12 computers; Mexico can produce 3 tonnes of paper/9 computers  To determine which trading partner should supply, each country should determine the opportunity cost of each product, and supply the product where opportunity cost is lowest

Comparative Advantage Hypothetical Output per WorkerOpportunity Cost PaperComputersOf 1 tonne of paperOf 1 computer Canada12 tonnes12 computers1.0 computer1.0 tonnes of paper Mexico3 tonnes9 computers3.0 computers0.33 tonnes of paper  Paper has a lower opportunity cost in Canada  Canadians have a comparative advantage in producing paper  Mexicans have a comparative advantage in making computers  Each has the lower opportunity cost of producing one product

Total Gains from Specialization Before TradeAfter Trade PaperComputersPaperComputers Canada60 tonnes (5x12) 60 computers120 tonnes0 computes Mexico30 tonnes (10x3) 90 computers0 tonnes180 computers 90 tonnes150 computers120 tonnes180 computers  Imagine there are 10 workers in Canada, 20 in Mexico  Before trade, each country devotes half its labour to each product  By specializing on the basis of comparative advantage, both countries are able to raise their total output of both items and are now linked through trade

Terms of Trade  Terms of Trade:  The international price of one product in terms of another product  Depends on the opportunity costs of the products in each country  Recall that in Canada, tonnes of paper to units of computers have a cost ratio of one to one  In Mexico, the cost ratio of tonnes of paper and computer units is one to three

Terms of Trade cont’d  The international price of one product in terms of the other must fall somewhere between these limits in order for the two countries to trade  Limits to terms of trade:  1 tonne of paper : 1 computer  1 tonne of paper : 3 computers  The terms of trade are set by the international demand for each product  If demand for paper is high in both countries, the international price of paper in terms of computers will be close to the limit of 3 computers for 1 tonne of paper  If the demand of computers is high in both countries, the international price of computers will be pushed toward the limit of one computer for 1 tonne of paper (not 0.33 tonnes of paper)