Chapter 7 Trade McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Learning Objectives How does trade affect society? How does trade create wealth? What is absolute advantage? What is comparative advantage? What are the effects of exports and imports? What are tariffs and quotas? What are the additional benefits of trade? What are the arguments against objections to trade? 7-2

3 What Happened to Neanderthals? Neanderthals were intelligent cousins of humans. A plausible theory: Neanderthals’ wealth and population gradually shrank to extinction because they did not trade. By engaging in trade, humans created wealth and survived. 7-3

4 Trade Trade allows individuals to specialize and produce more. Trade creates wealth. 7-4

5 International Trade: Example 1 CostOne Computer One TV US1 hour’s work10 hours’ work Italy20 hours’ work1 hour’s work With Trade Hours Worked ComputersTVs US1165 Italy21516 Without Trade Hours Worked ComputersTVs US1111 Italy

6 International Trade: Example 2 CostOne ComputerOne TV US1 hour’s work10 hours’ work Slow Land2000 hours’ work1000 hours’ work Opportunity Cost One ComputerOne TV US1/10 of a TV10 computers Slow Land2 TVs½ computer 7-6

7 International Trade: Example 2 With Trade :Scenario 2 Hours worked ComputersTVs US Slow Land 30,00015 With Trade: Scenario 1 Hours worked ComputersTVs US2010 Slow Land 20,00010 Without Trade Hours worked ComputersTVs US11010 Slow Land 30,

8 International Trade Trade gives an indirect means of production. Trade allows: Either more production with same resources, compared to without trade. Or same production with less resources, compared to without trade. 7-8

9 Absolute vs. Comparative Advantage Absolute advantage = If the nation can produce a good using fewer resources than its trading partners. Comparative advantage = If the nation can produce a good at lower opportunity cost than its trading partners. 7-9

10 Comparative Advantage David Ricardo formulated the theory of comparative advantage. Even when one nation has an absolute advantage in the production of all goods, nations can still benefit by trading goods according to comparative advantage. Every person and every nation must have a comparative advantage in something. Individuals and nations benefit from trade when they sell (export) goods for which they have a comparative advantage, and buy (import) goods other people or nations have a comparative advantage in producing. 7-10

11 Comparative Advantage Comparative advantages can come from: Natural resources, soil and climate. Large labor force of unskilled workers. Freedom. Human capital = Education and skills. Language skills. Work and experience. Genetics and family environment. 7-11

12 Exports When a country opens up for trade, domestic price becomes equal to world price. If world price > Domestic price: Quantity supplied > Quantity demanded Excess domestic supply is exported. Higher price = Increase in producers surplus and decrease in consumers surplus. Producers’ gains > Consumers’ loss = Increase in total surplus. Price Quantity Supply Demand $ CS PS Consumers and producers are here World price Exports $11 Producers are here Consumers are here 7-12

13 Imports If world price < Domestic price: Quantity supplied < Quantity demanded. Excess domestic demand is satisfied by imports. Lower price = Increase in consumers surplus and decrease in producers surplus. Consumers’ gains > Producers’ loss = Increase in total surplus. Price Quantity Supply Demand $10 CS PS World price 2001,100 Imports $5 Consumers are here Producers are here 7-13

14 International Trade Trade increases the wealth of society. Trade creates losers as well as winners: Imports = Consumers gain, producers lose. Exports = Producers gain, consumers lose. Producer’s lobby against imports. 7-14

15 Tariffs Tariff = Tax on imports. Tariff increases price of imports. Consumers lose and producers gain. Government gets tax revenue. Losses > Gains from tariffs. Tariff creates deadweight loss. Price Quantity Supply Demand $10 World price 2001,100 Imports $5 Consumers are here with tariff Producers are here with tariff $7 World price + Tariff 1, Producers are here without tariff Consumers are here without tariff 7-15

16 Quotas Quota restricts imports by placing a limit on the number of goods that can be imported. Quota helps producers but harms consumers. Quota does not raise money for the government. Quota benefits some foreign firms by increasing their revenue. Quota allows the government to protect domestic producers without endangering the country’s political alliances. 7-16

17 Additional Benefits of Trade Specialization: Trade allows individuals/nations to concentrate on only a few areas. Specialization leads to expertise. Innovation: Trade increases innovations. To compete with others and to gain comparative advantage, individuals/nations have to innovate new technology. 7-17

18 Additional Benefits of Trade Reduced corruption: Trade increases competition. International trade forces companies and nations to compete against players beyond their political influence and so it reduces corruption. Brain gain: International trade encourages effective use of intelligence. Competition drives international firms to seek brainpower throughout the world. 7-18

19 Arguments Against Objections to Trade Trade harms workers in poor countries by paying low wages: Trade offers jobs and wages to workers in poor countries. International trade offers an opportunity to poor countries to increase their wealth. International trade increases child labor in poor countries: These jobs make it possible for children in poor countries to have better means of subsistence than available without international trade. 7-19

20 Arguments Against Objections to Trade Trade harms workers in rich countries: International trade creates losers as well as winners. Some workers in rich nations are hurt. They can successfully compete against workers in poor countries by being more productive. Nations need trade restrictions to protect infant industries: Government protection of infant industry from foreign competition can encourage inefficient practices, waste of resources and political corruption. 7-20

21 Arguments Against Objections to Trade Nations shouldn’t trade with potential military enemies: Trade creates wealth for all trading partners. So trade might reduce potential military enemy’s desire to harm a nation. Trade generates economic cooperation between trading partners which in turn influences political decisions. 7-21

22 Arguments Against Objections to Trade Nations can use their threat of retaliatory trade restrictions to promote free trade: Threatening to retaliate against trade restrictions can sometimes work to increase trade. The Santa Claus problem: Job destruction because of cheap imports: Trade both destroys and creates jobs. There is a change in types of job. 7-22

23 Do You Know? When does a nation have a comparative advantage in the production of a good? When a nation can produce a good at lower opportunity cost than its trading partners. Why do politicians often oppose imports? Imports hurt producers. Producers lobby for trade restrictions by providing economic and political incentives to politicians. 7-23

24 Do You Know? How can trade promote innovation? By forcing individuals/nations to compete with others and gain comparative advantage, trade encourages innovations. Why does trade enable human civilization? Trade allows division of labor, specialization and innovation, so humans can create the tools of civilization and enjoy numerous goods and services. 7-24

25 Summary Trade is the basis of human civilization. Trade creates wealth by allowing specialization. Absolute advantage is the ability to produce a good using fewer resources. Comparative advantage is the ability to produce a good at lower opportunity cost. Comparative advantage is the basis of international trade. 7-25

26 Summary Though exports and imports increase the total surplus for society as a whole, they harm some sections of society. Trade restrictions such as tariffs and quotas protect producers but create deadweight loss for society. Specialization, innovation, reduced corruption and brain gain are the additional benefits of international trade. The objections to international trade usually do not stand up to economic principles. 7-26

27 Coming Up How do costs affect production? 7-27