1. Chapter 37
International Trade

2. Nations, like individuals can gain by specializing in the products they can produce with the greatest relative efficiency and by trading for the goods they cannot produce as efficiently.
The reason nations’ trade is because it is beneficial.

3. Three underlying facts help explain why different nations produce different goods and services.
Nations’ differ in their endowments of economic resources.
Nation’s have differing levels of technological expertise.
Nation’s have different preferences for certain goods and services.

4. For example, China, which has abundant and inexpensive labor may produce a variety of labor-intensive goods, such as textiles, electronics, clothing, toys, and sporting goods.

5. In contrast, Australia has vast amounts of land and can inexpensively produce such land-intensive goods, as beef, wool, and meat.

6. The U.S. and Germany that have relatively large amounts of capital can inexpensively produce capital-intensive goods, such as airplanes, automobiles, agricultural equipment, machinery, and chemicals.

7. A country is said to have an absolute advantage over other producers of a product if it is the most efficient producer of that product, which means it can produce more output from the same amount of resources compared to another country.

8. Comparative advantage is achieved when a country can produce a good or service at a lower opportunity cost, compared to other countries.

9. In the early 1800’s David Ricardo stated that a nation does not need an absolute advantage, or total superiority in the efficiency with which it produces goods, in order to benefit from specialization and trade. It needs only a comparative advantage.

10. Ricardo’s idea is illustrated in the example of the CPA vs
Ricardo’s idea is illustrated in the example of the CPA vs. the House Painter.
Paint houses Tax Return
Madison/ $ hrs hrs.
Mason/ $ hrs hrs.

11. Who has the absolute advantage in painting, taxes?

12. Madison

13. Who has the comparative advantage in painting, taxes?
(Madison should do tax returns while Mason should paint houses even though Madison is better at both tasks).

14. To solve this problem we use the input method which looks at the amount of inputs (usually time) necessary to do an activity.
Here we look at the lower number to see who does it faster.

15. Paint Do taxes
Madison ÷ ÷ 30
Mason ÷ ÷ 40

16. For Madison each house she paints would have an opportunity cost of 15 tax returns. For Mason each house he paints has an opportunity cost of 4 tax returns. Since Mason gives up fewer tax returns for each house painted, he has the comparative advantage in painting houses.

17. Now look at the tax column
Now look at the tax column. Madison gives up 1/15 of a house painted for each tax return completed while Mason gives up ¼ of a house painted for each tax return. Since Madison gives up fewer houses painted, she has the comparative advantage in tax returns.

18. Notice that Madison has an absolute advantage in both painting and taxes whereas Madison only has a comparative advantage in taxes. If each person or nation has an absolute advantage in one product that will also be their comparative advantage.

19. Two Isolated Nations
Now let’s take the concept of comparative advantage and apply it to nations. Suppose the world consists of just two nations, the U.S. and Mexico. Also for simplicity, suppose that the labor forces in both countries are of equal size. Each nation can produce both beef and vegetables, but at different levels of economic efficiency.

20. We will make 3 simplifying assumptions concerning our analysis.
Constant costs- the curves are drawn as straight lines, in contrast to the bowed curves in chapter 1. This means we have replaced the law of increasing opportunity cost with the assumption of constant costs.

21. Different costs- the PPF of each nation reflects different resource mixes and differing levels of technology. The different slopes of each PPF reveal that the opportunity cost of producing beef and vegetables are different for the 2 countries.

22. U. S. absolute advantage in both- If the U. S
U.S. absolute advantage in both- If the U.S. and Mexico use their labor forces to produce either vegetables or beef, the U.S. can produce more of either than Mexico.

23. In the graph below with full employment, the U. S
In the graph below with full employment, the U.S. will operate at some point on its PPF. On that curve, it can increase its output of beef from 0 tons to 30 tons by forgoing 30 tons of vegetables. So the slope of the PPF is 1 (= 30 v/30 b), meaning that 1 ton of vegetables must be sacrificed for each extra ton of beef.

24. vegetables
United States 30 V A 12 B 18 30
beef

25. In Mexico 20 tons of vegetables must be given up to obtain 10 tons of beef, so the slope is 2.
(2v = 1b)

26. vegetables
Mexico v 20 4 Z b 8 10

27. Self-Sufficiency output
If each nation is isolated and self sufficient, then the U.S. will produce at point A while Mexico will produce at point Z.

28. Specializing Based on Comparative Advantage
Let’s see whether the total output of vegetables and beef will increase when each nation specializes according to its comparative advantage. Notice the U.S. has an absolute advantage in both vegetables and beef, but let’s see who has the comparative advantage in each product.

29. To solve this question we use the output method which looks at the amount of output produced with a given amount of inputs.
Here we are looking for the higher number.

30. Vegetables Beef
United States
Mexico

31. Looking at the vegetable column we take the number from the beef column and bring in over the vegetable number so for the U.S. it’s 30 ÷ 30 and for Mexico it’s 10 ÷ 20 and then reduce.

32. The U.S. has an opportunity cost of 1 beef for 1 vegetable whereas Mexico’s opportunity cost is ½ beef for each vegetable.
Mexico then has the comparative advantage in vegetables.

33. Looking at the beef column we take the number from the vegetable column and bring it over the beef column so for the U.S. it’s still 30 ÷ 30 and for Mexico it’s 20 ÷ 10 and again reduce.

34. The opportunity cost of 1 beef in the U. S
The opportunity cost of 1 beef in the U.S. is 1 vegetable, but for Mexico the opportunity cost of 1 beef is 2 vegetables so the U.S. has the comparative advantage in beef.

35. U.S.- Beef/30
Mexico- Vegetables/20

36. The world now produces more vegetables and beef than it would if each nation had been self sufficient,(30 beef vs. 26 beef and 20 vegetables vs. 16 vegetables).

37. Terms of Trade
The terms of trade reflect the exchange ratio at which the U.S. and Mexico will find it beneficial to trade. The question is can each nation “get a better deal” by specializing and trading than it could if it opted instead for self sufficiency.

38. Because 1b =1v in the U.S., it must get more than 1 ton of vegetables for each ton of beef it exports in order to gain.

39. Similarly, because 1b = 2v in Mexico, Mexico must obtain 1 ton of beef by exporting less than 2 tons of vegetables if it is to benefit.

40. The only thing we can say with certainty at this point is that the terms of trade will be somewhere in between each nations domestic opportunity cost ratio, say 1b = 1 ½ v.

41. The trading possibilities line shows the amounts of the 2 products that a nation can obtain by specializing in 1 product and trading for the other. The U.S. will specialize completely in beef, at point B, and Mexico will specialize completely in vegetables at point v.

42. U.S. exports 10 tons of beef to Mexico and receives 15 tons of vegetables in return (10 × 1.5), reflected by point A’ in the graph below.

43. U.S. Trading possibilities line
vegetables 45 V’
U.S. Trading possibilities line 30 V A’ 15 A 12 B 18 20 30
beef

44. Mexico exports 15 tons of vegetables to the U. S
Mexico exports 15 tons of vegetables to the U.S. and receives 10 tons of beef (15 ÷ 1.5), shown by point Z’.

45. Mexico’s Trading possibilities line
vegetables
Mexico’s Trading possibilities line 20 v Z’ 5 Z 4 b b’ 8 10

46. Superior Positions
Points A’ and Z’ in the above graph are superior economic positions to points A and Z. We know that a nation can expand its PPF by expanding the quantity and quality of its resources or realizing technological progress. We have now established that international trade can enable a nation to circumvent the output constraint illustrated by its PPF.

47. Review Input vs. Output
Output problems state that you get a certain amount of product out of a given input. Input problems state that it takes a certain amount of input to get a given output.

48. Now let’s work through the 5 examples in the notes
Now let’s work through the 5 examples in the notes. Indicate the following:
Input vs. output Question
Absolute advantage
Comparative advantage
Terms of Trade

49. Case for Free Trade
The case of free trade reduces to one compelling argument. The world economy can achieve a more efficient allocation of resources and a higher level of material well-being than it can without free trade.

50. Government trade barriers lessen or eliminate gains from specialization. If nations cannot trade freely, they must shift resources from efficient to inefficient uses to satisfy their diverse wants.

51. One side benefit of free trade is that it promotes competition and deters monopoly. The increased competition from foreign firms forces domestic firms to find and use the lowest-cost production techniques. And finally, free trade gives consumers a wider range of product choices.

52. Trade Barriers
While a nation as a whole gains from trade, trade may harm particular domestic industries and their workers. Those industries might seek to preserve their economic positions by persuading their respective governments to protect them from imports.

53. Trade Barriers
Tariffs- are excise taxes or “duties” on the dollar values or physical quantities of imported goods.
There are 2 types of tariffs.

54. Revenue Tariff- is usually applied to a product that is not being produced domestically, for example, tin, coffee, or bananas. Rates on revenue tariffs tend to be modest and are designed to provide the Federal government with revenue.

55. Protective Tariff- is implemented to shield domestic producers from foreign competition. These tariffs impede free trade by increasing the prices of imported goods and therefore shifting sales toward domestic producers.

56. Although protective tariffs are usually not high enough to stop the importation of foreign goods, they put foreign producers at a competitive disadvantage.

57. 2. Import Quotas- are a limit on the quantities or total values of specific items that are imported in some period. Once a quota is filled, further imports of that product are choked off. Import quotas are more effective than tariffs in impeding international trade.

58. 3. Non-tariff Barrier (NTB)- includes onerous licensing requirements, unreasonable standards pertaining to product quality, or simply bureaucratic hurdles and delays in customs procedures.

59. 4. Voluntary Export Restriction (VER)- is a trade barrier by which foreign firms “voluntarily” limit the amount of their exports to a particular country. VER’s have the same effect as import quotas and are agreed to by exporters to avoid more stringent tariffs or quotas.

60. 5. Export Subsidies- consists of a government payment to a domestic producer of export goods and is designed to aid that producer. By reducing production costs, the subsidies enable the domestic firm to charge a lower price and thus to sell more exports in world markets.

61. The Case for Protection
Despite the logic of specialization and trade, there are still protectionists in some union halls, corporate boardrooms, and congressional conference rooms.

62. What arguments do protectionists make to justify trade barriers?

63. Military Self-Sufficiency Argument- The argument here is not economic but political-military. Protective tariffs are needed to preserve or strengthen industries that produce the materials essential for national defense.

64. 2) Diversification for Stability Argument- Highly specialized economies such as Saudi Arabia and Cuba are dependent on international markets for their income. Tariff and quota protection are allegedly needed in such nations to enable greater industrial diversification.

65. 3) Infant Industry Argument- this argument contends that protective tariffs are needed to allow new domestic industries to establish themselves and give these young industries a chance to develop and become efficient producers.

66. 4) Protection Against Dumping Argument- this argument contends that tariffs are needed to protect domestic firms from “dumping” by foreign producers.

67. Dumping is the sale of a product in a foreign market at prices either below cost or below the prices commonly charged at home.

68. 5) Increased Domestic Employment Argument- arguing for a tariff to “save U.S. jobs” becomes fashionable when the economy encounters a recession. In this argument, reducing imports will divert spending on another nation’s output to spending on domestic output. Thus, domestic output and employment will rise.

69. 6) Cheap Foreign Labor Argument- this argument says that domestic firms and workers must be shielded from the ruinous competition of countries where wages are low. If protection is not provided, cheap imports will flood U.S. markets and the prices of U.S. goods, along with the wages of U.S. workers, will be pulled down.

70. Multilateral Trade Agreements
Aware of the detrimental effects of trade wars and the general weaknesses of arguments for trade protections, nations have worked to lower tariffs worldwide. Here are some examples of these efforts.

71. General Agreement on Tariffs & Trade(GATT)- In 1947, 23 nations, including the U.S., signed this agreement. It gradually expanded and was eventually replaced by the WTO.

72. 2) World Trade Organization(WTO)- oversees trade agreements reached by the member nations, and rules on trade disputes among them.

73. 3) The European Union(EU)- Countries have also sought to reduce tariffs by creating regional free-trade zones. As of 2007, there are 27 nations that comprise the EU. One of the most significant accomplishments of the EU was the establishment of the so-called Euro Zone. As of 2010, 16 members use a common currency, called the euro.

75. 4) North American Free Trade Agreement(NAFTA)- In 1993 Canada, Mexico, and the United States created a major free-trade zone. NAFTA has eliminated tariffs and other trade barriers for most goods and services.

77. 5) Association for Southeast Asian Nations (ASEAN): a 10 nation group working to promote regional peace, stability and accelerate economic growth and liberalize trade policies.