1. Comparative Advantage and the Gains from International Trade
Consumers love bargains
Should we let these bargain goods into the country?
Do cheap foreign goods threaten the jobs of American workers and the profits of American producers?
Over the post-World War II period, there has been a worldwide movement toward a policy of free trade
Hall & Leiberman; Economics: Principles And Applications, 2004

2. Comparative Advantage and the Gains from International Trade
While many barriers have come down, others are being put up
Poor countries have imposed tariffs on computers, semiconductors, and software exported by rich countries
Rich countries have announced their intention to maintain existing quotas on textiles and clothing sold by poor countries
Is free international trade a good thing that makes us better off
Hall & Leiberman; Economics: Principles And Applications, 2004

3. The Logic of Free Trade Many of us like the idea of being self-reliant
Defects of self-sufficiency explain why most people do not choose it
Principle applies not just to individuals, but also to groups of individuals
What would happen if residents of your state switched from a policy of open trading with other states to one of self-sufficiency?
Hall & Leiberman; Economics: Principles And Applications, 2004

4. The Logic of Free Trade
It would make no sense to insist on the economic self-sufficiency of each of the 50 states
What is true for states is also true for entire nations
Long-term goal of WTO is to remove all barriers to exports and imports
Hall & Leiberman; Economics: Principles And Applications, 2004

5. The Theory of Comparative Advantage
Economists who first considered the benefits of international trade focused on a country’s absolute advantage
A country has an absolute advantage in a good when it can produce it using fewer resources than another country
In 1817, however, British economist David Ricardo disagreed
A nation has a comparative advantage in producing a good if it can produce it at a lower opportunity cost than some other country
Mutually beneficial trade between any two countries is possible whenever one country is relatively better at producing a good than the other country
Being relatively better means having ability to produce a good at a lower opportunity cost
Hall & Leiberman; Economics: Principles And Applications, 2004

6. Opportunity Cost and Comparative Advantage
To illustrate Ricardo’s insight, let’s consider a hypothetical world of two countries—China and United States
Both countries can gain from trade
If China could be persuaded to produce more suits and United States more computers
World’s total production of goods will increase
Each country can come out ahead by trading with the other
Hall & Leiberman; Economics: Principles And Applications, 2004

7. Specialization and World Production
Additional production lies behind the substantial benefits countries enjoy from free trade
If countries specialize according to comparative advantage, a more efficient use of given resources occurs
That is, with the same resources, the world can produce more of at least one good
Without decreasing production of any other good
Hall & Leiberman; Economics: Principles And Applications, 2004

8. The Terms of Trade Exchange ratio is known as the terms of trade
Quantity of one good that is exchanged for a unit of the other
Determine how gains from international trade are distributed among countries
Hall & Leiberman; Economics: Principles And Applications, 2004

9. How Potential Gains Turn Into Actual Gains
Within framework of WTO, government officials are supposed to create environment for free trade
But they do not decide who has a comparative advantage in what, or what should be produced in this or that country
In today’s market economies around the world, it is individual consumers and firms who decide to buy things—at home or abroad
What makes China shift resources into its comparative advantage good?
And what makes the U.S. shift resources in the other direction?
Prices
Hall & Leiberman; Economics: Principles And Applications, 2004

10. How Potential Gains Turn Into Actual Gains
When consumers are free to buy at the lowest prices
They will naturally buy a good from the country that has a comparative advantage in producing it
That country’s industries respond by producing more of that good and less of other goods
Countries naturally move toward specializing in those goods in which they have a comparative advantage
Conclusion applies even beyond simple example we’ve been considering
Applies when there are many countries and many goods
Applies when countries use a variety of resources to produce goods, rather than just labor
Hall & Leiberman; Economics: Principles And Applications, 2004

11. Some Important Provisos
Following real-world considerations can lead to reduced trade or incomplete specialization
Costs of Trading
If there are high transportation costs or high costs of making deals across national boundaries
Trade may be reduced and even become prohibitively expensive
Sizes of Countries
Sometimes a very large country trades with a very small one
If the smaller country specialized completely, its output would be insufficient to fully meet demand of the larger one
Increasing Opportunity Cost
Have assumed opportunity cost remains constant as production changes
More typically, opportunity cost of a good rises as more of it is produced
In the end, while trading will occur, there will not be complete specialization
Government Barriers to Trade
Hall & Leiberman; Economics: Principles And Applications, 2004

12. The Sources of Comparative Advantage
What determines comparative advantage in the first place?
A country that has relatively large amounts of a particular resource at its disposal
Will tend to have a comparative advantage in goods that make heavy use of that resource
Countries often develop strong comparative advantage in the goods they have produced in the past
Regardless of why they initially began producing those goods
Hall & Leiberman; Economics: Principles And Applications, 2004

13. Why Some People Object to Free Trade
Given the clear benefits that nations can derive by specializing and trading
Why would anyone ever object to free international trade?
Despite benefit to nation as a whole, some groups within the country, in short-run, are likely to lose from free trade
Even while others gain a great deal more
Instead of finding ways to compensate the losers
Often allow them to block free-trade policies
Hall & Leiberman; Economics: Principles And Applications, 2004

14. Figure 1: The Impact of Trade
China
United States
Thousands of Suits per Month
Price
(Dollars)
Supply
$500 F
Supply
Exports C D
$350
$350 A B
Imports
Demand
$250 E
Demand
200
300
250
310
150
160
Hall & Leiberman; Economics: Principles And Applications, 2004

15. The Impact of Trade in the Exporting/Importing Country
When opening of trade results in increased exports of a good
Producers of the good are made better off
Consumers of the good in exporting country will be made worse off
When opening of trade results in increased imports of a product
Domestic producers of the product are made worse off
Consumers of the good in importing country are better off
Hall & Leiberman; Economics: Principles And Applications, 2004

16. Attitudes and Influence on Trade Policy: The Anti-Trade Bias
Distribution of gains and losses create a policy-bias against free trade
Those who benefit from trade in a specific product either have little incentive to lobby for it (consumers of imports)
Or have limited power to influence policy (producers of exports)
But one constituency harmed by trade has both a powerful incentive to lobby and ability to influence policy
Domestic producers threatened by imports
Hall & Leiberman; Economics: Principles And Applications, 2004

17. Attitudes and Influence on Trade Policy: The Anti-Trade Bias
Antidotes to this policy bias
Multilateral Agreements
Two or more countries agree to trade freely in many goods—or even all goods—simultaneously
World Trade Organization
By setting standards for acceptable and unacceptable trade restrictions, and making rulings in specific cases, WTO has some power to influence nations’ trade policies
Industries as Consumers
Term can apply to any buyer of a product, including a firm that uses it as an input
Hall & Leiberman; Economics: Principles And Applications, 2004

18. Figure 2: The Effect of a Tariff on Suits
China
United States
Price
(Dollars)
Thousands of Suits per Month
Supply K L
$425
Supply C
Imports D
$350
$350 A
Exports B
$300 H J
Demand
Demand
150
250
300
160
205
280
175
310
Hall & Leiberman; Economics: Principles And Applications, 2004

19. How Free Trade Is Restricted
When government decides to accommodate opponents of free trade
It is apt to use tariffs or quotes to restrict trade
Tariffs
Tax on imported goods
Can be a fixed dollar amount per physical unit or a percentage of good’s value
In either case, effect in tariff-imposing country is similar
Both countries, as a whole, are worse off
Tariffs reduce volume of trade and raise domestic prices of imported goods
In the country that imposes the tariff, producers gain and consumers lose
World as a whole loses, because tariffs decrease volume of trade and therefore decrease gains from trade
Hall & Leiberman; Economics: Principles And Applications, 2004

20. How Free Trade Is Restricted
Quotas
Government decree limiting imports of a good to a specified maximum physical quantity
Because goal is to restrict imports, a quota is set below the level of imports that would occur under free trade
General effects are same as a tariff
Reduce quantity of imports and raise domestic prices
While both tariffs and quotas help domestic producers
They reduce benefits of trade to the nation as a whole
However, a tariff has one saving grace
Increased government revenue
Hall & Leiberman; Economics: Principles And Applications, 2004

21. Protectionism
Groups who suffer from trade with other nations have developed a number of arguments against free trade
Together, these arguments form a position known as protectionism
Belief that a nation’s industries should be protected from free trade with other nations
Myths about international trade
A high-wage country cannot afford free trade with a low-wage country
High-wage country will either be undersold in everything and lose all of its industries, or else its workers will have to accept equally low wages and equally low living standards
Low-productivity country cannot afford free trade with a high-productivity country
Former will be clobbered by latter and lose all of its industries
In recent times, America’s unskilled workers have suffered because of ever-expanding trade between United States and other countries
Hall & Leiberman; Economics: Principles And Applications, 2004

22. Sophisticated Arguments for Protection
Strategic trade policy and support for infant industries are controversial
Opponents stress three problems
Once government assistance to an industry is accepted
Special interest groups of all kinds will lobby to get the assistance
Whether it benefits general public or not
When one country provides assistance to an industry by keeping out foreign goods, other nations may respond in kind
If they respond with tariffs and quotas of their own, result is a shrinking volume of world trade and falling living standards
If subsidies are used to support a strategic industry, and another country responds with its own subsidies, then both governments lose revenue
Neither gains the sought-after profits
Strategic trade policy assumes that government has information to determine which industries, infant or otherwise, are truly strategic and which are not
Hall & Leiberman; Economics: Principles And Applications, 2004

23. Sophisticated Arguments for Protection
Arguments help to remind us of conditions under which free trade is most beneficial to a nation
Production is most likely to reflect principle of comparative advantage
When firms can obtain funds for investment projects
When they can freely enter industries that are profitable
Thus, free trade, without government intervention, works best when markets are working well
May partly explain why United States has for decades been among the strongest supporters of free trade ideal
Hall & Leiberman; Economics: Principles And Applications, 2004

24. Protectionism in the United States
U.S. consumers have suffered and U.S. producers have gained, from some persistent barriers to trade
Protection is costly
In some cases, cost per job saved is staggering
In addition to the dozens of industries in U.S. permanently protected from foreign competition
Dozens more each year are granted temporary protection when the U.S. government finds a foreign producer or industry guilty of dumping
Selling their products in U.S. at “unfairly” low prices that harm a U.S. industry
Most economists believe that these low prices are most often the result of comparative advantage
U.S. as a whole would gain from importing the good
Hall & Leiberman; Economics: Principles And Applications, 2004

25. Using the Theory: The U.S. Sugar Quota
United States has protected U.S. sugar producers from foreign competition since 1930s
Since 1980s protection has been provided in the form of a price guarantee
If U.S. sugar prices fall below 22¢, government will buy the sugar at that price
May not sound like a lot
But in the rest of the world, people and businesses can buy sugar for a lot less
Government decides how much foreign sugar it will allow in each year free of any tariff
All sugar beyond the allowed amount faces a heavy tariff of about 16¢ a pound
Sugar producers benefit
Sugar consumers are hurt substantially
Hall & Leiberman; Economics: Principles And Applications, 2004

26. Using the Theory: The U.S. Sugar Quota
Taxpayers pay a cost for the sugar quota
Because as part of its price support program, U.S. government must occasionally buy excess sugar from producers
Hurts the poorest countries in the world that rely on sugar as an important source of export revenue
Sugar quota’s harm to these countries has been estimated at about $1.5 billion per year
Why do we bear these costs?
Because of lobbying by groups who enjoy highly concentrated benefits
Hall & Leiberman; Economics: Principles And Applications, 2004