1. Chapter 20 International Trade
In this chapter we will take a look at some key facts about international trade and then start evaluating international trade using comparative advantage. We will also use demand and supply curves to explain how countries determine which goods they will import, which goods they will export, and the price that is charged for these goods. Lastly we will look at trade barriers and how they impact the outcomes of international trade.
International Trade

2. Some Key Trade Facts U.S. trade deficit in goods $529 billion in 2015
U.S. trade surplus in services
$220 billion in 2015
Canada largest U.S. trade partner
Trade deficit with China
$366 billion in 2015
Exports are 13% U.S. output
Dependence on oil
International trade is a key component in most nations’ economies. It is one of the reasons that will allow a country’s economy to grow. Without it, a nation might not have access to a key resource or a way to exchange its own key resources for other items needed. The U.S. economy has thrived on international trade throughout its history. In one sense, the U.S. was founded on the very basis of international trade as Christopher Columbus discovered the new world while looking for a new route to engage in international trade.
We can understand why Canada is our largest trading partner given the fact that we share a lengthy border that facilitates trade. The trade deficit with China has been decreasing in recent years as their economy grows, providing the citizens with more disposable income with which to purchase imported items coming from the U.S. Our dependence on foreign oil still causes concerns in many sectors because if the supply was disrupted for any reason, it could cause severe supply shocks in the economy.
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3. Some Key Trade Facts Continued
Principal U.S. exports include:
Chemicals
Agricultural products
Consumer durables
Semiconductors
Aircraft
U.S. provides about 8.5% of world’s exports
The principal U.S. exports reflect the fact that we have a more skilled workforce and also a thriving agricultural industry. Frequently, the U.S. is referred to as the breadbasket of the world due to our ability to produce crops such as wheat and corn.
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4. Some Key Trade Facts Concluded
Principal U.S. imports include:
Petroleum
Automobiles
Metals
Household appliances
Computers
It is interesting to note that we import some of the same products we export. In today’s economy, most goods that involve basic manual labor are made in countries that have a less skilled workforce. Clothing is a prime example.
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5. Shares of World Exports
This Global Perspective illustrates the largest export nations in the world in China has the largest share of world exports, followed by the United States and Germany. These eight countries account for approximately 44.8% of the world exports.
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6. Shares of World Exports Continued
Some Key Trade Facts
Shares of World Exports Continued
This Global Perspective shows exports of goods and services as a percentage of GDP for selected countries. Although the United States is one of the world’s largest exporters, as a percentage of GDP, its exports are quite low relative to many other countries.
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7. Economic Basis for Trade
Nations have different resource endowments
Labor-intensive goods
Land-intensive goods
Capital-intensive goods
Why trade? The reason is that nations, as well as individuals, can gain by specializing. With trade, everyone ends up better off than before. The benefits are derived from three facts: (1) the distribution of natural, human, and capital resources is uneven among nations, (2) not all nations have the same degree of technology, and (3) people have different preferences. In a country such as China, which has an abundant supply of cheap labor, producing labor-intensive goods makes sense. Other countries may be blessed with an abundance of natural resources and therefore can produce land-intensive goods inexpensively. Industrially-advanced nations can produce goods that require large amounts of capital at a low cost. As countries evolve, their economies will also evolve and change. Countries that once focused on labor-intensive goods may now move towards more capital-intensive goods as their firms acquire more capital and experience.
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8. Comparative Advantage
Assumptions
Two nations
Same size labor force
Constant costs in each country
Different costs between countries
U.S. absolute advantage in both
Opportunity cost ratio
Slope of the curve
Vegetables sacrificed per ton of beef
Comparative advantage is used to explain the relationship between specialization and international trade. A nation does not have to have an absolute advantage in producing a good to benefit by trading. Absolute advantage exists when one nation is the most efficient producer of a good, meaning it can produce the good at the lowest possible price. Under comparative advantage, the country can produce the good at a lower opportunity cost, which measures what must be given up to produce it. In our initial analysis, we will look at two nations with similarities. We will use the U.S. and Mexico and assume that the U.S. has an absolute advantage over Mexico in producing two goods, beef and vegetables.
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9. Production Possibilities
(a) United States
(b) Mexico
Vegetables (Tons) 30 25 20 15 10 5 35 40 45
Beef (Tons) 12 18 8 4 A Z
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The production possibilities curves illustrate the relationship between vegetables and beef in each nation. For example, in the U.S., if the country produces 12 tons of vegetables, it can only produce 18 tons of beef. If the U.S. were to increase vegetable production to 15 tons, beef production would go down to 15 tons.
In Mexico, the numbers are much smaller as their economy is not as large. If Mexico produces 4 tons of vegetables, then it can only produce 8 tons of beef. To produce more beef, a country must produce less vegetables and vice versa.

10. Comparative Advantage Continued
Self-sufficiency output mix
Specialization and trade
Produce the good with the lowest domestic opportunity cost
Opportunity cost of 1 ton of beef:
1 pound of vegetables in U.S.
2 pounds of vegetables in Mexico
If each country is isolated and self-sufficient, each must decide what mix of beef and vegetables it desires to produce, recognizing the fact that to get more beef, the country must produce less vegetables. Mexico has a higher opportunity cost as it must give up 2 pounds of vegetables for every pound of beef, whereas in the U.S., it is a 1 to 1 ratio.
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11. International Specialization
Comparative Advantage
International Specialization
This table lists the international specialization according to comparative advantage and the gains from trade for the U.S. and Mexico.
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12. Terms of Trade U.S. 1V = 1B U.S. will sell 1B for more than 1V
Mexico 2V = 1B
Mexico will pay less than 2V for 1B
Settle between the two
Depends on supply/demand factors
Assume 1B = 1.5V
Since the U.S. can produce beef for less than Mexico, it makes sense for the U.S. to produce beef and trade with Mexico for vegetables. Mexico has a comparative advantage in vegetables as the country would only have to sacrifice ½ ton of beef to gain a ton of vegetables, whereas the U.S. would have to give up 1 ton of beef to gain a ton of vegetables. By doing so, both nations will benefit as they work out the terms of trade. The U.S. will end up getting more than 1 ton of vegetables for one ton of beef, and Mexico will get more than ½ ton of beef for 1 ton of vegetables, which it would get without trade.
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13. Gains from Trade Trading possibilities line
Slope equals terms of trade
Improved options
Complete specialization
More of both goods
More efficient resource allocation
The trading possibilities line shows that both countries end up better off with trade. With comparative advantage, the nations have complete specialization in which each nation only produces the good that it has the comparative advantage in and then imports all of the good for which it has a comparative disadvantage. Each country ends up with more of both goods. Both the U.S. and Mexico made more efficient use of their resources by specializing in production of the good for which they have a comparative advantage.
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14. Gains from Trade Continued
(a) United States
(b) Mexico
Vegetables (Tons) 30 25 20 15 10 5 35 40 45
Beef (Tons) 12 18 8 4 A Z A’ Z’ V V’ W v b b’
Trading
Possibilities Line B
As we can see in these graphs, the maximum production line for each country has rotated outwards to provide each with a higher level of output with trade. In the long run, all parties benefit from trade, at any level. The slope of the trading possibilities line reflects the terms of trade between the two countries.
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15. Comparative Advantage Concluded
Trade with increasing costs
Concave production curve
Resources not perfectly substitutable
Incomplete specialization
Case for free trade
Promote efficiency
Promote competition
While we were using a very simple example of two products and two countries, the analysis would be the same for any number of products and countries. In the real world we are also faced with a concave production possibilities curve instead of the linear one from our analysis. This means there are increasing opportunity costs in the real world and, at some point, the underlying basis for further specialization and trade disappears so both countries end up producing some of both products.
This is why we end up with domestically-produced products competing with similar imported products. However the numbers come out, everyone ends up benefitting somehow from trade. In addition to promoting efficiency and competition among firms, nations benefit as they build relationships with their trading partners that can help to prevent disagreements that might lead to wars.
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16. Supply and Demand Analysis
World price
Domestic price with no trade
World price > domestic price
Export surplus
Export supply curve
World price < domestic price
Import shortage
Import supply curve
We can apply supply and demand analysis to see how equilibrium prices and quantities of imports and exports are determined. The amount that a nation imports or exports of a particular good depends on the difference between the equilibrium world price and the equilibrium domestic price. It is assumed that when the country starts to trade, then the domestic price will either rise or fall to the world price level.
The equilibrium domestic price is the price that would prevail in a closed economy that does not engage in trade. When the world equilibrium price is above the domestic equilibrium price, there would be an export surplus as suppliers would produce more than that demanded by the domestic economy and would then export it to receive the higher world price.
If the world equilibrium price is less than the domestic equilibrium price, the opposite effect occurs.
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17. Supply and Demand Analysis Continued
U.S. Domestic
Aluminum Market
(b) U.S. Export Supply
and Import Demand
Price (Per Pound; U.S. Dollars
1.50
1.25
1.00
.75
.50 50 75
100
125
150
Quantity of Aluminum
(Millions of Pounds)
Surplus = 100
1.50
1.25
1.00
.75
.50 50
100
Quantity of Aluminum
(Millions of Pounds)
Price (Per Pound; U.S. Dollars Sd c
Surplus = 50
U.S.
Export
Supply b a
U.S.
Import
Demand
Here in these graphs we see the effects of differences between the world price and the domestic equilibrium price. The domestic equilibrium price is $1.00/pound. If the world price is above that point, say at $1.25/pound, domestic producers will produce 125 million pounds, which creates a surplus of 50 million pounds over the domestic demand. The surplus will be exported and sold at the higher price. For each price above the domestic equilibrium price, there will be surplus and the U.S. will export that surplus at that price, creating the U.S. export supply.
For each price below the domestic equilibrium price, the U.S. will have a shortage and will import aluminum equivalent to the size of the shortage. Doing this for each price creates the U.S. import demand. x
Shortage = 50 y
Shortage = 100 Dd
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18. Supply and Demand Analysis Concluded
Canada’s Domestic
Aluminum Market
(b) Canada’s Export Supply
and Import Demand
Price (Per Pound; U.S. Dollars
1.50
1.25
1.00
.75
.50 50 75
100
125
150
Quantity of Aluminum
(Millions of Pounds)
1.50
1.25
1.00
.75
.50 50
100
Quantity of Aluminum
(Millions of Pounds)
Price (Per Pound; U.S. Dollars
Surplus = 100 Sd s
Surplus = 50
Canadian
Export
Supply r
Here we switch our viewpoint to Canada for illustration purposes. We can see their domestic equilibrium price is $.75/pound, and we see the surpluses and shortages that occur when the world price is higher or lower than that. q
Canadian
Import
Demand t
Shortage = 50 Dd
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19. International Equilibrium
Import demand = Export supply
1.00
.75
.88 50
100
Quantity of Aluminum
(Millions of Pounds)
Price (Per Pound; U.S. Dollars
U.S.
Export
Supply
Canadian
Export
Supply e
Equilibrium
U.S.
Import
Demand
Now we can combine the two countries into one analysis to determine a world equilibrium price. If we combine the U.S. export supply curve and import demand curve with the Canadian export supply curve and import demand curve, we find the equilibrium point where one country’s export supply curve intersects the other country’s import demand curve. In this example that occurs at a price of $.88/pound. After trade, this would be the price found in both countries.
Canadian
Import Demand
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20. Trade Barriers and Export Subsidies
Tariffs
Revenue tariff
Protective tariff
Import quota
Nontariff barrier (NTB)
Voluntary export restriction (VER)
Export subsidy
Even though a nation gains from trade as a whole, some domestic industries may be hurt by trade and some industries may need to be maintained even if they are not cost effective for reasons such as national security or defense. Countries use several different techniques to protect industries from the harmful effects of trade.
Tariffs are one of the most common barriers to trade. A tariff is an excise tax on the dollar value, or quantity of an imported good. Revenue tariffs are applied to a good that is typically not produced in the domestic country, and they are designed to raise revenue for the domestic government. Revenue tariffs tend to be fairly low.
Protective tariffs are another matter. They are applied to goods that do have a domestic competitor and are designed to make the imported goods cost at least as much as, or more than, the domestic good, so these tariffs can be quite high.
Import quotas are another common barrier countries use. A quota is a limit on the amount of a particular good that could imported in a given amount of time. By limiting the supply, you drive the price up, thereby making the imported good more expensive than its domestic competitor.
A nontariff barrier can include such things as requiring extensive documentation for imported goods, restricting the location available to receive the imported goods, or having unreasonable standards for imported goods.
A voluntary export restriction is when foreign firms “voluntarily” agree to limit the amount of their exports to a particular country. The catch is that even though it was voluntary, it was done under the threat of mandatory barriers so it really was not done through free will.
Export subsidies consist of government payments to a domestic producer of export goods and are designed to help that producer by reducing its production costs. This should enable the producer to compete more effectively against the imported goods.
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21. Economic Impact of Tariffs
Direct effects
Decline in consumption
Increase in domestic production
Decline in imports
Tariff revenue
Indirect effects
Because tariffs are the most commonly used trade barrier, we will look closer at their effect on the economy. The direct impact of tariffs includes a decline in domestic consumption as the desired goods are now at a higher price than consumers are willing to pay, an increase in domestic production as suppliers will be able to receive a higher price for the goods, a decline in imports which was the whole point of the tariff, and tariff revenue accruing to the domestic government.
Tariffs also have an indirect effect beyond just basic supply and demand concepts. Since the foreign country supplying the import will sell less, their economy will decline. If they imported any products from the domestic country, those would decline as well. Tariffs also, to some extent, subsidize inefficient producers, which can be a drain on the economy.
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22. Economic Impact of Quotas
Decline in consumption
Increase in domestic production
Decline in imports
Quotas do not provide for any government revenue but instead transfer it to foreign producers
Quotas have much the same effect as tariffs with the major difference being that quotas do not provide any government revenue. With a tariff, the government could theoretically use the revenue to compensate firms and individuals who have been adversely affected by the international trade. With quotas, the excess revenue provided accrues to the foreign producer, not the domestic government.
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23. Economic Effects of a Tariff or Quota
Quantity
Price Sd
Sd + Q Pd Pt Pw
This graph illustrates the effects of a tariff or quota on domestic supply and demand. At the world price, there is a shortage in the market equivalent to ad. This shortage will be solved with imports equivalent to ad. When a tariff is placed on the good, the price increases, and the quantity produced by domestic firms will rise while the quantity demanded by domestic consumers falls. The shortage shrinks from ad to bc. The foreign producers will continue to receive the world price.
The quota has essentially the same effects except that the higher price is now received by foreign and domestic producers. Note that the yellow area reflects the additional revenue that under a tariff will go to the government but with a quota will go to the foreign producer. Dd a b q c d
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24. The Case for Protection
Military self-sufficiency
Diversification for stability
Infant industry
Protection against dumping
Increased domestic employment
Cheap foreign labor
There are many different arguments used to support the use of trade barriers. Military self-sufficiency preys on people’s fear of another war and being unable to defend themselves, so they argue that the industry related to the military must be protected and maintained domestically.
Diversification for stability looks at the need to have a well-rounded economy that is not too heavily invested in any one area that could be subject to collapse. (That is the proverbial “all of our eggs in one basket” argument.)
New or infant industries argue that they need protection during the infancy stage to help them grow and become strong enough to compete on their own. This may be needed especially in a developing nation that is just moving into the world economy, but care must be taken not to prolong the support. Other options besides tariffs or quotas may work better to help the industry develop.
Dumping is also considered a big problem that needs addressing. Dumping occurs when a foreign firm deliberately sells goods below their cost in an attempt to drive the domestic industry out of business. Once the domestic industry is gone, the foreign firm is then free to raise prices to whatever level they desire. This may even be done with the support of the foreign government. Dumping is considered an “unfair trade practice,” and sanctions can be imposed against the countries or firms involved.
The final arguments deal with labor issues. Saving American jobs is a standard campaign slogan for political candidates. While imports do eliminate some U.S. jobs, they also create new jobs in industries that will be exporting to the foreign country that now has disposable income to spend due to selling their exports. It also creates jobs for individuals involved with importing the good into the country. History has shown that trade barriers often have the reverse effects and can reduce domestic employment especially if foreign countries retaliate. It is argued that the cheap foreign labor will drive the wage rates in the U.S. down, reducing our standard of living. Again, the saying is “a rising tide lifts all boats.” Everyone benefits from trade.
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25. Multilateral Trade Agreements
General Agreement on Tariffs and Trade (GATT)
World Trade Organization (WTO)
European Union (EU)
North American Free Trade Agreement (NAFTA)
The modern trend is for nations to seek to reduce or eliminate trade barriers as they recognize the fact that trade is a good thing. Each of these trade agreements reflect the trend towards increased free trade.
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26. GATT Three principles:
Equal, nondiscriminatory trade between member nations
Reduction in tariffs
Elimination of import quotas
First signed in 1947 by 23 nations, including the U.S., GATT’s aim was to provide a forum for multilateral negotiations to reduce trade barriers. Since the enactment of GATT, tariffs on thousands of products have been eliminated or reduced with overall tariffs decreasing by 33%. Each round of negotiations added more countries to the agreement and further increased international trade.
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27. WTO Established by Uruguay Round of GATT 161 member nations in 2015
Oversees trade agreements and rules on disputes
Critics argue that it may allow nations to circumvent environmental and worker-protection laws
The WTO is the largest organization devoted to promoting international trade. The current round of negotiations began in 2001 in Doha, Qatar and are aimed at further reducing tariffs and quotas as well as agricultural subsidies that can distort trade.
Critics are concerned that the WTO may supersede the authority of a member nation to protect its own environment and workers by allowing firms to move to countries with less restrictive laws. Proponents respond that these concerns are outside the scope of WTO authority and should be dealt with in other forums. They also feel that as developing nations gain from trade, they will be better equipped to help protect their workers and environment.
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28. European Union Initiated in 1958 as Common Market
Abolished tariffs and import quotas between member nations
Established common tariff with nations outside the EU
Created Euro Zone with one currency
Currently at 28 member nations, the EU is one of the most dramatic examples of a free-trade zone. In addition to eliminating almost all tariffs and quotas between the member nations, it has also liberalized the movement of capital and labor within the union and created common policies on matters of joint concern, such as agriculture, transportation, and business practices. The introduction of the Euro currency in the early 2000s, which was adopted by 19 of the member nations by 2015, has enabled those nations to improve their standard of living by making it easier to price and sell their products in the euro zone nations.
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29. NAFTA Agreement between U.S., Canada, and Mexico
Established a free trade zone between the countries
Trade has increased in all countries
Enhanced standard of living
So far, time has proven the critics of NAFTA wrong. Since NAFTA was enacted in 1993, over 25 million jobs have been created in the U.S., trade among the three nations has increased, and the standard of living in each nation has also increased.
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30. Helping Those Hurt by Free Trade
Trade Adjustment Assistance Act
Designed to help individuals hurt by international trade
Offshoring of jobs
Shifting of work previously done by American workers to workers abroad
The Trade Adjustment Assistance Act of 2002 introduced some innovative policies designed to help those workers who had been displaced by international trade. The Act provided financial assistance beyond unemployment benefits, relocation allowances, and retraining services. Critics argue that helping one small section of workers is not fair to other workers who lose jobs for a variety of reasons.
Offshoring of jobs is another major concern to American workers, but it is not necessarily bad for the economy. Offshoring can increase the demand for complementary jobs in the U.S. and increase the off-shored workers’ income to purchase goods produced in the U.S.
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31. Petition of the Candlemakers
Petition of candlemakers asking for protection from natural light producers such as the sun
Tongue-in-cheek argument supporting the idea of free trade
French economist Frederic Bastiat argued that the lawmakers must impede the power of the sun in order to increase the production of candles. This was used to show protectionists the inefficient arguments and conclusions that are associated with trade protections.