Comparative Advantage and the Gains from International Trade

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

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

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?

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

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

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

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

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

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

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

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

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

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

China United States Price Price (Dollars) (Dollars) Thousands of Suits per Month Thousands of Suits per Month Figure 1: The Impact of Trade Supply F $500 Supply Exports C D $350 $350 A B Imports Demand $250 E Demand 200 300 250 310 150 160

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

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

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

China United States Price Price (Dollars) (Dollars) Thousands of Suits per Month Thousands of Suits per Month Figure 2: The Effect of a Tariff on Suits Supply K L $425 Supply D C Imports $350 $350 Exports B A $300 H J Demand Demand 150 250 300 160 205 280 175 310

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

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

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

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

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

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

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

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

Comparative Advantage and the Gains from International Trade