International Trade, Comparative Advantage, and Protectionism

Chapter 20

Trade Surpluses and Deficits

z A trade surplus exists when a country exports more than it imports. z A trade deficit exists when a country imports more than it exports.

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Canadas Major Exports and Imports in 1999 (Table 20.1)

Canadas Balance of Trade, 19461999 (millions of dollars) Table 20.2

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Corn Laws
z The tariffs, subsidies, and restrictions enacted by British parliament in the early nineteenth century to discourage imports and encourage exports of grain.

Theory of Comparative Advantage

z Ricardos theory that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

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Absolute Advantage
z A country has an absolute advantage in the production of a good if it can produce more of the good with a fixed amount of resources than can any other country. (i.e. when the country uses fewer resources to produce a product than the other country)

Comparative Advantage
z Comparative advantage is the advantage in the production of a product enjoyed by one country over another when that product can be produced at a lower opportunity cost. z The opportunity cost of a product is the alternative products that must be sacrificed to facilitate its production.

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Australia and New Zealand: An Example (from Table 20.3)

z Yield per hectare of wheat and cotton: z New Zealand
y 6 tonnes wheat y 2 bales cotton

Mutual Absolute Advantage

z In this example Australia has the absolute advantage in producing cotton and New Zealand the absolute advantage in producing wheat. In cases like this the countries are said to have a mutual absolute advantage.

z Australia
y 2 tonnes wheat y 6 bales cotton

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Australia and New Zealand: An Example (from Table 20.4)

z Total production of wheat and cotton assuming no trade, mutual absolute advantage, and 100 hectares available
y New Zealand
x Wheat: 25 hectares x 6 tonnes/hectare = 150 tonnes x Cotton: 75 hectares x 2 bales/hectare = 150 bales

Production Possibilities of Australia and New Zealand Before Trade (Figure 20.1)

y Australia
x Wheat: 75 hectares x 2 tonnes/hectare = 150 tonnes x Cotton: 25 hectares x 6 tonnes/hectare = 150 tonnes

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Advantages of Trade and Specialization

z Both countries are initially restricted to their own PPF which represents all the combinations of goods that can be produced given the countries resources and state of technology. z After trade both countries are able to move out beyond their previous resource and productivity constraints.

Production and Consumption of Wheat and Cotton After Specialization (Table 20.5)

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Expanded Possibilities After Trade

(Figure 20.2)

Gains from Trade When One Country Has an Absolute Advantage in Both Goods (Tables 20.6 and 20.7)
z Yield per Hectare of Wheat and Cotton

z Total Production of Wheat and Cotton Before Trade (100 hectares)

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Realizing a Gain From Trade When One Country Has a Double Absolute Advantage
(Table 20.8)

Comparative Advantage Means Lower Opportunity Cost (Figure 20.3)

When countries specialize in producing those goods in which they have a comparative advantage, they maximize their combined output and allocate resources more efficiently.
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Terms of Trade
z The terms of trade refers to the ratio at which a country can trade domestic products for imported products.

Exchange Rates
z The price of one countrys currency in terms of another countrys currency. The ratio at which two currencies are traded z For any pair of countries, and given domestic prices, there is a range of exchange rates that can lead automatically to both countries realizing the gains from specialization and comparative advantage
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Trade and Exchange Rates in a Two Country / Two Good World (from Table 20.9)
z Domestic Prices of Lumber and Cloth in Canada and the United States
y Canada
x Cloth: C$5/metre x Lumber: C$5/metre

Canadian-Dollar Prices of Lumber and Cloth in Canada and the United States If C$1=US$0.50
(from Table 20.10)

y Canada
x Lumber: C$5/metre x Cloth: C$5/metre

y United States
x Lumber: US$4/metre = C$8/metre x Cloth: US$3/metre = C$6/metre

y United States
x Cloth: US$4/metre x Lumber: US$3/metre

y Since both products are cheaper in Canada, no Canadian will purchase US products but Americans will import both products from Canada.
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Canadian-Dollar Prices of Lumber and Cloth in Canada and the United States If C$1=US$1
(from Table 20.11)

Canadian-Dollar Prices of Lumber and Cloth in Canada and the United States If C$1=US$0.80
(from Table 20.12)

y Canada
x Lumber: C$5/metre x Cloth: C$5/metre

y Canada
x Lumber: C$5/metre x Cloth: C$5/metre

y United States
x Lumber: US$4/metre = C$4/metre x Cloth: US$3/metre = C$3/metre

y United States
x Lumber: US$4/metre = C$5/metre x Cloth: US$3/metre = C$3.75/metre

y Americans will have no interest in Canadian products but Canadians will convert dollars to purchase (import) both products from the U.S.
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y Americans will have no interest in Canadian products but Canadians will convert dollars to purchase (import) cloth from the U.S.
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Canadian-Dollar Prices of Lumber and Cloth in Canada and the United States If C$1=US$0.75
y Canada
x Lumber: C$5/metre x Cloth: C$5/metre

Trade Flows Determined By Exchange Rates (Table 20.13)

y United States
x Lumber: US$4/metre = C$5.33/metre x Cloth: US$3/metre = C$4.00/metre

y Americans will wish to purchase Canadian lumber and Canadians will convert dollars to purchase (import) cloth from the U.S.
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z If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it has a comparative advantage. Only those products in which a country has a comparative advantage will be competitive on world markets.
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Sources of Comparative Advantage

z Factor endowments (Heckscher-Ohlin Theorem)
y The quantity and quality of labour, land and natural resources of a country.

Heckscher-Ohlin Theorem
z The H-O Theorem explains the existence of a countrys comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

z Product differentiation

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Trade Barriers
z Protection: The practice of shielding a sector of the economy from foreign competition. z Tariffs: A tax on imports. z Export Subsidies: Government payments made to domestic firms to encourage exports. z Quotas: A limit on the quantity of imports.

Dumping
z Dumping is when a firm or an industry sells products on the world market at prices below the cost of production.

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Smoot-Hawley Tariff
z The U.S. tariff law of the 1930s that set the highest tariffs in US history (60%). It set off an international trade war and caused a decline in trade that is often considered a cause of the worldwide depression of the 1930s.

General Agreement on Tariffs and Trade (GATT)

z The GATT is an international agreement signed by the Canada and 22 other countries in 1947 to promote the liberalization of foreign trade.

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World Trade Organization

z The body currently responsible for governing world trade. z The WTO replaced the General Agreement on Tariffs and Trade (GATT) on January 1, 1995.

European Union (EU)

z The EU is the European trading bloc composed of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. z The EU is an example of economic integration which occurs when two or more countries join to form a free trade zone.
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Canada-US Free-Trade Agreement

z An agreement which came into effect January 1, 1989, in which Canada and the United States agreed to eliminate all barriers to trade between the two countries over a ten-year period.

North American Free-Trade Agreement (NAFTA)

z An agreement, which came into effect on January 1, 1994, signed by Canada, the United States, and Mexico, in which the three countries agreed to establish all of North America as a free trade zone.

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The Gains From Trade

(Figure 20.4a)

Losses from the Imposition of a Tariff (Figure 20.4b)

z A tariff of $1 per metre increases the market price. The government collects the tariff revenue. z Loss of efficiency occurs because:
y Consumers pay a higher price y Inefficient producers are drawn into domestic textile production.
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z Foreign producers are able to provide textiles on the world market much cheaper than Canadian producers. z Trade lowers the price for Canadian consumers and allocates resources into industries in which Canada has the comparative advantage.
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The Case for Protection

z z z z z z Saves jobs Unfair trade practices by other countries Cheap foreign labour Safeguard national security Discourages dependency Safeguard infant industries

Review Terms & Concepts

z absolute advantage z Canada-US Free Trade Agreement z comparative advantage z Corn Laws z dumping z economic integration z European Union z exchange rate
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z z z z z z z z

export subsidies factor endowments GATT Heckscher-Ohlin Theorem infant industry NAFTA protection quota
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Review Terms & Concepts (cont.)

Smoot-Hawley tariff tariff terms of trade theory of comparative advantage z trade deficit z trade surplus z World Trade Organization z z z z

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