International Trade, Comparative Advantage, and Protectionism

CHAPTER 30
International Trade,
Comparative Advantage, and
Protectionism
Prepared by: Fernando

Quijano and Yvonn Quijano
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
International Trade
All economies, regardless of their size,

depend to some extent on other
economies and are affected by events
outside their borders.
The internationalization or globalization

of the U.S. economy has occurred in the
private and public sectors, in input and
output markets, and in business firms and
households.
Trade Surpluses and Deficits
U.S. Balance of Trade (Exports Minus Imports), 1929 1999 (Billions of Dollars)
EXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTS
1929 + 0.4 1984 102.0
1933 + 0.1 1985 114.2
1945 0.9 1986 131.9

1955 + 0.4 1987 142.3
1960 + 2.4 1988 106.3
1965 + 3.9 1989 80.7
1970 + 1.2 1990 71.4
1975 + 13.6 1991 20.7
1976 2.3 1992 27.9
1977 23.7 1993 60.5
1978 26.1 1994 87.1
1979 24.0 1995 84.3
1980 14.9 1996 89.0
1981 15.0 1997 89.3
1982 20.5 1998 151.5
1983 51.7 1999 254.0
The Economic Basis for Trade:
Comparative Advantage
Corn Laws were the tariffs, subsidies, and
restrictions enacted by the British Parliament
in the early nineteenth century to discourage
imports and encourage exports of grain.
David Ricardos theory of comparative

advantage , which he used to argue against
the corn laws, states that specialization and
free trade will benefit all trading partners (real
wages will rise), even those that may be
absolutely less efficient producers.
Absolute Advantage Versus
A country enjoys an absolute advantage
over another country in the production of a
product if it uses fewer resources to produce
that product than the other country does.
A country enjoys a comparative advantage

in the production of a good if that good can
be produced at a lower cost in terms of
other goods.
Mutual Absolute Advantage
YIELD PER ACRE OF WHEAT AND COTTON

NEW ZEALAND AUSTRALIA
Wheat 6 bushels 2 bushels
Cotton 2 bales 6 bales
In this example, New Zealand can produce three

times the wheat that Australia can on one acre of
land, and Australia can produce three times the
cotton. We say that the two countries have mutual
absolute advantage.
Mutual Absolute Advantage
Suppose that each country divides its land to obtain

equal units of cotton and wheat production.
TOTAL PRODUCTION OF WHEAT AND COTTON
ASSUMING NO TRADE, MUTUAL ABSOLUTE
ADVANTAGE, AND 100 AVAILABLE ACRES
Wheat 25 acres x 6 bushels/acre 75 acres x 2 bushels/acre
150 bushels 150 bushels
Cotton 75 acres x 2 bales/acre 25 acres x 6 bales/acre

150 bales 150 bales
Production Possibility Frontiers for Australia
and New Zealand Before Trade
Because both countries have an absolute advantage in

the production of one product, specialization and trade
will benefit both.
Gains from Specialization
An agreement to trade 300 bushels of wheat for

300 bales of cotton would double both wheat and
cotton consumption in both countries.
PRODUCTION AND CONSUMPTION OF WHEAT
AFTER SPECIALIZATION
PRODUCTION CONSUMPTION
NEW NEW
AUSTRALIA AUSTRALIA
ZEALAND ZEALAND
Wheat 100 acres x 6 bu/acre 75 acres x 2 bu/acre 300 bushels 300 bushels
Cotton 0 acres 100 acres x 6 bales/acre 300 bales 300 bales

0 600 bales
Gains from Specialization
Gains from Comparative Advantage
Even if a country had a considerable

absolute advantage in the production of
both goods, Ricardo would argue that
specialization and trade are still mutually
beneficial.
When countries specialize in producing the

goods in which they have a comparative
advantage, they maximize their combined
output and allocate their resources more
efficiently.
The real cost of producing

cotton is the wheat that must
be sacrificed to produce it.
A country has a comparative
advantage in cotton production
if its opportunity cost, in terms
of wheat, is lower than the
other country.
To illustrate the gains from comparative advantage,

assume (again) that in each country people want to
consume equal amounts of cotton and wheat.
Now, each country is constrained by its domestic
production possibilities curve, as follows:
YIELD PER ACRE OF WHEAT AND COTTON

Wheat 6 bushels 1 bushel
TOTAL PRODUCTION OF WHEAT AND COTTON

ASSUMING NO TRADE AND 100 AVAILABLE ACRES
Wheat 50 acres x 6 bushels/acre 75 acres x 1 bushels/acre

300 bales 75 bales
The gains from trade in this example can be

demonstrated in three stages.
Stage 1: Australia transfers all its land into cotton

production. New Zealand cannot completely
specialize in wheat because it needs 300 bales of
cotton and will not be able to get enough cotton
from Australia (if countries are to consume equal
amounts of cotton and wheat).
REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY
HAS A DOUBLE ABSOLUTE ADVANTAGE
STAGE 1
Wheat 50 acres x 6 bushels/acre 0 acres
300 bushels 0

300 bales 300 bales
Stage 2: New Zealand transfers 25 acres out of

cotton and into wheat.

STAGE 2
Wheat 75 acres x 6 bushels/acre 0 acres
450 bushels 0

150 bales 300 bales
Stage 3: Countries trade

STAGE 3
100 bushels (trade)
Wheat 350 bushels 100 bushels
(after trade)
200 bushels (trade)
(after trade)
Both countries are better off than they were before

trade. Both have moved beyond their own
production possibility frontiers.
Exchange Rates
When trade is freeunimpeded by

government-instituted barrierspatterns of
trade and trade flows result from the
independent decisions of thousands of
importers and exporters and millions of
private households and firms.
To understand these patterns we must

know something about the factors that
determine exchange rates.
Exchange Rates
An exchange rate is the ratio at which two

currencies are traded. The price of one
currency in terms of another.
For any pair of countries, there is a range of

exchange rates that can lead automatically
to both countries realizing the gains from
specialization and comparative advantage.
Exchange rates determine the terms of

trade.
Exchange Rates
Domestic Prices of Timber (Per Foot) and Rolled

Steel (Per Meter) in the United States and Brazil
UNITED STATES BRAZIL
Timber $1 3 Reals
Rolled steel $2 4 Reals
The option of buying at home or importing

will depend on the exchange rate.
Exchange Rates
Trade Flows Determined by Exchange Rates

EXCHANGE PRICE
RATE OF REAL RESULT
$1 = 1 R $1.00 Brazil imports timber and steel

$1 = 2 R .50 Brazil imports timber
$1 = 2.1 R .48 Brazil imports timber; United
States imports steel
$1 = 2.9 R .34 Brazil imports timber; United
States imports steel
$1 = 3 R .33 United States imports steel
$1 = 4 R .25 United States imports timber and
steel
Exchange Rates
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
enjoys a comparative advantage.
Only those products in which a country has

a comparative advantage will be competitive
in world markets.
The Sources of
Factor endowments refer to the quantity
and quality of labor, land, and natural
resources of a country.
Factor endowments seem to explain a

significant portion of actual world trade
patterns.
The Sources of
The Heckscher-Ohlin theorem is a theory
that explains the existence of a countrys
comparative advantage by its factor
endowments.
According to the theorem, 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.
The Sources of
Product differentiation is a natural response
to diverse preferences within an economy,
and across economies.
Some economists also distinguish between
acquired comparative advantage and
natural comparative advantages.
Economies of scale may be available when
producing for a world market that would not
be available when producing for a limited
domestic market.
Trade Barriers: Tariffs,
Export Subsidies, and Quotas
Protection is the practice of shielding a
sector of the economy from foreign
competition.
A tariff is a tax on imports.
Export subsidies are government payments
made to domestic firms to encourage exports.
Closely related to subsidies is dumping. A
firm or industry sells products on the world
market at prices below the cost of production.
A quota is a limit on the quantity of imports.
Trade Barriers: Tariffs,
Export Subsidies, and Quotas
The Smoot-Hawley tariff was the U.S. tariff
law of the 1930s, which set the highest tariff in
U.S. history (60 percent). It set off an
international trade war and caused the decline
in trade that is often considered a cause of the
worldwide depression of the 1930s.
The General Agreement on Tariffs and
Trade (GATT) is an international agreement
singed by the United States and 22 other
countries in 1947 to promote the liberalization
of foreign trade.
Economic Integration
Economic integration occurs when two

or more nations join to form a free-trade
zone.
The European Union (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.
Economic Integration
The U.S.-Canadian Free-Trade Agreement

is an agreement in which the United States
and Canada agreed to eliminate all barriers
to trade between the two countries by 1988.
The North American Free-Trade

Agreement (NAFTA) is an agreement
signed by the United States, Mexico, and
Canada in which the three countries agreed
to establish all of North America as a free-
trade zone.
The North American Free-Trade
Agreement (NAFTA)
The U.S. Department of Commerce has
estimated that as a result of NAFTA trade
between the United States and Mexico
increased by nearly $16 billion in 1994.
In addition, exports from the United States
to Mexico outpaced imports from Mexico.
By 1998, a general consensus emerged
among economists that NAFTA had led to
expanded employment opportunities on
both sides of the border.
The Case for Free Trade
The case for free trade is based on the

theory of comparative advantage. When
countries specialize and trade based on
comparative advantage, consumers pay
less and consume more, and resources
are used more efficiently.
When tariffs and quotas are imposed,

some of the gains from trade are lost.
The Gains from Trade
When world price is

$2, domestic quantity
demanded rises, and
quantity supplied falls.
U.S. supply drops and
resources are
transferred to other
sectors.
The Losses from the
Imposition of a Tariff
The loss of efficiency
from a $1 tariff has two
components:
1. Consumers must pay a
higher price for goods
that could be produced
at a lower cost.
2. Marginal producers are
drawn into textiles and
away from other goods,
Government revenue
resulting in inefficient
equals the shaded area.
domestic production.
The Case for Protection
Protection saves jobs

Some countries engage in unfair trade
practices
Cheap foreign labor makes competition
unfair
Protection safeguards national security
Protection discourages dependency
Protection safeguards infant industries

International Trade, Comparative Advantage, and Protectionism

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International Trade, Comparative Advantage, and Protectionism

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CHAPTER 30

Prepared by: Fernando

All economies, regardless of their size,

The internationalization or globalization

1945 0.9 1986 131.9

David Ricardos theory of comparative

A country enjoys a comparative advantage

YIELD PER ACRE OF WHEAT AND COTTON

In this example, New Zealand can produce three

Suppose that each country divides its land to obtain

Cotton 75 acres x 2 bales/acre 25 acres x 6 bales/acre

Because both countries have an absolute advantage in

An agreement to trade 300 bushels of wheat for

Cotton 0 acres 100 acres x 6 bales/acre 300 bales 300 bales

Even if a country had a considerable

When countries specialize in producing the

The real cost of producing

To illustrate the gains from comparative advantage,

YIELD PER ACRE OF WHEAT AND COTTON

TOTAL PRODUCTION OF WHEAT AND COTTON

Cotton 50 acres x 6 bales/acre 25 acres x 3 bales/acre

The gains from trade in this example can be

Stage 1: Australia transfers all its land into cotton

Cotton 50 acres x 6 bales/acre 100 acres x 3 bales/acre

Stage 2: New Zealand transfers 25 acres out of

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY

Cotton 25 acres x 6 bales/acre 100 acres x 3 bales/acre

Stage 3: Countries trade

Wheat 350 bushels 100 bushels

Cotton 350 bales 100 bales

Both countries are better off than they were before

When trade is freeunimpeded by

To understand these patterns we must

An exchange rate is the ratio at which two

For any pair of countries, there is a range of

Exchange rates determine the terms of

Domestic Prices of Timber (Per Foot) and Rolled

UNITED STATES BRAZIL

The option of buying at home or importing

Trade Flows Determined by Exchange Rates

$1 = 1 R $1.00 Brazil imports timber and steel

If exchange rates end up in the right ranges,

Only those products in which a country has

Factor endowments seem to explain a

According to the theorem, a country has a

Economic integration occurs when two

The European Union (EU) is the

The U.S.-Canadian Free-Trade Agreement

The North American Free-Trade

The case for free trade is based on the

When tariffs and quotas are imposed,

When world price is

Protection saves jobs

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