Comparative Advantage and the Gains from Trade

1. Chapter 3 Comparative Advantage and the Gains from Trade

2. Learning Objectives • Analyze numerical examples of absolute and comparative advantage. • Draw a diagram showing gains from trade. • Define and state the differences between the concepts of absolute advantage, comparative advantage, and competitiveness. • Discuss the economic and ethical considerations of economic restructuring caused by international trade.

3. Introduction: The Gains from Trade • The improvement in national welfare is known as the gains from trade

4. Adam Smith and the Attack on Economic Nationalism • In 1776, Adam Smith published the first modern statement of economic theory, An Inquiry into the Nature and Causes of the Wealth of Nations • The Wealth of Nations attacked mercantilism—the system of nationalistic economics that dominated economic thought in the 1700s • Smith proved wrong the belief that trade was a zero sum game—that the gain of one nation from trade was the loss of another • Voluntary exchange (trade) is a positive sum game —both nations gain

5. Implications of Adam Smith’s Theory Access to foreign markets helps create wealth • If no nation imports, every company will be limited by the size of its home country market • Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs • Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation

6. Adam Smith and Trade Barriers • Smith was highly critical of trade barriers • Trade barriers decrease - Specialization - Technological progress - Wealth creation • The modern view of trade shares Smith’s dislike for trade barriers

7. A Simple Model of Production and Trade • A basic model, often referred to as the Ricardian model, named after economist David Ricardo • Assumptions • Markets are competitive: Firms are price takers • Static world: Technology is constant and there are no learning effects • Labor is perfectly mobile: It can easily move back and forth between industries but perfectly immobile across national borders.

8. TABLE 3.1 Assumptions of the Simple Ricardian Trade Model

9. Absolute Productivity Advantage and the Gains from Trade • Productivity: The amount of output obtained from a unit of input • Labor productivity:(units of output) / (hours worked) If two loaves of bread can be produced in 1 hour, productivity = (2 loaves) / (1 hour) • Absolute productivity advantage: The advantage held by a country that produces more of a certain good per hour worked than another

10. TABLE 3.2 Output per Hour Worked

11. Absolute Productivity Advantage and the Gains from Trade • The U.S. opportunity cost of bread is 1.5 tons of steel: each unit of bread produced requires the economy to move labor out of steel production, forfeiting 1.5 tons of steel that it could have produced instead. • In sum, trade between U.S. and Canada will occur at a price between these two limits

12. Comparative Productivity Advantage and the Gains from Trade • Question: What happens if a country does not have an absolute productivity advantage in anything? • Answer: Even if a country does not have any goods with an absolute productivity advantage, it can still benefit from trade - The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good

13. Production Possibilities Curve (PPC) • A production possibilities curve (PPC) shows the tradeoffs a country faces when choosing between two goods

14. FIGURE 3.1 A Production Possibilities Curve for the United States

15. FIGURE 3.2 Opportunity Costs and the Slope of the PPC

16. What Determines the Slope of the PPC? • Using Figure 3.2 as an example, the slope of the PPC is -0.67: The number of loaves of bread forgone divided by the quantity of steel obtained

17. Relative Prices • Without trade, the U.S. would forgo 0.67 loaves of bread for an additional ton of steel. This is the opportunity cost of steel, or the relative price of steel • Why relativeprice? Because the price is not in monetary units but in units of the other good -Relative price of steel is the inverse of the price of bread: if 0.67 loaves of bread is the price of a ton of steel in the U.S., then 1.5 tons of steel is the price of one loaf of bread

18. The Consumption Possibilities Curve • Autarky: The complete absence of trade; all nations can only consume the goods they produce at home • Trade allows countries to raise their consumption • Example: • If the opportunity cost of steel in Canada is 3 loaves of bread per ton, and in the U.S. 0.67 loaves per ton, both countries can consume more by trading • Gains from trade will occur if the price of steel settles somewhere between the opportunity costs in Canada and the U.S.

19. FIGURE 3.3 Production and Trade Before Specialization • Let the price of bread settle at 2 loaves per ton • U.S. trading possibilities are illustrated by the consumption possibilities curve (CPC) with a slope of -2 • A = the combination of steel and bread available for trade

20. The Gains from Trade • In sum, suppose the relative price of steel is 2 loaves of bread • When the U.S. increases steel output by 1 ton, it gives up 0.67 loaves of bread output; however, it can now trade the steel for 2 loaves, leaving a net gain of 1.33 loaves (2 - 0.67 = 1.33) • To meet U.S. demand for 2 more loaves of bread, Canada gives up 0.67 tons of steel output; however, it can now trade 2 loaves for 1 ton of steel, leaving a net gain of 0.33 tons (1 - 0.67 = 0.33)

21. FIGURE 3.4 Production to Maximize Income • By specializing production at B and trading for bread, the U.S. obtains the largest possible consumption bundle • C = the consumption bundle the U.S. obtains by producing at B, or by specializing in steel and trading for bread

22. FIGURE 3.5 Canada’s Gains from Trade • Conversely, Canada, by specializing in the production at B and trading for steel, Canada obtains the largest possible consumption bundle.

23. Domestic Prices and the Trade Price • How do we make sure that the trade price settles within • If the trade price was 4 loaves of bread, both countries would specialize in steel. However, the consequent bread shortage and steel glut would increase the price of bread and decrease the price of steel; once the price of bread fell to less than 3.0, Canadian producers would switch back to bread • If trade price is closer to 0.67, gains are larger for Canada; if it is closer to 3.0, gains are larger for the U.S.; however, both would gain from trade when the price falls in this range

24. Absolute and Comparative Productivity Advantage Contrasted Absolute productivity advantage is having a higher labor productivity. If each country has an absolute productivity advantage in one of the goods, both benefit by specializing in that good and trading it for the other good.

25. Absolute and Comparative Productivity Advantage Contrasted (cont.) Comparative productivity advantage is if a country’s opportunity costs of producing a good are lower than those of its trading partners. The concept is based on the idea that nations maximize their material well-being when they use their resources where they have their highest value.

26. Gains from Trade with No Absolute Advantage • Japan has an absolute advantage in both cars (2>0.5) and steel (3>1), yet it can still gain from trade, as can Malaysia • Once trade opens, the world price of cars will be between one and two tons of steel per car

27. TABLE 3.3 Output per Hour Worked

28. TABLE 3.4 Indicators of the Korean Economy

29. Comparative Advantage and “Competitiveness” • Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity • Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs -Imbalances result from government policies, such as subsidies or protection

30. Competitive Advantage • Suppose that Germany decides to become self-sufficient in bananas and even to export them. In order to accomplish this, large tax incentives are granted to companies that will invest in banana production. Soon, the German industry is competitive and able to sell bananas at the lowest price anywhere. • Does Germany have a comparative advantage? Why, or why not? What are the consequences for the overall economy?

31. Economic Restructuring Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear • In the Ricardian model, trade opening moved labor from bread to steel production: restructuring improved U.S. overall economic welfare but made its bread industry disappear • If trade results in net gain (in an increase of the consumption bundle), a country will be better off by trading; however, some sectors may still lose

32. Economic Restructuring(cont.) • Given that some lose due to economic restructuring, the government can seek to get the winners from trade and restructuring to compensate the losers • Trade adjustment assistance (TAA) helps losers by providing extended unemployment benefits, worker retraining, and temporary tax on imports • For example, the U.S. government created a special program for workers laid off because of NAFTA; in 1994, 17,000 workers qualified for the program

33. TABLE 3.5 Low-Cost and High-Cost Cotton Producers