Comparative Advantage and the Gains from International Trade

2. 9 Comparative Advantage and the Gains from International Trade CHAPTER Chapter Outline and Learning Objectives

3. Does the Federal Government’s “Buy American” Policy Help U.S. Firms? • In response to the economic recession of 2007–2009, Congress and President Obama passed the American Recovery and Reinvestment Act of 2009, which included tax cuts and increased government spending. • The bill included a “Buy American” provision that required all manufactured goods bought with these funds to be made in the United States. • The intention was to increase the number of jobs the bill would create by preventing foreign companies from participating in the new spending projects. • Some U.S. firms were opposed to the Buy American provision. • AN INSIDE LOOK AT POLICY on page 354examines a federal lawsuit against Home Depot, alleging that the company violated the Buy American provision.

4. Economics in Your Life Have You Heard of the “Buy American” Provision? Politicians often support restrictions on trade to convince people to vote for them. The workers in the industries these restrictions protect are likely to vote for them because they think trade restrictions will protect their jobs. But most people are not workers in industries protected from foreign competition by trade restrictions. Many people work for firms that sell goods in foreign markets and risk losing their jobs if foreign countries retaliate against U.S. attempts to reduce imported goods. See if you can answer these questions by the end of the chapter: How did some U.S. companies convince Congress to include the Buy American provision in the American Recovery and Reinvestment Act of 2009, and why have relatively few people even heard of this provision?

5. The United States in the International Economy 9.1 LEARNING OBJECTIVE Discuss the role of international trade in the U.S. economy.

6. Tariff A tax imposed by a government on imports. Imports Goods and services bought domestically but produced in other countries. Exports Goods and services produced domestically but sold in other countries.

7. The Importance of Trade to the U.S. Economy Figure 9.1 International Trade Is of Increasing Importance to the United States Exports and imports of goods and services as a percentage of total production—measured by GDP—show the importance of international trade to an economy. Since 1970, both imports and exports have been steadily rising as a fraction of U.S. GDP.

8. U.S. International Trade in a World Context Figure 9.2 The Eight Leading Exporting Countries, 2010 The United States is the leading exporting country, accounting for 9.7 percent of total world exports. The values are the shares of total world exports of merchandise and commercial services.

9. Figure 9.3 International Trade as a Percentage of GDP International trade is still less important to the United States than to most other countries.

10. MakingtheConnection How Caterpillar Depends on International Trade Caterpillar has become increasingly dependent on foreign markets, with its firm’s exports rising from just over half of total sales in 2004 to more than two-thirds in 2010. • Your Turn:Test your understanding by doing related problem 1.7 at the end of this chapter. MyEconLab

11. Comparative Advantage in International Trade 9.2 LEARNING OBJECTIVE Understand the difference between comparative advantage and absolute advantage in international trade.

12. A Brief Review of Comparative Advantage Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Comparative Advantage in International Trade An Example of Japanese Workers Being More Productive Than American Workers Table 9.1

13. Absolute advantage The ability to produce more of a good or service than competitors when using the same amount of resources. Table 9.2 The Opportunity Costs of Producing Cell Phones and Tablet Computers The table shows the opportunity cost each country faces in producing cell phones and tablet computers. For example, the entry in the first row and second column shows that Japan must give up 2 cell phones for every tablet computer it produces.

14. How Countries Gain from International Trade 9.3 LEARNING OBJECTIVE Explain how countries gain from international trade.

15. Autarky A situation in which a country does not trade with other countries. Table 9.3 Production without Trade Increasing Consumption through Trade Terms of trade The ratio at which a country can trade its exports for imports from other countries. Countries gain from specializing in producing goods in which they have a comparative advantage and trading for goods in which other countries have a comparative advantage.

16. Table 9.4 Gains from Trade for Japan and the United States

17. Solved Problem 9.3 The Gains from Trade David Ricardo provided a famous example of the gains from trade, using wine and cloth production in Portugal and England. The following table is adapted from Ricardo’s example, with cloth measured in sheets and wine measured in kegs: a. Explain which country has an absolute advantage in the production of each good. b. Explain which country has a comparative advantage in the production of each good. c. Suppose that Portugal and England currently do not trade with each other. Each country has 1,000 workers, so each has 1,000 years of labor time to use producing cloth and wine, and the countries are currently producing the amounts of each good shown in the following table: Show that Portugal and England can both gain from trade. Assume that the terms of trade are that one sheet of cloth can be traded for one keg of wine.

18. Solved Problem 9.3 The Gains from Trade Solving the Problem Step 1: Review the chapter material. Step 2: Answer part a. by determining which country has an absolute advantage. The first table in the problem shows that Portugal can produce more cloth and more wine with one year’s worth of labor than can England. Thus, Portugal has an absolute advantage in the production of both goods and England has an absolute advantage in the production of neither. Step 3: Answer part b. by determining which country has a comparative advantage. To produce 100 sheets of cloth, Portugal must give up producing 150 kegs of wine. Therefore, the opportunity cost to Portugal of producing 1 sheet of cloth is 150/100, or 1.5 kegs of wine. England has to give up producing 60 kegs of wine to produce 90 sheets of cloth, so its opportunity cost of producing 1 sheet of cloth is 60/90, or 0.67 keg of wine. Portugal has a comparative advantage in wine because its opportunity cost is lower. England has a comparative advantage in cloth because its opportunity cost is lower.

19. Solved Problem 9.3 The Gains from Trade Step 4: Answer part c. by showing that both countries can benefit from trade. • Your Turn:For more practice, do related problems 3.5 and 3.6 at the end of this chapter. MyEconLab

20. Why Don’t We See Complete Specialization? We do not see complete specialization in the real world for three main reasons: • Not all goods and services are traded internationally. Some services are difficult to export, such as medical care. • Production of most goods involves increasing opportunity costs.If a country devotes more workers to producing a good, the opportunity cost of producing more of that good will increase, causing the country to stop short of complete specialization. • Tastes for products differ.Most products are differentiated. As a result, countries may each have a comparative advantage in producing different varieties of a particular product. Does Anyone Lose as a Result of International Trade? Countries do not produce goods—firms do, and some lose. The losers are likely to try to convince their governments to interfere by barring imports of the competing products from the other country or by imposing high tariffs on them. Don’t Let This Happen to You Remember That Trade Creates Both Winners and Losers Trade is a win–win situation for all countries that participate, but some individuals always lose. • Your Turn:Test your understanding by doing related problem 3.12 at the end of this chapter. MyEconLab

21. Where Does Comparative Advantage Come From? Among the main sources of comparative advantage are the following: • Climate and natural resources.Geology can create comparative advantage. • Relative abundance of labor and capital.Some countries have a comparative advantage in producing goods requiring highly skilled workers and sophisticated machinery, while others have a comparative advantage requiring unskilled workers and relatively simple machinery. • Technology.Broadly defined, technology is the process firms use to turn inputs into goods and services. • Some countries are strong in product technologies, which involve the ability to develop new products. • Other countries are strong in process technologies, which involve the ability to improve the processes used to make existing products. • External economies. Once an industry becomes established in an area, firms that locate in that area gain advantages over firms located elsewhere. External economies Reductions in a firm’s costs that result from an increase in the size of an industry.

22. MakingtheConnection Leave New York City? Risky for Financial Firms The original concentration of financial firms in Manhattan was something of a historical accident, thanks to the Erie Canal. New York has since continued to see a high concentration of financial firms, with some firms that temporarily left deciding to return because of the benefits they receive from the external economies of being located in New York City. Large financial firms located outside Manhattan, particularly those that heavily trade securities or attempt to make deals that involve mergers between firms, may have higher costs than firms located in Manhattan. Having many financial firms originally located in Manhattan was a historical accident, but external economies gave the area a comparative advantage in providing financial services once the industry began to grow there. • Your Turn:Test your understanding by doing related problem 3.13 at the end of this chapter. MyEconLab

23. Comparative Advantage over Time: The Rise and Fall—and Rise—of the U.S. Consumer Electronics Industry A country may develop a comparative advantage in the production of a good, and then, as time passes and circumstances change, the country may lose its comparative advantage in producing that good and develop a comparative advantage in producing other goods. For several decades, the United States had a comparative advantage in the production of consumer electronic goods, such as televisions, radios, and stereos. The comparative advantage of the United States in these products was based on having developed most of the underlying technology, having the most modern factories, and having a skilled and experienced workforce. Gradually, however, other countries, particularly Japan, gained access to the technology, built modern factories, and developed skilled workforces. By 2011, however, as the technology underlying consumer electronics had evolved, comparative advantage had shifted again, and several U.S. firms had surged ahead of their Japanese competitors. Once a country has lost its comparative advantage in producing a good, its income will be higher and its economy will be more efficient if it switches from producing the good to importing it, as the United States did when it switched from producing televisions to importing them.

24. Government Policies That Restrict International Trade 9.4 LEARNING OBJECTIVE Analyze the economic effects of government policies that restrict international trade.

25. Free trade Trade between countries that is without government restrictions. Figure 9.4 The U.S. Market for Ethanol under Autarky This figure shows the market for ethanol in the United States, assuming autarky, where the United States does not trade with other countries. The equilibrium price of ethanol is $2.00 per gallon, and the equilibrium quantity is 6.0 billion gallons per year. The blue area represents consumer surplus, and the red area represents producer surplus.

26. Figure 9.5 The Effect of Imports on the U.S. Ethanol Market When imports are allowed into the United States, the price of ethanol falls from $2.00 to $1.00. U.S. consumers increase their purchases from 6.0 billion to 9.0 billion gallons. Equilibrium moves from point F to point G. U.S. producers reduce the quantity of ethanol they supply from 6.0 billion to 3.0 billion gallons. Imports equal 6.0 billion gallons, which is the difference between U.S. consumption and U.S. production. Consumer surplus equals the areas A, B, C, and D. Producer surplus equals the area E. Government policies that restrict trade usually take one of two forms: tariffs or quotas and voluntary export restraints.

27. Tariffs Figure 9.6 The Effects of a Tariff on Ethanol Without a tariff on ethanol, U.S. producers will sell 3.0 billion gallons of ethanol, U.S. consumers will purchase 9.0 billion gallons, and imports will be 6.0 billion gallons. The U.S. price will equal the world price of $1.00 per gallon. The $0.50-per-gallon tariff raises the price of ethanol in the United States to $1.50 per gallon, and U.S. producers increase the quantity they supply to 4.5 billion gallons. U.S. consumers reduce their purchases to 7.5 billion gallons. Equilibrium moves from point G to point H. The ethanol tariff causes a loss of consumer surplus equal to the area A + C + T + D. The area A is the increase in producer surplus due to the higher price. The area T is the government’s tariff revenue. The areas C and D represent deadweight loss.

28. Quotas and Voluntary Export Restraints Quota A numerical limit a government imposes on the quantity of a good that can be imported into the country. Voluntary export restraint (VER) An agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country. Measuring the Economic Effect of the Sugar Quota We can use the concepts of consumer surplus, producer surplus, and deadweight loss to measure the economic impact of the sugar quota.

29. Figure 9.7 The Economic Effect of the U.S. Sugar Quota Without a sugar quota, U.S. sugar producers would have sold 4.7 billion pounds of sugar, U.S. consumers would have purchased 27.5 billion pounds of sugar, and imports would have been 22.8 billion pounds. The U.S. price would have equaled the world price of $0.28 per pound. Because the sugar quota limits imports to 5.3 billion pounds (the bracket in the graph), the price of sugar in the United States rises to $0.53 per pound, and U.S. producers supply 15.9 billion pounds. U.S. consumers purchase 21.2 billion pounds rather than the 27.5 billion pounds they would purchase at the world price. Without the import quota, equilibrium would be at point E; with the quota, equilibrium is at point F. The sugar quota causes a loss of consumer surplus equal to the area A + B + C + D. The area A is the gain to U.S. sugar producers. The area B is the gain to foreign sugar producers. The areas C and D represent deadweight loss. The total loss to U.S. consumers in 2010 was $6.08 billion.

30. Solved Problem 9.4 Measuring the Economic Effect of a Quota The U.S. government decides to restrict international trade in apples by imposing a quota that allows imports of only 4 million boxes of apples into the United States each year. Fill in the following table, using the prices, quantities, and letters in the figure: Solving the Problem Step 1: Review the chapter material. Step 2: Fill in the table. • Your Turn:For more practice, do related problem 4.14 at the end of this chapter. MyEconLab

31. The High Cost of Preserving Jobs with Tariffs and Quotas Table 9.5 Preserving U.S. Jobs with Tariffs and Quotas Is Expensive

32. Table 9.6 Preserving Japanese Jobs with Tariffs and Quotas Is Also Expensive

33. MakingtheConnection Save Jobs Making Hangers . . . and Lose Jobs in Dry Cleaning Under trade agreements signed with other countries, the United States is allowed to impose tariffs on imports if foreign firms are selling products in the United States at below their production cost. The U.S. International Trade Commission (ITC) determined that Chinese firms had, in fact, been selling wire garment hangers in the United States at below the firms’ production cost and so imposed a tariff on imports of the hangers. A tariff on hangers increased the cost of doing business for U.S. dry cleaners. The tariff sharply increased dry cleaners’ costs as many struggled to pay their workers, let alone stay in business. As dry cleaners, their employees, and consumers buying wire hangers found out, tariffs can be both an expensive and ineffective way to attempt to preserve jobs. • Your Turn:Test your understanding by doing related problem 4.15 at the end of this chapter. MyEconLab

34. Gains from Unilateral Elimination of Tariffs and Quotas Some politicians argue that eliminating U.S. tariffs and quotas would help the U.S. economy only if other countries eliminated their tariffs and quotas in exchange. It is easier to gain political support for reducing or eliminating tariffs or quotas if it is done as part of an agreement with other countries that involves their eliminating some of their tariffs or quotas. But as the example of the sugar quota shows, the U.S. economy would gain from the elimination of tariffs and quotas even if other countries did not reduce their tariffs and quotas. Other Barriers to Trade In addition to tariffs and quotas, governments sometimes erect other barriers to trade, such as stricter health and safety requirements on imported goods. Many governments also restrict imports of certain products on national security grounds.

35. The Arguments over Trade Policies and Globalization 9.5 LEARNING OBJECTIVE Evaluate the arguments over trade policies and globalization.

36. To reduce tariffs and revive international trade after World War II, government officials in the United States and Europe set up the General Agreement on Tariffs and Trade (GATT) in 1948. A series of multilateral negotiations, called trade rounds, took place, in which countries agreed to reduce tariffs from the very high levels of the 1930s. In the following decades, trade in services and in products incorporating intellectual property, such as software programs and movies, grew in importance and in January 1995, GATT was replaced by the World Trade Organization (WTO). World Trade Organization (WTO) An international organization that oversees international trade agreements.

37. Why Do Some People Oppose the World Trade Organization? Globalization The process of countries becoming more open to foreign trade and investment. • The opposition to the WTO comes from three sources: • Some opponents are specifically against the globalization process that began in the 1980s and became widespread in the 1990s. • Other opponents have the same motivation as the supporters of tariffs in the 1930s—to erect trade barriers to protect domestic firms from foreign competition. • Some critics of the WTO support globalization in principle but believe that the WTO favors the interests of the high-income countries at the expense of the low-income countries.

38. Anti-Globalization Many of those who protest at WTO meetings distrust globalization. Some believe that by increasing the variety of products available to consumers in developing countries, free trade and foreign investment destroy the distinctive cultures of those countries. Globalization has also allowed multinational corporations to relocate factories from high-income countries to low-income countries. Some people have argued that firms with factories in developing countries should pay workers wages as high as those paid in high-income countries, abiding by the same health, safety, and environmental regulations. The governments of most developing countries have arguments against these proposals.

39. MakingtheConnection The Unintended Consequences of Banning Goods Made with Child Labor In the United States, boycotts have been organized against stores that stock goods made in developing countries with child labor. Many people assume that if child workers in developing countries weren’t working in factories, they would be in school, as are children in high-income countries. In fact, there is substantial evidence that as incomes begin to rise in poor countries, families rely less on child labor, which the United States didn’t outlaw until 1938. Meanwhile, children in developing countries usually have few good alternatives to work: When France banned soccer balls made by child workers for the 1998 World Cup, many Pakistani children went from hand-stitching in a structured environment to begging or prostitution. Would eliminating child labor, such as stitching soccer balls, improve the quality of children’s lives? • Your Turn:Test your understanding by doing related problem 5.5 at the end of this chapter. MyEconLab

40. “Old-Fashioned” Protectionism Protectionism The use of trade barriers to shield domestic firms from foreign competition. Protectionism is usually justified on the basis of one of the following arguments: • Saving jobs. Supporters of protectionism argue that free trade reduces employment by driving domestic firms out of business. • Protecting high wages. Some people worry that firms in high-income countries will have to start paying much lower wages to compete with firms in developing countries. • Protecting infant industries. Others argue that under free trade, established foreign producers can sell their products at a lower price and drive domestic producers out of business before they gain enough experience to compete. • Protecting national security. It is rare for an industry to ask for protection without raising the issue of national security, even if its products have mainly nonmilitary uses.

41. Dumping Dumping Selling a product for a price below its cost of production. Positive versus Normative Analysis (Once Again) Positive analysis concerns what is. Normative analysis concerns what ought to be. The success of industries in getting the government to erect barriers to foreign competition depends partly on some members of the public knowing the costs of trade barriers but supporting them anyway. However, two other factors are also at work: • The costs tariffs and quotas impose on consumers are large in total but relatively small per person. • The jobs lost to foreign competition are easier to identify than are the jobs created by foreign trade.

42. Economics in Your Life Have You Heard of the “Buy American” Provision? At the beginning of the chapter, we asked you to consider how some U.S. companies convinced Congress to include the Buy American provision in the American Recovery and Reinvestment Act and why relatively few people have heard of this provision. In the chapter, we saw that trade restrictions tend to preserve relatively few jobs in the protected industries, while leading to job losses in other industries and costing consumers billions per year in higher prices. This might seem to increase the mystery of why Congress enacted the Buy American provision, yet we have also seen that per person, the burden of specific trade restrictions can be small. In fact, few people will even spend the time to become aware that a specific trade restriction exists.

43. AN INSIDE LOOK AT POLICY Did Home Depot Knowingly Defy the “Buy American” Policy? The Home Depot case is not the first filed against a major U.S. corporation for violating the Buy American provision. The table above lists several major companies that made settlement payments to the U.S. government following litigation for allegedly violating the Buy American provision or the Trade Agreements Act. The effect of the “Buy American” provision on the steel market in the United States.