CHAPTER
20
International Trade,
Comparative Advantage,
and Protectionism
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
• All economies, regardless of their
size, depend to some extent on other
economies and are affected by
events outside their borders.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
International Trade
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Karl Case, Ray Fair
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
International Trade
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Trade Surpluses and Deficits
• When a country exports more
than it imports, it runs a trade
surplus.
• A trade deficit is the situation
when a country imports more
than it exports.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Trade Surpluses and Deficits
U.S. Balance of Trade (Exports Minus Imports), 1929–2002 (Billions of Dollars)
EXPORTS MINUS IMPORTS
1929
1933
1945
1955
1960
1965
1970
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
EXPORTS MINUS IMPORTS
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
+ 0.4
+ 0.1
– 0.9
+ 0.4
+ 2.4
+ 3.9
+ 1.2
+ 13.6
– 2.3
– 23.7
– 26.1
– 24.0
– 14.9
– 15.0
– 20.5
– 51.7
– 102.0
– 114.2
– 131.9
– 142.3
– 106.3
– 80.7
– 71.4
– 20.7
– 27.9
– 60.5
– 87.1
– 84.3
– 89.0
– 89.3
– 151.7
– 249.9
– 365.5
– 348.9
– 423.6
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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Karl Case, Ray Fair
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
The Economic Basis for Trade:
Comparative Advantage
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
The Economic Basis for Trade:
Comparative Advantage
• David Ricardo’s 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.
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Karl Case, Ray Fair
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• A country enjoys an absolute
advantage over another country in
the production of a product when it
uses fewer resources to produce that
product than the other country does.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Absolute Advantage
versus Comparative Advantage
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Karl Case, Ray Fair
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• A country enjoys a comparative
advantage in the production of a
good when that good can be
produced at a lower cost in terms of
other goods.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Absolute Advantage
versus Comparative Advantage
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Mutual Absolute Advantage
Yield Per Acre Of Wheat And Cotton
Wheat
Cotton
NEW ZEALAND
AUSTRALIA
6 bushels
2 bales
2 bushels
6 bales
• 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.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Mutual Absolute Advantage
• Suppose that each country divides its land
to obtain equal units of cotton and wheat
production as shown below:
Total Production Of Wheat And Cotton Assuming No Trade,
Mutual Absolute Advantage, And 100 Available Acres
NEW ZEALAND
AUSTRALIA
Wheat
25 acres x 6 bushels/acre
150 bushels
75 acres x 2 bushels/acre
150 bushels
Cotton
75 acres x 2 bales/acre
150 bales
25 acres x 6 bales/acre
150 bales
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Production Possibility Frontiers for
Australia and New Zealand Before Trade
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Mutual Absolute Advantage
• 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 and Cotton after Specialization
PRODUCTION
New Zealand
Wheat
Cotton
Australia
100 acres x 6 bu/acre
600 bushels
0 acres
0
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0 acres
0
100 acres x 6 bales/acre
600 bales
Principles of Economics, 7/e
CONSUMPTION
New
Zealand
Australia
300 bushels
300 bushels
300 bales
300 bales
Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Expanded Possibilities after Trade
• Because both countries have an absolute advantage
in the production of one product, specialization and
trade will benefit both.
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Karl Case, Ray Fair
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Comparative Advantage
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Karl Case, Ray Fair
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Comparative Advantage
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Comparative Advantage
• Assume that people in each country want
to consume equal amounts of cotton and
wheat, and that each country is
constrained by its domestic production
possibilities curve, as follows:
Yield Per Acre of Wheat and Cotton
Wheat
Cotton
© 2004 Prentice Hall Business Publishing
NEW ZEALAND
AUSTRALIA
6 bushels
6 bales
1 bushel
3 bales
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Comparative Advantage
Total Production of Wheat and Cotton Assuming No
Trade and 100 Available Acres
NEW ZEALAND
AUSTRALIA
Wheat
50 acres x 6 bushels/acre
300 bushels
75 acres x 1 bushels/acre
75 bushels
Cotton
50 acres x 6 bales/acre
300 bales
25 acres x 3 bales/acre
75 bales
• The gains from trade in this example can
be demonstrated in three stages.
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Realizing a Gain from Trade When One
Country Has a Double Absolute Advantage
Stage 1: Countries specialize
STAGE 1
New Zealand
Australia
Wheat
50 acres x 6 bushels/acre
300 bushels
0 acres
0
Cotton
50 acres x 6 bales/acre
300 bales
100 acres x 3 bales/acre
300 bales
• Australia transfers all its land into cotton production. New
Zealand cannot completely specialize in wheat production
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).
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Realizing a Gain from Trade When One
Country Has a Double Absolute Advantage
Stage 2:
STAGE 2
New Zealand
Australia
Wheat
75 acres x 6 bushels/acre
450 bushels
0 acres
0
Cotton
25 acres x 6 bales/acre
150 bales
100 acres x 3 bales/acre
300 bales
• New Zealand transfers 25 acres out of
cotton and into wheat.
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Realizing a Gain from Trade When One
Country Has a Double Absolute Advantage
Stage 3: Countries trade
STAGE 3
New Zealand
Australia
100 bushels (trade)
Wheat
350 bushels
100 bushels
(after trade)
200 bales (trade)
Cotton
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350 bales
100 bales
(after trade)
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Gains from Comparative Advantage
• 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.
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Comparative Advantage
Means Lower Opportunity Cost
• Both Australia and New Zealand will gain when the terms
of trade are set between 1:1 and 3:1, cotton to wheat.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Terms of Trade
• The ratio at which a country can
trade domestic products for imported
products is the terms of trade.
• The terms of trade determine how
the gains from trade are distributed
among trading partners.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Exchange Rates
• When trade is free—unimpeded by
government-instituted barriers—
patterns 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 learn about exchange rates.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Exchange Rates
• An exchange rate is the ratio at
which two currencies are traded, or
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.
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Trade and Exchange Rates
in a Two-Country/Two-Good World
• Exchange rates determine the terms of
trade.
Domestic Prices of Timber (Per Foot) and Rolled
Steel (Per Meter) in the United States and Brazil
Timber
Rolled steel
UNITED STATES
BRAZIL
$1
$2
3 Reals
4 Reals
• The option of buying at home or importing
will depend on the exchange rate.
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Trade and Exchange Rates
in a Two-Country/Two-Good World
Trade Flows Determined by Exchange Rates
EXCHANGE
RATE
PRICE
OF REAL
$1 = 1 R
$1 = 2 R
$1 = 2.1 R
$1.00
.50
.48
$1 = 2.9 R
.34
Brazil imports timber; United States
imports steel
$1 = 3 R
$1 = 4 R
.33
.25
United States imports steel
© 2004 Prentice Hall Business Publishing
RESULT
Brazil imports timber and steel
Brazil imports timber
Brazil imports timber; United States
imports steel
United States imports timber and
steel
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Exchange Rates
and Comparative Advantage
• 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.
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
The Sources of
Comparative Advantage
• 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.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
The Heckscher-Ohlin Theorem
• The Heckscher-Ohlin theorem is a
theory that explains the existence of
a country’s 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.
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Other Explanations for
Observed Trade Flows
• Product differentiation is a natural
response to diverse preferences
within an economy, and across
economies.
• Some economists also distinguish
between gains from acquired
comparative advantage and gains
from natural comparative
advantages.
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Karl Case, Ray Fair
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• Economies of scale may be available
when producing for a world market
that would not be available when
producing for a limited domestic
market.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Other Explanations for
Observed Trade Flows
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Karl Case, Ray Fair
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• Protection is the practice of
shielding a sector of the economy
from foreign competition.
• A tariff is a tax on imports.
• A quota is a limit on the quantity of
imports.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Trade Barriers: Tariffs,
Export Subsidies, and Quotas
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Karl Case, Ray Fair
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
Trade Barriers: Tariffs,
Export Subsidies, and Quotas
• Export subsidies are government
payments made to domestic firms to
encourage exports.
• Dumping refers to a firm or industry
that sells products on the world
market at prices below the cost of
production.
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
U.S. Trade Policies and GATT
• 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.
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
U.S. Trade Policies and GATT
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Economic Integration
• Economic integration occurs when
two or more nations join to form a
free-trade zone.
• The European Union (EU) and the
North American Free-Trade
Agreement NAFTA are examples of
economic integration.
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Economic Integration
• 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.
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• 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.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Economic Integration
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Economic Integration
• 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.
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Karl Case, Ray Fair
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
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.
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
The Gains from Trade
© 2004 Prentice Hall Business Publishing
• When world price is
$2, domestic quantity
demanded rises, and
quantity supplied falls.
U.S. supply drops and
resources are
transferred to other
sectors.
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International Trade, Comparative Advantage,
and Protectionism
C H A P T E R 20:
The Losses from the
Imposition of a Tariff
• The loss of efficiency
from a $1 tariff:
1. Consumers must pay a
higher price for goods
that could be produced
at a lower cost.
2. Marginal producers are
• Government revenue equals
the shaded area.
© 2004 Prentice Hall Business Publishing
drawn into textiles and
away from other goods,
resulting in inefficient
domestic production.
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
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
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• An infant industry is a young
industry that may need temporary
protection from competition from the
established industries of other
countries to develop an acquired
comparative advantage.
C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
The Case for Protection
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C H A P T E R 20:
International Trade, Comparative Advantage,
and Protectionism
Review Terms and Concepts
absolute advantage
General Agreement on
Tariffs and Trade
comparative advantage
(GATT)
Corn Laws
Heckscher-Ohlin
dumping
theorem
economic integration
infant industry
European Union (EU)
North American FreeTrade Agreement
(NAFTA)
exchange rate
export subsidies
protection
factor endowments
quota
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Principles of Economics, 7/e
Smoot-Hawley tariff
tariff
terms of trade
theory of comparative
advantage
trade deficit
trade surplus
U.S.-Canadian FreeTrade Agreement
Karl Case, Ray Fair
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