Comparative
Advantage and the
Gains from
International Trade
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Comparative Advantage and the
Gains from International Trade
• Consumers love bargains
• Should we let these bargain goods into the
country?
– Do cheap foreign goods threaten the jobs of American
workers and the profits of American producers?
• Over the post-World War II period, there has been
a worldwide movement toward a policy of free
trade
– In 1995 a new international body was created
• World Trade Organization (WTO)
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Comparative Advantage and the
Gains from International Trade
• While many barriers have come down, others are
being put up
• Poor countries have imposed tariffs on computers,
semiconductors, and software exported by rich
countries
– Rich countries have announced their intention to
maintain existing quotas on textiles and clothing sold by
poor countries
• Is free international trade a good thing that makes
us better off
– Or is it bad and something that should be kept in
check?
3
The Logic of Free Trade
• Many of us like the idea of being self-reliant
– But consider the defects of self-sufficiency
• If you lived all by yourself, you would be poor
• Defects of self-sufficiency explain why most people do not
choose it
• Principle applies not just to individuals, but also to groups
of individuals
– Such as those living within boundaries that define cities, countries,
states, or nations
• What would happen if residents of your state switched
from a policy of open trading with other states to one of
self-sufficiency
– Refusing to import anything from “foreign states” or to export
anything to them
4
The Logic of Free Trade
• It would make no sense to insist on the economic selfsufficiency of each of the 50 states
– Founders of United States placed prohibitions against tariffs,
quotas, and other barriers to interstate commerce in U.S.
Constitution
• What is true for states is also true for entire nations
– Members of WTO have carried argument to its ultimate conclusion
• National specialization and exchange can expand world living
standards through free international trade
• Long-term goal of WTO is to remove all barriers to exports
and imports
– In order to encourage among nations specialization and trade that
have been successful within nations
5
The Theory of Comparative
Advantage
• Economists who first considered the benefits of international trade
focused on a country’s absolute advantage
– A country has an absolute advantage in a good when it can produce it
using fewer resources than another country
• In 1817, however, British economist David Ricardo disagreed
– A nation has a comparative advantage in producing a good if it can
produce it at a lower opportunity cost than some other country
• Mutually beneficial trade between any two countries is possible
whenever one country is relatively better at producing a good than the
other country
– Being relatively better means having ability to produce a good at a lower
opportunity cost
• At a lower sacrifice of other goods foregone
6
Opportunity Cost and Comparative
Advantage
• To illustrate Ricardo’s insight, let’s consider a
hypothetical world of two countries—China and
United States
• Both countries can gain from trade
– If China could be persuaded to produce more suits and
United States more computers
• World’s total production of goods will increase
– Each country can come out ahead by trading with the
other
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Specialization and World Production
• Additional production is the kind of gain
that, multiplied a million times, lies behind
the substantial benefits countries enjoy from
free trade
• If countries specialize according to
comparative advantage, a more efficient
use of given resources occurs
• That is, with the same resources, the world can
produce more of at least one good
– Without decreasing production of any other good
8
How Each Nation Gains From
International Trade
• By trading some of its comparative advantage good for the
other good, each country can consume more of both
goods
• As long as such benefits continue, a country can gain
even greater benefits by shifting more and more of its
resources toward its comparative advantage good
– As long as opportunity costs differ, specialization and trade can be
beneficial to all involved
• Remains true regardless of whether parties are different nations,
different states, different countries, or different individuals
• Remains true even if one party has an all-round absolute advantage or
disadvantage
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The Terms of Trade
• Exchange ratio is known as the terms of trade
– Quantity of one good that is exchanged for a unit of the
other
• Determine how gains from international trade are
distributed among countries
– For the world as a whole, gains from international trade
are due to increased production as nations specialize
according to comparative advantage
• How those world gains are distributed among specific countries
depends on terms of trade
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How Potential Gains Turn Into Actual
Gains
• Within framework of WTO, government officials
are supposed to create environment for free trade
– But they do not decide who has a comparative
advantage in what, or what should be produced in this
or that country
– In today’s market economies around the world, it is
individual consumers and firms who decide to buy
things—at home or abroad
• What makes China shift resources into its
comparative advantage good?
– And what makes the U.S. shift resources in the other
direction?
• Prices
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How Potential Gains Turn Into Actual
Gains
• When consumers are free to buy at the lowest prices
– They will naturally buy a good from the country that has a
comparative advantage in producing it
• That country’s industries respond by producing more of that good and
less of other goods
• Countries naturally move toward specializing in those goods in which
they have a comparative advantage
• Conclusion applies even beyond simple example we’ve
been considering
– Applies when there are many countries and many goods
– Applies when countries use a variety of resources to produce
goods, rather than just labor
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Some Important Provisos
• Following real-world considerations can lead to reduced trade or
incomplete specialization
– Costs of Trading
• If there are high transportation costs or high costs of making deals across
national boundaries
– Trade may be reduced and even become prohibitively expensive
– Sizes of Countries
• Sometimes a very large country trades with a very small one
– If the smaller country specialized completely, its output would be insufficient to fully
meet demand of the larger one
– Increasing Opportunity Cost
• Have assumed opportunity cost remains constant as production changes
• More typically, opportunity cost of a good rises as more of it is produced
• In the end, while trading will occur, there will not be complete specialization
– Government Barriers to Trade
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The Sources of Comparative
Advantage
• What determines comparative advantage in the
first place?
– A country that has relatively large amounts of a
particular resource at its disposal
• Will tend to have a comparative advantage in goods that make
heavy use of that resource
• Countries often develop strong comparative
advantage in the goods they have produced in the
past
– Regardless of why they initially began producing those
goods
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Why Some People Object to Free
Trade
• Given the clear benefits that nations can derive by
specializing and trading
– Why would anyone ever object to free international
trade?
• Despite benefit to nation as a whole, some groups
within the country, in short-run, are likely to lose
from free trade
– Even while others gain a great deal more
• Instead of finding ways to compensate the losers
– Often allow them to block free-trade policies
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Figure 1: The Impact of Trade
China
United States
Price
(Dollars)
Price
(Dollars)
Supply
F
$500
Supply
Exports
$350
$250
A
$350
B
C
D
Imports
Demand
E
Demand
200 300
150
Thousands
of Suits
per Month
250 310
160
Thousands
of Suits
per Month
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The Impact of Trade in the
Exporting/Importing Country
• When opening of trade results in increased
exports of a good
– Producers of the good are made better off
– Consumers of the good in exporting country will be
made worse off
• When opening of trade results in increased
imports of a product
– Domestic producers of the product are made worse off
– Consumers of the good in importing country are better
off
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Attitudes and Influence on Trade
Policy: The Anti-Trade Bias
• Distribution of gains and losses create a
policy-bias against free trade
– Those who benefit from trade in a specific
product either have little incentive to lobby for it
(consumers of imports)
• Or have limited power to influence policy (producers
of exports)
– But one constituency harmed by trade has both
a powerful incentive to lobby and ability to
influence policy
• Domestic producers threatened by imports
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Attitudes and Influence on Trade
Policy: The Anti-Trade Bias
• Antidotes to this policy bias
– Multilateral Agreements
• Two or more countries agree to trade freely in many goods—or
even all goods—simultaneously
– World Trade Organization
• By setting standards for acceptable and unacceptable trade
restrictions, and making rulings in specific cases, WTO has
some power to influence nations’ trade policies
– Industries as Consumers
• Term can apply to any buyer of a product, including a firm that
uses it as an input
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Figure 2: The Effect of a Tariff on
Suits
China
United States
Price
(Dollars)
Price
(Dollars)
Supply
$350
$300
A
Exports
H
B
Supply
K
$425
$350
C
Imports
D
J
Demand
150
175
L
250300 Thousands
of Suits
per Month
Demand
160 205
Thousands
280
of Suits
310 per Month
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How Free Trade Is Restricted
• When government decides to accommodate
opponents of free trade
– It is apt to use tariffs or quotes to restrict trade
• Tariffs
– Tax on imported goods
• Can be a fixed dollar amount per physical unit or a percentage
of good’s value
• In either case, effect in tariff-imposing country is similar
– Both countries, as a whole, are worse off
» Tariffs reduce volume of trade and raise domestic prices of
imported goods
» In the country that imposes the tariff, producers gain and
consumers lose
» World as a whole loses, because tariffs decrease volume of
trade and therefore decrease gains from trade
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How Free Trade Is Restricted
• Quotas
– Government decree limiting imports of a good to a
specified maximum physical quantity
– Because goal is to restrict imports, a quota is set below
the level of imports that would occur under free trade
– General effects are same as a tariff
• Reduce quantity of imports and raise domestic prices
• While both tariffs and quotas help domestic
producers
– They reduce benefits of trade to the nation as a whole
• However, a tariff has one saving grace
– Increased government revenue
22
Protectionism
• Groups who suffer from trade with other nations have developed a
number of arguments against free trade
– Together, these arguments form a position known as protectionism
• Belief that a nation’s industries should be protected from free trade with other
nations
• Myths about international trade
– A high-wage country cannot afford free trade with a low-wage country
• High-wage country will either be undersold in everything and lose all of its
industries, or else its workers will have to accept equally low wages and equally
low living standards
– Low-productivity country cannot afford free trade with a high-productivity
country
• Former will be clobbered by latter and lose all of its industries
– In recent times, America’s unskilled workers have suffered because of
ever-expanding trade between United States and other countries
23
Sophisticated Arguments for
Protection
• Strategic trade policy and support for infant industries are controversial
• Opponents stress three problems
– Once government assistance to an industry is accepted
• Special interest groups of all kinds will lobby to get the assistance
– Whether it benefits general public or not
– When one country provides assistance to an industry by keeping out
foreign goods, other nations may respond in kind
• If they respond with tariffs and quotas of their own, result is a shrinking volume
of world trade and falling living standards
• If subsidies are used to support a strategic industry, and another country
responds with its own subsidies, then both governments lose revenue
– Neither gains the sought-after profits
– Strategic trade policy assumes that government has information to
determine which industries, infant or otherwise, are truly strategic and
which are not
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Sophisticated Arguments for
Protection
• Arguments help to remind us of conditions under
which free trade is most beneficial to a nation
– Production is most likely to reflect principle of
comparative advantage
• When firms can obtain funds for investment projects
• When they can freely enter industries that are profitable
– Thus, free trade, without government intervention,
works best when markets are working well
• May partly explain why United States has for
decades been among the strongest supporters of
free trade ideal
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Protectionism in the United States
• U.S. consumers have suffered and U.S. producers have
gained, from some persistent barriers to trade
• Protection is costly
• In some cases, cost per job saved is staggering
• In addition to the dozens of industries in U.S. permanently
protected from foreign competition
– Dozens more each year are granted temporary protection when
the U.S. government finds a foreign producer or industry guilty of
dumping
• Selling their products in U.S. at “unfairly” low prices that harm a U.S.
industry
– Most economists believe that these low prices are most often the
result of comparative advantage
• U.S. as a whole would gain from importing the good
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Using the Theory: The U.S. Sugar
Quota
• United States has protected U.S. sugar producers from
foreign competition since 1930s
– Since 1980s protection has been provided in the form of a price
guarantee
• If U.S. sugar prices fall below 22¢, government will buy the sugar at
that price
• May not sound like a lot
– But in the rest of the world, people and businesses can buy sugar
for a lot less
• Government decides how much foreign sugar it will allow
in each year free of any tariff
– All sugar beyond the allowed amount faces a heavy tariff of about
16¢ a pound
• Sugar producers benefit
– Sugar consumers are hurt substantially
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Using the Theory: The U.S. Sugar
Quota
• Taxpayers pay a cost for the sugar quota
– Because as part of its price support program, U.S.
government must occasionally buy excess sugar from
producers
• Hurts the poorest countries in the world that rely
on sugar as an important source of export
revenue
– Sugar quota’s harm to these countries has been
estimated at about $1.5 billion per year
• Why do we bear these costs?
– Because of lobbying by groups who enjoy highly
concentrated benefits
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