Chapter 7
Trade
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
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How does trade affect society?
How does trade create wealth?
What is absolute advantage?
What is comparative advantage?
What are the effects of exports and imports?
What are tariffs and quotas?
What are the additional benefits of trade?
What are the arguments against objections to
trade?
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What Happened to Neanderthals?
Neanderthals were intelligent cousins of
humans.
A plausible theory:
• Neanderthals’ wealth and population
gradually shrank to extinction because
they did not trade.
• By engaging in trade, humans created
wealth and survived.
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Trade
• Trade allows individuals to specialize and
produce more.
• Trade creates wealth.
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International Trade: Example 1
Cost
One
Computer
One TV
US
1 hour’s work
10 hours’ work
Italy
20 hours’ work
1 hour’s work
Without Trade
Hours Computers
Worked
With Trade
TVs
Hours Computers
Worked
TVs
US
11
1
1
US
11
6
5
Italy
21
1
1
Italy
21
5
16
5
7-5
International Trade: Example 2
Cost
One Computer
One TV
US
1 hour’s work
10 hours’ work
Slow Land
2000 hours’ work
1000 hours’ work
Opportunity
Cost
One Computer
One TV
US
1/10 of a TV
10 computers
Slow Land
2 TVs
½ computer
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International Trade: Example 2
Without Trade
Hours
worked
Computers
TVs
US
110
10
10
Slow
Land
30,000
10
10
With Trade: Scenario 1
With Trade :Scenario 2
Hours
worked
Computers
TVs
US
20
10
10
Slow
Land
20,000
10
10
Hours
worked
Computers
TVs
US
110
95
15
Slow
Land
30,000
15
15
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International Trade
• Trade gives an indirect means of
production.
Trade allows:
• Either more production with same
resources, compared to without trade.
• Or same production with less resources,
compared to without trade.
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Absolute vs. Comparative Advantage
• Absolute advantage
= If the nation can produce a good using
fewer resources than its trading partners.
• Comparative advantage
= If the nation can produce a good at lower
opportunity cost than its trading partners.
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Comparative Advantage
• David Ricardo formulated the theory of comparative
advantage.
• Even when one nation has an absolute advantage in the
production of all goods, nations can still benefit by
trading goods according to comparative advantage.
• Every person and every nation must have a comparative
advantage in something.
• Individuals and nations benefit from trade when they sell
(export) goods for which they have a comparative
advantage, and buy (import) goods other people or
nations have a comparative advantage in producing.
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Comparative Advantage
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Comparative advantages can come from:
Natural resources, soil and climate.
Large labor force of unskilled workers.
Freedom.
Human capital = Education and skills.
Language skills.
Work and experience.
Genetics and family environment.
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Exports
• When a country opens up for
trade, domestic price becomes
equal to world price.
If world price > Domestic price:
• Quantity supplied > Quantity
demanded
• Excess domestic supply is
exported.
• Higher price
= Increase in producers surplus
and decrease in consumers
surplus.
• Producers’ gains >
Consumers’ loss
= Increase in total surplus.
Consumers
are here
Producers are
here
Price
Exports
Consumers
and producers
are here
$11
CS
Supply
World price
$10
PS
Demand
300
650
705
Quantity
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Imports
If world price < Domestic price:
• Quantity supplied < Quantity
demanded.
• Excess domestic demand is
satisfied by imports.
• Lower price
= Increase in consumers surplus
and decrease in producers
surplus.
• Consumers’ gains >
Producers’ loss
= Increase in total surplus.
Producers are
here
Price
Consumers are
here
Supply
CS
$10
World price
$5
PS
Demand
Imports
200
1,100
Quantity
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International Trade
• Trade increases the wealth of society.
• Trade creates losers as well as winners:
• Imports = Consumers gain, producers
lose.
• Exports = Producers gain, consumers
lose.
• Producer’s lobby against imports.
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Tariffs
• Tariff = Tax on imports.
• Tariff increases price of
imports.
• Consumers lose and
producers gain.
• Government gets tax
revenue.
• Losses > Gains from
tariffs.
• Tariff creates deadweight
loss.
Price
Producers are
here with tariff
Producers are
here without
tariff
Consumers are
here with tariff
Supply
Consumers are
here without
tariff
$10
$7
World price + Tariff
$5
World price
Demand
Imports
200
300
1,000
1,100
Quantity
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Quotas
• Quota restricts imports by placing a limit on the
number of goods that can be imported.
• Quota helps producers but harms consumers.
• Quota does not raise money for the government.
• Quota benefits some foreign firms by increasing
their revenue.
• Quota allows the government to protect
domestic producers without endangering the
country’s political alliances.
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Additional Benefits of Trade
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Specialization:
Trade allows individuals/nations to
concentrate on only a few areas.
Specialization leads to expertise.
Innovation:
Trade increases innovations. To compete
with others and to gain comparative
advantage, individuals/nations have to
innovate new technology.
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Additional Benefits of Trade
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Reduced corruption:
Trade increases competition. International
trade forces companies and nations to
compete against players beyond their political
influence and so it reduces corruption.
Brain gain:
International trade encourages effective use of
intelligence. Competition drives international
firms to seek brainpower throughout the world.
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Arguments Against Objections to Trade
Trade harms workers in poor countries by
paying low wages:
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Trade offers jobs and wages to workers in poor
countries. International trade offers an opportunity to
poor countries to increase their wealth.
International trade increases child labor in poor
countries:
•
These jobs make it possible for children in poor
countries to have better means of subsistence than
available without international trade.
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Arguments Against Objections to Trade
Trade harms workers in rich countries:
•
International trade creates losers as well as winners.
Some workers in rich nations are hurt. They can
successfully compete against workers in poor
countries by being more productive.
Nations need trade restrictions to protect infant
industries:
•
Government protection of infant industry from foreign
competition can encourage inefficient practices, waste
of resources and political corruption.
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Arguments Against Objections to Trade
Nations shouldn’t trade with potential military
enemies:
•
Trade creates wealth for all trading partners. So trade
might reduce potential military enemy’s desire to harm
a nation. Trade generates economic cooperation
between trading partners which in turn influences
political decisions.
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Arguments Against Objections to Trade
Nations can use their threat of retaliatory trade
restrictions to promote free trade:
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Threatening to retaliate against trade restrictions can
sometimes work to increase trade.
The Santa Claus problem: Job destruction
because of cheap imports:
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Trade both destroys and creates jobs. There is a
change in types of job.
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Do You Know?
• When does a nation have a comparative
advantage in the production of a good?
When a nation can produce a good at lower
opportunity cost than its trading partners.
• Why do politicians often oppose imports?
Imports hurt producers. Producers lobby for
trade restrictions by providing economic and
political incentives to politicians.
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Do You Know?
• How can trade promote innovation?
By forcing individuals/nations to compete with
others and gain comparative advantage, trade
encourages innovations.
• Why does trade enable human civilization?
Trade allows division of labor, specialization and
innovation, so humans can create the tools of
civilization and enjoy numerous goods and
services.
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Summary
• Trade is the basis of human civilization.
• Trade creates wealth by allowing
specialization.
• Absolute advantage is the ability to
produce a good using fewer resources.
• Comparative advantage is the ability to
produce a good at lower opportunity cost.
• Comparative advantage is the basis of
international trade.
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Summary
• Though exports and imports increase the
total surplus for society as a whole, they
harm some sections of society.
• Trade restrictions such as tariffs and
quotas protect producers but create
deadweight loss for society.
• Specialization, innovation, reduced
corruption and brain gain are the
additional benefits of international trade.
• The objections to international trade
usually do not stand up to economic
principles.
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Coming Up
How do costs affect production?
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