Trade Issues
• If one country gains, must the other lose?
• Think comparative advantage.
• Do imports reduce employment?
• Do tariffs/quotas/restrictions save jobs?
• When might they?
• Should weak domestic industries be subsidized?
• Is a trade deficit “bad”? Is a surplus “good”?
• Does “fair trade” mean that our exports to a
country will equal our imports from it?
Historical development of trade theory
• Mercantilism: get positive trade balance
• David Hume: specie flow balances payments
• Absolute advantage (Adam Smith)
– Countries benefit from exporting what they make
cheaper than anyone else…and buying abroad what they
can buy for less
Specialization  Division of Labor  Growth
• Comparative advantage (David Ricardo)
– Nations can gain from specialization, even if they lack an
absolute advantage
Absolute & Comparative Advantage
Absolute advantage: each nation is more efficient in
producing one of the goods
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom
5 bottles 20 yards
15 bottles 10 yards
Comparative advantage: the US has an absolute
advantage in both goods
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom
40 bottles 40 yards
20 bottles 10 yards
•Expect more productive US workers to have higher real wage.
Comparative advantage
Ricardo’s Comparative Advantage in money prices
Nation
Labor
Wage
US
1 hr
$20/hr
UK
1 hr
£5/hr
:
:
:
UK
1 hr
$10
(at $2.00 = £1)
Cloth (yards)
Quant. Price
40
10
:
10
$0.50
£0.50
:
$1.00
Wine (bottles)
Quant. Price
40
20
:
20
 No reason to buy British stuff
$0.50
£0.25
:
$0.50
Ricardo’s Comparative Advantage in money prices:
British workers take wage cut
Nation
Labor
Wage
US
1 hr
$20/hr
UK
1 hr
£4/hr
:
:
:
UK
1 hr
$8
(at $2.00 = £1)
Cloth (yards)
Quant. Price
40
10
:
10
$0.50
£0.40
:
$0.80
Wine (bottles)
Quant. Price
40
20
:
20
$0.50
£0.20
:
$0.40
Ricardo’s Comparative Advantage in money prices:
the pound depreciates
Nation
Labor
Wage
US
1 hr
$20/hr
UK
1 hr
£5/hr
:
:
:
UK
1 hr
$8
(at $1.60 = £1)
Cloth (yards)
Quant. Price
40
10
:
10
$0.50
£0.40
:
$0.80
Wine (bottles)
Quant. Price
40
20
:
20
$0.50
£0.20
:
$0.40
Comparative advantage: autos and wheat
Production possibilities schedules: constant
opportunity costs
Canada
160
140
120
100
80
60
40
20
0
Slope = 0.5 = MRT
When US resources are
redeployed from wheat to autos,
produce 2 cars for every ton of
wheat sacrificed:
Oppty cost of 1 Car = ½ Wheat
0
40
80
Autos
120
Wheat
Wheat
United States
160
140
120
100
80
60
40
20
0
Slope = 2.0 = MRT
In Canada,
Oppty cost of 1 Car = 2 Wheat
0
40
80
Autos
120
Trading under constant opportunity costs
Marginal Rates of Transformation in Production:
US: 60 wheat = 120 cars  ½ wheat/car
CND: 160 wheat = 80 cars  2 wheat/car
United States
Trading
possibilities line
(terms of trade 1:1)
160
140
tt
120
80
C
60
20
20
40
60
D’
C’
100
80
A’
80
100
Autos
120
tt
20
B
D
0
120
40
F
0
140
60
A
40
Trading
possibilities line
(terms of trade 1:1)
B’
160
Wheat
E
100
Wheat
Canada
140
160
0
0
20
40
60
80
100
Autos
120
140
160
Comparative advantage
Production gains from specialization:
constant opportunity costs
Before
Specialization
After
Specialization
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
40
40
40
80
120
0
0
160
80
-40
-40
80
World
80
120
120
160
40
40
Comparative advantage
Consumption gains from trade: constant
opportunity costs and Terms of Trade = 1:1
(Trade 60 Wheat for 60 Cars)
Before
Trade
After
Trade
Net Gain
(Loss)
Autos Wheat
Autos Wheat
Autos Wheat
US
Canada
40
40
40
80
60
60
60
100
20
20
20
20
World
80
120
120
160
40
40
Possible terms of trade
– Less than ½ Wheat/Car  US won’t trade
– More than 2 Wheat/Car  Canada won’t trade
Equilibrium terms of trade: enter DEMAND
– The importance of being unimportant
• large country continues to produce some of everything
• Terms – of – trade settle at (near) large country’s MRT
• Small country gains (almost) all
Dynamic gains from trade
• The division of labor is limited by the extent of the market
– Economies of scale
• Global competition  Creative destruction  Efficiency
• Technology transfer  Growth
Trade restrictions and reduced gains from trade
(Limit Oil Imports to 200)
tt’
350
tt
Crude oil
300
C
Production Poss
@ MRT = 5/8 : 1
250
200
E
A
Consumption possibilities
@ 1.5:1 terms of trade
150
100
D
50
B
0
0
100
200
300
Manufactured goods
400
500
Why is complete specialization rare?
Wheat
Production possibilities schedule
under increasing costs
160
140
120
100
80
60
40
20
0
A Slope 1Auto = 1Wheat
Slope 1Auto = 4Wheat
B
0
20
40
60
80
Autos
Oppty cost of autos
increases as more autos
are produced.
100
120
140
Trading under increasing costs: US stops short of total
specialization in autos
Trading possibilities line
25
C
Wheat
20
A
15
D
10
tUS (1A = 0.33W)
B
5
tt (1A =1W)
0
0
5
10
15
20
Autos
25
30
35
40
Trading under increasing costs: Canada stops short of total
specialization in wheat.
At limit, MRT = 1:1 in both countries. But …
Trading possibilities line
25
Wheat
20
tC (1A = 3W)
15
B’
10
5
D’ A’
C’
tt (1A =1W)
0
0
5
10
15
20
Autos
25
30
35
40
Additional Considerations
• Spectrum of comparative advantage
• Multilateral trade…“triangle trade”
• Entry barriers/Exit barriers
– Irreversible commitments slow adjustments to
changes in competitive advantage
• Outsourcing and its discontents
– Costs, costs, costs
– Cultural disconnects
• Pat Mulroy (SNWA): “We’ve brought employees in from back
East. It takes them a good year to learn how different the
West Coast is.”
Insights and Review
Humian adjustment (David Hume, 1711-1776)
An early equilibrium model
Suppose one country enjoys a balance of trade surplus
– It’s trading partner experiences a deficit
“Gold” flows from deficit country to surplus country
– The surplus country’s money supply increases
–Prices rise in the surplus country
The surplus country’s goods become less attractive
– It sells less to the other country
– It buys more from the other country
The balance of trade balances
Insights and Review
A country enjoys a comparative advantage in the good for which its
opportunity cost of production is low.
• Trade proceeds as long as the terms of trade (wine/cloth) is less than
the wine exporting country’s opportunity cost of producing cloth and
greater than the wine importing country’s opportunity cost of
producing cloth.
– The wine exporting country trades less of its wine for cloth than it would
have to sacrifice in autarky
– The wine importing country gets more wine for its cloth than it would
get in autarky
• In general, a country’s Terms of Trade equals
{Price It Receives for Its Exports}/{Price It Pays for Its Imports}
– The closer the terms of trade are to its own opportunity cost, the
less a country gains from trade: it may as well not trade
– If its demand for the good it imports is high, it will pay a high
price for its import and not gain much from trade.
Dynamic Gains from Trade
• Competitive pressure  Efficiency
– Domestic suppliers must compete globally
– The firm itself must compete globally
• Technology transfer  Efficiency
• Increased extent of the market
 Economies of scale  Efficiency
Insights and Review
•
If a country is not competitive because its workers are
inefficient or “overpaid” (its costs are high), it can
become competitive by
– Depreciation of its currency
But if its exchange rate is fixed
– It pays for its import surplus with “gold” (Hume)
– Its wages and prices deflate … while wages and prices
in the export surplus country inflate
Or
– If its workers resist taking wage cuts, they suffer
unemployment
– Its trade balances because it imports less