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PART VII THE WORLD ECONOMY

Chapter

33
International Trade,
Comparative Advantage,
and Protectionism

Prepared by:

Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
PART IV THE WORLD ECONOMY

International Trade,
Comparative Advantage, 33
Chapter Outline
and Protectionism Trade Surpluses and Deficits

The Economic Basis for Trade:


Comparative Advantage
Absolute Advantage versus
Comparative Advantage
Terms of Trade
Exchange Rates
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The Sources of Comparative


Advantage
The Heckscher-Ohlin Theorem
Other Explanations for Observed
Trade Flows

Trade Barriers: Tariffs, Export


Subsidies, and Quotas

Free Trade or Protection?


The Case for Free Trade
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The Case for Protection

An Economic Consensus
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INTERNATIONAL TRADE, COMPARATIVE
ADVANTAGE, AND PROTECTIONISM

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.
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All economies, regardless of their size, depend to some extent on other economies and are
affected by events outside their borders.
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TRADE SURPLUSES AND DEFICITS

trade surplus The situation when a


country exports more than it imports.

trade deficit The situation when a country


imports more than it exports.
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TRADE SURPLUSES AND DEFICITS
TABLE 18.1 U.S. Balance of Trade (Exports Minus Imports), 1929–2004
(Billions of Dollars)
EXPORTS MINUS IMPORTS EXPORTS MINUS IMPORTS
1929 + 0.4 1986 – 132.7
1933 + 0.1 1987 – 148.2
1945 – 0.8 1988 – 110.4
1955 + 0.5 1989 – 88.2
1960 + 4.2 1990 – 78.0
1965 + 5.6 1991 – 27.5
1970 + 4.0 1992 – 33.2
1975 + 16.0 1993 – 65.0
1976 – 1.6 1994 – 93.6
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1977 – 23.1 1995 – 91.4


1978 – 25.4 1996 – 96.2
1979 – 22.5 1997 – 101.6
1980 – 13.1 1998 – 159.9
1981 – 12.5 1999 – 260.5
1982 – 20.0 2000 – 379.5
1983 – 51.7 2001 – 367.0
1984 – 102.7 2002 – 424.4
1985 – 115.2 2003 – 500.9
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2004 – 624.4
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Corn Laws The tariffs, subsidies, and


restrictions enacted by the British Parliament
in the early nineteenth century to discourage
imports and encourage exports of grain.

theory of comparative advantage Ricardo’s


theory that specialization and free trade will
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benefit all trading partners (real wages will rise),


even those that may be absolutely less efficient
producers.
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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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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE
ABSOLUTE ADVANTAGE VERSUS COMPARATIVE ADVANTAGE

absolute advantage The advantage in the


production of a product enjoyed by one
country over another when it uses fewer
resources to produce that product than the
other country does.
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comparative advantage The advantage in


the production of a product enjoyed by one
country over another when that product can
be produced at lower cost in terms of other
goods than it could be in the other country.
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Gains from Mutual Absolute Advantage


TABLE 18.2 Yield Per Acre of Wheat and Cotton

NEW ZEALAND AUSTRALIA

Wheat 6 bushels 2 bushels


Cotton 2 bales 6 bales

TABLE 18.3 Total Production of Wheat and Cotton Assuming No Trade, Mutual
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Absolute Advantage, and 100 Available Acres


NEW ZEALAND AUSTRALIA

Wheat 25 acres x 6 bushels/acre 75 acres x 2 bushels/acre


150 bushels 150 bushels
Cotton 75 acres x 2 bales/acre 25 acres x 6 bales/acre
150 bales 150 bales
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THE ECONOMIC BASIS FOR TRADE:
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COMPARATIVE ADVANTAGE

FIGURE 18.1 Production Possibility Frontiers for Australia and New Zealand before Trade
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

TABLE 18.4 Production and Consumption of Wheat and Cotton after Specialization

PRODUCTION CONSUMPTION
New Zealand Australia New Australia
Zealand

Wheat 100 acres x 6 bushels/acre 0 acres 300 bushels 300 bushels


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600 bushels 0

Cotton 0 acres 100 acres x 6 bales/acre 300 bales 300 bales


0 600 bales
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THE ECONOMIC BASIS FOR TRADE:
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COMPARATIVE ADVANTAGE

FIGURE 18.2 Expanded Possibilities after Trade


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Trade enables both countries to move beyond their previous resource and productivity
constraints.
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Gains from Comparative Advantage


TABLE 18.5 Yield Per Acre of Wheat and Cotton

NEW ZEALAND AUSTRALIA

Wheat 6 bushels 1 bushel


Cotton 6 bales 3 bales
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TABLE 18.6 Total Production of Wheat and Cotton Assuming No Trade and
100 Available Acres
NEW ZEALAND AUSTRALIA

Wheat 50 acres x 6 bushels/acre 75 acres x 1 bushels/acre


300 bushels 75 bushels
Cotton 50 acres x 6 bales/acre 25 acres x 3 bales/acre
300 bales 75 bales
P A HC

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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE
TABLE 18.7 Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
STAGE 1 STAGE 2
New Zealand Australia New Zealand Australia

Wheat 50 acres x 6 bushels/acre 0 acres 75 acres x 6 bushels/acre 0 acres


300 bushels 0 450 bushels 0

Cotton 50 acres x 6 bales/acre 100 acres x 3 bales/acre 25 acres x 6 bales/acre 100 acres x 3 bales/acre
300 bales 300 bales 150 bales 300 bales

STAGE 3
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New Zealand Australia


100 bushels (trade)

Wheat 350 bushels 100 bushels


(after trade)
200 bales (trade)

Cotton 350 bales 100 bales


P A HC

(after trade)

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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Why Does Ricardo’s Plan Work?


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FIGURE 18.3 Comparative Advantage Means Lower Opportunity Cost


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When countries specialize in producing goods in which they have a comparative advantage,
they maximize their combined output and allocate their resources more efficiently.
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

TERMS OF TRADE

terms of trade The ratio at which a country


can trade domestic products for imported
products.
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

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.

exchange rate The ratio at which two


currencies are traded. The price of one
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currency in terms of another.

First, 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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Second, within that range, the exchange rate will determine which country gains the most
from trade. In short, exchange rates determine the terms of trade.
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Trade and Exchange Rates in a Two-Country/Two-


Good World

TABLE 18.8 Domestic Prices of Timber (Per Foot) and Rolled Steel (Per
Meter) in the United States and Brazil
UNITED STATES BRAZIL
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Timber $1 3 Reals
Rolled steel $2 4 Reals
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THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE
TABLE 18.9 Trade Flows Determined by Exchange Rates
EXCHANGE PRICE RESULT
RATE OF REAL

$1 = 1 R $1.00 Brazil imports timber and steel


$1 = 2 R .50 Brazil imports timber
$1 = 2.1 R .48 Brazil imports timber; United States imports
steel
$1 = 2.9 R .34 Brazil imports timber; United States imports
steel
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$1 = 3 R .33 United States imports steel


$1 = 4 R .25 United States imports timber and steel

Exchange Rates and Comparative Advantage


If exchange rates end up in the right ranges, the free market will drive each country to shift
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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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THE SOURCES OF COMPARATIVE ADVANTAGE

factor endowments The quantity and


quality of labor, land, and natural resources
of a country.

THE HECKSCHER-OHLIN THEOREM

Heckscher-Ohlin theorem A theory that


explains the existence of a country’s comparative
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advantage by its factor endowments: 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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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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OTHER EXPLANATIONS FOR OBSERVED
TRADE FLOWS

Some theories argue that comparative advantage


can be acquired. Just as industries within a country
differentiate their products to capture a domestic
market, so too do they differentiate their products to
please the wide variety of tastes that exists
worldwide. This theory is consistent with the theory
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of comparative advantage.
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TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

protection The practice of shielding a sector of


the economy from foreign competition.

tariff A tax on imports.

export subsidies Government payments


made to domestic firms to encourage exports.
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dumping A firm or industry’s sale of


products on the world market at prices
below the cost of production.

quota A limit on the quantity of imports.


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TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

U.S. Trade Policies and GATT


Smoot-Hawley tariff The U.S. tariff law of
the 1930s, which set the highest tariffs 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
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1930s.

General Agreement on Tariffs and Trade


(GATT) An international agreement
signed by the United States and 22 other
countries in 1947 to promote the
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liberalization of foreign trade.


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TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

Economic Integration

economic integration Occurs when two or


more nations join to form a free-trade zone.

European Union (EU) The European


trading bloc composed of Austria, Belgium,
Denmark, Finland, France, Germany,
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Greece, Ireland, Italy, Luxembourg, the


Netherlands, Portugal, Spain, Sweden, and
the United Kingdom.
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TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

U.S.-Canadian Free Trade Agreement An


agreement in which the United States and
Canada agreed to eliminate all barriers to
trade between the two countries by 1998.

North American Free Trade Agreement


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(NAFTA) An agreement signed by the


United States, Mexico, and Canada in which
the three countries agreed to establish all
North America as a free-trade zone.
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FREE TRADE OR PROTECTION?
THE CASE FOR FREE TRADE
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FIGURE 18.4 The Gains from Trade and Losses from the Imposition of a Tariff

Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt
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relatively inefficient production techniques, and force consumers to pay higher prices for
protected products than they would otherwise pay.
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FREE TRADE OR PROTECTION?
THE CASE FOR PROTECTION

Protection Saves Jobs


Some Countries Engage in Unfair Trade
Practices

Cheap Foreign Labor Makes Competition


Unfair
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Protection Safeguards National Security

Protection Discourages Dependency


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FREE TRADE OR PROTECTION?

Protection Safeguards Infant Industries

infant industry A young industry that may


need temporary protection from competition
from the established industries of other
countries to develop an acquired
comparative advantage.
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AN ECONOMIC CONSENSUS

Critical to our study of international economics is the


debate between free traders and protectionists.

Foreign trade and full employment can be pursued simultaneously. Although economists
disagree about many things, the vast majority of them favor free trade.
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REVIEW TERMS AND CONCEPTS

absolute advantage North American Free Trade


comparative advantage Agreement (NAFTA)
Corn Laws protection
dumping quota
economic integration Smoot-Hawley tariff
European Union (EU) tariff
exchange rate terms of trade
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export subsidies theory of comparative


factor endowments advantage
General Agreement on trade deficit
Tariffs and Trade (GATT) trade surplus
Heckscher-Ohlin theorem U.S.-Canadian Free Trade
infant industry Agreement
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