1. International Trade

2. International Trade and the Theory of Comparative Advantage The “globalisation” of the economy has occurred in the private and public sectors, in input and output markets, and in firms and households. All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. Just as consumer sovereignty in microeconomics is a somewhat mythical idea, so macroeconomic national sovereignty is increasingly mythical. When the USA or China sneezes, the world catches cold.

3. Trade Surpluses and Deficits trade surplus The value (P x Q) of exports is greater than the value of imports. trade deficit the value (P x Q) of imports is greater than the value of exports.

4. 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 David Ricardo’s theory that specialisation and free trade will benefit all trading partners (economic growth will be higher, and real wages will rise), even those that may be absolutely less efficient producers.

5. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage absolute advantage The advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does. comparative advantage The advantage in the production of a good enjoyed by one country over another when that good can be produced at lower cost in terms of other goods than it could be in the other country.

6. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Yield per Acre of Wheat and Cotton New Zealand Australia Wheat 6 bushels 2 bushels Cotton 2 bales 6 bales Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage, and 100 Available Acres New Zealand Australia Wheat 25 acres × 6 bushels/acre = 150 bushels 75 acres × 2 bushels/acre = 150 bushels Cotton 75 acres × 2 bales/acre = 150 bales 25 acres × 6 bales/acre = 150 bales

7. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Production Possibility Frontiers for Australia and New Zealand Before Trade: Without trade, countries are constrained by their own resources and productivity.

8. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Production and Consumption of Wheat and Cotton after Specialisation Production Consumption New Zealand Australia New Zealand Australia Wheat 100 acres × 6 bushels/acre 600 bushels 0 acres 0 Wheat 300 bushels 300 bushels Cotton 0 acres 0 100 acres × 6 bales/acre 600 bales Cotton 300 bales 300 bales

9. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Expanded Possibilities After Trade: Trade enables both countries to move beyond their individual production possibility frontiers.

10. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Yield per Acre of Wheat and Cotton New Zealand Australia Wheat 6 bushels 1 bushel Cotton 6 bales 3 bales Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres New Zealand Australia Wheat 50 acres × 6 bushels/acre 300 bushels 75 acres × 1 bushels/acre 75 bushels Cotton 50 acres × 6 bales/acre 300 bales 25 acres × 3 bales/acre 75 bales

11. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Gains from Mutual Absolute Advantage Realising 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 × 6 bushels/acre 300 bushels 0 acres 0 Wheat 75 acres × 6 bushels/acre 450 bushels 0 acres 0 Cotton 50 acres × 6 bales/acre 300 bales 100 acres × 3 bales/acre 300 bales Cotton 25 acres × 6 bales/acre 150 bales 100 acres × 3 bales/acre 300 bales STAGE 3 New Zealand Australia 100 bushels (trade) Wheat 350 bushels 100 bushels (after trade) 200 bales (trade) Cotton 350 bales 100 bales (after trade)

12. The Economic Basis for Trade: Comparative Advantage Absolute Advantage versus Comparative Advantage Why Does Ricardo’s Plan Work? The real cost of cotton is the wheat sacrificed to obtain it. The cost of 3 bales of cotton in New Zealand is 3 bushels of wheat (a half acre of land must be transferred from wheat to cotton). However, the opportunity cost of 3 bales of cotton production in Australia is only 1 bushel of wheat. Australia has a comparative advantage over New Zealand in cotton production, and New Zealand has a comparative advantage over Australia in wheat production.

13. 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. Exchange Rates exchange rate The price of one currency in terms of another.

14. The Economic Basis for Trade: Comparative Advantage Exchange Rates Trade and Exchange Rates in a Two-Country/Two-Good World Domestic Prices of Timber (per Foot) and Rolled Steel (per Metre) in the United Kingdom and Brazil United Kingdom Brazil Timber £1 3 Reals Rolled steel £2 4 Reals TABLE 19.9 Trade Flows Determined by Exchange Rates Exchange Rate Price of Real Result £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; UK imports steel. £1 = 2.9 R .34 Brazil imports timber; UK imports steel. £1 = 3 R .33 UK imports steel. £1 = 4 R .25 UK imports timber and steel.

15. The Economic Basis for Trade: Comparative Advantage Exchange Rates Exchange Rates and Comparative Advantage If exchange rates adjust to real (not speculative) forces, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only in a country with a comparative advantage will those products be competitive in world markets.

16. The Sources of Comparative Advantage factor endowments The quantity and productivity (efficiency) of labour, 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 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.

17. The Sources of Comparative Advantage Other Explanations for Observed Trade Flows Comparative advantage is not the only reason countries trade. It does not explain why many countries import and export the same kinds of goods. Just as industries within a country differentiate their products to capture a domestic market, they also differentiate their products to please the wide variety of tastes that exist worldwide. Just as product differentiation is a natural response to diverse preferences within an economy, it is also a natural response to diverse preferences across economies. Some economists distinguish between gains from acquired comparative advantages and gains from natural comparative advantages.

18. 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. dumping A firm’s or an industry’s sale of products on the world market at prices below its own cost of production. quota A limit on the quantity of imports.

19. Trade Barriers: Tariffs, Export Subsidies, and Quotas UK Trade Policies, GATT, and the WTO European Union established in 1957 as a free trade area. Britain joins in 1973 after initial veto by France in 1967. The European trading bloc comprises 27 countries (of the 27 countries in the EU, 16 have the same currency—the euro). General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United Kingdom and 22 other countries in 1947 to promote the liberalization of foreign trade. World Trade Organization (WTO) A negotiating forum dealing with rules of trade across nations. Doha Development Agenda An initiative of the World Trade Organization focused on issues of trade and development.

20. Trade Barriers: Tariffs, Export Subsidies, and Quotas UK Trade Policies, GATT, and the WTO Economic Integration economic integration Occurs when two or more nations join to form a free-trade zone. 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 (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.

21. Free Trade or Protection? The Case for Free Trade The Gains from Trade and Losses from the Imposition of a Tariff: A tariff of £1 increases the market price facing consumers from £2 per yard to £3 per metre. The government collects revenues equal to the gray shaded area in b. The loss of efficiency has two components. First, consumers must pay a higher price for goods that could be produced at lower cost. Second, marginal producers are drawn into textiles and away from other goods, resulting in inefficient domestic production. The triangle labelled ABC in b is the dead weight loss resulting from the tariff. £4.20 £2.00 £1{ £3 ↑ £2 £1 tariff per unit

22. Free Trade or Protection? The Case for Protection Protection Saves Jobs The main argument for protection is that foreign competition costs Americans their jobs. Victims of free trade can be aided constructively without giving up the gains from trade. Some Countries Engage in Unfair Trade Practices The WTO is the vehicle currently used to negotiate trade disputes. Cheap Foreign Labor Makes Competition Unfair Wages in a competitive economy reflect productivity: a high ratio of output to units of labour, and trade flows not according to absolute advantage, but according to comparative advantage: all countries gain, even if one country is more efficient at producing everything.

23. Free Trade or Protection? The Case for Protection Protection Safeguards National Security Even if we acknowledge another country’s comparative advantage, we may want to protect our own resources or self-sufficiency eg in food production or energy. Protection Discourages Dependency Protecting industries in areas where a country has a comparative disadvantage may prevent trading relationships that might lead to political dependence. Environmental Concerns Some environmental groups argue that the WTO’s free trade policies may harm the environment and that penalties could be imposed on high-polluting products produced with few controls to ensure that the prices of goods imported this way reflect the harm that those products cause.

24. An Economic Consensus Critical to our study of international economics is the debate between free traders and protectionists. According to the theory of comparative advantage, all countries benefit from specialization and trade. Free international trade raises real incomes and improves the standard of living. Although protectionists point to the loss of jobs and argue for the protection of workers from foreign competition, foreign competition is unlikely to cause net job loss in an economy. Foreign trade and full employment can be pursued simultaneously.

25. Key terms • absolute advantage • comparative advantage • Corn Laws • Doha Development Agenda • dumping • economic integration • European Union (EU) • exchange rate • export subsidies • factor endowments • General Agreement on Tariffs and Trade (GATT) • Heckscher-Ohlin theorem • infant industry • protection • Quota • tariff • terms of trade • trade deficit • trade surplus • World Trade Organization (WTO)