International TradeInternational Trade

ECO 285 – Macroeconomics – Dr. D. Foster – Spring 2014

International Trade

Basis for trade: Comparative Advantage

Who has the lower “opportunity Who has the lower “opportunity cost?”cost?”

Mistaken basis for trade: Absolute Advantage

Who has the lower resource cost?Who has the lower resource cost?

Consider Senegal and Peru:

Example: Absolute Advantage

Who can more cheaply produce wool?Who can more cheaply produce wool?

Who can more cheaply produce beef?Who can more cheaply produce beef?

Wool (#) Beef (#) # of R.U.Senegal 2.5 1 100,000

Peru 3 2 150,000

Resource Units to produce:

Example: Comparative AdvantageReconsider Senegal and Peru:

What does it “cost” to produce wool?What does it “cost” to produce wool?

What does it “cost” to produce beef?What does it “cost” to produce beef?

Wool (#) Beef (#)Senegal 40,000 100,000

Peru 50,000 75,000

Maximum production of:

Comparative AdvantageOpportunity costs in Senegal and Peru:

With trade, wool would “sell” for . . .?With trade, wool would “sell” for . . .?

With trade, beef would “sell” for . . .?With trade, beef would “sell” for . . .?

Price = Terms of Trade; say 1# W=2# B

1# Wool 1# BeefSenegal 2.50 0.40

Peru 1.50 0.67in # beef in # wool

Opportunity Cost:

Trade ObservationsNot all countries have absolute advantages.Not all countries have absolute advantages.

All countries do have comparative All countries do have comparative advantages.advantages.

Country size is irrelevant.Country size is irrelevant.

Opportunity cost = what you give up.Opportunity cost = what you give up.

The international trading price of goods is The international trading price of goods is called the “terms of trade.”called the “terms of trade.”

Back to Senegal/Peru trade example:Assume without trade, resources are split evenly.

Senegal always wants 50,000 #B;Peru always wants 25,000 #W.

Advantages to Trade

A - the “no trade” outcome; production=consumptionA - the “no trade” outcome; production=consumption

B - the specialized production outcome, with tradeB - the specialized production outcome, with trade

#Wool

#Beef

Senegal

40,000

100,000

50,0050,0000

20,0020,0000

#Wool

#Beef

Peru

50,000

75,00037,5037,5000

AA AA

BB

BB

25,0025,0000

Advantages to Trade

A - the “no trade” outcome; production=consumptionA - the “no trade” outcome; production=consumption

B - the specialized production outcome, with tradeB - the specialized production outcome, with trade

C - the consumption outcome, with trade.C - the consumption outcome, with trade.

#Wool

#Beef

Senegal

40,000

100,000

#Wool

#Beef

Peru

50,000

75,000

BB

BB

CC

50,0050,0000

25,0025,0000

CC

50,0050,0000

25,0025,0000

Advantages to Trade

Before trade, world production was:Before trade, world production was:Wool: 45,000 lbs.Wool: 45,000 lbs.Beef: 87,500 lbs.Beef: 87,500 lbs.

With trade, world production has become:With trade, world production has become:Wool: 50,000 lbs.Wool: 50,000 lbs.Beef: 100,000 lbs.Beef: 100,000 lbs.

Gains to trade:Gains to trade:Wool: +5,000 lbs.Wool: +5,000 lbs.Beef: +12,500 lbs.Beef: +12,500 lbs.

Effects of Trade BarriersIn Senegal, unrest among the shepherds.

Workers must relocate.

Owners must relocate.

Politicians seek to “protect” domestic producers. Here, wool . . .

Consider two trade barriers – an import quota and a tariff.

Policy #1 - Import QuotaPolicy #1 - Import Quota

Limit imports to 10,000 pounds of wool.Limit imports to 10,000 pounds of wool.

Now, neither can completely specialize.Now, neither can completely specialize.

Each has a lower standard of living.Each has a lower standard of living.

World production:World production:

Wool: 47,000#Wool: 47,000#

Beef: 92,500#Beef: 92,500#

#Wool

#Beef

Senegal

40,000

100,000

#Wool

#Beef

Peru

50,000

75,000

QQ

QQQ*Q*

50,0050,0000

22,0022,0000

Q*Q*

42,5042,5000

25,0025,0000

35,0035,0000

22,5022,5000

They can only trade They can only trade 10,000#, so they only 10,000#, so they only

produce 35,000#.produce 35,000#.This takes 70% of This takes 70% of their RUs, so rest is their RUs, so rest is

used to produce beef.used to produce beef.They can only They can only get 20,000# get 20,000# B in trade.B in trade.

70,0070,0000

12,0012,0000

They can only trade They can only trade 20,000#, so they only 20,000#, so they only produce 70,000# B.produce 70,000# B.Trade Trade

20,000# B for 20,000# B for 10,000# W.10,000# W.

Use remaining Use remaining resources to produce resources to produce

12,000 # W.12,000 # W.

Policy #2 - TariffPolicy #2 - Tariff

Tariff (tax) changes ToT: 1# W = 2.25# BTariff (tax) changes ToT: 1# W = 2.25# B

Tax goes to government of Senegal.Tax goes to government of Senegal.

But, still no domestic wool production!But, still no domestic wool production!

#Wool

#Beef

40,000

100,000

#Wool

#Beef

50,000

75,000

FF

FF

F*F*

50,0050,0000

22,2222,2222

F*F*

48,6148,6111

25,0025,0000

47,2247,2222

Senegal Peru

4,164,1677

World production:World production:

Wool: 47,222#Wool: 47,222#

Beef: 100,000#Beef: 100,000#

50,000# B 50,000# B now “cost” now “cost”

22,222# W!!22,222# W!!

(50,000/2.25)(50,000/2.25)

But, 22,222# But, 22,222# wool will still wool will still

earn Peruvians earn Peruvians 44,444# beef.44,444# beef.

Advantages to Trade & Disadvantages to Trade Barriers

Before trade, world production was:Before trade, world production was:Wool: 45,000 lbs. Beef: 87,500 lbs.Wool: 45,000 lbs. Beef: 87,500 lbs.

With trade, world production was:With trade, world production was:Wool: 50,000 lbs. Beef: 100,000 lbs.Wool: 50,000 lbs. Beef: 100,000 lbs.

With tariff, world production was:With tariff, world production was:Wool: 47,222 lbs. Beef: 100,000 lbs.Wool: 47,222 lbs. Beef: 100,000 lbs.

With quota, world production was:With quota, world production was:Wool: 47,000 lbs. Beef: 92,500 lbs.Wool: 47,000 lbs. Beef: 92,500 lbs.

Trade LessonsWe trade on the basis of our comparative We trade on the basis of our comparative advantage.advantage.

Everyone has a comparative advantage.Everyone has a comparative advantage.

Trade raises our material standard of Trade raises our material standard of living.living.

Trade barriers lower our standard of Trade barriers lower our standard of living.living.

Responding to trade barriersResponding to trade barriersin kind makes us worse off.in kind makes us worse off.

Trade BarriersImport quotas to keep foreign goods out.Import quotas to keep foreign goods out.

Tariffs that serve as a tax on foreign Tariffs that serve as a tax on foreign goods.goods.

Subsidies for producers of export goods.Subsidies for producers of export goods.

Impose standards on foreign goods (Impose standards on foreign goods ( costs).costs).

The false rhetoric of protection:The false rhetoric of protection:cheap foreign labor, infant industry,cheap foreign labor, infant industry,national defense, beggar-thy-neighbornational defense, beggar-thy-neighbor

International TradeInternational Trade

ECO 285 – Macroeconomics – Dr. D. Foster – Spring 2014