III. Miscellaneous

A. Comparative Advantage and the Gains from International Trade

1.  Definitions

• Imports - goods and services bought domestically but produced in other countries
  
  - About 16 percent of U.S. Gross Domestic Product (GDP) in 2016

•  Exports - goods and services produced domestically but sold in other countries
  
  - About 13 percent of U.S. GDP in 2016

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2.  Comparative advantage and trade

a.  Absolute advantage

• Ability of an individual, firm, or country to produce more of a good or service than competitors, using the same amount of resources

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Ex. - Production is for one hour of labor

	Smart Phones	Wheat
Japan	12	1
U.S.	2	10
	Production Possibilities

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• Japan has an absolute advantage in smart phone production, U.S. has an absolute advantage in wheat production

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b.  Comparative advantage

• Ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than competitors

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Ex. - Production is for one hour of labor

 

	Smart Phones	Tablets			Smart Phone	Tablets
Japan	12	6		Japan	0.5 TA	2 SP
U.S.	2	4		U.S.	2 TA	0.5 SP
	Production Possibilities				Opportunity Cost

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• Japan has a comparative advantage in smart phone production, U.S. has a comparative advantage in tablet production

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c.  Gains from trade

• Specialization and trade allows greater consumption for both parties

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Ex. - Suppose each country as 1,000 hours of labor

 

	Smart Phones	Tablets			Smart Phones	Tablets			Smart Phones	Tablets
Japan	9,000 (750 hrs)	1,500 (250 hrs)		Japan	12,000 (1,000 hrs)	0 (0 hrs)		Japan	9,500 (+500)	2,000 (+500)
U.S.	1,500 (750 hrs)	1,000 (250 hrs)		U.S.	0 (0 hrs)	4,000 (1,000 hrs)		U.S.	2,500 (+1,000)	2,000 (+1,000)
	No Trade				Specialization				With Trade

• Japan wants at least 1,500 tablets, U.S. will trade at most 3,000

• U.S. wants at least 1,500 smart phones, Japan will trade at most 3,000

• Suppose U.S. trades 2,000 tablets for 2,500 smart phones

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c.  Terms of trade

• How much of one good must be given up to get the other?

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Ex. - 2,000 TA = 2,500 SP

1 TA = 1.25 SP

0.8 TA = 1 SP

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• Limited by opportunity costs

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1 TA = 0.5 - 2 SP

1 SP = 0.5 - 2 TA

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- If terms of trade are outside these limits, it would be better for the country to produce the product instead of trade for it

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d.  Why there isn't complete specialization

(1)  Not all goods and services traded internationally

 Ex. - Medical services

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(2) Production has increasing opportunity cost

• Opportunity cost increases as more of a product is produced

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Ex. -

	Smart Phones	Tablets			Smart Phone	Tablets
Japan	12	6		Japan	0.5 TA	2 SP
U.S.	2	4		U.S.	2 TA	0.5 SP

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(3)  Tastes for products differ

• Products are differentiated - have different features

• Comparative advantage may be in different types of the same product

Ex. - Cars

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e.  Reasons for comparative advantage

(1) Climate and natural resources

• Some countries have unique climate and/or natural resources

Ex. - Saudi Arabia, Costa Rica

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(2) Relative abundance of labor and capital

• Some countries have more labor and/or capital than others

Ex. - China (labor), U.S. (capital)

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(3) Technology

• Some countries have better technology than others

- Product technologies - ability to develop new products

- Process technologies - ability to improve productive processes

Ex. - U.S. (product), Japan (process)

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(4) External economies

• Reductions in a firm's costs that result from an increase in the size of an industry

- More skilled labor available

- Can interact with firms in the same industry

- Proximity to suppliers

Ex. - Tokyo/London/New York (finance), London (theater), Los Angeles (movies)

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3.  Restrictions on trade

a.  Autarky

• No trade

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Demand intercept = $4.00

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Consumer surplus (CS) = 1/2 * b * h = 1/2 * 6.0 * ($4.00 - $2.00) = $6.0 billion

Producer surplus (PS) = 1/2 * b * h = 1/2 * 6.0 * ($2.00 - $0.00) = $6.0 billion

Economic surplus (ES) = CS + PS = $6.0 + $6.0 = $12.0 billion

DWL = $15.0 - $12.0 = $3.0 billion

b.  Free trade

• No restrictions on trade

.

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A = 1/2 * b * h = 1/2 * 6.0 * ($4.00 - $2.00) = $6.0 billion

B = b * h + 1/2 * b * h = 3.0 * ($2.00 - $1.00) + 1/2 * (6.0 - 3.0) * ($2.00 - $1.00) = $4.5 billion

C = 1/2 * b * h = 1/2 * (6.0 - 3.0) * ($2.00 - $1.00) = $1.5 billion

D = 1/2 * b * h = 1/2 * (9.0 - 6.0) * ($2.00 - $1.00) = $1.5 billion

E = 1/2 * b * h = 1/2 * 3.0 * ($1.00 - $0.00) = $1.5 billion

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CS = A + B + C + D = $6.0 + $4.5 + $1.5 + $1.5 = $13.5 billion

PS = E = $1.5 billion

ES = CS + PS = $13.5 + $1.5 = $15.0 billion

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c.  Tariffs

• Tax on imports

A = b * h + 1/2 * b * h = 3.0 * ($1.50 - $1.00) + 1/2 * (4.5 - 3.0) * ($1.50 - $1.00) = $1.875 billion

T = tariff revenue = b * h = (7.5 - 4.5) * (1.50 - 1.00) = $1.5 billion

C = 1/2 * b * h = 1/2 * (4.5 - 3.0) * ($1.50 - $1.00) = $0.375 billion

D = 1/2 * b * h = 1/2 * (9.0 - 7.5) * ($1.50 - $1.00) = $0.375 billion

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Change in CS = - (A + C + T + D) = - (1.875 + 0.375 + 1.5 + 0.375) = -$4.125 billion

Change in PS = A = +$1.875 billion

Change in tariff revenue = T = +$1.5 billion

DWL = C + D = 0.375 + 0.375 = +$0.75 billion

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• Summary

- Consumers worse off

- Producers better off

- More domestic production and employment

- Revenue to the government

- Economic surplus down

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d.  Quotas and voluntary export restraints

• Quota - limit on the quantity of a good that can be imported into a country

• Voluntary export restraint - agreement between two countries to limit imports from one country to another

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A = b * h + 1/2 * b * h = 9.6 * ($0.28 - $0.18) + 1/2 * (18.0 - 9.6) * ($0.28 - $0.18) = $1.38 billion

B = gain to foreign producers = b * h = (24.7 - 18.0) * ($0.28 - $0.18) = $0.67 billion

C = 1/2 * b * h = 1/2 * (18.0 - 9.6) * ($0.28 - $0.18) = $0.42 billion

D = 1/2 * b * h = 1/2 * (27.0 - 24.7) * ($0.28 - $0.18) = $0.12 billion

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Change in CS = - (A + C + B + D) = - (1.38 + 0.42 + 0.67 + 0.12) = -$2.59 billion

Change in PS = A = +$1.38 billion

Gain to foreign producers = B = +$0.67 billion

DWL = C + D = 0.42 + 0.12 = $0.54 billion

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• Summary

- Consumers worse off

- Producers better off

- More domestic production and employment

- Benefit to foreign producers accepted by quota

- Economic surplus down

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e.  Other restrictions

(1)  Health and safety requirements

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(2)  Restrictions based on national security considerations

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4.  Opposition to free trade and globalization

• Globalization - countries become more open to foreign trade and investment

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a.  Trade institutions

• General Agreement on Tariffs and Trade (GATT) - post-WWII

• World Trade Organization (WTO) - current

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b.  Anti-globalization

(1)  Arguments against globalization

(a)  Trade and investment destroys distinctive cultures of many countries

(b)  Jobs relocated from high-income countries to low-income countries

(c)  Low wages paid

(d)  Lower environmental and safety regulations

(e)  Child labor sometimes used

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(2)  Counterarguments

(a)  More cultural choices

(b)  Due to comparative advantage

(c)  Wages high compared to other jobs

(d)  Easier for developed countries to have high standards

(e)  Alternatives could be worse 

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c.  Protectionism

• Use trade barriers to protect domestic firms from foreign competition  

(1)  Arguments for protectionism

(a)  Saving jobs

• Foreign competition drives domestic firms out of business

• Some geographic areas particularly hurt

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(b) Protecting high wages

• Firms in high-income countries will have to pay lower wages to compete with firms in developing countries

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(c)  Protecting infant industries

• Domestic firms may have high costs initially, need help until they gain experience and become more productive

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(d) Protecting national security

• Countries should not depend on other countries for goods critical to national defense

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(2)  Counterarguments

(a)  Due to comparative advantage; jobs in export industries hurt

(b)  Leads to increases in prices

(c)  Firms become dependent on protection, don't become efficient

(d)  Difficult to determine which goods are necessary for national security