ACC-105: ECONOMIC DEVELOPMENT

LESSON 6:
2ND SEMESTER | A.Y. 202Y – 202Y
LECTURER: SIR/MS.

INTERNATIONAL TRADE, COMPARATIVE ADVANTAGE, ABSOLUTE ADVANTAGE VERSUS COMPARATIVE

AND PROTECTIONISM ADVANTAGE

International Trade  A country enjoys an absolute advantage over

another country in the production of a product if it
 All economies, regardless of their size, depend to uses fewer resources to produce that product than
some extent on other economies and are affected the other country does.
by events outside their borders.  A country enjoys a comparative advantage in the
o No man is an island  we have to transact with production of a good if that good can be produced
the rest of the world. at a lower cost in terms of other goods.
o There are certain goods that we have to import
in certain countries. Yield Per Acre Of Wheat and Cotton (per week)
 The “internationalization” or “globalization” of the New Zealand Australia
any economy has occurred in the private and public Wheat 6 bushels 2 bushels
sectors, in input and output markets, and in Cotton 2 bales 6 bales
business firms and households.
o All countries have trading partners. ─ In this example, New Zealand can produce three
o You need other countries for certain goods that times the wheat that Australia can on one acre of
you need or you are not able to produce. land, and Australia can produce three times the
cotton. We say that the two countries have mutual
absolute advantage.
Philippine Trade Balance ─ New Zealand specializes in Wheat.
─ Australia specializes in Cotton.
 Trade Balance = Exports minus Imports
─ Suppose that each country divides its land to obtain
 Negative Trade Balance = imports are greater than
equal units of cotton and wheat production.
exports
 Greater imports means that we are heavily
dependent on other countries. Total Production Of Wheat And Cotton
(Assuming No Trade, Mutual Absolute Advantage,
and 100 Available Acres)
THE ECONOMIC BASIS FOR TRADE: COMPARATIVE New Zealand Australia
ADVANTAGE 25 acres x 6 bushels/acre 75 acres x 2 bushels/acre
Wheat
150 bushels 150 bushels
 David Ricardo’s theory of comparative advantage, Cotton
75 acres x 2 bales/acre 25 acres x 6 bales/acre
150 bales 150 bales
which he used to argue against the corn laws, states
that specialization and free trade will benefit all
─ Where the country has a comparative advantage,
trading partners (real wages will rise), even those
they reduced that.
that may be absolutely less efficient producers.
─ In this part, they have an equal quantity of
o Even those more efficient producer countries
production (150 bushels and bales each).
will benefit from specialization and free trade.
─ Divided the land to obtain equal cottons and wheat
 Corn Laws were the tariffs, subsidies, and
(150), considering that there is 100 available
restrictions enacted by the British Parliament in the
hectares.
early nineteenth century to discourage imports and
encourage exports of grain.
o Corn laws are imposition of tariffs, subsidies,
and restrictions.
o This is a contrary to the theory of comparative
advantage.
o This is because, according to Corn Laws, we
need to restrict the trading in order to protect
the local industry.

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PRODUCTION POSSIBILITY FRONTIERS FOR AUSTRALIA trading, they can now reach this point, which is
AND NEW ZEALAND BEFORE TRADE outside their PPF line.

Gains from Comparative Advantage

 Even if a country had a considerable absolute

advantage in the production of both goods, Ricardo
would argue that specialization and trade are still
mutually beneficial.
 When countries specialize in producing the goods in
which they have a comparative advantage, they
maximize their combined output and allocate their
resources more efficiently.
─ Production Possibility Frontiers is the combination of  The real cost of producing cotton is the wheat that
2 goods. must be sacrificed to produce it.
─ PPF of Australia is steep because it is a better o This is because we would want to maximize the
producer of cotton. While PPF of New Zealand is resources we have in something we specialize.
flatter because it is a better producer of wheat.  A country has a comparative advantage in cotton
─ Because both countries have an absolute advantage production if its opportunity cost, in terms of wheat,
in the production of one product, specialization and is lower than the other country.
trade will benefit both. o Because we only sacrifice a little (low
─ There are 100 acres of land. Australia can dedicate opportunity cost).
all of its land to produce cotton, in which case it
produces 600 bales (or 6 bales per acre). On the
other hand, if Australia dedicates all of its land to EXHANGE RATES
produce wheat, it produces 200 bushels (or 2 bushels
 An exchange rate is the ratio at which two
per acre).
currencies are traded. The price of one currency in
terms of another.
Gains from Specialization
$1 = P55.39 $1 = P50.00
 An agreement to trade 300 bushels of wheat for 300
bales of cotton would double both wheat and cotton o If use it as an expense, $1 = P50.00 is better.
consumption in both countries. o If it is a gain or income, $1 = P55.39 is better.
o There is gain or income during export.
Production And Consumption Of Wheat o If you are the exporter, you want a higher
After Specialization dollar exchange rate because for every dollar
PRODUCTION CONSUMPTION
you earn out of selling goods, you are gaining
New Zealand Australia New Zealand Australia
100 acres x 6 P55.39.
0 acres
Wheat bushels/acre
0
300 bushels 300 bushels o If you are an importer, you want a lower dollar
600 bushels
exchange rate because for every dollar you
100 acres x 6
0 acres spend, you are only spending P50.00.
Cotton bales/acre 300 bales 300 bales
0
600 bales

─ If both countries specialize on something they are Regimes of Exchange Rates

good, they don’t have to produce other goods. But
FIXED EXCHANGE RATE
instead, rely on other country for other goods that
they cannot produce efficiently. ─ Denotes a nominal exchange rate that is set firmly by
the monetary authority with respect to a foreign
currency or a basket of foreign currencies.
─ It cannot be change.
─ But because of many factors, it need to be floating
exchange rate.

FLOATING EXCHANGE RATE

─ Determined in foreign exchange markets depending

on demand and supply, and it generally fluctuates
constantly.

─ Both countries can now consume 300 wheat and

cotton each, compared to only 150 each. Because of

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Factors Affecting Exchange Rates  For any pair of countries, there is a range of
exchange rates that can lead automatically to both
(1) Demand and Supply in the Foreign Exchange Market countries realizing the gains from specialization and
 The price which is the exchange rate will depend comparative advantage.
on the interaction of demand and supply. o The theory of comparative advantage will only
 If supply increases, it will depend on the be comparable if exchange rate is favorable.
demand.  Exchange rates determine the terms of trade.

Example:

Domestic Prices of Timber (Per Foot) and Rolled

Steel (Per Meter) in the United States and Brazil
United States Brazil
Timber $1 3 Reals
Rolled steel $2 4 Reals

─ The option of buying at home or importing will

depend on the exchange rate.
 e.g., If demand for imported goods increased,
naturally, exchange rate will increase. Trade Flows Determined by Exchange Rates
Exchange Rate Price of Real Result
Brazil imports timber and
$1 = 1 R $1.00
steel
$1 = 2 R $0.50 Brazil imports timber
Brazil imports timber;
$1 = 2.1 R $0.48
United States imports steel
Brazil imports timber;
$1 = 2.9 R $0.34
United States imports steel
$1 = 3 R $0.33 United States imports steel
United States imports
$1 = 4 R $0.25
timber and steel

─ Brazil imports timber and steel because it is cheaper

in US ($1 = 1 R).
(2) Interest Rates
─ US imports timber and steal because it is now
 When interest rates in one country increase
cheaper in Brazil ($1 = 4 R)
relative to those in another country, it tends to
─ This tells us that your imports and exports depend on
attract capital flows from the latter to the former
the prevailing exchange rates between the 2
country. This is because investors seek higher
countries.
returns on their investments and are more likely
to invest in a country that offers higher interest
 If exchange rates end up in the right ranges, the
rates.
free market will drive each country to shift
resources into those sectors in which it enjoys a
(3) Inflation and Growth in the Domestic Market
comparative advantage.
 When there is an inflation, there is an increase
 Only those products in which a country has a
in price of goods and services—increases
comparative advantage will be competitive in world
exchange rates as well.
markets.
 When a country experiences high inflation, its
goods and services become less competitive in
the global market, as they become more THE SOURCES OF COMPARATIVE ADVANTAGE
expensive relative to goods and services in other
countries. As a result, the demand for the  Factor endowments refer to the quantity and quality
country's currency decreases, leading to a of labor, land, and natural resources of a country.
depreciation of its exchange rate.  Factor endowments seem to explain a significant
 On the other hand, when a country experiences portion of actual world trade patterns.
strong economic growth, its goods and services  The Heckscher-Ohlin theorem is a theory that
become more attractive to foreign investors, explains the existence of a country’s comparative
leading to an increase in demand for the advantage by its factor endowments.
country's currency. This can cause an  According to the theorem, a country has a
appreciation of the exchange rate. comparative advantage in the production of a
product if that country is relatively well endowed
 Exchange rates will determine if it is logical to trade with inputs used intensively in the production of
or not. that product.

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TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND
QUOTAS

 In contrast with the concept of comparative

advantage.
 Trade Barriers is about protecting one’s country’s
local industry—that’s why we impose trade barriers.
 Governments of each country have to intervene the
area of national trade for economic and non-
economic reasons.
 Protection is the practice of shielding a sector of the
economy from foreign competition.
 A tariff is a tax on imports. o If there is free trade, the international price will
 Export subsidies are government payments made prevail (PW)—lower.
to domestic firms to encourage exports. Closely o Price lowers when there is free trade (no tariffs
related to subsidies is dumping. A firm or industry and no quotas) because of more supply.
sells products on the world market at prices below o In you engage in free trade, importers can
the cost of production. easily buy rice at cheap price from abroad.
 A quota is a limit on the quantity of imports Price lowers because there is a lot of supply.
(quantitative restrictions).

Two Types of Protection of Government (to protect the

domestic industries)

 Tariff is a tax on imports.

o Government impose tariff to protect local
industry.
o It will protect the local industry in a way that a
country will opt to buy domestically rather than
internationally because if they imported goods,
there will be tax. But if they buy domestically,
it would be more affordable. o At lower price in a free trade, a country only
o This will discourage importers from importing produces at this much, but consume at this
because they will have tax burden, as they much.
have to pay for their importation. o Therefore, if consumption is greater than
production, there is a deficit of that large
 Quota is a quantity limit. (purple)—that will be the amount of
o Imported goods are limited or have importation or amount need to import.
restrictions. o There is deficit because demand is greater than
o Quota restricts import of commodities because supply.
it specifies the amount that can be purchased o Quantity supplied is only up to the point of
or imported given a time-period. production.
o Quantity demanded is up to the point of deficit.
How does the tariff and quota affect the domestic price?

 Domestic Supply Curve

o The higher the price, the higher the supply.
Sellers would want to sell more if the price is
high.
o The lower the price, the lower the supply.
Seller would want to sell less if the price is low.
o The point of intersection will determine the
domestic price—free trade price (based on
demand and supply).

 Foreign Supply Curve

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 o If we will impose a tariffs on imports, o This is because you are paying taxes and
immediately, the price of the product will rise. engage in free trade.
o PT is the price with tariff.
o Since tariff raises the price, the consumers will
buy less—consumption will declined up to that THE CASE FOR FREE TRADE
point.  Protection saves jobs.
o Since tariff raises the price, it raises domestic o Farmers and other domestic jobs retain their
output as well because people will opt to buy jobs.
domestically rather than to import goods and o We can ban imports and give up the gains from
pay tax for importation. free trade, acknowledging that we are willing
o Because of higher price, quantity demanded to pay premium prices to save domestic jobs in
went down and quantity supply went up. industries that can produce more efficiently
o As tariffs is imposed, imports will basically abroad or we can retrain workers for jobs with
decline. The amount of imports will decline a future, or adopt programs to relocate people
from (purple) to (orange). in expanding regions.
o Importers will be discouraged to import  Some countries engage in unfair trade practices.
because it is expensive. o This is because developed countries are
gaining out of less developed countries.
 Cheap foreign labor makes competition unfair.
 Protection safeguards national security.
 Protection discourages dependency.
 Protection safeguards infant industries.

 When one’s industry is protected, it somehow

teaches us how to be independent.
 The government has to protect the local industry.

o The same will happen to quota, as tariff and

quota are nearly same.
o The main difference is that quota restrict
quantity, while tariff works through prices.
o The benefits of quotas goes to the
producers/importers who manage to get the
scars of valuable import permits.
o The government earns something in tariffs
because of taxes, while in quota, the
government isn’t earning.

 The General Agreement on Tariffs and Trade (GATT)

is an international agreement singed by the United
States and 22 other countries in 1947 to promote
the liberalization of foreign trade.
o Here, tariffs decreases and the countries
benefits, as it is almost free trade.

THE CASE FOR FREE TRADE

 The case for free trade is based on the theory of

comparative advantage.
 When countries specialize and trade based on
comparative advantage, consumers pay less and
consume more, and resources are used more
efficiently.
 When tariffs and quotas are imposed, some of the
gains from trade are lost

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Rice Tariffication Law (Republic Act 11203)
o The Rice Tariffication Act amends the Agricultural
Tariffication Act of 1996 (RA B178). The law
replaces the system of quantitative restriction (OR)
on rice importation with a purely tariff system.
o Quota was replaced by tariff, in order that
government can also earn.
o The government supposedly supports the local
farmers in order to maintain the sustainability of
rice production.
o We shifted to a tariff system (instead of quota)
because limiting the supply of goods in the market
results in higher prices.
o It is our commitment to the World Trade
Organization (WTO) to replace all ORs (quota)
imposed on agricultural products into tariffs since
1995. We have allowed the tariffication of all other
agricultural products, except rice.
o Tariff is supposed to be given back to the farmers
in order to support them. Tax collected from tariff
out of the imported rice will be distributed to the
farmers.
o Rice Tariffication Law is opposed by farmer
organizations.
o The main criticism is that The Rice Tariffication Law
gives up the power of the government to protect
the local industries, especially the small farmers.
o Since the passage of the law, the palay prices have
gone down.
o Farm Gate price rose from P14 to P15 per kilo. But
the estimated production cost is actually P19 to
P21 per kilo—this is a loss to the local rice
producer.
o The passage of the law resulted in the collapse of
palay or rice prices around the country.
o Many rice producers are even contemplating the
idea of giving a price farming and just sell their
lands, because they are losing (lugi).
o There was a move made by the government—buy
a locally produced rice. This somehow boosted the
price of rice, however, it still cannot reach the
production cost of P19 to P21 per kilo.
o Overall, the local farmers are angry and furious at
The Rice Tariffication Law.
o Because of The Rice Tariffication Law, price of rice
decreases and the one benefited is the importer.
o Thailand spend roughly 2 billion dollar as subsidy.
They subsidize their rice farmers in form of price
support to their palay producers.
o The Rice Tariffication Law may not be the solution.
o The local and small farmers cannot compete with
cheap imported rice. The industry will die in natural
death because of that.
o The government has to protect the local industry.
o The revenues from the Rice Tariffication Law will
be used to support the local farmers—however,
this is not what is actually happening.

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