chapter:
WHAT YOU WILL LEARN IN THIS CHAPTER
8
>> International Trade
Krugman/Wells
©2009 Worth Publishers 1 of 46
WHAT YOU WILL LEARN IN THIS CHAPTER
How comparative advantage leads to mutually beneficial
international trade
The sources of international comparative advantage
Who gains and who loses from international trade, and
why the gains exceed the losses
How tariffs and import quotas cause inefficiency and
reduce total surplus
Why governments often engage in trade protection to
shelter domestic industries from imports and how
international trade agreements counteract this
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Comparative Advantage and International Trade
Goods and services purchased from other
countries are imports; goods and services sold to
other countries are exports.
Globalization is the phenomenon of growing
economic linkages among countries.
To understand why international trade occurs and
why economists believe it is beneficial to the
economy, we will first review the concept of
comparative advantage.
The following graph illustrates the growing
importance of international trade…
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The Growing Importance of International Trade
a) U.S. Imports and Exports 1960-2006(b) Imports and Exports for Different Countries, 200
Percen Percen
t of t of
GDP GDP90%
Imports
18% 80
16 70
14 60
12 50
10 40
8
30
6 Exports
4 20
2 10
1960 19701980 1990 2000 2006
China
Mexico
France
Germany
U.S.
Canada
Belgium
Year
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Production Possibilities and Comparative
Advantage, Revisited
Let’s repeat the definition of comparative advantage from
earlier: A country has a comparative advantage in producing
a good or service if the opportunity cost of producing the
good or service is lower for that country than for other
countries.
The Ricardian model of international trade analyzes
international trade under the assumption that opportunity
costs are constant.
Autarky is a situation in which a country cannot trade with
other countries.
The following figure shows hypothetical production
possibility frontiers for the U.S. and Colombia and we
assume that: there are only two goods and the production
possibility frontiers are straight lines.
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Comparative Advantage and the Production
Possibility Frontier
(a) U.S. Production Possibility Frontier (b) Vietnamese Production Possibility Frontier
Quantity of Quantity
computers of
computers
2,000
U.S. production
and consumption
in autarky Vietnamese production
and consumption in
autarky
1,000 C 1,000
US
Slope = –2 C Slope = –0.5
500 V
PPF PPF
US V
0 500 1,000 0 1,000 2,000
Quantity of shrimp (tons) Quantity of shrimp (tons)
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The Gains from International Trade
The Ricardian model of international trade shows
that trade between two countries makes both
countries better off than they would be in autarky—
that is, there are gains from trade.
The following tables and figures illustrate that
specialization has the effect of increasing total
world production of both goods and that each
country can consume more of both goods than it
did under autarky.
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Production and Consumption Under Autarky
(a) United States Production Consumption
Quantity of shrimp (tons) 500 500
Quantity of computers 1,000 1,000
(b) Vietnam Production Consumption
Quantity of shrimp (tons) 1,000 1,000
Quantity of computers 500 500
(c) World (United States and Vietnam) Production Consumption
Quantity of shrimp (tons) 1,500 1,500
Quantity of computers 1,500 1,500
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Production and Consumption After Specialization
and Trade
(a) United States Production Consumption
Quantity of shrimp (tons) 0 750
Quantity of computers 2,000 1,250
(b) Vietnam Production Consumption
Quantity of shrimp (tons) 2,000 1,250
Quantity of computers 0 750
(c) World (United States and Vietnam) Production Consumption
Quantity of shrimp (tons) 2,000 2,000
Quantity of computers 2,000 2,000
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The Gains from International Trade
(a) U.S. Production and Consumption (b) Vietnamese Production and Consumption
Quantity Quantity
of of
computers Q computer Vietnamese production and
US U.S. production consumption in autarky
2,000 with trade s
U.S.
consumption Vietnamese
C’ US with trade consumption with
1,250 C trade
PPF
1,000 US 1,000 V
U.S. production and C’
750 VVietnamese
consumption in C
autarky 500 V production with
trade
PPFUS QV
0 500 750 1,000 0 1,000 1,250 2,000
Quantity of shrimps (tons) Quantity of shrimps (tons)
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Sources of Comparative Advantage
The main sources of comparative advantage are:
International differences in climate
e.g. winter deliveries of Chilean grapes to the U.S.
Differences in technology
Factor endowments
The relationship between comparative advantage and
factor availability is found in an influential model of
international trade, the Heckscher–Ohlin model.
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Heckscher-Ohlin Model
According to the Heckscher-Ohlin model, a country has a
comparative advantage in a good whose production is
intensive in the factors that are abundantly available in that
country.
A key concept in the model is factor intensity.
The factor intensity of production of a good is a measure
of which factor is used in relatively greater quantities than
other factors in production. Oil refining is capital-intensive
compared to clothing manufacture, because oil refiners use
a higher ratio of capital to labor than clothing producers.
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Heckscher-Ohlin Model
The Heckscher–Ohlin model shows how
comparative advantage can arise from differences
in factor endowments: goods differ in their factor
intensity, and countries tend to export goods that
are intensive in the factors they have in abundance.
Trade in manufactured goods amongst developed
countries is best explained by increasing returns to
production.
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►ECONOMICS IN ACTION
Skill and Comparative Advantage
In 1953, most economists thought that America’s comparative
advantage lay in capital-intensive goods, but Wassily Leontif
discovered that this was not true.
• The main resolution of this paradox, it turns out, depends on
the definition of capital. U.S. exports aren’t intensive in
physical capital—machines and buildings. Instead, they are
skill- intensive—intensive in human capital.
U.S. exporting industries use a substantially higher ratio of
highly educated workers compared to other industries that
compete against imports.
In general, countries with highly educated workforces tend to
export skill-intensive goods, while countries with less educated
workforces tend to export goods whose production requires
little skilled labor.
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Supply, Demand, and International Trade
The Effects of Imports
The domestic demand curve shows how the
quantity of a good demanded by domestic
consumers depends on the price of that good.
The domestic supply curve shows how the
quantity of a good supplied by domestic producers
depends on the price of that good.
The world price of a good is the price at which that
good can be bought or sold abroad.
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The Effects of Imports
When a market is opened to trade, competition
among importers or exporters drives the domestic
price to equality with the world price.
If the world price is lower than the autarky price,
trade leads to imports and a fall in the domestic
price compared to the world price.
There are overall gains from trade because
consumer gains exceed the producer losses.
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Consumer and Producer Surplus in Autarky
Price of shrimp
Domestic
supply
Consumer
surplus
P A
A
Producer
surplus
Domestic
demand
Q Quantity of shrimp
A
Consumersurplus
Producer surplusisisrepresented
representedbybythe
thered-shaded
blue-shaded area.
area.
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The Domestic Market with Imports
Price of shrimp
Domestic
supply
Autarky price
A
P
A
P
W
World price
Domestic demand
Q Q Q Quantity of
Domestic S A D Domestic quantity
quantity supplied demanded with shrimp
with trade Import trade
s
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The Effects of Imports on Surplus
Changes in surplus
Price of Gain Loss
shrimp
Consumer surplus X+Z
Domesti Producer surplus -X
c supply
Change in
total surplus +Z
W
PA A
X Z
P
W
Y Domestic
demand
QS QA Q Quantity of shrimp
D
Imports
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The Effects of Exports
If the world price is higher than the autarky price,
trade leads to exports and a rise in the domestic
price compared to the world price.
There are overall gains from trade because
producer gains exceed the consumer losses.
The graph that follows shows the domestic market
with exports.
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The Domestic Market with Exports
Price of
computer
Domestic
World price supply
P
W
A
P
A
Autarky price
Domestic
demand
Domestic Q Q Q Quantity of
D A S Domestic
quantity quantity computers
demanded Exports supplied
with trade with trade
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The Effects of Exports on Surplus
Changes in surplus
Price of Gain Loss
comput
er Consumer surplus –X
Domesti Producer surplus X+ Z
c supply
W Change in
PW total surplus +Z
X Z
PA A
Domestic
demand
QD QA Q
S Quantity of
computers
Exports
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International Trade and Wages
Exporting industries produce goods and services
that are sold abroad.
Import-competing industries produce goods and
services that are also imported.
International trade tends to increase the demand
for factors that are abundant in our country
compared with other countries, and to decrease the
demand for factors that are scarce in our country
compared with other countries. As a result, the
prices of abundant factors tend to rise, and the
prices of scarce factors tend to fall as international
trade grows.
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►ECONOMICS IN ACTION
Trade, Wages and Land Prices in the Nineteenth
Century
Beginning around 1870, there was an explosive growth of world
trade in agricultural products based largely on the steam engine —
it enabled faster movement of goods across the ocean and by rail.
The result was that land-abundant countries such as Canada, U.S.
and Argentina began shipping large quantities of agricultural goods
to the densely-populated, land-scarce countries of Europe.
This opening up of international trade led to higher prices of
agricultural products in exporting countries and a decline in their
prices in importing countries. These changes in prices brought
about changes in factor prices as land prices fell by half compared
with average wages in England. This reduced the land owners
purchasing power as workers benefitted from cheaper food. In the
U.S., the reverse happened. Land owners did well, but workers’
purchasing power reduced as food prices rose.
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Effects of Trade Protection
An economy has free trade when the government
does not attempt either to reduce or to increase the
levels of exports and imports that occur naturally as
a result of supply and demand. Policies that limit
imports are known as trade protection or simply
as protection.
Most economists advocate free trade, although
many governments engage in trade protection of
import-competing industries. The two most
common protectionist policies are tariffs and import
quotas. In rare instances, governments subsidize
export industries.
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Effects of a Tariff
A tariff is a tax levied on imports.
It raises the domestic price above the world price,
leading to a fall in trade and total consumption and
a rise in domestic production.
Domestic producers and the government gain, but
consumer losses more than offset this gain, leading
to deadweight loss in total surplus.
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The Effect of a Tariff
Price of shrimp
Domestic
supply
Price
with
tariff
P
T
Tariff
P
W Domestic
World demand
price
Q Q Q Q Quantity of
S ST DT D
Shrimp
Imports
after tariff
Imports before tariff
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A Tariff Reduces Total Surplus
Price of Changes in surplus
shrimp Gain Loss
Domestic Consumer surplus –( A+B+C +D)
supply
Producer surplus A
Government revenue C
Change in total
PT surplus –( B+D)
Tariff A B C D
PW
Domesti
c
demand
QS QST QDT QD Quantity of
Import Shrimp
s after
tariff Imports before
tariff
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Effects of an Import Quota
An import quota is a legal limit on the quantity of a
good that can be imported.
Its effect is like that of a tariff, except that revenues
—the quota rents—accrue to the license-holder, not
to the government.
Now, let’s move on to the political economy of trade
protection…
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The Political Economy of Trade Protection
Arguments for Trade Protection
Advocates of tariffs and import quotas offer a
variety of arguments. Three common arguments
are:
national security
job creation
the infant industry argument
Despite the deadweight losses, import protections
are often imposed because groups representing
import-competing industries are smaller and more
cohesive than groups of consumers.
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International Trade Agreements and the World
Trade Organization
To further trade liberalization, countries engage in
international trade agreements.
International trade agreements are treaties in which a
country promises to engage in less trade protection
against the exports of other countries in return for a
promise by other countries to do the same for its own
exports.
Some agreements are for only a small number of
countries, such as the North American Free Trade
Agreement which is among the United States, Canada
and Mexico.
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International Trade Agreements and the World
Trade Organization
The World Trade Organization (WTO) is a
multinational organization that seeks to negotiate
global trade agreements as well as adjudicate trade
disputes between member countries.
The European Union, or EU, is a customs union
among 27 European nations.
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►ECONOMICS IN ACTION
Tariffs reached a peak in the
early 1930s. From then on,
tariff rates have steadily
ratcheted down, with U.S.
moves matched in other
advanced countries.
At this point world trade in
manufactured goods is
subject to low tariffs and
relatively few import quotas,
with clothing the main
exception.
Agricultural products are
subject to many more
restrictions, reflecting the
political power of farmers in
advanced countries.
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SUMMARY
1. International trade is of growing importance to the United
States and of even greater importance to most other
countries. Foreign trade has been growing rapidly, a
phenomenon called globalization.
2. The Ricardian model of international trade assumes
that opportunity costs are constant. It shows that there are
gains from trade: two countries are better off with trade
than in autarky.
3. The Heckscher–Ohlin model shows how differences in
factor endowments determine comparative advantage.
• Goods differ in factor intensity.
• Countries tend to export goods that are intensive in the factors they
have in abundance.
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SUMMARY
4. The domestic demand curve and the domestic supply
curve determine the price of a good in autarky. When
international trade occurs, the domestic price is driven to
equality with the world price, the price at which the good
is bought and sold abroad.
5. If the world price is below the autarky price, a good is
imported. This leads to an increase in consumer surplus, a
fall in producer surplus, and a gain in total surplus. If the
world price is above the autarky price, a good is exported.
This leads to an increase in producer surplus, a fall in
consumer surplus, and a gain in total surplus.
6. International trade leads to expansion in exporting
industries and contraction in import-competing
industries.
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SUMMARY
7. Most economists advocate free trade, but in practice
many governments engage in trade protection.
8. A tariff is a tax levied on imports. An import quota is a
legal limit on the quantity of a good that can be imported.
9. Although several popular arguments have been made in
favor of trade protection, in practice the main reason for
protection is probably political: import-competing industries
are well-organized and well-informed about how they gain
from trade protection, while consumers are unaware of the
costs they pay.
10. Many concerns have been raised about the effects of
globalization:
• Income inequality due to the surge in imports from relatively poor
countries
• Offshore outsourcing
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The End of Chapter 8
Coming attraction:
Chapter 9:
Making Decisions
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