Prof. Gustavo Indart
Department of Economics
University of Toronto
ECO 100Y
INTRODUCTION TO ECONOMICS
Lecture 17. INTERNATIONAL TRADE
The first thing we want to explain is the basis for trade, that is, why international trade
takes place. The obvious intuitive answer is that trade between two partners takes place
if it is mutually beneficial, that is, if both partners gain from trading.
By definition, a country gains from trade when trading increases the quantity of
commodities available for consumption compared to the situation of autarky. In
other words, trade is beneficial to both countries when trade allows the overall
production of commodities to increase through specialization in production.
In order to arrive to an understanding of why trade takes place we must start developing
economic models that explain in a simplified manner how the gains from trade are
generated and how they are divided among the different partners. As our
understanding increases, more sophisticated models will be developed in order to better
explain the complex real world.
We are going to start with models that take technology as the bases for trade, that is,
models that emphasize technological differences between countries as the main
source for beneficial trade.
We are going to consider two different models of this kind:
1) the simplest model was developed by Adam Smith and is based on the principle
of absolute advantage in the production of a commodity;
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2) the second model was mainly developed by David Ricardo and is based on the
principle of comparative advantage of producing a given commodity.
We are going to make some simplifying assumptions:
1) only two countries;
2) only two goods;
3) labour is the only factor of production; and
4) there are constant returns to scale.
17.1
THE MODEL OF ABSOLUTE ADVANTAGE
According to this model, trade between two nations is based on the principle of
absolute advantage. A nation has an absolute advantage in the production of a
commodity when it can produce this commodity utilizing less labour than any other
nation.
Therefore, when one nation is more efficient (has an absolute advantage) than the
other in the production of a commodity but is less efficient (has an absolute
disadvantage) than the other in the production of the other commodity, both nations
can gain by specializing in the production of the commodity in which they have the
absolute advantage.
In this way, resources are utilized in the most efficient way and the overall output of
both commodities rises − that is, both nations can improve their situation when they
specialize in production and engage in trade.
Let’s have a look at an example. Suppose we have:
1) two countries, Canada and Mexico;
2) two commodities being produced in each country, wheat (W) and cloth (C);
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and
3) one unit of labour (e.g., one man per year) produces the following quantities
of W and C in each country according to the technology available in each:
Table 17.1: Output of One Man Per Year
Canada
Mexico
Wheat
6
1
Cloth
4
5
In this example, on the one hand, a unit of labour produces more wheat (6 units) in
Canada than in Mexico (1 unit) − and thus Canada has an absolute advantage in the
production of wheat as compared to Mexico.
On the other hand, a unit of labour produces less cloth (4 units) in Canada than in
Mexico (5 units) − and thus Canada has an absolute disadvantage in the production
of cloth as compared to Mexico (or, equivalently, Mexico has an absolute advantage
in the production of cloth as compared to Canada).
It becomes rather obvious that both countries would benefit if each specializes in the
production of the commodity in which each has an absolute advantage and trades
some of its output for some of the output of the commodity the other countries
specializes in.
In the absence of international trade between Canada and Mexico, a unit of W
exchanges for 4/6 (or 2/3) units of C in Canada and for 5 units of C in Mexico.
Canada:
6W = 4C or 1W = (2/3)C
Mexico:
1W = 5C [or, equivalently, 1C = (1/5)W]
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If the international terms of trade were such that each country could exchange the
commodity in which it had an absolute advantage for a greater quantity of the other
commodity, then both countries would certainly benefit from trade and thus trade
would ensue.
Suppose that the international terms of trade are 1 unit of wheat for 1 unit of cloth.
International market:
1W = 1C (or 1C = 1W)
In this case, for instance, Canada could transfer one unit of labour from the cloth
industry to the wheat industry, thus increasing the domestic production of wheat by
6 units and decreasing the production of cloth by 4 units.
Table 17.2: Changes in Consumption in Canada after Trade
Wheat
Cloth
Change in Production
+6
-4
Change through Trade
-6
+6
Net change
0
+2
Next, for instance, Canada could trade these 6 extra units of wheat for 6 units of cloth
with Mexico − the net gain for Canada would be 2 units of cloth (it can consume the
same quantity of wheat as before and 2 units more of cloth).
To complete this example, Mexico also has to divert some units of labour into the
production of the other commodity in which it has an absolute advantage (cloth).
Suppose that Mexico diverts one unit of labour to the production of cloth, thus
increasing the domestic production of cloth by 5 units and decreasing the
production of wheat by 1 unit.
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Table 17.3: Changes in Consumption in Mexico after Trade
Wheat
Cloth
Change in Production
-1
+5
Change through Trade
+5
-5
Net change
+4
0
Next, for instance, Mexico could trade these 5 extra units of cloth for 5 units of wheat
with Canada − the net gain for Mexico would be 4 units of wheat (it can consume the
same quantity of cloth as before and 4 units more of wheat).
It becomes apparent that each country’s gains from trade depend on the international
terms of trade − the more they diverge from the domestic terms of trade the better.
This model shows that, through trade, both countries can gain from specializing in the
production of the commodity in which each has an absolute advantage. The model,
however, doesn’t explain how the terms of trade are determined. This is an
important shortcoming of the model.
At the same time, though the principle of absolute advantage has an intuitive appeal, it
cannot help to explain the bases for trade in a more realistic world.
In order to advance in our understanding of the bases for trade we must develop a more
sophisticated model: the model based on comparative advantages.
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17.2
THE MODEL OF COMPARATIVE ADVANTAGE
The law of comparative advantage states that even when a nation has an absolute
disadvantage in the production of both commodities, there is still a basis for mutually
beneficial trade.
It indicates that such a nation should specialize in the production of a commodity in
which it has a smaller absolute disadvantage, and import the commodity in which it
has a greater absolute disadvantage.
The other country, of course, should specialize in the production of a commodity in
which it has the greater absolute advantage, and import the commodity in which it
has the smaller absolute advantage.
This means that a country should specialize in the production of the commodity in
which it has a comparative advantage (that is, when we compare it to the production
conditions of the other commodity).
Let’s have a look at an example:
Table 17.4: Output of One Man per Year
Canada
Mexico
Wheat
6
1
Cloth
4
2
Here Canada has an absolute advantage in the production of both W and C (and,
therefore, Mexico has an absolute disadvantage in the production of both W and C).
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However, Canada’s absolute advantage is greater in the production of W (6 to 1)
than in the production of C (4 to 2). Therefore, since Canada’s absolute advantage is
greater in W than in C, Canada is found to have a comparative advantage in the
production of W.
Similarly, since Mexico has a greater absolute disadvantage in the production of W
than in the production of C, Mexico has a comparative advantage in the production
of C.
Therefore, according to the law of comparative advantage, both countries can gain if
Canada specializes in the production of W and exports some of it in exchange for
Mexico’s C.
Once again, specialization and trade would ensue if both countries could benefit
from it, that is, if both countries could exchange the commodity they specialize in for a
greater quantity of the other commodity in the international market.
Before international trade, the domestic markets are as follows:
Canada:
6W = 4C or 1W = (2/3)C
Mexico:
1W = 2C [(or, equivalently, 1C = (1/2)W]
Therefore, if Canada could obtain more than 2/3 units of C for each unit of W in the
international market, then it would benefit from trade.
Similarly, Mexico would also benefit from trade if it could obtain more than 1/2 units
of W for each unit of C in the international market.
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Thus, the conditions for trade to take place are:
1)
1W > (2/3)C
2)
1W < 2C [or 1C > (1/2)W]
and this reduces to 2C > 1W > (2/3)C, that is, 1 unit of W must be traded for at least
2/3 units but not more than 2 units of C in the international market for both
countries to benefit from and thus engage in trade.
Suppose that the international terms of trade are 1W for 1C.
In this case, Canada could transfer, for instance, one unit of labour from C production
to W production (thus increasing the production of W by 6 units and decreasing the
production of C by 4 units).
Then it could trade the 6 extra units of W for 6 units of C in the international market.
As a result, Canada could still consume the same amount of good W as before but
could enjoy 2 extra units of C (6 - 4). Canada would be better off with specialization
and trade under these international terms.
Table 17.5: Changes in Consumption in Canada after Trade
Wheat
Cloth
Change in Production
+6
-4
Change through Trade
-6
+6
Net change
0
+2
You could also verify that Mexico would also benefit if it specialized in the production
of the commodity in which it has a comparative advantage. I will leave this as an
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exercise.
We can conclude that the distribution of the gains from trade will depend on the
international terms of trade. Within the limits indicated, the closer the international
terms are to the domestic terms, the smaller is the benefit for the given country.
This result also suggests that when the domestic terms of trade are identical in both
countries, no country has a comparative advantage in the production of either
commodity. In this case, international trade would not ensue.
17.3
COMPARATIVE ADVANTAGE AND OPPORTUNITY COST
We can also explain comparative advantages using the concept of opportunity
costs. According to the opportunity cost theory, the cost of a commodity is the
amount of the second commodity that must be given up in order to produce an extra
unit of the first.
Therefore, the country with the lower opportunity cost in the production of a
commodity has a comparative advantage in that commodity (and a comparative
disadvantage in the second commodity). Let’s take a look at the same example as
before:
Table 17.6: Output of One Man per Year
Canada
Mexico
Wheat
6
1
Cloth
4
2
In the absence of trade, the opportunity cost of producing one extra unit of W in
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Canada is 2/3 units of C. In Mexico, however, the opportunity cost of producing one
extra unit of W is 2 units of C.
Certainly the opportunity cost of producing W is lower in Canada and thus Canada is
found to have a comparative advantage in the production of W.
Similarly, the opportunity cost of producing one extra unit of C in Canada is 3/2 units
of W. In Mexico, however, the opportunity cost of producing one extra unit of C is 1/2
units of W.
Certainly the opportunity cost of producing C is lower in Mexico and thus Mexico is
found to have a comparative advantage in the production of C.
17.4
THE GAINS FROM TRADE: GEOMETRIC ANALYSIS
Opportunity costs can be illustrated with the production possibility curve (PPC) or
transformation curve. The PPC shows the different combinations of the two
commodities that a country can produce when fully utilizing all of its resources with
the best technology available.
In order to construct the PPC we need to know the total quantity of resources
available in each country.
Suppose, for instance, that Canada has 30 units of labour and Mexico has 60 units.
The production possibility schedules would then be as follows:
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Table 17.7: Production Possibility Schedules
Canada
Mexico
Wheat
Cloth
Wheat
Cloth
180
0
60
0
150
20
50
20
120
40
40
40
90
60
30
60
60
80
20
80
30
100
10
100
0
120
0
120
This table shows that Canada must forgo the production of 30 units of wheat in order
to produce 20 more units of cloth. That is, the opportunity cost of producing one
extra unit of cloth is 3/2 units of wheat.
Moreover, this opportunity cost is constant for any production combination (that is,
labour productivity is assumed to be the same at all output levels of each
commodity).
Alternatively, we can say that Canada’s opportunity cost of producing one extra unit of
wheat is 2/3 units of cloth. The opportunity cost is always measured in terms of the
forgone quantity of the other commodity.
The table also shows that the constant opportunity cost of producing an extra unit of
wheat in Mexico is 2 units of cloth (and that the constant opportunity cost of
producing an extra unit of cloth is thus 1/2 units of wheat).
Therefore, as before, the table shows that the opportunity cost of producing wheat is
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lower in Canada, and thus Canada has a comparative advantage in the production of
wheat.
Accordingly, the opportunity cost of producing cloth is lower in Mexico, and thus
Mexico has a comparative advantage in the production of cloth.
Under these circumstances, there are conditions for both countries to benefit from
trade.
Diagram 17.1: Canada’s Production and Consumption Possibility Curves
W
C
180
A
B
PPC
120
I1
CPC
I2
180
C
The data of the above table can be used to construct the PPC of each country. Each
point on or below the PPC is feasible, that is, it represents a combination of W and C
that can be produced with the available resources. However, only those points on
the PPC are efficient in the sense that they fully utilize all resources and the best
technologies available. Points below the PPC do not achieve the maximum output
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combination possible and thus are not efficient.
Note that the slope of the PPC is negative and constant. It is negative because when
all resources and best technologies are being used, an increase in the production of
a commodity requires a redistribution of resources and thus a reduction in the
production of the other commodity. It is constant because we assume there is a
unique condition of production in each industry.
In the absence of trade, Canada is producing and consuming at point A reaching
certain level of welfare given by indifference curve I1. With trade, Canada can
specialize in the production of wheat (that is, producing at point C) and consume on
CPC. Canada would maximize welfare at point B, reaching indifference curve I2.
17.5
OPPORTUNITY COSTS AND RELATIVE PRICES
Assuming that prices equal costs of production, the opportunity cost of producing a
commodity is equal to the relative prices.
That is, the opportunity cost of producing wheat in a country is equal to the domestic
price of wheat relative to the domestic price of cloth − Pw / Pc.
A lower relative price of wheat means that a country has a comparative advantage
in the production of this commodity.
17.6
INCREASING OPPORTUNITY COSTS
Suppose now that opportunity costs are increasing instead of constant. Moreover,
let’s assume that technologies are the same in both countries but that their factor
endowments are different.
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In this case, the difference in the relative prices of commodities between two
countries is due to differences in factor endowments.
For instance, a country relatively capital abundant will produce capital intensive
commodities relatively cheaper, and a country relatively labour abundant will
produce labour intensive commodities relatively cheaper.
This is the Heckscher-Ohlin theory of international trade which indicates that the
bases of trade are differences in factor endowments.
Diagram 17.2: Increasing Opportunity Costs
W
C
D
A
B
C
According to this theory, countries have comparative advantages in the production of
commodities that are intensive in the use of the factors of production with which
their endowments are relatively abundant.
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In the case of increasing opportunity costs, the production possibility curve is
convex to the origin. The gains from trade can be split between the gains due to
exchange and the gains due to specialization in production. This can be observed in
Diagram 17.2 above.
In autarky, consumption and production is at point A. With trade, keeping
production constant at A, consumption is at point B (on a higher indifference
curve). With specialization in production, production is at point C and consumption
is at point D (on an even higher indifference curve).
17.7
BARRIERS TO FREE TRADE
We have shown that free trade allows the maximization of world output. Therefore,
free trade has the potential to make everyone better off. However, everything
depends on how the gains from trade are distributed among countries and among
interest groups within countries.
Since it is not guaranteed that everyone will be better off with free trade,
protectionism is used to increase the production of one country at the cost of
another country and to favour one interest group within a country at the cost of
another group.
For this reason, not everyone is in favour of free trade between Canada and the U.S.
and Mexico. Particularly, those who have the most to lose, the workers in the
manufacturing industry, are opposed to the free trade deal.
Let’s have a look at the effects of two types of barriers to free trade: tariffs and
quotas.
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17.7.1 The Effects of a Tariff
A tariff is a tax on the imported commodity. In this way, the domestic price of the
commodity is increased, the quantity demanded decreased, and the domestic
quantity supplied increased.
The tariff could be a specific tariff or an ad valorem tariff.
A specific tariff is a fixed tax imposed on each unit of the product. An ad valorem
tariff is a percentage tax imposed on the price of the product.
Diagram 17.3: The Effect of a Tariff
P
S
PW+T
1
PW
SW+T
3
2
4
SW
D
QS
QS’
QD’ QD
Q
Suppose that initially there is no tariff. The domestic demand and supply curves are
given by the curves D and S respectively. The world supply curve is horizontal at the
world price level PW.
Under these circumstances, the quantity demanded is QD and the quantity supplied
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domestically is QS. The difference, the excess demand, is satisfied through imports.
That is, the quantity imported is QD - QS.
Suppose now that a tariff T is imposed on each unit imported. Therefore, the
domestic price is now PW+T, the quantity demanded is QD’ and the quantity
supplied domestically is QS’. Imports decrease to QD’ - QS’.
The effect of the tariff is the following. Consumer surplus is reduced by the areas
1+2+3+4. Producer surplus increases by the area 1. The government collects taxes
equal to the area 3.
Assuming that taxes are not wasted and thus somehow distributed to the domestic
population, that is, neither a loss nor a gain, the welfare cost of the tariff is the
deadweight or net loss in welfare equal to the area 2+4.
17.7.2 The Effects of a Quota
A quota is a restriction in the quantity of the imported commodity. A quota
indicates the maximum quantity that can be imported of the commodity.
Diagram 17.3 shows that, in the initial situation, price is PW, quantity demanded is
Q2, quantity supplied domestically is Q1, and the quantity imported is Q1Q2.
When a quota Q3Q4 is imposed, the price rises to P1, the quantity demanded
decreases to Q4, the quantity supplied domestically increases to Q3, and the quantity
imported is equal to the quota.
In the case of a quota, the government does not collect any taxes. Therefore, the
cost to society is greater than in the case of the tariff.
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Here, the deadweight loss in total surplus is equal to the loss in consumer surplus
plus the gain in (domestic) producer surplus, that is, it is equal to the area 2+3+4.
Diagram 17.3: The Effects of a Quota
P
S
P1
1
3
PW
2
4
SW
D
Q1
Q3
Q4
Q2
Q