ECON 102 - Chapter 10

Prepared by Ifeanyi Uzoka, Sheridan College

Principles of Macroeconomics

International Trade

Chapter 10

Learning Objectives

  • Explain the importance of international trade and why nations trade with each other
  • Explain why nations import certain goods, even though they can be made more cheaply at home
  • Explain how the gains from trade are divided between trading partners
  • Describe why some groups win and others lose as a result of freer trade
  • Identify various restrictions to, and some arguments against, free trade

Trends in World Trade and GDP (1971-2021)

  • Visual representation purposes only.
    • Data represented in an index format, where 2005 = 100.
    • The graph trends include fluctuations in World Trade and World GDP over the years.

Factor Endowment

  • Definition: An advantage in production arises from better skills, equipment, or other resources.
  • Illustration: Example of Canada
    • Canada possesses the necessary factors endowments to produce wheat due to:
    • Fertile soil
    • Sufficient rainfall
    • Skilled agricultural labor
    • Advanced technology
    • Illustrative question: Why doesn't Canada produce bananas despite potential greenhouse conditions?
    • Cost of production for one banana could be $5.
    • Comparison: Importing a banana from Mexico could cost 5 cents.
    • Conclusion: It is more cost-effective for Canada to produce wheat while Mexico specializes in banana production, leading to mutual gains from trade.

Theory of Absolute Advantage

  • Definition: Nations should specialize in producing goods/services where they have an advantage and trade for goods/services where they lack that advantage.
  • Connection: This theory emphasizes the benefits of specialization among trading partners to increase overall efficiency.

Specialization and Trade

Determining Specialization

  • Example of Freedonia and Libraland:
    • Beer Production:
    • Freedonia: 4 units (Labor productivity)
    • Libraland: 3 units
    • Wine Production:
    • Freedonia: 1 unit
    • Libraland: 4 units
  • Conclusion: Freedonia should specialize in beer, whereas Libraland should specialize in wine.

Total Output Before Specialization

  • Scenario:
    • Population of 20 million in each country, 10 million working in each industry.
    • Total output calculations:
    • Freedonia:
      • Beer: 10imes4=4010 imes 4 = 40
      • Wine: 10imes1=1010 imes 1 = 10
      • Total: 50 units
    • Libraland:
      • Beer: 10imes3=3010 imes 3 = 30
      • Wine: 10imes4=4010 imes 4 = 40
      • Total: 70 units
    • Combined Total: 50 + 70 = 120 units.

Total Output After Specialization

  • If each country specializes where it has an advantage:
    • Freedonia: 80 Beer, 0 Wine
    • Libraland: 0 Beer, 80 Wine
    • Gains from Trade:
    • Beer: Gain of 10 units
    • Wine: Gain of 30 units
    • Total trade gain: 40 units.

Theory of Comparative Advantage

  • Definition: The advantage of producing goods at a lower opportunity cost than others.
  • Strategy: Each nation calculates opportunity costs to determine production efficiency.

Opportunity Costs in Production

  • Example Data:
    • United States:
    • Wheat Output: 4
    • Beans Output: 4
    • Cost of 1 wheat: 1 bean
    • Philippines:
    • Wheat Output: 1
    • Beans Output: 3
    • Cost of 1 wheat: 3 beans
  • Conclusion: Philippines should specialize in beans, and the U.S. should focus on wheat due to their comparative advantages.

Production Possibilities Tables

U.S. Output Scenario
  • United States Production without Trade Data:
    • Output Levels:
    • Maximum wheat: 400 million bushels/day
    • Maximum beans: 0 million bushels/day
Philippines Output Scenario
  • Philippines Production without Trade Data:
    • Output Levels:
    • Maximum wheat: 100 million bushels/day
    • Maximum beans: 0 million bushels/day

Total Production Comparison Without Trade vs. With Trade

  • With specialization:
    • U.S. produces 400 wheat and 0 beans.
    • Philippines produces 0 wheat and 300 beans.
  • Combined outcome of specialization yields more goods available post trade.
    • Gains from trade reflect increased production of goods overall when countries specialize and exchange.

Terms of Trade

  • Definition and Calculation: Terms of Trade measures a country's export price relative to import prices.
  • Formula:
    extTermsofTrade=extAveragepriceofexportsextAveragepriceofimportsimes100ext{Terms of Trade} = \frac{ ext{Average price of exports}}{ ext{Average price of imports}} imes 100
  • Favorability: A country benefits when the price of exports rises or the price of imports drops.

Practical Terms of Trade Example

  • Example using Coho Salmon and Daiwa Fishing Rods:
    • Price Increase Scenario: 5 Coho salmon @ $40 each increases import terms to favorable outcomes for exporters.
    • Price Drop Scenario: Reductions in Daiwa rod prices lead to more imports for fewer exports.
    • In either scenario, Canada's terms of trade improve.

Practical Application of Trade Examples

  • Assuming US trade of wheat to beans with favorable terms of trade, gains from trade exist if:
    • Terms set between 1 to 3 beans for 1 wheat is healthy for both nations.

Advantages of Free Trade

  • Lower Prices: Benefiting from lower costs of production leads to reduced prices for consumers.
  • Increased Variety: Access to a broader range of products enhances consumer choices and satisfaction.
  • Increased Competition: Ensuring market diversity prevents monopoly situations and promotes innovation.

Demand, Supply, and Free Trade

The Market for Wine in France and Germany

  • Size of demand and supply tables show how prices adjust under free trade conditions.
  • General equilibrium is established when the pricing mechanisms equalize across borders.

Winners and Losers from Free Trade

  • Winners: Consumers gain more choices and lower prices.
    • French Producers: Access to larger markets yields better prices and more sales.
  • Losers: Some domestic producers face intense competition and reduced prices.

Trade Protection

  • Definition: Protectionism is a policy aimed at shielding domestic industries through restrictions on imports.
  • Types of Trade Protection:
    • Import Quotas: Limitations on amounts of goods that can be imported.
    • Tariffs: Taxes on imported goods.
    • Currency Exchange Controls: Restrictions on currency conversions affecting trade.
    • Bureaucratic Regulations: Barriers to foreign goods based on compliance regulations.

Arguments Against Free Trade

  • Strategic Industry Argument: Protecting industries vital for national security.
  • Infant Industry Argument: Allowing emerging industries time to mature before facing international competition.
  • Cultural Identity and Standards: Concerns about mass production undermining local values and environmental standards.
  • Economic Implications: Addressing potential long-term impacts of unrestricted trade practices.

Key Concepts to Remember

  • Theories of Absolute and Comparative Advantage.
  • Gains stemming from differences in opportunity costs.
  • Impacts and distribution of gains from trade.
  • Notable winners and losers in the context of free trade introduction.
  • Overview of trade restrictions and their economic arguments.