Free trade and Barriers to trade (Protection)

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Comparative Advantage, Exchange
Rates, and Globalization

The Principle of Comparative Advantage

 The principle of comparative advantage is that as

long as the relative opportunity costs of producing
goods differ among countries, then there are potential
gains from trade

 Opportunity cost is what must be given up in one

good in order to get another good

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Comparative advantage
Labor time required to produce one unit of :
Wine Cloth

Portugal 80 90

England 120 100

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Establishing comparative advantage

1 unit of wine in Portugal = 80/120 = 67% of English effort
1 unit of cloth in Portugal = 90/100= 90% of English effort
1 unit of wine in England = 120/80 = 150% of Portuguese
effort
1 unit of cloth in England = 100/90 = 111% of Portuguese
effort
Establish absolute advantage in the production of both
goods in Portugal
Establish comparative advantage and disadvantage in the
two goods across the two countries

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Terms of trade/exchange rate

Portugal has complete advantage as it is more productive
and England has complete disadvantage as it is a
developing country and is less productive.
However comparative advantage in the production of wine
is with Portugal and comparative disadvantage is with
England in the production of cloth.
Trade will take place if the terms of trade are suitable to
both the countries

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Opportunity cost
Domestic Terms of Trade (ToT) in Portugal
1 unit of wine = 80/90 units of cloth = 0.89 units of cloth
Domestic ToT in England
1 unit of wine = 120/100 units of cloth = 1.2 units of cloth
So the Exchange rate should lie between 0.89 units of cloth
and 1.2 units of cloth for 1 unit of wine.
Explain this in terms of the opportunity cost to show how
both the countries benefit from trade
So if the exchange rate is 1 unit of wine for 1 unit of cloth,
both countries gain.

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Opportunity cost
England gives up less than 1.2 units of cloth and gets 1 unit
of wine
Portugal gets more than 0.89 units of cloth for 1 unit of
wine.
Trade results in gain

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Rates, and Globalization

Gains from trade

• Increased consumption
• Increased production and specialization
• Increased leisure

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Dividing Up the Gains from Trade

Three determinants of the terms of trade are:

1. The more competition, the less the trader gets

2. Smaller countries get a larger proportion of the
gain than larger countries
3. Countries producing goods with economies of
scale get a larger gain from trade

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Rates, and Globalization

Why Economists and Laypeople Differ in

Their Views of Trade
If trade is good, why do so many people oppose it?
 The gains of trade, lower prices, are harder to
see than the cost, lost jobs
 The public believes that lower wages in other
countries give them the comparative advantage
in everything, so we will lose all jobs
 Laypeople often think of trade as trade only in
manufactured goods
 Laypeople are extremely concerned about the
impact of trade on the distribution of income
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Demand for protection

• Infant industry protection
• Protect employment levels
• Reduce dependence on imports
• Tariffs are a source of revenue for the government
• Political reasons
• Defence and military reasons
• Strategic reasons

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Rates, and Globalization

Varieties of Trade Restrictions

 Tariffs are taxes governments place on internationally
traded goods (generally imports)
 Quotas are quantity limits placed on imports
 Voluntary restraint agreements are when countries
voluntarily restrict their exports
 An embargo is a total restriction on the import or export
of a good
 Regulatory trade restrictions are government-imposed
procedural rules that limit imports
 Nationalistic appeals, such as “Buy American” can help
to restrict international trade
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Application: Tariffs when the domestic country is small

P Tariffs decrease imports,

increase domestic production,
and generate tariff revenue
Tariff revenue
SDomestic

$3.00
$2.50 PWorld + $0.50Tariff = S’World
$2.00 PWorld = SWorld
Imports’
DDomestic
Q
Imports

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Tariffs are inefficient

Tariffs result in :
• Loss in consumer surplus as (1) higher prices for
consumers and (2) lower consumption levels
• But the winners are: domestic producers (infant industry)
and government (revenue earned)
• Net loss seen in deadweight loss

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Some Concerns about the Future

The law of one price
 The law of one price means that in a competitive market,
there will be pressure for equal factors to be priced equally

 If factor prices aren’t equal, firms can reduce costs by

redirecting production to countries with lower factor prices

 The convergence hypothesis is the tendency of economic

forces to eliminate transferable comparative advantage.

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Some Concerns about the Future

Methods of equalizing trade balances

 Adjustments eventually occur to make surplus countries

less competitive and deficit countries more competitive

 Wages rise in the surplus countries, making their goods

more expensive

 The exchange rate of the deficit country falls and makes

its goods less expensive

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