- Study Guide (Course-wide Content)
A. The Nature of International Trade
- Specialization, division of labor, and trade increase productivity and consumption possibilities. The gains from trade hold among nations as well as within a nation. Engaging in international exchange is more efficient than relying only on domestic production. International trade differs from domestic trade because it broadens the market, because trade takes place among sovereign nations, and because countries usually have their own monies which must be converted using foreign exchange rates.
- Diversity is the fundamental reason that nations engage in international trade. Within this general principle, we see that trade occurs (a) because of differences in the conditions of production, (b) because of decreasing costs (or economies of scale), and (c) because of diversity in tastes.
- Recall that trade occurs because of differences in the conditions of production or diversity in tastes. The foundation of international trade is the Ricardian principle of comparative advantage. The principle of comparative advantage holds that each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will also benefit if it imports those goods which it produces at relatively high cost. This principle holds even if one region is absolutely more or less productive than another in all commodities. As long as there are differences in relative or comparative efficiencies among countries, every country must enjoy a comparative advantage or a comparative disadvantage in the production of some goods.
- The law of comparative advantage predicts more than just the geographic pattern of specialization and the direction of trade. It also demonstrates that countries are made better off and that real wages (or, more generally, total national income) are improved by trade and the resulting enlarged world production. Quotas and tariffs, designed to "protect" workers or industries, will lower a nation's total income and consumption possibilities.
- Even with many goods or many countries, the same principles of comparative advantage apply. With many commodities, we can arrange products along a continuum of comparative advantage, from relatively more efficient to relatively less efficient. With many countries, trade may be triangular or multilateral, with countries having large bilateral (or two-sided) surpluses or deficits with other individual countries.
- Completely free trade equalizes prices of tradeable goods at home with those in world markets. Under trade, goods flow uphill from low-price to high-price markets.
- A tariff raises the domestic prices of imported goods, leading to a decline in consumption and imports along with an increase in domestic production. Quotas have very similar effects and may, in addition, lower government revenues.
- A tariff causes economic waste. The economy suffers losses from decreased domestic consumption and from the wasting of resources on goods lacking comparative advantage. The losses generally exceed government revenues from the tariff.
- Most arguments for tariffs simply rationalize special benefits to particular pressure groups and cannot withstand economic analysis. Three arguments that can stand up to careful scrutiny are the following: (a) The terms-of-trade or optimal tariff can in principle raise the real income of a large country at the expense of its trading partners. (b) In a situation of less-than-full employment, tariffs might push an economy toward fuller employment, but monetary or fiscal policies could attain the same employment goal with fewer inefficiencies than this beggar-thy-neighbor policy. (c) Sometimes, infant industries may need temporary protection in order to realize their true long-run comparative advantages.
- The principle of comparative advantage must be qualified if markets malfunction because of unemployment or exchange-market disturbances. Moreover, individual sectors or factors may be injured by trade if imports lower their returns. Opening up to trade may hurt the factors that are most embodied in imported goods.