International Trade and Trade Policy

This is Unit Sixteen of Principles of Microeconomics, part one of two: trade between countries, why it benefits both partners, and what a barrier to it costs. Unit fifteen ended with one interest rate pricing every claim on the future. This unit applies the course's first idea, opportunity cost, between countries. The result is comparative advantage: a country should make what it gives up least to make, even if it is worse at everything, and trade lets both partners consume beyond their frontiers. The second half of this part builds the wedge a tariff drives into that gain. By the end you will be able to read absolute and comparative advantage from a table. To show the gain from trade and pick terms that leave both better off. To explain intra-industry trade and weigh the gains. To find the world price and trade flow between two countries. And to measure a tariff's four areas and compare it with a quota.

Five entries on comparative advantage: trade as mutual gain, the two kinds of advantage, reading them from a table, and the reciprocal rule.

Trade as mutual gain.

MIC 1501 Trade as Mutual Gain

Trade is mutually beneficial exchange, not a contest with a winner; two rival firms can be each other's largest supplier and competitor. Exports reached about a tenth of world output by nineteen thirteen, collapsed through two wars and the thirties, and regained that weight only in the eighties. Openness is reversible: it is a policy choice, and it has been reversed before.

The first kind of advantage.

MIC 1502 Absolute Advantage

A country has an absolute advantage in a good when it can produce more of it with the same resources, from more resources, more productive ones, or endowment such as oil, farmland or climate: eight tons of wheat per worker against two. Absolute advantage says who is more productive; it does not say who should make what.

The idea that decides.

MIC 1503 Comparative Advantage

A country has a comparative advantage in the good it produces at lower opportunity cost, measured in the other good given up: not who makes more, but who gives up less. Ricardo showed in eighteen seventeen that specializing and trading on it benefits every partner, the less efficient included. Opportunity cost is unit one's idea, and comparative advantage applies it between countries.

Reading it from a table.

MIC 1504 Reading a Productivity Table

From a table of output per worker in two countries and two goods, find absolute advantage by comparing the larger numbers. Find each country's opportunity cost of one good as the other good's output divided by that good's output; the lower cost is the comparative advantage, and the other good's cost is its reciprocal, so the other country holds it there. Do it for a country better at everything. A Northland worker makes eight tons of wheat or four bolts of cloth a day; a Southland worker makes two tons or two bolts, so Northland has the absolute advantage in both. Northland's bolt costs two tons and its ton half a bolt; Southland's bolt costs one ton and its ton one bolt. Northland's ton is cheaper, so its comparative advantage is wheat; Southland's bolt is cheaper, so its is cloth. Northland exports wheat and imports cloth, though it could make more of both. Divide to get opportunity cost, never compare raw outputs across countries, and when one country is better at both, its advantage is where its lead is largest and the other's where its lag is smallest.

Why the answer is never both.

MIC 1505 The Reciprocal Rule

One good's opportunity cost is the reciprocal of the other's, so a country cheaper in wheat is dearer in cloth: half a bolt per ton means two tons per bolt. No country holds the comparative advantage in both goods, and every country holds it in something. Sometimes absolute and comparative advantage coincide; the exam tests the case where they differ.

Two entries on the gain: consuming beyond the frontier, and the ratio that makes it work.

Where the gain shows up.

MIC 1506 The Straight-Line Frontier and Consuming Beyond It

With constant opportunity cost the frontier is a straight line, simplifying unit one's bowed curve. Trade does not move the frontier; it lets consumption sit outside it, and that is the gain from trade: Northland makes eight hundred tons and consumes five hundred plus two hundred bolts, beyond it. Production stays on the frontier and only consumption goes beyond, and with rising costs specialization is partial.

The ratio that makes it work.

MIC 1507 The Terms of Trade and the Gain

Any trading ratio strictly between the two countries' opportunity costs leaves both better off, since each gets the other good cheaper than by making it. Pick a ratio in that range, let each specialize, choose an exchange, and show that each ends up with more of at least one good and no less of the other; then add world output before and after. Northland's bolt costs two tons and Southland's one, so take one and a half. Northland, one hundred workers, made four hundred tons and two hundred bolts; it now makes eight hundred tons, sends three hundred for two hundred bolts, and keeps five hundred tons and two hundred bolts. Southland, three hundred workers, made three hundred tons and three hundred bolts; it now makes six hundred bolts, sends two hundred for three hundred tons, and keeps three hundred tons and four hundred bolts. World wheat rose from seven hundred to eight hundred and cloth from five hundred to six hundred. A ratio outside the range makes one country worse off than self-sufficiency, and the range, not the exact ratio, is the theory's result; where in the range it lands, demand and supply decide.

Two entries on trade the model does not predict: cars for cars, and what the gains are worth.

Trade the model does not predict.

MIC 1508 Intra-Industry Trade

Much rich-country trade is with other rich countries in the same industry, cars for cars: design in one country, components in another, assembly in a third. Two explanations: learning in particular products, and economies of scale, which fall up to a point. Trade delivers scale and variety at once, and advantage built on learning and scale can be built and lost.

What the gains are worth.

MIC 1509 What the Gains from Trade Are Worth

Estimates of the gain from cutting barriers are under one percent of world output; but it recurs yearly, the estimates miss variety, competition and transferred knowledge, and small economies gain most. The World Trade Organization negotiates in rounds, and Doha, launched in two thousand one, is the latest launched. Weigh the estimate by the share, the recurrence, and what it leaves out.

Three entries on barriers and the world price: three forms of protection, two countries and one good, and who gains and loses.

The barriers themselves.

MIC 1510 Three Forms of Protection

Protectionism reduces imports in three forms: tariffs, taxes on imports; import quotas, numerical limits; and nontariff barriers, rules and paperwork that raise the cost of importing, such as a rule of origin that makes producers reroute the last stage to qualify. All three raise the domestic price, and a safety standard can restrict as effectively as a tariff unless it binds domestic goods too.

The model behind every barrier.

MIC 1511 Two Countries, One Good

Each country has its own demand and supply for the good and its own no-trade price. When trade opens, traders buy where the price is low and sell where it is high until one price clears both markets; at that price the exporter's excess supply equals the importer's excess demand, and that quantity is the trade flow. Find the two no-trade prices, then search between them for the price where the excess quantities match. Steel by the ton: Home's no-trade price is eight hundred dollars and Foreign's four hundred. At six hundred, Home wants one hundred tons and makes sixty, forty short; Foreign makes seventy and wants thirty, forty over. The world price is six hundred and forty tons cross the border. The world price lies between the two no-trade prices, never outside; if the gaps do not match, move the price toward the country whose gap is larger. The exporter's price rose while the importer's fell, and the next entry starts there.

Who won and who lost.

MIC 1512 Who Gains and Who Loses from Trade

In the exporting country the price rises, and producers gain more than consumers lose. In the importing country the price falls, and consumers gain more than producers lose; Foreign's steelmakers and Home's steel users are the winners. Social surplus rises in both, with losers inside each, and gains from trade with losers inside each country is the politics of protection in one diagram.

Two entries on the wedge: a tariff's four areas, and the same wedge as a quota.

A tariff's four areas.

MIC 1513 A Tariff's Geometry

Take an importing country too small to move the world price. Under free trade it consumes where demand meets the world price and produces where supply meets it, and the gap is imports. A tariff lifts the domestic price by its amount, so consumption falls, production rises and imports shrink. Between the two prices, consumers lose a trapezoid, producers gain a smaller one, the government collects the tariff times the new imports, and the remainder is two deadweight triangles, costlier production and lost consumption. Home faces a world price of six hundred, consumes one hundred tons, makes sixty and imports forty. A one-hundred-dollar tariff raises the price to seven hundred: consumption ninety, production seventy, imports twenty. Consumer surplus falls by nine thousand five hundred, producer surplus rises by six thousand five hundred, revenue is two thousand, and the remaining one thousand is the deadweight loss, half on each side. The triangles are unit four's tax deadweight loss split by the domestic supply curve, and the rectangle is the wedge on imported units only. Consumers lose more than producers and government gain together, a loss the anchor leaves undrawn.

The same wedge as a quota.

MIC 1514 Tariff Against Quota

An import quota below the free-trade flow raises the importer's price until its excess demand equals the quota, and lowers the exporter's price until its excess supply does; the gap between the two prices is the quota's wedge. Compare with a tariff of that size: same prices, same quantities, same triangles. The difference is the rectangle, which a tariff sends to the importer's government as revenue and a quota sends to whoever holds the licences, often foreign producers, as quota rent. With free trade Home imports forty tons at six hundred. A quota of twenty raises Home's price to seven hundred, where it is twenty short, and lowers Foreign's to five hundred, where it is twenty over; the wedge is two hundred dollars on twenty tons, four thousand. Under a two-hundred-dollar tariff that is Home's revenue; under the quota it is rent to the licence holders, and if foreign exporters hold them the money leaves the country. A quota raises foreign sellers' price without raising their cost, so it can raise their profit and no entry can compete it away, which is why exporters sometimes accept a quota they would fight as a tariff.

Look at what you can now do. You can say that trade is mutual gain and that openness is reversible, separate absolute advantage from comparative, and read both from a table by dividing, never by comparing raw outputs. You can show the gain as consumption beyond an unchanged frontier, and pick any ratio strictly between the two opportunity costs so that both countries end up with more. You can explain cars-for-cars trade by learning and scale, and weigh a gain estimate by its share, its recurrence, and what it leaves out. You can name tariffs, quotas and nontariff barriers, find the world price between two no-trade prices where the excess quantities match, and say who wins and loses in each country. And you can measure a tariff's two trapezoids, its rectangle and its two triangles, and show that a quota of the same size differs only in where the rectangle goes. Part two asks what protection is for, and whether it saves jobs.