2. free trade and protection. summary 1.theory of comparative advantage: why trade is good. 2.where...

2. Free Trade and Protection

Summary

1. Theory of Comparative Advantage:Why trade is good.

2. Where comparative advantage comes from:Heckscher-Ohlin Model (factor endowments)Equalization of factor income

3. Welfare Effects of a Tariff :Consumers LoseGov’t gainsLocal producers gain

4. Arguments for protection:Optimal tariffInfant industryEmployment

Ricardo’s Theory of Comparative Advantage

Suppose:• Country A and Country B. Equally sized.

Country A is better at producing both wine and wheat than B.

Ricardo’s Theory of Comparative Advantage

Suppose:• Country A and Country B. Equally sized.

Country A is better at producing both wine and wheat than B.

• Even then, both countries can benefit from trade.

Ricardo’s Theory of Comparative Advantage

Suppose:• Country A and Country B. Equally sized.

Country A is better at producing both wine and wheat than B.

• Even then, both countries can benefit from trade.

• Key is relative advantage.

Ricardo’s Theory of Comparative Advantage

Suppose:• Country A and Country B. Equally sized.

Country A is better at producing both wine and wheat than B.

• Even then, both countries can benefit from trade.

• Key is relative advantage.• For example, assume A is relatively better at

wheat production than wine.

Before trade: Country A

Wine

wheatwheat

120

60

A's Production

Before trade A produces a=wine and 120-2a=wheat.

Wine

wheatwheat

120

60

A's Production

a

120-2a

Before trade B

 Wine

Wheat

15

60

B's Production

Before trade B produces b=wine and 15-(b/4)=bread.

Total world production is

(a + b wine, 135 - 2a - 0.25b wheat).

Wine

wheat

15

60

B's Production

b

15-(b/4)

Now let trade occur

• Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.

Now let trade occur

• Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.

• At the same time the A produces one less unit of wine and two more unit of wheat (its comparative advantage). 

Now let trade occur

• Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.

• At the same time the A produces one less unit of wine and two more unit of wheat (its comparative advantage). 

• Total wine production has not changed, but total wheat output has increased by 1.75 units!

Now let trade occur

• Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.

• At the same time the A produces one less unit of wine and two more unit of wheat (its comparative advantage). 

• Total wine production has not changed, but total wheat output has increased by 1.75 units!

• Everyone is better off.

Theory of Comparative Advantage

What are the prices?

A was prepared to swap 1 unit of wine for 2 wheat so:

Price of WheatA = 1/2 X (Price of Wine)A

Theory of Comparative Advantage

What are the prices? A was prepared to swap 1 unit of wine for 2 wheat so:

Price of WheatA = 1/2 X (Price of Wine)A

B (Supplies Wine) was prepared to swap 1 unit of wine for ¼ of wheat so:

Price of WheatB = 4 X (Price of Wine)B

Theory of Comparative Advantage

What are the prices? A was prepared to swap 1 unit of wine for 2 wheat so:

Price of WheatA = 1/2 X (Price of Wine)A

B (Supplies Wine) was prepared to swap 1 unit of wine for ¼ of wheat so:

Price of WheatB = 4 X (Price of Wine)B

As long as

½ X (World Price of Wine) < World Price of Wheat < 4 X (World Price of Wine)

Some Pictures: Country A Production Possibilities

Wine

Wheat

A Autarky

A

Some Pictures: Country A Production Possibilities

Wine

Wheat

A Autarky

Prices in A

A

Country B’s Production Possibilities

Wine

Wheat

B Autarky

B

Country B’s Production Possibilities

Wine

Wheat

B Autarky

B

Prices in B

Who has higher prices?

Wine

Wheat

A Autarky

B Autarky

AB

Trade raises the price of wheat in B and raises the price of wine in A

Wine

Wheat

AB

Trade raises the price of wheat in B and raise the price of wine in A

Wine

Wheat

A Autarky

AB

Trade raises the price of wheat in B and raises price of wine in A

Wine

Wheat

AB

Same Prices => lines are parallel

At the new prices B is better off

Wine

Wheat

B

It produces more wheat

Wine

Wheat

It produces more wheat and consumes more wine

Wine

Wheat

Export Wheat

It produces more wheat and consumes more wine

Wine

Wheat

Export Wheat

Import

Wine

2. Sources of Comparative Advantage

1) Preferences:Even if we were completely identical but just

liked different things trade would be a good idea.

Example Country A has 100 units lamb and 100 units porkCountry B has 100 units lamb and 100 units pork

One really likes Kebabs the other really likes Sausages!

2. Sources of Comparative Advantage:

2) Factor endowmentsSet Up: 2 Countries (A,B)

2 Goods (Wheat, Wine)2 Inputs (labour, capital)

Assumption:Capital and Labour can move between industries within their own country but not across countries.

Technologies

Both countries have identical technologies at their disposal these have constant returns to scale.

Wheat production requires a lot of capital and B has a lot of capital.

Wine production requires a lot of labour and A has a lot of labour.

Wine

Wheat

A Autarky

B Autarky

AB

Trade occurs to move immobile inputs around

Country A is rich in labour and exports the good that requires a lot of labour.

Hence

Before trade the price of labour in A will be low relative to the price of capital.

Trade occurs to move immobile inputs around

Country B is rich in capital and export the good that is rich in capital.

Before trade the price of capital in B will be low relative to the price of labour.

They can’t move the factors but they can move goods.

Consequence=Factor Price Equalization

As a result of trade the prices of labour and capital in each country will tend to be the same.

Income Distribution and Growth

An increase in the price of wine (labour intensive) will increase the wages (relative to the price of wine and wheat)

It will also decrease the reward to capital (relative to the prices of wine and wheat).

3. Protection

Instruments of Public Policy:

• Tariff (Taxes)• Quotas (quantity restrictions)• Non-tariff barriers (Product standards,

voluntary restraints etc.)

Effect of Tariff on Value

We will assume the country is small relative to the rest of the world.

If there was no trade the domestic supply and demand would look like:

Domestic Equilibrium Price and Quantity (No trade)

Domestic Supply

Domestic Demand

Quantity

Price

Once Imports are allowed there is infinite supply at the world price.

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Efficient domestic producers continue to produce.

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Supply

From

Local Firms

But there is an increase in supply from importers.

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Supply

From

Local Firms

Supply

From

Importers

Consumers’ value with trade:

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Local Producers’ value:

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

The Government Imposes a Tax/Tariff

We could describe this as a shift in the demand function.

Or We could think of this as an increase in the

price of imports

Before Tariff

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

After Tariff

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

World Supply with Tariff

Who gains who loses?

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff

Consumers lose this

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff

Producers gain this

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff

Government gains this much tax

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff

Net the country loses

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff

What Justification is there for Protection

(1)The above shows that if your country is small you always lose form protection.If your country is large this may not be so.

(2) Infant Industries:Government is necessary to protect industries until they are ‘grown up enough’ to face international competitors.

(3) Revenue.(4) Employment.

Infant Industries

Need LR profits in country to exceed SR costs of subsidization.

This implies industry itself should be willing to undergo the SR costs (contradiction)

Unless there is a market failure that stops such projects being undertaken

Examples of Market Failure

Failure in human capital:(skills, education, health)

Information:(Government has better knowledge?)

Capital market failure(hard for firms to get loans)

Employment Argument

The above assumes the labour market is in equilibrium (i.e. full employment).

If this is not so, then the opportunity cost of labour being used in the exporting industries is less than the equilibrium wage => may increase welfare.