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2. Free Trade and Protection
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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
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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.
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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.
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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.
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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.
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Before trade: Country A
Wine
wheatwheat
120
60
A's Production
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Before trade A produces a=wine and 120-2a=wheat.
Wine
wheatwheat
120
60
A's Production
a
120-2a
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Before trade B
Wine
Wheat
15
60
B's Production
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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)
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Now let trade occur
• Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.
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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).
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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!
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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.
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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
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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
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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)
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Some Pictures: Country A Production Possibilities
Wine
Wheat
A Autarky
A
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Some Pictures: Country A Production Possibilities
Wine
Wheat
A Autarky
Prices in A
A
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Country B’s Production Possibilities
Wine
Wheat
B Autarky
B
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Country B’s Production Possibilities
Wine
Wheat
B Autarky
B
Prices in B
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Who has higher prices?
Wine
Wheat
A Autarky
B Autarky
AB
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Trade raises the price of wheat in B and raises the price of wine in A
Wine
Wheat
AB
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Trade raises the price of wheat in B and raise the price of wine in A
Wine
Wheat
A Autarky
AB
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Trade raises the price of wheat in B and raises price of wine in A
Wine
Wheat
AB
Same Prices => lines are parallel
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At the new prices B is better off
Wine
Wheat
B
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It produces more wheat
Wine
Wheat
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It produces more wheat and consumes more wine
Wine
Wheat
Export Wheat
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It produces more wheat and consumes more wine
Wine
Wheat
Export Wheat
Import
Wine
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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!
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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.
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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.
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Wine
Wheat
A Autarky
B Autarky
AB
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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.
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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.
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Consequence=Factor Price Equalization
As a result of trade the prices of labour and capital in each country will tend to be the same.
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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).
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3. Protection
Instruments of Public Policy:
• Tariff (Taxes)• Quotas (quantity restrictions)• Non-tariff barriers (Product standards,
voluntary restraints etc.)
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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:
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Domestic Equilibrium Price and Quantity (No trade)
Domestic Supply
Domestic Demand
Quantity
Price
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Once Imports are allowed there is infinite supply at the world price.
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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Efficient domestic producers continue to produce.
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Supply
From
Local Firms
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But there is an increase in supply from importers.
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Supply
From
Local Firms
Supply
From
Importers
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Consumers’ value with trade:
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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Local Producers’ value:
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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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
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Before Tariff
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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After Tariff
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
World Supply with Tariff
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Who gains who loses?
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Consumers lose this
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Producers gain this
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Government gains this much tax
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Net the country loses
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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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.
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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
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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)
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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.