2.

Free Trade and Protection

Summary
1. 2. Theory of Comparative Advantage: Why trade is good. Where comparative advantage comes from: Heckscher-Ohlin Model (factor endowments) Equalization of factor income Welfare Effects of a Tariff : Consumers Lose Govt gains Local producers gain Arguments for protection: Optimal tariff Infant industry Employment

3.

4.

Ricardos Theory of Comparative Advantage

Suppose: Country A and Country B. Equally sized. Country A is better at producing both wine and wheat than B.

Ricardos 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.

Ricardos 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.

Ricardos 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

wheat
120 A's Production

Wine 60

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

wheat
120 A's Production 120-2a

Wine a 60

Before trade B
Wheat

15

B's Production

60

Wine

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

wheat

15 15-(b/4)

B's Production

60

Wine

Total world production is (a + b wine, 135 - 2a - 0.25b wheat).

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 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 of wheat so: Price of WheatB = 4 X (Price of Wine)B As long as X (World Price of Wine) < World Price of Wheat < 4 X (World Price of Wine)

Some Pictures: Country A Production Possibilities

Wheat

A Autarky

A Wine

Some Pictures: Country A Production Possibilities

Wheat Prices in A

A Autarky

A Wine

Country Bs Production Possibilities

Wheat B Autarky

Wine

Country Bs Production Possibilities

Prices in B B Autarky

Wheat

Wine

Who has higher prices?

Wheat B Autarky

A Autarky

A Wine

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

Wheat

A Wine

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

Wheat

A Autarky

A Wine

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

Same Prices => lines are parallel Wheat

A Wine

At the new prices B is better off

Wheat

B Wine

It produces more wheat

Wheat

Wine

It produces more wheat

and consumes more wine

Wheat Export Wheat

Wine

It produces more wheat

and consumes more wine

Wheat Export Wheat

Import Wine 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 pork Country 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 endowments Set 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.

Wheat B Autarky

A Autarky

A Wine

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 cant 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 Price

Domestic Demand

Quantity

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

World Supply

Domestic Demand

Quantity

Efficient domestic producers continue to produce.

Domestic Supply Price

World Supply

Domestic Demand Supply From Local Firms Quantity

But there is an increase in supply from importers.

Domestic Supply Price

World Supply

Domestic Demand Supply From Local Firms Supply From Importers Quantity

Consumers value with trade:

Domestic Supply Price

World Supply

Domestic Demand

Quantity

Local Producers value:

Domestic Supply Price

World Supply

Domestic Demand

Quantity

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 Price

World Supply Domestic Demand

Quantity

After Tariff
Domestic Supply Price

World Supply with Tariff World Supply Domestic Demand

Quantity

Who gains who loses?

Domestic Supply Price

Tariff World Supply Domestic Demand

Quantity

Consumers lose this

Domestic Supply Price

Tariff World Supply Domestic Demand

Quantity

Producers gain this

Domestic Supply Price

Tariff World Supply Domestic Demand

Quantity

Government gains this much tax

Domestic Supply Price

Tariff World Supply Domestic Demand

Quantity

Net the country loses

Domestic Supply Price

Tariff World Supply Domestic Demand

Quantity

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.