Lecture 3 International trade and comparative advantage. 3- 1. Learning Objectives. Use the production possibilities curve model to examine the trade-off between current and future consumption, and the importance of comparative advantage as a basis for trade between nations.
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International trade and comparative advantage
Use the production possibilities curve model to examine the trade-off between current and future consumption, and the importance of comparative advantage as a basis for trade between nations.
Assess the microeconomic impact of trade.
The case for free trade.
Describe the most common forms of trade barriers used to provide protection to local industry.
Examine the consequence of trade barriers for achieving the goal of economic efficiency, using the examples of tariffs and quotas.
Discuss the income distribution impact of tariffs and quotas.
State and critically evaluate the arguments for protectionism.
The general case for trade
Two isolated nations:
We use the following assumptions:
Two different countries without trade
Without trade, relative prices in the two countries are different – computerland can produce more shirts and more computers than shirtland.
Relative equilibrium prices determined by opportunity cost
Computerland: price of 1 computer is 1 shirt –shown by the slope of its PPF
Shirtland: price of 1 computer is 3 shirts – shown by the slope of its PPF
These are prices that would occur in the absence of trade
If one agent (a smuggler) could trade between the two countries, they could make a profit by:
Start with buying one computer in Computerland
Take it to Shirtland, exchange for 3 shirts – remember that in Shirtland: the price of 1 computer is 3 shirts – shown by the slope of its PPF
Take the 3 shirts back to Computerland, exchange for 3 computers, in Computerland the price of 1 computer is 1 shirt –shown by the slope of its PPF
Take the 3 computers to Shirtland, exchange for 9 shirts – and so on.
If the countries allow free trade, what will happen?
Each country will tend to specialise in producing the good in which it has a comparative advantage:
Produce and export that good
Import the other
(Note: it’s not necessarily true that both countries will specialise, especially if one is bigger than the other. In this setting, at least one will certainly specialise.)
Computerland will specialise in computers, Shirtland in shirts
Trade depends on comparative advantage, not absolute advantage! Computerland has an absolute advantage in producing both shirts and computers – see its PPF.
Specifically, Shirtland will export shirts even though it takes more labour to produce a shirt in Shirtland than in Computerland
Wages will turn out to be lower in Shirtland, of course, which is why this works
Comparative advantage- economic concepts in 60 seconds http://www.youtube.com/watch?v=FpTBjRf8lGs
We’re thinking of a barter economy here, so the relevant prices are relative prices –- prices of computers in terms of shirts (or vice-versa).
Equilibrium price of computers will be established at some intermediate price
Suppose it is 2 shirts for one computer
Can calculate consumption possibility curves after trade:
After trade between the 2 countries
Does this mean everyone in both countries is benefited by free trade?
In this simple world, yes.
In reality, of course not.
Suppose, realistically, that there exists capital specialised to shirt production in Computerland.
Owners of this capital will lose under free trade,
They will complain that shirt producers in Shirtland are competing unfairly because their wages are lower
Similarly, computer producers in Shirtland are made worse off by trade – they can’t compete with the computer producers in Computerland
Computer producers in Computerland can undersell the computermakers in Shirtland even though the computer makers in Computerland earn higher wages
Nations should specialise in the production of those goods and services in which they have a comparative advantage.
Total output will be greatest when each good is produced by that nation which has the lower domestic opportunity cost.
Barriers to free trade:
Sw + t
If there is free trade the world price of $20 would also be the domestic price.
At this price domestic consumers will buy 100 units, domestic producers will supply 20 units, and 80 units will be imported.
A tariff of $5 per unit will raise the domestic price to $25. At this price, domestic consumers will buy 75 units, domestic producers will supply 30 units and 45 units will be imported.
Tariff revenue for the government will be the area fghi - $5 times 45 imported units - $225.
A similar impact can be obtained by putting a quota – ie. a limit –on the number of imports.
A quota of 45 imports would mean there is an excess demand at a price of $20.
Domestic price would rise to $25 – where domestic producers would supply 30 units and there would be 45 imports.
But the government gets no revenue.
The quota is a more restrictive policy than the tariff.
Tariffs distort the operation of the price mechanism, but demand and supply still determine the quantity of imports.
Quotas are more restrictive and break the link between domestic and foreign prices completely.
If demand for the product increases – this extra demand can only be met by domestic producers and this will also lead to a rise in domestic prices.
Tariffs provide revenue to the government, while quota benefits go to the protected industry.
military self-sufficiency argument
increase domestic employment
diversification for stability
cheap foreign labour argument.