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Comparative Advantage. Overheads. The Logic of Free Trade. Self-sufficiency is nice but …. Advantages of doing things ourselves. Good information about quality. Don’t need to depend on others and their foibles. Can customize the product. Can coordinate production and consumption.

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slide2

The Logic of Free Trade

Self-sufficiency is nice but …

slide3

Advantages of doing things ourselves

Good information about quality

Don’t need to depend on others and their foibles

Can customize the product

Can coordinate production and consumption

Can keep information secret

Don’t have to worry about enforcing any contracts

Don’t have to worry about being exploited

Will not have any transactions costs

slide4

Disadvantages of doing things ourselves

May not be able to achieve any economies of scale

May not have necessary knowledge, skill or intelligence for task

May have limited experience for some tasks

May have to keep continually changing tasks

slide5

Principle of specialization and exchange

Specialization and exchange enable us to enjoy

greater production and higher living standards

than would otherwise be possible.

As a result, all economies have been characterized by

high degrees of specialization and exchange.

The principle of specialization and exchange

applies not just to individuals,

but to groups of individuals,

such as those living within the boundaries that define

cities, counties, states or nations.

slide6

International Trade -

International trade is trade between nations

Exports are goods and services that are

produced domestically, but sold abroad.

Imports are goods and services that are

produced abroad, but consumed domestically.

slide7

Absolute and comparative advantage

An individual producer has an absolute advantage

in the production of a product if he has the ability

to produce the good or service using fewer resources

than other producers use.

Similarly a country has an absolute advantage

in the production of a product if it has the ability

to produce the good or service using fewer resources

than other countries use.

slide8

Comparative advantage

An individual producer has a comparative advantage

in the production of a product if she has the ability

to produce the good or service at a lower opportunity cost

than other producers.

Similarly, a country has a comparative advantage

in the production of a product if it has the ability

to produce the good or service at a lower opportunity cost

than other countries.

slide9

How to measure comparative advantage

We measure the opportunity cost of a good,

not by the resources used to produce it,

but rather by the other goods

whose production must be sacrificed.

slide10

Mutually Beneficial Trade

Mutually beneficial trade between any two countries

is possible whenever one country is relatively better

at producing a good than the other is at producing the good.

Being relatively better means having the ability

to produce a good at a lower opportunity cost —

that is, at a lower sacrifice of other goods foregone.

slide11

Measuring Productivity

We often measure productivity in terms of

output per unit of input (or other resource)

a. labor time or hours

b. land

c. expenditure or cost

slide12

Labor time example

Labor requirement data for White House cleaning

Load of wash Vacuum a room

Bill .80 hours .40 hours

Hillary .75 hours .25 hours

This data is input per unit of output

slide13

Convert requirement data to output per unit of input data

Take the reciprocal of the requirement data

Loads per hour Rooms per hour

Bill 1 / .80 = 1.25 loads 1 / .40 = 2.5 rooms

Hillary 1 / .75 = 1.333 loads 1 / .25 = 4 rooms

slide14

Corn (bu)

Peanuts (lbs)

$0.25

$2.50

U.S.

$4.00

$0.50

Mexico

Corn and peanut example

Cost requirement data

$ per output

slide15

Convert requirement data to output per unit of input data

Take the reciprocal of the requirement data

Bushels of corn per $ Pounds of peanuts per $

U.S. 1 / 2.50 = 0.40 bu. 1 / .25 = 4 lbs.

Mexico 1 / 4.00 = 0.25 bu. 1 / .50 = 2 lbs

(1/4)

slide16

Corn (bu)

Peanuts (lbs)

4 lbs

0.40 bu

U.S.

2 lbs

Mexico

0.25 bu

Corn and peanut example

Output per $

slide17

How to determine who has the comparative advantage in what

Output per unit of input data

1. Determine the output per per unit of input for each agent

2. Make an opportunity cost table (agents by goods)

3. For each good (column) choose a unit of exchange

4. Determine the opportunity cost of each good in terms

of the unit of exchange by dividing the production of

the unit of exchange by the production of the other good

5. The country with the lower opportunity cost has a comparative advantage in the production of each good

slide18

Example Computation

Loads

Loads

Rooms

Rooms

1.25

2.5

Bill

Bill

1.33

4

Hillary

Hillary

2 r

1/2 l

3 r

1/3 l

  • Rooms is unit of exchange for wash
  • Wash is unit of exchange for rooms

4. Fill in comparative advantage table (unit of exchange per unit of good)

5. Bill has the comparative advantage in washing

5a. Hillary has the comparative advantage in room cleaning

slide19

Example Computation

Corn

Peanuts

Corn

Peanuts

4

0.40

USA

USA

0.25

2

Mexico

Mexico

1/10 c

10 p

8 p

1/8 c

  • Peanuts is unit of exchange for corn
  • Corn is unit of exchange for peanuts

4. Fill in comparative advantage table (unit of exchange per unit of good)

slide20

Example Computation

Corn

Corn

Peanuts

Peanuts

USA

USA

4

0.40

Mexico

Mexico

0.25

2

1/10 c

10 p

8 p

1/8 c

  • Peanuts is unit of exchange for corn
  • Corn is unit of exchange for peanuts

4. Fill in comparative advantage table (unit of exchange per unit of good)

5. Mexico has the comparative advantage in corn

5a. USA has the comparative advantage in peanuts

slide21

Determining comparative advantage

Using input per unit of output data

Using cost per unit of output data

slide22

Output per unit of input data

We want the most possible

Most output per unit of input

Input (cost) per unit of output data

We want the least possible

Least input per unit of output

slide23

Wash

Rooms

Bill

Hours per task

Hillary

What does Bill give up to do a load of wash?

0.8

0.4

0.75

0.25

Bill gives up 2 rooms to do a load of wash

1 load of wash costs two rooms

Washing takes twice the resources of rooms

slide24

1 Load

1 Room

Opportunity Cost of:

2 rooms

Bill

Hillary

slide25

Wash

Rooms

Bill

Hours per task

Hillary

What about Hillary?

0.8

0.4

0.75

0.25

Hillary gives up 3 rooms to do a load of wash

1 load of wash costs three rooms

Washing takes 3 times the resources of rooms

slide26

1 Load

1 Room

Opportunity Cost of:

2 rooms

Bill

3 rooms

Hillary

slide27

1 Load

1 Room

Bill

Hillary

Who has the lowest opportunity cost for washing?

2 rooms

3 rooms

Bill has a comparative advantage in washing

slide28

Loads

Rooms

0.8

0.4

Bill

Hours per task

0.75

0.25

Hillary

What does Bill give up to vacuum a room?

Bill gives up 1/2 load of wash to vacuum a room

1 room costs ½ load of wash

Vacuuming takes ½ as long as washing

slide29

1 Load

1 Room

Bill

Hillary

Opportunity Cost of:

2 rooms

½ load

3 rooms

slide30

Wash

Rooms

Bill

Hours per task

Hillary

What does Hillary give up to vacuum a room?

0.8

0.4

0.75

0.25

Hillary gives up 1/3 load of wash to vacuum a room

1 room costs 1/3 load of wash

Vacuuming takes 1/3 as long as washing

slide31

1 Load

1 Room

Bill

Hillary

Opportunity Cost of:

2 rooms

½ load

1/3 load

3 rooms

slide32

Bill has a comparative advantage in washing

Hillary has a comparative advantage in vacuuming

slide33

How to determine who has the comparative advantage in what

Input per unit of output data

1. Determine the input per per unit of output for each agent

2. Make an opportunity cost table (agents by goods)

3. For each good (column) choose a unit of exchange

4. Determine the opportunity cost of each good in terms

of the unit of exchange by dividing the input use of each good

by the input use of the unit of exchange

5. The country with the lower opportunity cost has a comparative advantage in the production of each good

slide34

Example Computation

Corn

Peanuts

Corn

Peanuts

2.50

0.25

U.S.

U.S.

4.00

0.50

Mexico

Mexico

10 p

1/10 c

8 p

1/8 c

  • Peanuts is unit of exchange for corn
  • Corn is unit of exchange for fish

4. Fill in comparative advantage table (unit of good per unit of exchange)

5. Mexico has the comparative advantage in corn production

5a. U.S. has the comparative advantage in peanut production

slide36

Specialization and Gains from Trade

If individuals/countries specialize

according to their comparative advantage,

a more efficient use of given resources occurs.

As a result, the output of at least one good rises,

without decreasing that of any other good.

slide37

Loads

Rooms

2 rooms

Bill

½ load

Opportunity cost

Hillary

3 rooms

1/3 load

The rate of substitution between outputs

If Bill cleans 1 less room, he washes 1/2 more load of laundry.

(1 less room) x (½ load per room) = ½ more loads of laundry

If Bill cleans 2 less rooms, he washes 1 more load of laundry.

(2 less rooms) x (½ load per room) = 1 more loads of laundry

slide38

Loads

Rooms

2 rooms

Bill

½ load

Opportunity cost

Hillary

3 rooms

1/3 load

The rate of substitution between outputs

If Bill does 1 more load of laundry, he cleans 2 less rooms.

(1 more load) x (2 rooms per load) = 2 less rooms

If Bill does 2 more loads of laundry, he cleans 4 less rooms.

(2 more loads) x (2 rooms per load) = 4 less rooms

slide39

Loads

Rooms

2 rooms

Bill

½ load

Opportunity cost

Hillary

3 rooms

1/3 load

The rate of substitution between outputs

If Hillary does 1 more load of laundry, she cleans 3 less rooms

(1 more load) x (3 rooms per load) = 3 less rooms

If Hillary cleans 2 more rooms, she washes 2/3 less loads of laundry

(2 more rooms) x (1/3 load per room) = 2/3 more loads of laundry

slide40

Loads

Rooms

2 rooms

Bill

½ load

Opportunity cost

Hillary

3 rooms

1/3 load

Now adjust tasks and see what happens

Bill does 2 more loads of laundry and Hillary does 2 less loads

(2 more loads) x (2 rooms per load) = 4 less rooms (Bill)

(2 less loads) x (3 rooms per load) = 6 more rooms (Hillary)

Net impact is 2 more rooms vacuumed

slide41

Corn

Peanuts

U.S.

Mexico

Now adjust tasks and see what happens

10 p

1/10 c

Opportunity cost

8 p

1/8 c

US grows 1,000 less bu corn and Mexico grows 1,000 more bu corn

(1,000 less bu corn) x (10 lbs per bu) = 10,000 more lbs of peanuts

(1,000 more bu) x (8 lbs per bushel) = 8,000 less lbs of peanuts

Net impact is 2,000 more lbs of peanuts

slide42

Corn

Peanuts

U.S.

Mexico

Another example

10 p

1/10 c

Opportunity cost

8 p

1/8 c

US grows 10,000 less corn and Mexico grows 100,000 less peanuts

(10,000 less bu corn) x (10 lbs per bu) = 100,000 more lbs of peanuts

(100,000 less lbs) x (1/8 bushels per pound) = 12,500 more corn

Net impact is 2,500 more bushels of corn

slide43

Corn

Peanuts

U.S.

Mexico

A third example

10 p

1/10 c

Opportunity cost

8 p

1/8 c

US grows 4,000 more corn and Mexico grows 40,000 more peanuts

(4,000 more bu corn) x (10 lbs per bu) = 40,000 less lbs of peanuts

(40,000 more lbs) x (1/8 bushel per pound) = 5,000 less corn

Net impact is 1,000 less bushels of corn

Oops!!

slide44

Helpful note on finding tradeoffs

The tradeoff in the US is 1 bushel corn for 10 pounds of peanuts

Suppose we produce 3,000 less bushels of corn in the US

How much will peanuts rise?

slide45

Helpful note on finding tradeoffs

The tradeoff in the Mexico is 1 bushel corn for 8 pounds of peanuts

Suppose we want 30,000 less lbs of peanuts

How much will corn rise?

slide46

If countries specialize

according to their comparative advantage,

a more efficient use of given resources occurs.

The world output of at least one good rises,

without decreasing that of any other good.

slide47

Gains from trade

With the opening of trade, there will be a

net increase in world output.

Therefore, international trade flows can be arranged

so that no country would have less of anything,

while each country would some of the gain in total output.

slide48

Corn

Peanuts

Corn

Peanuts

U.S.

U.S.

Mexico

Mexico

World

Corn

U.S.

Peanuts

Corn

Mexico

Peanuts

Opportunity cost

+ 1000

- 100

+ 100

- 800

10 p

1/10 c

+ 0

+ 200

8 p

1/8 c

Gain from imports (+)

Loss from exports (-)

Gain

Production

+0

- 100

+ 100

+100

-900

+ 1000

+0

-100

+ 100

- 800

+900

+100

US imports 100 corn and exports 900 peanuts

900/100 = 9 so the US is trading 9 for 1

slide49

Corn

Peanuts

Corn

Peanuts

U.S.

U.S.

Mexico

Mexico

World

Corn

U.S.

Peanuts

Corn

Mexico

Peanuts

Opportunity cost

+ 100

- 10

+ 12

- 96

10 p

1/10 c

+ 2

+ 4

8 p

1/8 c

Gain from imports (+)

Loss from exports (-)

Gain

Production

+1

- 10

+ 11

+2

-98

+ 100

+1

-11

+ 12

- 96

+98

+2

US imports 11 corn and exports 98 peanuts

98/11 = 8.909 the US is trading 8.909 for 1

slide50

Corn

Peanuts

Corn

Peanuts

U.S.

U.S.

Mexico

Mexico

World

Corn

U.S.

Peanuts

Corn

Mexico

Peanuts

Opportunity cost

+ 400

- 40

+ 45

- 360

10 p

1/10 c

+ 5

+ 40

8 p

1/8 c

Gain from imports (+)

Loss from exports (-)

Gain

Production

+5

- 40

+ 45

+40

-360

+ 400

+0

-45

+ 45

- 360

+360

+0

US imports 45 corn and exports 360 peanuts

360/45 = 8 so the US is trading 8 for 1

slide51

As long as the opportunity costs differ,

specialization and trade can be beneficial to all involved.

This remains true regardless of whether the parties involved

are nations, state, countries, or individuals.

It remains true even if one party holds an all-around

absolute advantage or disadvantage.

slide54

Corn

Peanuts

Corn

Peanuts

U.S.

U.S.

Mexico

Mexico

World

Corn

U.S.

Peanuts

Corn

Mexico

Peanuts

Terms of trade

Opportunity cost

+ 1000

- 100

+ 100

- 800

10 p

1/10 c

+ 0

+ 200

8 p

1/8 c

Gain from imports (+)

Loss from exports (-)

Gain

Production

+0

- 100

+ 100

+100

-900

+ 1000

+0

-100

+ 100

- 800

+900

+100

The US is trading 100 bu corn for 900 lbs peanuts

slide55

Terms of trade

The U.S. is exporting 900 pounds of peanuts and importing 100 bushels of corn.

The US is exchanging 900 lbs peanuts for 100 bu corn

This exchange ratio is known as the terms of trade.

slide56

More formally, the terms of trade is the ratio at

which a country can trade

domestically produced products

for foreign-produced products.

The exchange ratio in this example is 9 to 1

(900/100) = 9

With different terms of trade, the benefits

of specialization and exchange would be

apportioned in different manner.

slide57

Bounds on the terms of trade

What is the most the US will pay for a bushel of corn

in terms of peanuts?

No more than what it can transform

peanuts into corn domestically.

slide58

Bounds on the terms of trade

What is the least Mexico will take for a bushel of corn

in terms of peanuts?

No more than what it can transform

corn into peanuts domestically.

slide59

Corn and Peanuts

Country Opportunity Cost of a Bushel of Corn

US

1 bu. corn costs 10 lbs. of peanuts

What if Mexico asks for 15 lbs of peanuts per bushel?

What if Mexico asks for 5 lbs of peanuts per bushel?

Will Mexico ask only 5 lbs of peanuts for a bushel of corn?

Mexico

1 bu. corn costs 8 lbs. of peanuts

NO!!!

slide60

Bounds on the terms of trade

The U.S. will not trade peanuts for corn

for more than

10 pounds for 1 bushel

Mexico will not trade peanuts for corn at less than

8 pounds for 1 bushel

slide62

Analysis of Comparative Advantage using PPF’s

Output Combinations of Peanuts & Corn - US

Peanuts Corn

0 10,000

100,000 0

20,000 8,000

40,000 6,000

slide63

11000

10000

9000

Corn

8000

7000

6000

PPF_US

5000

4000

3000

2000

1000

0

0

20000

40000

60000

80000

100000

120000

Peanuts

This is a linear PPF which we can see by plotting it

slide64

Corn Peanuts

10,000 0

0 100,000

We can find the slope of the PPF using two of the points

In particular, use the first two points in the set

The implication is that the US gains 1 corn for 10 peanuts

slide65

11000

10000

9000

Corn

2000

8000

7000

6000

PPF_US

5000

4000

3000

2000

1000

0

0

20000

40000

60000

80000

100000

120000

Peanuts

-20,000

We can see this slope graphically

slide66

The US produces 10,000 corn when it produces no peanuts

So the intercept in the line describing the PPF is 10,000

The equation for the PPF is then given by

corn = (- 1/10) peanuts + 10,000

slide67

Some example points

corn = (- 1/10) peanuts + 10,000

corn = (- 1/10) (20,000) + 10,000

corn = - 2,000 + 10,000

corn = 8,000

corn = (- 1/10) (40,000) + 10,000

corn = - 4,000 + 10,000

corn = 6,000

slide68

 peanuts

 corn

Given a change in peanuts we can get the change in corn

 corn = slope *  peanuts

Corn Peanuts

8,000 20,000

6,000 40,000

 corn = (-1 / 10) * (40,000 - 20,000)

 corn = (-1 / 10) * (20,000)

 corn = -2,000

slide69

11000

10000

9000

Corn

8000

7000

6000

PPF_US

4000

5000

4000

3000

2000

1000

0

0

20000

40000

60000

80000

100000

120000

Peanuts

-40,000

Graphically

slide70

Now consider Mexico

Output Combinations of Corn & Peanuts - Mexico

Corn Peanuts

8,000 0

0 64,000

6,000 16,000

3,000 40,000

2,500 44,000

slide71

9000

8000

Corn

7000

6000

PPF_Mexico

5000

4000

3000

2000

1000

0

0

10000

20000

30000

40000

50000

60000

70000

Peanuts

The linear PPF

slide72

Corn Peanuts

0 64,000

6,00016,000

We can find the slope of the PPF using two of the points

In particular, use the second two points in the set

The implication is that Mexico gains 1 corn for 8 peanuts

slide73

9000

8000

Corn

5500

7000

2500

6000

PPF_Mexico

5000

4000

3000

2000

1000

0

0

10000

20000

30000

40000

50000

60000

70000

-20,000

Peanuts

Graphically

slide74

Mexico produces 8,000 corn when it produces no peanuts

So the intercept in the line describing the PPF is 8,000

The equation for the PPF is then given by

corn = (- 1/8) peanuts + 8,000

slide75

 peanuts

 corn

Given a change in peanuts we can get the change in corn

 corn = slope *  peanuts

Corn Peanuts

6,000 16,000

2,500 44,000

 corn = (-1 / 8) * (16,000 - 44,000)

 corn = (-1 / 8) * (- 28,000)

 corn = 3,500

slide76

PPF_US

PPF_Mexico

Combine the diagrams

Production Possibility Frontier

11000

10000

Corn

9000

8000

7000

6000

5000

4000

3000

2000

1000

0

0

20000

40000

60000

80000

100000

120000

Peanuts

slide77

PPF_US

PPF_Mexico

Production Possibility Frontier

11000

10000

Corn

9000

8000

7000

6000

5000

4000

3000

2000

1000

0

0

20000

40000

60000

80000

100000

120000

16000

Peanuts

The US gets more peanuts for corn compared to Mexico.

slide78

Now consider some initial production point for each country

Country Corn Peanuts

US 6,000 40,000

Mexico 3,000 40,000

Total 9,000 80,000

slide79

PPC_US

PPC_Mexico

US Corn

Mexico Corn

Graphically we can see this point as follows

Production Possibility Frontier

6500

6000

Corn

5500

5000

4500

4000

3500

3000

2500

2000

1500

36,000

38,000

40,000

42,000

44,000

Peanuts

slide80

PPF_US

Initial Corn

Less Corn

Now decrease US corn production by 1 unit

Production Possibility Frontier

6001.5

6001

Corn

6000.5

6000

5999.5

5999

5998.5

5998

39,990

39,995

40,000

40,005

40,010

40,015

40,020

Peanuts

 peanuts = + 10

slide81

PPC_Mexico

Initial Corn

More Corn

Now increase Mexican corn production by 1 unit

3002

Production Possibility Frontier

Corn

3001

3000

2999

39,984

39,988

39,992

39,996

40,000

40,004

Peanuts

 peanuts = - 8

slide82

Initial

Subsequent

Corn Peanuts

Corn Peanuts

Mexico

U.S.

Total

Putting it all together

3,000 40,000

3,001 39,992

6,000 40,000

5,999 40,010

9,000 80,000

9,000 80,002

slide83

What have we learned?

By growing one less bushel of corn in the U.S.

and one more bushel in Mexico,

there is a net gain of 2 pounds of peanuts.

slide84

Now drop US corn production by 1000

Country Corn Peanuts

US 6,000 40,000

 corn = (-1 / 10) *  peanuts

-1000 = (-1 / 10) *  peanuts

-10000 = (-1 ) *  peanuts

10000 =  peanuts

slide85

Now increase Mexican corn production by 1000

Country Corn Peanuts

Mexico 2,500 44,000

 corn = (-1 / 8) *  peanuts

1000 = (-1 / 8 ) *  peanuts

8000 = (-1 ) *  peanuts

-8000 =  peanuts

slide86

Summarizing

Corn stays the same

In the US,  peanuts = 10000

In Mexico,  peanuts = -8000

In Total,  peanuts = 2000

slide87

Total Production

Country Corn Peanuts

US 5,000 50,000

Mexico 4,000 32,000

Total 9,000 82,000

Previously

Total 9,000 80,000

slide88

Consider a variety of alternative production points

Mexico

US

Total

3000 40000

Corn Peanuts

Corn Peanuts

Corn Peanuts

Corn Peanuts

8000 0

2501 39992

2502 39984

6000 40000

5999 44010

5998 44020

1000 90000

9,000 80,000

9,000 80,002

9,000 88,004

9,000 90000

Corn stays the same, peanuts increase by 10,000

slide89

Practice Problem

Output Combinations of Cotton and Sugar

US

Cuba

Cotton Sugar

Cotton Sugar

30,000 0

100,000 0

0 25,000

0 15,000

slide90

US

Cuba

Cotton Sugar

Cotton Sugar

US

Cuba

Cotton Sugar

Cotton Sugar

Practice Problem

Initial Outputs of Cotton and Sugar

10,000 10,000

60,000 10,000

Final Outputs of Cotton and Sugar

? 15,000

? 5,000

slide91

Outputs of Cotton and Sugar

US

Cuba

Cotton Sugar

Cotton Sugar

Initial

10,000 10,000

60,000 10,000

For the US

For Cuba

Final

80,000 5,000

0 15,000

slide92

Consumption beyond the frontier

Suppose terms of trade are 9 pounds of peanuts for 1 bushel of corn.

Any time the U.S. stops producing a bushel of corn,

it gets 10 pounds of peanuts.

It can trade 9 of these for a bushel of corn and have

1 left over to bring it outside the frontier.

slide93

Consumption beyond the frontier

Any time Mexico stops growing a pound of peanuts

it can produce 1/8 of a bushel of corn.

So if Mexico stops growing 8 pounds of peanuts,

it will have a bushel of corn to trade.

It can trade this for 9 pounds of peanuts and be better off.

slide94

If opportunity costs differ and countries specialize

according to their comparative advantage,

they can consume combinations of goods

that lie outside

their production possibilities frontiers.

As a result, both countries are better off

slide95

Turning potential gains into actual gains

Convert domestic currency into the foreign currency

and then compare prices.

Buy at the lowest price and sell at the highest price.

Exchange rates will adjust so that trade occurs.

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Provisos

Costs of trading

Sizes of countries

Size of market

Market power

Increasing opportunity cost and a concave PPF

Barriers to trade

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Sources of Comparative Advantage

Natural resources

Capital stock

Physical

Human

Experience

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Objections to free trade

Alternative groups in society are made

better and worse off

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Exports

Good for domestic producers

Bad for domestic consumers

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Imports

Good for domestic consumers

Bad for domestic producers

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Compensation principle

With free trade the gainers can compensate

the losers such that everyone is better off

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Barriers to trade

Tariffs

Quotas

Clever rules