2. Free Trade and Protection
Summary
1.
2.
3.
4.
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
Gov’t gains
Local producers gain
Arguments for protection:
Optimal tariff
Infant industry
Employment
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
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
b
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 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
Wheat
A Autarky
A
Wine
Some Pictures: Country A Production Possibilities
Wheat
Prices in A
A Autarky
A
Wine
Country B’s Production Possibilities
Wheat
B Autarky
B
Wine
Country B’s Production Possibilities
Prices in B
Wheat
B Autarky
B
Wine
Who has higher prices?
Wheat
B Autarky
A Autarky
B
A
Wine
Trade raises the price of wheat in B and raises the price of
wine in A
Wheat
B
A
Wine
Trade raises the price of wheat in B and raise the price of
wine in A
Wheat
A Autarky
B
A
Wine
Trade raises the price of wheat in B and raises price of wine
in A
Same Prices => lines are parallel
Wheat
B
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
B
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 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
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
Supply
From
From
Local Firms
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.