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1. Lecture 3 International trade and comparative advantage 3-1

2. 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. 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. 3-2

3. Learning Objectives (cont.) 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. 3-3

4. Economic Basis for Trade The general case for trade • Distribution of economic resources differs between nations. • Different technologies and/or resources are required for production: • labour-intensive commodities • land-intensive commodities • capital-intensive commodities. 3-4

5. Specialisation and Comparative Advantage Two isolated nations: We use the following assumptions: • constant costs • i.e. this means a straight line production possibilities curve • different opportunity costs • different resource mix and different levels of technology • Currently they are both self sufficient – ie they do not trade with each other. 3-5

6. Production possibility curves Two different countries without trade 3-6

7. Assume no 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 3-7

8. Arbitrage 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. 3-8

9. International Trade 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 3-9

10. Comparative Advantage 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 3-10

11. Another way of looking at this Comparative advantage- economic concepts in 60 seconds http://www.youtube.com/watch?v=FpTBjRf8lGs 9-11

12. Prices 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: 3-11

13. Consumption Possibilities After trade between the 2 countries 3-13

14. Employment Effects of Free Trade 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 3-14

15. Similarly 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 3-15

16. Principles of Comparative Advantage 3-15 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.

17. Trade Barriers Barriers to free trade: • Tariffs • excise taxes on imported goods • can be either revenue tariffs or protective tariffs • Import quotas • restrictions on the amount of foreign product imported over a specific period • zero quota indicates complete prohibition. 3-17

18. Trade Barriers • Non-tariff barriers • licensing standards or procedures designed with the primary purpose of protecting local production against foreign competition • Voluntary export restrictions • negotiated restrictions on the level of exports to a particular country. 3-18

19. Trade Barriers • Motivations: special-interest effect • Trade can hurt particular industries and resource suppliers. • There is a need to protect the interest of special groups, like the Australian clothing or car industry. 3-19

20. Economic Impact of Tariffs Sd 35 f i 25 Sw + t e j g h Sw D Price 20 Quantity 0 20 30 75 100 60 3-20

21. Tariffs 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. 3-21

22. Impact of tariff • A tariff increases the price in the nation for the good. As a result, the following occur: • Consumers buy less of the good and domestic producers increase the quantity they supply • Government collects tariff revenue equal to the tariff times the quantity imported of the good • Less of the good is imported • Domestic consumers are worse off – domestic producers are better off 9-22

23. Economic Impact of Tariffs (cont.) • Consumption loss • a measure of the benefit lost to consumers that is not captured by other elements in society • Production loss • the value of production lost to society • Deadweight loss • the reduction in the total level of welfare (or real incomes) across society due to tariff protection 3-23

24. Economic Impact of Tariffs • Effects on foreign producers • income of foreign producers will fall • Government revenue • the government gains by obtaining tariff revenue • tariff revenue is essentially a transfer of income from consumers to government and does not represent any net change in the nation’s economic wellbeing. 3-24

25. Economic Impact of Quotas Sd Price 35 f i 25 e j g h Sw 20 Dd Quantity 0 20 30 60 75 100 3-25

26. Quotas 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. 3-26

27. Impact of quotas • An import quota increases the price in the nation for the good. As a result, the following occur: • Consumers buy less of the good at a higher price and domestic producers increase the quantity they supply • The importers gain additional profit – they get a higher price • Less of the good is imported • Again – domestic consumers are worse off and domestic producers are better off – as are the importers. 9-27

28. Tariffs vs Quotas 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. 3-28

29. Economic Impacts of Tariffs and Quotas Indirect Effects • Tariffs and quotas directly promote the expansion of relatively inefficient industries. • Indirectly, they cause the contraction of relatively efficient industries in which a country may have a comparative advantage. 3-29

30. Arguments for Protection military self-sufficiency argument increase domestic employment diversification for stability infant-industry argument cheap foreign labour argument. 3-30

31. International Negotiations • In the past decade there has been a general movement to free up trade between nations. • GATT and the WTO • General agreement on tariffs and trade • equal, non-discriminatory treatment for all member nations • the reduction of tariffs by multilateral negotiations • the elimination of import quotas • World Trade Organisation • forum for the negotiation of reduction in tariff barriers. 3-31