2 Trade or Protection

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2. Free Trade and Protection : 

2. Free Trade and Protection

Summary: 

Summary 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 : 

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 : 

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 : 

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 : 

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.

Slide7: 

Before trade: Country A

Slide8: 

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

Slide9: 

Before trade B  

Slide10: 

Before trade B produces b=wine and 15-(b/4)=bread.   Total world production is (a + b wine, 135 - 2a - 0.25b wheat). b 15-(b/4)

Now let trade occur: 

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: 

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: 

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: 

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: 

Theory of Comparative Advantage What are the prices? A was prepared to swap 1 unit of wine for ¼ wheat so: Price of WheatA = 4 X (Price of Wine)A B (Supplies Wine) was prepared to swap 1 unit of wine for 2 of wheat so: Price of WheatB = ½ 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: 

Some Pictures: Country A Production Possibilities Wine Wheat A Autarky Prices in A

Country B’s Production Possibilities: 

Country B’s Production Possibilities Wine Wheat B Autarky

Who has higher prices: 

Who has higher prices Wine Wheat A Autarky B Autarky

Trade lowers the price of wine in A and lowers the price of wheat in B: 

Trade lowers the price of wine in A and lowers the price of wheat in B Wine Wheat A Autarky

Trade lowers the price of wine in A and lowers the price of wheat in B: 

Trade lowers the price of wine in A and lowers the price of wheat in B Wine Wheat A Autarky

This makes A better off: 

This makes A better off Wine Wheat

It produces more wheat and consumes more wine : 

It produces more wheat and consumes more wine Wine Wheat

2. Sources of Comparative Advantage : 

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 Lamb the other really likes sausages!

Sources of Comparative Advantage: factor endowments.: 

Sources of Comparative Advantage: factor endowments. 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: 

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.

Slide26: 

Wine Wheat A Autarky B Autarky

Trade occurs to move immobile inputs around: 

Trade occurs to move immobile inputs around Country A is rich in labour and exports the good that requires a lot of labor. Country B is rich in capital and export the good that is rich in capital. They can’t move the factors but they can move goods.

Factor Price Equalization: 

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: 

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: 

3. Protection Instruments of Public Policy: Tariff (Taxes) Quotas (quantity restrictions) Non-tariff barriers (Product standards, voluntary restraints.

Effect of Tariff on Value: 

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:

Slide32: 

Domestic Equilibrium Price and Quantity (No trade) Domestic Supply Domestic Demand Quantity Price

Slide33: 

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

Slide34: 

Efficient domestic producers continue to produce. Domestic Supply Domestic Demand Quantity Price World Supply Supply From Local Firms

Slide35: 

But there is an increase in supply from importers. Domestic Supply Domestic Demand Quantity Price World Supply Supply From Local Firms Supply From Importers

Slide36: 

Consumers’ value with trade: Domestic Supply Domestic Demand Quantity Price World Supply

Slide37: 

Local Producers’ value: Domestic Supply Domestic Demand Quantity Price World Supply

The Government Imposes a Tax/Tariff: 

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

Slide39: 

Local Producers’ value: Domestic Supply Domestic Demand Quantity Price World Supply

Slide40: 

Local Producers’ value: Domestic Supply Domestic Demand Quantity Price World Supply World Supply with Tariff

Slide41: 

Who gains who loses? Domestic Supply Domestic Demand Quantity Price World Supply Tariff

Slide42: 

Consumers lose this Domestic Supply Domestic Demand Quantity Price World Supply Tariff

Slide43: 

Producers gain this Domestic Supply Domestic Demand Quantity Price World Supply Tariff

Slide44: 

Government gains this much tax Domestic Supply Domestic Demand Quantity Price World Supply Tariff

What Justification is there for Protection : 

What Justification is there for Protection 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: Gov’t is necessary to protect industries until they are ‘grown up enough’ to face international competitors. (3) Revenue (4) Employment

Infant Industries : 

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: 

Examples of Market Failure Failure in human capital (skills, education, health) Information (gov’t has better knowledge?) Capital market failure (hard for firms to get loans)

Employment Argument: 

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 labor being used in the exporting industries is less than the equilibrium wage => may increase welfare.