International Trade Countries can consume beyond their own PPF if they trade each specialise in goods with comparative advantage The rate of exchange will be somewhere between their opportunity cost ratios The rate of exchange is measured by the “terms of trade” – an index of export prices divided by index of import prices (the greater a quantity of imports a country can acquire for a given quantity of exports, the higher the “terms of trade”)

The Importance of International Trade Bananas Bananas B C C A A B Wine Wine EU USA Without trade, each produces at A With complete specialisation, each produces at B Trade occurs at an exchange rate somewhere between opportunity costs (same slope for both countries) therefore both can consume greater quantity of Bananas and Wine

Advantages and disadvantages of free trade Specialisation leading to increased output Trade allows economies of scale (larger market to sell to) Lower price and increased choice Competition and innovation Risk – interdependence, over- reliance on trade, loss of control Unemployment (perhaps) Income inequality Environmental impact Culture

Welfare Gain From Trade S domestic P domestic A B C S world P world D domestic Q S domestic Q D domestic Imports Consumer surplus gain = A + B + C Producer surplus loss = A Total welfare gain = B + C

Trade Protection Options Tariffs: taxes on imports Quotas: quantity restrictions on imports Subsidies: given to domestic firms to help them compete in foreign markets Regulations: can make it very difficult or expensive for foreign products to comply

Tariffs – A Loss of Welfare S domestic P tariff A B C D S world P world D domestic Q S1 free trade Q S2 with tariff Q D2 with tariff Q D1 free trade Lower Imports Consumer surplus reduced by A + B + C + D Producer surplus increased by A (domestic producers expand production at ↑ price) Gov’t tax revenue = C Total loss of welfare = B + D

Welfare loss from quota Quota amount decided, added to domestic production Loss in consumer surplus is A+B+C+D SD1 Price Gain in producer surplus is A PW +q Who receives C? A B C D PW SW Generally importers, so welfare loss is B+C+D D If the government sold licences to import, welfare loss is between B+D and B+C+D So tariffs are better than quotas QS1 QS2 QD2 QD1 Quantity

Welfare loss from subsidy Original producer surplus is A SD1 Price New producer surplus is A+B+C+D SD2 Gain in producer surplus is B+C+D PW SW S A C Subsidy costs taxpayers A+B+C+E B E D PW - S So loss from subsidy is A+B+C+E minus B+C+D Which is A+E-D D QS1 QS2 QD1 Quantity Since A is the same as D the loss is E

Why have trade restrictions? If countries specialise according to comparative advantage there are major gains from trading Tariffs, quotas and other restrictions lead to welfare loss, so why do some countries have protectionist policies?

OUT

Reasons for Protection Reasons might generally be counted as excuses, but include: The infant industry argument. This is the key one Dumping Job protection Strategic industries

The Infant Industry Argument It states that countries, especially developing countries, have a potential comparative advantage in manufacturing and they can realise that potential through an initial period of protection Without protection, domestic firms cannot compete at the world price It is therefore argued that it is a good idea to use tariffs, import quotas or subsidies as temporary measures to get industrialisation started Once the industry has developed – eg has learnt how to produce and has economies of scale – then it can compete with large international firms, and the protection can be removed

Problems Lots of problems Who decides which industries to protect, and how? Why can’t the private sector invest in the industry knowing it will be profitable in the future? It may be wasteful to support industries now that will have a comparative advantage in the future With protection, infant industries may never “grow up” or become competitive. In other words does protection actually lead to developing comparative advantage? Do governments withdraw protection, or does it become semi-permanent?

Extension: market failure and infant industry Two principal arguments for why protection is needed because market failures prevent infant industries from becoming competitive: Imperfect (financial) capital markets Because of poorly working financial laws and markets, new industries are not allowed to borrow as much as they need, which results in restricted growth. If creating better functioning laws and markets is not feasible, then high tariffs would be a second-best policy to increase profits for new industries, leading to more rapid growth.

Extension: market failure and infant industry The problem of appropriability Firms may not be able to privately appropriate (keep the profits) the benefits of their investment in new industries. Most obvious in technology, when the benefits of a firm’s investment in technology become available to the rest of the economy. The knowledge created when starting an industry may be not appropriable because of a lack of property rights. If establishing a system of property rights is not feasible, then high tariffs would be a second-best policy to encourage growth in new industries.

Theoretical Costs and Benefits of Infant Industry Protection (with tariffs) Today n Price MC = Domestic Supply Pw + t Pw Domestic Demand QS1 QS2 QD2 QD1 Quantity

Theoretical Costs and Benefits of Infant Industry Protection (with tariffs) Today Revenue from tariff C n Plus increase in producer surplus Price A MC = Domestic Supply Pw + t A C Pw Domestic Demand QS1 QS2 QD2 QD1 Quantity

Theoretical Costs and Benefits of Infant Industry Protection (with tariffs) Today Minus loss in consumer surplus Quantity QD1 Future Domestic Demand E Is E greater than B + D? A + B + C + D n Price Equals B + D MC = Domestic Supply MCI= SI Pw + t A C B D Pw Domestic Demand QS1 QS2 QD2 QD1 Quantity QS3

Empirical Evidence Yes, welfare increased due to intervention Various attempts to measure effectiveness. For example, input per unit of output must fall more rapidly in more protected industries if there is to be any rational for infant industry protection. Most quoted case is Krueger (1982) finds no such tendency over the period covered analysing protection in Turkish industries Industry-specific case studies Yes, welfare increased due to intervention Aircraft in Europe (Baldwin and Krugman (1989)) Steel rail industry in the USA (Head (1994)) Production of electricity from wind power (Hansen et al (2003)) No, welfare fell as a consequence of intervention Semi-conductors in Japan (Baldwin and Krugman (1986)) Tinplate in the United States ( Irwin (2000)) Computers in Brazil (Luzio and Greenstein (1995))

Other reasons - dumping From the World Trade Organisation (WTO) Article VI of the GATT provides for the right of contracting parties to apply anti-dumping measures, i.e. measures against imports of a product at an export price below its “normal value” (usually the price of the product in the domestic market of the exporting country) if such dumped imports cause injury to a domestic industry in the territory of the importing contracting party. In other words countries can protect domestic industries if they are damaged by the sale of a product by a foreign firm at a price well below the price in the firm’s own domestic market Must be a much lower price and must be shown to damage domestic firms for protection to be permitted Sometimes written that dumping is when firms sell below cost. This may be a reasonable assumption since firms should not be selling below cost in their own market, but the test is based on price Dumping may happen when: The goods have already been produced and the firm cannot sell them in its own market (or others) A firm may have excess capacity and will produce and sell as long as the price is above variable cost A large foreign firm is trying to predatory price – force the domestic firm out of the industry (very naughty)

Other reasons Protecting jobs Protecting strategic industries When cheap imports leads to structural unemployment This is a poor argument. This negates the advantage of specialisation from comparative advantage and there is a welfare loss (as seen before). The exporting country might retaliate Protecting strategic industries Particularly in an interdependent world, there may be industries which a country views must be protected, particularly defence