2. Free Trade and Protection

Summary 1.Theory of Comparative Advantage: Why trade is good. 2.Where comparative advantage comes from: Heckscher-Ohlin Model (factor endowments) Equalization of factor income 3.Welfare Effects of a Tariff : Consumers Lose Gov’t gains Local producers gain 4.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 Wine wheat wheat A's Production

Before trade A produces a=wine and 120-2a=wheat. Wine wheat wheat A's Production a 120-2a

Before trade B Wine Wheat B's Production

Before trade B produces b=wine and 15-(b/4)=bread. Total world production is (a + b wine, a b wheat). Wine wheat B's Production b 15-(b/4)

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 Wheat A = 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 Wheat A = 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 Wheat B = 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 Wheat A = 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 Wheat B = 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 Wine Wheat A Autarky A

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

Country B’s Production Possibilities Wine Wheat B Autarky B

Country B’s Production Possibilities Wine Wheat B Autarky B Prices in B

Who has higher prices? Wine Wheat A Autarky B Autarky A B

Trade raises the price of wheat in B and raises the price of wine in A Wine Wheat AB

Trade raises the price of wheat in B and raise the price of wine in A Wine Wheat A Autarky AB

Trade raises the price of wheat in B and raises price of wine in A Wine Wheat AB Same Prices => lines are parallel

At the new prices B is better off Wine Wheat B

It produces more wheat Wine Wheat

It produces more wheat and consumes more wine Wine Wheat Export Wheat

It produces more wheat and consumes more wine Wine Wheat Export Wheat Import 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.

Wine Wheat A Autarky B Autarky AB

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 Domestic Demand Quantity Price

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

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

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

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

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

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 Domestic Demand Quantity Price World Supply

After Tariff Domestic Supply Domestic Demand Quantity Price World Supply World Supply with Tariff

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

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

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

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

Net the country loses Domestic Supply Domestic Demand Quantity Price World Supply Tariff

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.