Free Trade Theory Why Nations Trade

Why Trade?

Basics of Trade Defined: 2 Countries engage in economic activity Exports: goods/services leave country Imports: goods/services enter country Trade Surplus: Export more than import Trade Deficit: Import more than export

Ways to Limit Trade Protectionism: Gov’t policy which seeks to limit trade –Tariffs– taxes on imports –Quotas- limits on quantity imported Globalization: the “global” movement towards free trade –Trade without Tariffs & Quotas –Worldwide movement towards free market capitalism

2 Free Trade Terms Comparative Advantage = when a country can produce a good at a lower opportunity cost –They give up less! Absolute Advantage = when a country can produce a good more efficiently –They use fewer resources

 Countries should produce (specialize) in goods where they have a comparative advantage  Trade benefits both parties (each country gets “more”)  Free Trade promotes a more “efficient” world economy  Absolute Advantage is not relevant in trade analysis Here is my great theory! David Ricardo Trade Theory

Specialization works! Any illegal activity you can think of… + Idaho Nevada Texas Florida

Wheat Coffee Wheat BRAZIL MEXICO (PPF) Production Possibilities Frontier Review: Illustrates the maximum output for a country with current resources Any point on the line is efficient Below line is inefficient Above the line is not obtainable in short run PPF CURVE Review

Free Trade Worksheet Handout #1

Wheat Coffee Wheat BRAZIL MEXICO 1 Coffee = ____ Wheat 1 Coffee = _____ Wheat 1 Wheat = ____ Coffee Opportunity Cost Table BRAZIL MEXICO (gain) (give-up) 1 2 1/2 1 PPF Illustrates Opportunity Cost between goods

BRAZIL MEXICO 1 Coffee = ____Wheat 1 Coffee = _____ Wheat 1 Wheat = ____ Coffee 1 Wheat = ____Coffee 1/ Wheat : BRAZIL has comparative advantage---produce only WHEAT Coffee : MEXICO has comparative advantage---produce only COFFEE coffee wheat Wheat Coffee Wheat BRAZIL MEXICO Determining Comparative Advantage

BRAZIL MEXICO Wheat Coffee Wheat * (500,500) * (250,500) 400 Coffee 300 Wheat BRAZIL 0 Coffee 1,000 Wheat 1,000 Coffee 0 Wheat MEXICO. (700, 400). (300, 600) after trade Trade Example: Theoretical Benefits of Free Trade There is not one right answer Any trade that produces a point ABOVE current PPF is efficient trade

Use Economic Logic! Betty- types 120 w.p.m. Jim- types 60 w.p.m. Who should do the typing? Betty or Jim? Assumption: No errors Betty & Jim

Betty is a lawyer & Jim is a secretary Betty earns $140 an hour. Jim earns $20 an hour. Now, who should type the letter? Jim Should! Jim gives up less when he types! He has a comparative advantage in typing Why: Betty types 2 times as fast as Jim Betty earn 7 times as much as Jim Betty- types 120 w.p.m. Jim- types 60 w.p.m. Betty has an absolute advantage in typing (she is more efficient)

Summary: Free Trade Theory Countries should specialize in a good where they have a comparative advantage Trade is mutually beneficial –End country ends up at a point above their own PPF curve World wide efficiency increases as a result –Produce more with same resources

BRAZIL MEXICO Wheat Coffee Wheat * (500,500) * (250,500). (700, 400). (300, 600) after trade Theoretical Benefits of Free Trade