Download Chapter 14: Monopolistic Competition and Oligopoly:

Chapter 10 Economics of Taxation:
Definition of tax incidence: the manner in which the burden of a tax is shared
among participants in a market.
How Taxes on Sellers Affect Market Outcomes
1.
If the government requires the seller to pay a certain dollar amount
for each unit of a good sold, this will cause a decrease in supply.
2.
The supply curve will shift up by the amount of the tax.
3.
The quantity of the good sold will decline.
4.
Buyers and sellers will share the burden of the tax; buyers pay
more for the good and sellers receive less (because of the tax).
Case Study: Can Congress Distribute the Burden of a Payroll Tax?
1.
FICA (Social Security) taxes were designed so that firms and
workers would equally share the burden of the tax.
2.
This type of payroll tax will simply put a wedge between the wage
the firm pays and the wage the workers will receive.
3.
It is true that firms and workers share the burden of this tax, but it
is not necessarily 50-50.
Elasticity and Tax Incidence
1.
When supply is elastic and demand is inelastic, the largest share of
the tax burden falls on consumers.
2.
When supply is inelastic and demand is elastic, the largest share of
the tax burden falls on producers.
3.
In general, a tax burden falls more heavily on the side of the
market that is less elastic.
4.
a.
A small elasticity of demand means that buyers do not have
good alternatives to consuming this product.
b.
A small elasticity of supply means that sellers do not have
good alternatives to producing this particular good.
Case Study: Who Pays the Luxury Tax?
a.
In 1990, Congress adopted a new luxury tax.
b.
The goal of the tax was to raise revenue from those who
could most easily afford to pay.
c.
Because the demand for luxuries is often relatively more
elastic than supply, the burden of the tax fell on producers
and their workers.
Monopolistic Competition and Oligopoly:
The Concept of Imperfect Competition:


Refers to market structures between perfect competition and monopoly
More than one seller, but too few to create a perfectly competitive market

Other conditions of perfect competition, such as the requirement of a standardized
product or easy entry/exit are not satisfied
Monopolistic Competition:
Characterized by Three Fundamental Characteristics:
1. Many buyers and sellers
2. Easy entry and exit
3. Differentiated products
Definition: Monopolistic Competition: A market structure in which there are many
firms selling products that are differentiated, yet are still close substitutes, and in which
there is free entry and exit.
 Each firm produces a differentiated product in a monopolistic competitive market;
thus each firm faces a downward sloping demand curve. Therefore it will not lose all
of its customers if it raises its price. We know that whenever a firm faces a downward
sloping demand curve, its marginal revenue curve lies below the demand curve. The
relationship between the demand and marginal revenue curves is illustrated below.
Monopolistic Competition in the Short Run:
The constraints of a monopolistic competitor are very similar to a monopoly:
1. Its current technology of production
2. The prices for inputs
3. The downward sloping demand curve
Profit case:
 The restaurant marketplace in Beverly Hills is a good example of a monopolistically
competitive market. Every restaurant offers a different menu and special dishes, but
still has to compete with other comparable restaurants. Further, each restaurant sells
a somewhat unique product; therefore the restaurants are not perfectly competitive
and can raise their price and not lose all customers.

A monopolistically competitive firm (as does any other firm) maximizes its profit
by producing the level of output where MR = MC.

MR = MC at point output level Qo. In monopolistic competition the price is
determined by the amount that customers are willing to pay to buy Qo units of
output.
 Under monopolistic competition, firms can earn positive or negative economic
profit in the short run
Monopolistic
Monopolistic Competition
Competition in
in the
the Short
Short Run
Run
Dollars
Dollars
$70
$70
AA
MC
MC
ATC
ATC
dd1
1
30
30
MR
MR11
250
250
Homes
HomesServiced
Serviced
per
perMonth
Month
 The monopolistically competitive firm illustrated above faces a downward
sloping demand curve d1 and marginal revenue MR1. MR = MC at 250 units per
month and a price of $70 per unit. Therefore the firm illustrated above earns a
short-run profit of $10,000 ($40*250), represented by the blue shaded rectangle.
Monopolistic Competition in the Long Run

Economic profits will not last due to easy entry/exit. Where a monopoly market
has barriers to entry, a monopolistically competitive market does not. Therefore
we should expect any economic profit to be reduced to zero due to entry of new
firms:
 Monopolistic competition allows firms to profit or incur losses in the short run.
However, in the long run, easy entry and exit will ensure that, in the long run,
there is no economic profit.
Monopolistic Competition in
the Long Run
Dollars
MC
ATC
$40
E
d
MR2
100
200
d2
Homes Serviced
per Month
The individual firm’s demand curve “d” shifts to the left to “d2” when new firms enter the
market, and each firm eventually earns zero economic profit. Point “E” represents the
long run equilibrium at which price ($40) equals ATC.
Excess Capacity under Monopolistic Competition:
 In the long run, a monopolistic competitor will operate with excess capacity—that is,
it will produce too little output to achieve minimum cost per unit.

The monopolistic competitor will always produce with P> minimum ATC in the
long run, unlike perfectly competitive firms, which, in the long run, produce at an
output level where P = minimum ATC. Perfectly competitive markets are more
efficient, have lower prices but they produce a standardized product. If we wish to
enjoy the benefit of differentiated products, we, as a society must bear the price.
Definition: Nonprice Competition: Any action a firm takes to increase the demand for
its product, other than cutting its price; advertising, free gifts, etc.
Oligopoly:
An oligopoly market is characterized by:
1.
2.
3.
4.
Few firms
A standardized or a differentiated product
Strategically interdependent firms
Difficult entry
 Today’s music industry is an example of an oligopoly. “The Big Five,” (WMG, EMI,
Sony Music, UMG, and BMG) control over 80% of all the musical titles released in
the world.
 The market for soft drinks is also considered an oligopoly market.
 Definition: Oligopoly: A market structure in which a small number of firms are
strategically interdependent. These strategically interdependent firms produce the
dominant share of output in the market.
Economies of Scale: Natural Oligopolies

Some industries remain oligopolies due to economies of scale. When these
industries reach the output level where the long run average total cost (LRATC)
in at minimum, they have reached the minimum efficient scale.
Definition: The minimum efficient scale (MES): The level of output at which
economies of scale are exhausted and minimum LRATC is achieved.

Depicted above is the LRATC curve for a hypothetical firm. Economies of scale
cause LRATC to decrease as output increases, constant returns to scale results
in no change in LRATC as output increases, and diseconomies of scale cause
LRATC to increase as output increases. It is important to note where MES is
located. If the minimum efficiency scale for the firm depicted above is 10,000
units and 500,000 units are demanded in the market, then the market is not a
monopoly. However, if the MES for a firm is 125,000 and market demand is
500,000, then we can assume very few firms coexist in that market and the market
might be an oligopoly.
Why Oligopolies Exist:
 Reputation as a barrier: In several markets, such as the markets for soft drinks
and breakfast cereals, it is difficult for a new entrant to enter the market when a
natural oligopoly already exists due to the loyalty consumers’ exhibit to well
advertised and established brands.
 Strategic barriers: Oligopolists often use strategies to keep out potential
competitors.
 Government-created barriers: Oligopolies commonly lobby politicians to
defend their market dominance (US Steel example).
Oligopoly Behavior:


Strategic interdependence is the essence of oligopoly
The MC = MR rule, as we used it for other types of markets, is largely invalid in
the analysis of oligopoly.
The Game Theory Approach:
Definition: Game theory: An approach to modeling the strategic interaction of
oligopolists in terms of moves and countermoves.
 Firms do not know which response its rivals will make
 The firm needs to be able to measure the effect of each possible response (this
becomes difficult when many firms are at “play”); therefore the fewer firms at
play the better estimate
 How well do “players” control the game?
1. Every game depends on the number of players—they greater the number of firms
the more difficult it becomes to anticipate the next move.
2. The firms with the larger amount of cash will better be able to fund advertising,
research, or development.
3. Brainpower: the degree to which the firm understands the market they are
playing.
The Prisoner’s Dilemma:
Definition: Payoff Matrix: A table showing the payoffs to each of two players for each
pair of strategies they choose.
Jane
confesses
Jane does
not
confess
Bob confesses
Bob does not confess
Jane gets 3 years
Bob gets 3 years
Jane gets 4 months
Bob gets 4 years
Jane gets 4 years
Bob gets 4 months
Jane gets 6 months
Bob gets 6 months
 The prisoner’s dilemma is a game situation like that in an oligopoly market. In
this example Bob and Jane committed a felony punishable by up to 4 years in
prison. The prisoner’s dilemma focuses on the non-cooperative strategy Bob and
Jane pursue when arrested and placed in separate rooms. The police tell Bob and
Jane separately that if they confess and their partner in crime does not, they will
get 4 months in jail and their partner will get 4 years. At the same time both Bob
and Jane recognize that if they both confess they will each get 3 years. However,
if Bob and Jane trusted each other (colluded) they would both only serve 6 month
sentences.
Definition: Dominant strategy: A strategy that is best for a firm no matter what strategy
its competitor chooses.
Simple Oligopoly Games:
Definition: Duopoly: An oligopoly market with only two sellers
When is cheating likely?
1. Difficulty in observing other firm’s prices: in markets where it is difficult for
firms to monitor the prices charged by their competitors.
 Retail auto sales
 Retail jewelry sales
2. Unstable market demand: Often in markets in which prices are constantly
changing it is more difficult to evaluate firms’ actions.
3. A large number of sellers: Cheating will often go undetected in larger markets.
Resource Economics
Definition: Product markets: Markets in which firms sell goods and services to
households or other firms. In product markets, households demand the products and
firms supply them.
Definition: Factor markets: Markets in which resources—capital, land, labor, and
natural resources—are sold to firms. In factor markets, firms demand land, labor, and
capital and households are the suppliers.
Competitive Labor Markets:
Definition: Perfectly competitive labor market: A market with many indistinguishable
sellers of labor and many buyers, and that involves no barriers to entry or exit.
A labor market is considered perfectly competitive if it satisfies three conditions:
1. There are many buyers (firms) and sellers (households) of labor in the market.
2. All workers in the market appear the same to firms.
3. There are no barriers to entering or leaving the labor market.
Firms in Labor Markets:

The demand side of a labor market includes all firms hiring labor in that market.
These firms may, but do not necessarily, compete in the same product market.
Therefore product markets and labor markets do not always have the same
constituents. For example:
 Volvo uses the Swedish labor market to manufacture their vehicles for
sale in the US product market. GM uses the US labor market to
manufacture their cars and sells them in the US product market.
Demand for Labor by a Single Firm:
Definition: Derived demand: The demand for an input that arises from, and varies with,
the demand for the product it helps to produce.
 The demand for labor is a derived demand—it arises from, and will vary with, the
demand for the firm’s output. Therefore the demand for labor for a firm will increase
when the demand for their product increases, and vice versa.
Goals and Constraints:
 In competitive labor markets, each firm is a wage taker: it takes the market wage rate
as a given. The firm in a competitive labor market has no choice about what rate to
pay, but can only decide how many workers to hire at the going wage for its labor.
The firm (hiring in a perfectly competitive labor market) faces three constraints:
1. Its technology:
 Determines how much output the firm can produce with each quantity of
labor.
2. The market price:
 The product market tells the firm how much it can sell its output for.
3. The market wage rate:
 The labor market tells the firm how much it must pay each worker.
The firm’s Employment Decision When Only Labor is Variable:
Marginal Revenue Product:
Definition: Marginal revenue product: The change in revenue from hiring one more
worker. The marginal revenue product (MPR) of labor is the change in total revenue
from hiring one more worker. Mathematically, MRP is calculated by dividing the change
TR
in total revenue ( TR ) by the change in employment ( L )  MRP 
L
Recall: Marginal Product of Labor: The additional output produced when one more
worker is hired
(1)
(2) Total
(3)
(4) Price
(5) Total
(6)
(7) Wage
Quantity
product
Marginal
per unit
revenue
Marginal
(W)
of Labor
(quantity) Product of
Revenue
Labor
Product
(MPL)
(MRP)
0
0
$4
$0
30
$120
$60
1
30
$4
$120
60
$240
$60
2
90
$4
$360
40
$160
$60
3
130
$4
$520
31
$124
$60
4
161
$4
$644
23
$92
$60
5
184
$4
$736
12
$48
$60
6
196
$4
$784
6
$16
$60
7
200
$4
$800







Column (1):
Column (2):
Column (3):
Column (4):
Column (5):
Column (6):
Column (7):
The number of workers hired
The quantity produced each day
Marginal product of labor (MPL)
Price per unit (constant at $4)
Total revenue (Price*quantity)
Marginal revenue product of labor
Wage
 When output is sold in a competitive market, the MRP can be calculated
by multiplying the marginal product of labor by the price of output: MRP
= MPL * P Recall that marginal product of labor (MPL) is the rise in
output when a firm hires another worker—therefore MPL * Price (P) will
be the corresponding increase in revenue.
 Notice how the MRP values in column (6) rise and then fall—we have come to
expect increasing returns to labor (or rising MPL) at lower levels of labor
followed by diminishing returns to labor (or declining MPL) at higher levels of
employment. Also note that with price constant at $4, MPL will have the same
behavior as MRP.
The Cost of an Additional Worker: The Profit Maximizing Employment Level:
 The marginal approach to profit states that a firm should take any action
that adds more to its revenue that to its cost. When evaluating whether or
not to hire one more worker, the profit maximizing firm uses the marginal
approach to profit. The firm must decide whether the increased revenue is
greater than the wage paid to the new laborer.
The general rule:
 Hire another worker when MRP>W, but not when MRP<W. Note in the
table above that revenue increases by $120 (MRP) and costs increase by
$60, the amount paid as wage (W). Clearly revenue (MRP) is greater
than costs (W) MRP>W, thus hiring an employee allows the firm to
profit. Note that MRP>W continues until the firm hires the sixth laborer,
where MRP<W. Therefore the firm should not hire the sixth worker.
Dollars
$200
The ProfitMaximizing
Employment
Level
150
100
Wage
60
50
MRP
1
2
3
4
5
6
7
8
Number
of W orkers
 To maximize profit, the firm should hire the number of workers such that
MRP = W—that is, where the MRP curve intersects the wage line.
The Firm’s Labor Demand Curve:
 When labor is the only variable input, the downward-sloping portion of
the MRP curve is the firm’s labor demand curve, telling us how much
labor the firm will want to employ at each wage rate. The optimum level
of employment will always depend on the wage rate.
The Firm’s Labor Demand Curve
Dollars
Firm’s
Labor Demand
Curve
W1
A
W1
B
W2
n1
n2
W2
Number
of Workers
As the wage rate varies, the firm moves along its MRP curve in deciding how many
workers to hire. As a result, the downward sloping portion of the MRP curve is the
firm’s labor demand curve. It shows how many workers will be demanded at each wage
rate.
The firm’s employment decision when several inputs are variable:
 We still optimize profit by satisfying the condition that MRP =W
 With more than one variable input, the marginal product of labor and
the marginal revenue product (of labor) will depend on other inputs the
firm uses.
The firm’s labor demand curve with more than one variable input:
 When the wage rate declines inputs besides labor are demanded
 Whether the firm can vary just labor, or several inputs simultaneously,
the optimal level of employment will satisfy the MRP = W rule, and the
firm’s labor demand curve will slope downward: A decrease in the
wage rate will cause an increase in employment.
Definition: The Market Demand for Labor: The curve indicating the total number of
workers all firms in a labor market want to employ at each wage rate. It is found by
horizontally summing across all firms’ individual labor demand curves. Note that the
market demand curve slopes downward just as the individual firms’: a decline in wage
rate causes each firm to acquire more laborers and at the same time quantity demanded
increases throughout the market.
Shifts in the labor demand curve:
(a)
Typical Firm
Hourly
Wage
$10
(b)
Labor Market
Hourly
Wage
A
B
n2
Number
of Workers
B
D
D
 2d
 1d
n1
A
L2
L1
N1
N2
Number
of Workers
 A change in the wage rate will cause a move along a labor demand curve
 When something other than wage rate changes the labor curve will shift
 The following would cause a shift from 1d to 2 d :
1. Advances in technology
2. Lowering in the prices of inputs
3. Increase in price of output
 Will all cause the individual firm’s demand for labor to increase
A Change in the price of the Price of Firm’s Output
Recall:
 Demand for labor will increase when the demand for a firms outputs increases
(demand for labor is a derived demand)
 MRP = P * MPL
 A rise in selling price of a firm’s output causes MRP to be greater at each
level of employment
 The MRP curve and the labor demand curve would then shift up
and to the right. The market demand for labor increases.
Therefore:
 The effect of a change in output price on labor demand depends on
whether many firms in the labor market also share the same product
market. When they do, a rise in output price will shift the market labor
demand curve rightward; a fall in output price will shift the market
demand curve leftward.
A Change in technology/A Change in the Price of another Input:
Definition: Complementary input: An input whose utilization increases the marginal
product of another input.
Definition: Substitute input: An input whose utilization decreases the marginal product
of another input.
 When many firms in a labor market acquire a new technology, the market labor
demand curve will shift rightward if the technology is complementary with labor and
leftward if the technology is substitutable for labor. When the price of some other
input decreases, the market labor demand curve may shift rightward or leftward. It
will shift rightward if that other input is complementary with labor and leftward if the
other input is substitutable for labor. Automated phone systems are substitutable for
human operators but complementary with skilled technicians who program and
maintain the automated systems. The introduction of these new technologies shifted
the market demand for telephone operators to the left while simultaneously shifting
the market demand for the skilled technicians to the right.
Shifts in the Labor Demand Curve:
An increase in
Will cause the market labor demand
curve to:
Demand for the firm’s output
shift rightward
The price of a complementary input
Shift leftward
The price of a substitutable input
Shift rightward
The number of firms in the market
Shift rightward
Technology
If a new input is complementary with
laborshift rightward
If a new input is substitutable for
laborshift leftward
 Note that a decrease in each case above would shift the labor demand curve in
the opposite direction.
Labor Supply: Individuals as Wage Takers
 In a competitive labor market, each seller is a wage taker; he or she takes the market
wage rate as given.
Reservation Wages:
Definition: Reservation wages: The lowest wage rate at which an individual would
supply labor to a particular labor market. .
Market Labor Supply:
Definition: Labor supply curve: A curve indicating the number of people who want jobs
in a labor market at each wage rate. The higher the wage rate, the greater the quantity of
labor supplied.
Shifts in the Market Labor Supply Curve:


A movement along LS 1 in (a) from point C to point D represents a change in the wage
rate
A shift from LS 1 to LS 2 in (b) depicts an increase in labor supply in the market.
 A market labor supply curve will shift when something other than a change in the
wage rate causes a change in the number of people who want to work in a particular
market.
A Change in the Market wage rate in other labor markets:
 As long as some individuals can choose to supply their labor in two different markets,
a rise in the wage rate in one market will cause a leftward shift in the labor supply
curve in the other market.
Changes in the Cost of Acquiring Human Capital:
 An increase in the cost of acquiring human capital needed to enter a labor market—
say, due to an increase in school fees, fewer scholarships, or longer schooling
requirements—will shift the labor supply curve leftward; a decrease in the cost of
acquiring human capital will shift the labor supply curve rightward.
Population Changes:

Population growth will shift the labor supply curve rightward, and migration from
a region will shift the labor supply curve leftward.
Shifts in the Labor Supply Curve:
An increase in
Tastes for work in a market
Population
Human capital costs
Will cause the market labor supply
curve to
Shift rightward
Shift rightward
Shift leftward
The wage rate in an alternative market
Shift leftward
 Note that a decrease in each case above would shift the labor supply curve in the
opposite direction.
 The long-run labor supply curve tells us how many (qualified) people will want to
work in a labor market at each wage rate, after all adjustments have taken place.
Specifically, all those who want to acquire new skills or who want to move to another
location have done so.




The long-run labor supply response is more wage elastic than the short-run labor
supply response
The forces of supply and demand will drive a competitive labor market to its
equilibrium point—the point where the labor supply and labor demand curves
intersect.
In the short run, a shift in labor demand moves us along a short run labor supply
curve. In the long run, the resulting increase in the wage rate will cause the
short-run labor supply curve to shift as well.
Wage rates, like that prices of goods and services, act as market signals—leading
workers to move to areas where their work is most valued. When the labor
demand curve shifts, the wage rate will overshoot its long-run equilibrium value.
But as the signal begins to work, the temporary overshooting of the wage rate
subsides.
Chapter 19: International Trade
Definition: Exports: Goods and services produced domestically, but sold abroad.
Definition: Imports: Goods and services produced abroad, but consumed domestically.
Definition: Absolute advantage: The ability to produce a good using fewer resources
than another country. A country has an absolute advantage in a good when it can
produce it using fewer resources than another country.
Definition: Comparative advantage: The ability to produce a good at a lower
opportunity cost than another country. A nation has a comparative advantage in
producing a good if it can produce it at a lower opportunity cost than some other
country.
Opportunity Cost and Comparative Advantage:
Suppose that China and the United States produce only two goods: suits and computers:
Chinese currency is the yuan (CNY) and US currency is the dollar ($), we will associate
each country with its currency.
Costs of Production:
Per suit
Per computer
China
2,000 CNY
10,000 CNY
United States
$500
$1,000
 For each additional computer China produces, it has to divert 10,000 yuan’s from the
suit industry. Since each suit costs China 2,000 CNY to produce, and each computer
cost 10,000 to produce, the production of one additional computer costs China
10,000/2,000 = 5 fewer suits.
 The table below indicates the opportunity costs of suits in terms of computers
forgone and computers in terms of suits forgone for China and the United
States:
Opportunity costs:
Per suit
Per computer
China
1/5 computer
5 suits
United States
½ computer
2 suits

In China the opportunity cost of a computer is 5 suits; in the United
States the opportunity cost of another computer is just 2 suits,
therefore the US has a comparative advantage in manufacturing
computers.
 In the United States, the opportunity cost of another suit is ½ a
computer while in China the opportunity cost of another suit is just 1/5
a computer, thus China has a comparative advantage in producing
suits.
Specialization and World Production
Using the table above we know;
 If China produces 10 more suits it would have to sacrifice the production of 2
computers (recall China has a comparative advantage in producing suits).
 If the United States produced 4 more computers it would have to forgo producing
8 suits (recall the US has a comparative advantage in producing computers).
A small change in production
Suit Production
China
+10
United States
-8
World
+2

Computer Production
-2
+4
+2
In this example, China and the United States each specialize production in
products in which they hold a comparative advantage. If countries specialize
according to comparative advantage, a more efficient use of given resources
occurs. That is, with the same resources, the world can produce more of at least
one good, without decreasing production of any other good.
Gains from International Trade:
 As long as opportunity costs differ, specialization and trade can be beneficial to
all involved. This remains true regardless of whether the parties involved are
nations, states, counties, or individuals. It remains true even if one party has an
all around absolute advantage or disadvantage.
The Gains from Specialization and Trade
Production
Loss from Exports
(-) or gain from
imports (+)
China:
Suits
+10
-9
Computers
-2
+3
United States:
Suits
-8
+9
Computers
+4
-3
Net gain
+1
+1
+1
+1
The Terms of Trade:
Definition: Terms of trade: The ratio at which a country can trade domestically
produced products for foreign-produced products.
 For example (using the data above): note that China imports 3 computers
in exchange for 9 suits. The 9/3 ratio defines terms of trade.
Turning Potential Gains into Actual Gains:
Definition: Exchange rate: The amount of one currency that is traded for one unit of
another currency.
Prices in China and the United States with an Exchange Rate of 8 CNY for $1
Per suit
Per computer
China
2,000 CNY ($250)
10,000 CNY ($1,250)
United States
$500 (4,000 CNY)
$1,000 (8,000 CNY)

Now you can clearly see that a suit produced in China costs (USD $250) less than
a suit produced in the United States (USD $500). Therefore Americans will
prefer to buy suits from China.
 On the other hand, a computer produced in China costs 10,000 CNY while a
computer produced in the United States will only cost 8,000 CNY. Therefore
China will prefer to buy computers from the United States.
 When consumers are free to buy at the lowest prices, they will naturally buy a
good from the country that has a comparative advantage in producing it. That
country’s industries respond by producing more of that good and less of other
goods. In this way, countries naturally tend to specialize in those goods in which
they have a comparative advantage.
The Sources of Comparative Advantage:
 Countries often specialize in products based on their own particular endowments
of natural resources. But natural resources are not the only basis for
comparative advantage.
Country
Specialty resulting from Natural
resources or Climate
Saudi Arabia
Oil
Canada
Timber
United States
Grain
Spain
Olive oil
Mexico
Tomatoes
Jamaica
Aluminum ore
Italy
Wine
 Countries often develop strong comparative advantages in the good they have
produced in the past, regardless of why they began producing those goods in the
first place.
Country
Japan
United States
Switzerland
Korea
Hong Kong
Great Britain
Specialty not resulting from Natural
resources or Climate
Cars, consumer electronics
Software, movies, music
Watches
Steel, ships
Textiles
Financial services
Objections to Free Trade
China
United States
Price
(Dollars)
Price
(Dollars)
Supply
F
P'
N
Supply
PT
P
N
B
A
P
C
D
T
E
Q 2 QN
Demand
Demand
Quantity
Q
of Suits
3
Q’ Q’
2
N
Q’
3
Quantity
of Suits
Before trade, the Chinese suit market is in equilibrium at point E, and the U.S. market is
in equilibrium at point F. When trade begins, Americans buy the cheaper Chinese suits,
driving up their price. In response, Chinese manufacturers increase output, and Chinese
consumers decrease their purchases. At the world equilibrium price PT, the Chinese buy
Q2 suits, American buy Q3 – Q2 Chinese suits, and the total quantity of Chinese suits
produced and sold is Q3, distance CD, which shows US imports of suits, equals distance
AB, which shows Chinese exports.
As a result of trade, Chinese suit makers sell more units at a higher price, but Chinese
consumers pay more for their suits. In the United States, suit makers are worse off, but
suit buyer’s benefit from the lower price.
The Impact of Trade in the Exporting Country:
 In our example above, we see that free trade in suits benefits Chinese suit
producers and workers, but Chinese suit buyers are worse off.
 When the opening of trade results in increased exports of a good, the
producers of the good are made better off and will support increased
trade. Consumers of the good will be made worse off and will oppose
increased trade.
The Impact of Trade in the Importing Country:
 In our example above, we saw that free trade in suits harms the U.S. suit
producers and workers, but US suit buyers are better off. Why?
 When the opening of trade results in increased imports of a product, the
domestic producers of the product are made worse off and will oppose the
increased trade. Consumers are better off and will favor the increased
trade.
How Free Trade is Restricted:
Definition: Tariff: A tax on imports.
 In the country that imposes the tariff, producers gain and consumers lose:

Tariffs decrease the volume of trade and

Therefore decrease the gains from trade
Tariffs
China
United States
Price
(Dollars)
Price
(Dollars)
Supply
Supply
K
P3
B
A
PT
P2
PT
H
C
L
D
J
Demand
Demand
Quantity
of Suits
Quantity
of Suits
A US tariff on imports of Chinese suits raises their price in the U.S. from PT to P3. As a
result of the price increase, US imports fall to KL, which equals Chinese exports of HJ.
With fewer suits produced, the price in China falls to P2.
Definition: Quota: The limit on the physical volume of imports.


Reduces the volume of trade
Raises the domestic prices of imported goods
Myths about Free Trade:
1. “A high wage country cannot afford free trade with a low wage country.”

More developed countries (US) have higher wages than their less developed
counterparts (China). Therefore it may seem that the poorer countries can
charge lower prices for their goods and that their work will displace the
American workers in their field. This is incorrect for two reasons:
1) American workers are more productive than Chinese workers. It is
particularly important to observe the productivity per person in
each country in comparison to their wage. If a typical American
can produce 80 times as much as his Chinese counterpart, but the
American earns 50 times as much, then the per unit cost in
America still is lower.
2) Now suppose China could produce everything at a lower cost than
America. Both countries could still gain from free trade if China
specialized in products in which its cost advantage was relatively
large and the United States specialized in goods in which China’s
cost advantage was relatively small. China would have an
absolute advantage in everything, but the United States would still
have a comparative advantage in some things. The mutual gains
arise not from absolute advantage, but from comparative
advantage.
2. “A low-productivity country cannot afford free trade with a high productivity
country.”

Could a less developed country be harmed by trade with a richer country?
Be sure to know the differences between absolute and comparative
advantage. Assume the United States could produce every good at a
lower resource cost than China. Although the United States would have an
absolute advantage in the production of every good, China would still
have a comparative advantage in some goods.

Closing off trade will make a nation, as a whole, worse off, regardless of
its level of wages or productivity.
3. “In recent times, America’s unskilled workers have suffered because of everexpanding international trade.”

A college education now plays an important role in the US labor market.
Many unskilled workers with only a high school education have lost their
jobs in the last two decades. Increased trade with low wage countries has
been blamed for this trend.
 Economists who have looked at the relation between changes in trade
patterns and the depressed earnings of unskilled American workers
have concluded that foreign trade is a small contributor.
Protectionism
Definition: Protectionism: The belief that a nation’s industries should be protected from
foreign completion.
 Production is most likely to reflect the principle of comparative advantage when firms
can obtain funds for investment projects and when they can freely enter industries
that are profitable. Thus, free trade, without government intervention, works best
when markets are working well.