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3AECO - Free Trade and Protection
2.
Free Trade and Protection
Objectives:
 outline the significance of trade for the Australian economy.
 outline the sources of comparative advantage.
 demonstrate and explain the gains from specialisation and trade using the models of demand and supply
analysis and/or opportunity cost.
 identify different forms of protection.
 demonstrate and explain how the main types of protectionist policies operate including tariffs and
subsidies.
 evaluate the arguments for protection and trade liberalisation.
 outline the influence of trade agreements, organisations and blocs on world trade.
REASONS FOR TRADE
International Trade and the Circular Flow
Imports of goods and services
Firms
Households
Payments for imports
Exports of goods & services
Investment flow
Payments for exports
Savings flow
Finance market
Australian investment overseas
Income from overseas investment &
transfers
Taxation
receipts
Government
spending
Public sector
INTERNATIONAL
ECONOMY
More than 50 times
the size of the
Australian economy
Foreign investment in Australia
Income to foreign investors & transfers
DOMESTIC ECONOMY
Australia is a small open economy dependent on international trade for its living
standards. The removal of tariffs and other trade barriers has made Australia and
the world economy much more interdependent (economically integrated) and
Australia more trade-oriented. This process has been going on around the world for
the past thirty years and is called GLOBALISATION.
REASONS FOR INTERNATIONAL TRADE
No country is capable of being totally self-sufficient, because no country has all the
resources needed to satisfy all its needs and wants. Nations rely on each other to
supplement domestic production and increase their consumption possibilities.
Countries need to produce surpluses which can be sold overseas.
Resources are unevenly distributed globally in terms of quantity and quality due to:
i) climatic and topographical differences
ii) minerals and soils
iii) technology and labour.
A country’s factor endowments determine what it exports and imports. Nations
with open economies, ie. encourage export growth and have fewer import
restrictions, enjoy higher rates of economic growth and more rapidly rising living
standards than countries which don’t. Freer trade allows consumers in an open
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economy to gain access to the factor advantages of other economies. Countries with
strong economic growth tend to be countries which are most open to trade.
Factors of production exist in different proportions between countries so that they
produce the goods and services best suited to their factor endowments. Cost
differences between countries reflect these factor differences and determine
specialisation. Therefore countries are better off trading with each other and
specialising in producing things which cost the least to produce in real terms (ie
have the lowest opportunity cost) and trading the surplus for things which other
countries can produce more cheaply. This is called international specialisation. The
benefits show that a country should specialise in goods and services that it has a
real cost or opportunity cost advantage in over other countries. However for
countries to benefit from free trade, trade barriers have to come down.
Free or freer trade:
 is a major component of globalisation.
 increases economic opportunities.
 raises standards of living.
 offers consumers the most choices.
 encourages competition prompting companies to develop new and better products
encourages innovation in production and technology.
 competition and innovation results in lower prices and higher quality products
which benefits consumers.
Think about the role of culture too. Economic
potential depends on how well a country uses its
resources or deals with the problem of resource
deficiencies. How liberal or repressive its
culture is will have an important bearing on its
capacity to do this.
STUDENT ACTIVITY 2.1
STUDENT ACTIVITY 5.1
1. Group discussion: In groups of four brainstorm the consequences of nations not
trading with each other. In what circumstances would nations not trade with each
other?
2. Group discussion: Next to the examples of countries on the next page, list their
factor advantages which illustrate the above ideas supporting international trade.
Use the chart on the next page. The first country is done as an example.
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Countries
Australia
Factor Endowments
Natural resources such as minerals, agricultural land, tourist sites, skilled
labour force, advanced technology, free enterprise and democratic culture.
Japan
Saudi Arabia
USA
Indonesia
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ABSOLUTE AND COMPARATIVE ADVANTAGE
To understand the previous section clearly, the principles of absolute and
comparative advantage need to be understood.
Absolute Advantage: Absolute advantage occurs when an economy produces more
of a product than another economy by using its resources more efficiently (fewer
resources are used per unit of output, ie. the productivity of inputs is higher).
Comparative Advantage: A country may or may not have an absolute advantage
in the production of all goods and services but will still benefit from trade if it is
relatively more efficient at producing a product than another country. This means it
must have a lower opportunity cost in the production of a particular product than
another country. If it does then it has a comparative advantage in the production of
that product.
The concept of opportunity cost is the basis of comparative advantage,
specialisation and trade.
The Model of Comparative Advantage
The following example illustrates the concept of comparative or opportunity cost
advantage.
Assumptions:
2 countries - X and Y
2 products - A and B
labour is the only input
no artificial barriers to trade exist
constant costs and returns on inputs
Country
Output per worker
Product A
Product B
Country X
50
30
Country Y
20
40
This means in
country X each
worker can produce
50A or 30B and
country Y can
produce 20A or 40B.
Step 1 - Identify absolute advantage and Production Possibility Frontiers
a) X has an absolute advantage in A.
b) Y has an absolute advantage in B.
From here we can construct PPFs for X and Y on the following axes. Assume each
country has 10 workers and costs are constant, ie as resources are shifted between
A & B production, returns remain the same. Before specialising and trading with
each other, countries X and Y can produce anywhere on or within their PPFs. The
consumption and production possibilities within each country are constrained by
resource endowments. If country Y wants to devote 5 workers to A production and
5 workers to B production, the most that can be produced and consumed is 100A
and 200B. In country X, 5 workers allocated to each of industries A and B would be
limited to an output of 250A and 150B.
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By allocating half their resources to each product, total world production
would be 350A and 350B.
500A
Country X
250A
200A
Country Y
100A
150B
300B
200B
400B
For every worker shifted from A production to B production.
a) Country X gives up 50 units of A and gains 30 units of B.
b) Country Y gives up 20 units of A and gains 40 units of B.
Now revise step 1 before you proceed to steps 2 and 3 which you are to complete
yourself.
Step 2 - Calculate opportunity costs (ie. comparative advantage) &
specialisations in each country
a)
or
b)
or
c)
or
d)
or
The opportunity cost of a worker in X producing 1 unit of A is 300/500 units of B
1A = 0.6B.
The opportunity cost of a worker in Y producing 1 unit of A is 400/200 units of B
1A = 2B.
The opportunity cost of a worker in X producing 1 unit of B is 500/300 units of A
1B = 1.67A.
The opportunity cost of a worker in Y producing 1 unit of B is 200/400 units of A
1B = 0.5A.
Step 3 - State comparative advantage and specialisations based on
opportunity costs in each country.
a) X has a comparative advantage in the production of A
b) Y has a comparative advantage in the production of B
c) Therefore X should specialise in A (produce 500A) and Y should specialise in B
(produce 400B)
Step 4 - Decide on a ratio of exchange (Terms of Trade) first and then
calculate gains from trade in each country.
The ratio of exchange, (ie. how much of one product trades for the other product
between the two countries), must lie between the opportunity costs of producing one
product in terms of the other product in each of the countries for them to benefit from
trade.
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Assume the ratio of exchange (terms of trade) is 1A = 1B (which lies between the
opportunity costs of producing each good in each country). Check it out referring to
the opportunity costs you calculated in step 2. (ie 2B > 1A > 0.6B)
Calculate gains from trade per unit of product traded for each country:
Country X gains 0.4B for each unit of A it trades.
Country Y gains 0.5A for each unit of B it trades.
So both countries are better off by specialising and trading with each other.
If we use the diagrams on the previous page, we can locate new consumption
combinations of A and B for each country. If we assume We can do the same on the
diagram for country Y at point N and shade in the gains from trade on each
diagram.
500 A
300 A
If we assume that country X specialises in A and
produces 500A but wants to consume 300A then
it has a surplus of 200A to trade. Each 1A trades
for 1B, therefore 200A trades for 200B so given
this assumption, country X’s new consumption
combination is at point M (300A, 200B). A line
drawn from the specialisation end of the PPF
through point M to the x-axis traces all the
possible consumption possibilities of products A
and B. Any point on this CPF is an alternative
consumption choice. The important thing to note
is that any point on the CPF is outside the PPF
therefore represents improved material living
standards. It is only possible to consume more
than is produced domestically by entering into
trade and accessing the resource advantages of
other countries.
Country X
M
120B 200B
300 B
In the case of country Y, it too is better off as
represented by point N on its CPF. If it specialises
in B in which it has a comparative or opportunity
cost advantage, decides to consume half of its B,
it can trade its surplus of 200B for 200A (at a
trade ratio of 1A=1B). The shaded boxes in each
diagram represent the gains from trade given
each countries’ consumption preference of its
specialised product.
Country Y
200 A
N
100 A
400 B
200B
In our simple 2 country world model, the world is
better off when specialisation and trade occurs.
Total world production after trade is 500A and 400B which is a better result
than the before trade world output (see step 1)
Both countries are better off. This shows trade is a substitute for factor deficiencies and
allows economies to achieve higher living standards (consumption possibilities at M and
N) than would be possible under self-sufficiency (production possibilities).
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What if the production figures are as follows? What do you notice?
Country
X
Y
Country Output per Worker
Product A
Product B
50
30
10
20
Country X has an absolute advantage in both products A and B! Both countries
have the same opportunity cost ratios as before therefore nothing has changed in
terms of what each should specialise in. Country X should still specialise in A
production and Y should specialise in B production. Country X should trade its
surplus of A output for more than 0.6 units of B for each unit of A and Country Y
should pay less than 2 units of B for each unit of A it purchases otherwise neither
country will benefit from specialisation and trade.
The terms of trade ratio of 1A = 1B achieves this.
STUDENT ACTIVITY 2.2
1. In a group of four brainstorm the weaknesses of this model of comparative
advantage. Choose a leader and report back to the whole class.
2. The table below shows the annual production possibilities for two commodities,
Trucks (T) and Boats (B), that can be produced with a given stock of resources in
two countries, Country A and Country B.
Country
A
B
Trucks
80
60
Boats
80
30
This means country A can produce 80 T or 80 B using its resources and country B
can produce 60T or 30B using its resources.
a) Which country has an absolute advantage in Trucks? _______________
b) Which country has an absolute advantage in Boats? _______________
c) Calculate the opportunity cost of 1 Truck and 1 Boat in Country A and Country B.
Country A: 1 Truck = ____________ and 1 Boat = ____________
Country B: 1 Truck = ____________ and 1 Boat = ____________
d) Which country has the comparative advantage in Trucks? _______________
e) Which country has the comparative advantage in Boats? _______________
f) If each country specialised in its comparative advantage
A would produce ________________ B would produce ________________
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g) Using a pencil draw the production possibility curves for country A and B on the
axes below.
Place Trucks on the vertical (Y) axis and Boats on the horizontal (X) axis.
Country A
Country B
h) Assume terms of trade is 1 truck = 0.8 boat (ie. 1B = 1.25 T). The TOT must be
between the opportunity costs of both countries, ie. TOT must lie between country
A’s 1T = 1 B and country B’s 1T = 0.5 B).
If country B consumes half of its output and trades its surplus with country A, how
many _______________________ will it get in exchange?
Answer: _______________________
i) Locate B’s consumption combination on your diagram for country B. Label the
point R.
j) What would country A’s consumption combination be?
Answer: ___________ Trucks and ___________ Boats.
Locate this point on your diagram for A. Label it S.
k) If country A sells its surplus it will be better off by _________________ for every
boat it sells to country B which will benefit by _________________ for each truck it
sells to country A.
Brainteaser for homework: What can you say about the consequences of changing
the TOT? What would the gains from trade for each country be if the terms of trade
were 1T = 0.7B?
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3.
MULTIPLE CHOICE QUESTIONS
3.1. The basic reason for international specialisation and trade is that different
countries
have different:
(a) currencies.
(b) per capita incomes.
(c) resource endowments.
(d) factor mobilities.
3.2. Country M is said to have a comparative advantage over country N in the
production of sugar when:
(a) N uses less capital in sugar production than M when capital is the only
resource.
(b) M uses less labour in sugar production than N when labour is the only
resource.
(c) the opportunity cost of sugar production is lower in M.
(d) the money cost of sugar production is higher in N.
Questions 3.3 – 3.5 refer to the following table which shows the output of DVD
recorders and
television sets in countries A and B using the same quantity of resources.
Product
DVD recorders
TVs
Country A
80
20
Country B
100
50
3.3. Country A has an absolute advantage in the production of:
(a) DVD recorders only.
(b) TVs only.
(c) both products.
(d) neither product.
3.4. The opportunity cost of one DVD recorder in country B is:
(a) 0.5 TVs.
(b) 2 TVs.
(c) 1.25 TVs.
(d) 4 TVs.
3.5. Country A has:
(a) a comparative advantage in the production of TVs.
(b) a comparative advantage in the production of DVD recorders.
(c) more resources devoted to DVD recorder production than country B.
(d) lower production costs per unit of output than country B.
3.6. According to the theories of comparative advantage and absolute advantage
(a) if a country has an absolute advantage in a good, it also has a
comparative advantage in the good.
(b) if a country has a comparative advantage in a good, it cannot have
absolute advantage in the good.
(c) a country can have a comparative advantage in a good at the same time
that it has an absolute advantage in the good.
(d) a country with an absolute advantage in all goods cannot gain from trade.
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3.7. Examine the PPF models for country A and B.
60 cars
50 cars
50 iron ore
80 iron ore
i) Country A should specialise in cars and export iron ore.
ii) Country B should import cars and export iron ore.
iii) Country A should import cars and export iron ore.
iv) Country B has a comparative advantage in cars.
v) Country A has a comparative advantage in cars.
vi) Country B should export both cars and iron ore.
Which of the following pairs of statements are correct?
(a) i) and iv)
(b) ii) and v)
(c) i) and iii)
(d) iv) and v)
3.8 Refer to the table below which shows the production possibilities for Australia
and Japan producing wheat and steel.
Australia
Japan
Wheat
200
100
Steel
X
200
For which value of X is the following correct?
a) If X is less than 200, Australia has an absolute advantage in the
production of both wheat and steel.
b) If X is greater than 200 and less than 400, Australia has a comparative
advantage in the production of steel.
c) If X is equal to 400, Australia has an absolute and comparative
advantage in the production of wheat.
d) If X is equal to 200, Australia has a comparative advantage in the
production of wheat.
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THE BENEFITS OF FREE TRADE – Using Supply and Demand Analysis
First some revision - THE CONSUMER AND PRODUCER SURPLUS
Consumer Surplus
Price
Consumer surplus: area above the market price (Pe) to the left of
the demand function. Anywhere on the D function is a higher price
the consumer is prepared to pay for the product. The difference
between these higher price points and the market price Pe is called
the consumer surplus. As the consumer buys more (movement down
the D function) this difference diminishes, ie net consumer benefit
falls until it reaches zero at Pe.
S
Pe
D
0
Q
Qe
Producer Surplus
Producer surplus: is the area below the
market price (Pe) to the left of the supply
function. At 0Qe the cost of producing the
last unit of output (the marginal or
additional cost of the last unit or MC) is
equal to the price received. The price
received for that last unit of product
(called marginal revenue or MR) = the
cost of making it, ie MR = MC. At lower
levels of production (lower points on the S
function), the cost of making each unit of
output is lower but the price received is Pe,
MR > MC ( P > MC). This difference
diminishes as output rises until at Pe, P =
MC. This difference between the cost of
making each unit of output and Pe is
called the producer surplus. At Pe is is
zero.
Price
S
Pe
D
0
Q
Qe
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What happens to the consumer and producer surplus when trade takes
place?
In the case of exports:
Exports occur when a domestically produced product has a comparative advantage
over the same product produced in other countries. This means the after trade
world price for the product is higher than the domestic price before trade. In terms
of our simple S and D model:
Consumer surplus: area
above the price line to the left
of the demand function is
smaller because the world
price (Pw) is higher than the
domestic price (Pd).
Price
Sd
Net gains from trade (the dark
triangle area) – in the case of exports,
this is part of the producer surplus. The
net gains from trade accrue to
producers while consumers must now
compete with foreign consumers and
pay a higher price for goods now
traded in the global market place. So
not only have exporting firms gone
global but so have consumers.
Pw
Producer surplus: area below
the market price (Pd) to the
left of the supply function
increases with the higher
world price (Pw). Domestic
firms expand production (to
0Qw) in response to the
higher price resulting from
higher world demand (Dw).
Pd
Dw
Dd
Exports
Quantity
0
Qw
Qd2
Qd1
Local firms increase output to meet global
demand (to 0Qw) but domestic demand
contracts (to 0Qd2) due to the higher price.
A port scene – notice the port infrastructure for loading and
unloading container ships
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In the case of Imports:
Imports occur when a product produced overseas has a comparative advantage
over the same product produced domestically. This means the after trade world
price for the product is lower than the domestic price before trade. In terms of our
simple S and D model:
Consumer surplus: the consumer
surplus increases as the price falls to the
world price Pw. So the consumer surplus
is the total area above Pw to the left of
the D function. Consumers benefit from
cheaper goods – lower priced imports
and local rival goods which are forced
by competition to reduce prices – and a
greater variety of goods on offer (more
choice).
Price
Net gains from trade (the dark triangle area) – in the case
of imports, this is part of the consumer surplus. The darker
area represents the net gain in the surplus. The net gains
accrue to consumers while producers must now compete
with foreign firms and lower prices for their goods which
are now traded in what is part of the global market place.
Domestic import-competing firms really have to go global
if they are to survive.
S
Pd
Pw
Producer surplus: the producer
surplus decreases as the price
falls to the world price Pw. As
supply contracts to Qs, domestic
output by local firms falls as
does employment in those
industries.
D
Imports
Quantity
0
Qs
Qd1
Qd2
With free trade consumers benefit from the lower price
(Pw) so consumption rises from 0Qd1 to 0Qd2. More
competitive imports take market share from less
competitive local firms and their production falls.
The Net Gains from Trade are represented by the darker triangle area in each
diagram. The net gain in the surplus (producer in the case of exports and consumer
in the case of imports) is the rationale for free trade.
A container ship
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Economic Model 1 – the Export Model: When domestic producers enjoy a
comparative advantage they export their product
World price (Pw) > Domestic price (Pd)
Price
Domestic consumption
Domestic production
Sdomestic
Pw
Pd
Ddomestic
Domestic
consumption
0
Exports
Qd
Qe
Quantity
Qs
At Pd: Total output = domestic demand (before trade)
At Pw: Total output = domestic demand + exports (after trade)
Total revenue to the domestic industry = Pw x 0Qs
Export revenue = Pw x (0Qs – 0Qd)
Gains:
1. Exporting firms benefit – receive a higher price on world market → expand
production (0Qe → 0Qs) → profits rise.
2. Employment increases in exporting industries – exporting firms employ more
factors of production (suppliers of inputs benefit eg workers – more
employment and higher wages).
3. Rising income in exporting firms due to more revenue → higher wages and
dividend payments to shareholders.
4. Rising income from export revenue → more spending (AD rises) → economy
expands → more employment and income growth generally – initial benefits
to exporting industries spread through the economy.
5. Exporting firms face global competition → incentive to innovate and invest in
new technology and human capital (training and education) → higher
productivity which benefits whole economy including non-exporting firms.
Losses:
1. Consumers must pay higher price for product (Pw) → consumption contracts
(0Qe → 0Qd) → purchasing power falls.
2. Rising demand for inputs by exporting firms → upward pressure on input
prices may occur → costs of production in non-exporting firms rise → falling
profitability ceteris paribus (eg labour demand increase → labour scarcity rises
→ wages rise across economy). Rising productivity in exporting firms may offset
this effect to some degree.
3. Rising export income → income distribution disparities may worsen across
economy – ie bigger gap between incomes in successful export oriented firms
and non-exporting firms. Income distribution inequalities may worsen.
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Economic Model 2 – the Import Model: When foreign producers enjoy a
comparative advantage Australia imports their product.
World price (Pw) < Domestic price (Pd)
Price
Sdomestic
Before trade level of
domestic supply & price
Pd
Domestic Consumption
Pw
Ddomestic
After trade level of
domestic production
Imports
O
Quantity
Qs
Qe
Qd
At Pd:
Total output = domestic demand (before trade)
At Pw: Total output = domestic demand + imports (after trade)
Total revenue to domestic industry = Pw x 0Qs
Total import cost = Pw x (0Qd – 0Qs)
Gains:
1. Consumers benefit from lower price Pw (increased consumer welfare) →
demand expands (bigger market).
2. Real income (purchasing power) increases.
3. Other industries benefit from higher consumer real income → economy
expands increasing employment.
4. Domestic firms in this market reduce output → demand for inputs falls
releasing resources for other parts of economy → downward pressure on
factor prices (ceteris paribus) which improves the international
competitiveness of exporting firms and the economy in general.
Losses:
1. Employment in this market declines as domestic firms reduce production.
2. Economy may lose an industry of national or cultural significance.
3. Retraining and re-employing displaced labour may be difficult and costly.
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