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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 1 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 2 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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 3 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 4 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 5 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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). 6 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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 ________________ 7 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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? 8 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 9 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 10 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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 11 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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 12 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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 13 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 14 Free Trade and Comparative Advantage 3AECO - Free Trade and Protection 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. 15 Free Trade and Comparative Advantage