Download Ch9

International Trade and Trade
Policy
Applying Comparative Advantage
and Supply and Demand
Chapter 9
Major Issues
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Why trade with other nations (regions)?
Recognizing comparative advantage
Benefits and costs
Effects of tariffs, quotas, and other
impediments to trade
• Subsidies as alternative to tariffs or quotas
Why Trade?
• Take advantage of specialization and
division of labor
• Not much controversy among economists
over the benefits of free trade in the long
run. Consider the U.S or the European
Union.
• Controversy arises about moving to freer
trade or putting restrictions on trade,
because these changes generate winners and
losers.
Principle of Comparative
Advantage (CA)
• The producer who has the smaller
opportunity cost of producing a good is said
to have a comparative advantage in
producing that good compared to other
producers.
• Applies to regions and countries as well as
individuals and firms.
• Some examples: Eastern Kentucky and Bluegrass,
– Colorado and Iowa, U.S and Haiti
– U.S. and Mexico, U.S and Japan
Applying CA to Regions
• In the same way that Mike and Paddy were
able to increase total output by specializing
according to the principle of CA, so also
can regions increase joint output through
their people following CA.
Gains from Specialization
• Country A can produce 24 units of nuts and
zero coffee or zero nuts and 12 units of
coffee or any combination in between. The
reverse is true in Country B.
• If country A produces one less unit of
coffee, it can produce two more units of
nuts. If country B produces one less unit of
nuts, it can produce two more units of
coffee. Result: one more unit of nuts and
one more unit of coffee available for
consumption!
PPF when OC Varies Continuously
PPF for a Small Island Nation
How Trade Expands the Consumption Menu
IT and Supply and Demand
• What happens in the market for a good
when a country goes from autarky to free
trade in the good?
• How do trade restrictions such as a tariff or
a quota affect the equilibrium in the market
for a good?
A Classic Case: The Corn Laws
• United Kingdom passed a law in 1815
banning the importation of grain, including
wheat. The law was repealed in 1846.
• In 1846, the wheat market in Great Britain
went from autarky to free trade.
Autarky in the wheat market
Assume:
– The country’s wheat market is isolated in that
there is no trade in wheat with the rest of the
world.
– The market for wheat consists of the buyers and
sellers of the country.
– Domestic Price adjusts to balance Demand and
Supply.
United Kingdom Market in Wheat
under Autarky
12
S
10
$
p
e
r
u
n
i
t
8
6
4
D
2
0
0
10
20
30
40
Quantity
50
60
70
80
Equilibrium Without Trade
• When an economy cannot trade in world
markets, the price adjusts to equilibrate
domestic supply and demand.
• Equilibrium price of $8 and quantity of 30.
• Consumer (buyer) surplus: (12-8)30/2=60
• Producer (seller) surplus: (8-2)30/2=90
• TOTAL SURPLUS OR economic benefit:
150
Impacts of International Trade
• If the country decides to engage in
international trade will it be an importer or
exporter of wheat?
• Who will gain from free trade in wheat and
who would lose?
• Will gains from trade exceed losses?
Determinants of IT
If a country has a comparative advantage
relative to other counties, then the domestic
price will be below the world price and the
country will be an exporter of the good.
If the rest of the world has a comparative
advantage, then the domestic price will be
higher than the world price and the country
will be an importer of the good.
International Trade Example Importer
• Since the world price of wheat is lower than the
U.K. price, the U.K would be an importer of wheat,
when trade is permitted.
– U.K consumers will want to buy the lower priced wheat
at the world price.
• U.K producers of wheat will have to lower their
output until the supply price is equal to the world
price.
United Kingdom Market in Wheat
with Free Trade
12
$
p
e
r
S
10
8
6
World price
D
4
u
n
2
0
0
10
20
30
40
Quantity
50
60
70
80
Free IT: Winners and Losers
• When a country allows trade and becomes
an importer of a good, domestic consumers
of the good are better off. They pay a
lower price.
• However, domestic producers of the good
are worse off. They receive a lower price.
Computing the Gain from Trade
• World price is $4.
• Price in U.K. falls to $4. Quantity supplied
by U.K. producers is 10 while quantity
demanded is 60. Imports of 50 fill the gap.
• Consumer surplus: (12-4)60/2 = 240
• Producer surplus: (4-2)10/2 = 10
• Economic benefit: 240 + 10 = 250
• Gain from free trade: 250 – 150 = 100
Free Trade: Winners and Losers
• When a country allows trade and becomes
an exporter of a good, domestic producers
of the good are better off. They receive a
higher price.
• However, domestic consumers of the good
are worse off. They pay a higher price.
Winners and Losers From
Free International Trade
• Trade raises the economic well-being of the
nation.
• The net change in total surplus is positive.
• The total surplus is the sum of the consumer
surplus and the producer surplus. How do we
figure out the total surplus?
Gains from Free Trade in U.K.
• At a price of $8 per unit, consumer surplus
is (12-8)x30/2=60 and producer surplus is
(8-2)x30/2=90 for a total surplus of $150.
• At $4, consumer surplus is (12-4)x60/2=240
while producer surplus is (4-2)x10/2=10 for
a total of $250.
• The net gain is $100.
Volume of Trade
• The volume of international trade has
grown substantially over time
• Most nations produce less than a small
fraction of the total supply of any good or
service, which allows these nations to
benefit from the differences in domestic
opportunity costs and global opportunity
costs
Why Trade Barriers?
• If exchange is beneficial, why does anyone oppose
it?
• International trade does increase the total value of
all goods and services, but certain industries may
be harmed
• E.G. Concerns over NAFTA
– U.S. consumers would benefit from lower prices
– But, some thought that the U.S. would lose some
unskilled jobs to Mexico, which, however, has not been
shown
Arguments for Restricting Trade
Arguments Against Free Trade
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Jobs
National Security
Infant Industry
Unfair-Competition
Protection-as-a-Bargaining-Chip
Trade Restrictions
• Have demonstrated the gains from free
trade. Now want to look at the issue of
protectionism or restrictions on trade.
• Major Kinds: Tariff, Quota, and Regulation
• Tariff: tax on imports of a good
• Quota: limits the amount of good imported
• Regulation: health, transport, other
The Welfare Effects of a Tariff
• A tariff is a tax on imported goods.
• A tariff raises the price of imported goods, above the
world price by the amount of the tariff.
• Domestic suppliers of the good with the tariff are
gainers while domestic consumers of the good are
losers.
U.K. Market in Wheat
Effect of a Tariff of $2/bu
$
/
b
u
12
10
8
6
4
2
0
0
S
W.P.+$2
World price
D
10
20
30
40
Quantiy
50
60
70
80
The Welfare Effects of a Tariff
• Like any tax on the sale of a good, an
import tariff distorts incentives and pushes
the allocation of scarce resources away
from the efficient point.
– Raises domestic prices and encourages more
domestic production of the good.
– Higher domestic prices reduces the amount
purchased by domestic consumers
The Cost of a Tariff
• At a price of $6 per unit, consumer surplus is (126)x45/2=135, producer surplus is (6-2)x20/2=40,
and government revenue is (45-20)2=50 for a total
surplus of $225.
• In free trade, consumer surplus is (12-4)x60/2 =
240 while producer surplus is (4-2)x10/2=10 for a
total of $250.
• The net gain is - $25. Tariff causes an economic
loss of $25
An Import Quota
• A quota is a quantitative restriction on
imports in the sense that a limited quantity
of the good is allowed into the country.
• Qualitative effect of a quota is the same as
that of a tariff. However, the difference in
price between the domestic market and the
world market accrues to the holder of the
import license. (Can lead to corruption!)
U.K. Market in Wheat
Effect of an Import Quota of 25
$
/
u
n
i
t
12
10
8
6
4
2
0
0
S
S + Quota
World price
D
10
20
30
40
Quantity
50
60
70
80
Effects of Quota
• In our example, quota restricts imports to
25. This appears as a horizontal addition to
the domestic supply curve above the world
price.
• Relative to free trade, price in importing
country is increased to $6, imports are
reduced to 25, and domestic output is
increased from 10 to 20. Value of an import
license $2 times quantity authorized.
Tariffs, Quotas, and Subsidies
• What is the difference between the effects of a
tariff and a quota? The government receives the
revenue from the tariff, while that revenue accrues
to the importer under a quota. Who decides who
can import? If import quota rights are auctioned,
government can capture that revenue.
• An alternative to a tariff is a per unit subsidy to
domestic producers. Consider a $2 per bushel
subsidy.
U.K. Market in Wheat
Effect of a Subsidy of $2 /bu
12
S
10
S + Subsidy
8
$
/
u
n
i
t
6
World price
4
D
2
0
0
10
20
30
40
Quantity
50
60
70
80
Welfare Cost of a Subsidy
• At a price of $4, consumer surplus is
(12-4)60/2 = 240, producer surplus is (40)x20/2=40, and government revenue is
negative 2x20=40 because of the subsidy.
The total surplus is 240 compared with
$250 under free trade.
Conclusion...
A Parable of Free Trade
• Throughout its history, the United States has
allowed unrestricted trade among the states,
and the country as a whole has benefited
from the specialization that trade allows.