2 Trade or Protection

8/3/2019 2 Trade or Protection

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2. Free Trade and Protection



Summary

1. Theory of Comparative Advantage:

Why trade is good.

2. Where comparative advantage comes from:

Heckscher-Ohlin Model (factor endowments)

Equalization of factor income3. Welfare Effects of a Tariff :

Consumers Lose

Gov¶t gains

Local producers gain

4. Arguments for protection:Optimal tariff

Infant industry

Employment



Ricardo¶s Theory of Comparative Advantage

Suppose:

Country A and Country B. Equally sized.Country A is better at producing both wine andwheat than B.




Suppose:


Even then, both countries can benefit fromtrade.




Suppose:


Even then, both countries can benefit fromtrade.

Key is relative advantage. For example, assume A is relatively better at

wheat production than wine.



Before trade: Country A

Wine

wheatwheat

120

60

A's Production



Before trade A produces a=wine and 120-2a=wheat.

Wine

wheatwheat

120

60

A's Production

a

120-2a



Before trade B

Wine

Wheat

15

60

B's Production



Before trade B produces b=wine and 15-(b/4)=bread.

Total world production is

(a + b wine, 135 - 2a - 0.25b wheat).

Wine

wheat

15

60

B's Production

b

15-(b/4)



Now let trade occur

Let B produce 1 more unit of wine (its comparativeadvantage) and therefore 0.25 less units of wheat.



Now let trade occur


At the same time the A produces one less unit of wine and two more unit of wheat (its comparativeadvantage).



Now let trade occur



Total wine production has not changed, but total

wheat output has increased by 1.75 units!



Now let trade occur



Total wine production has not changed, but total

wheat output has increased by 1.75 units! Everyone is better off.



Theory of Comparative Advantage

What are the prices?

A was prepared to swap 1 unit of wine for 2 wheat so:

Price of Wheat A = 1/2 X (Price of Wine) A





A was prepared to swap 1 unit of wine for 2 wheatso:


B (Supplies Wine) was prepared to swap 1 unit of wine for ¼ of wheat so:

Price of WheatB = 4 X (Price of Wine)B





A was prepared to swap 1 unit of wine for 2 wheat so:


B (Supplies Wine) was prepared to swap 1 unit of wine for ¼ of wheatso:

Price of WheatB = 4 X (Price of Wine)B

As long as

½ X (World Price of Wine) < World Price of Wheat < 4 X (World Price of Wine)



Some Pictures: Country A Production Possibilities

Wine

Wheat

A Autarky

A



Some Pictures: Country A Production Possibilities

Wine

Wheat

A Autarky

Prices in A

A



Country B¶s Production Possibilities

Wine

Wheat

B Autarky

B



Country B¶s Production Possibilities

Wine

Wheat

B Autarky

B

Prices in B



Who has higher prices?

Wine

Wheat

A Autarky

B Autarky

AB



Trade raises the price of wheat in B and raises the price of

wine in A

Wine

Wheat

AB



Trade raises the price of wheat in B and raise the price of

wine in A

Wine

Wheat

A Autarky

AB



Trade raises the price of wheat in B and raises price of

wine in A

Wine

Wheat

AB

Same Prices => lines are parallel



At the new prices B is better off

Wine

Wheat

B



It produces more wheat and consumes more wine

Wine

Wheat

Export Wheat



It produces more wheat and consumes more wine

Wine

Wheat

Export Wheat

Import

Wine



2. Sources of Comparative Advantage

1) Preferences:

Even if we were completely identical but just liked

different things trade would be a good idea.

Example

Country A has 100 units lamb and 100 units pork

Country B has 100 units lamb and 100 units pork

One really likes Kebabs the other really likes

Sausages!



2. Sources of Comparative Advantage:

2) Factor endowments

Set Up: 2 Countries (A,B)

2 Goods (Wheat, Wine)

2 Inputs (labour, capital)

Assumption:

Capital and Labour can move betweenindustries within their own country but not across

countries.



Technologies

Both countries have identical technologies at their

disposal these have constant returns to scale.

Wheat production requires a lot of capital and B

has a lot of capital.

Wine production requires a lot of labour and A hasa lot of labour.



Wine

Wheat

A Autarky

B Autarky

AB



Trade occurs to move immobile inputs

around

Country A is rich in labour and exports the good

that requires a lot of labour.

Hence

Before trade the price of labour in A will be lowrelative to the price of capital.



Consequence=Factor Price Equalization

As a result of trade the prices of labour and capital

in each country will tend to be the same.



Income Distribution and Growth

An increase in the price of wine (labour intensive)

will increase the wages (relative to the price of

wine and wheat)

It will also decrease the reward to capital (relative

to the prices of wine and wheat).



3. Protection

Instr uments of Public Policy:

Tariff (Taxes)

Quotas (quantity restrictions)

Non-tariff barriers (Product standards, voluntary

restraints etc.)



Effect of Tariff on Value

We will assume the country is small relative to the

rest of the world.

If there was no trade the domestic supply and

demand would look like:



Domestic Equilibrium Price and Quantity (No trade)

Domestic Supply

Domestic Demand

Quantity

Price



Once Imports are allowed there is infinite supply at

the world price.Domestic Supply

Domestic Demand

Quantity

Price

World Supply



Efficient domestic producers continue to produce.

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Supply

From

Local Fir ms



But there is an increase in supply from importers.

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Supply

From

Local Fir ms

Supply

From

Importers



Consumers¶ value with trade:

Domestic Supply

Domestic Demand

Quantity

Price

World Supply



Local Producers¶ value:

Domestic Supply

Domestic Demand

Quantity

Price

World Supply



The Government Imposes a Tax/Tariff

We could describe this as a shift in the demand

f unction.

Or

We could think of this as an increase in the price of

imports



Before Tariff

Domestic Supply

Domestic Demand

Quantity

Price

World Supply



After Tariff

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

World Supply with Tariff



Who gains who loses?

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff



Consumers lose this

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff



Producers gain this

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff



Government gains this much tax

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff



Net the country loses

Domestic Supply

Domestic Demand

Quantity

Price

World Supply

Tariff



What Justification is there for Protection

(1) The above shows that if your country is small

you always lose for m protection.

If your country is large this may not be so.

(2) Infant Industries:

Government is necessary to protect industries

until they are µgrown up enough¶ to face

international competitors.

(3) Revenue.

(4) Employment.



Infant Industries

Need LR profits in country to exceed SR costs of

subsidization.

This implies industry itself should be willing toundergo the SR costs (contradiction)

Unless there is a market failure that stops such

projects being undertaken



Examples of Market Failure

Failure in human capital:

(skills, education, health)

Infor mation:

(Government has better knowledge?)

Capital market failure

(hard for fir ms to get loans)



Employment Argument

The above assumes the labour market is in

equilibrium (i.e. f ull employment).

If this is not so, then the opportunity cost of labour being used in the exporting industries is less

than the equilibrium wage => may increase

welfare.

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