2 trade or protection
TRANSCRIPT
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2. Free Trade and Protection
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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
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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.
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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.
Even then, both countries can benefit fromtrade.
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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.
Even then, both countries can benefit fromtrade.
Key is relative advantage. For example, assume A is relatively better at
wheat production than wine.
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Before trade: Country A
Wine
wheatwheat
120
60
A's Production
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Before trade A produces a=wine and 120-2a=wheat.
Wine
wheatwheat
120
60
A's Production
a
120-2a
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Before trade B
Wine
Wheat
15
60
B's Production
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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)
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Now let trade occur
Let B produce 1 more unit of wine (its comparativeadvantage) and therefore 0.25 less units of wheat.
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Now let trade occur
Let B produce 1 more unit of wine (its comparativeadvantage) and therefore 0.25 less units of wheat.
At the same time the A produces one less unit of wine and two more unit of wheat (its comparativeadvantage).
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Now let trade occur
Let B produce 1 more unit of wine (its comparativeadvantage) and therefore 0.25 less units of wheat.
At the same time the A produces one less unit of wine and two more unit of wheat (its comparativeadvantage).
Total wine production has not changed, but total
wheat output has increased by 1.75 units!
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Now let trade occur
Let B produce 1 more unit of wine (its comparativeadvantage) and therefore 0.25 less units of wheat.
At the same time the A produces one less unit of wine and two more unit of wheat (its comparativeadvantage).
Total wine production has not changed, but total
wheat output has increased by 1.75 units! Everyone is better off.
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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
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Theory of Comparative Advantage
What are the prices?
A was prepared to swap 1 unit of wine for 2 wheatso:
Price of Wheat A = 1/2 X (Price of Wine) A
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
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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
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)
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Some Pictures: Country A Production Possibilities
Wine
Wheat
A Autarky
A
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Some Pictures: Country A Production Possibilities
Wine
Wheat
A Autarky
Prices in A
A
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Country B¶s Production Possibilities
Wine
Wheat
B Autarky
B
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Country B¶s Production Possibilities
Wine
Wheat
B Autarky
B
Prices in B
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Who has higher prices?
Wine
Wheat
A Autarky
B Autarky
AB
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Trade raises the price of wheat in B and raises the price of
wine in A
Wine
Wheat
AB
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Trade raises the price of wheat in B and raise the price of
wine in A
Wine
Wheat
A Autarky
AB
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Trade raises the price of wheat in B and raises price of
wine in A
Wine
Wheat
AB
Same Prices => lines are parallel
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At the new prices B is better off
Wine
Wheat
B
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It produces more wheat and consumes more wine
Wine
Wheat
Export Wheat
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It produces more wheat and consumes more wine
Wine
Wheat
Export Wheat
Import
Wine
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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!
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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.
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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.
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Wine
Wheat
A Autarky
B Autarky
AB
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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.
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Consequence=Factor Price Equalization
As a result of trade the prices of labour and capital
in each country will tend to be the same.
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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).
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3. Protection
Instr uments of Public Policy:
Tariff (Taxes)
Quotas (quantity restrictions)
Non-tariff barriers (Product standards, voluntary
restraints etc.)
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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:
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Domestic Equilibrium Price and Quantity (No trade)
Domestic Supply
Domestic Demand
Quantity
Price
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Once Imports are allowed there is infinite supply at
the world price.Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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Efficient domestic producers continue to produce.
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Supply
From
Local Fir ms
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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
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Consumers¶ value with trade:
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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Local Producers¶ value:
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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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
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Before Tariff
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
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After Tariff
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
World Supply with Tariff
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Who gains who loses?
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Consumers lose this
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Producers gain this
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Government gains this much tax
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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Net the country loses
Domestic Supply
Domestic Demand
Quantity
Price
World Supply
Tariff
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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.
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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
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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)
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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.