free trade theory why nations trade. why trade? basics of trade defined: 2 countries engage in...
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Free Trade Theory
Why Nations Trade
Why Trade?
Basics of Trade
• Defined: 2 Countries engage in economic activity
• Exports: goods/services leave country
• Imports: goods/services enter country
• Trade Surplus: Export more than import
• Trade Deficit: Import more than export
Ways to Limit Trade
• Protectionism: Gov’t policy which seeks to limit trade– Tariffs– taxes on imports– Quotas- limits on quantity imported
• Globalization: the “global” movement towards free trade – Trade without Tariffs & Quotas – Worldwide movement towards free market capitalism
2 Free Trade Terms
• Comparative Advantage = when a country can produce a good at a lower opportunity cost– They give up less!
• Absolute Advantage = when a country can produce a good more efficiently – They use fewer resources
Countries should produce (specialize) in goods where they have a comparative advantage
Trade benefits both parties (each country gets “more”)
Free Trade promotes a more “efficient” world economy
Absolute Advantage is not relevant in trade analysis
Here is my great theory!David Ricardo
Trade Theory
Specialization works!
Any illegal activity you can think of…
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Idaho
Nevada
Texas
Florida
1000
500
1000
1000 Wheat
Coffee
Coffee
Wheat
BRAZILMEXICO
(PPF) Production Possibilities Frontier Review:
Illustrates the maximum output for a country with current resourcesAny point on the line is efficientBelow line is inefficientAbove the line is not obtainable in short run
PPF CURVE Review
Free Trade Worksheet
• Handout #1
1000
500
1000
1000 Wheat
Coffee Coffee
Wheat
BRAZIL MEXICO
1 Coffee = ____ Wheat 1 Coffee = _____ Wheat
1 Wheat = ____ Coffee 1 Wheat = ____ Coffee
Opportunity Cost Table
BRAZIL
MEXICO
(gain) (give-up)
1
2
1/2
1
PPF Illustrates Opportunity Cost between goods
BRAZIL MEXICO
1 Coffee = ____Wheat 1 Coffee = _____ Wheat
1 Wheat = ____ Coffee 1 Wheat = ____Coffee
1/2
2
1
1
Wheat : BRAZIL has comparative advantage---produce only WHEAT
Coffee : MEXICO has comparative advantage---produce only COFFEE
coffee
wheat
1000
500
1000
1000 Wheat
Coffee
Wheat
BRAZIL
MEXICO
Determining Comparative Advantage
BRAZIL MEXICO
1000
500
1000
1000Wheat
Coffee
Coffee
Wheat
* (500,500)* (250,500)
400 Coffee
300 Wheat
BRAZIL
0 Coffee
1,000 Wheat
1,000 Coffee
0 Wheat
MEXICO
.(700, 400)
.(300, 600)
after trade
after trade
Trade Example:
Theoretical Benefits ofFree Trade
There is not one right answer Any trade that produces a point ABOVE current PPF is efficient trade
Use Economic Logic!
Betty- types 120 w.p.m. Jim- types 60 w.p.m.
Who should do the typing? Betty or Jim?
Assumption: No errors
Betty & Jim
Betty is a lawyer & Jim is a secretary
Betty earns $140 an hour.
Jim earns $20 an hour.
Now, who should type the letter?
Jim Should!
Jim gives up less when he types!He has a comparative advantage in typing
Why: Betty types 2 times as fast as Jim Betty earn 7 times as much as Jim
Betty- types 120 w.p.m. Jim- types 60 w.p.m.
Betty has an absolute advantagein typing (she is more efficient)
Summary: Free Trade Theory
• Countries should specialize in a good where they have a comparative advantage
• Trade is mutually beneficial– End country ends up at a point above their own PPF curve
• World wide efficiency increases as a result– Produce more with same resources
BRAZIL MEXICO
1000
500
1000
1000Wheat
Coffee
Coffee
Wheat
* (500,500)* (250,500).(700, 400)
.(300, 600)
after trade
after trade
Theoretical Benefits ofFree Trade
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