Johnson’s oyster farm in Point Reyes

• Should the farm be shut down for environmental reasons?

• Most students said no • What does that mean? • It supports the economic liberal position that

the state should stay out of the market. • Would you consider yourself an economic

liberal? 1)yes 2)No

An economic liberal’s answer to state coordination: Coase Theorem

• . So, for example, I should have the right and freedom to play my piano whenever I want, but my neighbor has a right to peace and quiet. According to this theorem, if people could bargain at low cost, there would be no problem of externalities and, indeed, the outcome would be the same no matter who had the rights

• Or we could use the market to solve the problem • My neighbor calculates what his peace and quiet is worth and how much he is

willing to pay me for it • I calculate the cost of restrictions on my playing • We come to an agreement on the price of peace and quiet • And my neighbor pays me to restrict the times I’m allowed to play

Econ. Liberals say Governments aren’t efficient….don’t have good information and they

make mistakes Brussels Sprouts Farm using pesticides

Herb Farm that wants organic certification

Let’s look again at the problem of illegal drugs and try to bring all these things together

What would the Coase theorem say?

• When drugs are sold, we are in the presence of a voluntary transfer of property; • when the transfer is consensual, the risk of inefficiency is low because the parties are engaged in

interaction. • But the consumption and sale of drugs generate externalities that affect third parties. (what could those

be?: illnesses fostered by drug consumption, addiction leads to lack of productivity and responsibility etc.) Even if the two parties improve their circumstances in the course of a drugt exchange, they diminish the welfare of those who may have to suffer the consequences of consumption.

• Whose rights are more important? The rights of traders in the market or the rights of third parties to live in a world without drugs?

• The Coase theorem would say that drugs can be consumed but calls for compensation of victims in cases where drug consumption generates negative consequences for third parties. The parties should negotiate freely. Drug dealers must pay for addition treatment, just like cigarette manufacturers should pay for lung cancer treatment

Free Trade and Comparative Advantage

Specialization + Trade

Get out your clickers! Assume you are

an American…. • Which world would you prefer to live in:

• A. a world in which every American is 25 per cent wealthier than he/she is now, but every Chinese Indian, and Brazilian is much wealthier than the average American.

• B. A world in which Americans are only 10 per cent wealthier than now but way ahead of the average Chinese, Indian, or Brazilian?

Why Free Trade?

In any event, we cannot prosper by trying to impoverish our neighbours. A nation is more likely to grow rich from trade if its trading partners are also rich, industrious, commercial nations, than if they are poor. • --Adam Smith

David Ricardo (1772-1823) and the corn laws (1815-1846)

Production without specialization and division of labor

Wine Cloth Total

England 3 5 8

Portugal 9 (Absolute Advantage)

6 15

Total goods produced 23

Production with specialization before trade

Before trade: Resources put where they are most efficient (specialization) Note: Efficiency increases total number of goods available, from 23 to 27

Wine Cloth Total

England 1 10 11

Portugal 16 0 16

Total goods produced 27

Opportunity costs

The “lost opportunity” of doing A is the value of any benefit given up by not doing B

A certain good should always be produced in the country which has the lowest opportunity

cost

If a country can choose between producing two goods it should choose the one where it is

most EFFICIENT

Production with specialization and trade

Total goods produced is still 27 but each country is better off than before trade and both are better off than before “efficiency”

England trades Portugal 4 units of cloth for 4 units of wine Exchange rate is 1 to 1.

Wine Cloth Total

England 5 6 11

Portugal 12 4 16

Total goods produced 27

Wine Cloth Total

England 5 6 11

Portugal 12 4 16

Total goods produced 27

Wine Cloth Total

England 3 5 8

Portugal 9 6 15

Total goods produced 23

Without specialization and trade:

With specialization and trade:

Two important principles

1) Efficiency produces wealth

2) Trade is necessary to be efficient, because through competition among producers, all countries grow = there is an absolute gain

Why we all should drive Toyota!

Assumptions of Ricardo’s Theory

• Assumes static givens in a country’s economy ...

• ... and doesn’t discuss technology as a factor of production.

• Labor theory of value • What?

Labor Theory of Value

• The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it. What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.(Wealth of Nations Book 1, chapter V)

Hechscher-Ohlin-Samuelson modernizes Ricardo and Smith

• Not labor, but a bundle of things: capital, labor, resources, management, and technology give a country a comparative advantage.

• It’s factor proportions that count!

Krugman expands on Hechscher-Olin and wins Nobel Prize

• Krugman noticed that the accepted model economists used to explain patterns of international trade did not fit the data.

– The Hecksher-Ohlin model predicted that trade would be based on such factors as the ratio of capital to labor, with "capital-rich" countries exporting capital-intensive goods and importing labor-intensive goods from "labor-rich" countries.

• Mr. Krugman noticed that most international trade takes place between countries with roughly the same ratio of capital to labor.

– The auto industry in capital-intensive Sweden, for example, exports cars to capital-intensive America, while Swedish consumers also import cars from America.

Beyond Ricardo’s Comparative Advantage

• Consumers want variety • But tradeoffs between

variety and cost of production—the lower the cost, the less variety

• Because of economies of scale

• Trade gives the consumer more variety but the world produces fewer varieties of each good

• There are 2 identical countries: They don’t trade

• Country 1 produces A, B, C. • Country 2 produces X, Y, Z • = 6 varieties produced. • Consumers only get three • Then they trade…. • Production scales and

concentrates • Now A, B, X, Y are produced and

available in both countries • Consumers get 4 choices. • But only 4 varieties are

produced.

Free Trade leads to growth in Exports: Biggest growth in Developing countries

Comparative Advantage is Dynamic

• While the United States has long imported oil and other raw materials from the third world, we used to import manufactured goods mainly from other rich countries like Canada, European nations and Japan.

• But recently we crossed an important watershed: we now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages (Krugman 2007)

Sum: Effects of Free Trade

• Efficiency Growth Good life for everyone • Harmonious International Relations • Role of the State: To let producers produce most

efficiently—to separate politics and economics: • the key actors for liberals are firms and

consumers, not states. • Commerce Peace Why? • Efficiency should be the basis of all political

relations • Does Free Trade make the state obsolete?