3.1. International Trade

Benefits of Free Trade

‘Free trade increases prosperity for Americans—and the citizens of all participating nations—by allowing consumers to buy more, better-quality products at lower costs. It drives economic growth, enhanced efficiency, increased innovation, and the greater fairness that accompanies a rules-based system. These benefits increase as overall trade—exports and imports—increases.

• Free trade increases access to higher-quality, lower-priced goods. Cheaper imports, particularly from countries such as China and Mexico, have eased inflationary pressure in the United States.1 Prices are held down by more than two percent for every one-percent share in the market by imports from low-income countries like China.

• Free trade means more growth. At least half of US imports are not consumer goods; they are inputs for US-based producers, according to economists from the Bureau of Economic Analysis. Freeing trade reduces imported-input costs, thus reducing businesses’ production costs and promoting economic growth.

• Free trade improves efficiency and innovation. Over time, free trade works with other market processes to shift workers and resources to more productive uses, allowing more efficient industries to thrive. The result is higher wages, investment in such things as infrastructure, and a more dynamic economy that continues to create new jobs and opportunities.2

• Free trade drives competitiveness. Free trade does require American businesses and workers to adapt to the shifting demands of the worldwide marketplace. But these adjustments are critical to remaining competitive, and competition is what fuels long-term growth.

• Free trade promotes fairness. When everyone follows the same rules-based system, there is less opportunity for cronyism, or the ability of participating nations to skew trade advantages toward favored parties. In the absence of such a system, bigger and better-connected industries can more easily acquire unfair advantages, such as tax and regulatory loopholes, which shield them from competition.’

Source: http://mercatus.org/publication/benefits-free-trade-addressing-key-myths, accessed Thursday 17th September 2015

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Equilibrium without trade (steel market)

With no trade (country pursuing economic self sufficiency), the following will occur:

• Domestic price adjusts to balance demand and supply • The sum of consumer and producer surplus measures the total

benefits that buyers and sellers receive.

Country decides to move from a closed economy to an open economy

If a country decides to engage in international trade, will it be an importer or exporter of steel?

The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of a good. The world price refers to the price that prevails in the world market for that good.

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If a country’s steel industry is so efficient so that its domestic price is below the world price then it will be an exporter of steel (has a comparative advantage)

If a country’s steel industry is inefficient so that its domestic price is above the world price then it will be an importer of steel

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How free trade affects welfare in an exporting country

Before Trade After trade ChangeConsumer SurplusProducer surpusTotal surplus

International Trade in an importing country

If the world price of steel is lower than the domestic price, the country will be an importer of steel when trade is permitted. Domestic consumers will want to buy steel at the lower world price. Domestic producers will have to lower their output because the domestic price moves to the world price.

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How free trade affects welfare in an importing country

Before Trade After trade ChangeConsumer SurplusProducer surpusTotal surplus

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Absolute and Comparative Advantage (HL only)

Law of Absolute Advantage

‘Absolute advantage: In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources’.

Source: Boundless. “Absolute Advantage and the Balance of Trade.” Boundless Business. Boundless, 21 Jul. 2015. Retrieved 17 Sep. 2015 from https://www.boundless.com/business/textbooks/boundless-business-textbook/international-business-4/the-drive-for-international-trade-37/absolute-advantage-and-the-balance-of-trade-188-1791/

Example

Country A can produce 1000 parts per hour with 200 workers. Country B can produce 2500 parts per hour with 200 workers. Country C can produce 10000 parts per hour with 200

workers.

Country Parts per hour Number of workersA 1000 200B 2500 200C 10000 200

Conclusion: Party C has the absolute advantage.

Source URL: http://en.wikipedia.org/wiki/Absolute_advantage Saylor URL: http://www.saylor.org/courses/econ102

Law of Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower. Countries will usually specialize in and then export products, which use intensively the factors inputs, which they are most abundantly endowed. If each country specializes in those goods and

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services where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and economic welfare.

This is true even if one nation has an absolute advantage over another country. So for example the Canadian economy, which is rich in low cost land is able to exploit this by specializing in agricultural production. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods, which take advantage of much lower unit labour costs.

In highly developed countries, the comparative advantage is shifting towards specializing in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.

Assumptions behind Trade TheoryThis theory of the potential benefits from trade and exchange using the law of comparative advantage is based on a number of underlying assumptions:1. Perfect occupational mobility of each of the factors of production (land, labour, capital etc.) –this means that switching factor resources from one industry to another involves no loss of relative efficiency and productivity. In reality of course we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the economic benefits from trade are reduced. Conversely, increasing the scale of production can generate increasing returns to scale - in which case the benefits from trade are even stronger than the numerical example we have considered3. No externalities arising from production and/or consumption – meaning that there is no divergence between private and social costs and benefits. Again this is a simplifying assumption. No discussion about the overall costs and benefits of specialization and trade should ignore many of the environmental considerations arising from increased production and trade between countries.4. Zero or insignificant transportation costs

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Worked example of Comparative Advantage

Consider two countries producing two products – digital cameras and vacuum cleaners. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

Pre-specialization Digital cameras Vacuum cleanersUK 600 600USA 2400 1000Total 3000 1600

To identify which country should specialise in a particular product we need to analyse the internal opportunity costs for each country.

Opportunity Cost Digital cameras Vacuum cleanersUK 600/600 = 1 600/600 = 1USA 1000/2400 = 0.4167 2400/1000 = 2.4

For example, were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners (its opportunity cost is lower).

If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 0.4167 of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest.

According to the principle of comparative advantage, each country specializes in the products in which it has an advantage.

Post-specialization Digital cameras Vacuum cleanersUK 1200USA 4800Total 4800 1200

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Of course, it is likely that at least one of the countries will not fully specialise in the production of one good. This could be for various economic and political considerations.

The following is a possible trade configuration between the UK and USA

The UK specializes totally in producing vacuum cleaners – doubling its output to 1200

The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners (400 x 2.4 = 960)

Post-specialization Digital cameras Vacuum cleanersUK 0 1200USA 3360 (2400 + 960) 600Total 3360 1800

As a result of specialization according to the principle of comparative advantage, output of both products has increased - representing a gain in economic welfare.

Criticisms of the principle of Comparative Advantage

However, the principle of comparative advantage can be criticized in a several ways:

• It may overstate the benefits of specialization by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.

• The theory also assumes that markets are perfectly competitive - in particular, there is perfect mobility of factors without any diminishing returns and with no transport costs. The reality is likely to be very different, with output from factor inputs subject to diminishing returns, and with transport costs. This will make the PPF for each country non-linear and bowed outwards.  If this is the case, complete specialization might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialization. For example, it may

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be that the maximum output of cars produced by country A is only 20 million (compared with 30), and the maximum output of trucks produced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units (instead of the 51 million units initially predicted).

• Complete specialization might create structural unemployment as some workers cannot transfer from one sector to another.

• Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.

• Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade. Countries can develop new advantages, such as Vietnam and coffee production. Despite having a long history of coffee production it is only in the last 30 years that it has become a global player seeing its global market share increase from just 1% in 1985 to 20% in 2014, making it the world's second largest producer.

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• Many countries strive for food security, meaning that even if they should specialize in non-food products, they still prefer to keep a minimum level of food production.

• The principle of comparative advantage is derived from a highly simplistic two-good/two country model. The real world is far more complex, with countries exporting and importing many different goods and services.

• According to influential US economist Paul Krugman, the continual application of economies of scale by global producers using new technology means that many countries, including China, can produce very cheaply, and export surpluses. This, along with an insatiable demand for choice and variety, means that countries typically produce a variety of products for the global market, rather than specialize in a narrow range of products, rendering the traditional theory of comparative advantage almost obsolete.

• However, the underlying principle of comparative advantage can still be said to give some ‘shape’ to the pattern of world trade, even if it is becoming less relevant in a globalized world.

Source: http://www.economicsonline.co.uk/Global_economics/Comparative_advantage.html, accessed Thursday, 17th September 2015

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Describe the objectives and functions of the WTO The Uruguay round of GATT (1986-93) gave birth to World Trade Organization. The members of GATT singed on an agreement of Uruguay round in April 1994 in Morocco for establishing a new organization named WTO. It was officially constituted on January 1, 1995, which took the place of GATT as an effective formal, organization. GATT was an informal organization, which regulated world trade since 1948. Contrary to the temporary nature of GATT, WTO is a permanent organization, which has been established on the basis of an international treaty approved by participating countries. It achieved the international status like IMF and IBRD, but it is not an agency of the United Nations Organization (UNO).

Structure:The WTO has nearly 153 members accounting for over 97% of world trade. Around 30 others are negotiating membership. Decisions are made by the entire membership. This is typically by consensus.A majority vote is also possible but it has never been used in the WTO and was extremely rare under the WTO’s predecessor, GATT. The WTO’s agreements have been ratified in all members’ parliaments.

The WTO’s top-level decision-making body is the Ministerial Conferences, which meets at least once in every two years. Below this is the General Council (normally ambassadors and heads of delegation in Geneva, but sometimes officials sent from members’ capitals),which meets several times a year in the Geneva headquarters. The General Council also meets as the Trade Policy Review Body and the Disputes Settlement Body.

At the next level, the Goods Council, Services Council and Intellectual Property (TRIPs) Council report to the General Council. Numerous specialized committees, working groups and working parties deal with the individual agreements and other areas such as, the environment, development, membership applications and regional trade agreements.

Secretariat:The WTO secretariat, based in Geneva, has around 600 staff and is headed by a Director-General. Its annual budget is roughly 160 million Swiss Francs. It does not have branch offices outside Geneva. Since decisions are taken by the members themselves the secretariat

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does not have the decision making the role that other international bureaucracies are given.

The secretariat s main duties to supply technical support for the various councils and committees and the ministerial conferences, to provide technical assistance for developing countries, to analyze world trade and to explain WTO affairs to the public and media. The secretariat also provides some forms of legal assistance in the dispute settlement process and advises governments wishing to become members of the WTO.

Objectives:The important objectives of WTO are:1. To improve the standard of living of people in the member countries.2. To ensure full employment and broad increase in effective demand.3. To enlarge production and trade of goods.4. To increase the trade of services.5. To ensure optimum utilization of world resources.6. To protect the environment.7. To accept the concept of sustainable development.

FunctionsThe main functions of WTO are discussed below:1. To implement rules and provisions related to trade policy review mechanism.2. To provide a platform to member countries to decide future strategies related to trade and tariff.3. To provide facilities for implementation, administration and operation of multilateral and bilateral agreements of the world trade.4. To administer the rules and processes related to dispute settlement.5. To ensure the optimum use of world resources.6. To assist international organizations such as, IMF and IBRD for establishing coherence in Universal Economic Policy determination.Source: http://www.yourarticlelibrary.com/trade-2/world-trade-organization-wto-objectives-and-functions/23529/accessed Thursday 17th September 2015Benefits of WTO -https://www.wto.org/english/thewto_e/whatis_e/10ben_e/10b01_e.htm

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Restrictions on free trade

Protectionism represents any attempt by a government to impose restrictions on trade in goods and services between countries

1. Tariffs - import taxes2. Quotas - quantitative limits on the level of imports allowed3. Voluntary Export Restraint Arrangements – where two

countries make a bi-lateral agreement to4. Limit the volume of their exports to one another over an

agreed period of time5. Embargoes - a total ban on imported goods6. Subsidies - a government payment to encourage domestic

production by lowering their costs7. Import licensing - governments grants importers the license to

import goods8. Exchange controls - limiting the amount of foreign exchange

that can move between countries

TariffsA tariff raises the price of imported products and causes a contraction in demand and an expansion in domestic supply. The net effect is that the volume of imports is reduced and the government received some tax revenue from the tariff.

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How does the imposition of a tariff affect welfare?

Before Trade After trade ChangeConsumer SurplusProducer surpusGovernment revenueTotal surplus

Effects of a tariff

A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade. With a tariff total surplus decreases in the market by the areas of deadweight loss.

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Imposition of a tariff using linear equations

Market for cooking oil

The market for cooking oil has the following demand and supply functions: QD = 3 – P and QS = P

Where price is given in dollars per litre of cooking oil and quantity is given in millions of litres of cooking oil per month.

Plot the demand and supply curves for cooking oil from the functions above and identify the equilibrium price and quantity.

When we plot the curves, we get the diagram below:

Calculating from diagrams the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government.

Assume that the world price is $0.50 and that in response to this world price the government of this country imposes a tariff on imports. The tariff is $0.50.

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Add the world supply curve if foreign producers are prepared to supply cooking oil at $0.50. Then show the effect on the diagram of the government putting a tariff of $0.50 on all imports of cooking oil.

This is simple and you just have to add a perfectly elastic supply curve to the diagram, at a price of $0.50. and label it SWorld.

Then you put on another curve, $0.50 above the first one and label it SWorld + Tariff.

Proceed through the following steps and calculate the values at each step

1. Identify the level of domestic production before the tariff and after.

2. Calculate the amount of revenue for domestic producers before the tariff and after.

3. Identify the level of imports before the tariff and after.

4. Calculate the amount of revenue for foreign producers before the tariff and after.

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5. Calculate the amount of government revenue from the tariff.

6. Calculate the fall in consumer surplus resulting from the imposition of the tariff.

7. Calculate the dead-weight losses suffered as a result of imposing the tariff.

Import Quota The Government might seek to limit the level of imports through a quota. Examples of quotas are found in the textile industry under the terms of the Multi-Fibre Agreement. Quotas can be in terms of volume (number of units imported) or value (value of imports) permitted.

Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off and domestic sellers of the good are better off. License holders are better off because they make a profit from buying at the world price and selling at the higher domestic price.

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Before Trade After trade ChangeConsumer SurplusProducer surpusLicense holdersTotal surplus

With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. The quota can potentially cause an even larger deadweight loss if a mechanism such as lobbying is employed to allocate the import licenses.

If the government sells import licenses for full value, revenue equals that of an equivalent tariff and the results of tariffs and quotas are identical.

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Imposition of a quota using linear equations

Market for cooking oil

The market for cooking oil has the following demand and supply functions: QD = 3 – P and QS = P

Where price is given in dollars per litre of cooking oil and quantity is given in millions of litres of cooking oil per month. Plot the demand and supply curves for cooking oil from the functions above and identify the equilibrium price and quantity.

When we plot the curves, we get the diagram below:

Calculating from diagrams the effects of setting a quota on foreign producers on different stakeholders, including domestic producers, foreign producers, consumers and the government.

Suppose that the world price is again $0.50 so add the world supply curve if foreign producers are prepared to supply cooking oil at $0.50. Then the government decides to impose a quota on imports of 1 million units. Show the effect on the diagram of the government imposing a quota on imports of 1 million units.

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Market with imposition of an import quota of 1 million units

Domestic producers supply 500,000 units and then the foreign producers are now allowed to supply 1 million more and no more. So, the domestic supply curve above 50c and an output of 500,000 litres, shifts to the right.

The price now rises to $1 and total quantity demanded and supplied falls to 2 million litres.

Proceed through the following steps and calculate the values at each step

1. Identify the level of domestic production before the quota and after.

2. Calculate the amount of revenue for domestic producers before the quota and after.

3. Identify the level of imports before the quota and after.

4. Calculate the amount of revenue for foreign producers before the quota and after.

5. Calculate the fall in consumer surplus resulting from the imposition of the quota.

6. Calculate the dead-weight losses suffered as a result of imposing the quota.

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Export subsidy

Granting of a subsidy to domestic producers using linear equations

Market for cooking oil

The market for cooking oil has the following demand and supply functions: QD = 3 – P and QS = P

Where price is given in dollars per litre of cooking oil and quantity is given in millions of litres of cooking oil per month.

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Plot the demand and supply curves for cooking oil from the functions above and identify the equilibrium price and quantity.

When we plot the curves, we get the diagram below:

Calculating from diagrams the effects of giving a subsidy to domestic producers on different stakeholders, including domestic producers, foreign producers, consumers and the government.

Add the world supply curve as foreign producers are prepared to supply cooking oil at $0.50. The government of the country decides to give domestic producers a per-unit subsidy of $0.50. Thus show the effect on the diagram of the government giving a subsidy of $0.50 per unit on all domestic production of cooking oil.

You just have to add a perfectly elastic supply curve to the diagram, at a price of $0.50. and label it SWorld.

Then you shift the domestic supply curve downwards by 50c at all levels of output and label it S + Subsidy.

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1. Identify the level of domestic production before the subsidy and after.

2. Calculate the amount of revenue for domestic producers before the subsidy and after.

3. Identify the level of imports before the subsidy and after.

4. Calculate the amount of revenue for foreign producers before the subsidy and after.

5. Calculate the amount of government expenditure on the subsidy.

6. Calculate the dead-weight losses suffered as a result of granting the subsidy.

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Other forms of protectionism

Administrative BarriersCountries can make it difficult for firms to import by imposing restrictions and being 'deliberately' bureaucratic. These trade barriers range from stringent safety and specification checks to extensive holdups in the customs arrangements. A good example is the quality standards imposed by the EU on imports of dairy products.

Preferential Government Procurement Policies and State AidFree trade can be limited by preferential behaviour by the government when allocating major spending projects that favour domestic rather than overseas suppliers. These procurement policies run against the principle of free trade within the EU Single Market – but they remain a feature of the trade policies of many developed countries within Western Europe. Good examples include the award of contracts to suppliers of defense equipment or construction companies involved in building transport infrastructure projects.

The use of financial aid from the state can also distort the free trade of goods and services between nations, for example the use of subsidies to a domestic coal or steel industry, or the widely criticized use of export refunds (subsidies) to European farmers under the Common Agricultural Policy (CAP) which is criticized for damaging the profits and incomes of farmers in developing countries.

Voluntary Export Restraints (VERs)

A voluntary export restraint is a restriction set by a government on the quantity of goods that can be exported out of a country during a specified period of time. Often the word voluntary is placed in quotes because these restraints are typically implemented upon the insistence of the importing nations.

Typically VERs arise when the import-competing industries seek protection from a surge of imports from particular exporting countries. VERs are then offered by the exporter to appease the importing country and to avoid the effects of possible trade restraints on the part of the importer. Thus VERs are rarely completely voluntary.

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Also, VERs are typically implemented on a bilateral basis, that is, on exports from one exporter to one importing country. VERs have been used since the 1930s at least, and have been applied to products ranging from textiles and footwear to steel, machine tools and automobiles. They became a popular form of protection during the 1980s, perhaps in part because they did not violate countries' agreements under the GATT. As a result of the Uruguay round of the GATT, completed in 1994, WTO members agreed not to implement any new VERs and to phase out any existing VERs over a four-year period. Exceptions can be granted for one sector in each importing country.

VERs in automobile exports from Japan to USA

In 1981, the US was suffering the effects of the second OPEC oil price shock. Faced with higher gasoline prices, consumers began to shift their demand from low fuel efficiency US autos to higher fuel efficiency Japanese autos. This increase in auto imports contributed to lower sales and profits of US automakers. The Japanese, faced with continuing calls by the US auto industry for legislated protection and following discussions with the US trade representative's office, eventually announced VERs on auto exports.

The bilateral nature of VERs contributes to a series of subsequent effects. Since a VER can raise the price of the product in the importing country, there is an incentive created to circumvent the restriction. In the case of the Japanese auto VERs, the circumvention took a variety of forms. Since the quantity of auto trade between Japan and the US was limited but the value of trade was not, Japanese automakers began upgrading the quality of their exports to raise their profitability. By the late 1980s, new higher-quality auto lines such as Acura, Infiniti, and Lexus made their debut. Alternatively, Japanese autos assembled in the US were not counted as part of the export restriction - only complete autos exported from Japan were restricted. Thus, after the VERs were implemented, Honda, Mazda, Toyota, Mitsubishi, and Nissan all opened assembly plants in the US. A quicker circumvention was accomplished by shipping knockdown sets (unassembled autos) to Taiwan and South Korea, where they were assembled and exported to the US market.

Source: http://internationalecon.com/Trade/Tch10/T10-3A.php, accessed Sunday 20th September 2015

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Economic justifications for protectionismInfant Industry ArgumentCertain industries possess a potential (latent) comparative advantage but have not yet exploited the potential economies of scale. Short-term protection from established foreign competition allows the ‘infant industry’ to develop its comparative advantage. At this point the trade protection could be relaxed, leaving the industry to trade freely on the international market. The danger of this form of protection is that the industry will never achieve full efficiency. The short-term protectionist measures often start to appear permanent.

Protection – a reaction against “import dumping”If a company exports a product at a price lower than the price it normally charges on its own home market, it is said to be “dumping” the product. In the short term, consumers benefit from the low prices of the foreign goods, but in the longer term, persistent undercutting of domestic prices will force the domestic industry out of business and allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer. Therefore protection, via tariffs on 'dumped' goods can be justified to prevent the long-term exploitation of the consumer. The World Trade Organization www.wto.org allows a government to act against dumping where there is genuine ‘material’ injury to the competing domestic industry. In order to do that the government has to be able to show that dumping is taking place, calculate the extent of dumping (how much lower the export price is compared to the exporter’s home market price), and show that the dumping is causing injury. Usually an ‘anti-dumping action’ means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the “normal value”.

Externalities, Market Failure and Import ControlsProtectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and are termed de-merit goods. Protectionism can safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation of the good altogether.

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Non-Economic ReasonsCountries may wish not to over-specialize in the goods in which they possess a comparative advantage. One danger of over-specialization is that unemployment may rise quickly if an industry moves into structural decline as new international competition emerges at lower costs. The government may also wish to protect employment in strategic industries, although clearly value judgments are involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision by the United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in the late autumn of 2003.

Economic Arguments against Import ControlsAccording to Professor Jagdish Bhagwati, “the fact that trade protection hurts the economy of the country that imposes it is one of the oldest but still most startling insights economics has to offer.”

Some studies indicate that protectionism has brought few benefits but imposed substantial costs.

1. Market distortion: Protection has proved an ineffective and costly means of sustaining employment.a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalize foreign producers and encourage the inefficient allocation of resources both domestically and globally. In general terms, import controls impose costs on society that would not exist if there was completely free trade in goods and servicesb. Reduction in market access for producers: Export subsidies, depressing world prices and making them more volatile while depriving efficient farmers of access to the world market. This is a major criticism of the EU common agricultural policy. In 2002 the EU sugar regime lowered the value of Brazil, Thailand and South Africa’s sugar exports by over $700 million – countries where nearly 70 million people survive on less than $2 a day.2. Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a loss of allocative

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efficiency. Welfare is reduced through higher prices and restricted consumer choice.3. Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. Governments must consider these disadvantages carefully4. Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importing new technologies5. Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in total trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. The negative multiplier effects are more pronounced when trade disputes boil over and lead to retaliation.

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Questions

1: Suppose that a worker in the United States can produce a maximum of 50 computers and 100 shirts in a year, while a worker in Brazil can produce a maximum of 2 computers or 50 shirts per year. For simplicity assume that each country only has one worker and that there is a total of 200 working days in a year.

(a) Find the number of days required to produce a shirt and a computer for each country

(b)Draw the production possibility frontiers(c) Calculate the opportunity cost for each product in both

countries(d)Which country has an absolute advantage? Explain why(e) Which country has a comparative advantage in the production

of computers? Shirts?

2: Suppose initially there is no trade between these countries. In this situation the American worker produces 41 computers and 18 shirts, while the Brazilian worker produces 1 computer and 25 shirts.

a) Draw the table for consumption before trade.b) Assume that the American agrees to specialise in computers

and produces 50 computers. The Brazilian specialises in shirts and his production doubles. Draw the new table

c) The Brazilian worker suggests the following trade: He will trade 20 shirts in return for 2 computers. Explain why this trade has benefited each country in terms of the price that each country pays for each good.

d) Suggest a trade that will only benefit the United States.

3: Outline the reasons for why the assumptions pertaining to the Principle of Comparative Advantage are unrealistic.

4: Assume that two countries Germany and France with similar amounts of resources both produce only two goods, wine and cheese.

Wine Cheese(Millions of bottles) (Millions of Kilos)

Germany 150 100France 200 200Total 350 300

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a) Draw the production possibility curves for both Germany and France.

b) Which country has the absolute advantage? c) Calculate the opportunity cost for each productd) Determine which product Germany and France should

specialize in and draw out the new table (post-specialization) e) Comparing the new table to the pre-specialization table, why

should these two countries not specialize entirely in the production of one product?

f) How could one of the countries rectify this problem (make the post-specialisation table demonstrate a benefit to world trade)

5: Before 1995, the United States imposed tariffs on goods imported from Mexico. In 1995, Mexico joined NAFTA. US tariffs on imports from Mexico and Mexican tariffs on imports have gradually been removed. Explain how the removal of tariffs will change:

(a) The price that US consumers pay for goods imported from Mexico.(b) The quantity of US imports from Mexico(c) The quantity of US exports to Mexico(d) The US government’s tariff revenue from trade with Mexico.

6: If the US government places a ban on potato imports, explain how this ban influences:

(a) The price that US consumers pay for potatoes(b) The quantity of potatoes consumed in the US(c) The price received by Canadian potato growers(d) The US and Canadian gains from trade.

7: In 2000, the US Congress and Senate decided to extend an arrangement that limits the tariffs on imports from China. If the United States imposed higher tariffs on imports from China, explain how the higher tariffs would change:

(a) The price that US consumers pay for toys imported from China(b) The quantity of US imports of toys from China(c) The quantity of toys produced in the United States(d) The US government’s tariff revenue from trade in toys with China(e) The US and Chinese gains from trade.

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8: Australia has a comparative advantage in producing beef, but the United States sets a quota on beef imports from Australia. Explain how the quota influences:

(a) The price that US consumers pay for beef(b) The quantity of beef produced in the United States(c) The US and Australian gains from trade.

9: (a) Japan sets quotas on imports of rice. California rice growers would like to export more rice to Japan. What are Japan’s arguments for restricting imports of Californian rice? Are these arguments correct? Who loses from this restriction in trade?(b) The United States has, from time to time, limited imports of steel from Europe. What is the argument that the United States has used to justify this quota? Who wins from this restriction? Who loses?(c) The United States maintains a quota on imports of textiles. What is the argument for this quota? Is this argument flawed?

10: The world price of wine is below the price that would prevail in the US in the absence of trade.

a) Assuming that American imports of wine are a small part of total wine production, draw a graph for the US market for wine under free trade. Identify consumer surplus, producer surplus and total surplus in an appropriate table.

b) Now suppose that an unusual shift of the Gulf Stream leads to an unseasonably cold summer in summer in Europe destroying much of the grape harvest there. What effect does this shock have on the world price of wine? Using your graph and the table from part (a) show the effect on consumer surplus, producer surplus and total surplus in the United States. Who are the winners and losers? Is the United States better or worse off?

11: Suppose that the US Congress imposes a tariff on imported automobiles to protect the US auto industry from foreign competition. Assuming that the US is a price taker in the world auto market, show on a diagram: the change in the quantity of imports, the loss to US consumers, the gain to US manufacturers, government

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revenue and the deadweight loss associated with the tariff. The loss to consumers can be decomposed into three pieces: a transfer to domestic producers, a transfer to the government, and a deadweight loss. Use your diagram to identify these three pieces.

12: An article in The Wall Street Journal (June 26, 1990) about sugar beet growers explained that “the government props up domestic sugar prices by curtailing the imports of low cost sugar. Producers are guaranteed a “market stabilisation price” of $0.22 a pound, about $0.09 higher than the current world market price”. The government maintains the higher price by imposing an import quota.

a) Illustrate the effect of this quota on the US sugar market. Label the relevant prices and quantities under free trade, and under the quota system.

b) Analyse the effects of the sugar quota using an appropriate table illustrating the change in economic surplus.

c) The article states, “At home, the sugar program has helped make possible the spectacular rise of the high-fructose corn syrup industry”. Why has the sugar program had this effect?

13: As you are now budding economists, evaluate each of the following policy positions.

a) The government should not allow imports if foreign firms are selling below their costs of production (dumping)

b) The government should temporarily stop the import of goods for which the domestic industry is new and struggling to survive.

c) The government should not allow imports from countries with weaker environmental regulations than ours.

14: In the market for bottled water, the demand function is QD = 3 – 2P and the supply function is QS = 2P, where price is given in $ per litre of water and quantity is given in millions of bottles per month.

i. Plot the curves from the functions above on a graph. Fully label the axes.

ii. Identify the equilibrium prices and quantities. iii. Add the world supply curve if foreign producers are

prepared to supply bottled water at $0.50.

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iv. Show the effect on the diagram of the government putting a tariff of $0.10 on all imports of bottled water.

v. Identify the level of domestic production before the tariff and after.

vi. Calculate the amount of revenue for domestic producers before the tariff and after.

vii. Identify the level of imports before the tariff and after. viii. Calculate the amount of revenue for foreign producers

before the tariff and after. ix. Calculate the amount of government revenue from the tariff. x. Calculate the fall in consumer surplus resulting from the

imposition of the tariff. xi. Calculate the dead-weight losses suffered as a result of

imposing the tariff.

15: In the market for bottled water, the demand function is QD = 3 – 2P and the supply function is QS = 2P, where price is given in $ per litre of water and quantity is given in millions of bottles per month. (The x-axis should be from 0 to 4 and the y-axis should be from 0 to 2.)

i. Plot the curves from the functions above on a graph. Fully label the axes.

ii. Identify the equilibrium prices and quantities. iii. Add the world supply curve if foreign producers are

prepared to supply bottled water at $0.50. iv. Show the effect on the diagram of the government putting a

quota on imports of 600,000 litres of bottled water. v. Identify the level of domestic production before the quota

and after. vi. Calculate the amount of revenue for domestic producers

before the quota and after. vii. Identify the level of imports before the quota and after. viii. Calculate the amount of revenue for foreign producers

before the quota and after. ix. Calculate the fall in consumer surplus resulting from the

imposition of the quota. x. Calculate the dead-weight losses suffered as a result of

imposing the quota.

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16. In the market for bottled water, the demand function is QD = 3 – 2P and the supply function is QS = 2P, where price is given in $ per litre of water and quantity is given in millions of bottles per month. (The x-axis should be from 0 to 4 and the y-axis should be from 0 to 2.)

i. Plot the curves from the functions above on the graph below. Fully label the axes.

ii. Identify the equilibrium prices and quantities. iii. Add the world supply curve if foreign producers are

prepared to supply bottled water at $0.50. iv. Show the effect on the diagram of the government grants a

subsidy of $0.20 on all domestic production of bottled water.

v. Identify the level of domestic production before the subsidy and after.

vi. Calculate the amount of revenue for domestic producers before the subsidy and after.

vii. Identify the level of imports before the subsidy and after. viii. Calculate the amount of revenue for foreign producers

before the subsidy and after. ix. Calculate the amount of government expenditure on the

subsidy. x. Calculate the dead-weight losses suffered as a result of

granting the subsidy.

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