2' Free Trade and Protection

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2. Free Trade and Protection

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Summary

• Theory of Comparative Advantage
• Why trade is good.
• Where comparative advantage comes from
• Heckscher-Ohlin Model (factor endowments)
• Equalization of factor income
• Welfare Effects of a Tariff
• Consumers Lose
• Govt gains
• Local producers gain
• Arguments for protection
• Optimal tariff
• Infant industry
• Employment

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Ricardos Theory of Comparative Advantage

• Suppose
• Country A and Country B. Equally sized. Country A
  is better at producing both wine and wheat than
  B.

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Ricardos Theory of Comparative Advantage

• Suppose
• Country A and Country B. Equally sized. Country A
  is better at producing both wine and wheat than
  B.
• Even then, both countries can benefit from trade.

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Ricardos Theory of Comparative Advantage

• Suppose
• Country A and Country B. Equally sized. Country A
  is better at producing both wine and wheat than
  B.
• Even then, both countries can benefit from trade.
• Key is relative advantage.

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Ricardos Theory of Comparative Advantage

• Suppose
• Country A and Country B. Equally sized. Country A
  is better at producing both wine and wheat than
  B.
• Even then, both countries can benefit from trade.
• Key is relative advantage.
• For example, assume A is relatively better at
  wheat production than wine.

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• Before trade Country A

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• Before trade A produces awine and 120-2awheat.

120-2a
a
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• Before trade B
•  

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• Before trade B produces bwine and
  15-(b/4)bread.
•  
• Total world production is
• (a b wine, 135 - 2a - 0.25b wheat).

15-(b/4)
b
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Now let trade occur

• Let B produce 1 more unit of wine (its
  comparative advantage) 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
  comparative advantage) 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 comparative
  advantage). 

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Now let trade occur

• Let B produce 1 more unit of wine (its
  comparative advantage) 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 comparative
  advantage). 
• 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
  comparative advantage) 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 comparative
  advantage). 
• 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 WheatA 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
  wheat so
• Price of WheatA 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 WheatA 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
• As long as
• ½ X (World Price of Wine) lt World Price of Wheat
  lt 4 X (World Price of Wine)

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Some Pictures Country A Production Possibilities

Wheat
A Autarky
A
Wine
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Some Pictures Country A Production Possibilities

Wheat
Prices in A
A Autarky
A
Wine
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Country Bs Production Possibilities

Wheat
B Autarky
B
Wine
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Country Bs Production Possibilities

Prices in B
Wheat
B Autarky
B
Wine
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Who has higher prices?

Wheat
B Autarky
A Autarky
A
B
Wine
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Trade raises the price of wheat in B and raises
the price of wine in A

Wheat
A
B
Wine
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Trade raises the price of wheat in B and raise
the price of wine in A

Wheat
A Autarky
A
B
Wine
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Trade raises the price of wheat in B and raises
price of wine in A

Same Prices gt lines are parallel
Wheat
A
B
Wine
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At the new prices B is better off

Wheat
B
Wine
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It produces more wheat

Wheat
Wine
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It produces more wheat and consumes more wine

Wheat
Export Wheat
Wine
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It produces more wheat and consumes more wine

Wheat
Export Wheat
Import Wine
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 between industries
  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
  has a lot of labour.

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Wheat
B Autarky
A Autarky
A
B
Wine
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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 low
  relative to the price of capital.

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Trade occurs to move immobile inputs around

• Country B is rich in capital and export the good
  that is rich in capital.
• Before trade the price of capital in B will be
  low relative to the price of labour.
• They cant move the factors but they can move
  goods.

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ConsequenceFactor 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

• Instruments 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
Price
Domestic Demand
Quantity
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• Once Imports are allowed there is infinite supply
  at the world price.

Domestic Supply
Price
World Supply
Domestic Demand
Quantity
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• Efficient domestic producers continue to produce.

Domestic Supply
Price
World Supply
Domestic Demand
Supply From Local Firms
Quantity
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• But there is an increase in supply from importers.

Domestic Supply
Price
World Supply
Domestic Demand
Supply From Local Firms
Supply From Importers
Quantity
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• Consumers value with trade

Domestic Supply
Price
World Supply
Domestic Demand
Quantity
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• Local Producers value

Domestic Supply
Price
World Supply
Domestic Demand
Quantity
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The Government Imposes a Tax/Tariff

• We could describe this as a shift in the demand
  function.
• Or
• We could think of this as an increase in the
  price of imports

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• Before Tariff

Domestic Supply
Price
World Supply
Domestic Demand
Quantity
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• After Tariff

Domestic Supply
Price
World Supply with Tariff
World Supply
Domestic Demand
Quantity
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• Who gains who loses?

Domestic Supply
Price
Tariff
World Supply
Domestic Demand
Quantity
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• Consumers lose this

Domestic Supply
Price
Tariff
World Supply
Domestic Demand
Quantity
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• Producers gain this

Domestic Supply
Price
Tariff
World Supply
Domestic Demand
Quantity
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• Government gains this much tax

Domestic Supply
Price
Tariff
World Supply
Domestic Demand
Quantity
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• Net the country loses

Domestic Supply
Price
Tariff
World Supply
Domestic Demand
Quantity
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What Justification is there for Protection

• The above shows that if your country is small you
  always lose form protection.
• If your country is large this may not be so.
• (2) Infant Industries
• Government is necessary to protect industries
  until they are grown 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 to
  undergo 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)
• Information
• (Government has better knowledge?)
• Capital market failure
• (hard for firms to get loans)

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Employment Argument

• The above assumes the labour market is in
  equilibrium (i.e. full employment).
• If this is not so, then the opportunity cost of
  labour being used in the exporting industries is
  less than the equilibrium wage gt may increase
  welfare.