International Trade and Trade Policy

Applying Comparative Advantage and Supply and Demand

Chapter 9

Major Issues

• Why trade with other nations (regions)?

• Recognizing comparative advantage

• Benefits and costs

• Effects of tariffs, quotas, and other impediments to trade

• Subsidies as alternative to tariffs or quotas

Why Trade?• Take advantage of specialization and division

of labor• Not much controversy among economists

over the benefits of free trade in the long run. Consider the U.S or the European Union.

• Controversy arises about moving to freer trade or putting restrictions on trade, because these changes generate winners and losers.

Principle of Comparative Advantage (CA)

• The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good compared to other producers.

• Applies to regions and countries as well as individuals and firms.

• Some examples: Eastern Kentucky and Bluegrass,

– Colorado and Iowa, U.S and Haiti

– U.S. and Mexico, U.S and Japan

Applying CA to Regions

• In the same way that Mike and Paddy were able to increase total output by specializing according to the principle of CA, so also can regions increase joint output through their people following CA.

Gains from Specialization• Country A can produce 24 units of nuts and

zero coffee or zero nuts and 12 units of coffee or any combination in between. The reverse is true in Country B.

• If country A produces one less unit of coffee, it can produce two more units of nuts. If country B produces one less unit of nuts, it can produce two more units of coffee. Result: one more unit of nuts and one more unit of coffee available for consumption!

PPF when OC Varies Continuously

PPF for a Small Island Nation

How Trade Expands the Consumption Menu

IT and Supply and Demand

• What happens in the market for a good when a country goes from autarky to free trade in the good?

• How do trade restrictions such as a tariff or a quota affect the equilibrium in the market for a good?

A Classic Case: The Corn Laws

• United Kingdom passed a law in 1815 banning the importation of grain, including wheat. The law was repealed in 1846.

• In 1846, the wheat market in Great Britain went from autarky to free trade.

Autarky in the wheat market

Assume:– The country’s wheat market is isolated in that

there is no trade in wheat with the rest of the world.

– The market for wheat consists of the buyers and sellers of the country.

– Domestic Price adjusts to balance Demand and Supply.

United Kingdom Market in Wheatunder Autarky

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Equilibrium Without Trade

• When an economy cannot trade in world markets, the price adjusts to equilibrate domestic supply and demand.

• Equilibrium price of $8 and quantity of 30.

• Consumer (buyer) surplus: (12-8)30/2=60

• Producer (seller) surplus: (8-2)30/2=90

• TOTAL SURPLUS OR economic benefit: 150

Impacts of International Trade

• If the country decides to engage in international trade will it be an importer or exporter of wheat?

• Who will gain from free trade in wheat and who would lose?

• Will gains from trade exceed losses?

Determinants of IT

If a country has a comparative advantage relative to other counties, then the domestic price will be below the world price and the country will be an exporter of the good.

If the rest of the world has a comparative advantage, then the domestic price will be higher than the world price and the country will be an importer of the good.

International Trade Example - Importer

• Since the world price of wheat is lower than the U.K. price, the U.K would be an importer of wheat, when trade is permitted.– U.K consumers will want to buy the lower priced wheat

at the world price.

• U.K producers of wheat will have to lower their output until the supply price is equal to the world price.

United Kingdom Market in Wheatwith Free Trade

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Free IT: Winners and Losers

• When a country allows trade and becomes an importer of a good, domestic consumers of the good are better off. They pay a lower price.

• However, domestic producers of the good are worse off. They receive a lower price.

Computing the Gain from Trade• World price is $4.

• Price in U.K. falls to $4. Quantity supplied by U.K. producers is 10 while quantity demanded is 60. Imports of 50 fill the gap.

• Consumer surplus: (12-4)60/2 = 240

• Producer surplus: (4-2)10/2 = 10

• Economic benefit: 240 + 10 = 250

• Gain from free trade: 250 – 150 = 100

Free Trade: Winners and Losers

• When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off. They receive a higher price.

• However, domestic consumers of the good are worse off. They pay a higher price.

Winners and Losers From Free International Trade

• Trade raises the economic well-being of the nation.

• The net change in total surplus is positive.

• The total surplus is the sum of the consumer surplus and the producer surplus. How do we figure out the total surplus?

Gains from Free Trade in U.K. • At a price of $8 per unit, consumer surplus

is (12-8)x30/2=60 and producer surplus is (8-2)x30/2=90 for a total surplus of $150.

• At $4, consumer surplus is (12-4)x60/2=240 while producer surplus is (4-2)x10/2=10 for a total of $250.

• The net gain is $100.

Volume of Trade

• The volume of international trade has grown substantially over time

• Most nations produce less than a small fraction of the total supply of any good or service, which allows these nations to benefit from the differences in domestic opportunity costs and global opportunity costs

Why Trade Barriers?

• If exchange is beneficial, why does anyone oppose it?

• International trade does increase the total value of all goods and services, but certain industries may be harmed

• E.G. Concerns over NAFTA– U.S. consumers would benefit from lower prices– But, some thought that the U.S. would lose some

unskilled jobs to Mexico, which, however, has not been shown

Arguments for Restricting TradeArguments Against Free Trade

• Jobs

• National Security

• Infant Industry

• Unfair-Competition

• Protection-as-a-Bargaining-Chip

Trade Restrictions

• Have demonstrated the gains from free trade. Now want to look at the issue of protectionism or restrictions on trade.

• Major Kinds: Tariff, Quota, and Regulation

• Tariff: tax on imports of a good

• Quota: limits the amount of good imported

• Regulation: health, transport, other

The Welfare Effects of a Tariff

• A tariff is a tax on imported goods.

• A tariff raises the price of imported goods, above the world price by the amount of the tariff.

• Domestic suppliers of the good with the tariff are gainers while domestic consumers of the good are losers.

U.K. Market in WheatEffect of a Tariff of $2/bu

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Quantiy

The Welfare Effects of a Tariff

• Like any tax on the sale of a good, an import tariff distorts incentives and pushes the allocation of scarce resources away from the efficient point. – Raises domestic prices and encourages more

domestic production of the good.– Higher domestic prices reduces the amount

purchased by domestic consumers

The Cost of a Tariff

• At a price of $6 per unit, consumer surplus is (12-6)x45/2=135, producer surplus is (6-2)x20/2=40, and government revenue is (45-20)2=50 for a total surplus of $225.

• In free trade, consumer surplus is (12-4)x60/2 = 240 while producer surplus is (4-2)x10/2=10 for a total of $250.

• The net gain is - $25. Tariff causes an economic loss of $25

An Import Quota

• A quota is a quantitative restriction on imports in the sense that a limited quantity of the good is allowed into the country.

• Qualitative effect of a quota is the same as that of a tariff. However, the difference in price between the domestic market and the world market accrues to the holder of the import license. (Can lead to corruption!)

U.K. Market in WheatEffect of an Import Quota of 25

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Effects of Quota• In our example, quota restricts imports to

25. This appears as a horizontal addition to the domestic supply curve above the world price.

• Relative to free trade, price in importing country is increased to $6, imports are reduced to 25, and domestic output is increased from 10 to 20. Value of an import license $2 times quantity authorized.

Tariffs, Quotas, and Subsidies• What is the difference between the effects of a

tariff and a quota? The government receives the revenue from the tariff, while that revenue accrues to the importer under a quota. Who decides who can import? If import quota rights are auctioned, government can capture that revenue.

• An alternative to a tariff is a per unit subsidy to domestic producers. Consider a $2 per bushel subsidy.

U.K. Market in WheatEffect of a Subsidy of $2 /bu

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Welfare Cost of a Subsidy

• At a price of $4, consumer surplus is (12-4)60/2 = 240, producer surplus is (4-0)x20/2=40, and government revenue is negative 2x20=40 because of the subsidy. The total surplus is 240 compared with $250 under free trade.

Conclusion... A Parable of Free Trade

• Throughout its history, the United States has allowed unrestricted trade among the states, and the country as a whole has benefited from the specialization that trade allows.