free trade economics
TRANSCRIPT
Economics of Trade
Revision webinar on the economics of free trade
Revision MC1
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Analysis diagram showing tariff cut
Price
Domestic Demand for Cars
Domestic Supply of Cars
P1 + T Price including tariff
Q2 OutputQ1
Price with lower tariffP2
Q3 Q4
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Country Y has a comparative advantage in applesFull specialisation – they can supply 50 apples
Country X has a comparative advantage in bananas75% specialisation – they can supply 60 bananas25 % of resources into apples = 25 apples
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German exports of goods
UK exports of goods
Germany
UK
What is the model of comparative advantage?
• David Ricardo, one of the founding fathers of classical economics developed the idea of comparative advantage
• Comparative advantage exists when
1. Relative opportunity cost of production for a good or service is lower than in another country
2. A country is relatively more productively efficient than another
• Basic rule – specialise in the goods and services that you are relatively best at
• This opens up important potential gains from specialisation and trade leading to a more efficient allocation of scarce resources
David Ricardo
Absolute & Comparative Advantage – An Example
Output with ½ resources allocated to each industry in both countries
Beef Tobacco
Australia 250 200
Malawi 100 150
Total 350 350
In this example:• Australia has the absolute advantage in producing beef and tobacco• With ½ of their resources allocated to each product then Australia can produce
more quantities of both beef and tobacco• When it comes to comparative advantage, Malawi has the comparative
advantage in producing tobacco – it is ¾ as good at producing Tobacco than Australia but less efficient (2/5ths as good) at producing beef
Comparative Advantage and Gains from Trade
Beef
Raw Tobacco
Australia
Malawi
500
250
200
100
150 300200 400
Output with ½ resources allocated to each industry in both countries
Beef TobaccoOpportunityCost Ratio
Australia 250 200 5:4
Malawi 100 150 10:15
Total 350 350
Australia has a comparative advantage in producing Beef - the opportunity cost of an extra unit of beef is 4/5th unit of tobacco, whereas for Malawi it is 1.5 units of tobacco.
Malawi has a comparative advantage in producing tobacco – the opportunity cost of an extra unit of tobacco is 2/3rd of beef whereas for Australia it is 5/4.
Comparative Advantage and Gains from Trade
Beef
Raw Tobacco
Australia
Malawi
500
250
200
100
150 300200 400
If both countries specialise according to comparative advantage, and assuming constant returns to scale, then total output can rise.
Output after specialisation has taken place
Beef Tobacco
Australia 400 (+150) 80 (-120)
Malawi 0 (-100) 300 (+150)
Total 400 (+50) 380 (+30)
Comparative Advantage and Gains from Trade
Beef
Raw Tobacco
Australia
Malawi
500
250
200
100
150 300200 400
If both countries trade at a mutually beneficial terms of trade of 1 Beef for 1 tobacco – then they can both end up with more of both products
Output after trade has taken place
Beef Tobacco
Australia 270 210
Malawi 130 170
Total 400 380
300
Comparative Advantage and Gains from Trade
Beef
Raw Tobacco
Australia
500
250
200
100
150 300200 400
Output after trade
Beef Tobacco
Australia 270 210
Malawi 130 170
Total 400 380
Output with ½ resources allocated to each industry in both countries
Beef Tobacco
Australia 250 200
Malawi 100 150
Total 350 350
Malawi
Trade with a 1:1 exchange rate
500
Comparative Advantage and Gains from Trade
Beef
Raw Tobacco
Australia
500
250
200
100
150 300200 400
Malawi
Trade with a 1:1 exchange rate
300
500
Key analysis points:• When you draw two countries’
PPFs, if they have the same gradient, then the opportunity costs are the same, and thus no country has a comparative advantage, so there are no gains from trade to be had.
• If their PPFs have different gradients, then the opportunity costs are different, so comparative advantage exists, so there are potential gains from specialisation and trade.
Assumptions behind theory of Comparative Advantage
• The key assumptions behind the theory are as follows:
1. Constant returns to scale – i.e. no economies of scale – which might amplify the gains from trade
2. Factor mobility between industries (geographical + occupational)
3. No import controls such as import tariffs and quotas
4. Low transportation costs to get products to overseas markets –high logistics costs might erode comparative advantage
5. No externalities from production and/or consumption
• Mutually beneficial terms of trade is not necessarily one that benefits both countries equally – the benefits may be skewed.
• In the real world – a two-country, two-product model is a simplification. Many products are now assembled from inputs drawn from multiple countries – this is called vertical specialisation
• Intra-industry trade is growing – this is when countries that export and import similar products – they have strong capabilities in each!
Does Free Trade lead to improved Economic Efficiency?
Economic efficiency Possible impact of trade on economic efficiency
Allocative efficiencyCompetition from lower-cost import sources drives market prices down and reduces monopoly (supernormal) profits
Productive efficiencySpecializing and selling in larger markets encourages increasing returns to scale (economies of scale) – i.e. a lower long run AC
Dynamic efficiency
Open economies may see more innovative businesses who invest more in research and development and also in the human capital of their workforce to raise labour productivity
X-inefficiencyIntense competition in markets provides a discipline on businesses to keep their unit costs under control to remain price competitive
What are Dynamic Gains from Free Trade?
• Trade makes countries better off by allowing them to specialise according to their comparative advantage
• Trade provides access to new and cheaper imported goods, and increases competition between producers
• Dynamic gains from trade make a domestic economy more productive.
• Examples of potential dynamic gains include:1. Diffusion of knowledge and technology (positive spillovers)2. Increased contestability of markets and faster innovation3. A within-country selection of more productive firms who act
as a catalyst for other businesses to raise their game4. Access to cheaper and more productive input goods and
services into a country’s supply-chain5. Less rent-seeking behaviour by monopolists6. Reduced incentives for corruption which then aids long-run
economic development
Why is Trade important for Developing Countries?
• Successful trade provides for developing nations:
1. A source of foreign currency to help a nation’s balance of payments (trade surplus countries build up US$ reserves)
2. An important way of financing imports of essential imports of capital equipment / technologies and energy supplies
3. An injection of demand into the circular flow of income and spending + creating positive export multiplier effects
4. Increased employment in export industries and related industries and rising per capita incomes and strong HDI scores
5. Falling prices for consumers helps to increase real incomes e.g. by opening up monopoly suppliers of energy to new competition
The share of least-developed countries (LDCs) in world exports increased from 0.5 per cent of total trade in 1995 to 1.1 per cent in 2014 (Source: WTO)
Risks of Trade & Investment for Emerging Countries
• Overseas trade and investment carries risks1. Volatile global prices affecting export revenues and
profits and tax revenues for governments
2. There are risks that exports will be affected by geo-political uncertainties and cyclical shifts in demand
3. Capital flows into developing nations are highly volatile
4. Opening up to trade and investment may actually cause rising structural unemployment in some industries as the pattern of demand, output and jobs changes – poorer countries may opt for rapid industrialisation aided by import protectionism before they eventually open up
5. Countries that specialise in only a few natural resources may suffer from the “natural resource trap” which may make them poorer than countries less dependent on exporting commodities to the rest of the world
Evaluation: Potential Costs of International Trade
Transport costs e.g. problems from carbon
emissions from increased food miles
Negative externalities arising from production and
consumption of products traded around the world
Risk of structural unemployment as patterns
of trade change and jobs are lost e.g. in manufacturing
Rising inequality – the gains from trade and globalisation
are unequal
Pressure on real wages and working conditions in
advanced and emerging countries
Risks from global (external) external shocks such as the 2008 Global Financial Crisis
Revision MC5
Revision MC5
Economics of Trade
Revision webinar on the economics of free trade