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Summary
1. 2. 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
3.
4.
Suppose: Country A and Country B. Equally sized. Country A is better at producing both wine and wheat than B.
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.
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.
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.
wheat
120 A's Production
Wine
60
wheat
120 A's Production 120-2a
Wine
a 60
Before trade B
Wheat
15
B's Production
60
Wine
15 15-(b/4)
B's Production
60
Wine
Let B produce 1 more unit of wine (its comparative advantage) and therefore 0.25 less units of wheat.
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).
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!
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.
Wheat
A Autarky
A
Wine
Wheat Prices in A
A Autarky
A
Wine
Wheat
B Autarky
Wine
B Autarky
Wine
Wheat
B Autarky
A Autarky
A
Wine
Trade raises the price of wheat in B and raises the price of wine in A
Wheat
A
Wine
Trade raises the price of wheat in B and raise the price of wine in A
Wheat
A Autarky
A
Wine
A
Wine
Wheat
B Wine
Wheat
Wine
Wine
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.
Wheat
B Autarky
A Autarky
A Wine
Hence
Before trade the price of labour in A will be low relative to the price of capital.
It will also decrease the reward to capital (relative to the prices of wine and wheat).
3. Protection
Instruments of Public Policy: Tariff (Taxes) Quotas (quantity restrictions) Non-tariff barriers (Product standards, voluntary restraints etc.)
Price
Domestic Demand
Quantity
Once Imports are allowed there is infinite supply at the world price.
Domestic Supply
Price
World Supply
Domestic Demand
Quantity
Price
World Supply
Domestic Demand
Supply From Local Firms
Quantity
Price
World Supply
Domestic Demand
Supply From Local Firms Supply From Importers
Quantity
Price
World Supply
Domestic Demand
Quantity
Price
World Supply
Domestic Demand
Quantity
Before Tariff
Domestic Supply
Price
Quantity
After Tariff
Domestic Supply
Price
Quantity
Price
Tariff
Quantity
Price
Tariff
Quantity
Price
Tariff
Quantity
Price
Tariff
Quantity
Price
Tariff
Quantity
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
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 => may increase welfare.