Comparative Advantage and Trade

• Topics covered include how much a country will import/export, who benefits/is harmed by trade, the effects of restricting imports, and common arguments for trade restrictions

Consumer and Producer Surplus

• Consumer surplus exists when a consumer pays less than their willingness to pay
• Producer surplus exists when a producer is paid more than the cost of production
• Total surplus is the sum of consumer and producer surplus

Comparative Advantage and Trade

• A country has a comparative advantage in a good if it has a lower opportunity cost compared to other countries
• Countries can benefit from trading by exporting goods they have a comparative advantage in
• A country has a comparative advantage if the domestic price is lower than the world price
• Producers are eager to export to foreign markets for higher prices
• If the domestic price is lower than the world price, trade will lead to exports

Welfare Economics and Trade

• Welfare economics tools can be used to see where gains from trade come from and who receives them
• If the domestic price is higher than the world price, trade will lead to imports
• A country doesn't have comparative advantage if the domestic price is higher than the world price
• Domestic price can be higher if the cost of producing is higher relative to the world
• Consumers are eager to import for lower prices coming from foreign markets

Small Economy Assumption

• A small economy is a price taker in world markets and their actions do not affect the world price (Pw)
• When a small economy engages in free trade, the world price is the only relevant price
• No seller would accept less than the world price
• No buyer would pay more than the world price

Case Study: Soybeans

• Without trade, the domestic price of soybeans is $4, and the quantity is 500
• With free trade, the world price is $6
• Domestic consumers demand is 300, domestic producers supply is 750 and exports are 450

Case Study: Plasma TVs

• Without trade, domestic price is $3000, and the quantity is 400
• In world markets, the world price is $1500
• With free trade, domestic consumers demand 600, domestic producers supply 200, and imports are 400
• Without trade, consumer surplus is area A and producer surplus is area B + C and total surplus is A + B + C
• With trade, consumer surplus is area A + B + D, producer surplus is area C, and total surplus is A + B + C + D

Welfare Effects of Trade

• When the domestic price is lower than the world price, the direction of trade is exports
• Consumer surplus falls, producer surplus rises, and total surplus rises
• When the domestic price is higher than the world price, the direction of trade is imports
• Consumer surplus rises, producer surplus falls, and total surplus rises
• Trade creates both winners and losers, whether exporting or importing, but the gains exceed the losses

Benefits of International Trade

• Consumers enjoy an increased variety of goods
• Producers can sell to a larger market and lower costs through larger-scale production
• Competition from abroad can reduce the market power of domestic firms
• Trade enhances the flow of ideas which facilitates the spread of technology

Opposition to Trade

• Protection of trade can make everyone better off
• The winners from trade could compensate the losers and still be better off
• The compensation rarely occurs
• Losses are often concentrated among a small group of people, who feel them acutely
• The gains are often spread thinly over many people
• Losers have more incentive to organize and lobby for trade restrictions

Tariffs

• A tariff is a tax on imports
• The tax on imports is paid from consumer surplus gained due to imports
• Deadweight loss areas are societal losses
• Taxes on imports are just on the consumer surplus

Tariff Case Study: Cotton Shirts

• In free trade, the world price for cotton shirts is $20, buyers demand 80, sellers supply 25, and imports are 55
• Due to tax imposed of 10/shirt,thepricerisesto10/shirt, the price rises to 10/shirt,thepricerisesto30, the buyers demand 70, the seller’s supply 40 and imports are 30
• Deadweight loss with trade due to tariff is the area of D+F
• D represents the efficiency loss from the overproduction of shirts
• F represents the efficiency loss from the under-consumption of shirts

Import Quotas

• An import quota is a limitation on the amount of imports of a good
• Generally has the same effects as a tariff
• Raises the price, reduces the quantity of imports
• Reduces the buyers welfare
• Increases seller’s welfare
• Tariffs create revenue for the government, while quotas create profits for foreign producers

The Jobs Argument

• Trade destroys jobs in industries that compete with imports
• Total unemployment does not necessarily rise as imports rise
• Job losses from imports is offset by job gains in export industries
• A country only needs a comparative advantage to have a viable export industry, even if all goods could be produced more cheaply abroad

The National Security Argument

• An industry vital to national security should be protected from foreign competition
• This would prevent dependence on imports during wartime
• Policy should be based on true security needs
• Producers may exaggerate their importance to national security to obtain protection from foreign competition

The Infant-Industry Argument

• A new industry argues for protection until it can compete with foreign firms
• It is difficult for the government to determine which industries will be able to compete
• Also assessing whether benefits of establishing industries exceeds the cost of restricted imports is difficult
• Firms willing to be profitable in the long run should be willing to incur temporary losses

The Unfair Competition Argument

• Producers argue their competitors in other countries have an unfair advantage
• This is often due to government subsidies
• Subsidized products allow an opportunity to import extra-cheap products
• Gains to consumers will exceed losses to producers in this instance

The Protection-as-Bargaining-Chip Argument

• A country can threaten to limit imports of another good unless the country lifts quotas on another good
• If the other country refuses, there are two bad options
• Restricting imports reduces welfare
• Not restricting imports reduces believability

Trade Agreements

• Trade can be liberalized with unilateral reductions in trade restrictions
• Trade can also be liberalized by use of multilateral agreements with other nations
• The North American Free Trade Agreement (NAFTA), established in 1993, is one example
• The General Agreement on Tariffs and Trade (GATT) is another example
• The World Trade Organization (WTO), established in 1995, enforces trade agreements and resolves disputes

Overall Summary

• A country will export a good if the world price is higher than the domestic price without trade
• Trade raises producer surplus, reduces consumer surplus and raises total surplus
• A country will import a good if the world price is lower than the domestic price without trade
• Trade lowers producer surplus, but raises consumer and total surplus
• A tariff benefits producers and generates revenue for the government but can exceed consumer gains
• Common arguments for restricting the trade includes protecting jobs, national security, infant industries, preventing unfair competition and responding to foreign trade restrictions
• Some of these arguments have merit; however, economists believe free trade is the better policy