L28 - International Trade and Commercial Policy Flashcards
What is it called when a country does not engage in trade?
Autarky
What is International trade necessary for?
- international trade is necessary to achieve the gains that international specialisation makes possible
- for example without trade, everyone would have to be self-sufficient, but if people could trade, everyone could specialise to make everyone’s lives better, this principle hold between countries
- Trade allows each individual,region or nation to concentrate on producing those goods and services that it produces relatively efficiently while trading to obtain goods and services that it would produce less efficiently than is done by others
What are the three main sources of gains from trade?
1 - the first is differences between region of the world in climate and resources endowment that lead to advantages in producing others
- these gains would occur even if each country’s costs of production were unchanged by the existence of trade
2 - The second source is the reduction in each country’s costs of production that results from the greater production that specialisation brings
3 - The thud is the international competition that usually promotes more rapid technological change and economic growth than would occur if domestic firms produced solely for a protected home market
What is Absolute Advantage?
- was developed by Adam Smith (1776) in his publication The Wealth of Nations.
- one region has an absolute advantage over another in the production of good X when an equal quantity of resources can produce more X in the first region than in the second.
- Total production can be increased if each country specializes in producing the product for which it has an absolute advantage.
- These gains from specialization make the gains from trade possible. If consumers in both countries are to get the goods they desire in the required proportion each must export some of the commodity in which it specializes and import commodities in which other countries are specialized.
What is Comparative Advantage?
- When each country has an absolute advantage over others in a product, the gains from trade are obvious.
- But what if one country can produce all commodities more efficiently than other countries?
- This is the question English economist David Ricardo (1772 -1823) posed 200 years ago.
- The answer underlies the theory of
comparative advantage and is still accepted by economists today as a valid statement of the potential gains from trade. - The gains from specialization and trade depend on the pattern of comparative, not absolute, advantage.
- This is based on the concept of
opportunity cost, it tells us how much of one good we have to give up in order to produce one more unit of the other
What does Gains From Trade with Constant opportunity Costs look like?
- Looking at two separate separate graphs of the United states and the RU
- With Wheat on the y-axis and Cloth on the x-axis
- two negative gradient curve with the one on the US having a higher intercept on the y-axis but a steeper gradient - while the one on the EU graph has a lower intercept on the y-axis but has a flatter gradient
- International trade leads to specialization in production and increased consumption possibilities.
These lines represent the production-possibility boundary for the United States and the EU, respectively. - In the absence of international trade these also represent each country’ s consumption possibilities.
- The difference in the slopes of the production-possibility boundaries
reflects differences in comparative advantage.
How can we interpret the Graph of gains from trade with constant opportunity costs?
- In each part the opportunity cost of increasing production of wheat by
the same amount (measured by the distance ba or the y distance) is the amount by which the production of cloth must be reduced (measured by the
distance bc or the x distance). - The relatively steep production possibility boundary for the United States thus indicates that the opportunity cost of producing wheat in the United States is less than that in the European Union.
- If trade is possible at some terms of trade between the two countries’ opportunity costs of production, each country will specialize in the production of the good in which it has comparative
- In each part of the figure production occurs at U; the United States produces only wheat, and the EU produces only cloth. –> on their respective axis
- Consumption possibilities are given by the red line that passes through U and has a slope equal to the terms of trade. –> this basically a line that swing out creating a more 45 degree gradient
- Consumption possibilities are increased in both countries; consumption may occur at some point such as d that involves a
combination of wheat and cloth that was not obtainable in the absence of trade.
What is the conclusion we draw about the gains from trade arising from international difference in opportunity costs?
1- Country A has a comparative advantage of country B in producing a product when the opportunity cost (in terms of some other product) of production in country A is lower. However, this implies that it has a comparative disadvantage in the other product
2- Opportunity costs depend on the relative costs of producing two products not on absolute costs
3- When opportunity costs are the same in all countries there is no comparative advantage and there is no possibility of gains from specialisation
4 - When opportunity costs differ in any two countries and both countries are producing both products it is always possible to increase production of both products by a suitable reallocation of resources within each country
What does the Graph of Gains from Trade with Varying Opportunity Costs look like?
- Looking at two graphs With Quantity of Good Y on the y-axis and Quantity of Good X on the x-axis
- one is fixed production and the other is Variable Production
- Both have the same downwards curve of the Production Possibility Boundary
- they both also have the same negative gradient line of (tt) which shows the quantity of Y that changes for a unit of X on the international market
What occurs at Stage 1: Fixed Production on the graph Gains from Trade with Varying Costs look like?
- If there is no international trade the economy must consume the same
bundle of goods that it produces. - Thus the production-possibility boundary is also the consumption-possibility boundary.
- In contrast to the when there were fixed opportunity costs , opportunity cost here varies along the boundary.
- Suppose the economy produces, and consumes, at point a, with x{1} o good X and y{1} of good Y
- Next suppose that, with production point a, good Y can be exchanged for good X internationally.
- The production possibilities are now shown by the line tt drawn through point a.
- The slope of tt indicates the quantity of Y that exchanges for a unit of X on the international market.
Although production is now fixed at a, consumption can now be anywhere on the line tt - for example, at b. - This could be achieved by exporting y{1} - y{2} units of Y and importing x{2} - x{1} units of X
- Since point b (and all others on line tt to the right of a) lies outside the production-possibility boundary, there are potential gains from trade.
- Consumers are no longer limited by their country’s production - possibilities.
- Let us assume they prefer point b to point a.
- They have achieved a gain from trade by being allowed to exchange some of their production of good Y for some quantity of good X and thus to consume more of good X than is produced at home
What occurs at Stage 2: Variable Production on the graph Gains from Trade with Varying Costs look like?
- There is a further opportunity for the expansion of the country’s consumption possibilities: with trade the production boundary may be profitably altered in response to international prices.
- The country may produce the bundle of goods that is most valuable in world markets.
This is represented by the bundle d on the PPB curve - The consumption-possibility set is shifted to the line t’t’ by changing production from a to d and thereby increasing the country’s degree of specialization in good Y .
- For every point on the original consumption-possibility set, tt, there are
points on the new set, t’t’ which allow more consumption of both goods; compare point b and f , for example. - Notice also that, except at the zero-trade point, d, the new consumption-possibility set lies everywhere above the production-possibility curve.
- The benefits of moving form a no-trade position such as a to a trading position such as b or f are gains from trade to the country.
- When production of good Y is increased and the production of good X decreased, the country is able to move to a point such as f by producing more of good Y , in which the country has a comparative advantage, and trading the additional production for good X
What does Free Trade look like on a graph?
- Price (P) on the y-axis and Quantity (Q) on the x-axis
- With a upwards sloping curve of Domestic Supply and Domestic Downward sloping curve of Demand
- under free trade –> the world price level P{w} under the equilibrium
- The gap between domestic supply and domestic demand is quantity imported
What happens when we restrict trade through tariffs on the Free Trade graph?
- Protectionist policies can restrict imports by levying a tariff of T per unit, this causes the price in the domestic market to rises by the full amount of the tariff –> shift the world price level up by T
- this causes consumer consumption to reduce as they now have to pay more for what they want –> goes to domestic producers and the government in tariff revenue
- Domestic production also rises, as well as they receive the domestic price, their receipt rise too
- Foreign suppliers of the imported good continue to receive the world price, so the government receives as tariff revenue the extra amount paid by consumers that are still imported
What happens when we restrict trade through quotas on the Free Trade graph?
- When the same result is accomplished by a quantity restriction, the government - through either a quota or a voluntary export agreement - (VER) - reduces imports to q2 - q3.
- This drives the domestic market price up to p{d} and has the same effect on domestic producers and consumers as the tariff.
- Since the government has merely restricted the quantity of imports, both foreign and domestic suppliers get the higher price in the domestic market
- Thus foreign suppliers now receive the extra amount paid by domestic consumers for the units that are still imported
What is a Voluntary Export Agreement?
An agreement by an exporting country to limit the amount of a good that it sells to the importing country
