Lecture material week 2

Question 1

What are the effects of opening up to trade?

Answer 1

• In (uncompetitive) importing economy:
  – Lowers price
  – Increases consumer surplus
  – Decreases producer surplus
• In (competitive) exporting economy:
  – Increases price
  – Increases producer surplus
  – Decreases consumer surplus

Question 2

Absolute advantage

Answer 2

• the superior production capabilities of one entity versus another
• Adam Smith’s house hold analogy:
  – “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost … more than to buy”
• Extension to society as a whole:
  – Material well-being is maximized if people specialize
  in what they are best at and exchange
• Extension to world economy:
  – Nations should “do what they do best, and trade for the rest” (in Baldwin, 19)

Question 3

Gains of trade

Answer 3

• Free trade increases efficiency of world production
• Because specialization and trade lowers the RELATIVE PRICE of goods
• As such…
  – … it increases profits of internationally competitive
  producers since they can sell more
  – … people can consume more because they have to pay less
• Thus: free trade = greater material welfare for society
• and, according to economic theory, more consumption = more happiness

Question 4

Key ideas

Answer 4

• Having a COMPARATIVE ADVANTAGE does not mean you’re better at something, but less bad than trading partners
• OPPORTUNITY COST: the more you produce of one good, the less you can produce of the other
• RELATIVE PRICE: price of one good in terms of the other good
• ARBITRAGE: buying product in one market (where it is cheap) to sell it in another (where it is more expensive)
• PRODUCTION POSSIBILITY FRONTIER: constraint on the maximum bundle of goods an economy can achieve

Question 5

Will arbitrage opportunities persist when trade barriers are removed?

Answer 5

– No Relative prices will adjust

Question 6

Beyond comparative advantage

Answer 6

• Comparative advantage is a key cornerstone of international economic theory
• But there are also some problems with this “textbook” explanation of international trade

Historical context: Watson

• Ricardo’s theory is a (Panglossian) abstraction; real-world examination of Portugal-England trade indicates a “darker” reality

Intra-industry trade: Krugman

• Comparative advantage theory faces limitations in explaining actual trading patterns, such as North-North trade in similar products