Economics of Trade

Revision webinar on the economics of free trade

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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

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Economics of Trade

Revision webinar on the economics of free trade