Adam Smiths Theory of Absolute Advantage A country has an absolute advantage over another country in the production of a good

d when it requires fewer labor hours to produce that good than the other country. David Ricardos Theory of Comparative Advantage A country has a comparative advantage over another country in the production of certain goods when the ratio of producing Good A and Good B is more favorable to Good A, and vice versa (Good B > Good A) for the second country. This is regardless of which country has absolute advantage. - Arguments of Increasing Marginal Cost: Ricardian Economic Theory assumes that marginal cost remains constant regardless of however many units of a good is produced. o However, more realistically is the argument of increasing marginal costs, that as one industry expands at the expense of another, the opportunity cost in expanding that industry increases. That is, as one industry expands, increasing amounts of units of the other industrys products must be given up to get each extra unit of the expanding industrys product. o Assumption of increasing marginal costs results in a bowed production probability curve.

Community Indifference Curves - Without trade, an economy will tend to default to autarky equilibrium, where the ratio between two goods demanded/supplied by the domestic economy matches the relative price ratio between the two goods (price being a defined loosely as labor hours). - Under free trade between two countries, the equilibrium price ratio is that which is tangential to the community PPCs of both countries. The preexisting, respective indifference curves of each country becomes tangential to this new equilibrium price ratio (rather than the autarky price ratio equilibrium), leading to a higher indifference curve and, thus, greater utility.

Winners and Losers in Trade (Pugel Chpt 5) Heckscher-Ohlin Theory - A theory that postulates that a country will export products that use its relatively abundant factors intensively and import products that use its relatively scarce factors intensively. Stopler-Samuelson Theorem - An event that changes relative product prices (e.g. an autarky opening up to free trade): o Increases the real returns to the factor used intensively in the risingprice industry (in the example of opening to free trade, this can be the export-oriented sector or the industry for whom factors of productions are relatively abundant in their country) o Decreases the real returns to the factor used intensively in the fallingprice industry (in the example of opening to free trade, this can be the import-oriented sector or the industry for whom factors of production are relatively scarce in their country) - This occurs regardless of domestic consumption habits. o For example, a large proportion of a households income is spent on buying clothing. o Because price of a good is a function of the quantity and cost to factors i.e. Pricewheat = MCwheat = wages*(laborwheat) + rent*(landwheat) And; Pricecloth = MCcloth = wages*(laborcloth) + rent*(landcloth)
(Under competition, price of a unit of good must equal MC.)

If the price of wheat goes up 10% and the price of cloth remains the same in response to the country opening up to trade, rent will likely go up 10% as well (as wheat is landintensive). This means that for the price of cloth to remain the same after an increase in rent, wages must have decreased. Furthermore, if the price of wheat had increased by 10% while wages simultaneously decreased, rent must have increased by more than 10%. o This means that opening up to trade in the above situation means that between households of landowners and laborers, one factor (landowners as rents are up) can buy more of both goods while the other (laborers as wages are down) must buy less.

The Specialized-Factor Pattern - The more a factor is specialized in the production of a product, the more they stand to gain if the price of the product increases or lose if the price of the product decreases. - Holds true over both short- and long-run The Factor-Price Equalization Theorem - Free trade causes the prices of both products and factors between two countries to equalize more than if there were no free trade at all. - Occurs even if factors are not mobile as trade allows factors that cannot migrate to be implicitly shipped between countries. o E.g. land cannot be exchanged between nations, but if the US exports wheat, the US land prices increase and the wheat-importing countrys land decreases until they equalize. In the short-run, when factors are not mobile, the industry one is in determines the winners and the losers. Those who work in an export-oriented industry gain while those in import-competing industries lose. However, in the long-run, the those who make a living off a countrys relatively abundant factor gains while those who make a living from the countrys relatively scarce factor loses. Scale Economies, Imperfect Competition (Pugel Chpt 6) Internal Scale Economies - Economies of scale within a firm; easier to produce more of good for cheaper when firm is larger. External Scale Economies (aka agglomeration economies) - Average cost of firm producing a product in an area declines as the output of the industry itself increases in the same area; infrastructure and other services concentrate in these areas to make it easier to produce a particular product (e.g. finance in New York).

Agglomeration shifts supply to the right, from S1 to S2. Free trade causes production to be concentrated in a few locations.

Scale economies can affect the type of market seen in an industry: - Perfect competition - Monopolistic competition o Three attributes: Firms products are differentiated from each other There is some internal scale economies There is easy entry and exit of firms in the long run - Oligopoly o Occur as a result of substantial scale economies o Implicit collusion to maintain profitable prices for products. But there is always incentive to cut prices to increase market share. - Monopoly Intra-industry Trade (IIT) - When two countries trade products that are the same or similar. o More prevalent when trade barriers and transport costs between two countries are low. - May reflect several things between countries such as: o Seasonal comparative advantages (e.g. US exports cherries in July but imports cherries in January) o More often, it is due to product differentiation, as consumers may demand an imported brand from another country over similar domestic products (e.g. clothing, appliances, cosmetics, cars) Calculating IIT: IIT = 1 |X M| X+M

With free trade, the world transforms from several individual markets in many countries into one large market. In the above diagram: - The US only has access to 10 models of cars offered at $19,000. - With free trade, competition brings down the price of the car for US consumers from $19,000 to $17,000 and increases the number of models offered from 10 to 18. Product differentiation is part of the reason why the Heckscher-Ohlin Theorem doesnt always hold true. - Exporting can be driven by foreign demand for a specific, unique brand of a product - Importing can be driven by domestic demand for the same. - This can lead to IIT between countries being quite large. Gains from IIT: - Greater variety of products - Lower prices of domestic varieties

Tariffs (Pugel Chpt 8) Specific Tariff - Stipulated money amount per unit of import. Ad Valorem Tariff - A percentage of the estimated market value of the import.

Before Tariff - World price is at P = 300, allowing for domestic consumption of S0 = 600,000 bicycles and importing the difference between D0 and S0 (1.6 0.6 = 1,000,000 bicycles). - P = $210 represents the most efficient domestic firm producing the first bicycle at $210, while the intersect between the supply curve and P = $300 is the least efficient domestic producer producing the last bike at exactly $300. - P = $540 represents the consumers willing to pay up to $540 for a bicycle. After Tariff - The price-taking country imposes a $30 tariff on bicycle imports, represented by P increasing from $300 to $330. - This causes the domestic supply of bicycles to increase from S0 (600,000 bicycles) to S1 (800,00 bicycles) as domestic firms increase prices and/or output. - Imports decrease from D0 S0 = 1,000,000 bicycles to D1 S1 = 600,000 bicycles. - Consumer surplus, represented by the area under the demand curve and above price, is reduced by a + b + c + d = $45,000,000 - Producer surplus, represented by the triangle above the supply curve and below price, increase by a = $21,000,000 - Government revenue from the tariff is c = $18,000,000 - There is a deadweight loss represented by b + d = $6,000,000 - b is production loss, the loss of having inefficient domestic firms supplying 200,000 bicycles that foreign firms could supply more efficiently - d is consumption loss, the decrease in consumption due to the rise in prices. 7

Note that the loss to consumers exceeds the gain to producers. This is largely because producers gain only from the supply of domestic goods while consumers lose on the price increase to both domestic and imported goods.

When a large, price-making country imposes a tariff, it has the potential to affect world prices.

Above, a large country imposes a $6 tariff on bicycles. A decrease in domestic demand in a very large country can cause world price to drop as well as this large country may hold monopsony power. This means that foreign exporters who have had to lower prices are now paying part of the tariff, represented as a gain to the country of e = $2,880,000. o This gain from monopsony power has its limits, however. If the tariff were too high and importers couldnt make a profit, they could choose to not sell to the large country at all, saddling the country with all the losses involved with tariff imposition.

Nationally Optimal Tariff - The tariff that creates the greatest net gain for the country imposing it. - A nationally optimal tariff is still unambiguously bad on an international scale: o The price-making countrys gain is, dollar-for-dollar, at the expense of foreign exporters. Foreign exporters also lose the additional surplus on exports discouraged by the tariff, resulting in a net loss for the world. o This is not including the possibility of retaliatory tariffs levied by foreign governments.

Nontariff Barriers to Imports Import Quota - Quantitative limit on imports - May be preferred to a tariff as it puts a quantitative limit on imports. o With a tariff, quantity can still increase if importers lower costs or domestic demand increases. o Can be used as a political tool as it gives officials more administrative authority over who can import. The division of this import license can be determined through: Fixed favoritism (government discretion) Auction held amongst firms Resource-using procedures o E.g. awarding licenses based on production capacity (although this encourages wasting resources) o Domestic monopolies also prefer quotas as a quantitative limit on imports means once this limit is reached, these firms can increase prices without losing demand to imports.

With free trade, quantity of bikes supplied (domestic and importers combined) is 1,000,000 at the world price $300. A quota (represented by the supply curve shifting to the left) brings quantity of bikes imported to 600,000 at the world price. The excess of demand in response to the reduction of supply causes domestic price to increase to $330. o The domestic quantity supplied is 800,000 at $330. o Domestic quantity demanded is 1,400,000. Domestic producers gain a Domestic consumer lose a + b + c + d b is a deadweight loss (production effect), representing the bicycles produced by domestic firms (200,000 bicycles) that could be produced more efficiently by foreign firms.

d is a deadweight loss (consumption effect), representing the loss of domestic demand (by 200,000 bicycles) as a result of the increase in price. c represents the markup gained by importers from bicycles imported at the world price and sold in the country at the higher price (caused by the quota). o c is received by whoever holds the import quota license (rent). o Some of c is a loss to the nation as firms waste productive resource in rent-seeking activities

When a large country imposes a quota, the reduction in demand for foreign imports causes world price to drop from $300 to $285 as foreign firms compete for import licenses, absorbing some of the price gain. Domestic price for bicycles is pushed up to $315. e represents gains to the nation as the world price decreases due to the quota causing a reduction in demand.

Voluntary Export Restraint - Quantitative limit on exports (based on threat of foreign trade sanctions) - Effects on price similar to quota, except no one receives the gains from c, making the deadweight loss b + c + d. o This represents a greater loss to the nation if VERs are implemented. - Export producers have less incentive to compete as the exporting countrys government usually distributes licenses to export specified quantities to its producers. o Instead tend to act like a cartel to limit sales and divide market amongst themselves, charging at the highest price the market will bear. Tariff-quota - Allows imports to enter at low/no tariff at a specified quantity, imports after that quantity have a higher tariff imposed. Government procurement - When the government purchases local products Local content and mixing requirements - Require local labor and materials

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Do not generate revenue for government; markup captured by local producers. o Local Content: Government can create barriers to foreign products Can also limit the import of foreign materials otherwise used in domestic production (e.g. Malaysia forces domestic automakers to use local components) o Mixing Requirement: Government can require domestic retailers to buy a percentage of their supply domestically. Technical and product standards - Enforcing standards that favor local products, but force costly modifications to foreign products. o E.g. EU banning beef from cows given growth hormones, specifically protecting European beef producers from imports from American producers. Advance deposit - Requires some of the value of intended imports to be deposited with government at low/no interest Import licensing - Requires importers to apply for the right to import True Costs of Barriers to Trade - We can calculate Net National Loss (deadweight loss b + d) due to the tariff as a percentage of GDP by using the following formula: Net national loss from the tariff GDP -

* Tariff rate * % reduction in import quantity * Import value GDP

However, there are other costs to erecting barriers to trade: o Foreign retaliation Other governments can respond to barriers by erecting their own and hindering trade. o Enforcement costs Enforcing protectionism can become costly. o Rent-seeking costs Firms may waste resources seeking protection (e.g. lobbying). o Rent to foreign producers VERs encourage foreign exporters to raise export prices. o Innovation Less competitive pressure can remove incentive to innovate.

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Arguments For and Against Protectionism (Pugel Chpt 10) Generic Arguments in Favor of Protectionism - If there is something extra good about local production of a product. - If there is something extra good in employing people or other resources in producing a product. - If there is something extra bad about local consumption of a product. - If there is something extra good about the government collecting more revenue. - If it is desirable to enhance the incomes of factors used in the importcompeting industry. So long as gaps exist between what private individuals use to make decisions and the full effects of these actions on society, private actions will not lead to the best possible outcomes for society. If some costs of producing or consuming a product are ignored by individuals, too much of the product is produced/consumed If some benefits of the activity are ignored by individuals, too little of the activity occurs. Government Policies toward Externalities Tax-or-Subsidy - The approach of spotting distortions in peoples/firms private incentives and correct the incentives with taxes or subsidies. - E.g. if social marginal cost exceeds private cost, the government should levy a tax so that this private marginal cost equals social marginal cost. o Conversely, if social marginal benefit does not equal private marginal benefit, then subsidies so that they do equal. Assigning Property-Rights - The approach of assigning property rights so that the existence of private property creates private incentives to rectify negative externalities. - E.g. A paper mill polluting a river. Either people downstream own the river and charge the paper mill for any pollution, or the paper mill owns the river and demands compensation for cleaning it up. The Specificity Rule - It is usually more efficient to use the government policy tool that acts as directly as possible on the source of economic distortion separating the association between private and social benefits or costs.

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Arguments for Protectionism - Local production produces spillover benefits as other firms and industries benefit from it. - Employment in this industry imparts new worker skills. - By producing now at a high cost, firms can find ways to lower their costs over time. - There are extra costs to workers if they are forced to switch to another industry. - National pride in domestic production of a product. - Product is essential to national defense. - Employment in the industry is a way to redistribute income to the poor or disadvantaged. Effective Rate of Protection: New value added Old value added Old value added Subsidy

A tariff of $30 (like the one on the left) would result in the deadweight loss of both b (production loss) and d (consumption loss). However, a subsidy of $30 increases revenue per unit sold to $330 ($300 paid by consumers, $30 paid by the government). Both tariff and subsidy of $30 causes firms to raise annual domestic production from 600,000 to 800,000 bicycles. o NOTE: Domestic consumption does not decrease from 1.6 million units due to the subsidy as it would with the tariff (down to 1.4 million). This is due to the fact that consumers still pay the $300, just as before the subsidy was implemented. Assumption that there are no sources of net social loss from having the government raise additional taxes or reduce other spending to pay the subsidy. 13

Politics of Subsidies - Subsidies generate smaller losses to the nation, but arent used as often as tariffs. o Due to the fact that industries tend to lobby for tariffs rather than subsidies because subsidies are targets for price cuts. Tariffs and NTBs are a more consistent shelter. Infant Industries - An argument that a temporary tariff is justified in cutting down imports while the infant domestic industry learns how to produce at low enough costs.

Initially, the domestic industry is producing at a cost per unit far above the world price The tariff allows the domestic industry to capture a small portion of the market (represented by b). Eventually, the domestic industry will be able to push its costs low enough that its supply curve shifts from Sdn to Sdf, where its products are cost competitive to the world price. Why this may be necessary: o Imperfections in the financial market: It might be difficult for young industries to convince financial institutions to provide capital. o The first domestic entrant to the industry incurs costs in learning the industry. However, subsequent follower firms can take advantage of the pathway forged by the first entrant. Protectionism can even out this initial disadvantage. Risks: o There is a potential that the infant industry is never able to bring its costs down to a competitive level. There may be little incentive to do so if firms expect that they can ask for more time with protection.

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Dying Industries - Rationale for: o Firms in an industry tend to concentrate geographically. If many workers loser their jobs in such an industry in a short period of time, the labor market can become congested. o - Problems: o May encourage firms to enter import-vulnerable industries as they expect a safety net. Pushing Exports (Pugel Chpt 11) Dumping Selling exports at a price that is lower than fair market value. - Where fair market value is defined o As the price charged to comparable domestic buyers in the home market o A price that is equal to/greater than the marginal cost of the product. Types of Dumping - Predatory Dumping when a firm is trying to drive its foreign competitors out of business, with the intention of using monopoly power to raise prices later. - Cyclical Dumping - when a recession occurs and the firm lowers prices to limit the decline in quantity sold in response to reduced demand. - Seasonal Dumping when a firm tries to sell excess inventory of a product at a time in the year when the inventory is no longer in as high a demand. - Persistent Dumping when a firm with market power uses price discrimination between markets to increase its total profits, such as charging lower prices in a foreign market where it has less monopoly power compared to its home market, and home buyers cannot buy the good abroad and import it cheaply. o The home buyers cannot buy cheaper imports often due to tariffs or NTBs. o So long as these markets remain separate, persistent dumping is possible. Reactions to Dumping - In the case of persistent, seasonal, and introductory-price dumping, generally the importing country should welcome it as they receive more favorable terms of trade. o Furthermore a tariff for these types of dumping would have to be prohibitively high (due to possibly enormous price differences between countries) and would wipe out both trade and a great deal of domestic consumer surplus for a relatively small amount of domestic producer surplus. - Predatory dumping is often viewed negatively as there is a tacit promise that prices will increase once the firm achieves monopoly power.

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o Some believe that predatory dumping may not occur that often anyways. Many firms fear the uncertainty of making a profit later in relation to the certain losses of selling below fair market value. There is no guarantee that new competitors may not spring up later on once the firm increases prices. In the case of cyclical dumping, it would be difficult to convince the importing country that it is fair for them to bear the weight of the global reduction in output. o It is also viewed as unfair if the exporting country is facing a national recession only as they would be exporting some of their unemployment to the importing country. The WTO allows for retaliation against dumping by granting the ability for the importing country to impose an antidumping duty. o A tariff equal to the discrepancy between export price and fair market value. o Process begins with a complaint from the US producers, examined by the Department of Commerce and the US Intl Trade Commission. The DOC and ITC often find dumping and injury (respectively) as they are naturally biased towards US producers, even when no dumping or less dumping than claimed has occurred. Eventually the duty may be lifted after a subsequent review by the DOC. o The simple threat of dumping complaints by import-competing firms can prod exporters to raise the prices and restrain their competition. o The WTO does not allow subsidies linked directly to exporting while subsidies not linked directly to exporting but still have an impact on exports are actionable. Safeguard policy is the use of temporary import protection when a sudden increase in imports causes injury to domestic producers. o Intended to give import-competing firms and their workers time to adjust to heightened competition. o Could be used proactively, in place of antidumping policies. o As it is temporary, there is more pressure for domestic firms to adjust. The WTO

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Export subsidy - Expands exports and production of the subsidized product. Can switch product from being imported to being exported. - Lowers price paid by foreign buyers relative to the price local customers pay (assuming something prevents local buyers from importing the product at lower foreign prices). - Export subsidy reduces net national well-being of the exporting country. Small country example

f is the consumption effect, h is the production effect. Big country example

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Turning an Import into an Export

Gains to domestic producers = ACEF Loss to domestic consumers = ABJE Strategic Export Subsidies - In some industries, two firms in different countries may want to enter in direct competition. - Both entering may wipe out profits for both sides.

For example, in the case of Boeing and Airbus, if both were to enter the exact same airplane market at the same time, they might both lose $8 billion. However, if Airbus was promised a subsidy of $10 billion if and only if it produced, Airbus would have incentive to produce (as it would generate income either way). o This could be a good strategy for an exporting country. However, it is dependent on too many conditions to be reliable.

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For example, if both EU and US give Airbus and Boeing $10 billion subsidies, both countries spend a great deal of money for not much in the way of returns.

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