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Date Created: 09/19/15
Economics 340 International Economics Andrew T Hill Summer Session 2000 Comparative Advantage with Increasing Cost Production Possibilities Frontiers Textbook Readings Pugel 8 Lindert International Economics 11th Edition pp 43754 In the previous section we looked at the Ricardian model using constant cost production pose sibilities frontiers Now we must ask ourselves Is it reasonable to assume that all labor is homogeneous quot Ricardo s original assumption that labor could produce both goods in his two country twoegood world is unrealistic So neoeclassical economists developed the idea of an increasing costs model Recall from ECON151 Increasing Opportunity Costs and the PPF 0 Increasing marginal costs imply that as the production of one good in the twoegood model increases at the expense of production of the other good increasing amounts of the other good must be given up in order to get each additional unit of the good who s output is increasing Increasing costs will give rise to a bowedeout production possibilities frontier such as the one shown here The earliest explanation of the bowedeout production possibilities frontier came from Gottfried Haberler in 1936 Haberler explained that in a move from point C to point B on the PPF to the left there will be resources A moved from the production of cars into the produce yl quotquotquot39 tion of wheat The resources that are moved first are yz those that are the most adaptable or most mobile In other words laborers who are best at growing wheat C will be moved to wheat production before workers y3 who are not as good at growing wheat As the econe omy moves from point B to point A the resources that are moved are those that are less adaptable to the production of wheat Therefore these resources perhaps workers provide a smaller increase in the production of wheat once they are moved from car production to wheat production than did the resources that were shifted from car to wheat production in the move from point C to point B These results give rise to the fact that opportunity costs will rise as you produce more and more of a certain good since more and more of the other good will have to be given up in order to achieve the same increase in output whe at X1 X2 X3 cars Since we know that labor is not homogeneous 7 it is not equally adaptable to both wheat and car production 7 we should really advance the Ricardian model by examining the results that arise in a twoecountry twoegood world where labor is not homogeneous So let s look at the same set up as in the previous section but this time we will use bowedeout production possibilities frontiers rather than the flat constantecosts production possibilities frontiers from before 15 wheat wheat 5 10 l 5 20 5 10 l 5 20 cars cars United States Canada Autarky points in both countries are denoted by A and A respectively Remember that means that before trade the economies produce and consume at A and A Since the bowedeout production possibilities frontiers show increasing opportunity costs the MRT will be at every point on the production possibilities frontier THINKAPAIRASHARE How can we find the MRT in autarky in each country 0 So now we can draw the tUS and tC lines in their respective graphs Graphically we can see that since the tUS line is flatter than the tC line autos are relatively cheaper in the United States and wheat is relatively cheaper in Canada Alternatively we could find the MRT from the slope of the tUS and tC lines For the United States For Canada According to the law of comparative advantage the United States should specialize in while Canada should specialize in 16 Q As the United States specializes in cars it will slide down along its PPF As it moves along the PPF the MRT will be becoming less and less favorable to the US The US will have a smaller and smaller advantage over Canada in the production of cars We can show that on the graph by looking at the various tangents to the curve as we move down the PPF The US will eventually wind up at the point B where the MRT is lC 1W Similarly Canada will move along its PPF to the B As it moves along the curve it s MRT is becoming less and less favor able It will eventually stop specializing at the point B where the MRT is lCle the same MRT as in the US at point B So the increasing cost case is a story of specialization The process of specialization will continue until 1 the opportunity cost of cars or wheat is identical in both countries 2 US exports of cars exactly equals Canada s imports of cars and Canada s exports of wheat precisely equals the United States imports of wheat 0 At B and B there will be a tangent line called tt This tt line has a MRT of lCle and is identical in both countries This MRT is the terms of trade and the tt line will be the trading line 0 For this problem let s assume that the United States chooses to consume the same number of cars as it did in autarky Now we are able to locate the point C in the United States From this information we can also locate the point C in Canada given the terms of trade and the number of cars the US is willing to export So cars will be traded for bushels of wheat Q We can also identify the trade triangle on the graphs and complete the production gains from specialization and consumption gains from trade tables below Table 9 Production Gains from Specialization Country Before Specialization After Specialization Net Gain or Loss cars Wheat cars Wheat cars Wheat United States Canada World Table 10 Consumption Gains from Trade Country Before Trade After Trade Net Gain or Loss cars Wheat cars Wheat cars Wheat United States Canada World Economics 340 International Economics Andrew T Hill Summer Session 2000 Early International Trade Theories I Mercantilism 15001750 A loosely defined trade theory Which concentrated on 1 In order to increase bullion holdings Which were considered the root of national wealth countries in the Mercantilist period 1 2 Results of Mercantilism 1 I Adam Smith 17231790 Adam Smith was a Scottish born social philosopher who revolutionized the way gove ernments and individuals viewed their economic lives Born in Kirkcaldy County Fife Scotland in 1723 Smith attended Oxford for six years before being appointed Chair of Logic at the University of Glasgow In 1753 he was made Chair of Moral Philosophy at Glasgow and held that position until 1764 Smith s first book was The Theory of Moral Sentiments 1759 which was an inquiry into the origin or moral approbation and disape proval While tutor to the Duke of Buccleuch in the late 1760 s Smith began work on his most famous treatise The Wealth of Nations 1776 It is this work which is most important to us as international economists Smith was concerned about many issues of his day including the strict dichotomy between the lives of the leisured rich and the majority 7 working class poor He was a contemporary of David Hume and Benjamin Franklin both of whom he carried on correspondence with Smith lived the rest of his life in Edinburgh and died on 17 July 1790 He is buried in the cemetery at Cannongate s Kirk on the Royal Mile in Edinburgh Adam Smith argued 1 O The Principle of Absolute Advantage Countries should specialize in and export those commodities in which they have an absolute advantage and should import those commodities in which their trading partners has an absolute advantage Why 0 The Absolute Advantage Problem Table 1 Labor Requirements Country Cloth Wine England 1 hour yard 4 hours bottle Portugal 2 hours yard 3 hours bottle England has an absolute advantage in the production of Portugal has an absolute advantage in the production of I David Ricardo 177271823 David Ricardo was born in London on 18 April 1772 the son of wealthy Jewish immie grants He was an extremely bright individual and received private instruction until entering his family s stockbrokerage business at the age of 14 Ricardo s association with the family business ended when he married a Quaker and became a Unitarian He starte ed his own successful securities and real estate business and became a very rich man when he purchased British securities just days before Napoleon39s defeat at Waterloo Ricardo read Smith s The Wealth of Nations while on vacation in 1799 He became fascie nated by economics and was a leading critic of the British government s Corn Laws and gold policies He published his landmark book The Principles of Political Economy and Taxation in 1817 and became a member of Parliament in 1819 Ricardo is credited with the principle of comparative advantage He died on 11 September 1823 Some Basic Assumptions of the Ricardian Model You will not be asked to reproduce these on an exam but you should have some sense of them 0 The Principle of Comparative Advantage A nation like a person gains from trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage Even if one country has an absolute advantage in producing everything everyone can still gain from trade That is to say even if one nation is the most productive at produce ing everything and another is the least productive at producing everything they both gain by trading with each other and with third countries as long as their advantages and disadvantages in making different goods are different in any way 0 Autarky The state of the economy without trade or before trade O The Comparative Advantage Problem Table 1 Labor Requirements Country Cloth Wine England 1 hour yard 4 hours bottle Portugal 2 hours yard 3 hours bottle Calculating the Opportunity Cost of One Good in Terms of Another Table 2 Price of One Unit in Terms ofthe Other Good Country P cloth P Wine England Portugal Which country has a comparative advantage in cloth Which country has a comparative advantage in wine 0 Can we convert the number hours per yard into the number of yards per hour 0 We can determine the free trade price of cloth and wine from the opportunity costs above So the free trade price of cloth must lie between and the free trade price of wine must lie between and O Ineclass Group Problem Table 3 Amount Produced per Hour Country Beer Pizza Italy 6 bottles 6 pizzas Germany 5 bottles 3 pizzas Table 4 Price of One Unit in Terms ofthe Other Good Country Pbeer Ppizza Italy Germany Which country has the absolute advantage in beer Which country has the absolute advantage in pizza Which country has a comparative advantage in beer Which country has a comparative advantage in pizza The free trade price of beer must lie between and The free trade price of pizza must lie between and 0 Practice Problem for Homework Table 5 Amount Produced per Hour Country Bread Steel United States 2 loaves 3 tons Canada 1 loaf 2 tons Table 6 Price of One Unit in Terms ofthe Other Good Country Pbread P steel United States Canada Which country has the absolute advantage in bread Which country has the absolute advantage in steel Which country has a comparative advantage in bread Which country has a comparative advantage in steel The free trade price of bread must lie between and The free trade price of steel must lie between and Convert Table 5 into a labor requirements table Table 7 Number of Hours of Labor Required to Produce One Unit Country Bread Steel United States hours loaf hours ton Canada hours loaf hours ton Economics 340 International Economics Andrew T Hill Nontariff Barriers to Trade Textbook Readings Pugel 8 Lindert International Economics 11th Edition pp 139162 10th Edition pp 1337153 Textbook Web Site Key Graph 3 at httpwwwmhhecomeconomicspugel The General Agreement on Tariffs and Trade GATT made tremendous strides to reduce the overall levels of tariffs in the United States and around the world Since GATT members had multilaterally agreed to eliminate many tariffs these countries came up with more innovative ways to reduce imports and protect domestic industries These innovative measures are called nontariff barriers NTB s It is important to note that there are many different types of NTB s Any measure that reduces imports and leaves domestic producers unaffected is an NTB A tax on leather goods would reduce imports but it would also reduce consumption of domestically produced leather coats shoes belts etc Therefore such a tax on leather goods would not be an NTB There are a great number of nontariff barriers to trade that were not immediately intended to reduce imports and provide protection to domestic producer Examples American auto safety and emissions regulations enacted in the 1970 s Japanese standards and US baseball bats European skis and Canadian lumber French VCR regulations on importation of Japanese VCRs Japanese restrictions on leather goods Government procurement Ontario s tax on beer sold in cans WPWN More directly an import quota places a physical limit on the quantity of a good that may be imported during a specific time period Agricultural products and textiles were global industries that were heavily regulated by quotas The Uruguay Round of GATT forced the conversion of the agricultural quotas back into tariffs and phased out the quotas 0n apparel and textiles Why would GATT want to try to get countries to change quotas into tariffs when the original reason for GATT in the 1940 s was to reduce tariffs WE SHALL SEE Table 20 Examples of US Import Quotas prior to the complete of the Uruguay Round Import Article Quota Q per year Wheat Canada 216 million kg Swiss cheese EU 205 million kg Milk and cream N 2 57 million L Animal feeds Ireland 54 million kg Chocolate UK 33 million kg Cheddar cheese Australia 12 million kg Ice cream Belgium 09 million kg 43 Import quotas could be assigned in two general ways 1 Global quota 7 specifies a set amount allowed to be imported in a given year but does not specify from where There are some problems with this method of assigning the quota Selective quota 7 specifies amount allowed to be imported in a given year and tells where that amount can come from 0 Import Quota Graphically Unlike tariffs we will only consider the smallecountry case when looking at the import quota Differences between the smallecountry and largeecountry import quota cases are similar to those differences we saw when considering tariffs The key to imposing the import quota is to shift the domestic supply curve to the right by the amount of the quota Why Because total supply from domestic and foreign producers will be the quantity produced domestically plus the amount that is allowed to be imported under the quota regime P SNZ a b e f C g h 1 J d DNZ Q Market for widgets in New Zealand Pprice in autarky PWfree trade price Qequilibrium Q in autarky QSQ supplied domestically with free trade QdQ demanded domestically with free trade QSQdimports with free trade QS Q supplied domestically with import quota in place Qd Q demanded domestically with import quota in place QS Qd imports with quota in place SWworld supply curve SNZdomestic supply curve SNZQdomestic supply curve quota PQprice after the VER is imposed 44 Table 21 Welfare Effects of an Import Quota in a SmalleCountry Group Autarky Free Trade Quota Net Consumers Producers New Zealand As a Whole As with the tariff cases we studied before there are a number of specific effects stemming from the imposition of the quota in the market for widgets in New Zealand The redistributive effect is the economic welfare transferred from consumer surplus to producer surplus as a result of the quota The protective or production effect of the quota is the welfare loss associated with increased production of the good in the rela tively inefficient domestic market The consumption effect is the welfare loss associated with consumers purchasing less at a higher price Let s identify these areas on the graph above The production protection effect combined with the consumption effect are called deadweight losses The redistributive effect is the area The productive protective effect is the area The consumption effect is the area The revenue effect of the quota is the amount of the import quota times the amount by which the price is increased in the country as a result of the import quota s imposition The revenue effect of the quota is the area The big question is where does the revenue effect go To whom does this economic welfare accrue There are three distinct places that the revenue effect can go depending on the conditions that prevail when the quota is put in place 1 Import companies might bargain favorably with the foreign producers and purchase the good at the prevailing world price In this case the importing companies would obtain the revenue effect as additional profits I call these importing companies domestic middlemenquot In this case the economic welfare represented by the revenue effect would remain in the United States Example Walmart purchases sweaters from Venezuelan producers There is a US import quota on sweaters from Venezuela Walmart purchases the sweaters at the prevailing world price from Venezuela but sells the sweaters in their stores in the United States at the higher PQ price 2 Foreign producers might organize as sellers and drive up the delivered price of the good Therefore the foreign producers would capture the revenue effect for themselves In this case the revenue effect would be economic welfare that would 45 leave the home country and would be added to the deadweight losses to get the total net loss from the quota 3 The domestic government might auction off import licenses to the highest bidders thereby recouping the quota revenue as government revenue In this case the import quota and the tariff would be very similar in their welfare effects How would the import license auction take place and why would the sale of the import licenses guarantee the recouping of the revenue of the import quota given a per fectly competitive auction 0 Import Quotas Versus Tariffs In order for an import quota and tariff to be called equivalent they must have the same effect on imports and on the prevailing market price So an import quota and a tariff that reduce imports by the same amount and raise the prevailing domestic price by the same amount are called equivalent P P SNZ SNZ SNZQ a a b b e f SW e f C g h 1 SW C g h SW d DNZ DNZ Q Q Tariff Import Quota The tariff and the import quota illustrated immediately above are equivalent because they reduce imports by the same amount from to They also raise price by the same amount The consumption effect redistributive effect production protective effect and revenue effect are the same under the tariff as in the case of the import quota However there is more to the comparison of the tariff and the import quota than just this static comparison Over time we would expect that there may be significant increases in 46 demand for the good in question What effect does an increase in demand have in each case P SNZ SNZ S x NZQ a x a s x b b f f e SWt e s C g h 1 J s SW C g h j s SW d x DNZ DNZ Q Q Tariff Import Quota An equivalent increase in demand has been illustrated With the dashed line in each graph Now let s illustrate the consumption effect production protection effect revenue effect and redistributive effect after the increase in demand Legend Consumption effect I Production Protective effect I Redistributive effect I Revenue effect Let us now compare the graphs immediately above With those on the previous page As a result of the increase in demand show the changes or lack thereof in the prevailing domestic price level of imports size of the deadweight losses DWLs and the size of the revenue effect Tariff Import Quota P P DWLs DWLs Revenue Effect Revenue Effect lmports Imports 47 From this analysis we can conclude that the import quota is more restrictive than the tariff since the import quota will result in an increase in the domestic price an increase in DWLs an increase in the revenue effect and leave imports unchanged in response to an increase in demand Under the tariff regime the price and DWLs will remain unchanged while imports will increase So the import quota restricts imports more and provides a greater level of protection to the domestic firms The import quota s effects are more damaging to domestic and world economic welfare since demand increases will result in larger losses with the quota than with the tariff So given increases in demand over time the effective rate of protection provided by the import quota will increase over time 0 Voluntary Export Restraint In the 1980 s another form of nontariff barrier to trade that emerged was the voluntary export restraint V ER The voluntary export restraint is an agreement between the exporting country and the importing country whereby the exporting country places a restriction on the quantity of a good that can be exported from the exporting country to the importing country The VER looks very similar to the import quota graphically There is a fundamental difference that we will investigate P S Market for widgets in New Zealand NZ Pprice in autarky PWfree trade price a Qequilibrium Q in autarky QSQ supplied domestically with free trade b e f QdQ demanded domestically C h with free trade g 1 J QSQdimports with free trade d DNZ QS Q supplied domestically with VER in place Q Qd Q demanded domestically with VER in place QS Qd imports with VER in place SWworld supply curve SNZdomestic supply curve SNZQdomestic supply curve VER quantity PQprice after the VER is imposed The redistributive effect consumption effect production protective effect and revenue effect are exactly the same as they were in the import quota case above However the revenue effect in the case of the VER will always accrue to the foreign producers as increased profit 48 Therefore while with a properly placed import quota or a tariff it is possible for the revenue effect to stay in the domestic economy in the case of the VER the revenue effect will be a loss to the domestic economy So while the economic losses associated with the properly imposed import quota with import licenses or the tariff is only the deadweight losses in the case of the VER the economic losses will be the deadweight losses and the revenue effect The primary reason why a domestic government might be willing to enter into a voluntary export restraint agreement with the exporting country s government is for political reasons The VER if an agreement can be reached can be viewed by the domestic population as a victory by the domestic government in a trade battlequot with the exporting government The exporting government will usually be very willing to negotiate VER s because such agreements help the exporting country s producers Moreover VER s are nontariff barriers which are under the exporting country s control While the domestic government can lift tariffs and import quotas at will the exporting country has complete control as to when it will lift the VER For instance a VER agree ment between the United States and Japan negotiated during the Reagan Administration has been continued to today not because the US has insisted on it but rather because the Japanese have unilaterally decided to extend it since the net effect of the VER for Japanese producers was so positive Q Predicated Essays for Nonetariff Barriers l Which is a more restrictive trade barrierian import tariff or an equivalent import quota HINT Consider an increase in demand when answering Which tends to result in a greater welfare loss for the home economy a an import quota levied by the home government or b a voluntary export quota imposed by the foreign government Given your understanding of the different effects of tariffs and quotas why has the World Trade Organization formerly GATT attempted to reduce sharply the current reliance on quotas and other quantitative measures often in favor of tariffs 49
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