Trade in Economics

Jason Moore

These are my notes and thoughts on trade in economics.

The production possibilities curve tells us how much we can produce from existing resources and technology. The basis for trade is comparative advantage. Specialization is based on comparative advantage, not absolute, advantage. There are winners and losers in trading states and countries. The winners from trade can more than compensate the losers. Important arguments against free trade exist. 

 

A production possibilities curve shows the relationship between the maximum production of one good for a given level of production of another good.

 

Comparative advantage is the ability of an individual, firm, or country to produce a certain good at a lower opportunity cost than other producers.

 

Absolute advantage is the ability of an individual, firm, or country to produce more of a certain good than other competing producers, given the same amount of resources. 

 

The terms of trade is the negotiated exchange  rate of goods for goods. 

 

An export is any good that is produced domestically but sold abroad.

 

An import is any good that is produced abroad but sold domestically. 

 

A net importer means that imports are worth more than exports over a given time period.

 

Free trade is the ability to trade without hindrance or encouragement from the government.

 

A world price is the prevailing price of a good on the world market. 

 

Globalization is the shift toward more open, integrated economies that participate in foreign trade and investment.

 

Protectionism is the idea that free trade can be harmful and government intervention is necessary to control trade.

 

The North American free trade agreement is the agreement signed by Canada, Mexico, and the United States to create a trilateral trade bloc and reduce trade barriers among the three countries.

 

Free trade always benefits both trading partners overall. However, within any trading country, some individuals may be made worse off by trade. The losses potentially arise from reduced consumer or producer surplus, lost jobs, or lower wages.

 

The underlying motivation for trade relies on one simple principle: we can all be better off by trading with one another, because trade allows total production to be maximized.

 

\[ \text{opportunity cost} = \frac{\text{loss}{gains}} \]

 

Comparative advantage revolves around the notion of figuring out what you are relatively good at doing. The key to determining who has a comparative advantage is to compare individual opportunity costs. 

 

We can draw two conclusions about what happens when a country opens itself to trade and becomes an exporter of goods and services:

  1. Sellers win
  2. Buyers lose

 

We can also draw two conclusions about what happens when a country opens itself to trade and becomes an importer of goods and services.

  1. Sellers lose
  2. Buyers Win

 

The factors that contribute most to comparative advantage at the country level are:

  1. Natural resources
  2. Stocks of human made resources
  3. Technology
  4. Education
  5. Relative abundance of labor and physical capital
  6. Climate

 

Arguments against free trade are:

  1. National security concerns
  2. Fear of the effects of globalization on a nation’s culture
  3. Environmental and resource concerns
  4. Infant industry arguments
  5. Potential negative effects on local wages and jobs



People and countries are dependent on one another for goods and services. Although there are potential costs to this interdependency, the gains associated with taking advantage of specialization in the production of goods and services can be considerable.

 

Specialization and trade, which are driven by comparative advantage, not only allow us to consume beyond our individual ppc, but also lead to a wider variety of goods and services.

 

Whereas comparative advantage revolves around measuring production relative to the opportunity costs that you and the other person incur, absolute advantage relates to production per unit of inputs.

 

When a country opens up to trade, there are winners and losers. The gains from trade are larger than the losses. One key to avoiding protests about free trade, like the one in Seattle, is to develop policies that everyone can reap the gains from trade.

 

Empirically, the data do not reveal the sweeping job losses for US workers that trade critics cite. There is certainly a displacement of workers due to trade, but many workers soon find other jobs. Likewise, the supposed negative effect of trade on wages is difficult to find in the data. Beyond lost jobs, however, those against free trade often cite national security concerns, loss of cultural identity, environmental and resource concerns, and infant industry arguments.

 

The figure at right shows a ppc for Joe. he can spend his time making pizza or chocolate cakes.

For Joe, which production points are attainable?

  1. A,b,d,e (anything on the ppc line or inside of it)

For Joe, which production points are efficient?

  1. A,b (efficient points are those on the line)

Joe decides to go to baking school and learns to make chocolate cakes faster.

  1. Draw a line with the same number of pizzas but more cakes and line goes through c)

 

Consider the figure on the right. The blue line shows how many units of goods A and B a worker in Taiwan can produce, and the tan line shows the number of units of goods A and B that a worker in Korea can produce. Does this figure indicate anything about either worker having a comparative or absolute advantage in either good?

  1. According to the figure, Korea has an absolute advantage in the production of good A and Korea has an absolute advantage in the production of good B.

Considering comparative advantage:

  1. Taiwan has a comparative advantage in the production of good A and Korea has a comparative advantage in the production of good B.

 

Justin has 5 days in a work week, each day he can create either 2 android apps or 1 apple app. Pallas also has 5 days to work and each day she can produce either 2 android apps or 3 apple apps.

Justin has a comparative advantage in the production of:

  1. Android apps

Which of the following statements explains why Justin has a comparative advantage in the production of android apps?

  1. His opportunity cost of producing an android app is less than pallas’s opportunity cost of producing an android app.

Pallas has a comparative advantage in the production of:

  1. Apple apps

Which of the following statements explains why Pallas has a comparative advantage in the production of apple apps?

  1. Her opportunity cost of producing an apple app is less than justin’s opportunity cost of producing an Apple app.

Suppose a country has 100 westerners and 100 easterners. A westerner can produce either 6 units of food or 2 units of national defense. An easterner can produce either 2 units of food or 1 unit of national defense. 

According to the data:

  1. Easterners have a comparative advantage in the production of defense

Suppose this country has decided it wants to produce 60 units of defense.

In this case, the country will have more food to consume if the:

  1. Easterners produced these 60 units of defense

You should have anticipated this answer because:

  1. The easterners have a comparative advantage in the production of defense

Now suppose this country institutes a draft and chooses people for the military randomly. Suppose further it drafts 20 westerners and 20 easterners.

If the country chooses to have a military draft, it will produce:

  1. If the country uses 20 westerners and 20 easterners to produce defense, then 80 westerners and 80 easterners will be available to produce food. In this case, food production will be (80*6) + (80 * 2) = 640 units of food

Compare the cost in terms of foregone food production under a draft to the cost under a volunteer army where the country pays the easterners enough to persuade them to become soldiers.

The cost of defense measured in terms of foregone food production is:

  1. Higher with a draft than with a volunteer army



The figure at right shows a ppc for Joe. He can spend his time making pizzas or chocolate cakes. Using the information in the figure, calculates Joe’s opportunity cost of producing one pizza and his opportunity cost of producing one chocolate cake. Remember that the opportunity cost is how much of one good must be given up to produce one more unit of the other good. 

Joe’s opportunity cost of producing one pizza:

  1. 15 cakes / 30 pizzas = 0.5 cakes per pizza

Joe’s opportunity cost of producing one chocolate cake is:

  1. 2 pizzas

Joe’s friend Samantha also makes pizza and chocolate cakes. The figure at right shows the ppc for Samantha. Using the information in the figure, calculate Samantha’s opportunity cost of producing one pizza and her opportunity cost of producing one chocolate cake.

Samantha’s opportunity cost of producing one pizza is:

  1. 2 chocolate cakes

Samantha’s opportunity cost of producing one chocolate cake is:

  1. 0.5 pizzas

Comparative advantage is the ability to produce a certain good at a lower opportunity cost than other producers.

Who has the comparative advantage in the production of pizza and chocolate cake:

  1. Joe has a comparative advantage in pizza and Samantha has a comparative advantage in chocolate cake

Samantha’s little brother Rahul is also able to make pizzas or chocolate cake, and he is equally good at each. His opportunity cost of producing either pizza or chocolate cake is one unit of the other good. 

Use the line drawing tool, draw an example of Rahul’s ppc curve.

  1. I did a 20 unit pizza to 20 unit chocolate cake line

 

Suppose Joe has a comparative advantage in making pizzas and Samantha has a comparative advantage in making chocolate cakes. Both individuals will specialize and trade if the exchange rate is favorable. Using the information in the table below, determine whether or not each person will trade at the terms of trade offered.

  1. If the terms of trade is 1 cake for 1 pizza Joe will make the trade and Samantha will make the trade.

The terms of trade at 1 cake for 1 pizza:

  1. Favors Samantha

Using the opportunity cost of pizza column, a terms of trade of:

  1. (2.0-0.5)/2 + .5 = 1.25 cakes per pizza

If the terms of trade is 2.5 pizzas for 1 cake:

  1. Joe will not make the trade and Samantha will make the trade

 

Nearway:

  1. 2.00 coconuts and 0.50 fish

Farway:

  1. 1.50 coconuts and 0.67 fish

Which nation has an absolute advantage in the production of each good?

  1. Farway has an absolute advantage in the production of Fish
  2. Farway has an absolute advantage in the production of coconuts

Which nation has a comparative advantage in the production of each good?

  1. Farway has a comparative advantage in the production of fish
  2. Nearwy has a comparative advantage in the production of coconuts

Assume that nearway and Farway completely specialize according to their comparative advantage and decide to trade. Fill in the blanks:

  1. 100 150 200 225
  2. 0 300 400 0
  3. 0 100 160 0
  4. 100 200 240 160
  5. 0 50 40 -65

The terms of trade are:

  1. 160 coconuts / 100 fish = 1.60 coconuts per fish

 

Who benefits from trade?

  1. Both nations benefit from trade

Which nation received the better deal in this trade?

  1. Nearway received the better deal

Would Nearway and Farway wever trade trade 120 coconuts for 40 fish?

  1. No, because while Farway gains from this trade, nearway does not

 

The diagram on the right shows the market for tennis shoes in the US. If the US does not trade with other countries, what are the equilibrium price and quantity of tennis shoes?

  1. Price is 61 and quantity is 35 million

Suppose the US opens to free trade with other countries and the world price is 40 per pair of tennis shoes. What are the quantity demanded, quantity supplied by domestic producers, and the quantity of inputs?

  1. Quantity demanded is 70 million
  2. Quantity supplied by domestic producers is 25 million
  3. Quantity of imports is 45 million

Domestic producers complain and convince the government to impose a 7 tariff per pair of shoes. What are the equilibrium price, quantity demanded, quantity supplied by domestic producers, and the quantity of imports?

  1. Equilibrium price is 47
  2. Quantity demanded is 65 million
  3. Quantity supplied by domestic producers is 30 million
  4. Quantity of imports is 35 million

 

Figure 1 on the right shows the world market for tennis shoes and figure 2 shows the US market for tennis shoes without trade. Suppose the US opens to free trade with other countries.

The price of tennis shoes in the US is:

  1.  25

Draw the world price line on figure 2 to help determine whether the US is an importer or an exporter.

  1. Draw horizontal line above the equilibrium point

 

With trade, the US is an:

  1.  Exporter

 

The figure on the right shows the US market for tennis shoes where the US is an importer. The US currently has a tariff on imported tennis shoes

Draw a new price line without the tariff

  1. Horizontal line below equilibrium point

When the tariff is eliminated, what happens to the quantity supplied by domestic producers?

  1. Decreases

When the tariff is eliminated, what happens to the quantity demanded by domestic producers?

  1. Increases

When the tariff is eliminated, what is the impact on domestic producers, foreign products, and domestic producers?

  1. Foreign producers and domestic producers win. Domestic producers lose



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